401(k) plan fees: Three fundamental questions every advisor should be prepared to answer

If you advise 401(k) plans, you’ve probably heard the following fee questions from the plan sponsor or investment committee at some point in time.  If you consider the proposed 408(b)(2) regulations and the renewed focus by the SEC on the 12b-1 fee, the spotlight on fees is only going to get brighter in 2010. 

Here are three typical 401(k) plan fee questions you may encounter and some thoughts on how you might want to answer them:

Q. Why should I keep my plan with you when another firm is offering a “no-cost” solution?

Let’s start by examining two basic ways to pay for services in a 401(k) plan: 

• The plan can pay via check/invoice on a periodic basis based on a set price stated in the plan agreement. The price can be a flat dollar amount, a per-participant amount or a percentage of net assets (typically quoted in basis points).
• The plan can pay via the investments the participants hold, which is called revenue sharing. When using mutual funds, the total expense ratio paid to the mutual fund company can be used to compensate not only the fund manager, but also the investment advisor/broker/consultant and the service provider/TPA. Two components of the total expense ratio–the 12b-1 fee and the sub transfer agency (sub-TA) fee–are typically passed from the mutual fund to a third party.

It’s easy to see that when the services are paid via revenue sharing, an unknowing plan sponsor could consider the plan setup as “no-cost.”  Obviously, that’s not the case.  Have the plan sponsor ask the other firm for its revenue sharing arrangements with the fund companies the plan is using.

(Note: There is also an alternative method that many plans are moving towards, which we will address in Question #3.)

Q. How can I tell if our plan’s funds are paying any revenue sharing?

As mentioned above, a mutual fund can pay revenue sharing via the 12b-1 fee and the sub-TA fee. First, let’s look at the 12b-1 fee.

The maximum value for the 12b-1 fee is stated in the fund’s prospectus and can differ by fund share class.  Most financial reports, including the new fi360 Fee & Expense Report, also include the maximum 12b-1 fee as a standard data point.  What most plan sponsors don’t realize is that there can be two components of this fee:

• Sales fee: The most common use of the 12b-1 fee. It is used to compensate the selling agent, such as a financial advisor or broker. You could think of it as similar to a front or deferred load. Loads are typically much larger, but they are only assessed once. The 12b-1 fee is assessed annually.
• Service fee: Helps to reduce other costs of the plan, such as recordkeeping, custody, participant accounting, etc.

The two components may be listed in the prospectus, but you should specifically ask your TPA (or equivalent) if they are receiving any of the 12b-1 fee and, if so, exactly what percentage they receive.

Secondly, the sub-TA fee is used to compensate a third party such as a TPA for participant accounting.  This third party executes, clears and settles buy or sell orders for mutual fund shares, and maintains shareholder records of ownership.  Typically, sub-TA fees are not disclosed in the prospectus and can vary depending on the client's circumstances. Therefore, you should specifically ask your TPA (or equivalent) if they are receiving a sub-TA fee and, if so, exactly what percentage they receive.

Q. What is a “level-compensation” or “revenue neutral” fee structure?

When paying the plan fees through revenue sharing, plan fees can vary and increase drastically over time as the assets grow.  The increase in plan assets doesn’t necessarily correspond one-to-one with the required level of service needed to support the plan.  Hence, fees should not always rise proportionately with assets.  Revenue sharing can also be problematic in that it may incentivize an advisor providing advice to participants to recommend options where they receive greater compensation.

To help with these issues and to encourage complete fee transparency, many plans are beginning to use a combination of flat/contract stated fees and revenue sharing.  Here’s how it works:

1. The plan’s investments pay revenue sharing to the third parties (advisor, broker, TPA, etc.) as described above.
2. The third parties aggregate this money and rebate it back to the plan.
3. The rebated money is then used to pay the plan expenses. If the amount of rebated money is less than the total stated fees in the plan agreement, the plan will cut a check to the respective parties for the difference. Otherwise, the plan will maintain a positive balance in what is typically referred to as an “ERISA budget account.” This money can be used in the future to pay plan expenses, or, if it grows too large, it can be given back to the participants. If it does grow too large, the plan agreement should likely be revised to utilize lower cost investment options with less revenue sharing.

One item to note with this structure is when the investments in the plan lineup don’t all have the same revenue sharing levels.  In this situation, some participants could be paying more (or less) of the plan’s fees if they choose funds with higher (or lower) revenue sharing.

I hope these Q&As provide some guidance and insight into the ever-complicated world of 401(k) plan fees and expenses.  What do plan sponsors ask you?  Please comment.

Comments

[FiduciaryNews]

This is an excellent article that should be required reading not merely for advisers, but especially for plan sponsors. It's not that hard to understand these simple points, but too often plan sponsors unintentionally ignore these obvious facts. How can I help get others to read this?

[James Morgan - Puritan Financial Advisor]

Have the plan sponsor ask the other firm for its revenue sharing arrangements with the fund companies the plan is using.

[Dr Silver]

Excellent article. This is the most detailed information I've seen posted anywhere regarding fund feess