Investment Fees - Class 106

First, the preferred investment vehicles of 401(k) Plans are mutual funds. If you didn't already know this, a mutual fund is a collection of stocks and/or bonds wrapped into a single security. Now, you should know that there are certain fees associated with these investment options. These investment fees are known as expense ratios and they are charged to you as a participant before receiving your returns. This is the fee that the mutual fund company charges the investor for the operational costs of managing the fund. Let’s take a deeper dive into these investment fees.

The expense ratio mentioned above is charged to the investor before the participant receives any returns. Now, many people are surprised to learn this as they are not aware that they are paying anything by being a participant in a 401(k) Plan. I'm here to give you the shocking news that mutual fund companies are not non-profit organizations and they will make money on the investor regardless of whether the mutual fund makes a profit or incurs a loss in a given year. So if we, as investors, are committed to paying a fee to the mutual fund managers, wouldn't it make sense that we try to reduce this fee as much as possible?
 
This is where we get into the conversation of mutual fund share classes. Let's use a theoretical example of the Professor Deters mutual fund. The Professor Deters fund is offered to investors in a variety of share classes. Let's assume this fund is offered in share classes R1 through R6. The Professor Deters R1 mutual fund charges the highest expense ratio of 2.00% and the R6 share class charges the lowest expense ratio at 0.15%. Now, let’s assume that the Professor Deters fund experiences a gain of 10.00% in a given year. The R1 share class will yield a net return of 8.00% to the investor whereas the R6 share class will yield a net return of 9.85%. Therefore, why would anyone choose to invest in the R1 share class when you could be participating in the returns of the R6 share class? Did you ever wonder what those letters meant after the mutual fund name? Now you know.
 
The expense ratio can also be made up of a few components. As I mentioned above, the mutual fund company charges the investor for the operational costs of managing the fund. This component of the expense ratio is known as the “management fee”. The next component of the expense ratio is known as a 12(b)(1) fee. The 12(b)(1) fees are generally charged to the participant to pay for the fund’s marketing and distribution expenses. These fees compensate the broker to help oversee the investments offered in the retirement plan and to support the individual participants. The third and final component of the expense ratio is known as the sub-TA fee. A sub-TA fee is generally charged to the participants to offset the plan costs charged to the company sponsoring the 401(k). This type of fee offsetting is also known as “revenue sharing”. As the name implies, the revenue made from the participants in the form of sub-TA Fees is used to offset or share the cost of the retirement plan with the plan sponsor. Therefore, the sum of the management fees, 12(b)(1) fees, and sub-TA fees equal a mutual fund’s expense ratio.
 
We will discuss the fiduciary ramifications of having participants pay for the plan’s costs in a future class but, for today, we just need to know that participants will pay a fee for participating in the retirement plan. Join us for next week’s class when we discuss the differences between an Open Architecture & Closed Architecture 401(k) and how the fees listed above will determine how the plan gets billed…