The Tyranny of 401(k) Fees 

"The people walking in darkness have seen a great light."

- The Prophet Isaiah - sometime around the 8th Century B.C.

Defining a Pandemic Problem

Pandemic? Yes. Walking in darkness? Yes. Tyranny? Yes. These words aren’t too harsh or hyperbolic to describe what the fee structure of the retirement plan industry has become. Finally, the reality is garnering recognition through media coverage and increased regulatory scrutiny. Bottom line: if you’re a plan sponsor hoping to benefit your employees in a reasonable, cost-effective manner, or a plan participant simply hoping to maximize tax-deferred savings, then there’s a good chance your goals are being undermined by the tyranny of industry fees. We see the “fee problem” as five-fold.

Problem # 1: Fees are unknown.

Neither sponsors nor participants are experts when it comes to 401(k) and equivalent vehicles and the intricacies of the industry. Thus, it’s no surprise they simply don’t understand all the types of fees and the means of paying those fees. For example, we recently provided one plan sponsor an estimate of our flat consulting fee along with projections of total plan cost savings we could help them achieve. The response: “How could you possibly save us more than we’re currently paying?!” Such a reaction indicates the obvious failure to understand how much the plan was costing participants. The line items for “plan expenses” on financial statements or form 5500’s are often just the beginning of the costs. Specifically, revenue sharing practices commonly contribute to hidden fee structures. There also might be annuity products with wrap fee structures, a TPA platform receiving partner payments, and the list could go on and on. We won’t dive into all the specifics here. Suffice it to say every plan is different. Plans get nipped at by fees on multiple layers driven by a lack of transparency, which often necessitates an experienced professional to assess the real damage in total costs to a plan.

Problem # 2: Fees are unfairly Large.

When fee structures are unknown or misunderstood, they have a strange tendency to grow unfairly large—imagine that. In the 401(k) space, we believe cost structure is bloated on multiple levels. For the sake of brevity, here are just two.

(1) Fund-level costs can be unfairly assessed by including unnecessarily expensive share classes in plans to provide sufficient “revenue sharing” for multiple vendors, or simply because funds advertise themselves as deserving higher costs for superior active management. This graphic from Morningstar shows the success rates of actively managed funds across several recent one-year periods. Success is defined across fund styles by beating the returns of a passive equivalent. For instance, for the twelve months ending June 2016, only 14.1% of actively-managed U.S. Large Value funds beat their passive equivalents on a net basis. To be fair, the active vs. passive debate is a complex one, and looking at one-year returns doesn’t tell the whole story. Nonetheless, the industry is still filled with countless actively-managed mutual funds that consistently fail to beat their benchmarks across multiple time horizons.

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(2) Additionally, the asset-based fees charged by advisors contribute to a plan’s bloated cost structure. We believe flat fees are simply more transparent and more appropriate in retirement plan management. Consider a hypothetical company’s plan of $6M. It’s conceivable that over just a few years of the recent bull market, from both business/employee growth and market appreciation, the plan may have doubled in size to $12M. An advisor charging a fee based on percentage of assets will have doubled their revenue. While it may be legitimate to suggest larger plans deserve higher fees for increased fiduciary liability, the workload largely remains the same. In fact, the nature of a retirement plan consultant’s work is heaviest at the beginning of a sponsor relationship—when initial plan design, investment menu, and vendor relationship decisions must be made. This isn’t the hedge fund or day-trading world. Plan advisors are juggling ongoing administrative duties which don’t fluctuate with the asset base. The goal relative to the investment menu is to make sound, cost-effective decisions at the outset and monitor going forward, ideally making seldom changes. Few industries we know of can justify higher fees when the workload remains static and/or declines.

Problem # 3: Fees are often riddled with conflicts.

From revenue sharing deals between recordkeepers and advisors (thankfully, finally a dying practice) to advisors hosting elaborate “marketing events” for their clients on the dime of fund management firms, the industry is riddled with conflicts of interest. Such costly conflicts can easily limit the investable universe and breadth of vendors available for plans to choose from. More on this in subsequent articles.

Problem # 4: Fees create legal risks.

ERISA requires that expenses be reasonable. When fees are unknown, unfairly high, conflicted, or any combination of the three, they create fiduciary risk for a plan sponsor who must justify that the plan expenses are reasonable. Many industry experts note the growing trends in such risk, which is often attributed to misaligned or conflicted fee structures.

Problem # 5: Fees lead to exorbitant opportunity costs.

Perhaps the greatest tragedy of the 401(k) “fee problem” is the loss of would-be savings and investment gains in the accounts of hardworking participants, for whom the whole tax-deferred offering is designed to benefit.

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For example, let’s say a retirement plan of $10M in assets costs 1.5% annually to run in total. Assuming a 6% annual return and no additional contributions (just for simplicity sake), the plan would grow to $15.5M and $24.1M in 10 and 20 years, respectively. If costs were reduced to .75% of total assets (about $75K/year), the plan would grow by an additional $1.2M or $3.7M in those same time horizons. Over 20 years, that’s an incredible 15% of total plan assets transferred directly out of the pockets of industry players, and into the accounts of retirement savers. In speaking of the aggregate potential effect on the industry (estimated at $20B over four years), Jack Bogle the founder of Vanguard, said “By any measure, that’s a social good.” And if you think $75K or .75% of costs savings is difficult or impossible for a plan of $10M, oh think again my friend. That’s why we call it a tyranny—because it’s an unjust rule over retirement plan sponsors and participants. It’s high time we step into the light together, and save more responsibly and efficiently for our futures.

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