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401(k) Fee Disclosure and the American Funds

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About two years ago I wrote what remains one of the most popular posts on this blog American Funds-The Secret Sauce for 401(k) Plans.  The point of the article was to look at 401(k) plans sold by many commission-based advisors to smaller employers consisting solely of mutual funds from the American Funds as investment options.

Mutual Funds

In light of the new disclosure requirements which will shed light on the costs associated with the investment options offered in 401(k) plans I wanted to take a look at how the various share classes offered by the American Funds for retirement plans would stack up under the portion of the required disclosures that deal with the costs and performance of the plan’s investment options.

The one American Funds option that I use in a couple of 401(k) plans is the EuroPacific Growth fund.  This fund is a core large cap foreign stock fund.  It generally has some emerging markets holdings, but most of the fund is comprised of foreign equities from developed countries.  I am able to use the R6 share class, the least expensive of the retirement plan share classes.  Let’s look at how the various share classes would stack up in the disclosure format:

Share Class

Ticker

Expense Ratio

Expenses per $1,000 invested

Trailing 1 year return

Trailing 3 year return

Trailing 5 year return

R1

RERAX

1.62%

$16.20

-6.98%

16.16%

-0.49%

R2

RERBX

1.61%

$16.10

-7.00%

16.14%

-0.52%

R3

RERCX

1.13%

$11.30

-6.52%

16.71%

0.00%

R4

REREX

0.85%

$8.50

-6.26%

17.04%

0.27%

R5

RERFX

0.55%

$5.50

-5.98%

17.40%

0.57%

R6

RERGX

0.50%

$5.00

-5.94%

17.43%

0.48%

3 and 5 year returns are annualized.  Source:  Fi360   Data as of 3/31/2012

Note the 3 and 5 year returns for the R6 share class are estimated by Morningstar as this share class just came into being in 2009.  On an actual participant disclosure report the 3 and 5 year numbers would be left blank. 

While the chart above pertains only to the EuroPacific Growth fund, looking at the six retirement plan share classes for any of the American Funds products would offer similar relative results.   

The underlying portfolios and the management team are identical for each share class.  The difference lies in the expense ratio of each share class.  This is driven by the 12b-1 fees associated with the different share classes.  This fee is part of the expense ratio and is generally used all or in part to compensate the advisor on the plan.  In this case these would generally be registered reps, brokers, and insurance agents.  The 12b-1 fee can also revert to the plan to lower expenses.  In past years we have used the R4 shares of this fund and the 12b-1 fee went to lower the expenses for those participants investing in the fund.  The 12b-1 fees by share class are:

R1                   1.00%

R2                   0.75%

R3                   0.50%

R4                   0.25%

R5 and R6 have no 12b-1 fees.

The R1, R2, and R3 shares are generally used in plans where the 12b-1 fees are used to compensate a financial sales person.  This is fine as long as that sales person is providing a real service for their compensation and is not just being paid to place the business.

Plan sponsors (the employers sponsoring the plan) were supposed to receive disclosures from all covered service providers who receive any compensation from plan assets by July 1 which detail their compensation, the source(s) of their compensation, and the services they are providing to the plan.  It is my hope that any plan sponsor who looks at a disclosure from any financial advisor who has their plan in R1, R2, or R3 shares does a thorough round of due diligence to find out why their participants are in these expensive shares and what services the advisor is providing to justify receiving these hefty fees.

If you are a plan participant and you notice that your plan has one or more American Funds choices in the R1, R2, or R3 share classes, in my opinion you have a lousy plan and you are overpaying for funds that are generally mediocre to poor performers.  It is incumbent upon you to ask your employer if the plan can move to lower cost shares or even a different provider.

Please contact me at 847-506-9827 for a free 30-minute retirement planning consultation and to discuss all of your investing, 401(k), and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.   

Retirement plan sponsors, do you need an independent review of your company’s plan?  Do you need help selecting a new plan provider?  Are you looking for ongoing financial advice to help you meet your fiduciary obligations and to provide a superior retirement savings vehicle for your employees?  Please feel free to contact me to learn about our investment consulting services for retirement plan sponsors.

 

 

Morningstar

Photo credit:  Simon Cunningham
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Comments

  1. I personally don’t think too fondly of 401ks. I think it’s a scam, because there are so many restritions on them that most people lose money on their 401ks.

    • Roger Wohlner says:

      Tony thank you for your comment. Unfortunately I hear far too many comments like this about 401(k) plans. From looking at your excellent blog it looks like you live in Toronto, I’m not familiar with the Canadian equivalent to the 401(k). 401(k) plans themselves are not the problem, though there are too many plans out there that offer lousy, overpriced investment choices. However, like any investment account, the ultimate success or failure for a plan participant will fall to how much they have saved for retirement and how they’ve chosen to invest their money. I have a number of clients who have accumulated enviable amounts in their accounts for retirement. On the other hand I see much confusion out there among participants on how much they need to save and how they should allocate their investments. The Pension Protection Act of 2006 has made it easier for employers to offer advice to their participants and hopefully over time this will happen to a greater extent.

    • JoeTaxpayer says:

      Tony, I’m all about the numbers. An expense ratio of 1.6% isn’t just bad, in my book, it’s criminal. After the last decade, we might agree 8% might be a welcome return for the next ten years. 1.6% is 20% of that. Only they’ll take the 1.6 regardless of whether the market is up or down. In retirement, most planners recommend a limit of 4% per year withdrawal rate. Imagine withdrawing your $80K but handing over $32K every year?
      My company 401(k) expense is .05%. 2% over a 40 year career. That, I can live with.

