What Are My Costs?

Compliance

While compliance fees can be paid by the plan sponsor, they can also be passed on to the participants, who should therefore inquire about these fees.  As an example, there is a Department of Labor regulation called 404c that few participants know about.  Normally, participants wouldn’t care to inquire about the meaning of this regulation, but they should because they are often paying for it despite the fact that it only benefits their employer!  While it is optional for a plan sponsor to comply with regulation 404c, they often do so in order to protect themselves from potential participant lawsuits by offering a diversified range of investment options and providing a sufficient amount of relevant information about each investment option for the participants to make informed decisions.  Given that 71% of plan participants think their plan is “free”, they are clearly not informed.  In other words, not only are participants not being informed as a result of a regulation meant to inform them, but money is being deducted from their accounts to protect their employer while they are getting nothing in return!

Record Keeping

Recordkeeping is the largest component of recurring administrative expenses. This expense category includes enrollment, contribution and investment election processing, loan origination and processing, withdrawal processing, individual account maintenance, and preparation and mailing of account statements and summary annual reports.  Clearly, recordkeeping is a function that is independent of plan assets, yet many recordkeepers charge an asset based fee rather than a hard dollar fee based on the actual amount of work they are doing.  Recordkeepers often receive this asset based fee in the form of revenue sharing from the funds, so there can be a significant conflict of interest that arises because recordkeepers who earn revenue in this manner have the incentive to base their fund offering on which funds pay revenue sharing.  Similar to administration fees, most retirement plan service providers will only offer to charge for their recordkeeping services in this manner because charging their fees separately will likewise make their fees more visible and therefore subject to the downward pressure of competitive forces.   Consequently, it is best to only pay hard dollar fees for this service as well.

Fund Management

A charge levied by an investment manager for managing an investment fund. The management fee is intended to compensate the managers for their time and expertise.

Management fees vary from fund to fund.  Actively managed funds for example, tend to have higher management fees than passively managed funds.  U.S.-stock funds, for example, pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.  Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes.

Allocation of Revenue Sharing

Retirement plan service providers (i.e. recordkeepers, third party administrators, and commission-based investment advisors) often receive different amounts of revenue sharing from each fund.  However there are some plan investments such as self-directed brokerage accounts, company stock, and institutional mutual fund share classes that make no revenue sharing payments at all. Thus, participants whose accounts are invested in funds that make higher revenue sharing payments are essentially subsidizing retirement plan service costs for participants who have invested in funds that pay little or no revenue sharing.

Retirement plan sponsors have a fiduciary obligation to determine a process for allocating revenue sharing payments to service providers amongst participants.  As funds pay unequal amounts of revenue sharing and participants do not all invest in the same funds, eliminating revenue sharing by paying for each service separately will make participant fee allocation decisions far less complex for plan sponsors.

Investment Advice

These fees can be paid to a commission based advisor through 12b-1 fees or a fee-based advisor as a percentage of assets or flat dollar fee.

A 12b-1 fee is an annual marketing or distribution fee on a mutual fund. The 12b-1 fee is considered an operational expense and, as such, is included in a fund's expense ratio. It is generally between 0.25 - 1% (the maximum allowed) of a fund's net assets.

With 12b-1 fees, a conflict of interest can arise because a commission-based broker can only earn compensation from funds that pay 12b-1 fees, most of which are actively managed funds, and different funds pay different levels of 12b-1 fees while some funds don’t pay any 12b-1 fees at all.  As mentioned above, investment advice can also be paid to a fee-based advisor, often known as a registered investment advisor.  While 12b-1 fees have to be paid for by the participants, fees charged by a registered investment advisor are independent of the funds offered and can be paid for by the company instead of the participants.  For companies where most of the money in the plan is the owners’ money, having the company pay for the investment advisory fee may be a more cost effective option, as it can be paid for with pre-tax dollars.  Furthermore, because a registered investment advisor cannot earn 12b-1 fees, if investments offered by a registered investment advisor contain 12b-1 fees, these fees will be credited back to the participants.

Trading

When evaluating costs, many investors check a mutual fund’s expense ratio.  This ratio, however, often reflects less than half of the true costof the fund.  There are other costs, not included in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as shown, therefore making them often the largest portion of expenses a participants bears.  These costs, known as trading costs, can only be found in a document called “Statement of Additional Information” that is not required to be given to plan sponsors or participants.  There are four main components:

  1. Brokerage commissions
  2. Bid-ask spreads
  3. Opportunity costs
  4. Market-impact costs

Brokerage commissions arise from mutual funds buying and selling stocks and bonds just like individual buying and selling securities in a self-directed brokerage account.  Bid-ask spreads deal with the difference between the lowest price at which a seller is willing to sell a security and the highest price a buyer is willing to pay.  The difference between them is the spread.

Market-impact costs, and the resulting opportunity costs, are often the largest component of trading costs.  These costs occur when a large trade changes the price of a security before the trade is completed. Similarly, opportunity costs occur when the result of a trade prevents a fund manager from filling an order as intended, causing either a less optimal price or fewer shares purchased or sold.

The average U.S. equity fund has trading costs of 1.44% while the average U.S. equity fund as stated above has an expense ratio of 1.31%.

Selecting a portfolio of indexed funds, however, will drastically reduce trading costs. Since these index funds do no research and little trading, the costs of holding their portfolios are extremely small, some ranging as low as 0.10 percent a year.

Administration

Administrative fees include preparation of the 5500 form, compliance testing, plan design, plan document drafting, amendments, and restatements, profit sharing and forfeiture allocations, processing of various types of employee transactions.  While administration fees can be paid for by the plan sponsor, these fees can also be hidden in the fund expense ratios and often passed on to the participants to give the appearance that these costs are very low or even free.  Bundled retirement plan service providers will often only offer to charge for their services in this manner because charging their fees separately will make their fees more visible and therefore subject to the downward pressure of competitive forces.  Consequently, it is best to only pay hard dollar fees for this service.

Section 28(e) Fees (“Soft Dollars”)

Soft dollars are payments that occur between investment companies (i.e. mutual funds) and their service providers, pursuant to SEC rule 28(e). These fees are very difficult to uncover because they are buried in a mutual fund’s expense ratio. For example, if a mutual fund purchases research from a brokerage firm with hard dollars, these costs are included in the expense ratio of the fund. However, a mutual fund may receive research services by the brokerage firm in return for higher than reasonable commissions paid to the firm to execute trades for the fund. If a trade costs five cents per share to execute, the brokerage firm may charge the mutual fund a greater amount per share and use the excess commission to offset the cost of services provided to the mutual fund. Soft dollars do not provide any value to participants and can be avoided by offering index funds and exchange traded funds which do not perform research as actively managed funds do.

Implicit Costs

One implicit cost is the money market spread.  This spread is the difference between the amount of interest a participant is earning on a money market fund and the current yield on a 90 day treasury bill.  Even though a money market fund may be advertised as having “no fees”, in reality a participant is paying a fee if a treasury bill has a higher yield.

Another implicit cost is called the float, which is the interest a retirement plan service provider earns on participants’ money while participants are waiting for their contributions to be deposited into their retirement accounts.  Once participants receive deposits into their bank accounts, it could take just one day or perhaps several days for their deposits to be allocated to the funds in their retirement accounts.  The longer it takes, the more interest retirement plan service provider earns.