An automobile, an organization, a 401(k) plan—these seemingly unrelated items all have one very important unifying factor. For each to function in the most efficient and effective long-term capacity, the owner or sponsor must not only understand the day-to-day functions, but also periodically peel back the most evident layers to evaluate the underlying nuts and bolts.

Let’s look at the example of an imaginary organization. Organization X is comprised of many individuals—CPAs, administrative staff, attorneys, human resource generalists, information technology experts, etc. Each individual has a unique skill set, they are able to provide the service or expertise that they agreed to contribute upon employment, and the organization functions at an acceptable, but possibly not the most efficient, level.

Early in the year, Organization X decides to take a step back from the daily operations in an attempt to understand their human resources. They utilize personality profiles and skills/strengths and passions surveys, and they uncover a greater potential for success than they knew existed. The IT expert has a passion for development, an administrative assistant has a strong network of contacts with solid relationships in the industry, a certain CPA works well with one of the attorneys, and their ideas always seem to have a synergistic effect. Suddenly, a wealth of resources are identified that would have otherwise remained hidden, and the potential for future growth and success becomes unlimited.
 
Retirement plan sponsors have a responsibility to undertake a similar process in understanding the fee structure of their plan. They must approach plan costs from a fiduciary’s perspective. This involves understanding the breadth and scope of the fees charged to the plan and ensuring that these costs are reasonable and help the plan run more efficiently.
 
Most people now have an understanding that the 401(k) plan is not free, but what kind of fees are we talking about here? The most common investment for 401(k) plans in the United States is mutual funds. A mutual fund is a company that pools resources from thousands of investors and then diversifies its investment into many different holdings such as stocks, bonds, or government securities in order to provide higher relative safety and returns. Fees come into play because the mutual fund company must hire a number of service providers, including a custodian, fund management company, transfer agent, fund distribution company, attorneys, accountants, and other staff, to perform the various functions that are required to operate the fund. Each service provider enters into a contract with the mutual fund. The contracts are negotiated by the fund directors, and the fees are paid out of the net assets of the mutual fund on a periodic basis. These fees make up what is called the mutual fund’s expense ratio.
 
Plan sponsors must understand that not all plan providers share the revenue they receive from investment company complexes. This is critical, because providers that share revenue can be far less expensive than those that do not. The result is a more cost-effective plan, higher returns, and larger account balances for the plan’s participants. 

The Basics of 401(k) Pricing

So how does a plan sponsor undertake the process of evaluating the fee structure of their plan? This is a very complex task that can seem daunting, even to the experts in the industry. The first difficulty is the complex web of pricing combinations the 401(k) industry has created—there are possibly over 30,000 different ways to determine the price of a 401(k) plan! Several factors can determine the pricing, including:

• Average participant account balance
• Total plan assets
• Three major administrative architectures
• Four investment architectures
• Three different types of funding contracts
• Six major delivery channels
• At least 12 sources of revenue for plan service providers

• Potentially additional embedded expenses within each service area.

1. Disclosed
2. Partially disclosed

3. Believe it or not, hidden.

Plan sponsors must know that service providers charge these fees, understand that the information is not always presented in a clear manner, and learn how to approach providers to evaluate their fee structure. Returning to the analogy of our imaginary organization, we can identify techniques that may help to uncover the information that is disclosed, partially disclosed, or hidden. Organization X hires an employee based on the disclosed expertise and background indicated on their resume and revealed in the interview process. This information is very easy for the human resource expert to identify and understand. As Organization X begins to evaluate their human resources, the decision makers first attempt to use an informal approach of building relationships with the employees and asking questions based on information already known. In this process, the decision makers uncover and better understand the partially disclosed information. Finally, to gain the most accurate, in-depth information, the formal evaluation takes place and the decision makers act as detectives, uncovering information that is hidden.

Understanding 401(k) Fees

With all of this information in mind, let us look at the different fees and the techniques that plan sponsors can use as they evaluate their plans. See Table 1 for more information on what fees may apply depending on the type of funding vehicle being used: mutual fund, group variable annuity, and collective trust.
 
Table 1

Disclosed Fees: Simply Read the Facts
 
Billable Fees may include plan administration fees, plan audit fees, investment advisor fees, consulting fees, and legal fees. These fees, which are charged directly to the plan through an invoicing method, will vary depending on the type of pricing arrangement used, but will generally be less than 25% of the total plan expenses. The remainder of plan fees will generally come from a percentage fee tied directly to the plan assets.
 
