For most of us, our key retirement savings vehicle is our 401(k). Many investors think their 401(k) plan is free with no expenses. Nothing could be further from the truth. All plans have expenses that are paid all or in part by the plan participants. Here is a look at some of the expenses involved.
Mutual funds or other investment options, such as collective trusts, all have some sort of underlying expense ratio. Mutual fund returns are quoted net of the expense ratio, so higher expenses detract from your net return as an investor in the fund.
An example provided by Vanguard illustrates the impact of higher expenses on investment returns. In the example, an investor’s initial $100,000 investment grew to the following amounts after 30 years, assuming a 6% return with varying levels on expenses:
- With no costs, the initial $100,000 was worth $574,349.
- With an expense ratio of 0.25%, the initial investment was worth $532,899.
- With an expense ratio of 0.90%, the initial $100,000 was worth only $438,976 after 30 years, a cost of more than 20%.
While this is hypothetical and returns are rarely constant year to year, this example does a nice job of illustrating the impact of higher costs on your investment returns.
Another aspect of mutual fund expenses involves the use of different share classes by your plan. As an example, American Funds’ popular large growth fund the Growth Fund of America has six share classes for use in retirement plans.
|Ticker||Expense Ratio||12b-1 Commission||5-Year Return||Growth of $10,000 Over Five Years|
Source: Morningstar, as of 12/31/16.
As you can see, the difference in the amount of growth of a $10,000 investment made at the beginning of 2012 and held until the end of 2016, was $1,098 between the most expensive R1 shares and the least expensive R6. This is a five-year difference of 5.7% for the same portfolio, the only difference being the fund’s expenses.
A plan in which the outside advisor or registered rep who sold the plan is looking for compensation from the plan assets will often use the R1 or R2 shares. These will often be smaller plans in terms of total plan assets. The R5 and R6 shares are more institutionally priced and would often be used where the advisor is a fee-only. The plan would typically be a bit larger as well.
Retirement plans like a 401(k) require administration and record keeping at the plan and individual participant level. This involves doing the accounting for the plan and the participants, generating statements, performing the annual discrimination testing to ensure that the plan doesn’t favor employees who are considered highly compensated, and other related tasks.
The record keeper is in charge of ensuring that participant salary deferrals are correctly invested in the proper selections.
Outside Investment Advisor
If your employer retains an investment advisor or consultant to help choose and monitor the investments in the plan, this advisor will need to be paid. Their compensation could be as a percentage of the plan’s assets, a flat fee, via trailing commissions on the mutual funds such as 12b-1 fees, or any combination of these.
Plans sold by commission-based reps will likely have some compensation built into the cost. One form that used to be common was a group annuity plan in which there was a fee (usually a percentage of assets) wrapped around the mutual funds or annuity sub-accounts being used. This arrangement is much less prevalent than it was a few years ago, with the emphasis on fees and the number of 401(k) lawsuits in recent years.
Some custodians (Schwab, Vanguard, Fidelity, etc.) may charge fees based on assets or to cover transactions. This will vary by custodian and plan size.
Often, you do. At the very least, the expense ratios of the mutual funds or collective trusts used in the plan are paid by you in terms of the net returns you earn.
Beyond that, your employer may charge some or all of the other expenses involved in running the plan against the plan’s assets, meaning the money comes out of your account, reducing your balance and your return. Having the plan cover any or all legitimate expenses is legal and within the rules.
To say 401(k) accounting is murky is an understatement. Some fund companies pay fees to be on the plan provider’s platform (pay to play, as we call it here in Illinois). The official name is “revenue sharing.” This money comes out of the fund’s expense ratio and goes to the provider. This money can be used to cover fees or be returned all or in part to the participants. Again, this will vary by plan.
Since 2012, 401(k) plan sponsors have been required to provide an annual disclosure of the costs assessed to plan participants via all service providers, as part of the 408(b)(2) disclosures required by the Department of Labor under ERISA.
Sponsors, often via the plan provider, will send these to participants at least annually. Additionally, any plan costs (administration, etc.) that are deducted from your account should be disclosed on your quarterly statements.
Frankly, many participants find these disclosures confusing, and they often are.
What Can You Do?
Force yourself to become knowledgeable about the investments and the fees involved in your plan. This is your retirement money, and it is important. If you have questions, ask your benefits department. If you use a financial advisor for your investments and financial planning, have him or her review your plan and tell you what they think.
If you, and perhaps some co-workers, become knowledgeable and find that you are not enamored with the investments or the fees, bring your concerns to management or your benefits department. Obviously, do this in a constructive fashion. Your company might just listen and make some changes. Lawsuits have become more prevalent with even some smaller plans. Above all, this is where management invests for their retirement, and they want the best options they can afford.