401(k) Expense Recapture

The recent focus on fees and expenses is causing many employers to closely examine the fees and expenses of their plans. As a result, some employers have been able to negotiate reduced fees.

Generally, a plan has three major categories of expenses. Those are:

• Investments.
• Recordkeeping and compliance.
• Advice, including investment adviser fees and broker’s commissions.

For investments, high fees tend to fall into two categories. The first is that the expense ratio of one or more of the mutual funds is excessive. That can easily happen as a plan grows in size. For example, one share class may be appropriate for a small plan, but as the plan grows, a lower-priced share class may be proper. Obviously, plan sponsors, or their advisers, need to be attentive to that issue or their 401(k) plans could inadvertently be paying excessive fees. The second common area of excessive investment fees involves so-called “wrap” fees. While wrap fees are not per se inappropriate or overly expensive, they can be and, in our experience, they sometimes are. For example, we have seen cases where the total annual fees in a group annuity contract are 3% per year, or more. To properly evaluate these fees, the first step for a plan sponsor is to know the total annual fees. The second is to obtain information on the charges for similar plans (e.g., plans with similar assets and numbers of participants) . . . the competitive marketplace does a good job of establishing reasonable prices. Those two steps are rudimentary; a more sophisticated analysis can be done with expert advice.

With regard to fees and commissions for advice, when plan sponsors are writing checks for the advice, the cost is usually reasonable. However, where the fees or commissions are embedded in the investment products (and particularly where they are difficult to find and calculate), many plan sponsors do not know what they are paying. In those cases, plans often pay too much for the services they are receiving—thereby hurting their participants. Further, as a plan grows, the fees and commissions should become increasingly smaller as a percent of the assets. That is because the services required to operate a plan do not tend to grow proportionately with the assets. However, many advisers base their fees and commissions on a percentage of the assets in the plan, which is appropriate to a point, but which thereafter can be overly expensive. In those cases, lower fees and commissions can be negotiated either directly with the adviser or through the use of share classes that pay less compensation and, as a result, are less expensive to the plan and the participants.

With regard to the plan provider/recordkeeper, those expenses are usually either fixed or vary based on the number of participants, or both. In other words, the expenses are not based on the assets in the plan. However, plan providers are often—perhaps almost universally—the recipients of payments, such as 12b-1 fees, subtransfer agency fees and/or shareholder servicing fees—which are based on a percentage of assets. Since part or all of the revenue is based on a percentage of assets, but the costs are not, it is just a matter of time before a plan grows large enough that it is overpaying. Unfortunately, it is difficult for plan sponsors to know the true costs of recordkeeping. Nonetheless, plan sponsors should—and can—with the help of an adviser who specializes in 401(k) plans. In those cases, once a provider has recouped its operating costs, plus a reasonable profit, the balance of the revenue sharing should be restored to the plan. When the balance is restored, it is often done as a cash payment into the plan, which is sometimes called an “ERISA budget account” or an “expense recapture account.” That money is then available to pay other expenses of the plan or to be allocated to the participants. Either way, it ultimately improves the benefits for the participants. That is the fiduciary’s job.