home | contact

 

 

INVESTMENT-RELATED EXPENSES

Three major components largely determine investment-related expenses when investment management services are purchased from outside providers: 

1. Expenses ratios incurred for the management of mutual funds and other plan accounts, typically charged through deductions from the earnings of each participant's 401(k) account (not including trading costs); 

2. Other asset fees attached to plan accounts over and above the expense ratios, used most extensively – but not exclusively -- by insurance companies as additional charges for their plan management services and certain guarantees and benefit enhancements they provide to the plan; and 

3. Sales charges that may attach to the investment of new plan contributions, fund transfers from other plans, and withdrawals from the plan (deferred sales charges). 

Generally speaking, as plan size increases, investment-related expenses grow in absolute terms, but decline as a percentage of total plan assets. Larger plans carrying more substantial pools of total assets are able to take advantage of discounted expense ratios and/or the waiver or reduction of additional asset fees and sales charges. In particular, as described in Section III, larger plans have access to institutional accounts that can significantly reduce investment-related fees. 

Expense ratios decline gradually as plan size increases. Other asset charges vary more significantly by plan size. This likely reflects two factors. First, insurance company offerings tend to be more prevalent among smaller plans, and frequently include additional asset charges, such as "wrap fees," as discussed in Section III. Second, some providers who assess "front-end loads" or other sales charges often exempt larger plans with larger asset volumes from payment of these additional charges. Overall, larger plans  enjoy a broader range of lower-cost options within the 401(k) marketplace. 

The following table shows the average expense ratios for various major categories of retail mutual funds (Sheets, 1996). The expense ratio is expressed as a percentage of fund assets, and is debited from shareholders' assets as compensation for the fund'  investment management services. These estimates are for retail funds. Institutional funds have been observed to offer expense ratios that typically are 50 basis points lower (Cerulli Associates). 

 

Average Expense Ratios, U.S. Mutual Funds, by Fund Category, 1995

Fund Categories Average Expense Ratio
Stock Funds  Growth and Income   1.32%
Long-Term Growth 1.42%
Aggressive Growth 1.56%
Sector 1.69%
International/Global 1.76%
Bond Funds High Quality Corporate 0.93%
Government 1.02%
Mortgage Securities 1.11%
Junk (high-yield) 1.41%

 

(Source: Sheets)  

The expense ratios of individual mutual funds, and average expense ratios within fund categories, can fluctuate from year to year. There is some evidence that retail mutual fund expense ratios have been increasing in recent years. Using broader, more aggregated categories, (Anand) estimated that among all equity (stock) funds, the average expense ratios were 1.205% in 1994, 1.252% in 1995, and 1.283% in 1996. Among all balanced/mixed funds, the averages were 1.162% in 1994, 1.246% in 1995, and 1.283% in 1996. 

Anand posits that the booming U.S. stock market and resulting large inflows of mutual fund investments – fueled in large measure through 401(k) plans – has contributed to the upward cost pressure. Although aggregate asset holdings have grown substantially, there are millions of new investors with relatively small account balances. On a percentage basis, these small balances are relatively expensive to administer. Additionally, the growth of the mutual fund industry as a whole has spawned the emergence of thousands of new funds. These new funds typically have higher administrative costs than older funds (Anand). 

The average expense ratios for particular fund categories encompass wide ranges from low to high expense ratios across individual funds. Fortune (December 23, 1996) reported the following ranges of expense ratios for eight major fund categories. The categories are arranged from lowest to highest average expense ratios, beginning with government treasuries funds and ending with international stock funds. 

