By Justin Pritchard, CFP® and Craig Ciarlelli, ChFC, AIFA
Most people don't know how 401(k) plan service providers get paid, and they may even assume their plan is "free." Even with increased fee disclosure, it's not always clear where the money comes from and where it goes. How does it happen? This page will give you a basic understanding of how 401(k) plan assets turn into revenue for service providers, and why it's important to watch asset based fees over time.
The only way the money in the plan can become provider revenue is through the use of asset based fees. Asset based fees are charged against the assets in the plan; in other words, out of employee account balances. They are quoted as a percentage paid per year, such as 1.50%. For every $100 in a 401k account, 1.50% turns into $1.50 of expenses.
Asset based fees are important. They account for most of the expenses in a 401(k) plan and they affect the final account balance you'll have at retirement. They're paid by many -- every employee or participant in the plan -- but chosen by just a few people responsible for putting a retirement plan in place.
Asset based fees may appear to be "investment expenses" because they are collected as part of other investment fees (they're commonly built into a mutual fund's expense ratio, for example). However, they pay for more than just money management.
When asset based fees are charged, they pay for any number of services:
How does this happen? After fees are deducted from accounts, they may be kept by whoever collected them or split up among several service providers. For example, a mutual fund may charge fees on money invested in the fund, then:
These types of payments go by a variety of names including:
When payments are split among various service providers, it's called revenue sharing.
Is there anything wrong with paying 401k plan service providers out of the plan's assets? It depends how much they're getting paid, what employers want to do, and what service providers do for their pay. In many cases, small employers cannot afford to offer a 401k plan to employees; they can't pay for administration and recordkeeping. The only way their employees can benefit from a retirement plan is to pay for it themselves -- often out of plan assets.
When costs from asset based fees are similar to the costs that would be charged under more direct billing approaches, things are probably working more or less as they should. It starts to get ugly when employers and employees pay too much. With asset based fees, somebody's always getting paid but it's not very obvious (payments are recurring, automatic, and often unseen). When you get a bill or invoice, you're more likely to notice fees and consider whether or not you're getting a good deal. When funds come out invisibly, it's easy to pay too much.
Ultimately, employers make a choice:
Employers will make a decision based on a variety of factors, including their ability to pay and philosophical views. As long as everybody is informed about the fees and tradeoffs, the best approach is the one that allows the business to provide a benefit to employees at a reasonable cost.
When asset based fees pay for the retirement plan, they (ideally) reduce or eliminate the need to write checks. Employers can offer a 401k plan -- possibly along with matching and profit-sharing -- without paying as much for recordkeeping and administration. Employees get a valuable benefit, and employers limit the cost of providing the benefit.
As plan assets grow, something should change because asset based fees will produce more and more revenue. Either the fees need to go down (from 1.00% to 0.85%, for example) or the bills from service providers should get smaller (perhaps they go away entirely). When service providers earn more from asset based fees than they need to make a fair profit, they will ideally approach employers proactively to make adjustments -- but that doesn't always happen. A good financial advisor will routinely review service providers and fees to be sure that employers and their employees pay a fair price.
If asset based fees never change as plan assets increase, employees in the plan pay more than they should (remember that they're charged as a percentage: more money in the plan results in more dollars coming out of the plan). They'll end up with less spending money in retirement, and they may be able to bring legal action against their employer.
To figure out how much you pay, find all the asset based fees in your retirement plan. They may be difficult to identify, and even more difficult to understand. It's best to look through information specific to your 401k plan because the investments in your plan may have additional expenses that are not applied to the publicly available version of those investments.
Most asset based fees are part of your plan's "investment expenses." They come out invisibly every day. From there, revenue might be shared with other organizations that work with your plan. However, it's possible that your fees are completely transparent, with a transaction appearing on your statement for every payment.
With increased fee disclosure, it's easier to see where the money comes from and where it goes. Employers and employees both have access to detailed reports that explain how much the plan costs (or they will soon have access to these reports).
A good financial advisor or independent consultant can help employers by reviewing fee structures, shopping the plan with other providers periodically, and requesting fee adjustments if the current provider is still a good (but slightly expensive) partner. As a result, employees are likely to pay less over time and employers manage their fiduciary responsibilities.
Asset based fees can also be eliminated altogether. 401k providers can quote and charge fees based on the services they provide. These fees may or may not be billed to employee accounts; the point is that they are clearly defined and based on a menu of services -- as opposed to a level of assets.
Justin Pritchard is not affiliated or registered with Cetera Advisor Networks LLC. Any information provided by Justin Pritchard is no way related to Cetera Advisor Networks LLC or its registered representatives.