Finding the fees

You may not realize that you’re paying administrative fees. The expense may be clearly shown on your statement, or it may be hidden and simply reduce your investment return. For example, if the investment and administrative fees for your plan total 1 percent of plan assets annually, your investment return is reduced by 1 percent.

Figuring out exactly what your fees are can be harder than it sounds. You don’t get a bill that lists exactly how much you’re paying in fees — participants don’t see the bill. Nor will you necessarily see an entry on your 401(k) statement that reports all fees deducted. Instead, you have to do some detective work to find out what you’re paying.

A participant with a $100,000 account balance will pay $1,500 if the plan has total fees equal to 1.5 percent of total plan assets. A participant with a $5,000 account balance will pay only $75. Participants don’t get any tax break for fees paid from their accounts. Employers get to deduct these fees and have Uncle Sam share some of the cost. Better yet, employers may get tax credits to help them start and maintain a retirement plan. See Part 5 for more from the employer’s perspective.

Most 401(k) fees are expressed in basis points. One hundred basis points equals 1 percent. How much is 150 basis points? If you said 1.5 percent, you’re right. Fifty basis points equals 0.5 percent.

Understanding the fees

It’s worth the effort to discover what administrative costs you pay for your plan. In most cases, fees are deducted from your investment return — the money being earned by your investments. The higher the fees, the more they reduce your eventual balance.

401(k) fees can be tricky to understand because of the way plans are put together. A large number of people provide services to 401(k) plans including attorneys, accountants, record keepers, financial advisors, mutual fund companies, insurance companies, and more. Generally, you have a fixed administrative cost and variable costs associated with individual investment choices. Many plans are administered by financial companies that combine some or all of these fees and charge all participants’ accounts the same percentage fee. (In this case, the higher your account balance, the higher the dollar amount you pay.)

For example: Say you and your spouse each contribute $5,000 a year to 401(k) plans from age 30 to age 65. You both earn an average 8 percent return on your investment (before fees). Your spouse’s plan charges 1 percent in fees annually. Your plan charges 2 percent. Do you think this 1 percentage point will make a big difference in the end value of your accounts? You bet it will. Your spouse will have $641,000. Assuming everything else is equal, you’ll have $521,000 — $120,000 less! Higher fees don’t mean you will be getting better investments.

If you keep up on financial news, be aware that the investment return you receive for a fund held in your 401(k) account won’t match the return you see reported in financial publications. For example, if you invest in a mutual fund that has a 0.5% investment management fee on your own outside the plan, the 0.5 percent is the only fee you pay. But if your 401(k) plan fees are 2 percent of plan assets due to the additional services that are required, you lose out on 1.5 percent of investment earnings. Your investment return net of expenses would be 1.5 percent higher if you purchased the fund outside the 401(k) plan.

Mutual funds can have multiple share classes — sometimes more than ten — each with a different expense ratio. As a result, you can’t know what investment fee you’re paying unless you know the share class. This difference in share classes makes it difficult to check your fund’s performance because the returns shown in newspapers and elsewhere are class specific.

There are 14 different share classes according to Morningstar. The net investment return is different for each share class making it much more difficult to compare funds. Each one may have a different fee structure. Morningstar provides an array of investment research and investment management services.

The common types of services subject to fees include the following:

• Record-keeping and other administrative functions: The plan pays people to keep track of each participant’s account and the investments held in the account. Other administrative tasks include the following:
  • Doing compliance testing
  • Processing investment changes requested by participants
  • Providing summary annual reports to participants and completing and filing Form 5500 — an annual return that must be filed for the plan
  • Performing the independent audit that is required for plans with more than 100 participants
  • Making plan document amendments and restatements as requested by the employer or as required by the IRS
• Financial advising: This is done by an advisor, a person who helps your employer pick and oversee the plans investment menu.
• Investment management: The mutual funds where your contributions are invested charge fees.
• Benefit transactions: You may have to pay a fee to receive a benefit distribution such as a hardship withdrawal or a plan loan.
• Education and advice: Yes, the fees paid to have someone educate you about the plan can be charged to the plan. The plan also pays to provide support to participants online, via phone, and/or in person.

