Why consider fees?

In a 401k plan, your account balance will determine the amount of retirement income you will receive from the plan. While contributions to your account and the earnings on your investments will increase your retirement income, fees and expenses paid by your plan may substantially reduce the growth in your account. The following example demonstrates how fees and expenses can impact your account.

Assume that you are an employee with 35 years until retirement and a current 401k account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.

In recent years, there has been a dramatic increase in the number of investment options typically offered under 401k plans as well as the level and types of services provided to participants. These changes give today’s employees who direct their 401k investments greater opportunity than ever before to affect their retirement savings. As a participant you may welcome the variety of investment alternatives and the additional services, but you may not be aware of their cost. As shown above, the cumulative effect of the fees and expenses on your retirement savings can be substantial.

401k Tip---
According to Southern California-based (401k) Enginuity (www.401kenginuity.com), twenty-year veteran in developing and running 401(k) administration and 401(k) software and recordkeeping systems, the Internet will be the primary delivery system for 401(k)s by 2007. Many web-based 401(k) plans will run on administration and recordkeeping platforms that plan providers will outsource to 401k specialists and 401k Application Service Providers (ASP).

The advantages of web-based online 401(k) plans are obvious to today's workers, and include use conveniences, real-time monitoring and reporting, and instant re-allocation of their retirement assets. The internet has also dramatically reduce the cost of 401(k) plan administration, saving plan sponsor 50% or more in ongoing fees and costs when compared to the older traditional labor-intensive plans. Outsourcing of 401(k) functions by plan providers will extend the trend towards lower cost, high-quality 401(k) products.

401(k) plan providers of all types, financial institutions including banks, insurance companies, brokerages, mutual fund companies, credit unions, and third-party administrators, are now actively outsourcing 401(k) administration and recordkeeping tasks to 401(k) ASPs --- vendors such as 401k Enginuity, whose sole function is to maintain, updated and supervise software-based 401(k) administration and recordkeeping systems on behalf of plan providers. 401(k) ASP vendors are responsible for all routine day-to-day 401(k) recordkeeping and administration functions, thus allowing the plan providers to reduce internal staff, eliminate the expense and complications of licensing, housing and running hardware and 401(k) administration software in-house. Plan providers can refocus and concentrate their efforts on to the needs of their plan sponsors and plan participants, and rely upon the outsourced ASP 401(k) vendor for the recordkeeping and technical "backbone" supporting providers' Internet-based plans. It is inevitable that some of this 401(k) outsourcing to ASPs will include secondary outsourcing of certain non-critical low-level routine day-to-day tasks to non-US locations, where labor costs are less yet the expertise is abundant.

You should be aware that your employer also has a specific obligation to consider the fees and expenses paid by your plan. ERISA requires employers to follow certain rules in managing 401(k) plans. Employers are held to a high standard of care and diligence and must discharge their duties solely in the interest of the plan participants and their beneficiaries. Among other things, this means that employers must:

• Establish a prudent process for selecting investment alternatives and service providers;
• Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided;
• Select investment alternatives that are prudent and adequately diversified; and
• Monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices.

2. What are 401k plan fees and who pays for them?

If you want to know how fees affect your retirement savings, you will need to know about the different types of fees and expenses and the different ways in which they are charged.

401k plan fees and expenses generally fall into three categories:

Plan administration fees. The day-to-day operation of a 401k plan involves expenses for basic administrative services -- such as plan record keeping, accounting, legal and trustee services -- that are necessary for administering the plan as a whole. Today a 401(k) plan also may offer a host of additional services, such as telephone voice response systems, access to a customer service representative, educational seminars, retirement planning software, investment advice, electronic access to plan information, daily valuation and on-line transactions.

In some instances, the costs of administrative services will be covered by investment fees that are deducted directly from investment returns. Otherwise, if administrative costs are separately charged, they will be borne either by your employer or charged directly against the assets of the plan. When paid directly by the plan, administrative fees are either allocated among individual accounts in proportion to each account balance (i.e., participants with larger account balances pay more of the allocated expenses) or passed through as a flat fee against each participant’s account. Either way, generally the more services provided, the higher the fees.

Investment fees. By far the largest component of 401k plan fees and expenses is associated with managing plan investments. Fees for investment management and other investment-related services generally are assessed as a percentage of assets invested. You should pay attention to these fees. You pay for them in the form of an indirect charge against your account because they are deducted directly from your investment returns. Your net total return is your return after these fees have been deducted. For this reason, these fees, which are not specifically identified on statements of investments, may not be immediately apparent. (See Question 3 for more information on investment-related fees.)

Individual service fees. In addition to overall administrative expenses, there may be individual service fees associated with optional features offered under a 401(k) plan. Individual service fees are charged separately to the accounts of individuals who choose to take advantage of a particular plan feature. For example, individual service fees may be charged to a participant for taking a loan from the plan or for executing participant investment directions.

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.401ksolution.com 

401k plan investments and services may be provided through a variety of arrangements:

Employers may directly provide, or separately negotiate for, some or all of the various services and investment alternatives offered under their 401k plans (sometimes referred to as an unbundled arrangement). The expenses of each provider (i.e., investment manager, trustee, recordkeeper, communications firm) are charged separately.

In many plans, some or all of the various services and investment alternatives may be offered by one provider for a fee paid to that provider (sometimes referred to as a bundled arrangement). The provider will then pay out of that fee any other service providers that it may have contracted to provide the services.

Some plans may use an arrangement that combines a single provider for certain services, such as administrative services, with a number of providers for investment options.

Fees need to be evaluated keeping in mind the cost of all covered services.

3. What fees are associated with my investment choices in a 401k plan?

Apart from fees charged for administration of the plan itself, there are three basic types of fees that may be charged in connection with investment alternatives in a 401(k) plan. These fees, which can be referred to by different terms, include:

• Sales charges(also known as loads or commissions). These are basically transaction costs for the buying and selling of shares. They may be computed in different ways, depending upon the particular investment product.
• Management fees (also known as investment advisory fees or account maintenance fees). These are ongoing charges for managing the assets of the investment fund. They are generally stated as a percentage of the amount of assets invested in the fund. Sometimes management fees may be used to cover administrative expenses. You should know that the level of management fees can vary widely, depending on the investment manager and the nature of the investment product. Investment products that require significant management, research and monitoring services generally will have higher fees. (See Question 5.)
• Other fees. This category covers services, such as recordkeeping, furnishing statements, toll-free telephone numbers and investment advice, involved in the day-to-day management of investment products. They may be stated either as a flat fee or as a percentage of the amount of assets invested in the fund.

In addition, there are some fees that are unique to specific types of investments. Following are brief descriptions of some of the more common investments offered under 401k plans and explanations of some of the different terminology or unique fees associated with them.