 

Expense Ratios for Year Ending October 31, 1996

Fund Category Low  Average High
Government Treasuries 0.15% 0.77% 2.19%
General Corporate Bond 0.21% 1.04% 2.18%
Growth and Income 0.19% 1.34%  3.81%
Equity Income  0.45% 1.35% 2.46%
Balanced 0.20% 1.39% 3.27%
Growth 0.20% 1.42%  6.49%
Aggressive Growth 0.74% 1.71% 6.25%
International Stock 0.35% 1.80% 3.61%
(Source: Fortune, December 23, 1996)

  One factor in this wide range of expense ratios is the substantial difference in expense ratios generally observed among indexed (or passive) funds versus actively managed funds. In an indexed fund, the investment manager seeks to maintain a portfolio closely tracking an appropriate market performance indicator. For example, a U.S. large company stock fund might be benchmarked to the Standard & Poor's 500; a small company stock fund to the Russell 5000 index; an international stock fund to the Morgan Stanley EAFE  (Europe, Australia, Far East) Index. Other fund categories have similar benchmarks meant to capture the overall performance of particular segments of stock and bond markets. In actively managed funds, the investment manager expends more costs on research, investment selection, and buying and selling. In the past few years, during a period of strong market performance in general, the indexed funds have been able to generate very favorable returns at low expenses. 

Table IV-3 depicts a range of average investment management expenses for six investment objective categories, for various types of investment mechanisms. The findings were developed by Cerulli Associates and reflect data for 1996 from Bernstein Research, the magazine Pensions & Investments, and Lipper Analytical Services. For each investment category Table IV-3 shows the average expense ratio for retail mutual funds, the average expense ratio for institutional mutual funds, and the average account management fees for separate accounts based on a $25 million investment by a large plan. For four of the investment categories, Cerulli also computed an average expense ratio for "Top DC Options," based on the expenses in funds most heavily used by sponsors of defined contribution plans.  RRP

 

Mutual Fund Expense Ratios and Separate Account Management Fees, 1996 (as % of assets)

-Retail
Mutual 		 Institutional
Mutual		 $25 Million Top
DC Separate
Funds		 Funds Funds Options Account
Active Large Equity 1.47% .91% .83% .63%
Active Small Equity  1.57% 1.01% 1.06%  .95%
International Equity 1.95% 1.15% 1.33% .75%
Indexed Equity   .59% .35% .27% .13%
Active Fixed-Income 1.35% .69% NA .37%
Global Fixed Income  1.66% .83% NA .50%
(Source: Cerulli Associates)

     

As these figures illustrate, there are considerable differences in average expenses, depending on the type of fund used. The average expenses estimated by Cerulli for retail mutual funds are generally consistent with the expenses cited in earlier tables. 

401K MUTUAL FUNDS BACKGROUND

The Investment Company Institute (ICI), the trade association of the mutual fund industry, estimates that at the end of 1998 assets in 401(k) plans stood at $1.41 trillion. These plan assets grew at an average rate of 18% per year during the 1990s. Plansponsor.com reports that they rose nearly 22% in the final year of the decade, from $1.7 trillion in 1999 to $2.1 trillion in 2000. Average salary deferral rates of plan participants have also been on an exponential rise. The Profit Sharing 401(k) Council of America (PSCA) reports that the average salary deferral rate grew from 4.2% in 1991 to 5.4% by 1999, an increase of more than 28%

Mutual Fund Investment Companies have provided the best 401(k) option for small and medium-sized businesses. Plans offered by mutual fund companies tend to be tightly bundled, meaning the administration and administrative functions (which may be subcontracted out or conducted in-house by the mutual fund company) are designed to work exclusively with the mutual fund’s proprietary investments.

Mutual fund companies make most of their money by acquiring, holding, and managing investment assets in their various fund portfolios. In some cases, 401(k) administration may be offered to the employer-plan sponsor at a price below its actual cost to the mutual fund company as a device for attracting and holding new assets, on the assumption that 401(k) savings tend to be long-term, giving the mutual fund company many years to collect management fees.

Mutual fund 401(k) plans have been aggressively promoted to the small business communities both by no-load fund companies (e.g., Fidelity Funds, Vanguard Funds) and load fund companies (e.g., MFS, John Hancock, Putnam). Recent news articles, however, have reported a trend among many of these plan vendors to abandon the very small plans because the costs of providing 401(k) services for such plans versus the revenue generated from them has proved to be a losing proposition. For economic reasons, the sales target for mutual fund bundled plans has been raised, and now companies with fewer than 100 employees are not being actively solicited by most of these vendors.