Paying the fees

The biggest issue with paying fees is who pays — you or your employer. Fees are easy to determine when the employer pays all the non-investment fees because the employer is billed directly. No mystery in this case. If your employer pays, you can invest directly in the mutual funds and any other investments with the same fees you’d pay if you invested in an IRA.

When participants pay all the fees, it’s very difficult to sort out how much the various parties are paid. The charged fees are split up among the record keeper, the financial advisor, and the third-party administrator.

The financial advisor is retained by the employer to get the best deal; however, there is a direct conflict of interest when the investment advisor is paid a percentage of the plan assets. This often results in the advisor selecting mutual funds with higher expense ratios that may also include an additional wrap fee because the higher the fees, the more the investment advisor is paid. (See the later section “Unwrapping wrap fees” for more about wrap fees.)

When you participate in a 401(k) plan, you should receive a fee disclosure notice that can help you determine the fees paid by you and your account.

There’s no “right” amount of fees to pay — although, if you’re paying more than 1 percent of your account balance, you’re probably paying too much. As with just about everything in investing, you have trade-offs to consider; if your plan charges relatively high fees but provides many useful services, you may be satisfied.

Total fees for plans with more than $100 million of plan assets can be as low as 0.15 percent. More than 0.5 percent is probably too high. Total fees paid by the participants for plans in the $10-to-$100 million range should generally range between 0.5 and 1.0 percent.

Fees are usually higher for plans with less than $10 million in assets. An alternative that should be considered by such employers is for the employer to pay the non-investment fees because those with the largest account balances are paying most of the fees from their tax-deferred accounts.

Annual administrative fees in the $1,000 to $2,000 range aren’t unusual for a plan with only ten participants. The average would be $200 per participant if there are ten participants, making the total administrative fees $2,000, but this doesn’t mean that each participant pays $200 if the fees are paid from plan assets.

Typically, participants with higher balances pay more of the administrative fees. A participant with a $100,000 account balance may pay $1,500, while a participant with a $5,000 account balance pays only $75. The participant with the $100,000 account balance is helping subsidize the administrative costs for other participants.

Annual administration fees aren’t investment-related expenses that vary by account size; they’re expenses that are generally equal for all participants regardless of account size. Each participant will likely be charged a percentage of their account. For example, say your plan has 100 participants. The total administrative fee is $10,000 (100 × $100 each). If all participant accounts added together are worth $5 million, with some people having $200,000 in their accounts and others having $10,000, the plan fee is 0.2 percent of each person’s account. (The $10,000 administrative fee is 0.2 percent of $5 million.) The people with a $200,000 balance pay $400, while the people with $10,000 balances pay $20.

So, participants with larger account balances subsidize the fees of those with smaller account balances. This amazes me because those with the larger account balances are usually the business decision makers. Paying these fees from their plan accounts substantially reduces what they will accumulate in their accounts. The employer can pay this fee and receive a tax deduction for doing so. The participant with the $200,000 account balance is paying $400 from his tax-sheltered account and gets no tax break for doing so.

If you think that your plan fees are too high, you don’t necessarily have to abandon your 401(k), especially if your alternative is not saving for retirement at all. At least contribute enough to get the employer matching contribution, and explore other ways to save for retirement, such as an IRA. (Part 3 has more information about IRAs.)

Paying extra for extra services

If your plan offers special services, such as loans or hardship withdrawals, you’ll probably have to pay a fee when you take advantage of them. For example, you may be charged one fee when you take out the loan and a separate annual fee for each year that it takes you to repay it. You may even have to pay a fee for the privilege of taking your money out of the plan when you change jobs or retire. These fees are commonly in the $50 to $100 range.