Some Common Investments and Related Fees

Most investments offered under 401k plans today pool the money of a large number of individual investors. Pooling money makes it possible for individual participants to diversify investments, to benefit from economies of scale and to lower their transaction costs. These funds may invest in stocks, bonds, real estate and other investments. Larger plans, by virtue of their size, are more likely to pool investments on their own -- for example, by using a separate account held with a financial institution. Smaller plans generally invest in commingled pooled investment vehicles offered by financial institutions, such as banks, insurance companies or mutual funds. Generally, investment-related fees, usually charged as a percentage of assets invested, are paid by the participant.

Mutual funds. Mutual funds pool and invest the money of many people. Each investor owns shares in the mutual fund that represent a part of the mutual fund’s holdings. The portfolio of securities held by a mutual fund is managed by a professional investment adviser following a specific investment policy. In addition to investment management and administration fees, you may find these fees:

• Some mutual funds assess sales charges (see above for a discussion of sales charges). These charges may be paid when you invest in a fund (known as a front-end load) or when you sell shares (known as a back-end load, deferred sales charge or redemption fee). A front-end load is deducted up front and, therefore, reduces the amount of your initial investment. A back-end load is determined by how long you keep your investment. There are various types of back-end loads, including some which decrease and eventually disappear over time. A back-end load is paid when the shares are sold (i.e., if you decide to sell a fund share when a back-end load is in effect, you will be charged the load).
• Mutual funds also may charge what are known as Rule 12b-1 fees, which are ongoing fees paid out of fund assets. Rule 12b-1 fees may be used to pay commissions to brokers and other salespersons, to pay for advertising and other costs of promoting the fund to investors and to pay various service providers to a 401(k) plan pursuant to a bundled services arrangement. They are usually between 0.25 percent and 1.00 percent of assets annually.
• Some mutual funds may be advertised as “no load” funds. This can mean that there is no front- or back-end load. However, there may be a small 12b-1 fee.

Collective investment funds. A collective investment fund is a trust fund managed by a bank or trust company that pools investments of 401k plans and other similar investors. Each investor has a proportionate interest in the trust fund assets. For example, if a collective investment fund holds $10 million in assets and your investment in the fund is $10,000, you have a 0.1 percent interest in the fund. Like mutual funds, collective investment funds may have different investment objectives. There are no front- or back-end fees associated with a collective investment fund, but there are investment management and administrative fees.

Variable annuities. Insurance companies frequently offer a range of investment alternatives for 401k plans through a group variable annuity contract between an insurance company and an employer on behalf of a plan. The variable annuity contract “wraps” around investment alternatives, often a number of mutual funds. Participants select from among the investment alternatives offered, and the returns to their individual accounts vary with their choice of investments. Variable annuities also include one or more insurance elements, which are not present in other investment alternatives. Generally, these elements include an annuity feature, interest and expense guarantees and any death benefit provided during the term of the contract. In addition to investment management fees and administration fees, you may find these fees:

• Insurance-related charges are associated with investment alternatives that include an insurance component. They include items such as sales expenses, mortality risk charges and the cost of issuing and administering contracts.
• Surrender and transfer charges are fees an insurance company may charge when an employer terminates a contract (in other words, withdraws the plan’s investment) before the term of the contract expires or if you withdraw an amount from the contract. This fee may be imposed if these events occur before the expiration of a stated period and commonly decrease and disappear over time. It is similar to an early withdrawal penalty on a bank certificate of deposit or to a back-end load or redemption fee charged by some mutual funds.

Pooled guaranteed investment contract (GIC) funds. A common fixed income investment option, a pooled GIC fund generally includes a number of contracts issued by an insurance company or bank paying an interest rate that blends the fixed interest rates of each of the GICs included in the pool. There are investment management and administrative fees associated with the pooled GIC fund.

While the investments described above are common, 401k plans also may offer other investments which are not described here (such as employer securities).

4. Where can I get information about the fees and expenses charged to my 401k plan account?

If you have questions about the fees and expenses charged to your 401k plan, contact your plan administrator, who should be able to assist you with the following documents:

• If your plan permits you to direct the investment of assets in your account, the plan administrator should provide you with copies of documents describing investment management and other fees associated with each of the investment alternatives available to you (i.e., a prospectus). The plan administrator should also provide a description of any transaction fees and expenses that will be charged against your account balance in connection with the investments that you direct.
• Your account statement will show the total assets in your account, how they are invested and any increases (or decreases) in your investments during the period covered by the statement. It may also show administrative expenses charged to your account. Account statements will be provided once a year upon request, unless your plan document provides otherwise.
• Your 401(k) plan’s summary plan description (SPD) will tell you what the plan provides and how it operates. It may tell you if administrative expenses are paid by your plan, rather than by your employer, and how those expenses are allocated among plan participants. A copy of the SPD is furnished to participants when they join a plan and every 5 years if there are material modifications or every 10 years if there is no modification.
• The plan’s annual report (Form 5500 series) contains information regarding the plan’s assets, liabilities, income and expenses and shows the aggregate administrative fees and other expenses paid by the plan. However, it will not show expenses deducted from investment results or fees and expenses paid by your individual account. Fees paid by your employer also will not be shown. You may examine the annual report for free or request a copy from the plan administrator (for which there may be a charge). A complete explanation of the Form 5500 series is contained in the publication Protect Your Pension: A Quick Reference Guide, listed at the back of this booklet. In general, the summary annual report, which summarizes the annual report information, is distributed each year.

In addition, you may want to consult the business section of major daily newspapers, business and financial publications, rating services, the business librarian at the public library or the Internet (see the list of helpful Websites listed at the back of this booklet). These sources will provide information and help you compare the performance and expenses of your investment options with other investments outside of your 401k plan.

If, after doing your own analysis, you have questions regarding the rates of return or fees of your plan’s investment options, ask your plan administrator for an explanation.

5. What other factors might impact the fees and expenses of my 401k plan?

• Funds that are “actively managed” (i.e., funds with an investment adviser who continually researches, monitors and actively trades the holdings of the fund to seek a higher return than the market) generally have higher fees. The higher fees are associated with the more active management provided and sales charges from the higher level of trading activity. While actively managed funds seek to provide higher returns than the market, neither active management nor higher fees necessarily guarantee higher returns.
• Funds that are “passively managed” generally have lower management fees. Passively managed funds seek to obtain the investment results of an established market index, such as the Standard and Poor’s 500, by duplicating the holdings included in the index. Thus, passively managed funds require little research or trading activity.
• If the services and investment alternatives under your plan are offered through a bundled program, then some or all of the costs of plan services may not be separately charged to the plan or to your employer. For example, these costs possibly may be subsidized by the asset-based fees charged on investments. Compare the services received in light of the total fees paid.
• Plans with more total assets may be able to lower fees by using special funds or classes of stock in funds, which generally are sold to larger group investors. “Retail” or “brand name” funds, which are also marketed to individual and small group investors, tend to be listed in the newspaper daily and typically charge higher fees. Let your employer know your preference.
• Optional features, such as participant loan programs and insurance benefits offered under variable annuity contracts, involve additional costs. Consider whether they have value to you. If not, let your employer know.
• Pension plans, such as 401(k) plans, are group plans. Therefore, your employer may not be able to accommodate each employee’s preferences for investment alternatives or additional services.

