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401(k) Administrative Fees - Impact of an ERISA Expense Account

Overview:

An ERISA Expense Account, also known by names such as ERISA Accounts, Expense Budget Accounts, etc., are plan level accounts established to hold excess revenue that can be used to pay eligible plan expenses.  The term ERISA refers to the Employee Retirement Income Security Act.  For purposes of this article, we will refer to these accounts simply as “Expense Accounts”.

Where does the money come from?

Funds deposited in the Expense Account originate from the assets in the 401(k) plan.  The funds change hands a few times before being returned to the plan as illustrated below: 

During the year, mutual funds earn revenue by charging the plan fees equal to a percentage of assets held by the fund.  The fees are deducted directly from the investment returns and are expressed in a ratio equal to the total fees/total assets (commonly described as the “expense ratio”).  The fees charged cover all costs incurred by the fund (i.e., investment manager’s salary, legal, printing, etc.) with excess fees contributing to the profit of the mutual fund.  

As an incentive to have their mutual fund listed among the choices available in an investment lineup, fund managers enter into agreements and pay 401(k) providers.  These payments occur indirectly via “revenue sharing”.  Mutual fund managers “share” some of the revenue they have collected via the expense ratio with 401(k) providers by paying a fee.  The usual terms you will encounter are 12b-1 fees and sub-TA fees.

The revenue sharing payments are normally based on a percentage of the assets held in each mutual fund that are under control of the 401(k) provider.  As the assets grow, so do the amounts the 401(k) providers collect.  When the assets grow large enough, the 401(k) provider will receive more money than it can justify for the administrative services it provides.

In early 2012, Department of Labor fee disclosures became effective requiring 401(k) providers to present transparent fee schedules to Plan Sponsors.  The additional transparency made it difficult for 401(k) providers not to highlight the fact that, in some cases, they were significantly overcharging Plan Sponsors.  This resulted in 401(k) providers agreeing to deposit a portion of the excess revenue in Expense Accounts for use by the Plan Sponsor to pay eligible plan expenses.

What can be paid from the account?

Most reasonable administrative expenses may be paid from the Expense Account.  These would include costs related to record-keeping, accounting, auditing, legal, investment advice, etc.  Costs that are not allowable include costs to terminate the plan or costs incurred for corrective action taken to address plan failures.

Our 401(k) plan doesn’t have an ERISA Expense Account?

Not all 401(k) plans will have an Expense Account for a variety of reasons.  The balance in the plan may be insufficient to generate excess revenue or the plan may invest in mutual fund share classes that have low expense ratios or don’t participate in revenue sharing agreements.   Note, most mutual funds offer multiple “share classes” that range from institutional classes to retail classes.  These funds contain the same underlying investments with the only difference being the amount of fees charged.  Many institutional class shares charge very low expenses and do not participate in revenue sharing.

Takeaway

When examining the fees being charged to your 401(k) plan, it is important to understand how your providers get paid.  Mutual fund lineups will likely be available in different share classes and you may have the option to establish an Expense Account.  The way the lineup, share classes, and Expense Account are structured can have a significant impact on the net fees paid by plan participants.  Mutual funds with the lowest expense ratios don’t always result in the lowest net fees.  Selecting a share class with higher initial fees and revenue sharing could yield an Expense Account that ultimately results in lowest net fees available to the plan.