Mutual fund companies make their money by acquiring, holding, and managing inevitable assets in their various fund portfolios. In some cases, the bundled 401(k) administration may offer to small businesses at a loss as a device for attracting and holding new assets, on the assumption that 401(k) investing tends to be long-term, giving the mutual fund company many years to collect management fees.

 

 

 

Fees and Expenses of 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."

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).

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

 

 

 

9-G

 

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.

 

 

 

 

9-H

 

 

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%.

 

 

 

9-I

 

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.



Mutual Fund Prospectus

When you purchase shares of a mutual fund, the fund must provide you with a prospectus. But you can-and should-request and read a fund's prospectus before you invest. The prospectus is the fund's primary selling document and contains valuable information, such as the fund's investment objectives or goals, principal strategies for achieving those goals, principal risks of investing in the fund, fees and expenses, and past performance. The prospectus also identifies the fund's managers and advisers and describes its organization and how to purchase and redeem shares.

While they may seem daunting at first, mutual fund prospectuses contain a treasure trove of valuable information. The SEC requires funds to include specific categories of information in their prospectuses and to present key data (such as fees and past performance) in a standard format so that investors can more easily compare different funds.

Here's some of what you'll find in mutual fund prospectuses:
·         Date of Issue-The date of the prospectus should appear on the front cover. Mutual funds must update their prospectuses at least once a year, so always check to make sure you're looking at the most recent version.

Risk/Return Bar Chart and Table-Near the front of the prospectus, right after the fund's narrative description of its investment objectives or goals, strategies, and risks, you'll find a bar chart showing the fund's annual total returns for each of the last 10 years (or for the life of the fund if it is less than 10 years old). All funds that have had annual returns for at least one calendar year must include this chart.
Except in limited circumstances, funds also must include a table that sets forth returns-both before and after taxes-for the past 1-, 5-, and 10-year periods. The table will also include the returns of an appropriate broad-based index for comparison purposes. Here's what the table will look like:
  1-year 5-year
(or life
of fund) 10-year
(or life
of fund)
Return before taxes ___% ___% ___%
Return after taxes on distributions ___% ___% ___%
Return after taxes on distributions and sale of fund shares ___% ___% ___%
Index
(reflects no deductions for [fees, expenses, or expenses]) ___% ___% ___%

Note: Be sure to read any footnotes or accompanying explanations to make sure that you fully understand the data the fund provides in the bar chart and table. Also, bear in mind that the bar chart and table for a multiple-class fund (that offers more than one class of fund shares in the prospectus) will typically show performance data and returns for only one class.

Fee Table-Following the performance bar chart and annual returns table, you'll find a table that describes the fund's fees and expenses. These include the shareholder fees and annual fund operating expenses described in greater detail in our publication on Mutual Fund Fees and Expenses. The fee table includes an example that will help you compare costs among different funds by showing you the costs associated with investing a hypothetical $10,000 over a 1-, 3-, 5-, and 10-year period.

Financial Highlights-This section, which generally appears towards the back of the prospectus, contains audited data concerning the fund's financial performance for each of the past 5 years. Here you'll find net asset values (for both the beginning and end of each period), total returns, and various ratios, including the ratio of expenses to average net assets, the ratio of net income to average net assets, and the portfolio turnover rate.
 

Q: What are some typical investments that make up 401(k) plans?

A: Typical investment alternatives include money market funds, guaranteed investment contracts (GICs), bank investment contracts (BICs), debt securities, stock and bond funds, and employer stock. The TRA '97 imposed a limit on the amount of employer securities and real property that 401(k) plans may require participants to invest in with respect to their own contributions.


Q: What kinds of companies offer investment management services for 401(k) plans?-TOP

A: Banks offer a variety of 401(k) plan investment options to sponsors of 401(k) plans, usually through their trust departments. Insurance companies typically offer group annuity contracts that pay fixed streams of income, as well as variable return (equity-based) investment products. Mutual funds and investment advisory firms that offer mutual funds provide a wide range of investment opportunities. Broker/dealers offer both individual portfolio management services and pooled investment arrangements to sponsors of 401(k) plans. 