6. Is there a checklist I can use to review my 401k plan’s fees?

There are an array of investment options and services offered under today’s 401k plans. While there is no easy way to calculate the fees and expenses paid by your 401k plan due to the number of variables involved, you can begin by asking yourself questions and, if you cannot find the answers, by asking your plan administrator. Answers to the following 10 questions will help in gathering information about the fees and expenses paid by your plan.

1. What investment options are offered under your company’s 401k plan?

2. Do you have all available documentation about the investment choices under your plan and the fees charged to your plan?

3. What types of investment education are available under your plan?

4. What arrangement is used to provide services under your plan (i.e., are any or all of the services or investment alternatives provided by a single provider)?

5. Do you and other participants use most or all of the optional services offered under your 401(k) plan, such as participant loan programs and insurance coverages?

6. If administrative services are paid separately from investment management fees, are they paid for by the plan, your employer or are they shared?

7. Are the investment options tracking an established market index or is there a higher level of investment management services being provided?

8. Do any of the investment options under your plan include sales charges (such as loads or commissions)?

9. Do any of the investment options under your plan include any fees related to specific investments, such as 12b-1 fees, insurance charges or surrender fees, and what do they cover?

10. Does your plan offer any special funds or special classes of stock (generally sold to larger group investors)?

This booklet is only the beginning of your educational process. You should ask questions and educate yourself about investments. Monitoring your current investment selections and reviewing the investment alternatives offered under your plan are part of a process that you, as an informed participant, will need to undertake continually.

Keep in mind that the law requires the fees charged to a 401k plan be “reasonable” rather than setting a specific level of fees that are permissible. Therefore, the reasonableness of fees must be determined in each case.

For additional information regarding the level of fees typically charged to 401k plans and 401(k) plan fees and expenses generally, see the Pension and Welfare Benefits Administration’s Study of 401k Plan Fees and Expenses, available on PWBA’s website at http://www.dol.gov/dol/pwba

In Conclusion ...

When you consider the fees in your 401k plan and their impact on your retirement income, remember that all services have costs. If your employer has selected a bundled program of services and investments, compare all services received with the total cost.

Remember, too, that higher investment management fees do not necessarily mean better performance. Nor is cheaper necessarily better. Compare the net returns relative to the risks among available investment options.

And, finally, don’t consider fees in a vacuum. They are only one part of the bigger picture including investment risk and returns and the extent and quality of services provided.

7. What other sources of information are available?

Listed below are some organizations and their Websites, phone numbers and publications that can help in your research.

From the Pension and Welfare Benefits Administration:
Protect Your Pension: A Quick Reference Guide
What You Should Know About Your Pension Rights

Website:
Among the items available on PWBA's Website is Study of 401k Plan Fees and Expenses (available only on the Internet)
http://www.dol.gov/dol/pwba

From the Securities and Exchange Commission:
What Every Investor Should Know
Invest Wisely - An Introduction to Mutual Funds
Ask Questions - Questions You Should Ask About Your Investments ... and What To Do if You Run into Problems

Website: http://www.sec.gov

From the Board of Governors of the Federal Reserve System:
Website: http://www.bog.frb.fed.us

From the Comptroller of the Currency:
Website: http://www.occ.ustreas.gov/investmt.htm

From the American Savings Education Council (ASEC):
Website: http://www.asec.org

From the Certified Financial Planner Board of Standards:
Website: http://www.cfp-board.org  

From the National Association of Securities Dealers, Inc.:
Website: http://www.investor.NASD.com

The costs of 401(k) plan services are somewhat dependent on the information that a plan sponsor has about the range of prices in the marketplace that are charged by these providers. A search of the literature shows that gaining visibility of the universe of thousands of service providers would be difficult to impossible for any plan sponsor with limited resources. For example, Valletta (February 1997) estimates that there are in excess of 1500 third party administrators and over 3,000 firms offering asset management services to 401(k) plans. 

The directories cited offer only a small segment of the available vendors, although the majority of the larger providers are displayed. For example, the 401(k) Provider Directory, one of the best known, only contains information about the 94 of the larger full service providers (HR Investment Consultants). The other directory located in the literature search, the (k)form Catalog, contains information about both full service providers as well as TPAs and alliances. However, the (k)form Catalog lists only 79 such providers. (The publisher states that these 79 providers service over 50% of 401k plans in the country.) 

Information about service providers is also available from associations, advertising, and the Internet. In addition, the 401k plan provider industry is very aggressively seeking to make their services known, frequently through well structured sales networks. However, the plan sponsor relying solely on information furnished by those service providers that establish contact through a sales force, would have incomplete knowledge of the marketplace. 

The foregoing discussion suggests that the market for 401k plan services is not particularly efficient for the plans that do not have the resources or interest to search for information that would allow a comparison of available services and prices. 

This section will categorize and describe the fees and expenses that are typically paid by or on the behalf of 401(k) plans. We will also cite the typical range of these expenses as revealed in the literature. In the next section we will identify the ranges and averages of expenses paid by plans of various sizes. 

One dimension that is useful in understanding fees and expenses is the basis for computing them (Tiemann). Asset-based fees are computed as an annual percentage charge on the total assets of the plan. Census-based fees are imposed on a per capita participant basis and itemized fees specify a fixed charge for a specific service. 

A typical price quotation might show fees and expenses of all three types. For example, a mutual fund provider might charge an investment management fee as an expense ratio on the funds (asset-based), a per-participant recordkeeping fee (census-based), and a fixed charge for set-up and conversion (McNabb). 

A useful way to classify expenses and fees, for the purpose of this analysis, would relate directly to the services being provided to the 401k plan. Therefore the following set of fees and expenses is proposed that focuses on the functions related to each expense category. 

· Set-up and conversion fees
· Recurring administrative costs
· Communications expenses
· Investment management fees
· Distribution fees
· Mortality and expense risk fees

There are one-time costs associated with the establishment of a new 401k plan or with the conversion of a plan's records to  another administrator's custody. Set-up entails the preparation of a plan document, often by adapting a prototype document, and the enrollment of participants. It also includes entering the participant data on the service provider's computer system, reconciling the existing plan's assets (if any), and setting up existing participant loans. 

Set-up costs are relatively fixed, although the typical provider charges a fixed amount plus a variable, participant-based fee. The range of costs for set-up is $500 to $3,000; however, many providers charge a lesser amount and recoup the difference from investment management fees (k(la), (k)form Catalog). In one sample of providers, the range of average set-up charges for plans of 25, 50, and 100 lives was $992, $1102, $1,202 (HR Investment Consultants, Averages Book). 

