Why Small 401(k) Plans Should Remain Wary of Hidden Fees

Unchecked hidden fees in small business 401(k) plans continue to be an issue despite regulation, litigation and advancements in plan design leading to years of fee compression, according to a recent white paper by the advisory Beacon Financial Services, part of Beacon Financial Group Inc.

The Department of Labor’s regulation that plan fiduciaries only charge participants with “reasonable” and “necessary” fees has guided plan sponsors and their advisers, but it has not stopped the flood of fee litigation over the past decade pressing for stringent monitoring and decisionmaking, Beacon noted in its paper released in November, “The Hidden Fee Manifesto.”

“The past decade has seen a stark uptick in 401(k) litigation from disgruntled plan participants, many of whom felt excessive and hidden fees eroded their retirement savings,” the advisers wrote. “It’s hitting plan sponsors large and small.”

Small Plans Can Be Sued, Too

According to fiduciary insurance data cited by Beacon via North Carolina-based law firm Robinson Bradshaw, 40% of excessive fee suits filed in 2022 were related to plans with less than $1 billion in assets, and 20% were related to plans with less than $500 million in assets. The Beacon report noted several 401(k) plan fees to be aware of, including: administrative fees, investment fees and user-based service fees. It also laid out the players who contribute to the costs for plan sponsors to administer a plan, including recordkeepers, third-party administrators, custodians, retirement plan advisers and investment managers.

Mark Melnychuk, U.S. consulting services leader, retirement plan consulting, agrees that fee management is an important area on which plan advisers and sponsors should remain focused. He says via emailed response that advisers must be able to identify key fee drivers for proper oversight, including investment fees, administrative fees and revenue-sharing agreements as well as fee disclosure requirements.

“By being vigilant in identifying potential hidden, and possibly excessive, retirement plan fees, advisers can guide plan sponsors, by prudent process, in making informed decisions that impact all plan participants, thus documenting a process that participants’ retirement savings are not unnecessarily eroded by excessive fees,” says Melnychuk.

Watch the Share Class

The Beacon report homed in on revenue sharing as the biggest culprit of hidden fees, calling the practice a “deliberate overcharge at the fund level” used to help pay for a plan’s administrative costs or financial adviser broker commissions.

“Most participants have no idea they are paying those fees,” Brian Menickella, managing partner at Beacon Financial, says via email. “The share class of investment is a telling sign of whether revenue sharing exists.”

Among share classes often used in retirement plans, A, C, I and R shares may include revenue-sharing agreements, Beacon noted. But funds most likely to include hidden revenue sharing fees are those in the R share class, specifically designed for qualified plans.

“Typically, retirement Version A shares and various R2 through R5 shares are notorious for having these embedded hidden fees,” said Menickella. “Other share classes such as Y or N classes may also have some degree of hidden fields. While difficult to find, these fees are typically disclosed within the plan’s 408(b)(2) fee disclosure document.”

Depending on which share classes of mutual funds are included in a 401(k) plan’s investment lineup, participants may pay higher fees than they would for different share classes of similar funds, the report noted.

Because these fees are charged in addition to the standard flat fees and per-participant fees charged directly by the recordkeepers, TPAs and other vendors, Beacon Financial stated that it is critical for plan sponsors to pay close attention to the expense ratios of the funds included in their retirement plan’s fund lineup.

Revenue Sharing Trending Down

In analysis of retirement plan Form 5500 filings by Brightscope, about 25,000 DC plans out of 74,000 had some kind of revenue sharing arrangement as of 2022. Brightscope, like PLANADVISER, is owned by ISS STOXX GmbH.

Separate research by consultancy Callan finds that “very few clients” still use revenue sharing, and those that do are generally smaller plans, according to Patrick Wisdom, a member of the firm’s defined contribution practice.

“We do have larger clients that offer fund share classes with a revenue sharing component, but in most cases, participants are rebated the revenue share amount, and therefore those share classes are often less expensive than alternative share classes without revenue sharing on that net basis,” Wisdom says via email response.

When advising plan sponsors about hidden fees in 401(k) plans, Melnychuk of Gallagher says advisers should consider flat fees or arrangements to mitigate revenue-sharing charges.

“In promoting successful participant outcomes and mitigation of liability for the plan sponsor, the adviser should consider plan design and prudent processes for fee-management oversight,” Melnychuk says. “[This includes] established recordkeeper revenue requirements (bps and flat dollar) and exploring revenue-sharing arrangement oversight, including zero-revenue investment and lowest-net-share-class arrangements (with timely revenue-sharing re-allocation to plan participants) to support the documentation of fee-reasonableness.”

Correction: Fixes incorrect name spelling.