20 years ago, 401(k) plans were free. OK not really, but 401(k) providers used this lie a lot to sell 401(k) plans to small businesses that didn’t want to pay any out-of-pocket 401(k) fees. In truth, these plans paid “indirect” fees - like revenue sharing paid by mutual funds and/or wrap fees paid by insurance company variable annuities – to 401k providers based on a percentage of plan assets.
Ironically, many of these “free” 401(k) plans turned out to be very expensive, which has resulted in a groundswell of recent 401(k) fee lawsuits. These lawsuits have increased small business awareness of their fiduciary responsibility to keep their 401(k) plan fees reasonable. In growing numbers, they are demanding more transparent fees from their 401(k) provider to help make this job easier. Slowly, 401(k) providers are obliging them by replacing their indirect fees with easy to calculate “direct” fees, which are payable by the plan sponsor or participant account deduction.
However, even though the use of indirect 401(k) fees is declining, a problematic byproduct of them remains popular - asset-based fees for 401(k) administration services. These services include asset custody, participant recordkeeping and third-party administration. The problem with 401(k) providers charging asset-based administration fees is that plan assets have little to do with their level of service, meaning a 401(k) plan with lots of assets can pay way more than a 401(k) plan with fewer assets for the same 401(k) administration services. That’s not right and a potential source of liability for 401(k) fiduciaries with a responsibility to keep 401(k) fees reasonable.
Demonstrating the problem
Let’s compare two small business 401(k) plans and you tell me which company is getting the better deal.
Both companies have 50 employees and exactly the same plan provisions. Each company makes biweekly payroll contributions and each has the same plan terms. Same administration services right across the board.
- Company 1: Pays 0.78% (78 basis points) annually for administration services.
- Company 2: Pays 0.27% (27 basis points) annually for administration services.
Company 2 has the better deal, right? Wrong.
Company 1 has only $300,000 in assets and is paying a total of $2,340 for its administration services. Company 2 has $3 million in assets and is paying a total of $8,100 for its identical administration services. Company 2 is paying over three times more in actual dollars for the exact same service!
A better basis for 401(k) administration fees
The only 401(k) administration service that should scale with plan assets is asset custody. As such, only custody fees should be based on plan assets. This fee should be less than 0.10% of assets each year.
The fees for all other 401(k) administration services should be based on participant headcount. This basis is reasonable because 401(k) providers must work harder as a plan’s head count rises, processing more transactions (related to contributions, distributions, fund transfers) and completing more time-consuming ERISA compliance each year.
Make paying reasonable 401(k) administration fees easy
Small businesses have a fiduciary responsibility to pay only reasonable 401(k) fees. Like other fiduciary responsibilities, meeting this responsibility does not need to be difficult when fiduciaries keep things simple.
To do so, I recommend 401(k) fiduciaries only hire 401(k) administration providers that charge 100% direct fees and that limit their asset-based fees to asset custody. When this is done, 401(k) administration fees are simply evaluated and highly correlated to the value of provider services.