Most working Americans are familiar with 401ks. The 401k came of age in the early 1980s; it was originally designed as a means for highly paid executives to defer taxes on savings. Those savings were placed in a 401k and have tax advantaged growth potential until withdrawal at retirement age. Since its inception, the 401k has rapidly replaced the typically more employee-friendly defined benefit plan, often in the form of a pension. According to the Investment Company Institute, as of March 2016, 52 million Americans were active participants in a 401k plan, totaling $4.8 trillion in assets. For many, the 401k may be the primary means of funding retirement.
Managing a 401k saving plan is fraught with great responsibility, as well as complicated regulations and requirements mandated by the Employee Retirement Income Security Act (ERISA) of 1974. A plan sponsor’s responsibilities include understanding all associated plan fees and how those fees will impact the overall plan and its participants. While financial advisors often work with plan sponsors to help them manage plan fees, it is recommended that all parties within the plan have a basic understanding of the associated fees.
Lately, an increasing amount of attention is being paid to the subject of plan fees by both legislators and litigators. Why? Simply stated, fees reduce benefits and the cumulative effect on retirement savings can be substantial over time. Plan fees consist of investment expenses and administrative fees. Some plans may also include an individual service fee.
Plan administration fees cover day-to-day operating expenses. These expenses can include recordkeeping, legal, accounting, consulting, and trustee services. The investment fee is generally the largest piece of the total fee-pie. The investment fee pays for the costs of managing the 401k’s investments. Investment management fees vary based upon the funds being managed; the fee amount is often paid based on a percentage of the fund’s value. Plans that offer optional features, like a 401k loan, may incur an individual service fee.
The total amount of plan fees can fluctuate significantly depending on a number of aspects. Items that factor into the fee amount include which fees are paid from the plan, the value of the plan’s assets, the number of participants, and their average account balance. Other cost factors comprise of the type of funds offered by the plan, the allocation of assets among fund options, the types and amounts of services provided, and the relative complexity of the plan.
The next thing to understand is the allocation of plan fees. While ERISA does not specify how plan fees should be allocated among plan participants, the Department of Labor (DOL) has indicated that this is a fiduciary decision. Failure to consider and evaluate alternative methodologies for allocating fees, and their potential impact on all plan participants, could be seen as a fiduciary breach.
In general, there are two different fee allocation methodologies. The Indirect revenue method pays plan fees via revenue sharing payments embedded in the fund’s expense ratios. This is contingent on the plan’s investments generating sufficient revenue to pay the fees. Participant’s share of the fees is dependent upon the funds in which they invest. The other common practice is the Direct method. When this system is applied, a uniform fee is charged proportionately against each participant’s account.
The Direct method calls for the plan committee to determine whether fees should be allocated on a per capita or pro rata basis. The per capita system charges each participant’s account the same dollar amount. However, per capita allocations tend to favor those with larger account balances; the fees on those with smaller balances (newer or lower paid employees) can erode investment earnings. When using a pro rata allocation, each participant is charged the same percentage of their account balance. Although all participants pay the same percentage, in dollar terms, those with higher account balances will pay more.
A study performed by the Department of Labor in 2013 used an example of an employee with a $25,000 401k balance. That fictitious employee’s plan earned an average annual return of 7 percent for 35 years without any additional contributions. This example calculation accounted for a plan expense ratio of 0.5 percent of assets, leaving the balance at $227,000. Using the same example, but with a plan expense ratio of 1.5 percent, the balance falls by 28 percent, to $163,000. That difference of $64,000 could have been used to fund several years of retirement income.
The good news is that plan costs have been falling. While 401k savings plan fees may not be the most exciting topic, these fees are impactful. Therefore, it is recommended plan sponsors and participants take the time to fully understand the fees associated with their 401k plan.
Traditional 401(k) distributions taken prior to age 59 1/2 may be subject to a 10% penalty tax, in addition to ordinary income tax; minimum distributions required are at 70 1/2; exceptions to 10% penalty may apply.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended as authoritative guidance or tax or legal advice. You should consult your attorney or tax advisor for guidance on your specific situation.
Securities offered through LPL Financial, Member FINRA/SIPC. Investments advice offered through Global Retirement Partners (GRP), a registered investment advisor. GRP, StoneStreet Advisor Group and LPL Financial are separate non-affiliated entities.
( 1) The Brightscope/ICI Defined Contribution Plan Profile: A Close Look at 401k Plans, 2014