Financial Planning Blog

As an employee and participant of a 401K plan, you probably have not given much thought to the cost of administering and providing the plan. If you have, you likely have focused on the expense ratios of the mutual funds, unaware that other fees and costs may be siphoned from your account in a less-than-transparent fashion. There are significant differences in the costs associated with various 401K* plans, and it may well be worth the effort to take a close look at the retirement plan you are participating in.

Why is this important? Every dollar taken from your hard earned account contributions is a dollar not available for you when you retire. More significantly, it is a dollar that is not invested and earning a positive return, compounding over the years. The Government Accountability Office (GAO) has estimated that for every 1% increase in 401K fees and costs borne by the plan participants, there is a corresponding 17% drop in account balances after 20 years. (This assumes a lump sum, with no additions over the years. In the case of a constant amount invested over the years, the difference would be closer to about 12% after 20 years, and 20% after 30 years. Still this is a very big deal--especially if it is your retirement account.)

What are the costs and fees associated with your 401K plan? First of all, there are the basic costs to provide the plan. These expenses, which run into the thousands of dollars even for small plans, include:

• Administration: Generally there is a third party administrator (TPA) whose job it is to ensure the plan is in compliance with ERISA requirements. For example, making sure each participant stays within contribution limits, required documents are completed and filed with the government, and the plan as a whole remains compliant with complicated ERISA rules to ensure fairness for all employees.
• Recordkeeping: The record keeper tracks the plan participants and their individual account balances.
• Custodian: The custodian holds the plan investments, making sure they are kept separate from the employers' funds, and protected from the employers creditors.
• Investment advisor to the plan: This is the person or firm that assists the plan by selecting and monitoring the investment selections. The advisor often provides education or individual advice to plan participants.
• Other: These may include legal and audit fees, plan communications and education.

Then there are the costs associated with plan investments:

• The mutual fund expense ratio: These are the investment costs most familiar to 401K plan participants, and are usually disclosed in some manner. These costs are explained in more detail in "The Mutual Fund Expenses You Can See", and include the investment management costs associated with the mutual fund. However, the mutual fund expense ratio can have a whole lot else dumped into them-especially in 401K plans.
• Sales loads: Believe it or not, but participants in some 401K plans pay an up-front sales load to purchase mutual funds. In other words, they pay an up-front charge of 1-5% or so, just to buy into the fund.
• Annuity or insurance wrapper: If you are unfortunate enough to have a 401K plan administered by an insurance company, your investments may be "wrapped" in a group annuity. I'm not sure what the potential value of this added level of complexity is, but it adds another layer of costs.
• Mutual fund trading and transaction costs: These are the incurred by the investment managers as they buy and sell investments in the plan. These costs are hard to track and quantify, but with some actively managed funds they can be even more significant than the costs revealed in the expense ratio. These will not be disclosed as a separate expense anywhere, but they will eat at the value of your account, nonetheless. For more about these, check out "The Hidden Costs of Mutual Fund Investing."

Who pays all these costs, and how can you find out what they are? If you are fortunate, the cost to administer the plan is paid by your employer directly. This demonstrates that your employer is serious about providing an effective vehicle for participants to save for retirement. However for many plans, especially smaller ones, all of plan the costs are borne by the participants. The administrative costs and investment advisor fees may be directly deducted from your account in the form of reduced net returns. You likely won't see this itemized in any way--that would be transparent, and would only invite questions. You may also pay these fees in the form of bloated mutual fund expense ratios. If you are seeing expense ratios averaging close to 1.5% (and often more than 2%), it's a good bet a sizeable portion of those expenses are being rebated back in some fashion to pay third party administrators, record keepers, and the investment advisor. However, you will have a tough time determining what is really going on.

In a 2009 survey of 130 401K plans, Deloitte found the "all-in" fees associated with 401K plans differed significantly. (This "all-in" fee would include everything mentioned above, except for the mutual fund trading and transaction costs.) It should be no surprise that larger companies, with the ability to spread the fixed costs associated with administering a plan and negotiate lower fees, have much lower costs than small company plans on average. For example, plans with less than 100 employees and/or $1M in assets averaged "all-in" costs of >2% of assets. The largest plans-those with 10,000 or more employees and/or combined assets of >$500M, averaged "all-in" costs between .4 and .5% of assets. You can see that a difference of 1%, 2%, or even more between 401K plans is entirely feasible.

There has been much talk in Congress about making 401K fees more transparent. Maybe something will happen someday. In the meantime, people are waking up to the issue. One place to go to benchmark how good your company 401K plan is relative to others is BrightScope. This company rates over 30,000 different plans, and the BrightScope website is a good resource for participants or employers looking to improve their plans. 

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*Although there are differences between 401K plans and 403b or 457 plans, much of what is discussed is common among all of these employer provided retirement plans.