These fees cover trustee services, recordkeeping, compliance, distribution of account proceeds to departing participants, loan processing, and withdrawals. 

Trustee expenses typically are the smallest component of the total set of expenses, representing about 3% of fees on a typical plan with 500 participants and assets of $10 million (Stone). Trustee services are often offered at no additional, separate charge when the provider's funds are purchased by the plan. 

Compliance costs include the preparation of tax forms (Form 5500) and nondiscrimination testing. When administrative services are separately priced, the compliance expenses are typically included in the base charge rather than being separately priced. 

Recordkeeping is the largest component of recurring administrative expenses. This expense category includes enrollment, contribution and investment election processing, loan origination and processing, withdrawal processing, individual account maintenance, and preparation and mailing of account statements and summary annual reports. The 401(k) provider industry has made the investment in computer equipment and software to provide this recordkeeping in an efficient and relatively low cost manner. 

The recordkeeping expenses for a small plan can be quite high. Typically recordkeeping consumes about 14% of total expenses for a $10 million plan (Stone). However, providers make their margin on asset management, and where recordkeeping and asset management are done by the same provider, recordkeeping may be viewed as a loss leader, being included with the asset management fees. On a start-up plan, the provider may lose money for two to five years until the average account grows large enough so that the margin on asset-based fees is sufficient to cover the loss on recordkeeping (Richardson, May 1996). Larger funds experience substantially lower cost percentages. For a 500 life plan, for example, recordkeeping costs may be about 7% of total fees and expenses and may be even lower for a much larger plan (Valletta, November 12, 1997). 

In bundled mutual fund arrangements, recordkeeping expenses are included in the expense ratios. Where mutual fund providers out-source recordkeeping to third party administrators (TPA) alliances, there is typically a 15-20 basis point transfer from the expense ratio to the alliance for this expense (Rowland). 

Communications services typically include meetings with employees, printed and video materials describing the plan features and encouraging participation, basic election materials, and newsletters. More elaborate services might include a call center, interactive voice response system, participant asset allocation software, and Internet access. Communications services are valuable to the sponsor in that they encourage employee participation in the plan. They also help satisfy the disclosure requirement contained in section 404(c) of ERISA. 

For example, one typical, large full service provider offers all of the communications services listed above except participant software. There is no additional charge for these services except for a $500 setup, $6 per participant charge for the interactive voice response system support (HR Investment Consultants). 

The main purpose of investment management fees is to compensate the provider, who recommends the allocation of funds flowing into a particular 401k plan investment option from the universe of financial instruments available for this fund. For an equity mutual fund, for example, the investment management advisor selects the stocks that will be bought and sold. The investment management fee pays for the research that supports these buy-sell decisions. In addition, these fees compensate the mutual fund manager for the pro-rata operating expenses of the fund attributable to each 401(k) plan that buys shares. (These operating expenses include items such as rent, staff compensation, supplies, etc.) In practice, the distinction between investment management fees and other type fees is blurred. 

Investment management fees are the largest charges assessed against the plans. In plans where the assets are invested in mutual funds, for example, the investment management fee has been found to exceed 80% of total fees and expenses of a typical plan ("Retirement Planning;" Stone). Valletta found that the investment management fees may be as much as 90% of the total (Valletta, November 12, 1997). However, as will be seen below, these statistics may include certain other expenses such as marketing and distribution costs that are not separately disclosed. 

Other investment instruments, typically group variable annuities, include management fees in the "wrap." A wrap fee is an all-inclusive annual fee imposed on the value of total assets in an account. Wrap fees typically include expense elements other than investment management fees. 

Often, 401k providers rely on elaborate distribution networks to market their products. Distribution fees are charged to cover the expense of maintaining this network. For example, a large insurance, full service provider may market its products through one of three modes: 

· In-house sales force,
· A network of affiliated third party administrators, and
· Unaffiliated broker/dealers.

 Such a provider will establish commission schedules to compensate the sales force at all points in this network. When 401k plan investments are purchased through this distribution network, distribution fees are typically charged against the participants' accounts. Distribution fees compensate the distribution network participants for their labor. 

In the case of retail mutual funds, the sales commissions are disclosed in the prospectuses. Sales commissions can be collected in two ways: as front-end loads paid on new contributions to the fund (Class A shares) or as 12b-1 fees (combined with deferred contingent sales charges) deducted annually based on the fund's assets and reflected in the fund's net asset value (Class B shares). These sales commissions, whether collected when contributions are received or charged over a number of years against assets, are in the range of 3-4 percent of contributions (Schultz; Tuczak). For class B shares, the mutual fund manager pays sales commissions to broker/dealers up front and then recoups these funds over a number of years in the form of 12b-1 fees (Tuczak). Since the SEC limits the 12b-1 expenses to 100 basis points annually, a contingent deferred sales charge is imposed on the shares, typically for five years, to ensure that the mutual fund can recapture the sales commissions that were paid. A contingent deferred sales charge is only collected when the shares are sole during the contingent period. 

Insurance company providers (and other providers using a wrap fee) can collect distribution fees at two levels. On the first level, 12b-1 expenses are charged against the annual value of an individual mutual fund and transferred to the distributor. On the second level, part of the wrap fee imposed on the value of all instruments included in the group variable annuity may be used to pay for distribution costs. The amount of each 12b-1 fee is disclosed in each fund's prospectus, but the portion of the wrap fee that is devoted to distribution charges is not disclosed. 

Sales commissions for insurance products, including group and individual annuities, may be structured with two components. Deposit commissions are paid on balances transferred from other providers as well as periodic contributions into the plan. Trail commissions are paid on assets under management, including the growth from investment returns, and continue as long as the plan continues with the same insurance provider. The direct and trail commissions are typically combined and incorporated as part of the wrap fee. 

Insurance products, such as group and individual annuities, bear costs that are unique to these products and that reflect the insurance risk of each product. These risks include the mortality and expense guarantees inherent in the annuity contracts. (See Section II, Insurance Industry Products, for a discussion of these guarantees.) The M & E fees pay these costs. 

M & E fees are highest for individual variable annuities, generally ranging from 100 to 200 basis points (Hack). However, since distribution fees are often grouped with M & E fees, the total wrap fee for individual annuities might be in the range of 200 to 300 basis points. 

In the case of group variable annuities, the M & E fees are usually based on plan size (Hack). 

· For very small plans, less than 50 participants and $500k assets, 100 to 200 basis points, · For small plans, more than 50 participants and greater than $500 k assets, 75 to 150 basis points, · For medium sized plans, greater than 500 participants and $5MM assets, 30 to 75 basis points, and · For large plans, greater than 1,000 participants and $15MM assets, less than 50 basis points. M & E fees are typically imposed as wrap fee based on the total assets in the annuity accounts. 