 
 Q: What are the basic guidelines for NASD Registered Reps and SEC Registered Investment Advisors Use of Our Products?-TOP

A:  1) NASD Registered Rep sets up an Advisors 401(k), and gets 100% of all commissions and trailers IF the client selects LOAD mutual funds offered with Advisors 401(k). RIAs cannot collect mutual fund commissions, by law.
2) NASD Broker sets up an Advisors 401(k) and has convinced the client to open separate participant brokerage accounts with his employer's brokerage firm (i.e.Merrill Lynch, Dean Witter, etc). As the Registered Rep responsible for all the separate brokerage accounts at his firm he is going to collect a pre-set "asset fee", charged to each account typically on a quarterly basis, by his employer firm. This asset fee will be essentially his commission, and he will not collect commissions directly from the mutual funds the client uses.
3) RIA sets up an Easy 401(k) and is the Registered Investment Advisor of record. RIA recommends to his client only no-load mutual funds, and gets ZERO commissions from these funds. He invoices his client DIRECTLY for his services, and we have no involvement in this transaction.
4) RIA sets up an Easy 401(k) and is the Registered Investment Advisor of record. He persuades his client to select individual participant discount brokerage accounts (i.e. Schwab, E-Trade, Waterhouse, etc.) as the main investment vehicle for the plan. RIA has a special relationship with the discount brokerage, which allows him to collect an "asset fee" on the business he brings to the brokerage. The brokerage will, on a quarterly basis, deduct a pre-determined "asset fee" form each individual participant account, and forward this asset fee to the RIA as his compensation. We have NOTHING to do with this arrangement beyond directing the advisor to set-up with his client this capability on the discount brokerage he intends to use for his client's 401(k).



Q: Under what circumstances, according to the DOL, can a service provider receive fees from mutual funds without violating ERISAs self-dealing and anti-cutback provisions? -TOP

A: In two advisory opinions [DOL Adv Ops 97-15A, 97-16A], the DOL generally took the position that as long as a service provider does not exercise any authority or control to "cause" a plan to invest in a mutual fund, it will not violate the self-dealing and anti-kickback prohibitions under ERISA Sections 406(b)(1) and 406(b)(3), respectively, by receiving fees from mutual funds in connection with plan investments. A trustee that advises plan fiduciaries regarding mutual funds in which to invest plan assets would have such authority or control. A directed trustee would be considered to have the requisite discretionary authority or control if it assists plans in selecting mutual funds to be plan investment options or reserves unrestricted authority to add, delete, and substitute funds on the mutual fund menu for a bundled program, or both. When a service provider is a fiduciary and causes the plan to invest in mutual funds that pay fees, the service provider must disclose any fee arrangements and offset any fees received, on a dollar-for-dollar basis, against other fees the plan is obligated to pay to avoid violating ERISA's self-dealing and anti-kickback provisions. 
A nonfiduciary service provider that provides nondiscretionary Administration and recordkeeping services would not be prohibited from receiving fees solely as a result of deleting or substituting a fund from a bundled program, provided that the appropriate plan fiduciary makes the decision to accept or reject the change. In that regard, the fiduciary must be provided advance notice of the change, including any changes in the fees received, and afforded a reasonable period to decide whether to accept or reject the change and, in the event of a rejection, secure a new service provider. The fees need not be offset. 

 
 Q: What should a 401(k) plan investment policy cover? -TOP

A: Investment policies need to be flexible enough to adapt to an employer's specific situation and reflect the fiduciaries' attitudes and philosophies. For a typical 401(k) plan that allows participants a choice among investment funds, the policy should also recognize the participants' needs and goals. Further, the policy should deal with the number and types of funds to be made available. How many choices are enough? How many choices are too many? 
The policy should also cover how any loan program will affect investments and whether the withdrawal program is consistent with the types of funds selected. For example, if participants are expected to access funds through loans or withdrawals, do the investment funds allow for such withdrawals without penalty? 
Finally, the policy should deal with the regulatory issues, specifically the requirements of ERISA Section 404(c). 

