401(k) providers can charge “direct” and/or “indirect” fees for delivering plan administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and professional investment advice. The difference between the fees is how they are paid. Direct fees can be paid by the plan sponsor or deducted from participant accounts, while indirect fees increase the cost of plan investments – reducing their returns. If you’re a business owner, I strongly recommend you avoid indirect fees for two reasons – 1) they lack the transparency of direct fees – which makes excessive 401(k) fees harder to avoid and 2) they could limit your access to top 401(k) investments - which often pay no indirect fees.
However, steering clear of indirect fees – often maligned as “hidden” 401(k) fees due to their lack of transparency – can be easier said than done because there are so many different types. Here are the most common and how to uncover them.
Revenue sharing is the practice of adding non-investment related fees to the operating expenses of a mutual fund. Fund companies then pay these additional fees to 401(k) service providers in return for plan administration services. Revenue sharing increases the cost of 401(k) investments – which lowers participant returns. There are two general forms:
- 12b-1 fees – usually paid to a broker or insurance agent.
- Sub-Transfer Agency (sub-TA) fees – usually paid to a 401(k) recordkeeper.
In general, revenue sharing is more common with actively-managed mutual funds than passively-managed funds (i.e., index funds and ETFs). If your 401(k) investments pay revenue sharing, you can find its formula – but not its amount - in in your 401(k) provider’s 408b-2 fee disclosure.
Variable Annuity “Wrap” Fees
If you’re 401(k) provider is an insurance company, there is a very good chance your plan investments are variable annuities. A variable annuity is basically a mutual fund that’s owned by an insurance company and “wrapped” by an annuity contract.
Do variable annuities offer advantages over mutual funds in a 401(k) plan? Not really. They do, however, allow insurance companies to add a “wrap fee” – which can include administration fees, sales commissions, and surrender charges – to mutual funds. Insurance companies can add a wrap fee any mutual fund – including index funds.
If your 401(k) investments pay a wrap fee, you can find its formula – but not its amount - in your 401(k) provider’s 408b-2 fee disclosure.
Mutual fund companies often make their funds available to 401(k) plans in multiple share classes. While all share classes hold the same underlying securities, they can pay dramatically different indirect fees – including none at all. While 12b-1 and sub-TA fees are the most common forms, a “load” – a form of sales commission – is also possible.
There are two basic types - a front-end load and a back-end load. A front-end load is paid to the fund’s salesperson when shares are bought, while a back-end load - also known as a contingent deferred sales charge – is paid when shares are sold. The most common load-paying share classes are A, B, and C shares:
- A shares – Front-end load applies, but no back-end load.
- B shares – No front-end load, but a back-end load applies.
- C shares – No front-end load. Smaller back-end load than B shares, but an annual 12b-1 fee applies.
If your 401(k) investments pay a load, you can find its formula – but not its amount – in your 401(k) provider’s 408b-2 fee disclosure. You can also find the formula in the “comparative chart” section of participant fee disclosures.
Lower Your 401(k) Fees by Making Them More Transparent!
There is a lot of merit to the old saying “sunshine is the best disinfectant” when it comes to 401(k) fees. In my experience, 401(k) providers with the least transparent fees charge the most. In our 2018 small business 401(k) fee study, we found that insurance companies – which generally charge the highest percentage of indirect fees - charged the highest total fees.
The ONLY reason indirect fees exist today is to enrich 401(k) providers and mutual fund companies. They make it easier for 401(k) providers to overcharge for plan administration services and for fund companies to incentivize the use of their 401(k) investments. To avoid these conflicts-of-interest, I recommend business owners only pay direct 401(k) administration fees.