Imagine finding out your neighbor bought the exact same $40,000 car you own but paid $240,000 (or six times the price you paid). Such is the craziness of 401(k) plans. If you are a small business owner, or employed by one, it turns out that the fees you pay out of your hard-earned savings could be five to 10 times higher than your neighbor who happens to work for a Fortune 500 company.
Small business is as American as apple pie. It is undoubtedly the backbone of the economy. Doctors, dentists, lawyers, the local car dealer, etc. … These companies typically have 401(k) plans with fewer than 100 employees. In fact, according to a study by the Investment Company Institute, nearly 90 percent of all 401(k) plans in America fit into this category.
As a whole, the fees are substantially more for small business 401(k) plans, and in my estimation, for no good reason other than small businesses are typically dealing with several middlemen (i.e. the local broker who brings donuts and educational brochures) who intend to get paid handsomely. Owners, busy running the day-to-day operations, are painfully unaware of the fees that are quietly eroding their companies’ retirement savings.
Our firm comes in contact with thousands of small business owners annually, and we decided to produce a white paper on 401(k) fees to help the public understand what we see on a day-to-day basis when we evaluate existing 401(k) plans (the full white paper can be downloaded at www.401kstudy.com). First, we requested that small business owners provide us with a copy of their fee disclosure document (also known as a 408(b)(2), which can be accessed by calling the customer service number of your provider).
We then compiled data from nearly 250 plans and came up with the total average “asset-based” costs based on the sampling. Asset-based fees are simply the costs that are extracted from the account balances of the plan participants. Our study included 11 of the biggest-name providers that dominate the small business 401(k) plan marketplace. Below is the analysis showing our findings:
To be fair, this is just a sample of plans where we were able to obtain the fee disclosures from the owners. We readily acknowledge that fees vary from plan to plan and the fees from other plans may be higher or lower than the averages we found. But the reality is that these numbers are pretty startling when contrasted to plans offered by large companies. The industry median for plans with 100 participants or more and $1 million or more in assets is just 0.93 percent annually, with the rate dropping sharply as assets exceed $10 million or more to as low as 0.27 percent of plan assets per year (Source: BrightScope-ICI Dec. 2017 report, page 50).
Now you might think these fees sound like small percentages. What’s one percent between friends, after all? Turns out it’s a lot! All things being equal in terms of market performance, a one percentage point reduction in fees could put hundreds of thousands, if not millions, back into the pockets of plan participants that would have otherwise gone to fees (watch this two-minute video which spells it out).
But the question is still begging to be asked: Why are plans multiple times more expensive for small businesses?
It’s a combination of factors but here is my opinion: Big companies hire astute third-party consultants and make vendors compete for their business. They have major buying power and drive down costs. They eliminate expensive funds that aren’t performing well. They demand “institutionally” priced shares, which means that participants pay less than the normal retail price.
Contrast this with small businesses. The business owner usually engages a broker who seems like a likeable guy/gal. The broker typically wants to make as much as they can get away with. The broker selects a provider (often an insurance company or payroll company) and said provider typically makes money on “revenue-sharing,” which is a fancy way of saying that they get a cut of the mutual fund management fees. This means the funds in the plan are often expensive, and low-cost index funds, which don’t “pay to play,” are suspiciously missing from most plans (despite overwhelming evidence they outperform over time). Another common revenue source is the use of proprietary name-brand funds which often more profitable. And let’s not forget the local third-party administrator who can often get a cut of the action as well.
I know this all sounds like a bummer, but there is a silver lining. Any time there are high costs or unnecessary middlemen, capitalism finds the path to disruption. In the same way that Uber has transformed the taxi cab industry, next-generation 401(k) solutions are putting the traditional 401(k) providers on notice. Many of these solutions can have “asset-based” fees of just 0.65 percent annually, a 50 percent-or-more reduction from today’s averages.
Not only are fees coming down; how we interact with our 401(k) plans is also changing. Gone are the days of cafeteria-style meetings where employees have to listen to canned presentations. People want to interact with their plan provider in their car on their phone while waiting to pick up their daughter at soccer practice. Mobile devices have put the power back into the hands of participants who would rather have an on-demand experience.
In order for a true sea change to begin, business owners need to step up and rescue their 401(k) plans from high costs and unnecessary middlemen. The first step is to uncover all of the fees which are often buried deep in lengthy fee disclosures. Once this financial archeology is done, the answer to whether or not a company should switch plan providers will become abundantly clear.