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401(k) Mutual Funds – Pay Attention to Share Class!

Eric Droblyen

January 13, 2023


Mutual fund companies usually make their funds available to 401(k) plans in multiple share classes. While all classes hold the same underlying securities, they can charge very different fees. In general, employers have a fiduciary responsibility to choose the lowest-priced share class available to their 401(k) plan – so participant investment returns aren’t reduced unnecessarily by avoidable fees.

To meet this fiduciary responsibility, employers must be capable of evaluating share class fee differences. This capability can often be obtained with some basic education. Further, these differences are usually obvious in a mutual fund’s prospectus.

Below are some mutual fund fee basics. If you’re an employer, you can use this information to help evaluate the fund share class(es) used by your 401(k) plan. I recommend you complete this process annually – because mutual fund companies can make periodic changes to their share classes.

Mutual fund fee basics

Mutual fund fees increase the cost of investing for 401(k) participants. They fall into one of two general categories – shareholder fees and operating expenses. Shareholder fees apply to individual investor transactions and account maintenance, while operating expenses cover regular and recurring fund expenses.

The good news? Mutual funds are obligated by law to disclose these fees in their prospectus. Further, mutual funds usually disclose this information for all share classes in a single prospectus. These factors make it easier for employers to evaluate share class fee differences.

Shareholder expenses can include:

  • Sales loads – are basically a commission. They are paid to a salesperson – usually a broker. There are two general types. A “front-end” sales load reduces the dollar amount available to purchase fund shares. A “back-end “(or “deferred”) sales load reduces the proceeds from a redemption (sale) of fund shares.
  • Redemption fees – are deducted from redemption proceeds like a deferred sales load, but they are paid to the fund company instead of the salesperson. The fee is intended to defray fund expenses related to share redemptions.
  • Purchase fees – reduce the amount available to purchase fund shares like a front-end sales load, but they are paid to the fund company instead of the salesperson. The fee is intended to defray fund expenses related to share purchases.
  • Exchange fees – are imposed by some funds when its shares are exchanged for the shares of another fund.
  • Account fees – are imposed by some funds when account falls below a minimum balance.

Operating expenses can include:

  • Management fees – are paid out of fund assets to the fund’s investment adviser for portfolio management.
  • Distribution and/or service 12b-1 fees – are paid out of fund assets for marketing and selling fund shares, such as compensating brokers and others who sell fund shares. "12b-1 fees" get their name from the SEC rule that authorizes a fund to pay them.
  • Other Expenses - are expenses not included in the other two categories. Examples include custodial expenses, legal expenses, accounting expenses, transfer agent expenses, and other administrative expenses.

High 401(k) Fees

Revenue sharing increases fund operating expenses

Revenue sharing is the practice of adding additional non-investment related fees to a mutual fund’s operating expenses. These additional fees are then paid out to various 401(k) plan service providers. There are two general forms:

  • 12b-1 fees – these payments are usually made to a broker. They increase “Distribution and/or service 12b-1 fees.”
  • Sub-Transfer Agency (sub-TA) fees – these payments are usually made to a 401(k) recordkeeper. They increase “Other Expenses.” Sub-TAs are estimated in fund prospectuses. To learn their actual amount, employers must reference their 408b-2 fee disclosure.

Revenue sharing is more common with actively-managed mutual funds than their passively-managed counterparts (i.e., index funds and ETFs). Funds that pay revenue sharing tend to be offered in the most share classes – which each class paying a different rate of revenue sharing.

How share classes affect investment returns

Two see how different share classes affect investment returns, check out the following two tables from the latest American Funds Growth Fund of America prospectus. The first table discloses the different fees charged by the fund’s share classes, while the second one discloses their investment returns over specific periods of time.

401(k) plans most commonly use one of the eight “R” share classes. While R-1 shares pay the most revenue sharing, R-6 shares pay none at all. Free from the drag of revenue sharing, the R-6 shares returned 1.27% more in average annual returns over the past 5 years! These additional earnings can really add up over time due to the power of compound interest.

Shareholder Fees

Average Annual Total Returns

Lower your 401(k) fees by understanding fund share classes!

To meet fiduciary standards, employers must ensure their 401(k) plan investments are “prudent” – basically, meet their investment objective (e.g., track the S&P 500 index) for reasonable fees. When the investments are mutual funds, an important step in this process is ensuring the lowest-cost share class is used.

This job can easily seem overwhelming, but it doesn’t need to be. Knowing how to evaluate share class differences is the key. This evaluation can usually be done easily using a fund prospectus.

Think your 401(k) plan qualifies for a lower-priced share class? Ask your 401(k) provider. Be sure to document the discussion. Even if you’re wrong, you can prove you met your fiduciary responsibility.

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