 
Q: Does self-directed brokerage accounts comply with Section 404(c) with respect to instructing plan fiduciary? -TOP

A: Yes. One potential issue under Section 404(c) is whether a self-directed brokerage account complies with a condition that requires participants to have the opportunity to give investment instructions to an identified plan fiduciary. In a typical self-directed brokerage account, participants give investment instructions directly to the broker, who rarely assumes the role of a fiduciary. Nevertheless, it should be satisfactory for participants to give instructions directly to the broker, since the broker should be treated as having received those instructions as an agent of the plan fiduciary 

Q: What is an Investment Policy, and do our clients have one? -TOP

A: The Investment Policy is a written document that describes the steps and procedures plan trustee will deploy to select and review suitable investments for inclusion in the company's pension plans. A generic Investment Policy is included in the 401(k) Pro, Inc. Plan Adoption Agreement.


Q: What is the difference between a NASD-Registered Representative and an SEC-Registered Investment Advisor? -TOP

A: The NASD Registered Representative goes through a much more rigorous testing an licensing procedure, and is legally allowed to sell investment products (stocks, bonds, mutual funds, partnerships, etc.) to the public for a commission.
SEC-Registered Advisors are not allowed to collect commissions, and instead charge their clients a fee (either a percentage of the money they manage or a fixed dollar amount) in exchange for their advice. They are not allowed sell investments to the public, but only advise. 

 
Q: How does a NASD-Registered Representative use Advisor 401(k)? -TOP

A: The NASD-Registered Representative (RR) uses Advisors 401(k) as follows:
1) The RR sets up an Advisors 401(k), and as the broker of record, and gets 100% of all commissions and trailers IF the client selects the mutual funds we offer with Advisors 401(k)
2) The RR sets up an Advisors 401(k) and is the broker of record, but he has convinced the client to open separate brokerage accounts with HIS FIRM (i.e. Merrill Lynch, Dean Witter, etc). As the broker of separate brokerage accounts he is going to collect an asset fee, charged to each account by his brokerage company, and that will be his "commission".


Q: How does a SEC-Registered Investment Advisor use 401(k) Easy? -TOP

A: The SEC-Registered Investment Advisor (RIA) uses 401(k) Easy as follows:
1) The RIA sets up an Easy 401(k) and is the broker (or advisor) of record. He uses no-load funds, and gets ZERO commissions, but he bills his client separately for his "services."
2). The RIA sets up an Easy 401(k), and is the broker (or advisor) of record. He has his client select a discount broker like Charles Schwab for all the individual accounts. He independently and without our involvement has Schwab (or whomever) set him up as an advisor to each of the individual accounts, and Schwab (or whomever) will automatically deduct a "fee" from each account on a quarterly basis, and pay the fee directly to him. We have NOTHING to do with this arrangement beyond directing the advisor to set-up with his client this capability on the Schwab accounts we set-up.


Q: Does ERISA require Employers to provide investment information and eductation to plan participants? -TOP

A: No. The Department of Labor has explained that relief from fiduciary liability under ERISA Section 404(c) is conditioned on, among other things, plan participants "being provided or having the opportunity to obtain sufficient investment information regarding the investment alternatives available under the plan in order to make informed investment decisions." The DOL has also stressed that compliance with this condition, however, does not require that participants and beneficiaries be offered or provided either investment advice or investment education regarding general investment principles and strategies, to assist them in making investment decisions. This point is stated expressly in the regulation itself: "[A] fiduciary has no obligation under part 4 of Title I of the Act to provide investment advice to a participant or beneficiary under an ERISA Section 404(c) plan. In sum, there simply is no fiduciary obligation to provide participants, even those using self-directed accounts, with investment advice or investment education. 

 
 Q: What is a GIC? -TOP

A: Guaranteed investment contracts (GICs) are issued by insurance companies. They pay a rate of interest that is fixed for the life of the contract or for a specified period of time. 

 
Q: What is a BIC? -TOP

A: Bank investment contracts (BICs) are essentially the same as GICs except that they are issued by banks instead of insurance companies.

 

For more information/comments: comments@mutualfunds401k.com