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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.
401(k) Facts:
According to HR Investment consultants in Towson, MD, publisher of the "401k Provider Directory, "the cost of running a 401k plan with 25 participants and $750,000 in assets can range from as little as $6,750 per year to as much as $20,000, depending on which 401k vendor you select. (Sources: Nation's Business, September 1998, Myers, Randy "Your 401k Plan May Cost You Too Much." Business Week Online, July 2000, Brenner, Lynn " A Wealth of Choices."). By comparison, a 401(k) Easy or Easy Online system costs only $995 per year for a 25-person plan--a savings of between 60% and 80% in plan administration fees.. The employees of Target Laboratories
(www.targetlab.com) a small company, are maximizing the benefits of the company’s 401k, by saving for retirement in tax-advantaged accounts
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.
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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.
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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.
Additional non-profit websites
that include relevant unbiased information about 401k plans
include: www.mutual-funds-401k.com
and www.401k-recordkeepers.com
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.
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