You usually have to pay these fees yourself because you trigger the transactions.

Checking on small business challenges

A small business has options for offering owners and employees retirement plans, just like the big companies; however, small businesses have additional compliance issues to consider. The most significant are the “top heavy” rules that apply to plans where key employees own more than 60 percent of total plan assets. See Chapter 18 for more details about these constraints.

As a small business owner, you have a range of 401(k) types and employer-sponsored IRA plans to investigate to determine which best suits your company’s needs — or in the case of a 401(k), your employees’ needs. Chapters 18 and 19 go into these choices in detail.

Small employers can provide a plan with costs as low as or even lower than those offered by the largest employers. The way to do this with a 401(k) is for the employer to pay all the non-investment fees. Chapter 19 covers how to do this in detail. Surprisingly, it is easy for a small employer to set up an IRA-based plan with fees that are lower than those paid by the largest employers — ones with billions of dollars of 401(k) plan assets — because these plans don’t have any administrative fees. These plans are covered in detail in Chapter 18. If you are a solo entrepreneur or another type of small employer, consider these plans before jumping or being pushed into a 401(k) plan.

I have been the co-owner of several small businesses that had 401(k) plans. My businesses paid the administrative fees as an additional benefit to us as owners as well as the other employees, and it helped all our accounts grow faster. The last business I co-owned set up and administered 401(k) plans for small employers, and we strongly recommended that our clients have the business pay the administrative fees.

Small employers are often sold a 401(k) plan instead of an IRA-based plan, when a plan such as a SIMPLE IRA may be much better for both the employer and participants.

Small employers without a retirement plan should seriously consider the IRA-based alternatives because they avoid all this fee complexity and compliance baggage. There are no set-up or administrative fees, and there are no added layers of fees participants must pay. The chapters in Part 6 talk about plans for employers.

The 2021 maximum that may be contributed to an IRA-based plan is $13,500 for employees under age 50 and $16,500 for those over age 50 plus an additional 3-percent-of-pay employer contribution. The 401(k) maximum is $19,500 for employees under age 50 and $26,000 for those over age 50 plus any employer contribution. A 401(k) makes sense when there are employees who want to contribute significantly more than is possible with an IRA-based plan.

Making a mutual decision

An actively managed fund, which most mutual funds are, has a fund manager who constantly buys and sells stocks to try to improve the fund’s return. An index fund, which buys the stocks included in a specific index such as the S&P 500, doesn’t have a fund manager who picks the stocks and bonds for the fund. (I explain index funds and other investments in Chapter 13).

The annual fee for an actively managed fund is usually in the 0.5 to 1 percent range, compared to 0.2 percent for an index fund. Index funds can even be as low as 0.02 percent. These fees are usually referred to as the fund’s expense ratio. The fees may also be expressed as basis points (50 to 100 basis points for the managed fund, compared to 20 basis points for the index fund).

Retail mutual funds — those available to the average individual investor — are likely to be more expensive in a 401(k) plan than institutional funds that are geared toward traditional pension plans or other entities with large amounts to invest. Retail mutual funds are preferred by many participants due to brand-name comfort and because the funds can be readily tracked online. You won’t find daily performance results of institutional investment managers in the financial section of your paper, but the lower fees may make them a better deal than the higher-cost retail funds. Some large companies use institutional funds to help keep fees, including administrative and investment costs, low. A small employer can select indexed mutual funds with fees as low as those charged by institutional investment managers who are managing a plan with a billion dollars in assets. These funds are listed in financial publications.

An institutional fund is one managed by institutional investors — entities that invest a lot of money with a specific investment management firm. This includes large employer pension funds, university endowment funds, and corporations that have a lot of cash to invest.

In the early days of the 401(k), all employers paid administrative fees. This began to change during the mid-1990s with the arrival of what became known as bundling, which involves packing all services through one financial entity. Fees are what really got bundled, and now participants pay them.

