How to Offer a Low Cost 401(k) PlanBurke Johnson
October 4, 2011 — 1,646 views
Any employer wishing to provide a solid benefits package to its employees is likely to offer a 401(k) plan. However, just because an employer offers a plan does not necessarily mean that this vehicle is the best mechanism for an employee to save for their retirement. Especially for smaller employers, the "all in" cost of a 401k plan may amount to more than 2% of plan assets. Thus, an employer should pay close attention to all of the costs of their plan to assure that they are providing a great benefit to their employees.
According to a study by Deloitte and the Investment Company Institute1, over 74% of a plan's all in" cost is attributable to investment expense. Thus, ensuring that your plans offers investment options with low expense ratios is the best way to ensure that you're offering a low cost 401(k) plan.
1) Include index funds – Because index funds only track a certain market index rather than attempt to outperform it like actively managed mutual funds, their operating costs are much lower. According Morningstar, index funds are 0.51% cheaper than actively managed funds.2 Furthermore, over time; many index funds have proven to outperform their actively managed counterparts.
2) Include ETFs – Like index mutual funds, ETFs are a basket of securities that attempt to replicate a market index. While we are beginning to see some actively managed ETFs surface recently, for the most part, ETFs are passively managed funds. Like index funds, their primary benefits are their low cost and market like performance. Morningstar reports that the average expense ratio for a passively managed ETF is only .56%.3 However be sure to consider the commissions that will be charged for the purchase and sales of ETFs. Yet, even when factoring in these commissions, including ETFs in a plan's lineup if likely to reduce the overall cost of a plan.
3) Avoid funds with revenue sharing – Revenue sharing is when mutual fund companies pay either a broker dealer or recordkeeper a payment for the distribution of their funds or servicing of accounts using their funds. Revenue sharing can come in the form of 12(b)(1) fees, sub-transfer agency (Sub TAs), or shareholder servicing fees. Any of these types of increase the overall management fee of the fund itself. Unless your 401(k) provider uses all revenue sharing payments to offset plan expenses, you can lower your overall plan cost by sticking to funds that don't include these payments.
4) Avoid variable annuities – Many insurance providers "wrap" an added expense on top of a mutual fund. To the average investor, it appears as if they are invested directly in the mutual fund. However, their returns will not match that of the mutual fund due to these added expenses, which can sometimes amount to more than 1%. In addition to the above suggestions about the investment lineup, the following are some additional ways that an employer can assure they are offering a low cost 401(k) plan:
Force Out Terminated Participants with Low Balances
If your plan document allows you to force out terminated participants with balances less than $5,000, you should be diligent in doing so, especially if your recordkeeper or TPA is charging a per participant fee. Additionally, if your plan is around 100 participants, by distributing balances of these participants, you may lower your total participant count whereby you will not have to incur the added expense of performing an annual audit.
Join a Multiple Employer Plan (MEP)
A MEP allows many unrelated entities to become a part of the same 401(k) plan. If you are a small employer, it is possible that joining a MEP could be a cheaper option for you than a standalone plan whereby you may be subject to minimum fees because of a low participant count or asset size. Additionally, a MEP may allow you access to cheaper investment options because of the collective size of the plan.
Because every dollar of fees paid by the participants reduces their retirement nest egg, it's important that consideration be given to every possible way to lower plan costs. These suggestions should help get you started in your quest to offer a great low cost 401k plan to your employees.
1 Defined Contribution 401(k) Fee Study (2009). Deloitte and Investment Company Institute.
2 U.S. News and World Report, "Why Investors Are Flocking to Index Funds", March 16, 2010.
3 How ETFs Have Reshaped Investing. The Wall Street Journal, April 18, 2011.
Lincoln Trust Company
Burke Johnson is the Director of Marketing and Product Management at Lincoln Trust Company