More than 80% of Americans are unaware of how much they pay in 401(k) fees.
In a study conducted by the Center for American Progress, the problem with fees comes down to two key principles. First, fees are misunderstood or unclear. Second, they are often too high, eroding investment returns in plans over time.
Understanding the basics of fees can help plan participants:
- consider fees an important factor of investment decisions
- become empowered in decision-making
- learn how plan fees affect retirement investing
How 401(k) Fees Work
Distinguishing the different types of fees is beneficial to participants because it helps them understand how their plan works. 401(k) plan fees and expenses are generally separated into three groups:
Administrative fees can be defined as fees paid towards the costs of operating the plan. These costs include basic administrative services such as record keeping, legal, and accounting services. Many plan administrators also offer customer service, educational content, and planning services that can be attributed to this fee category.
Asset-based fees often are the largest of fees, covering the costs of investment management. These fees are typically assessed as a percentage of invested assets. It is important to note that net total return is the return after these fees have been deducted. Expense ratios are a common type of investment fee, which are essentially annual fees that funds charge shareholders. These are charged as a percentage of the assets invested into a fund. Additionally, participants who opt for managed account services, such as pre-allocated investment portfolios, pay an additional fee for those services.
Activity fees are fees associated with participant-initiated activities that take place in the account. These fees are charged individually to participant accounts when fee-based activities occur. For example, loan or hardship distributions are subject to individual activity fees.
Many 401(k) plans invest in mutual funds, which allow participants to hold lower cost funds, resulting in lower participant fees overall. The expense ratios for 401(k) participants investing in mutual funds have been on a consistent decline since 2000, so it is important that employers offer 401(k) plans that concentrate on mutual funds.
Share Class Access
Mutual funds offer several “classes” of shares to invest in. The main differences between classes are the fees that investors are charged. The R share classes are designated for retirement investing, and are only offered through employer sponsored retirement plans.
The lower R shares (R1, R2, R3), have higher fees, impacting long term investment performance. Higher share classes such as R4, R5, and R6 require a substantial amount of assets to invest, but have a significant decrease in fees over lower share classes. The Institutional share class offers even lower fees, but requires a substantial minimum investment (typically $500,000 or more) so access to this share class is reserved for plans with higher purchasing power.
401(k) plans have varied levels of purchasing power, which allows access to different share classes. The greater the plan assets, the higher share class access the participants have. Utilizing opportunities like the multiple employer plan (MEP) helps aggregate assets to get smaller companies into higher share classes.
Why Fees Matter
Fees are one of the most important factors that contribute to investment performance. To demonstrate the impact, use this example:
Kim and Mark are both 25 years old, make the same salary, and begin contributing identical amounts to their 401(k)s. Kim’s plan has low-fee funds that average out to a fee of 0.25%. Mark’s plan has high-fee funds that average out to a fee of 1%.
Because her return on investment is positively impacted by her plan’s lower-cost funds, Kim will have a $75,000 higher account balance than Mark by the time they both reach age 67. While .75% may not seem like a significant difference in fees at the outset, it equates to a substantial impact on savings over the long term. Here is a great resource for checking the long-term impact of 401(k) fees.
How Employers Can Help
Employers that administer retirement savings plans are legally responsible for ensuring that employees have a reasonably-priced plan, with measurable investments and sensible fees. This obligation can be met through the following strategies:
- Have an Investment Policy Statement (IPS) - An investment policy statement, or “IPS”, is a document outlining the overall investing strategy, as well as guidelines for funds to be eligible to be added to the plan. This document establishes a guide for the portfolio manager or investment committee to stay on track with investment objectives.
- Conduct Investment Committee Meetings - Using the IPS as a guideline, have a quarterly investment committee meeting to review the plan, assess fund performance, and take any action necessary to keep the plan affordable and compliant.
- Shop for a More Competitive Plan - A regular process of issuing a request for proposal (RFP) for the 401(k) plan allows employers to see if they can adopt a better plan with lower costs from a new plan provider.
- Consider Joining an MEP - If the legal and administrative responsibility of keeping the plan compliant is too complex or cumbersome for an employer, looking for multiple employer plan eligibility can be an alternative. By joining a multiple employer plan, fiduciary liability and most administrative duty is covered by the plan administrator. A multiple employer plan also provides greater purchasing power for investments, as described above.
Lawsuits regarding excessive 401(k) fees are at an all-time high. It is incumbent upon employers to ensure that their employees are receiving fair fees associated with their retirement plan. Offering 401(k) plans with competitive fees, low cost funds, and educational content can reduce company risk for exposure to litigation, beyond simply being the right thing to do for employees’ long-term future.