Assessing the Risks of 401(k) Fee Mismanagement
October 22, 2020
Josh ItzoeFounder & CEO
Okay, you should get the picture about 401(k) and 403(b) fee litigation trends. Large organizations are getting sued (and often losing/settling) because of fee mismanagement. Meanwhile, the pace of litigation is increasing. Here’s a key point to keep in mind: big companies are losing lawsuits despite having large, sophisticated HR and finance teams that you’d think would be knowledgeable and effective in this area. But if they have been making major mistakes, what’s the likelihood a small company is doing a better job without the same resources?
Quantifying The Impact From A Corporate Finance Perspective
It’s in the best interest of companies to gain control of retirement plan fees, both to manage corporate risk and also to enhance employee goodwill. I’ve already quantified the estimated financial impact on employees. But since most plan fees aren’t paid by the company, reducing costs isn’t often seen as high a priority from a corporate finance perspective because it doesn’t affect the bottom line. The best way for companies to get motivated is to quantify the long-term impact of high fees, at both the plan level and at the employee level.
Most CFOs can create a present value (PV) formula in Excel in their sleep. So that’s a great place to start. Think of retirement plan fees like any other potential business expense, even though very little direct cost may hit the company’s P&L statement. Just in case you slept through your finance class in college, let me refresh your memory about present value. Present value is what a future sum of money or a stream of cash flow is worth in today’s dollars. You determine present value by taking a future sum of money and then using an interest rate (called the discount rate) to factor in the time value of money. The higher the discount rate, the lower the present value of that future sum of money.
At the plan level, one way to think about the long-term impact of high fees is to project the impact over a period of time (e.g., ten years). So put on your CFO hat. Let’s assume you have a $20 million 401(k) plan with 200 participants, and the current total annual fees equate to 0.80 percent of plan assets ($160,000/year). Also, let’s assume that participants pay all plan fees, so there is no direct cost to your company.
If the plan grows at 5 percent over the next ten years there will be roughly $31 million in the plan. For simplicity, I will assume this includes market growth plus annual contributions, such as employee deferrals and employer contributions. With annual plan fees of 0.80 percent remaining constant over that period, the cumulative fees paid would be $2,013,601.
However, consider if you had negotiated plan fees of 0.40 percent during that same ten-year period. The plan would have only paid $1,029,394 in fees, which is a difference of $984,207! Look at this chart to see the difference:
Now, using a discount rate of 4 percent, the present value of that $984,207 in additional fees is worth $664,895 in today’s dollars. This is like depositing that amount of money in the plan today. With 200 participants, that’s like giving each one of them $3,324 in additional retirement assets ($664,895 ÷ 200) just from fee savings!
Remember that you’re still wearing your CFO hat. If you were projected to spend more than $2 million on IT services over the next decade and someone told you they could save you nearly $700,000 in today’s dollars, would you listen? I expect you would jump at the chance to save this kind of money for your company. Otherwise, you may not be CFO for long! The difference is that the cost of IT is a direct expense that hits the bottom line of your company’s P&L, while retirement plan fees do not since they are paid through the plan and absorbed by your employees. Because of a lack of awareness, a lack of concern, just sheer laziness, or a combination of all three, companies rarely have the same level of commitment to reducing plan costs as they do other types of business expenses.
From a fiduciary perspective (and for the good of your employees’ financial futures), that kind of thinking needs to change. This example illustrates the importance of thinking about retirement plan fees like any other corporate expense and applying a similar decision-making logic to the process.