Unwrapping wrap fees

Sometimes a 401(k) plan provider charges what’s known as a wrap fee, an additional fee added to the normal fund management fee and the administrative fees. The wrap fee usually provides additional income to the record keeper, investment advisor, and third-party administrator.

Small plans with fewer than 100 participants are most often charged this fee, which is likely to push total fees to between 1.5 and 2.5 percent of the total assets in the plan.

An insurance company, bank, or brokerage firm may charge a wrap fee if it offers funds managed by a number of different mutual fund companies, including ones the provider owns. For example, the provider may offer the well-known Vanguard Fortune 500 Index Fund but add an additional 100-to-150-basis-point annual fee to the standard fee charged by Vanguard.

The wrap fee is another reason why the published return you see for the funds you invest in may be different from what you see on your 401(k) statement or IRA. If the wrap fee is 1.5 percent, for example, your returns will be reduced by 1.5 percent each year, as compared with what’s in the newspaper. This may not sound like much, but a 1.5 percent additional wrap fee reduces your 30-year savings by 30 percent!

Prospecting in the prospectus

Looking at a fund’s prospectus generally helps you see what investment management fees are charged. The prospectus is a document that gives information such as what companies the mutual fund invests in, how often the manager buys and sells stocks within the fund, and what the manager is trying to achieve (the fund objective).

The prospectus also tells you the expense ratio, which is the fee deducted each year to operate the fund. For example, you pay $100 if you have $10,000 invested in a fund that has a 1 percent expense ratio. You won’t get a bill for this expense, and you won’t see it deducted from your 401(k) or IRA account. The fee reduces the net return you receive for the fund. The fact that you don’t see these deductions is why service providers and investment advisors can easily get away with high fees.

A fund’s prospectus doesn’t include information about any wrap fee charged by the 401(k) provider. Getting this information is often difficult because providers who charge wrap fees are often reluctant to disclose them. The Department of Labor requires employers to disclose their fees to be in compliance with Section 408(b)(2) 404(a)(5) of ERISA (the Employee Retirement Income Security Act). This notice explains to participants what fees are charged to and paid from their individual account.

Ask the plan provider for the Section 404(a)(5) fee information and get your employer involved. The employer receives a separate disclosure, 408(b)(2), that explains fees applicable to the plan. This information is useful; however, it still may be difficult to understand because organizations with high fees don’t want to make it easy for you to see those fees. Get someone familiar with this stuff to help you make sense of the information if necessary.

Many years ago, I helped the Department of Labor address the issue of fee transparency. That resulted in a fee brochure titled “A Look at 401(k) Plan Fees.” Enter the title into your browser to find a copy, which also lists many other great resources.

Find out what your plan charges in fees and then tell your employer if you think they’re too high. There may be a good reason for the fees charged by your plan (such as extra services), or there may not be.

Upgrading investment performance

If you have a caring employer, and if your investments really are performing poorly, you may be able to make a change.

Sometimes participants ask the employer to replace one fund with another that they think is performing better. This change may seem like a no-brainer, but it’s not. The employer needs to look not only at the fund’s recent performance, but also at long-term returns and other measures. Comparing the fund’s performance with that of similar funds is also important. If similar funds are also going through a bad spell, and the fund itself is solid and makes sense as part of the plan, a couple of years of less-than-ideal performance isn’t necessarily reason to boot it out of the plan completely.

Most employer-sponsored retirement plans are guided by an Investment Policy Statement. The Investment Policy Statement serves as a road map for selecting, overseeing, adding, and replacing funds. The Investment Policy Statement also identifies the individuals responsible for performing these services. They may be several members of senior management or a committee including a general mix of participants. A plan with $100 million of assets that was a client of mine had an advisory group of participants that provided recommendations to the chief executive officer, chief financial officer, and human resource manager, and these three had the final authority.

