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401(k)plans

Commentary

Fees and Expenses of 401k Mutual Funds Used in 401k Plans

As with any business, running a mutual fund involves costs. For example, there are costs incurred in connection with particular investor transactions, such as investor purchases, exchanges, and redemptions. There are also regular fund operating costs that are not necessarily associated with any particular investor transaction, such as investment advisory fees, marketing and distribution expenses, brokerage fees, and custodial, transfer agency, legal, and accountants fees.

Some funds used in 401k plans cover the costs associated with an individual investor's transactions and account by imposing fees and charges directly on the investor at the time of the transactions (or periodically with respect to account fees). These fees and charges are identified in a fee table, located near the front of a fund's prospectus, under the heading "Shareholder Fees."

A financially secure retirement is a goal of all Americans. The employees of Target Labs (www.targetlab.com) will confirm this. Since many of us will spend one-fourth to one-fifth of our lives in retirement, it is more essential than ever to begin preparations at an early age. Most financial planners report that an individual requires about 75 percent of his or her pre-retirement income to maintain the same standard of living enjoyed during one's working years.

Funds used in 401k plans typically pay their regular and recurring, fund-wide operating expenses out of fund assets, rather than by imposing separate fees and charges on investors. (Keep in mind, however, that because these expenses are paid out of fund assets, investors are paying them indirectly.) These expenses are identified in the fee table in the fund's prospectus under the heading "Annual Fund Operating Expenses."

A frequently asked question is whether the SEC imposes any specific limits on the size of the fees that a fund may charge. The short answer is the SEC generally does not, although the SEC limits redemption fees to 2% in most situations. The National Association of Securities Dealers, Inc. (NASD), however, does impose limits on some fees.

Under the heading of "Shareholder Fees," you will find:

Sales Loads (including Sales Charge (Load) on Purchases and Deferred Sales Charge (Load))

Redemption Fee

Purchase Fee

Exchange Fee

Account Fee

Under the heading of "Annual Fund Operating Expenses," you will find:

Management Fees

Distribution [and/or Service] (12b-1) Fees

Other Expenses

Total Annual Fund Operating Expense

Shareholder Fees
Sales Loads
Funds used in 401k plans that use brokers to sell their shares must compensate the brokers. Funds used in 401k plans may do this by imposing a fee on investors, known as a "sales load" (or "sales charge (load)"), which is paid to the selling brokers. In this respect, a sales load is like a commission investors pay when they purchase any type of security from a broker. Although sales loads most frequently are used to compensate outside brokers that distribute fund shares, some funds used in 401k plans that do not use outside brokers still charge sales loads.

The SEC does not limit the size of sales load a fund may charge, but the NASD does not permit mutual fund sales loads to exceed 8.5%. The percentage is lower if a fund imposes other types of charges. Most funds used in 401k plans do not charge the maximum.

There are two general types of sales loads-a front-end sales load investors pay when they purchase fund shares and a back-end or deferred sales load investors pay when they redeem their shares.

Sales Charge (Load) on Purchases
The category "Sales Charge (Load) on Purchases" in the fee table includes sales loads that investors pay when they purchase fund shares (also known as "front-end sales loads"). The key point to keep in mind about a front-end sales load is it reduces the amount available to purchase fund shares. For example, if an investor writes a $10,000 check to a fund for the purchase of fund shares, and the fund has a 5% front-end sales load, the total amount of the sales load will be $500. The $500 sales load is first deducted from the $10,000 check (and typically paid to a selling broker), and assuming no other front-end fees, the remaining $9,500 is used to purchase fund shares for the investor.

Deferred Sales Charge (Load)
The category "Deferred Sales Charge (Load)" in the fee table refers to a sales load that investors pay when they redeem fund shares (that is, sell their shares back to the fund). You may also see this referred to as a "deferred" or "back-end" sales load. When an investor purchases shares that are subject to a back-end sales load rather than a front-end sales load, no sales load is deducted at purchase, and all of the investors' money is immediately used to purchase fund shares (assuming that no other fees or charges apply at the time of purchase). For example, if an investor invests $10,000 in a fund with a 5% back-end sales load, and if there are no other "purchase fees," the entire $10,000 will be used to purchase fund shares, and the 5% sales load is not deducted until the investor redeems his or her shares, at which point the fee is deducted from the redemption proceeds.

