This article discusses the major categories of 401(k)
expenses and gives tips for evaluating them.
The first step for a plan sponsor is to know the total
annual fees. The second step is to benchmark—to obtain
information on the costs for similar plans (i.e., plans
with similar assets and numbers of participants); the
competitive marketplace does a good job of establishing
reasonable prices.
However, even where the total expenses are reasonable,
the costs for one of the categories may be too expensive.
As a result, fiduciaries need to identify, quantify, and
evaluate each major type of expense.
Investments
In my experience, the fees for 401(k) investments often
fall within the range of reasonableness. However, when we
see high investment expenses, they tend to be of two types.
The first is that the expense ratio of one or more of the
mutual funds is excessive. That can happen easily as a plan
grows in size. For example, one share class may be
appropriate for a small plan but, as the plan grows, a
lower-priced share class may be right. Stated slightly
differently, while small plans need to pay retail prices,
large plans should pay "wholesale," or
institutional, prices.
The second area involves so-called "wrap"
fees. While wrap fees are not necessarily too expensive,
they can be. I have seen cases where the total annual fees
in a group annuity contract are 3% or more per year.
Advice
When plan fiduciaries are writing checks for the advice,
the cost usually is reasonable. However, where the expenses
are embedded in the investments, many plan sponsors do not
know what they are paying, and they may pay too much.
Further, as a plan grows, the costs should become
increasingly smaller as a percent of the assets. That is
because the services do not grow proportionately with the
assets. Many advisers base their compensation on a
percentage of plan assets, which is appropriate to a point,
but which, thereafter, can be overly expensive. In those
cases, lower fees and commissions can be negotiated
directly with the adviser or through the use of
less-expensive share classes.
Recordkeeping/Compliance
These costs usually are fixed or can vary with the
number of participants. However, providers are often
recipients of payments㬈b-1 fees and subtransfer agency
fees—that are a percent of assets. Since part or all of the
revenue is based on assets but costs are not, it is just a
matter of time before a plan grows large enough that it is
overpaying for these services.
Once a provider has recouped its operating costs plus a
reasonable profit, any additional revenue-sharing should be
restored to the plan (alternatively, lower-cost share
classes, which pay less revenue-sharing, could be used).
When the excess is restored, it is often done as a cash
payment into the plan, which is sometimes called an
"ERISA budget account" or an "expense
recapture account." That money is available to pay
other expenses of the plan or to be allocated to the
participants. Either way, it improves the benefits for the
participants.
Some recordkeepers create an ERISA account on their
corporate ledger in lieu of putting the money into the
plan. That raises two legal issues. First, is the money a
"plan asset," which, under ERISA's Âfiduciary
rules, must be placed in the trust? Second, must the money
be allocated, under the qualification rules, to
participants' accounts as of the last day of each plan
year? Practitioners have conflicting views on these
questions. As a result, fiduciaries should check with their
ERISA attorneys.
Fiduciaries must identify, quantify, and evaluate
expenses of their plans—both the total costs and the major
categories of expenses. To evaluate those expenses
prudently, fiduciaries need to benchmark the amounts
against the costs for similar plans. As in all matters, if
fiduciaries lack the expertise or the benchmark information
to do the job properly, they should work with knowledgeable
advisers.
Fred Reish
is Managing Director and Partner of the Los Angeles-based
law firm of Reish & Reicher. A nationally recognized
expert in employee benefits law, he has Âwritten four books
and many articles on ERISA, IRS and DoL audits, and pension
plan disputes. Fred has been awarded the Institutional
Investor Lifetime Achievement Award and
PLANSPONSOR'
s Lifetime Achievement Award. He is also one of the 15
individuals named by PLANSPONSOR magazine as "Legends of
the Retirement Industry."