Why you may be subsidizing a co-worker’s 401(k) fees

Workers who participate in a company 401(k) plan pay fees for a host of associated services. Among them is the cost of administering the plan — for example, tracking daily fluctuations in account value, facilitating trades and issuing regular notices to investors.

But based on how your employer structures its retirement plan, you may unknowingly be subsidizing colleagues’ 401(k) fees.

The dynamic is a function of the investments you choose and how the 401(k) plan pays costs for administrative expenses.

Retirement savers (like players in the broader investment world) may be unaware of the fees they pay. Many financial firms inside and outside the 401(k) ecosystem often levy an annual fee directly from client accounts instead of asking them to write a check.

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Mutual funds in 401(k) plans are no different.

The overall cost of those funds may include a “revenue-sharing” fee (also known as a 12b-1 fee, a distribution fee or shareholder services fee, for example). The fund manager collects this fee and then passes it along to the 401(k) plan’s administrator.

This behind-the-scenes infrastructure is how many plans pay for record-keeping and other services delivered by firms such as Fidelity Investments, Empower Retirement and TIAA-CREF, which are among the largest 401(k) administrators.

Just 8% of workplace retirement plans such as 401(k) plans use revenue sharing to pay for plan administration, according to a recent annual survey published by Callan, a consulting firm. That’s down from 16% last year and about 40% a decade earlier.

However, its prevalence may be more widespread than the Callan survey suggests. The bulk of respondents have workplace retirement plans with more than $1 billion in worker savings — among the largest in the country.

But small 401(k) plans use revenue sharing more often to pay for services. A separate poll by the Plan Sponsor Council of America, an employer trade group, across a broader swath of plan sizes indicates almost 40% use funds with revenue sharing, and about three-quarters of those employers use the fees to pay for plan expenses.

This fee sharing is a somewhat opaque practice since it occurs behind the scenes. The practice also sometimes leads some workers to pay more for 401(k) administration than their peers — effectively subsidizing the service for colleagues.

That’s because not all investment funds carry a revenue-sharing fee. For example, actively managed funds levy such a fee more often than index funds. (Of course, there are exceptions.)

“There can be some inequalities in terms of who’s paying for what,” said Greg Ungerman, a senior vice president at Callan who leads a team working with workplace retirement plans.

The dynamic means a saver invested solely in index funds may not pay any revenue-sharing fees for 401(k) plan expenses, whereas another worker in the same 401(k) plan invested solely in actively managed funds may pay the fees.

Hence, the latter subsidizes costs for the former, even though they get the same services.

Employers have begun moving away from the practice, amid a flurry of lawsuits around excessive 401(k) fees and federal fee-disclosure rules to boost transparency, which were adopted about a decade ago.

Furthermore, money managers have increasingly offered versions of their investment funds that strip out a revenue-sharing fee. In this case, a 401(k) administrator would deduct a fee for their services from workers’ accounts separately, instead of getting paid by the fund manager directly.

Many employers have indeed shifted toward this type of fee model, Ungerman said. Often, that takes the form of a flat fee expressed in dollars, charged per plan participant.

Sometimes, employers may not have much of a choice — they are somewhat at the mercy of the investment firms. A particular mutual-fund family may always include revenue sharing, for example.

But technology has evolved such that many plan administrators are able to capture the revenue-sharing fee and funnel the money back to the investor who paid it — a workaround to make the 401(k) plan more equitable. However, this function isn’t always available, and the employer has to choose the option.

“It’s up to the plan sponsor to make that determination,” Ungerman said.