The preceding discussion related administrative fees and expenses to the functions that they support. The following subsection describes the structure of fee payment modes. 

· Invoiced expenses
· Sales charges
· Expense ratios
· Wrap fees
· Net asset value computations

 Invoiced expenses are generally for recordkeeping and administration. They are often charged on an itemized basis, and may be paid by the sponsor, by the plan, or shared. There should not be any issue concerning disclosure by service providers to plan sponsors, for the sponsor can read the charges from the plan contract or from the periodic invoices or statements from the provider. Examples of invoiced expenses that would be paid by the sponsor or the plan are start-up fees, annual base fees, trustee fees, tax form filing, and recordkeeping for company stock purchases. Examples of invoiced expenses that might be paid by individual participants (or the plan) are loan origination, loan maintenance, and distributions. 

Some invoiced fees are census based, i.e., fees charged as amounts per participant. These fees are similar to itemized expenses in  that they are charged for recordkeeping and administration and in that there should be adequate disclosure of their extent to sponsors. Census-based fees, charged as a fixed amount per participant, are typically paid from plan assets or by the sponsoring firm. Examples of census-based fees are a per-capita addition to the annual base fee, additional fees for communications options that are not in the basic package, adding investments from outside providers, and the use of non-electronic data inputs. Some expenses are charged as itemized expenses by some providers and as census based fees by other providers. 

Regulated securities, such as mutual funds, may impose sales charges on purchases and/or reinvested dividends. Where up-front sales charges are imposed, they are disclosed to the sponsors and participants in the prospectuses. Contingent deferred sales charges combined with 12b-1 expenses may be used to assess sales charges (as described above). These charges are also fully disclosed. 

Mutual funds impose asset-based administrative fees and expenses that are disclosed in the form of expense ratios. Expense ratios, which are incorporated in the prospectuses and published in the financial press (for retail funds), show the amount of fees and expenses that are deducted from the assets of each fund annually. Since expense ratios reflect deductions from the assets of a fund, these expenses are borne by the individual participants in a plan by a charge against net asset value of the funds in their individual accounts. 

The Securities Act of 1933 requires the disclosure of the magnitude of fees imposed on mutual funds. The industry has developed a standard display of expense ratios: 

· Management fees
· Marketing and distribution fees
· Other administrative expenses

 Management fees represent a percentage of the fund assets paid to the fund's investment manager. These fees include the costs of research, the manager's compensation, and the firm's profit margin, among other costs. The identity of items included in the management fees for any fund is typically not disclosed. 

Mutual funds charge additional fees to support the marketing and distribution costs of the fund. These fees are authorized by the Securities and Exchange Commission as section 12b-1 expenses. They may not exceed 100 basis points. There is a trend, however, to use 12b-1 fees for other purposes. One such use involves the transfer of a portion of the marketing and distribution fees to consultants through 12b-1 fees; one author suggests that this may be as much as 25 basis points (Richardson, January 1997). Bundled providers are also observed to be out-sourcing recordkeeping services and charging plan sponsors 15-20 basis points in 12b-1 fees that are rebated to the recordkeeping provider (Rowland). 

Other administrative expenses is a category that primarily includes the servicing of shareholder accounts, such as providing statements, reports, dispersing dividends, as well as custodial services. 

The net effect of these expense ratios is that it is difficult to separate the investment management fees from the administrative fees using the published information. For example, there has been a dramatic increase, 44%, in the total expense ratio of the average diversified stock fund since 1980. However, if we look at the detail in the ratios, we see that the cause of this increase has been the shifting of sales charges from a front-end load to the 12b-1 segment of the expense ratio. "Other expenses" have fallen while the 12b-1 share of the expense ratio has increased. The real increase in investment management expenses (apart from marketing and distribution) since 1980 is closer to 17% than to 44% (Sheets). 

A wrap fee is an all-inclusive annual fee imposed on the value of total assets in an account. Originally developed to use with separate account money managers to pay the manager's fee as well as transaction costs, wrap fees are often associated with funds that still have internal expense ratios (Stone). For example, one large insurance company provider offers a variety of mutual funds to smaller 401(k) plans. Each of these mutual funds contains its own expense ratio. In addition, this provider charges an asset based wrap fee on the overall value of all of the mutual funds in the plan participants' accounts (Ryan). 

Wrap fees are typically charged by insurance providers, who package their 401k investments in the form of group or individual annuities. In these plans, wrap fees typically include M & E expenses and distribution fees in addition to the cost of plan services and investment management fees. Wrap fees may also be charges by some bank and investment management company providers. The magnitude of wrap fees (as a percentage of the 401k fund) is observed to be inversely proportional to the value of assets in the 401(k) plan (HR Investment Advisors). 

The magnitude of the wrap fee in any plan is disclosed to the plan sponsor (and, in some plans, to the plan participants). However, information about the portion of the wrap fee devoted to the elements of expense (M & E, distribution, services, investment management) is generally not disclosed (HR Investment Advisors). Since the typical wrapped account is an annuity, it is qualified as an insurance investment and not required to be registered nor to disclose fees in the detail required of mutual funds under the Securities Act of 1933 (Hack). 

 Certain investment products do not directly disclose any of the fees and expenses imposed on the plan participants. Instead, these charges are netted into the periodic net asset value (NAV) computations. Stable value accounts, such as GICs and BDAs use this technique to impose fees. In such accounts the provider guarantees a specified annual rate of return on each account. However, the fees and expenses are converted into a percentage charge against the assets in the account and are built into the formula for crediting investment returns. The plan sponsors and participants will be provided with the NAV and may be given the net rate of return used to compute the NAV, but the percentage devoted to fees and expenses will not generally be disclosed (Hack). (This is in contrast to mutual funds where fees and expenses are netted into the NAV but where the magnitude of fees and expenses are disclosed in prospectuses.) 

The plan sponsor seeking to minimize the fees and expenses imposed on a 401k plan is constrained by a number of issues that bear on the magnitude of fees and expenses. An important strategy for minimizing costs is to obtain competitive bids from a number of 401(k) service providers. Other considerations related to costs of services are: 

· Plan size
· Plan features and investment options
· Behavior of plan participants
· Portfolio turnover

 PLAN SIZE

Plan size is clearly an important dimension in the amount of fees and expenses a plan will absorb. This is largely a result of the fact that there are certain fixed costs of providing services to a plan that are not highly sensitive to the number of plan participants, and the fewer the participants, the higher the per-capita expenses. More and more vendors, especially mutual funds, focus only on the larger plans, those with 200 or more lives (Richardson, July 1997). 

Another consideration related to plan size is that many small plans are new accounts with few assets. Access Research is reported to be encouraging technology companies to set up automated service bureaus that would handle administration for multiple 401k service providers as a cost savings for small plans (Richardson, July 1997). 

