Normal practice for 401(k) plan providers is to offer an investment lineup of mutual funds in multiple share classes. All of these share classes hold the same underlying securities and management but are offered to investors with different fee structures. Although this may be a convenient method to compensate selling agents, brokers, and record keepers, employers are required to make the lowest cost shares available to their plan so that participant returns are not negatively impacted by avoidable expenses.
Understanding the information available in a mutual fund prospectus and various fee disclosures is essential for employers to properly evaluate share classes offered to employees in a 401(k) plan. This information should be reviewed annually because mutual funds make frequent changes to share class fees. However, some basic education regarding mutual fund fees is necessary to properly complete this process.
Mutual Fund Fees: A Crash Course
Registered investment companies are compensated by charging both shareholder fees and operating expenses for their services. Shareholder fees apply to individual transactions and account maintenance while operating expenses are based on regular and recurring fund expenses. Mutual funds legally must be offered by a prospectus clearly disclosing these fees for all share classes, greatly simplifying the process of fee comparison for potential investors.
Shareholder expenses can include the following:
- Sales loads: A fund offered with a sales load is basically a commission offered to a broker or agent. A “front-end” sales load reduces the amount available to purchase shares. A “back-end” or deferred sales load reduces the proceeds available from a redemption of fund shares.
- Purchase Fees: These are similar to a front end sales load, the difference being that proceeds are paid to the investment company as opposed to a salesperson. The intent of purchase fees are to offset any costs involved in the purchase of shares.
- Redemption Fees: In a like manner, these fees are similar to deferred sales loads, with the proceeds paid to the investment company to offset expenses involved with the sale of shares.
- Account Fees: These are charged by some funds for falling below a minimum balance.
- Exchange Fees: Some mutual fund companies may charge a fee for exchanging shares of a fund for those of a different fund managed by the same company.
Operating expenses can include the following:
- Management Fees: These are fees paid out of assets to compensate the fund for portfolio management services.
- Distribution and/or 12b-1 Fees: These fees are paid out of fund assets for the market or sale of shares, usually as compensation for brokers or agents who sell the fund’s shares. 12b-1 shares are named after an SEC rule that authorizes their use.
- Other expenses: This category includes expenses other than those listed above. They can include transfer agent, legal, administrative and custodial expenses.
Revenue Sharing and 401(k) Investment Lineups
Mutual fund companies typically use share classes which include non-investment related fees to compensate agents of broker dealers and certain non-fee based advisors for including their funds within a 401(k) lineup. They are also utilized as a way to compensate other plan providers such as record-keeping firms and third party administrators. These compensating arrangements allocate a percentage of the total operating expenses charged by the mutual fund to plan participants in two general forms:
- 12b-1 Fees. These payments are usually made to a broker in exchange for providing plan services and for simply recommending that the plan utilize a certain fund and share class. They are disclosed in the fund’s prospectus as “distribution and/or service 12b-1 fees.”
- Sub-Transfer Agency Fees (also referred to as “Sub-TA” fees): These payments are usually made to a 401(k) plan recordkeeper to subsidize or pay for those services. They increase “Other Expenses” and are included in the fund prospectus as estimates. In order to determine the actual amount being charged against plan assets, employers must reference the annual 408b-2 fee disclosure prepared by the plan administrator.
These additional fee sharing arrangements are known in the 401(k) industry as revenue sharing. Funds that offer revenue sharing typically are offered in a greater number of share classes, with each share class paying a different rate. And because 12b-1 and sub-TA fees are not related to actual investment expenses, they are often buried in the fine print of fee disclosures and fund prospectuses.
Share Classes and Investment Returns
To see the impact of various share classes on investment returns, I have included the following information from the November 1, 2019 prospectus for the Growth Fund of America, managed by Capital Research and American Funds Group.
Although this fund is offered in many additional share classes for individual investors, 401(k) plans usually include one of the 6 “R” share classes. I have shown only three of these 6 share classes below for purposes of illustration:
American Funds: The Growth Fund of America[1]
| R1 | R3 | R6 | |
| Management Fees | 0.27 | 0.27 | 0.27 |
| Distribution/12b-1 Fees | 1.00 | 0.50 | 0 |
| Other Expenses | 0.14 | 0.19 | 0.04 |
| Total Annual Fund Operating Expenses | 1.41 | .96 | 0.31 |
| R1 | R3 | R6 | |
| Average Annual Total Returns-Lifetime[2] | 7.83% | 7.99% | 13.69% |
As you can see from the above table, R1 shares pay the highest 12b-1 fees, while R6 shares pay none at all. That means that R1 shares of the fund have significantly higher operating expenses than those of the R6 shares due to the additional fees which are deducted from participants holding these shares. These fees are paid to brokers who provide certain services to the plan and its participants.
Revenue sharing arrangements among retirement share classes present a very real fiduciary issue for plan sponsors. The reason? Fiduciaries are required to make the least expensive fund shares available to their participants. And as illustrated below, revenue sharing arrangements within share classes often have a devastating impact on investment results.
R1 vs R6 Shares: Do the Math!
Let’s take a look at a comparison of a participant who begins saving $10,000 a year at age 30 and who continues to invest this sum annually in the American Funds Growth Fund of America R1 shares. At age 65, he/she would have accumulated a balance of $1,728,850 assuming that the shares compound at the current lifetime rate. On the other hand, had the participant been offered the same fund’s R6 shares with lower expenses, he/she would have accumulated a far greater balance of $6,909,670. This represents a jaw-dropping difference of $5,180,820!
Employers Should Pay Attention to Share Class
When shopping for a 401(k) plan, employers should pay careful attention to share classes, since they have a meaningful and direct impact on retirement outcomes for participants.
They should also avoid advisors or brokers who are compensated by revenue sharing arrangements such as 12b-1 fees, since clear and obvious conflicts of interest exist between those advisors and plan participants.
If you are an existing plan sponsor not sure how your plan providers are compensated, you need to take a closer look at what share classes are offered in your plan. You may be paying more than you should.
Today, there are multiple low cost, open architecture platforms that allow institutional and retirement share classes free from 12b-1 and sub-TA fees. If your platform does not, it may be time to switch to a new provider.
At Strategic Retirement Partners, we avoid revenue sharing fee structures and are paid a flat fee based on total plan assets. If you would like a free evaluation of your plan fees, give us a call. We can help!
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
[1]Source: November 1, 2019 Prospectus, Growth Fund of America
[2]Ebit
