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Why isn't your 401(k) doing better? The reason may surprise you

Robert Powell

There are a lot of hands in your retirement accounts

Ever wonder why poorly performing or expensive mutual funds are among the investment choices in your 401(k) plan?

Well, wonder no more.

Researchers have discovered that something called revenue sharing is to blame.

According to a just published paper (link), recordkeepers in defined contribution pension plans are often paid indirectly in the form of revenue sharing from third-party funds on the menu.

And the researchers, Veronika Pool, professor at the Vanderbilt University, Clemens Sialm, a professor the University of Texas at Austin; and Irina Stefanescu, an economist at the Board of Governors of the Federal Reserve System, show that these arrangements affect the investment menu of 401(k) plans.

How so? According to the researchers, revenue-sharing funds are more likely to be added to the available investment options and are less likely to be removed.

The 401(k) recordkeeper is essentially the 401(k) plan's bookkeeper. The recordkeeper processes employee enrollment; tracks employee investments; logs the whether the contributions pre-tax, Roth, or employer pre-tax match, and the like; manages and records 401(k) loans and hardship withdrawals; and issues account statements to participants, according to David Ramirez's blog (link).

The recordkeeper does not, however, give investment advice or provide employee education and onboarding, for instance, according to Ramirez.

Now there are many different types of recordkeepers. In some cases, the fund company that manages the 401(k) investments has a side recordkeeping business. Fidelity, Vanguard, TIAA, MassMutual, and Schwab are among those fund companies that also provide recordkeeping services. In other cases, payroll companies such as ADP, Paychex, and Gusto will do the recordkeeping.

Or the recordkeeper might be an insurance company, such as Empower, Voya, John Hancock, and Prudential.

And then there are independent recordkeepers that don't sell funds, don't sell insurance products, and don't have additional payroll products, according to Ramirez.

A primer on reviewing 401(k) fees

What do experts say about this research? First a bit of background.

All fees (direct and indirect) must be disclosed as required by ERISA Section 408(b)(2), the primary requirement of which is the upfront "fee notice" that service providers must deliver to plan clients. That fee notice spells out the various types of direct or indirect compensation payable to the provider.

Of course, no one ever reads those fee disclosures but here's what you'd learn if you did:

Recordkeepers get paid in three ways, according to Bonnie Yam, a principal with Pension Maxima Investment Advisory.

1. Fees from investment companies for having their products listed on their platform;

2. Actual recordkeeping services; and

3. Investment fees from their own proprietary funds.

Recordkeepers also share some of these payouts by making rebates to third party administrators or TPAs, one time and on-going, according to Yam. Some of the TPAs use the revenue to offset their expense, some don't. A TPA is used when a recordkeeper doesn't perform any administrative work for your plan.

Now because there are so many ways these entities get compensated, it's hard to unravel each level of revenue sharing. So, "the easier way is to look at total cost," said Yam.

Though some of these costs can be paid directly by employers, participants bear all of these costs in the vast majority of plans.

And here are the components of total cost:

1. Recordkeeping fees (direct-billed fees, asset-based or headcount-based);

2. Additional TPA fees (direct-billed);

3. Adviser fees (direct fees); and

4. Fund expense (this is net of fund performance, so a higher fund expense will translate into a lower investment return).

Is the research current?

With that as a backdrop, Mike Webb, a senior financial adviser with CAPTRUST, said "the (researchers') findings of the paper are generally consistent with the real-world experience; namely, the less revenue sharing that exists in a retirement plan, the better."

This is true, he said, not only for the primary reasons cited in the paper, "but because it results in fee structures that are far less transparent to plan participants."

Webb did, however, note that the researchers used old data and that their assertion that revenue sharing funds are less likely to be deleted from a menu may be a bit outdated.

"Employer backlash against revenue sharing in general, particularly among larger plan sponsors that were studied in the paper, has led to a movement to fund lineups that are zero-revenue share," Webb said.

Still, the revenue sharing practice is still somewhat common among small- to mid-sized plans.

