Would you buy a product if you didn’t know its cost? I doubt it. What if overpaying for that product could lead to serious consequences like being sued or postponing retirement? I know you’re not buying then. And yet, I see business owners do something similar all the time. They’ll hire a 401(k) provider without fully understanding their fees. Even when they know that paying excessive 401(k) fees could get them sued or force plan participants - including themselves - to work longer than necessary to afford retirement.
If you’re a business owner, you must know how much your 401(k) plan costs because the consequences for paying excessive fees can be steep. Excessive fees reduce 401(k) investment returns unnecessarily – which could dramatically reduce plan participant account balances over time due to the power of compound interest. If this happens, you could be personally liable as a plan fiduciary for restoring participant losses.
Not sure how much your 401(k) plan costs? Below are three warning signs your 401(k) provider might be ripping you off.
Your 401(k) plan is “free”
There is no such thing as a free 401(k) plan. This may sound obvious, but I see business owners fall for this claim by some 401(k) providers all the time. In truth, a “free” 401(k) provider is paid “indirect” fees by plan investments.
Indirect fees increase fund expense ratios, so they reduce investor returns. They’re usually based on a percentage of assets. Because 401(k) providers are not obligated to disclose their dollar amount in plan fee disclosures or participant benefit statements, indirect fees are commonly considered hidden 401(k) fees. There are two basic types:
- Revenue sharing - Some mutual fund companies pay the 401(k) providers that use their funds. These payments are called revenue sharing. The two most common types are 12b-1 fees and Sub-Transfer Agency fees (Sub-TA fees).
- Wrap fees – Variable annuities are basically mutual funds “wrapped” in a thin layer of insurance. The wrap allows insurance companies to add a fee to plan investments. A wrap fee can turn a low-cost index fund into a pricey variable annuity.
I’m not going to lie, it’s generally tough to total indirect fees. That’s why I recommend you avoid them altogether. Doing so is easier to do than ever because a growing number of 401(k) providers now charge “direct” fees – which can be paid from a corporate bank account or allocated among plan participants – only.
You must pick from a “preferred” list of funds
It’s common practice for 401(k) providers to limit your investment options to a shortlist of “preferred” funds. Because there are thousands of investment funds available to 401(k) plans today, this limitation can seem like a godsend. However, the funds on these lists are rarely the best – they’re simply the funds that pay a sufficient amount of revenue sharing to the 401(k) provider.
Many of today’s top-performing funds pay no revenue sharing at all – including low-cost index funds and ETFs from Vanguard, Blackrock, Fidelity and Schwab. If your provider does not make these funds available, there is a good chance they are prioritizing their profit ahead of your investment returns.
Your administration fees are mostly asset-based
401(k) plan administration services include asset custody, participant record-keeping, and Third-Party Administration (TPA). Many 401(k) providers charge asset-based fees for these services. The problem? Except for asset custody, the level of administration services delivered by a 401(k) provider scales with employee headcount – not assets. If asset-based 401(k) administration fees outstretch their provider’s level of service, excessive fees are the result.
If your plan pays indirect fees, you’re almost certainly paying asset-based administration fees because revenue sharing and wrap payments are usually based on a percentage of assets.
To most easily avoid excessive 401(k) fees, I recommend you keep asset-based administration fees to a minimum – no more than 0.10% of assets to cover asset custody.
Getting ripped off? Switch 401(k) providers!
In my experience, 401(k) fiduciary responsibilities are easy to meet with some basic education and guidance from a qualified 401(k) provider. They are generally common sense and a qualified 401(k) provider will do most of the heavy lifting in meeting your administration-related responsibilities. That said, one of the most important responsibilities – avoiding excessive 401(k) fees – is impossible to meet when you don’t know the full cost of your plan.
Worried your 401(k) plan is being ripped off? Look for the warning signs. If you see them, there is a good chance you are – or will be as plan assets grow. If you find yourself in that boat, I have a simple recommendation - replace your 401(k) provider with one that charges 100% direct fees that match their level of service.