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Media Short-Cuts on Expense Ratios Can Misdirect 401k Fiduciary Due Diligence

Media Short-Cuts on Expense Ratios Can Misdirect 401k Fiduciary Due Diligence
March 08
04:19 2016

Much has been written about 401k plan fees, and often writers will casually link mutual fund expense ratios to this issue. These linguistic short-cuts can then lead to a butterfly effect of miscalculations. For example, the popular meme that “low expense ratio mutual funds always beat higher expense ratio mutual funds” has long been exposed as a myth (see “A 401k Must Read: Mutual Fund Expense Ratio Myth Busted,”, October 9, 2012). Yet, the meme persists in the mass media (and even some trade journals). Why has this myth survived and what can be done about it?

It’s easy to understand why the popular press continues to report this fallacy. Charles J. Stevens, Jr., Principal at Evergreen Financial, LLC in Plymouth, Massachusetts, says, “Either journalistic sloppiness or not understanding the fee/expense ratio  issue when making comments about either/both subjects. Under a deadline, many writers won’t take the time to learn the difference prior to expounding on the merits or drawbacks of either factor.”

Chris Georgandellis of Exchange Capital Management in Ann Arbor, Michigan suspects the media short-cuts are “often done in the pursuit of simplicity. The media often seeks to simplify concepts so that they are easily digestible after a quick read. To the average individual, the idea of ‘fees’ is straightforward – ‘it’s extra money I have to pay.’ Further, it can be the case that the author of the article isn’t interested in diving any deeper into the subject, for whatever reason. So, once ‘fees’ are mentioned, the job is essentially done. However, in wrapping up several separate fees and expenses into one term, the media is often doing consumers a disservice. For example: of the ‘fees’ an investor might pay, there are both one-time fees as well as ongoing expenses. The former will not show up in performance reports, but the latter will. With transaction fees, it can often be the case that investors who purchase funds from a 3rd party might pay a fee, while another investor who purchases the fund directly from the funds’ manager wouldn’t pay a fee. In the end, referring to ‘fees and expenses’ simply aim to provide a lay person with an understanding that it costs money to buy, own and sell a fund, whether it’s actively managed or otherwise – but it’s important to know some of the details.”

Reporters use short-hand phrases that are inconsistent with regulatory definitions only exasperates the confusion among readers, 401k plan sponsors, and other fiduciaries. Georgandellis sees a conversation including “expense ratios” and “high fees” and often wonders as to which “fees” the reporting is referencing. He says, “Are you discussing transaction fees? Those are not part of the expense ratio of a fund. Are you lumping together transaction fees and loads? Neither is part of a fund’s expense ratio. Are you discussing management fees? Those are part of the expense ratios. Further, not all funds charge transaction fees, and transaction fees (as well as loads) can vary even within the same fund. For example, Vanguard’s Total Stock Market Fund does not charge you a transaction fee on purchases and sales if you purchase the fund through Vanguard, but if you buy the fund through a broker you may pay a fee.”

Since the typical 401k plan sponsor is not an expert on mutual fund fees, it’s alarming how their fiduciary liability can skyrocket if they go no further than the mass media short-cuts. Mutual fund fee due diligence requires a fiduciary to dig much deeper than reporters often do. Douglas G. Prince, CEO of ProCourse Fiduciary Advisors, LLC in Carmel, Indiana, says, “One of the big issues with the fee and expense lawsuits has been because most of the fees were not transparent and the recordkeeping fees were paid out of revenue sharing from mutual funds. Today, many, but not all, plan sponsors have changed their investment options from funds with revenue sharing to funds that have lower cost expense ratios that eliminate or substantially reduce non transparent money to pay for recordkeeping fees. The choice of what funds (and the expense ratio and revenue sharing) are used is that of the plan sponsor. Whether or not funds with revenue sharing are used, Plan Sponsors should have written records to document this decision and why this decision was made. We believe that either method is appropriate as long as the decision is prudent for participants and is documented.”