12(b)-1 Fees range from 10 basis points (.1%) to 100 basis points (1.00%) of the assets in the account, although the most common 12(b)-1 fee used is 25 basis points (0.25%). The SEC rule 12(b)-1 permits mutual funds to increase their internal fund expense ratios by up to 1%. Although 12(b)-1 fees are fully disclosed in the fund prospectus, it is not always clear who is receiving the fees. Plan sponsors must understand that both sales and servicing revenue can be referred to as 12(b)-1 fees. For example, a registered representative receives the sales commission for selling mutual funds. The servicing fee is intended to be paid to a person or entity providing services after the sale. From a plan sponsor perspective it is extremely important to know who is receiving this payment.
 
It is common for some retirement plan providers to capture 12(b)-1 fees and use them for the benefit of participants by paying for plan expenses. Since they are being used as servicing fees they may not be disclosed as sales commissions, yet as we learned above they are actually one in the same. 12(b)-1 fees can, however, be the friend of a fully educated plan sponsor because they are relatively easy to find. Plan sponsors who use an open architecture plan provider and fee-based advisors will be able to assure and utilize all 12(b)-1 fees for the benefit of the plan and its participants.

Money Management Fees are wrapped inside of each fund’s expense ratio. The actual cost of managing money includes payments to the fund’s money manager and staff, the cost of research, and staff support. Typically there is a large difference between the money management fee and the total expense ratio. For large mutual funds, the money management fee will hover around 25 to 30 basis points. For smaller funds it may climb up to 45 basis points.

Other Expenses include distribution fees (similar to 12b-1 fees), performance fees, custodial fees, legal fees, transfer agent fees, and sub transfer agent/recordkeeping payments. Sub transfer agent/recordkeeping payments may be made to third parties (including affiliates of the fund’s investment adviser) that provide services with respect to certain shareholder accounts in lieu of the transfer agent providing such services.

Partially Disclosed Fees: Ask a Lot of Questions
 
Sub TA Fees help fund companies reduce their costs of account management in retirement plans. In the early 1980s, 401(k) accounts were maintained as separate accounts for each individual participant. This became extremely costly, especially for plan providers catering to larger companies. This was addressed by outsourcing the accounting of participants’ shares to third parties who are called sub-transfer agents. The transfer agent may be a bank and trust company or even an affiliate of the mutual fund itself. Their role is to execute, clear and settle, buy or sell orders for a security, and maintain shareholder level records of each transaction.

The sub transfer agent could be one of the following entities:

• A third party administrator
• The bank or trust company performing recordkeeping services
• Any other entity tracking the number of shares held for the specific benefit of a participant in a participant directed plan

• Brokerage Commissions are the charges that a broker collects as an agent for a customer in the process of executing and clearing a trade. All mutual funds buy and sell securities and therefore create brokerage commissions. According to the SEC, commission costs result in about 0.30% of assets.[1] These expenses are explicit and are a direct reduction of fund returns, yet they are not included in the mutual fund’s operating expense. Calculating the brokerage commissions paid by a mutual fund is an art at best. It requires an examination of the fund prospectus, the Statement of Additional Information (SAI), and the fund’s annual report.
• Spread is the difference between bid price and the asked price. This information is not disclosed in the prospectus! Spread costs will average about 0.45% of fund assets. Recent studies indicate that the spreads on equity mutual funds can range from 24 basis points on Large Cap funds to over 150 basis points for small cap funds.
• Market Impact Costs are incurred when the price of a security changes as a result of the effort to purchase or sell the security.
• Opportunity Costs are the cost of missed trades. 

Marketing Concessions are used in an effort to increase sales. Some fund companies will pay third parties additional compensation based on the total volume of their sales.
 
Finder’s Fees are paid up front by some fund companies for new sales of their funds. Finder’s Fees may range from 0.10% to 1.25% basis points of the assets contributed to the fund company. Over the last two decades, thousands of 401(k) plans have actually been sold without the plan sponsor knowing that the fees were paid. There is a trend away from using finder’s fees, but they do still exist and are still used by 401(k) plan brokers. Open architecture fund platforms will collect these fees, where available, and make them accessible to the plan for services provided. This is a great use of these funds, as it goes directly to the benefit of the plan participants.