The impact of financial market turbulence on 401(k) plans has prompted employers to redouble their efforts to manage these savings programs as effectively and economically as possible. In particular, sponsors are taking steps to ensure that they and plan participants are receiving appropriate value for fees paid.

Scrutiny of 401(k) fee structures was building prior to the 2008 stock market downturn. Adding urgency to sponsors’ focus on this issue is the prospect of enhanced fee disclosure requirements on their Form 5500 for post-2008 plan years, as mandated by regulations adopted by the Department of Labor in 2007. In addition, pending legislation in Congress, the 401(k) Disclosure for Retirement Security Act of 2009 sponsored by Rep. George Miller (D-Calif.), would greatly expand the scope of required 401(k) fee disclosure both for plan sponsors and plan providers.

A similar measure, the Defined Contribution Fee Transparency Act of 2009, has been proposed by Rep. Richard Neal (D-Mass.). That legislation would, among other things, require employers to disclose annual operating expenses for each investment alternative and whether those fees pay for services beyond investment, such as plan administration, and whether there are additional charges for purchasing or selling the particular investment.

Even without these recent forces at work, plan sponsors’ fiduciary obligations under ERISA have always required thoughtful and ongoing monitoring of plan expenses.

The good news is that many plan sponsors, using a methodical approach and working with 401(k) service providers interested in winning or keeping their business, may jointly find opportunities to optimize the costs/service mix. The ultimate result: more dollars in employee retirement accounts, whether through an enhanced cost structure, investment management, administrative service offerings, or a combination of all three, that will help participants prepare for a more secure retirement.

In some cases, sponsors that undergo a fresh review of the services they’re receiving may determine that an overly narrow focus on fees could be undermining the long-term achievement of the strategic objectives of their 401(k) plans.

401(k) fee basics

A basic overview of the three categories of 401(k) costs from the plan provider to plan sponsors and participants – investment, administrative services, and participant communication – frames the subject:

>> Investment expenses: Each investment option has an expense component expressed as an expense ratio (annual expenses as a percentage of fund assets). Expenses are deducted from investment income before it is distributed to investors, thus participants cover these costs. Investment expenses include administrative expenses associated with processing fund transactions and maintaining shareholder records, fees paid to portfolio managers, and in some cases, 12b-1 fees, which compensate brokers and cover other fund marketing costs. Another component of the investment expense is the redemption fee, which is charged to plan participants who sell fund shares if they haven’t satisfied a minimum holding period – a common fund requirement designed to discourage short-term trading.

>> Administrative expenses: These expenses are for plan operations, including recordkeeping and trustee services. Others include per-participant fees, such as loan fees, advice fees, and, where available, fees for brokerage services enabling plan participants to purchase individual securities. Some plan sponsors choose to passthrough to plan participants other plan administration expenses, such as legal, consulting and audit fees allocable to 401(k) plans.

>> Participant communication expenses: 401(k) providers offering sophisticated customized participant education and communication services may charge for them on an à la carte basis, rather than fold them into an umbrella administrative fee structure.

Allocating costs

Plan sponsors have choices regarding how plan administration and participant communication expenses are paid – specifically, the extent to which those costs are borne by the plan sponsor company itself, or by participants. According to a recent survey of plan sponsors by the Investment Company Institute (ICI), an average of 74% of 401(k) fees and expenses are defrayed by asset-based charges, and thus by plan participants.

At the option of sponsors, participants may also pay some or all of other plan costs, including per-participant administrative fees.

How plan expenses are paid is a philosophical decision for plan sponsors, as well as a practical one based on their financial position and employee benefits budget. Regardless of how 401(k) costs are paid, sponsors must take steps to assure that they are appropriate for services rendered.

That process begins with achieving clarity about the fees the plan is currently paying. Much progress has been made in recent years, and continues to be made, in improving the transparency of the presentation of plan expenses and fee structures. But in seeking a clear understanding, plan sponsors need to be careful to avoid becoming buried in the minutia of fee and cost data. (Such is the hazard that may be posed by pending federal fee disclosure proposals.)