Some sponsors may remain too small to easily afford a 401k plan. For firms with substantially less than 100 employees, the SIMPLE IRA plan or a profit-sharing arrangement may be a more affordable solution. Also, those small firms with higher than average income workers may prefer the higher maximum contribution limits in 401(k) plans over the SIMPLE IRA. 

Decisions by the plan sponsor have a considerable influence on the magnitude of fees and expenses that will be charged. These decisions involve the specification of services that will be provided to the plan as well as the selection of investment options that will be offered to the participants. An extensive set of services is available to 401(k) plans, and many of them are more elaborate than the minimum requirement mandated by law and regulation. When the plan sponsor chooses to include more elaborate services than the minimum requirement, albeit in response to employee demand, the administrative costs are increased. For example, the sponsor might specify that the plan allow employees to change their investments daily, and the service provider would quote an incremental price for this additional service (Quinn, January 1998). Increasing the frequency of compliance testing is an example of another service for which most providers would charge an additional fee (HR Investment Consultants, 401k Provider Directory). 

Another significant influence of plan sponsors' decisions on plan fees and expenses is in the selection of the suite of investment options that will be offered to participants. The plan that offers a wide spectrum of investment choices is likely to include investment options that have a higher than average expense ratio. For some investment options, for example employer stock and instruments purchased from institutions other than the full service provider, the provider will charge an additional itemized or census-based fee (HR Investment Consultants, 401k Provider Directory). Finally, including investment instruments that impose sales commissions on their purchases will increase the expenses being charged to participants who select these options. 

Plan sponsors influence the magnitude of fees and expenses when they select a service provider that only offers investments loaded with sales charges or that packages investment options in a group annuity. An example might be the typical major insurance provider that offers a set of investment options that feature choices among mutual funds. These funds are included in a group annuity wrapper and an asset-based wrap fee is imposed (except for the larger plans) (HR Investment Consultants, 401(k) Provider Directory). A similar set of investment options could be provided by a non-insurance provider, absent the group annuity. This does not suggest that the group annuity does not have value, only that it comes with an additional cost. Similarly, the plan sponsor that selects a full service mutual fund provider that offers only loaded retail funds, could find another provider that offers a set of no-load funds with similar risk-return characteristics. 

Participant behavior directly affects transaction costs. The typical plan provider charges additional fees for transactions such as withdrawals and loans. In the case of loans, there are charges for both loan origination and monthly maintenance (HR Investment Consultants, 401k Provider Directory). 

Participant behavior selection of the investment instruments also drives the level of fees and expenses. To the extent that participants understand the investment management fees imposed on alternative investment choices (mutual fund expense ratios, for example) they have the opportunity to influence the amount of expenses that will be charged to their accounts. This does not suggest that the rational choice is always the lowest cost fund. 

The participant's selection of actively managed versus passive investments will have an effect on investment management fees. The average expense ratios for particular fund categories encompass wide ranges from low to high expense ratios across individual funds (Fortune, December 23, 1996). 

One key factor in this wide range of expense ratios is the notable difference in expense ratios generally observed between indexed (or passive) funds and actively managed funds. In an indexed fund, the investment manager seeks to maintain a portfolio closely tracking an appropriate market performance indicator. For example, a U.S. large company stock fund might be benchmarked to the Standard & Poor's 500; a small company stock fund to the Russell 5000; an international stock fund to the Morgan Stanley EAFE (Europe, Australia, Far East) Index. Other fund categories have similar benchmarks meant to capture the overall performance of particular segments of stock and bond markets. In actively managed funds, the investment manager expends more costs on research, investment selection, and buying and selling. 

Similarly, the choice of equity versus fixed income investments affects expenses. Inspection of mutual fund expense ratios reveals that bond fund expenses are significantly lower than are those for equities (Sheets). 

PORTFOLIO TURNOVER Portfolio turnover is another factor affecting expenses. Higher portfolio turnover increases the transaction costs of buying and selling the individual securities in a mutual fund or other investment account. These transaction costs are not usually separately identified but are netted with the investment return, so it is difficult to observe them. Portfolio turnover results from decisions made by the investment manager, and is not under the direct control of the plan sponsor nor of the participants. However, portfolio turnover is often disclosed in the case of mutual funds and thus is indirectly controlled by sponsors and participants who select certain investment options in spite of the knowledge that the managers of that option are active traders. Portfolio turnover is an issue that should be considered by plan participants in choosing between actively managed and passive investments, as discussed in the preceding section. 

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The evidence shows that the largest element of expense for 401k plans is the investment management fees that are imposed principally as expense ratios in the case of mutual funds or as wrap fees imposed on assets in group annuities. It has been shown that investment management fees typically range from 75% to 90% of the total administrative fees and expenses imposed on a plan. The participants in a typical plan bear the mutual fund expense ratio and annuity wrap expenses. 

Recent surveys provide information showing that, apart from the investment management fees, participants are bearing a substantial fraction of the costs of administering 401k plans. Plan participants are more likely to pay non-mutual fund/group annuity investment management fees, while plan sponsors are more likely to pay other fees and expenses. Buck Consultants report that, in 51% of plans surveyed, participants paid all of the investment management fees; while sponsors shared in these fees in 19% of plans. The Profit Sharing/401(k) Council of America survey indicated that in 62% of plans participants paid all of the investment management fees. Hewitt Associates reported that, in 1997, participants paid 56% of non-mutual fund investment management fees. 

The opposite is the case with administrative fees (non-investment management fees). RogersCasey reports that, on average, 54% of plan sponsors pay all of these administrative fees, while 28% share these costs with participants. Larger plans (>10,000 lives) are more likely to shift administrative fees to participants. The Profit Sharing/401(k) Council of America survey results mirror these findings. 

The following table shows the results of a 1997 survey that asked plan sponsors how administrative fees and expenses are paid. 

The trend in recent years has been for plan sponsors to shift administrative and non-mutual fund expenses of the plans to plan participants (Hewitt Associates, 1997). The following table illustrates this trend. 

Another survey research study conducted over a four year base yielded comparable results. Table III-3 displays the results of this study.

The evidence that there is a trend to shift expenses from plan sponsors to plan participants is reinforced by a survey conducted in 1996 that asked plan sponsors to indicate their intentions for the future. This survey indicated that a modest but significant number of respondents intended to pay a lower percentage of such fees in the future. Table III-4 displays the results of this survey. 

The adequacy of the disclosure of fees and expenses to both plan sponsors and participants has been introduced as an important issue. (This was the focus of the public hearing held by the Department of Labor on November 12, 1997.) It is clear from evidence in the literature that not all investment products disclose the fees and expenses charged to a 401k plan, nor are all of the fees and expenses charged by service providers disclosed. For example, we have demonstrated that the fees imposed on stable value accounts are not usually identified and that other charges, such as sales fees, are often not disclosed. Adequate disclosure of fees and expenses should be important to sponsors as they select 401k service providers and monitor their performance. The disclosure of fees and expenses is also important to plan participants as they select among available investment options. ERISA charges DC plan sponsors with a fiduciary responsibility to act in the best interests of the plan participants. This implies that plan sponsors will know the costs of the services they procure and will apply due diligence to minimize these costs in the light of the level of services desired. 

