Hidden Subsidies in the Structure of 401k Fees

crr-boston-collegeThe Center for Retirement Research at Boston College put out an interesting brief this month on 401(k) fees.  While the brief didn’t contain anything completely new, it did tackle two issues that are very important, yet rarely discussed.  Both of these issues highlight a non-obvious subsidy that is incurring within 401k plans:

1.  Matching Fee Structure with Service Structure:  If a service provided to a retirement plan benefits all participants of the plan equally, yet the service fees are charged as a percentage of assets rather than per capita, then high account balance participants are subsidizing low account balance participants.  The authors rightfully flag this mismatch of services and fees as a “design issue” and highlight many questions that this practice raises:

“Are participants with relatively large 401(k) balances otherwise sufficiently wealthy to subsidize other participants? Does the bundling of expenses hinder sponsors and participants from making more economical choices, which consequently reduces retirement wealth for all participants? Might the importance of saving for retirement warrant funding the subsidies in another way? Might inequities in the treatment of participants in 401(k) plans discourage participants with higher balances from accumulating or holding assets within their plans? Within the intent of The Employment Retirement Income Security Act of 1974, should fees be reasonable for each and every participant?”

This list of questions is thought-provoking.  I don’t think any of these questions can be answered categorically without inviting vigorous disagreement.  The one thing I will say is that I have become convinced that the design of plan fees is as important as the level of plan fees.  Even if a plan sponsor believes the overall level of fees is reasonable, the fees might be unreasonable for a group of high account balance participants.  The last of the questions raised in the brief is particularly relevant for the plaintiffs bar.  Are any readers aware of existing litigation brought against a plan sponsor (or service provider for that matter) about this issue of fee inequity within a plan?

2. Implicit Costs in Investment Funds:  I applaud the authors for tackling the issue of implicit costs.  We at BrightScope include brokerage expenses, bid-ask spread and market impact in our total plan cost calculations and feel that plan sponsors should consider implicit costs in their investment review meetings.  However, the CRR authors took the implicit cost discussion one step further.  They highlight an example where even in an index fund with a low total level of trading, their could be fee inequities:

” . . .consider the case of a 401(k) plan that offers its participants a popular index fund. Suppose this fund also attracts other investors who trade more aggressively. The investment by the plan accounts for 1/10 of the total investment in the index fund, and the plan’s participants, on average, conduct one transaction a month, buying or selling 0.1 percent of their balances. The outside investors conduct transactions twice a month, buying or selling 0.2 percent of their balances. In these circumstances, the plan’s participants account for only 2.7 percent of the fund’s trading costs, but pay for 10 percent of these costs, a fee that is 3.7 times the cost of their services.”

Passive investors subsidizing active investors is not a problem unique to 401k plans.  It is a problem for any investor in a pooled investment vehicle. Yet this discussion is relevant to plan sponsors because the class of investor being subsidized in the CRR example is not a part of the plan.  I do not know the degree to which consultants and advisors to 401k plans consider and analyze the “trade share” between 401k investors and non-401k investors of the funds they invest in, but I would love to hear from a practitioner who does consider this factor and how they screen funds to minimize this subsidy.