Replacing a fund due to poor performance isn’t always an easy decision. A fund may be underperforming because the fund manager chose stocks that are likely to do well in the future but that aren’t currently in favor. The fund may have performed well for many years and be a favorite of many participants.

Sometimes, even though a fund has good managers and a strong, long-term track record, an Investment Policy Statement requires that it be replaced due to sub-par performance over a two-year span despite the fact that there is a strong possibility the fund will be a top performer in its category again in the future. An employer replacing a fund in this situation runs the risk that the new fund will not perform as well during the coming years.

Style drift is another problem an employer must deal with. Style drift means the investment holdings of the fund no longer fit the designated category. This is a common problem for small cap funds, which virtually every 401(k) plan includes. Small cap stocks are companies whose share value is in the $300 million to $2 billion range.

A small cap fund with superior performance attracts a lot of attention, which usually results in a large inflow of new investment money. The fund managers will have a tough time finding enough small companies stocks they’re comfortable buying. They may be forced to buy small company stocks they don’t really like or to drift into stocks of larger companies, which will ultimately force them out of the small cap category. Employers holding such funds in their 401(k)s will need to replace the fund with a new small cap fund.

Changes of these types often make participants frustrated and unhappy, and make them wonder why the people overseeing their plan can’t get it right.

401(k) plans are governed by a law known as ERISA — the Employee Retirement Income Security Act. ERISA lays out minimum standards for 401(k)s and other types of retirement plans. One thing ERISA says is that your employer has a responsibility (known as fiduciary responsibility) to make sure that the plan is operated in the best interest of the participants. Anyone else who exercises control over plan assets or management — which may include the plan trustee or the plan provider — is also considered to have fiduciary responsibility. This responsibility covers a number of issues, including what mutual funds you can invest in. Your employer must be able to show that it acted responsibly in choosing funds to offer in the plan. Changing funds every few years on a whim would probably not qualify as responsible. ERISA allows plan participants to sue fiduciaries (those who have control over the plan assets) for breaching their responsibilities. (I discuss ERISA in more detail in Chapter 1.)

Searching out information

Timely access to investment information is another big issue employees have with their retirement plans. Managing a retirement account in the best of circumstances is hard, but it’s almost impossible when important information isn’t available.

Employers are required to provide participants with five pieces of information about their 401(k):

• A summary plan description (SPD): The plan description explains the general terms of the plan — who is eligible and when, the types of contributions permitted, vesting, withdrawal rules, and so on. Although it’s useful when you need to know your plan’s rules, the information about plan investments is typically limited to generic fund descriptions. Some SPDs don’t even give fund descriptions; they say only that participants can split their contributions among various funds selected by the employer.
• A summary annual report (SAR): The annual report isn’t exactly what you’d call useful, up-to-date information. The SAR is pulled from a form that your employer has to file with the Department of Labor within seven months after the plan year ends. But the information on the form is for the previous year, ending December 31 (if the plan year ends on December 31), so the information is dated by the time you receive it. The summary annual report lists general financial results for the year for the entire plan, including total contributions, interest, dividends, realized and unrealized gains, and benefit distributions. None of this information helps you decide how to invest your money.
• An annual statement of their account: This statement doesn’t have to include detailed information on the actual return and expenses for each participant’s investments. It may be limited to the beginning balance, contributions, withdrawals, investment gains or losses, and ending balance. The service provider for your plan may also include each participant’s specific rate of return (the percentage by which your own investments grew, or shrank, over the year).

• Fee disclosure in compliance with Sections 408(b)(2) and 404(a)(5) of ERISA: You’re supposed to receive a copy of the fee disclosure form when you join your plan. Request it from your service provider or employer if you don’t have one.

  The Department of Labor (DoL) provides the 401(k) Plan Disclosure Form that service providers can use to satisfy the Section 408(b)(2) disclosure requirements.