Joe DeBello, a plan consultant with OneDigital, said he's still "amazed at how many plan sponsors we still encounter post-408(b)(2) that are still completely in the dark on what revenue sharing is and if it exists within their plan."

One of the most common issues is that revenue sharing exists -- usually in addition to a stated/direct recordkeeping fee -- and the amounts being generated by the various funds is unlevel, according to DeBello. "This creates a scenario where, depending on fund selection -- sometimes even by defaulting into the QDIA -- one participant unbeknownst to them may be subsidizing the cost of administering and recordkeeping the plan for their peers," he said.

What's more, DeBello said many recordkeepers still force plan sponsors to select from a limited menu of funds with, of course, the prerequisite of being on that limited menu is the existence of a certain minimum threshold of revenue sharing within the fund. "This one step greatly limits the opportunity for sponsors to choose what's in the best interest of their plan participants as opposed to what's best for their recordkeeper," he said. "Thankfully, we are seeing more and more 'open architecture' providers though there are still a lot of legacy problem plans out there."

Given that the practice of revenue sharing still exists today, what should plan participants do about it? What can employees do to be smarter about their 401(k) fees?

Review fee disclosure documents

Yam said 401(k) plan participants should first review their 404(a)(5) fee disclosure document, which provides a breakdown of the fees on plan administrative side and on an individual basis (i.e., fees for distribution, loan administration etc.).

Look for any language describing revenue sharing and how it is utilized: offsetting other fees, rebated back to you, for example. "Revenue sharing isn't always a problem, though how it's treated is where the inequities can arise," DeBello said.

With respect to recordkeeping fees, Webb said it's often expressed as an annual basis-point charge (e.g., 10 basis points = 0.10% = $10 per $10,000 of your account balance), but sometimes is the same regardless of account balance size (e.g., $50 per year per account regardless of size) particularly in larger plans.

"This fee is extremely important, as it often drives the total costs of plan investments as sponsors will often use revenue sharing to offset such fees rather than charging it directly to participants," he said.

Note: If you have a fee deducted from your account right now, do not assume that fee is the recordkeeping fee--account fee deductions may be made for a variety of purposes, said Webb.

Generally, plan participants are supposed to receive 404(a)(5) disclosure documents annually.

But if you don't receive your disclosure, DeBello recommends asking the human resources department or your provider directly for those documents.

Some, mostly large employers, have professionals on staff to explain the fee disclosure documents to you but often your employer may refer you to professionals employed by their recordkeeper, which is obligated to provide this information, said Fred Barstein, founder of The Retirement Advisor University.

Also of note: "If your employee benefits department cannot tell you the amount of the recordkeeping fee, you should view that as a red flag," said CAPTRUST's Webb.

Examine direct fees and fund expenses

Review too, your direct fees, which should appear on your account statement." It should state how much expense is being deducted," Yam said.

Finding out what your plan investments cost is easier than you might think, Webb said. Most participant websites have a page in their investments section that list all funds and their expenses.

Expenses are often listed in basis points, or fraction of 1%. If you are in a large plan, expect that few, or zero, investments will exceed 100 basis points (or 1% or $100/per $10,000 invested in the fund per year), with most investments in the 30-80 ($30-$80 per $10,000) basis point range, Webb noted.

Review Form 5500

Yam also recommends reviewing your company plan's Form 5500 from the Labor Department's website (link). The Form 5500 is an annual report, filed with the Labor Department, that contains information about a 401(k) plan's financial conditions, investments, and operations. Among other things, you can examine your plan's direct and indirect administrative fees in the Form 5500 report, said Yam.

Not all plans are required to provide such 5500 fee information--small plans with under 100 participants are exempt, and some plans don't file a 5500 at all--but many plans are required to provide this disclosure, said Webb.

In Yam's practice, they don't worry about the indirect payouts because all indirect will be captured by the fund expense. And if the fund expense is too high, it will affect the performance.

In the somewhat-rare instances when an employer pays a plan expense directly, it will not appear on the 5500, said Webb.

Contact HR department

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05-29-21 1707ET

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