Cost matters a lot when saving for retirement. When paid from plan assets, 401(k) fees reduce the investment returns of plan participants dollar-for-dollar. Over decades, these losses can cost a participant hundreds of thousands in lost principal and compound interest. Given the stakes, employers have a fiduciary responsibility to pay only “reasonable” 401(k) fees. When this responsibility is not met, business owners can be held personally responsible for restoring excessive 401(k) fees paid from plan assets.
And yet, according to a 2018 survey by The Pew Charitable Trusts, only 19% of small to midsize employers claimed to “very familiar” with the fees paid by their 401(k) plan, while 34% were “not at all familiar.” The remaining 47% said they were only “somewhat familiar.”
The reason for so much confusion? A safe bet is the hidden fees charged by many 401(k) providers.
To help employers protect the savings of their 401(k) plan participants, I think all 401(k) fees should be straightforward. Hidden 401(k) fees do not remotely fit that bill. Here are five reasons why I think they should be illegal.
Background on Hidden 401(k) Fees
There is no such thing as a free 401(k) plan. All 401(k) providers charge fees for delivering plan administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and investment advice. When these fees aren’t paid by the employer, they are paid from plan assets. When paid from plan assets, 401(k) administration fees can be direct or indirect in nature. The major difference is who pays them.
Indirect fees are called “hidden” 401(k) fees because they lack the transparency of direct fees. While the dollar amount of direct fees must be explicitly disclosed in 408b-2 and 404a-5 fee disclosures, Form 5500s, and participant statements, indirect fees can be estimated in 408b-2 fee disclosures, buried in the fund expenses of 404a-5 disclosures, and not appear at all in Form 5500s or participant statements. The most common forms of hidden 401(k) fees are revenue sharing and wrap charges.
Here are five reasons why hidden fees make it harder for employers to protect the interests of their 401(k) plan participants than direct fees.
Reason #1 – Hidden 401(k) Fees Can Be Impossible to Total
All 401(k) administration fees paid plan assets – regardless of their direct or indirect nature – reduce the account returns of plan participants dollar-for-dollar. That’s why employers have a fiduciary responsibility to limit their total to a “reasonable” amount.
Due to their lack of transparency, indirect fees can be impossible for employers to total correctly.
Reason #2 – Hidden 401(k) Fees Can Outstretch Services Rendered
401(k) providers typically charge hidden fees based on a percentage of assets. That’s a problem because a 401(k) provider’s level of service generally scales with employee headcount, not assets. This disconnect can result in a 401(k) plan with lots of assets paying much higher fees than a comparable plan with fewer assets for the same level of service. That’s not fair and a potential source of 401(k) fiduciary liability.
The only 401(k) administration service that should scale with plan assets is asset custody. As such, only custody fees should be based on a percentage of assets. Fees for other 401(k) administration services should be based on employee headcount. Only direct fees can be structured to accommodate this bifurcation.
Reason #3 – Hidden 401(k) Fees Can Limit Access to “Prudent” Investments
Imprudent investment selection is one of the top three reasons why 401(k) fiduciaries are sued today. While ERISA does not define a “prudent” investment, I think it’s safe to consider a cost-efficient investment – basically, a fund that meets its investment objective for reasonable fees – to be prudent. I’ve never seen an index fund from leading providers such as Vanguard, Fidelity, or Schwab fail ever fail to fit this bill. All deliver market-correlated returns for very low fees. They also tend to outperform comparable active funds over time, net of fees.
However, leading index funds pay no revenue sharing. That means 401(k) provider can boost their profit by offering alternative investments that do.
Reason #4 – Hidden 401(k) Fees Are Often Inequitable
ERISA is generally silent about the acceptable method(s) for allocating 401(k) administration fees among plan participants – it only says a plan’s allocation method used must be “reasonable.” Reasonable usually means a pro-rata or per capita formula.
If a 401(k) plan includes mutual funds that pay a different rate of revenue sharing, the participants invested in the higher-rate funds will pay a disproportionate share of their plan’s administration fees.
Reason #5 – Hidden 401(k) Fees Can’t Be Paid by Employers
In a recent study, we found about 80% of our small business clients pay 100% of our 401(k) administration fees from a corporate bank account, not plan assets. This approach is popular because it can be a win-win for plan participants and business owners. Participant returns will be higher, while business owners can lower their taxes, increase their personal 401(k) returns, and improve their plan’s attractiveness to employees.
Hidden 401(k) fees don’t give employers this opportunity because they are baked into the operating expenses of plan investments.
401(k) Plans that Pay Hidden Fees Cost More!
According to our most recent 401(k) fee study, six of the top ten highest-priced 401(k) providers also ranked in the top ten based on their % of hidden fees. The lesson – 401(k) plans that pay hidden fees cost participants more.
This finding should surprise no one. Asset-based hidden fees can explode unnoticed as plan assets grow. They should be illegal.