‘Zero-Fee’ IRAs Contain Many Hidden Costs

“Zero-fee” does not necessarily equate to lacking costs, according to a new PensionBee Inc. white paper, “The True Cost of Zero.”

Some providers of zero-fee individual retirement accounts may make structural changes that “can continue eroding wealth benefits beneath the surface,” the paper stated. Modeled on a $107,000 account balance, participants with zero-fee accounts could be charged more than $1,400 per year, based on an estimate of 1.3 basis points in structural and operational expenses. PensionBee, which charges a monthly fee for its IRAs, found in its report that even under low-cost assumptions, participants with zero-fee accounts would accrue costs between 0.16 and 0.32 bps, totaling between $160 and $340 per year.

The six “hidden ways” that zero-fee IRA platforms make their money, according to Pension Bee, are: cash sweep spreads; securities lending revenue; payments for order flows; fund building blocks; administrative and service charges; and advisory charges disclosed in “fine print.”

Cash Sweep Spreads 

In zero-fee IRAs, idle cash often gets parked in low-yield accounts while the platform profits from the yield, the paper stated. IRAs are “particularly vulnerable,” PensionBee wrote, with nearly 30% remaining in cash for at least seven years following a rollover, according to research from Vanguard.

The analysis found that providers generally employ one or two models: bank deposit or money market sweeps. Providers that invested customer cash into bank deposit accounts retained the spread between the rate paid by the bank and what was passed on to participants. Meanwhile, providers who leaned on the money market approach invested participants’ cash into in-house money market funds, from which the platform earned a management fee of approximately 0.42 bps on the swept balance.

PensionBee’s analysis found that because money market funds return higher yields than bank deposits, the model is comparatively more favorable toward savers. However, providers have trended toward offering bank deposit sweeps, allowing providers to retain more profits.

Romi Savova, PensionBee’s founder and CEO, says plan sponsors should be aware of cash sweep spreads for the sake of selecting IRA providers within their own businesses, such as when conducting mergers and acquisitions.

“The cash sweep spread is one [fee] we think is really prevalent with automatic rollovers,” Savova says. “We’ve seen cash spreads upwards of 3.5%, which is a hidden fee that the plan sponsor might not be aware of.”

To get past cash sweep spreads, participants can ensure they are invested in products in which they “reap most of the return,” the paper stated. Participants can also ensure their cash is intentionally invested, especially in the instance of an IRA rollover in which they may leave cash unintentionally uninvested.

Securities Lending Revenue

In addition, zero-fee accounts often loan securities to institutional short-sellers, who pay a fee to borrow. While account holders take on the risk, the platforms typically retain most of the profits, the paper stated. 

While the structure of the arrangement varies by product type, within the IRA itself, some plans offer opt-in lending programs in which economics are disclosed, but heavily weighted toward the provider, the paper stated. One such arrangement includes retaining 85% of net lending fees, with the remaining 15% paid to the customer.

PensionBee’s paper suggested participants should understand security lending before contributing to an account that engages in it and should try to optimize their returns from it. 

Savova says plan sponsors should always ask whether security lending applies to the investment products they offer their participants.

Payments for Order Flow

The paper noted that providers also make money by routing trades through a third party, which pays the platform broker for information on the order flow and profits from resulting trading opportunities.

“That middleman can make money by either filling the trade at a slightly worse price than the market offers, pocketing the difference, or matching the trade against orders from its other customers, taking the bid-offer spread,” the paper stated. “In either case, the platform profits, but the customer may end up with a slightly worse deal.”

The paper acknowledged that while payment for order flow can be difficult to control, participants may be able to reduce it by choosing liquid, high-volume funds and trading them less frequently. Each trade is a separate PFOF event, so a low cost per trade, combined with fewer trades, should yield better results than a high cost per trade combined with many trades.

Payment for order flows are “very covert practices,” Savova says, adding that employers can educate their participants on the risks of them.

Fund-Building Blocks

Moreover, the difference in the expense ratio between an active and passive version of the same fund can be significant, but a participant may not intend to pay, or benefit from paying, one or the other, the paper stated. Making an active selection within a “zero-fee” IRA could raise the cost by as much as 0.87 basis points annually, based on PensionBee’s analysis.

The paper acknowledged that although actively traded funds may be appropriate and beneficial for some participants, especially those with a shorter horizon and a need for more risk management or further diversification, customers often do not know the difference and may benefit equally from a passive fund. Participants with a long time horizon may be better suited for low-cost passive funds.

If choosing a more version of a fund, participants should ensure they understand the benefits and risks and how those align with participant objectives, the paper stated.

Administrative, Service Charges 

Lacking platform fees does not necessarily mean participants do not pay other fixed fees or a wider layer of charges that can attach to an account depending on how a participant uses it, the paper stated. Some examples provided by PensionBee included participants trading outside of core index-tracking building blocks, requesting a wire transfer, moving funds or processing a foreign exchange conversion.

To minimize transaction fees, participants should read fine print to see if they exist, the paper stated. Specifically, participants can watch for per-trade commissions on options, bonds, certificates of deposit and wire transfer fees; costs on moving assets between institutions; and balance thresholds that trigger advisory fees.

Fine Print

The sixth and final hidden fee concerns zero-fee accounts advertised alongside traditional advisory options, the paper stated. In some instances, advisory charges—disclosed in the fine print—apply once the balance surpasses a certain threshold. For instance, some platforms charge an annual advisory fee ranging between 0.25 and 0.27 bps for “zero-fee” accounts worth more than a certain threshold, which is only disclosed in fine print.

“Traditional providers and digital-first platforms alike will extract substantial revenue from mechanisms that most savers will never identify, let alone quantify,” the paper stated. “Cash sweep spreads, securities lending fee retention and PFOF together represent a systematic and largely invisible transfer of wealth from savers to platforms.”