Typically, a fund calculates the amount of a back-end sales load based on the lesser of the value of the shareholder's initial investment or the value of the shareholder's investment at redemption. For example, if the shareholder initially invests $10,000, and at redemption the investment has appreciated to $12,000, a back-end sales load calculated in this manner would be based on the value of the initial investment-$10,000-not on the value of the investment at redemption. Investors should carefully read a fund's prospectus to determine whether the fund calculates its back-end sales load in this manner.

The most common type of back-end sales load is the "contingent deferred sales load," also referred to as a "CDSC," or "CDSL." The amount of this type of load will depend on how long the investor holds his or her shares and typically decreases to zero if the investor hold his or her shares long enough. For example, a contingent deferred sales load might be 5% if an investor holds his or her shares for one year, 4% if the investor holds his or her shares for two years, and so on until the load goes away completely. The rate at which this fee will decline will be disclosed in the fund's prospectus.

A fund or class with a contingent deferred sales load typically will also have an annual 12b-1 fee.

A Word About No-Load Funds used in 401k plans

Some funds used in 401k plans call themselves "no-load." As the name implies, this means that the fund does not charge any type of sales load. As described above, however, not every type of shareholder fee is a "sales load," and a no-load fund may charge fees that are not sales loads. For example, a no-load fund is permitted to charge purchase fees, redemption fees, exchange fees, and account fees, none of which is considered to be a "sales load." In addition, under NASD rules, a fund is permitted to pay its annual operating expenses and still call itself "no-load," unless the combined amount of the fund's 12b-1 fees or separate shareholder service fees exceeds 0.25% of the fund's average annual net assets.

Redemption Fee
A redemption fee is another type of fee that some funds used in 401k plans charge their shareholders when the shareholders redeem their shares. Although a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not considered to be a sales load. Unlike a sales load, which is generally used to pay brokers, a redemption fee is typically used to defray fund costs associated with a shareholder's redemption and is paid directly to the fund, not to a broker. The SEC generally limits redemption fees to 2%.

Purchase Fee
A purchase fee is another type of fee that some funds used in 401k plans charge their shareholders when the shareholders purchase their shares. A purchase fee differs from, and is not considered to be, a front-end sales load because a purchase fee is paid to the fund (not to a broker) and is typically imposed to defray some of the fund's costs associated with the purchase.

Exchange Fee
An exchange fee is a fee that some funds used in 401k plans impose on shareholders if they exchange (transfer) to another fund within the same fund group.

Account Fee
An account fee is a fee that some funds used in 401k plans separately impose on investors in connection with the maintenance of their accounts. For example, some funds used in 401k plans impose an account maintenance fee on accounts whose value is less than a certain dollar amount.

Annual Fund Operating Expenses

Management Fees
Management fees are fees that are paid out of fund assets to the fund's investment adviser for investment portfolio management, any other management fees payable to the fund's investment adviser or its affiliates, and administrative fees payable to the investment adviser that are not included in the "Other Expenses" category (discussed below).

Distribution [and/or Service] (12b-1) Fees
This category identifies so-called "12b-1 fees," which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses.

"12b-1 fees" get their name from the SEC rule that authorizes their payment. The rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (12b-1 plan) authorizing their payment. "Distribution fees" include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature.

The SEC does not limit the size of 12b-1 fees that funds used in 401k plans may pay. But under NASD rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund's average net assets per year.

Some 12b-1 plans also authorize and include "shareholder service fees," which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. Unlike distribution fees, a fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund's 12b-1 plan, these fees will be included in this category of the fee table. If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the "Other expenses" category, discussed below. The NASD imposes an annual .25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan). Additional non-profit websites that include relevant unbiased information about 401k plans include: www.lifestyle401k.com and www.e401k.net

Other Expenses
Included in this category are expenses not included in the categories "Management Fees" or "Distribution [and/or Service] (12b-1) Fees." Examples include: shareholder service expenses that are not included in the "Distribution [and/or Service] (12b-1) Fees" category; custodial expenses; legal expenses; accounting expenses; transfer agent expenses; and other administrative expenses.

Total Annual Fund Operating Expense
This line of the fee table is the total of a fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets.

A Word About Mutual Fund Fees and Expenses
As you might expect, fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858-an 18% difference. It takes only minutes to use the SEC's Mutual Fund Cost Calculator to compute how the costs of different mutual funds used in 401k plans add up over time and eat into your returns.