There is evidence, however, that there is a lack of information about costs that may affect the level of some administrative fees and expenses. A Dalbar study in 1992 shows that 78% of plan sponsors did not know how much their costs were, largely because there are about 80 different ways in which vendors charge fees (Benjamin). Some observers have suggested that some plans absorb as much as 100 basis points in higher fees and expenses presumably due to ignorance about the extent of fees being charged (Butler, November 12, 1997). The logic supporting this assertion is that, absent knowledge of the fees and expenses, many plan sponsors will select a higher cost provider than would be selected with detailed cost information. 

The existence of such a large number of service providers suggests that competition in the marketplace should serve to minimize 401(k) plan fees and expenses. However, some observers believe that sponsors are not especially price sensitive in their purchasing decisions (Butler, November 12, 1997). Perhaps this is due to a lack of knowledge about the total fees and expenses being assessed. It also appears that some segments of the market are more efficient than are others. It is asserted, for example, that competition makes the market for large corporation plans very efficient (Barry). However, a valid distinction can be made between competitiveness in the market for services to large and small plans. This suggests that smaller plans do not benefit from this price competition (Cronin). 

Another issue related to whether sponsors need a greater disclosure of fees and expenses is the costs of the many plan features that are now characteristic of a typical plan. More services are being provided to plan participants today than was the case ten years ago — indeed — many did not exist ten years ago (interactive voice response systems, for example) (Saxon). The provision of these services is driven by demand. A valid question is: if participants knew how much optional features of their plans cost, would they demand so many (O'Brien). In a recent study conducted on the Internet, 85% of the 1000 respondents voted for greater investment returns versus more services from their plans (Butler, November 12, 1997). 

The imperatives for a greater disclosure of fees and expenses to participants are less clear. In one opinion, given in testimony at the public hearing before the Department of Labor on November 12, 1997, additional information would not benefit plan participants (Barry). They have one of two choices to make among the inventory of options offered by their plan. These decisions are yes or no for each investment option, and all they really need to know is now disclosed including historical rates of return and investment objectives. This argument would be much more persuasive if the evidence showed that plan sponsors have complete knowledge of fees and expenses and are acting responsibly on this information to minimize costs. 

An opposing view is that employees deserve the same access to information that the plan sponsors should be receiving when they select plan providers and investment vehicles. This argument starts from the construct of the DC benefit and especially of 401k plans in relation to an employee's retirement income security. Responsibility has been placed on employees to direct their own investments and to assume the risk of making bad decisions. Thus, they are entitled to all of the relevant information bearing on these decisions (Fink). Another factor arguing for the disclosure of information about plan costs to participants is that they have influence on the decisions of the plan sponsors in many firms. This influence may be exerted through employee advisory committees, their bargaining units, or through informal channels of communication. Thus participants deserve access to the information they need for informed participation in the sponsor's selection process. 

ERISA requires that participants receive information about the amount of fees and expenses charged against their plan in the summary annual report. In addition, plans are encouraged by section 404(c) (the ERISA safe harbor provision) to provide full disclosure of fees and expenses. However, except for investments covered by the Securities Act of 1933, for which a prospectus must be furnished to participants, there is generally no requirement in the law or Federal Code for a complete disclosure of investment expenses to plan participants (Fink). 

The disclosures required by plans seeking to comply with section 404(c) do not always display the full range of expenses charged to participants. Only that information relevant to the participant's capability to make rational choices among the investment options must be included. Thus, items such as the wrap fee and internal computations of the net asset values for stable value accounts would not necessarily be disclosed. 

What do the stakeholders in the 401k universe think about the adequacy of available information about fees and expenses? Testimony before a public hearing held by the Department of Labor revealed differing perspectives on this issue by industry and advocacy group representatives. The mutual fund industry appears to be solidly for a full disclosure of all fees and expenses to both plan sponsors and participants (McNabb; Fink). 

The Vanguard representative presented a model for a disclosure format that would appear to be acceptable to the mutual fund industry (McNabb; Fink; Tiemann). However, the industry's position on disclosure may be somewhat self-serving. The Securities Act of 1933 already requires them to disclose their administrative and investment management fees in a prospectus. Therefore, under current law, they are somewhat at a competitive disadvantage because they are subject to more stringent disclosure requirements than are insurance and bank investment products that are not similarly regulated and whose fees and expenses are often concealed in the net asset valuation computations. The Vanguard model disclosure would combine the asset-based, census-based, and itemized expenses into one "all-in" cost expressed as an expense ratio on total plan assets (McNabb). (This model disclosure is included in Appendix B, where several such models are displayed.) 

Representatives for the banking industry stated their support for adequate disclosure of information about fees and expenses but believe that such information is now available (Barry; Dudley). Strong sentiment was expressed that no actions should be taken to mandate what fees and expenses could be charged (Barry). Such an action would disrupt the structures that have been created to service the 401k industry. There was additional comment opposing the establishment of mandatory disclosure requirements (Barry; Saxon). 

The insurance industry was underrepresented at the hearing; the one insurance firm offering testimony operates in a niche market that offers mutual fund products wrapped in a group annuity to mostly small plans (Ryan). Anecdotal evidence was offered that some insurance companies would object to changes in their disclosure procedures that would separately identify their fees and expenses, such as distribution and M & E fees incorporated in the annuity wrap fees, to plan sponsors or participants (Butler, November 12, 1997; Snyder; Schultz). 

Testimony from individuals representing participants in 401(k) plans strongly advocated the need to provide participants with detailed information on the fees and expenses being charged against their accounts (Benna, O'Brien, Snyder). 

INTRODUCTION 

Systematic and reliable measurements of the fees and expenses incurred by 401k plans and their participants are difficult to establish. Within the 401(k) plan universe, the mechanisms through which recordkeeping and administration services are delivered, the manner in which expenses are charged for those services, and the expenses associated with the management of plan investments all vary widely. Additionally, there are difficulties in measuring the  differences between the total expenses involved in administering plans and the expenses actually paid by the plan participants. 

Most 401(k) plans purchase all or most of the essential plan administrative services from external providers, or alliances of multiple providers. For such plans, there are some data available regarding the structure and level of the fees quoted by the providers. However, at least three factors restrict the use of these data in this research effort. 

First, complete quantitative documentation of the major service providers' fee structures is not available for this study. A limited sample of fee structures was presented at the Department of Labor's public hearings (Valletta, November 12, 1997). 

