Disclosure Not the Only Issue with 401(k) Fees

Although clear and complete disclosure of fees and costs can help 401(k) plan sponsors ensure that plan fees are not unreasonable for participants, disclosure alone is not sufficient.

So assert researchers for the Center for Retirement Research at Boston College in a new Issue in Brief. The researchers conclude that the structure of fees commonly used in 401(k) plans tends to transfer wealth among participants and can reduce the returns that participants earn on their savings.

In reviewing the structure of 401(k) plans, the researchers found that most plans charge participants a fee that is expressed as a percent of their assets.

Although this expense ratio often varies by type of asset, reflecting differences in the cost of managing the funds, it is otherwise constant, according to the report. The researchers say charging fees in this way does not allow participants to weigh the benefits against the actual costs of their plans’ services.

In addition, the constant expense ratio transfers retirement wealth from accounts with higher balances to those with lower balances. The researchers point out that, other things equal, the fees collected from participants tend to be a constant proportion of the balances they hold in the plan, but some of the costs covered by these fees—administrative and sales costs, for example—are relatively constant for all participants, regardless of the size of their balances.

Participants with twice the balances of others do not necessarily incur twice the management cost, but they pay twice the management fee, which reduces the return credited to higher balance accounts and boosts that on lower balance accounts.

Sharing Costs with Non-plan Investors

The researchers also assert that investing 401(k) funds in pools of assets that include other investors can decouple fees and costs in a way that reduces the rate of return on 401(k) funds. All investors in a pool share proportionately the trading costs incurred in managing the pool’s assets, and if all investors traded their shares in the pool equally frequently and in amounts of nearly the same proportion to their balances, then shar¬ing the pool’s trading costs would be equitable, the researchers note.

However, when some of the pool’s investors trade more aggressively than others, the aggressive investors pay trading costs only in proportion to their average balances, not in proportion to their larger trading activity.

Therefore, according to the report, when 401(k) plans offer participants the opportunity to invest their money in funds or trusts that also include other investors who trade more actively, the participants sacrifice returns on their savings by subsidizing the trading costs of other investors.

The researchers note that while the Department of Labor is working on rules for fee disclosure, employers would benefit from more guidance.

“This guidance could encourage service providers to disclose the structure of their fees in more detail and to charge fees that correspond to the cost of services their participants use. It also could encourage plans to provide investments that do not expose participants to excessive trading costs and to the risk of subsidizing other investors who do not belong to the plans,” the report concludes.

The Issue in Brief is available