By Justin Pritchard, CFP® and Craig Ciarlelli, ChFC, AIFA

If you invest in mutual funds in a retirement plan, you may already know that you pay to invest in those funds. Do you know how much you pay and where the money goes? An AARP survey in 2007 found that 83% of people did not understand the fees in their retirement plan. This confusion is caused, in part, by difficult-to-understand fee structures.

401k plan fees have always been complicated. Fortunately, a lot of information about fees is already out there, and it's getting easier to see the details. In the past, you've had to hunt through thick documents, only to end up with a rough guess of what you pay and who ends up with the money. With increased transparency and fee disclosure, you can discover more precisely how much you pay and what services you get in return.

• Basics of 401(k) Fees

Revenue Sharing

Much of the complexity comes from revenue sharing. While you may be aware of mutual fund expenses, you may be surprised to find what those expenses cover. In some cases -- with 401k retirement plans in particular -- it's more than just investment management.

When revenue sharing takes place, somebody collects a fee from employee accounts and shares that fee with one or more other organizations. For example, the XYZ Growth Stock Fund may have an expense ratio of 1.25%. For every $100 in that fund, you might expect to pay roughly $1.25 per year for them to buy and sell stock, research companies, convert currencies, and so on. In fact, XYZ Fund Company may also share a portion of that fee with other entities involved in your 401k plan.

Why does revenue sharing take place? There are a variety of reasons, some of them easier to stomach than others. It may be as benign as passing on revenue when somebody performs a task or service for somebody else. In the example above, the mutual fund company bills you for services they expect to perform if you buy a fund directly through them.

However, with a 401k or mutual fund supermarket, somebody else performs those services (like offering a website, toll-fee customer support, mailing statements and tax documents, etc). Since the fund company didn't have to perform a service they billed you for -- but somebody else did -- the funds go to the organization that actually did something.

Revenue sharing is most likely when you can choose from a variety of fund families or "brands" (not just XYZ Funds, but also ABC Funds, etc). The fund companies make payments to the recordkeeping "platform" that they're offered on -- to a multi-fund-family 401k provider, for example.

Paying for Plans, and Maybe More

When employers cannot afford to provide a 401k plan, revenue sharing allows them to offer one to employees -- but the employees pay the costs themselves. For employers who are willing and able to pay plan expenses, it may bring their costs down over time and eventually lead to reduced costs for employees (as fees paid to service providers such as TPAs are "offset" or result in discounts). Although employees pay for the plan out of their own accounts, they may still come out ahead if the plan would otherwise not exist.

At worst, revenue sharing is a way to hide fees. Nobody sees the money change hands, and very few understand what the total investment expense pays for. It's a way to milk large sums of money out of large plans by charging a percentage-based fee that never goes down (when plans are ignored or taken advantage of). In some cases, employers and employees believe the plan is "free" when it is in fact expensive.

A Few Obscure Fees

Here are some of the most commonly misunderstood fees in 401k plans. These fees are generally charged as a percentage of money in employee accounts. They often appear (or are believed to be) investment expenses, but they end up somewhere else.

Sub-transfer agency (Sub-TA) fees: like the example above, a mutual fund company pays somebody else to perform a fee that that fund company charged for. Sub-TA fees pay for tracking and servicing you and your assets in the plan. These fees are generally included in a mutual fund's expense ratio.

12b-1 fees: fees traditionally designed for marketing. They are recurring payments made to whoever distributes a mutual fund -- whether it's a 401k provider, a mutual fund supermarket, or an individual financial advisor (as a Registered Representative being paid through a broker/dealer). They are also included in a mutual fund's expense ratio, and should be explicitly described in a fund's prospectus.

Loads, sales-charges, and finder's fees: paid to whoever distributes a fund, generally when new money goes into the fund. These charges are generally described in a fund's prospectus and accounted for in the fund's expense ratio. In many (but not all) 401k plans, sales-charges are "waived" -- not paid by employees.