Seeking clarity

Plan sponsors must have a clear understanding of the fees that they and their participants are paying. Some providers provide a plan cost analysis, which outlines a plan’s specific investment expense, plan administration expense, and communications expense. If your service provider does not offer this, you can ask the company to complete a standard fee disclosure form, such as that issued by the Department of Labor, available on the Web: http://www.dol.gov/ebsa/pdf/401kfefm.pdf .

Sponsors can also use that form as a starting point to devise a more boiled-down, user-friendly version suitable for their own purposes.

Plan sponsors can look to a variety of sources for survey data on 401(k) plan fees to be used for preliminary, rough ballpark benchmarking purposes. The Investment Company Institute survey noted above is an example of a free resource that plan sponsors can review for initial “round number” reference purposes and to gain perspective on how different analysts seek to analyze comparative fee data. That survey is available on the Web: http://www.ici.org/pdf/rpt_09_dc_401k_fee_study.pdf

Of course, survey data on 401(k) fees can only be evaluated in the context of the sponsor’s goals for its plan and its unique employee demographics; “high” or “low” are meaningless concepts in a vacuum. Plan sponsors that haven’t done so should establish and execute an objective process for defining plan goals, and for determining 401(k) plan features required to achieve them. (The premier plan service providers can help 401(k) sponsors with this effort.)

Cost factors

Sponsors are sometimes surprised to learn the extent to which certain variables within their own control impact plan costs. For example, complex payroll systems requirements and sponsoring multiple defined contribution plans (that could be consolidated) can add significantly to 401(k) administrative fees. Plan providers can assist sponsors in performing cost-benefit analyses of such factors from the participants’ and sponsors’ perspectives.

Sponsors also must be mindful of how their plan size (factoring both assets and the number of participants) and complexity impacts fee structures. Apples-to-apples comparisons are essential when reviewing general vendor survey data.

The ICI survey illustrates this starkly: The median “all-in fee” (all plan costs as a percentage of plan assets) for plans with between $1million and $10 million in assets, at 1.27%, was more than double the .61% figure for plans with assets in the $100 million to $500 million range.

However, the ICI survey also notes that additional factors can cause providers to charge different fees to plans of the same size, pointing to the need for judicious reliance on of survey data. Such factors include the size of average participant contributions and employer matching contributions, the proportion of participant assets invested in equity-based funds, use of auto-enrollment, average account balance, number of plans, number of payrolls, cash flow, a change in economics of the plan (due to a merger or acquisition), and plan complexity.

Factors related to 401(k) plan design can be managed in a way that can reduce fees; other variables may be beyond the plan sponsor’s power to change. In any event, sponsors should avoid letting the “tail” of plan fees wag the “dog” of overall 401(k) plan success, based on their strategic purposes for their 401(k) plans.

Once sponsors are confident they have established the appropriate service requirements for their plan, they can feel assured that they are meeting their fiduciary responsibility. In addition, they can reasonably assess next steps to assure fees are acceptable for services received. If they are not, they can consider putting their plan out to bid.

The re-bid process should not be undertaken casually, as it requires a significant investment of staff time, as well as hard expense, if outside consultants are retained for the process. There is no universal guideline for the frequency with which sponsors should undergo a re-bid.

A possible alternative to the resource-intensive re-bid process is to retain an independent party to perform a more limited scope service, such as a fee study, to ensure that fees and services being provided by the current vendor, are acceptable.

Evaluating fee studies or, for that matter, bids produced in a re-bid situation, involves more than looking at raw fee numbers, of course. Plan sponsors’ fiduciary responsibilities dictate more than a mechanical comparison of numbers on a vendor fee comparison spreadsheet. Qualitative assessments of service providers’ reputations, demonstrated track records and expected performance based on key service quality criteria, are essential in gauging whether fees are appropriate.

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Howard Heller is manager of regulatory and legislative strategy for T. Rowe Price Retirement Plan Services, Inc.