In a market where returns are expected to be lower than in the recent past, administrative and investment fees can take a very big bite out of the returns you earn in a 401(k) account and dramatically reduce the nest egg you accumulate from decades of saving.
In 2013 the Department of Labor, which regulates corporate retirement plans, provided a simple calculation demonstrating the impact of such expenses on retirement savers. If an employee with a $25,000 balance in a 401(k) plan earns an average annual return of 7 percent in the account over the next 35 years, that balance at retirement — without any further contributions — would be $227,000, assuming an annual plan expense ratio of 0.5 percent of assets. If the plan expense ratio was 1.5 percent, the balance would be only $163,000 — a whopping 28 percent less.
"We have simple advice for plan participants," said Laurie Rowley, president of the National Association of Retirement Plan Participants. "Understand that you are paying fees in your 401(k), know how much they are, and investigate the options you have in the plan."
The information is available, thanks to new disclosure rules passed by the Department of Labor in 2012. Corporate plan sponsors are required to provide quarterly disclosure of all expenses and fees to the plan participants. Unfortunately, most people don't read those quarterly mailings or don't understand what they mean.
"The disclosures have a lot of technical terms, and they're not very user-friendly," said Lori Lucas, leader of the defined contribution practice at Callan Associates. "Most plan participants probably don't have a good idea of what they represent."
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The good news is that the all-in costs of 401(k) plans have been falling for years, according to most studies. Corporate plan sponsors have a fiduciary obligation to participants, and part of that obligation is to make sure the costs of the plan are not excessive.
Between greater regulatory scrutiny and the threat of increasingly frequent class-action lawsuits, plan costs have been falling. The average total cost for more than 22,000 plans surveyed by Brightscope and the Investment Company Institute between 2009 and 2014 fell to 0.39 percent, from 0.47 percent, on an asset-weighted basis.
On a plan-weighted basis, however, the drop in costs is more modest: 0.97 percent, down from 1.02 percent.
In other words, size matters a lot when it comes to 401(k) plans.
Costs are lowest for the largest plans that have buying power with service providers and can spread costs over larger numbers of participants.
On a larger sample of nearly 29,000 plans, Brightscope/ICI found that the median cost for plans with more than $1 billion in assets was just 0.27 percent in 2014 compared to 1.13 percent for plans with between $1 million and $10 million in assets.
"As the plans reach scale, the sponsors have a lot more power to negotiate lower fees and access cheaper classes of fund shares," explained Brian Reid, chief economist for ICI.
Smaller employers, on the other hand, have less clout with service providers and smaller employee populations to share the cost burden.
"It's a different story for Jane's Machine Shop, which employs 10 people and has Jane's broker brother handling the plan," said Meigs of the 401khelpcenter.com.
For smaller plans, the fixed costs of managing it (things such as record-keeping, compliance, communications with participants and transaction processing) are shared by fewer employees. While some employers may cover those costs, most do not.
Fees for 401(k) plans can be simply categorized into two buckets: administrative and investment product and advisory fees. The administrative costs are fairly straightforward. Plan sponsors have to keep records, make disclosures and process transactions. Again, small plans have it tough. A $10,000 annual cost of administration represents 1 percent of a $1 million plan and just 0.1 percent of a $1 billion plan.
The investment- and advisory-related fees — predominantly for the management of the underlying funds offered in the plan — make up the biggest part of total expenses. If the plan has an advisor, determine whether the advisor is compensated through a simple asset-based fee, through commissions, via some form of revenue-sharing arrangement (more on this later) or through a combination thereof.