Second, providers' fee quotes may reasonably be regarded as typical "asking prices" within the 401k marketplace. They do not necessarily reflect the actual "buying prices" that emerge after negotiations between plan sponsors and the providers. 

Third, many plans purchase some plan services from outside vendors, but provide other services using internal staff and resources. While there is some limited survey data suggesting which types of services are more likely to be provided internally, there is no systematic basis for identifying the expenses incurred in doing so. 

Another major difficulty in assessing the types and levels of major plan expenses results from the wide variations in products and fee structures. Two examples are particularly noteworthy. Providers may offer identical arrays of plan services – investment management, recordkeeping, loan administration, trusteeship, and so on – under very different fee arrangements. For example, one provider may offer comparatively low investment management fees, but charge separate and additional fees on a per capita or per transaction basis for all other services. A second provider may offer many administrative services at no charge, but generate revenue to finance these services by charging comparatively high investment management fees. As a result, it is difficult to establish benchmarks for individual fee components. 

Information reported by plan sponsors on Forms 5500, 5500-C, and 5500- R provide a measurement of some of the plan expenses that are charged against plan assets. Here however, there are significant uncertainties about the significance and implications of the data. First, the expenses reported on the Form 5500 do not include investment management expenses debited directly from the earnings that accrue in participants' accounts. Depending on plan size and participants' asset levels, these "hidden" fees may comprise 75% to 90% of total plan expenses (HR Investment Consultants, Averages Book). 

Second, expenses reported on the Form 5500 include only the portion of other expenses that plan sponsors charge against the plan assets. They do not include the portion of the expenses paid out of general corporate funds, and therefore do not provide a reliable indicator of the actual total expenses involved in administering the plan. An preliminary analysis of the Form 5500 data shows promise for further investigation, but did not merit inclusion in this report. 

Within this ambiguous context, the project team has attempted to develop a "best sense" notion of the general range and tendencies of 401(k) plan administrative expenses. The findings are based on multiple sources from the available literature in the area and the limited body of somewhat systematic data about provider fees 

 There are various ways to categorize the components of total plan expenses. The following discussion is based on four categories that capture distinct sets of service functions. 

1. Costs associated with the investment and management of plan assets (not including trading costs); 

2. The costs of plan administration and recordkeeping; 

3. The charges incurred for processing participant loans; and 

4. Trustees' fees. 

For each functional area, plan sponsors typically either provide the services internally or purchase them from outside providers.     

Three major components largely determine investment-related expenses when investment management services are purchased from outside providers: 

1. Expenses ratios incurred for the management of mutual funds and other plan accounts, typically charged through deductions from the earnings of each participant's 401k account (not including trading costs); 

2. Other asset fees attached to plan accounts over and above the expense ratios, used most extensively – but not exclusively -- by insurance companies as additional charges for their plan management services and certain guarantees and benefit enhancements they provide to the plan; and 

3. Sales charges that may attach to the investment of new plan contributions, fund transfers from other plans, and withdrawals from the plan (deferred sales charges). 

Generally speaking, as plan size increases, investment-related expenses grow in absolute terms, but decline as a percentage of total plan assets. Larger plans carrying more substantial pools of total assets are able to take advantage of discounted expense ratios and/or the waiver or reduction of additional asset fees and sales charges. In particular, as described in Section III, larger plans have access to institutional accounts that can significantly reduce investment-related fees. 

Expense ratios decline gradually as plan size increases. Other asset charges vary more significantly by plan size. This likely reflects two factors. First, insurance company offerings tend to be more prevalent among smaller plans, and frequently include additional asset charges, such as "wrap fees," as discussed in Section III. Second, some providers who assess "front-end loads" or other sales charges often exempt larger plans with larger asset volumes from payment of these additional charges. Overall, larger plans  enjoy a broader range of lower-cost options within the 401(k) marketplace. 

The following table shows the average expense ratios for various major categories of retail mutual funds (Sheets, 1996). The expense ratio is expressed as a percentage of fund assets, and is debited from shareholders' assets as compensation for the fund'  investment management services. These estimates are for retail funds. Institutional funds have been observed to offer expense ratios that typically are 50 basis points lower (Cerulli Associates). 

(Source: Sheets)  

The expense ratios of individual mutual funds, and average expense ratios within fund categories, can fluctuate from year to year. There is some evidence that retail mutual fund expense ratios have been increasing in recent years. Using broader, more aggregated categories, (Anand) estimated that among all equity (stock) funds, the average expense ratios were 1.205% in 1994, 1.252% in 1995, and 1.283% in 1996. Among all balanced/mixed funds, the averages were 1.162% in 1994, 1.246% in 1995, and 1.283% in 1996. 

Anand posits that the booming U.S. stock market and resulting large inflows of mutual fund investments – fueled in large measure through 401k plans – has contributed to the upward cost pressure. Although aggregate asset holdings have grown substantially, there are millions of new investors with relatively small account balances. On a percentage basis, these small balances are relatively expensive to administer. Additionally, the growth of the mutual fund industry as a whole has spawned the emergence of thousands of new funds. These new funds typically have higher administrative costs than older funds (Anand). 

The average expense ratios for particular fund categories encompass wide ranges from low to high expense ratios across individual funds. Fortune (December 23, 1996) reported the following ranges of expense ratios for eight major fund categories. The categories are arranged from lowest to highest average expense ratios, beginning with government treasuries funds and ending with international stock funds. 

One factor in this wide range of expense ratios is the substantial difference in expense ratios generally observed among indexed (or passive) funds versus actively managed funds. In an indexed fund, the investment manager seeks to maintain a portfolio closely tracking an appropriate market performance indicator. For example, a U.S. large company stock fund might be benchmarked to the Standard & Poor's 500; a small company stock fund to the Russell 5000 index; an international stock fund to the Morgan Stanley EAFE  (Europe, Australia, Far East) Index. Other fund categories have similar benchmarks meant to capture the overall performance of particular segments of stock and bond markets. In actively managed funds, the investment manager expends more costs on research, investment selection, and buying and selling. In the past few years, during a period of strong market performance in general, the indexed funds have been able to generate very favorable returns at low expenses. 

Table IV-3 depicts a range of average investment management expenses for six investment objective categories, for various types of investment mechanisms. The findings were developed by Cerulli Associates and reflect data for 1996 from Bernstein Research, the magazine Pensions & Investments, and Lipper Analytical Services. For each investment category Table IV-3 shows the average expense ratio for retail mutual funds, the average expense ratio for institutional mutual funds, and the average account management fees for separate accounts based on a $25 million investment by a large plan. For four of the investment categories, Cerulli also computed an average expense ratio for "Top DC Options," based on the expenses in funds most heavily used by sponsors of defined contribution plans. 

As these figures illustrate, there are considerable differences in average expenses, depending on the type of fund used. The average expenses estimated by Cerulli for retail mutual funds are generally consistent with the expenses cited in earlier tables. RRP

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