Should I be concerned about 401k fees?

401k fees have come into focus as one of many ways the financial services industry leeches money from the investors. That focus turned into litigation by participants against their plans (and plan service providers). Eventually the Department of Labor instituted fee disclosure rules that require plan service providers to break down fees charged to the plan and participants.

Although most of the litigation has been unsuccessful in recovering awards for participants, the fee disclosure rules did force the financial service industry to better expose the relationships between the plan, participants, investments and fees. That way the plan can assess the fees paid for the services provided. Participants, if they chose, can make investment decisions in light of the potential fees paid. Because these fees add up, participants should take plan fees into consideration when choosing investments.

401k fees charged to employees

Plan sponsors have a fiduciary duty to participants to operate the plan to the benefit of the participants. One piece of that duty is to make sure plan fees are reasonable. Plans do not have to chose the lowest fees or that sponsors must pay fees entirely out of their pockets. Actually, participants in 401k plans tend to pay the majority of plan expenses.  A 2011 study by Deloitte Consulting LLP showed participants paid 91% of all plan fees. That is a tremendous expense to the participants. Especially compared to the older pension model where the plan sponsor paid for the entire benefit and all associated expenses.

This shift in bearing the costs of the plan to participants occurs in many ways. Sometimes plans charge annual or quarterly fees to participants as “administrative fees” or “maintenance fees”. Most plans also charge for specific participant services, such as loans, withdrawals, QDRO services, brokerage windows and so forth. However, the real source of participant expense payments comes through revenue sharing agreements, which were a major source of contention that led to both litigation and fee disclosure rules. After over a decade of fee litigation, employment lawyers in Texas and other states pushed the government to do more.

Revenue sharing and 401k fees

Revenue sharing agreements is a way of cycling money from participants through the fees associated with specific investments in the plan, to the investment management company, to the plan service provider to cover plan expenses. It is a sort of kickback system that seems at odds with the plan’s fiduciary duties to participants but nevertheless the Department of Labor, Congress and the courts accept these agreements as legitimate ways to fund plan expenses. Perhaps the justification is that without revenue sharing, participants would simply pay larger administrative fees as an outright fee.

If true, there would likely be more uproar from participants towards the plan sponsor that would lead to the sponsor accepting a larger share of the fees, so the real beneficiaries of this system seem to be the plan’s recordkeeping service provider and the plan sponsor. In my opinion these agreements are inherently at odds with the plan’s fiduciary duty but courts have held the agreements only violate that duty when the plan sponsor chooses investments intentionally to shift the expenses back to the participants.

Example

To be more specific, let’s say you work for a company that provides a 401k through Rhombus Investments, a mutual fund provider. Rhombus could charge your company thousands (or as much as millions) in fees to provide services to the plan; but it’s going to take most or all of the fees back in revenue sharing. Rhombus and your employer agree to offer a list of Rhombus mutual funds in the plan. Those funds may carry 0.5%-2% asset-based management fees (along with various other fees hidden deep within the prospectus). You pay the management fee each year, regardless of whether the fund performed well or not.

So if you have all your money in Rhombus Artic Polar Bear Fund and it has a 1% fee, each year you will pay Rhombus 1% of the total value of your holdings in the fund to pay for the hard work they did maybe making you money and maybe losing your money. The fee goes to Rhombus’s investment management company that oversees the fund operation. The investment management company then pays a portion of the management fee to Rhombus’s 401k service provider company. That portion then offsets the costs of the services Rhombus provides the plan. Anything the revenue sharing does not pay is then covered by money in the plan but not owned by specific participants, the employer pays them directly, or you pay fees direct to the plan.

Why you should be concerned about 401k fees

While we may not be able to change the law on revenue sharing, as plan participants you do have to be concerned about how these fees affect your plan account. The study referenced above asserted one percent asset-based fee over working years amounts to a twenty percent loss in assets. The one percent may be a small number but losing a fifth of your retirement savings is huge. That is why these fees do matter. Not all investments will charge the same fees. Generally, the more actively managed the option, such as a mutual fund or insurance-based product, the higher the fees charged. Active management means the investment manager selects investments with discretion, within the objective of the investment.

There are also passive management investments, such as index funds, that charge lower fees because the manager is simply trying to match the investment to a market index. Higher fees or more active management do not always correlate to greater returns. Often actively managed investments underperform comparable index funds, especially when those management fees calculate into the return. Participants should spend time understanding their investment options in light of their risk tolerance and investment goals and if necessary, consult with a financial adviser who can make sure selected investments are appropriate.

Consider investment options

Your plan may not offer investment options with low fees. Plans are not required to choose the cheapest investments. Courts interpret the fiduciary duty surrounding investment selection to require a value analysis. If the service provider charges high fees with revenue sharing it may be appropriate if it produces high value. Unfortunately, your best recourse for these high fees may be to talk to your employer about changing them.

Litigation may be an appropriate recourse when the plan has violated its fiduciary duties; but the courts have been incredibly limited in accepting these lawsuits. Typically they only treat them favorably when there is a clear indication that the sponsor failed to do the necessary research to determine if the plan investments and costs were prudent or if the sponsor intentionally chose investments with higher fees to get better revenue sharing.

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