With this increased liability exposure, determining the difference between fees that matter and fees that don’t matter becomes a critical objective of the 401k plan sponsor (see “401k Fees That Matter,”, April 27, 2010 and “401k Fees That Shouldn’t Matter,”, May 3, 2010). “One of the difficulties trustees face in making investment selections for a 401k portfolio is fees and costs,” says Stevens. “I’d classify costs as trading costs to buy and sell assets, pay the management company (decision makers) their incentive and do the accounting on the fund. Fees would include the cost of selling the shares (load and ‘no-load’) (there IS a cost in marketing each), fees for exchanging shares, and any other costs to the portfolio not related to management and distribution.”

Indeed, the relevant fees in the marquee court cases are generally not the mutual fund operating costs (a.k.a., the expense ratios), but the fees over and above these operating costs. Prince says, “A mutual fund expense ratio is deducted prior to earning allocations and is documented in the mutual fund prospectus. The fee discussed in the lawsuits is what the recordkeeper, custodian or other party charges for their services. In many of the lawsuits part of the expense ratio of the mutual fund was given to someone other than the mutual fund company.”

It’s not that hard to avoid the short-cuts of journalists and editors and target the offending fees directly. “As it turns out,” says Georgandellis, “the SEC mandates that mutual fund managers disclose a number of fees in a clearly identifiable manner.  These will be found in the form of a “fee table” near the front of any fund’s prospectus, under two different headings. Under the heading ‘Shareholder Fees,’ you will find: Sales loads; Redemption fees; Exchange fees; Account fees; and Purchase fees (if one is imposed by the fund). Under the heading ‘Annual Fund Operating Expenses,’ you will find: Management fees; Distribution fees; Other expenses; and, The total annual fund operating expenses.”

We’ll end with a cautionary tale. Even if the 401k plan sponsor can avoid being misdirected by mass media short-hand, mutual fund fee due diligence remains a tricky task. Prince says, “First of all, mutual funds can be classified into retail and institutional share classes. The basic difference it that institutional share classes are typically available for larger purchases, like 401k plans, whereas retail funds are for smaller investors, like individuals. From here funds can have a variety of share classes from which to invest. For example, one of the largest non–U.S. equity funds (American Funds Europacific Growth) has 18 share classes to invest in the same fund. Some of these share classes are only available to 529 college savings plans. Others may or may not be available for retirement plans. Of the series that are for retirement plans, there are eight different share classes. Based upon the American Funds website (February 24, 2016), the expense ratios for the “R” shares are as follows:

“R6 – 0.49%, R5 – 0.53%, R5E – 0.65%, R4 – 0.84%, R3 – 1.14%, R2E – 1.21%, R2 – 1.58%, R1 – 1.59%

“The R6 has little to no revenue sharing. Basically the difference of the above mutual funds from 0.49% is an amount that goes to ‘someone other’ than the manager to manage and to maintain the funds. The ‘someone other’ is typically a broker, recordkeeper, or plan custodian. Selection of a mutual fund is the first step in the process. The second step is to evaluate which share class is most appropriate for the plan.

“Every mutual fund organization has different terms they use to denote different share classes. Some use the ‘R’ system discussed above, some use ‘Admiral,’ some use ‘Y’ or ‘I,’ etc.  There is no consistency in the use of these designations, which makes the plan sponsor’s (or their investment consultant’s) job more difficult.

“Another less commonly understood item about mutual fund expense ratios is that this is typically not the total cost for the fund. Variable costs like stock trading fees are usually not included in the expense ratio. We have seen some funds that have expense ratios of under 1% and trading costs add another 1% to the overall costs. The expense ratio is described in the prospectus. The other costs are typically disclosed in either the Statement of Additional Information, the Semi-Annual Report or the Annual Report.”


Sometimes the plain vanilla approach is the safest approach. Simply by eliminating all funds with commissions, 12b-1 fees, and revenue sharing from the 401k investment due diligence process can greatly reduce the fiduciary liability exposure to the plan sponsor.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

 Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? –  How to Increase the Odds You Will Retire in Comfort is available from your favorite bookstore.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA


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