The Math Behind Plan Fee Evaluations

Plan sponsors have heard—and many excessive fee lawsuits state—that larger defined contribution (DC) plans, in terms of assets, pay lower fees. But do they really?

In a comparison of the average costs of two 401(k) plans with the same total assets, data from the most recent 401k Averages Book showed plans with larger average account balances will pay lower fees as a percentage of total assets. However, Eric Droblyen, president and CEO of Employee Fiduciary in Saint Petersburg, Florida, takes issue with this.

Droblyen says one reason he has an issue with some benchmarking services is that they look at fees on a percentage of assets basis, but he says, they should be looking at what the fees translate to on a per-head basis. How much is each participant paying? It requires doing some math.

His firm’s 2018 fee study found the average all-in fee for the plans studied was 2.1%, while the average 401(k) provider fee was $603.86 per participant. One plan studied had $1,625,825.48 in assets with seven participants. While its 1.58% all-in fee was below average, its $2,521.81 per-head provider fee was more than four times the average.

A blog post on Employee Fiduciary’s website compares two small business 401(k) plans. “Both companies have 50 employees and exactly the same plan provisions. Each company makes biweekly payroll contributions and each has the same employer match provisions. [They] have the same recordkeeping services right across the board. Company 1 pays 0.78% (78 basis points) for recordkeeping services, and Company 2 pays 0.27%.”

It looks like Company 2 has a better deal for participants. However, “Company 1 has only $300,000 in assets and is paying a total of $2,340 for its recordkeeping services. Company 2 has $3 million in assets and is paying a total of $8,100 for its identical recordkeeping services. Company 2 is paying over three times more in actual dollars for the same service.”

Droblyen caveats that having greater assets certainly helps with plan fees. Many funds come in multiple share classes, with the least costly being available to plans with large assets—he says this is mostly for actively managed funds. It takes $100 million to access the cheapest share classes in some cases.

On a plan level, Droblyen says most plans are paying the same for funds. And, he says, asset-based fees make sense for custody services—“asset-based fees for that cover our costs.” However, for administration services, such as recordkeeping, he says, “asset-based fees should be eliminated; they’re simply unreasonable.” Droblyen adds that asset-based fees increase automatically and seem to penalize participants for increasing account balances.

Evaluating Fees

Robyn Credico, North America Defined Contribution practice director at Willis Towers Watson in Arlington, Virginia, says, “When we do fee benchmarking—and we do a lot—we look at recordkeeping fees, investment fees and the total fees because ERISA [Employee Retirement Income Security Act] doesn’t say which one has to be reasonable, nor do any lawsuits.” She notes that the recordkeeping fee will include direct charges, revenue sharing, plus—something a lot of sponsors don’t consider—transaction fees.

A fee study by NEPC points out that recordkeepers collect fees for ancillary services such as loan origination, loan maintenance, qualified domestic relation order (QDRO) processing and managed accounts. Among the NEPC universe of plans, the composition of overall plan costs is 80% investment fees, 14% plan administration fees and 6% “other” fees.

Credico says plan sponsors should combine all fees and compare them to fees for plans of similar type, assets, number of participants, services and average account balances. While plan sponsors may see a lower fee for the plan if average account balances are larger, how these fees are passed down to participants needs to be considered. “If participants are charged based on plan assets, then those with larger account balances will pay more,” she says.

Credico adds, “We always recommend a per-participant fee charged to both plan sponsors and participants.” She says she sees things trending in this direction.

The data from NEPC’s fee study supports that. It finds that 21% of plans in the NEPC universe use an arrangement by which all administration fees are paid with revenue sharing; 22% are charged a fixed percentage of account assets; and 53% are charged a fixed dollar amount per participant.

Revenue Sharing and Fee Levelization

Credico says it is often up to plan sponsors to determine how participants are charged.

Some may think it is fairer to charge participants based on assets. For example, if a sponsor were to charge each participant an annual per capita fee, say $75, a participant with a $5,000 account balance would be paying 1.5% of their assets, whereas a person with a $500,000 account balance would be paying only 0.02%. A “pro rata” 10 basis-point fee for a participant with a $500,000 balance would result in $500 in plan fees, whereas a participant with a $5,000 balance would only pay $5.

But, Droblyen points out, it doesn’t take any more work to provide services to a participant with $500,000 than it does to a participant with $5,000 in savings. Likewise, on the plan sponsor level, it doesn’t take any more work to provide services to a 10-participant plan whether it has $10,000or $10 million in assets.

Credico warns that lawsuits crop up when assets go up and fees go up, so with asset-based fees, plan sponsors need to make sure they go up reasonably. She says she’s seen many larger employers revisit fees and move to a per participant—or per capita—model.

But things can get more complicated when revenue sharing is taken into account. The practice of revenue sharing occurs when an investment company or manager pays a portion of funds to the recordkeeper to decrease administrative service costs instead of paying a brokerage cash expense.

Credico says recordkeeping, transaction and investment fees don’t always add up to total plan fees because of revenue-sharing offsets. Some recordkeepers will lower the fees they charge knowing they will get revenue sharing from funds.

One trend sparked by Department of Labor (DOL) 408(b)(2) provider fee disclosure regulations and excessive fee lawsuits is to rebate revenue sharing back to participants to offset their fees. However, there are issues with how this is done. Credico says the simplest way to do this is to allocate revenue sharing back to participants on a pro-rata basis. However, with this method, participants invested in certain funds could end up subsidizing costs for participants in other funds.

But giving back revenue sharing based on what funds participants are invested in is complicated because it’s difficult to track where participants may move their money during a specific time period. Also, Credico says this can sometimes result in equity funds costing less than index funds for participants, and that could drive the wrong behavior, in her opinion.

Another trend that has emerged is “fee levelization.” Michael Volo, senior partner at Cammack Retirement, previously explained to PLANSPONSOR, “With fee levelization, the recordkeeper applies their recordkeeping fee as a percentage of assets to each individual investment option. If revenue sharing in the investment option exceeds the recordkeeper’s required revenue, the recordkeeper credits each participant who has assets in the fund with the amount of the excess. If the investment provides less than the required revenue amount, the recordkeeper adds an additional fee, in the amount of the shortfall, to the accounts of each participant using the investment.”

Not only is this complicated, but it is less transparent. “In 408(b)(2) filings, if the recordkeeper is doing fee levelization, it is not showing what each fund is paying in revenue sharing,” Droblyen says.

“Let’s just take revenue sharing away. Why would a provider do something complicated unless it is getting a benefit?” Droblyen adds.

Credico says she has been encouraged to see that more plan sponsors are benchmarking fees and taking action. She’s seen a substantial increase over the past few years.

“No two plans are alike. Look at all scenarios with your plan and make sure fees are reasonable for the services provided to participants,” she says. “We’ve seen some plan sponsors only benchmarking their investment fees, but they need to look at recordkeeping and transaction fees as well as revenue sharing. Look at the whole picture at least once every three years.”