Who pays? That simple question is becoming an explosive one for participants in 401(k) programs.
As the plan sponsor listens to sales people, he or she hears a lot of talk about one-stop shopping - the "packaged" or "bundled" plans from major mutual funds, banks, brokerage houses and insurance companies. Package deals initially are very appealing to the decision-maker, especially as the vendor talks cheerfully about lower administration costs from economies of scale.
In short, the plan sponsor saves administration fees, while participants receive a comprehensive investment package.
But there's a rule of thumb to apply while estimating these costs. A typical bundled, one-stop-shopping approach to investments and administration will, at a minimum, increase employees' cost by 56 times for every 25% reduction in the plan sponsor's administration fees.
Many 401(k) vendors are subsidizing the administration costs of their plans through hidden charges - even though these investments are described as being no-load to the participant. Often, however, the "no-load" label is simply not true.
In a small company, especially, major portions of the 401(k) plan are in accounts of the owners and key management employees. Administration expenses that could have been deductible if paid as a corporate expense are unwittingly paid with non-deductible dollars when pension money is tapped for these expenses.
For a small company's employees, expenses paid by the plan can lead to catastrophic opportunity costs. In some cases they chew up as much as one-third of what would have been the amount of money at retirement.
Worse yet, employees are paying with money that is not only deductible, but also could otherwise have been compounding tax free. In short, these participants are about to discover that, because of the inefficient structure of their 401(k) plan, the wonder of compound interest is working against them.
Some companies in the mutual fund industry, for example, have adopted the practice of charging 12b-1 fees, which also are known as "contingent deferred sales charges" or "distribution fees." It may be true that no sales commission is taken out of contributions to the plan; however, the participants are charged 1% per year of their total account balance. That's over and above the 1% management fee that most mutual funds routinely charge to cover the costs of managing the money and keeping track of the account. This extra 1% is extremely expensive over time, because it is charged on all money, including earnings, each year.
For the average executive contributing, say, $10,000 per year for the next 10 years, that 1% will cost $12,000 in earnings (assuming an average investment return of 10% per annum). In 20 years, these added charges will reduce the participant's account by $90,000.
For a plan as a whole, a smarter decision-maker will take the time to determine that, over 10 years, the 1% annual fee will place huge opportunity costs on participants. For example, take a small plan that receives in total, say, $250,000 each year in contributions from all participants. Those contributions over 10 years will compounded at, say, a 10% investment return a year. But a 1% annual fee on those contributions will, simply put, reduce the compound annual return to 9% a year, amounting to a $300,000 opportunity loss to participants over the 10 years. In return for this $300,000 paid by employees, the employer may have reduced administration costs by only $20,000 over the 10 years, or about $2,000 a year.
To express this imbalance in even more dramatic terms, given the geometric effects of compounding, over 20 years the employees will have given up $2.25 million in earnings, while the plan sponsor will have saved only $40,000. To say the least, this is not a responsible decision, but otherwise sophisticated managers are selecting this alternative without doing some elementary calculations or asking their 401(k) vendor some tough questions. Further stinging the participant, the plan sponsor's costs are tax deductible to the corporation, meaning Uncle Sam subsidizes part of it. But no one subsidizes the $2.25 million opportunity costs to participants.
Some vendors in the insurance industry are as bad. Their 401(k) plans are wrapped in an annuity contract so that they can be sold by agents with insurance licenses across the country. While some of the programs offer no-load mutual funds as part of the package, the actual investment includes the cost of the annuity packaging fee - which is typically 1.5% a year. This means a cost to the participant that is even higher than the mutual fund "hidden" load. Again assuming a 10% average per annum return, this fee would cost the $10,000-a-year contributor about $15,000 of lost earnings in 10 years and about $108,000 in 20 years.
The message for 401(k) decision-makers is clear. Use pure no-load funds and pay the costs of administration as a deductible corporate expense. Everybody benefits, especially decision-makers themselves as participants. Anything short of this is a disservice to the employee participants whose voluntary contributions deserve the best possible plan you can provide.
Remember, there is nothing magic about billing employees for all or a portion of the cost of a 401(k) plan. You are free to do this at any time. In the long run, it is better to be honest and upfront with employees than to subject them to a plan that has hidden commission charges, packaging fees, or both. The extra 1% may cost a plan participant one-third of what otherwise would have been in his or her retirement account. You owe it to yourself, your family and your employees to scrutinize and thoroughly understand these costs.
Stephen J. Butler is president of Pension Dynamics Corp., Lafayette, Calif. He is the author of "The Decision-Maker's Guide to 401(k) Plans," newly published by Berrett-Koehler Publishers Inc., San Francisco.