What you don't know about 401(k) fees can cost you plenty

Are you paying 12b-1 fees in your 401(k) plan? Are you charged front- or back-end loads on the funds you pick for the account? What's the size of the sub-transfer agency fee paid to the third-party service provider for your plan?

Relax, you're not alone if you can't answer those questions.

Studies show that most participants in 401(k) plans have no idea that the plans cost anything, let alone what the individual expenses are. However, when it comes to fees in your retirement savings account, what you don't know can definitely hurt you.

"It's death by a thousand cuts," said Rick Meigs, founder and president of the 401khelpcenter.com, a website devoted to issues and information regarding 401(k) plans. "Obviously, if you're paying 3 percent vs. 1 percent compounded over 25 years, it's a ton of money.

"But even 25 or 50 basis points (0.25 percent or 0.50 percent) extra adds up over time."

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.

The fiduciary rule proposed by the Department of Labor — now in limbo under the Trump administration — would force advisors to 401(k) plans to always act in the best interests of the plan participants. That would likely mean lower and more transparent costs for 401(k) investors.

The underlying management fees of mutual funds offered in a 401(k) plan typically represents the biggest expense for investors. They have been dropping for a decade or more as sponsors have shifted to lower-cost passively managed index funds or even collective investment trusts, a lower-cost vehicle that isn't regulated by the SEC and is managed by a bank or trust company.

There is also a wide range of different share classes in mutual funds that have different costs. So-called R6 shares are stripped-down shares where investors are paying for the simple asset-management expense of the fund. Other share classes incorporate expenses paid to the asset manager, advisor and/or other service providers. These revenue-sharing arrangements are the least transparent to plan participants but can have a big impact on net returns.

The so-called 12b-1 fee can cover commissions paid to the broker who sells the product or fees to other service providers to the plan. The sub-transfer agency fee is another pound of flesh that covers services to a third party handling some aspect of plan administration. Some such fees get reimbursed to plan participants. Some don't.

These revenue-sharing arrangements are a favorite target of plaintiff lawyers and have become much less common in large plans, but they are still used by many smaller plans looking to cover plan expenses.

"Flat fees are becoming the most common way to pay for expenses," said Callan Associates' Lucas, who focuses on corporate plan sponsors. "It's taken a long time, but the use of revenue-sharing arrangements has recently begun to drop rapidly."

Understanding the individual fees in your 401(k) plan is not as important as determining whether the all-in cost of the plan is reasonable, given your circumstances. The best way to do that is to compare what you're paying with a peer group of similar-sized plans.

If you've determined that the costs of your plan are unreasonably high, talk to your employer … in a non-confrontational way. "The best thing participants can do is bring it up with their employer," said Meigs at the 401khelpcenter.com. "Play to their self-interest.

"More than likely, they have a lot of money invested in the plan, too."

— By Andew Osterland, special to CNBC.com