The Most Obscure Fees

The fees above are less troublesome because they're probably part of a mutual fund's annual operating expense ratio, which you can read about in the fund's prospectus. The fees below are more difficult to understand; if all you do is look at publicly available data on funds in your 401k plan, you may not see everything. A fund's prospectus, printout, performance history, or online profile will generally not include the following fees. However, if you get fund data from your 401k provider (assuming it happens to be specific to your 401k plan) you have a better chance of getting an accurate picture.

Asset charges and wrap fees: there are a variety of names for fees charged by investment platforms, generally as a fee on top of investment management (mutual fund) expenses. These fees cover the cost of providing services, most often 401k recordkeeping. In some cases, they're subsidized or reduced by other revenue sharing payments (in other words, sub-TA fees may help keep asset charges lower). In other cases, the fee is shared with other service providers (a recordkeeper pays a Third Party Administrator or financial advisor out of the wrap fee proceeds). "Wrap" fees may also refer to additional fees paid for money management programs available in the plan.

Trading fees: to buy and sell securities, mutual funds have to pay transaction costs and other expenses. Presumably the costs are relatively low because they buy in bulk, but active trading and other factors can make trading expensive. Trading fees are not specific to 401k plans -- no matter where you hold the fund it faces trading fees. These fees are generally not reflected in a fund's expense ratio, but they are paid for out of fund assets.

Where to Find Fee Information

If you want to know how much you pay, you'll have to do some hunting. Fortunately, it's getting easier to get information on 401k fees. For mutual fund related expenses, read the fund's Prospectus, Statement of Additional Information, and any other documents available from the fund company. For 401k expenses:

• Employer Fee Disclosure - 408(b)(2)
• Employee Fee Disclosure Rules - 404(a)(5)
• Where to Find 401k Fees Listed

Share Classes Matter

Especially when it comes to mutual funds in 401k retirement plans, share classes are important. A mutual fund may be available in different "classes," which means there are different expense features built into the fund. For example, "Class A" shares often use an up-front sales charge with lower annual expenses (including the 12b-1 expense) than "Class C" shares.

Some share classes are designed specifically for retirement plans. They may include special revenue sharing arrangements to appeal to certain markets, or they may eliminate 12b-1 fees to keep costs low. When you look at the funds in your retirement plan, pay close attention to the share class.

How do you identify the share class? In most cases, the share class is shown using the last letter of the fund. However, you should always verify by speaking with the fund company or your 401k provider. For example:

• XYZ Growth Stock Fund Class A = Class A (is it a load-waived Class A share?)
• XYZ Growth Stock Fund A = Class A
• XYZ Growth Stock Fund Ret = R, sometimes known as "Retirement" Class
• XYZ Growth Stock Fund Class I = I, sometimes known as "Institutional" Class

What to do About Obscure Fees

What can you do about these fees? Employers have some choice in the fee structures used in 401k plans. It's important to understand those fees (what they are, where they go, and if they're appropriate), and then decide how to proceed.

The fees above are not necessarily bad -- service providers have to be paid one way or another. However, when fees are hidden it's easier for them to become excessive. To avoid trouble, work with a financial advisor or independent consultant who can review fee structures and get proposals from competing vendors. A formal review process (as part of your Annual Trustee Meeting) will help ensure that fees do not get out of line.

Ask the following questions as you evaluate a 401k program:

• Do decision-makers at the employer/plan-sponsor understand revenue sharing arrangements?
• What happens to revenue sharing dollars (reduction of other costs, or just extra profit for vendors)?
• Do service providers actually perform and deliver what they're getting paid for (does the financial advisor ever show up and help)?
• Are fees charged as a percentage higher than they would be if service providers charged a flat fee?

Eliminating Hidden Fees

If fee levels are appropriate, it may not make much difference to you how you pay. However, complicated fee structures are simply unacceptable to some. It is possible to have a completely transparent 401k plan -- where the employer and employees can see and understand every cost associated with the plan. Ask a financial advisor or consultant for help. As you compare options, ask about "open architecture," "full disclosure," or completely transparent plans.

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.