A very faithful reader emailed me a question this week that I thought was worth addressing in the column.
The question was, “Who pays the costs for my 401(k)? I know nothing is free but I can’t tell how much it costs and who is paying those costs.”
This is a great question, and it addresses a common misnomer. Yes, it’s true, 401(k) plans are not free. Every plan has administrative costs, custody costs and internal investment management expenses. Some plans also have investment advisory costs and education and consulting fees.
Administrative costs involve annual plan filings mandated by the government, called the Form 5500. They also involve the allocation of contributions into participant (employee) accounts, the processing of withdrawals and loans, the maintenance of online access websites and production of participant and sponsor (employer) statements. Administrative services may also include certain types of “testing” to make sure the plan stays in compliance with some of the complicated rules regarding 401(k)s.
In the most common and, in my opinion appropriate, cost structure these expenses are paid by invoice sent to the employer. In my experience, for a small business plan of under 100 employees these invoiced expenses can commonly range for $2,000 to $5,000 dollars a year. Sometimes a plan will have a per participant annual custody charge as well, which I have observed is typically in the $25 range. These per person charges are sometimes charged to each participant individually, but they can also be invoiced to the employer, depending on what the employer chooses.
Another level of cost associated with every 401(k) plan is investment management expenses that are internal to the funds available to the plan. While these expenses are not always transparent, they are definitely present and will vary depending on what investment options are made available and what investment options are selected by the participant.
These internal expenses are expressed as a percentage of the assets in a fund and in my experience can range from around 0.1 percent for low cost index funds, to around 1 percent for higher cost actively managed or international funds.
These expenses are not paid by the employer, and are borne by the funds themselves, so any actual investment returns are always net of these expenses. These expenses are always internal and always assessed to the actual participant or investor. These expenses can be discerned by reading the fund's prospectus or by looking up the fund's name or ticker symbol online.
Some plans may also utilize an investment adviser or consultant to advise the employer (sponsor) on choosing investments for the plan, help educate participants on how to use the plan, and to monitor investment performance and administrative fees in the plan. The adviser or consultant may also keep track of how well the plan is meeting the needs and goals of its participants and review these metrics annually with the sponsor.
These expenses can either be invoiced to the employer, or can be assessed as an additional charge against participant accounts. In my experience these costs can range from 0.1 percent to 0.4 percent of plan assets, but unfortunately in some older or poorly priced plans these expenses can be higher.
The government has required steps to make the costs associated with 401(k)s more transparent, and in my opinion the costs of these plans have come down nicely in the past few years.
Because of this, it’s a good idea to review some older plans, especially those for smaller employers, to make sure costs are optimized. And because these plans are so important to all parties involved, each plan should be reviewed annually to ensure that it is doing its job, and doing so in an efficient cost structure.