The three primary reasons why 80% of America's small businesses do not offer 401(k) plans to their employees are: (a) perceived cost of employer-sponsored retirement plans, (b) perceived complexity of company-sponsored retirement plans, and (c) limited investment options. Mutual fund companies offering 401(k) plans to small businesses do so by pre-packaging administration with their proprietary fund investments; this pre-packaged approach, called "bundled 401(k)" tends to be pricey for small companies, limited features and limited investment options. Employees who participate in bundled 401(k) plans typically do not have access to investments not offered by the mutual fund company, and do not have access to the most popular investment option today-the individual self-directed discount brokerage account.

401(k) Plans Must be Sponsored by an Employer

Millions of American workers can't take advantage of the 401(k)'s many attractive attributes because, for one reason or another - typically high plan costs, plan inflexibility, and/or prohibitive minimum participation standards - their employers do not sponsor a plan. In particular, very small, small, and medium-sized companies have found sponsorship difficult if not impossible. Some 89% of very small companies (10-50 employees), 72% of small companies (50 - 100 employees), and 66% of medium-sized companies (100 - 250 employees) do not have 401(k) plans (Census Bureau figures). These figures do not include the companies that have fewer than 10 employees, what might be called "micro" companies.

The tax deferral of 401k has a huge compounding effect: $150 per month put into a typical taxable savings account paying 8% annual interest will grow to $42,034 by the end of 20 years (assuming a combined federal and state personal income tax rate of 34%). In a 401(k), however, the same deposits earning the same rate of return during the same 20 years will yield $88,353 . Even if that amount is taxed at the 34% rate when the money is withdrawn from the plan, which is unlikely if the participant is retired, the 401(k) participant will walk away with more than $16,000 compared to the equivalent non-401(k) investment return.

401(k) plans have the highest annual contribution ceiling of any of the tax-deferred defined contribution savings programs (IRAs, SEPs, etc.). More money contributed equals more money earning money, equals more money in the account 20 years later. Add to this earning potential the convenience of contributions made through automatic payroll deductions and it's easy to see why 401(k)s are so popular.

The average 401K account balance at the end of 1998 was $47,000 per participant, up 26% from 1996, according to the ICI and the Employee Benefit Research Institute. On average, 78% of eligible employees will participate in a 401(k) plan if one is made available, with the number of participants growing from 19.5 million in 1990 to 53.2 million in 2000. Some of the increase in participation rates is due to the introduction of "negative election," which allows an employer to automatically enroll employees into the 401(k) when they meet the plan's eligibility requirements. The negative election deferral rate and investment(s) must be defined ahead of time, and the employee must be immediately notified of his or her participation status. Automatic enrollment programs are sanctioned by the IRS under ERISA as long as the employee has ample ability to cease enrollment at will.

Traditional 401(k) plan vendors did not think much about approaching smaller companies until recently, and did so then only because they recognized that the larger-company market was pretty well saturated. When they did turn their attention to the smaller and mid-sized plan market, they were well prepared with a library of useful educational materials for potential and actual plan participants. Participation is participation, after all, whether it is in a plan with 50 participants or 50,000

Unfortunately, however, these vendors were not equally well prepared to service the needs of the smaller companies: the plans they designed and the packages they offer are not always appropriate in price, substance, or style, and their pamphlets and publications are often too dry, legalistic, and expensive. Perhaps it is because most of these vendors are large companies themselves that they have difficulty designing 401(k) plans that embody the entrepreneurial, "do-it-yourself" spirit so prevalent in many small and medium-sized companies.

Internet penetration and usage by small businesses is a key component of 401(k). According to a survey conducted by IDC, Internet usage by small businesses reached 62% in 1998. Total small business spending on Internet related applications is expected to increase from $6.6 billion in 1998 to 418.2 billion by 2002, yielding an annual growth rate of 45%.

Financial institutions such as banks, brokerage firms, and trust companies (e.g., Union Bank of California, Wells Fargo Bank, Merrill Lynch, First Trust) offer 401(k) administration services that tend to be less expensive than services offered by benefit consulting firms. The main target of the financial institutions is also the Fortune-500-sized organization; however, they offer the advantage of more closely linking the investment vehicles with plan administration and recordkeeping. They can achieve vertical integration of investments and administration because banks, brokerages, and some trust companies offer a predefined group of proprietary and other mutual funds investments that pay 12b-1 and other asset-based fees to these plan providers, helping offset the cost of providing plan administration. Today these often "hidden" asset-based fees are coming under close scrutiny by government agencies and the press as being unfair to plan participants. As media and governmental investigation pressures mounts, financial institutions will need to find other ways to offset or cut their administration costs-401(k) Enginuity will become a more and more attractive alternative to traditional administration platforms as time goes on.


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