Too many times, we speak to plan sponsors who have been convinced the management of their company’s 401(k) plan is free. We hate to be the bearer of bad news, but it usually isn’t true. The plan sponsor might think their plan is free because they’ve never received an explicit invoice or bill that asks them to pay for plan management. Typically, this arises in situations where the underlying investments – the stock and bond funds that make up the 401(k) lineup – share their internal fees with the custodian / recordkeeper. This revenue sharing arrangement is convenient for paying for plan management, but it often translates into plans that are paying way too much, not getting credit for overpaying, and so on. In other words, the plan sponsors who incorrectly believe their plans are “free” are, paradoxically, generally the plan sponsors that are paying the highest fees.
Revenue sharing can be convenient way to pay for plan management, but you have to be careful using it. If you’re going to figure out which investment options are least expensive, you have to know everything you’re paying for.
For example, imagine you can select an investment for the 401(k) lineup, a S&P 500 index fund, but you have to select between two different versions – two share classes – of the product. The first version is an R5 plan share class that has an expense ratio (the fee) of 1%. The second version is an Institutional share class which has an expense ratio of 0.90%. It looks simple: the second share class is 0.1% cheaper. The second option should be the best choice, right?
Answer: It depends. If the only fee plan sponsors had to worry about is the fee which goes to the investment manager, then yes: the expense ratio is lower for the second share class and it’s the better option. However, if the plan management fees are paid with revenue sharing agreements between the investment manager and the recordkeeper, then the first option might be cheaper. Imagine the 1% R5 share class pays 0.25% of revenue sharing to the recordkeeper while the institutional share class pays nothing (0%) in revenue sharing. If the other investment options in the lineup aren’t paying enough in revenue sharing, the second option may end up being the best choice for the plan.