  The information provided isn’t easy to understand. Get help from the financial advisor for your plan or someone else who is familiar with this stuff if you don’t understand the info. The person at your employer who administers your plan may be able to help.

• Potential annuity income: The Secure Act contains a provision requiring 401(k) service providers to inform each participant how much monthly income would be provided if the participant’s account balance were used to buy a lifetime income annuity with payments starting at age 67.

  Some service providers currently provide lifetime annuity income projections often also showing a projected monthly annuity income if you continue your current rate of contributions until retirement.

Some funds offered by 401(k) plans are special funds created by the provider, and they aren’t available to the general public. In this case, you need to ask the provider or your employer for information about the fund. Written requests are usually the most effective.

Here’s a sample letter asking for more information about plan fees:

• Dear 401(k) Plan Representative:
• Planning for my retirement is a serious matter. I want to do everything I can to be sure that I have an adequate income during my retirement years.
• Unfortunately, I haven’t been able to make informed investment decisions because I can’t get adequate information about the fees that I pay. I called the service center at the Outback Investment Company, and their representative told me that I don’t pay any fees. Perhaps I should consider this wonderful news, but I’m not dumb enough to believe that it’s true.
• As a result, I’m requesting a written explanation of all the fees that I pay, including the ones deducted from plan assets by the organizations that invest and manage the plan, and that reduce the net investment return I receive.
• Sincerely,
• 401(k) Plan Participant

Questioning investment strategy

You may be convinced that your plan needs to offer more or better mutual funds. In some cases, you may be right; in others, you may not be. In any case, you have a better chance of getting your plan sponsor to listen and take action if you submit detailed written complaints. Generic complaints that simply state that a plan’s investment options stink aren’t very useful. It’s best to explain why, specifically, you’re dissatisfied. It may be the fact that a particular type of fund isn’t offered, or it may be generally due to high fees or poor performance.

Here’s a sample letter that may get the attention of a plan sponsor:

• Dear 401(k) Plan Representative:
• I take 401(k) investing very seriously, because I want to do everything I can to be sure that I have an adequate income when I retire. As you know, investment return has a major impact on the savings that I, and other participants, will accumulate.
• I am very dissatisfied with the return of our large-cap stock fund, the Outback Super Stock Fund. In the past year, the return for this fund was 2.4 percent less than the S&P 500 index. During the last three years, the fund returned an average of 2.6 percent less than the S&P. This fund has also ranked in the bottom quartile for three years, and it only has a two-star Morningstar rating.
• It would clearly be in the best interest of all participants to replace this fund with a similar fund that has a better track record and rating.
• Sincerely,
• 401(k) Plan Participant

This letter contains specific reasons for the dissatisfaction of the fund. The reasons are supported by Morningstar ratings, an independent source. The letter also properly identifies the type of fund and compares its performance with the S&P index, an appropriate benchmark for this type of fund. (Chapter 13 has more information about S&P and other indexes.) Gathering this information may appear to be very difficult, but it isn’t. The Morningstar.com website (or other similar fund resources we mention in Chapter 13) provides all of this information.

Consider your company culture before you attack the 401(k). You don’t want to be labeled a troublemaker if this is how your employer views people who complain. At your company, a casual remark at the water cooler followed up by an email with “just the facts” may be enough to spur someone in a position of authority to consider a change.

If you fail to get the information you need, consider writing to the United States Department of Labor. Explain what efforts you’ve made to get the information and the responses you received. Letters should be addressed to: The Assistant Secretary of Labor, Pension and Welfare Benefits Administration, 200 Constitution Ave., N.W., Washington, D.C. 20210-1111. You can go to the United States Department of Labor’s Pension and Welfare Benefits Administration website at http://askpwba.dol.gov and click on Postal Mail/National Office for up-to-date information.

In the end, as you evaluate your 401(k) plan, you’re really evaluating the corporate citizenship of your employer. If your employer realizes the importance of having a strong 401(k) plan, that’s a good sign.