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401(k) plan fees: Three fundamental questions every advisor should be prepared to answer

Posted by Michael Limbacher on May 07, 2015 in Fund Analysis

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If you advise 401(k) plans, you’ve probably heard the following fee questions from the plan sponsor or investment committee at some point in time. Before 408(b)(2) regulations went into effect in 2012, much of this expense information was hard for the plan sponsor to even find. While more readily available today, that doesn’t mean your plan clients necessarily understand it.      

Here are three typical 401(k) plan fee questions you may encounter and some thoughts on how you might want to answer them:

Q. Why should I keep my plan with you when another firm is offering a “no-cost” solution?

Let’s start by examining two basic ways to pay for services in a 401(k) plan: 

  • The plan can pay via check/invoice on a periodic basis based on a set price stated in the plan agreement. The price can be a flat dollar amount, a per-participant amount or a percentage of net assets (typically quoted in basis points).
  • The plan can pay via the investments the participants hold, which is called revenue sharing. When using mutual funds, the total expense ratio paid to the mutual fund company can be used to compensate not only the fund manager, but also the investment advisor/broker/consultant and the service provider/TPA. Two components of the total expense ratio–the 12b-1 fee and the sub transfer agency (sub-TA) fee–are typically passed from the mutual fund to a third party.

It’s easy to see that when the services are paid via revenue sharing, an unknowing plan sponsor could consider the plan setup as “no-cost.”  Obviously, that’s not the case. To find out the real cost of services, always refer to the 408(b)(2) disclosure. 

(Note: There is also an alternative method that many plans use, which we will address in Question #3.)

Q. Where do revenue share expenses go?

As mentioned above, a mutual fund can pay revenue sharing via the 12b-1 fee and the sub-TA fee. First, let’s look at the 12b-1 fee.

The maximum value for the 12b-1 fee is stated in the fund’s prospectus and can differ by fund share class. What most plan sponsors don’t realize is that there can be two components of this fee:

  • Sales fee: The most common use of the 12b-1 fee. It is used to compensate the selling agent, such as a financial advisor or broker. You could think of it as similar to a front or deferred load. Loads are typically much larger, but they are only assessed once. The 12b-1 fee is assessed annually.
  • Service fee: Helps to reduce other costs of the plan, such as recordkeeping, custody, participant accounting, etc.

The sub-TA fee is used to compensate a third party such as a TPA for participant accounting.  This third party executes, clears and settles buy or sell orders for mutual fund shares, and maintains shareholder records of ownership.

Q. What is a “level-compensation” or “revenue neutral” fee structure?

When paying the plan fees through revenue sharing, plan fees can vary and increase drastically over time as the assets grow.  The increase in plan assets doesn’t necessarily correspond one-to-one with the required level of service needed to support the plan.  Hence, fees should not always rise proportionately with assets.  Revenue sharing can also be problematic in that it may incentivize an advisor providing advice to participants to recommend options where they receive greater compensation.

To help with these issues and to encourage complete fee transparency, many plans use a combination of flat/contract stated fees and revenue sharing.  Here’s how it works:

  1. The plan’s investments pay revenue sharing to the third parties (advisor, broker, TPA, etc.) as described above.
  2. The third parties aggregate this money and rebate it back to the plan.
  3. The rebated money is then used to pay the plan expenses. If the amount of rebated money is less than the total stated fees in the plan agreement, the plan will cut a check to the respective parties for the difference. Otherwise, the plan will maintain a positive balance in what is typically referred to as an “ERISA budget account.” This money can be used in the future to pay plan expenses, or, if it grows too large, it can be given back to the participants. If it does grow too large, the plan agreement should likely be revised to utilize lower cost investment options with less revenue sharing.

One item to note with this structure is when the investments in the plan lineup don’t all have the same revenue sharing levels.  In this situation, some participants could be paying more (or less) of the plan’s fees if they choose funds with higher (or lower) revenue sharing.

* * * * *

Editor's note: The original version of this blog post was first published in 2010 and is one of the most popular and positively reviewed posts we've published. We're revisiting and updating it to reflect that the 408(b)(2) disclosure regulations from the DOL that went into effect in 2012 have made this fee information more accessible. This post is not only helpful to our primary audience of advisors, but to help explain plan fees to your plan sponsor clients. A companion post regarding two other common ratios, the Prospectus Gross Expense Ratio and Audited Net Expense Ratio, and how they compare and contrast to the Prospectus Net Expense Ratio, is forthcoming. Another good resource for plan's to better understand their 401(k) plans is the DOL website. To help you customize and communicate the fees and expenses for your clients, the fi360 Toolkit includes a section for client (plan) level fees, revenue sharing components, and transaction fees specific to the client. This section is included in our Fee & Expense report, the 408(b)(2) Fee Disclosure report, and 404(a)(5) Fee Disclosure report.

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