How much are you paying for the funds in your retirement plan?

Is your 401(k)/403(b) plan with an insurance company? It may be time to take a look at what you are actually paying. This is not as easy as it sounds, because logic would have you think if you own an index fund such as Vanguard inside your plan, you have chosen a low cost option. This is not always the case.

In fact, if your plan is with an insurance company, it is almost certainly not the case, and most employers and employees are surprised to learn this. Fortunately, the industry is continuing to move toward more transparency, and we believe over time plans will become more efficient. There are four main factors that drive the cost of a typical 401(k)/403(b) plan: underlying fund expenses, record-keeping costs, adviser fees, and charges for a third-party administrator. 

Let’s first take a look at underlying fund costs. Generally speaking, index funds are less expensive than managed funds. However, they are two very different animals. Index funds are designed to mimic an actual index and don’t have any active management, which greatly lowers the cost. Managed funds have an active manager who, on a daily basis, is deciding which investments to buy and sell; two very different, but viable approaches. We work with our clients to help determine which combination of funds makes the most sense for the company and their employees. 

Record-keeping fees cover the cost of the day-to-day operation of a 401(k) plan. For many years insurance companies were at the forefront of technology and were the only cost-effective way for a company to set up a multi-fund 401(k) plan. In other words, if an employer wanted to set up a plan with more than one mutual fund family, an insurance company was the only real option. As a result, insurance companies came to dominate the industry. The record-keeping fees associated with having this multi-fund platform were high. Usually, these expenses are passed on to the assets of the plan, which means they are paid by the participants. This is where a big problem begins. We routinely see plans where the record-keeping fee is as high as .3% to .4% per year. On a plan with a total of $5,000,000 in assets, that cost is $20,000 per year, all paid by the participants. Since the typical plan is growing through appreciation and contributions over time, it is not unreasonable to see a plan double in size in the future. That means that the future cost for record keeping could double to $40,000. We find solutions to this problem by moving the plan to a platform where the record-keeping fees are based on the number of participating employees. Every situation is different, but in many cases this cost can be reduced by 50% to 75% or more. Basically, the larger plans with fewer employees save the most. 

The adviser fee is also a factor and can vary quite a bit. We are a fee-only firm, so our advisory fee is transparent and easy to see on participant statements. On plans over $1,000,000 in assets, we charge .25%. Advisers who work on commission basis earn their fee through the expenses of the underlying mutual funds. It gets tricky to determine what they are being paid because the costs are generally hidden inside the fund’s overall expense ratio. On top of that, there are different class shares of the same fund that have different expenses, each paying the adviser a different amount, typically ranging from .25% to 1%. So it’s not enough to just have the XYZ fund in the plan. Trustees also have to be aware of the share class that is being used. When we review plans we look at the 12b-1 fees the funds pay, and review the plan annual disclosure document to get to the bottom line. We see the use of more expensive class shares most often in mutual-fund-based platforms. We believe that commission-based plans will slowly disappear, especially as plan trustee knowledge grows. It is not uncommon for us to see plans where the adviser fee is double what we would charge for that size plan, and in nearly all cases, the employer was unaware. 

The final major expense is the cost of a third-party administrator (TPA). The administrator takes care of all compliance testing and regulatory filing. Retirement plans can come bundled or unbundled; the bundled variety provides the TPA work in-house and is completed by the record keeper. This can be a popular option for smaller start-up plans, but the drawback is that the expense is typically tied to the value of the assets and becomes part of the record-keeping fee. Over time, the costs will increase as the plan assets grow. Hiring an outside third-party administrator (separate from your record keeper) will allow the retirement plan to be billed on a flat fee. The cost can vary greatly based on how much work the employer is willing to do. There are very good, no-frills companies that provide high quality service for employers with strong bookkeeping and accounting departments. On the other hand, there are full service administrators that cost more, but are perfect for companies that need the extra services. We work with employers to find the right fit. So how much does all of this matter? More than you may realize. We have seen plans where the cost of owning index funds approached 1%. On the right platform, that same fund’s cost would be more like .32%. That’s triple the cost for the same fund. Confusing? Yes. Deceiving? Yes. Illegal? No.