      • Roger Wohlner says:

        Thanks for your comment Joe. While I am not totally an indexer its high fees like this that make me question active management on a regular basis.

  2. Bill says:

    from your article – would these fees be taken out on the total in a fund on an annual basis – for example you have $10,000 total in an R3 fund – would the 12b fee alone be $500 for that year?

    R1 1.00%

    R2 0.75%

    R3 0.50%

    R4 0.25%

    R5 and R6 have no 12b-1 fees.

    • Roger Wohlner says:

      Bill thank you for your comment and for visiting the site. The answer to your question is yes. As a review in case you are not familiar with how 12b-1 fees work, they are a part of the overall expense ratio. Using the R3 shares as an example the overall expense ratio is 1.13% of which the 12b-1 fees of 0.50% are a part. Contrast this with the R6 shares that carry no 12b-1 fees with an expense ratio of 0.50% and you can see that the 12b-1 fess comprise most of the difference in the expense ratios between the two share classes. Also, typically the expense ratio is taken out of the gross returns on a daily basis by most fund companies, I’m not sure exactly how the American Funds does this.

  3. jeff says:

    Rodger is selfserving and not objective in any thing he write on this site!

    • Roger Wohlner says:

      Jeff thanks for your comment. Two things, there is no “d” in my name. Also I’m curious as to exactly what you find self-serving. As far as not being objective, part of a good blog is an author who expresses his/her opinion, guilty as charged. Lastly perhaps an “s” at the end of the word write would have been a better use of the English language.

  4. Well crafted post Roger showing this scam to be what it really is: a ripoff for plan participants.

    • Roger Wohlner says:

      Thanks for your comment Steven. In my opinion any plan using the R1,R2,or R3 shares is being ripped off and should be asking why they aren’t in lower cost shares or should be looking at another arrangement.

  5. Bruce Thomason says:

    Thanks for this story, Roger. My small company uses American Funds and are presently stuck in the R2 fee range. Do you have any advice on how a small company can move toward R5 or R6? Obviously we can grow our deposits over time – but being small limits the rate of growth — are there options with others that aggregate across clients to reduce fees or other fund managers with lower fees for a company w/ only $1-2M in total deposits?
    Thanks,
    Bruce

    • Roger Wohlner says:

      Bruce thank you for your comment. Once a plan moves above the $1 million mark in assets you have a few more options, though the choices are more limited than for plans with say $5-$10 million. The use of R2 shares could be for several reasons. It could be driven by the plan administrator to cover their costs/achieve the desired profit margin. Likewise it could be driven by the rep/advisor on the plan and their desire to be paid at a certain level.

      Perhaps the main question that I have is why bother trying to get into a better American Funds share class at all? I’m not knocking the American Funds, but there are many other alternatives that can be looked at. Perhaps this is a good point in time to look at another platform as well. One thing that makes a plan more or less attractive to providers is average balance per participant. Let’s say plan A has $1 million in assets and 200 participants. With an average balance of $5,000 per participant and would not be very attractive or profitable. Let’s look at plan B with the same $1 million, but with 25 employees. Plan B is much more attractive to providers with an average balance of $40,000 per participant.

      Hope this helps, please feel free to contact me directly with any questions or if you’d like to discuss.

      • Jim C says:

        My small firm is also in AmFunds in R2 class. With limited participants (3), and limited assets, I was lead to believe there were few to no choices for me when initially selecting a fund to host our 401k. Honestly, I couldn’t find another company who even offered anything to a small business.

        I don’t anticipate having millions any time soon, but now that we have 5 participants with ~$300K in assets, do I have more choices?

        I wasn’t aware that I have control of share class. I was told it’s up to the deal my advisor has with AmFunds. Can I “demand” lower fees? Or must we have much higher assets?

        If indeed there ARE other choices to move our 401k to, I’d appreciate names of alternatives.

        Appreciate the info.

        • Roger Wohlner says:

          Thanks for the comment Jim. On the one hand the total asset pool is small but your average balance at $60,000 would be pretty attractive to some administrators. I’d be glad to discuss with you please feel free to contact me http://thechicagofinancialplanner.com/contact/ offline if you are interested in some thoughts. Technically you don’t have control over the share class used and you are right that your advisor does. With R2 share it’s likely more money is going into his/her pockets, at the very least ask them why your plan can’t be in R4 or better shares.

  6. Roger- this is the problem. Employers want to offer an attractive benefit they generally they do not want to pay for. Employers generally do not have the time (or expertise) to do all the things that they need to do to manage and administer the plan. Many employees have no clue on investing and need help to make smart choices with their money. If the employer fails to give them the tools necessary to make smart decisions, the employer is liable for damages. So someone has to pay for an adviser (hopefully a good one) to assist in educating the employees and running the plan.

    American funds is a very good company with excellent performance and great manager tenure. They offer different share classes because it gives the adviser the ability to price a plan based on the work involved and the total assets in the plan. A R-2 share class that has an advisory fee of .75% may look high, but is the plan has $500k in assets, the annual advisory fee is $3,500. If you do two employee meetings, and two trustee meeting annually, plus all the calls and prep-work, the adviser is not making a killing on your plan.

    Fee disclosure is great and I am glad that it is now required. The problem is not American Funds, or the share class system. It is a matter that everyone wants something for nothing…both employers and employees. It costs money to administer and run these plans, and as long as you have a good adviser that provides value to the employees, the benefits far outweigh the costs!

    • Roger Wohlner says:

      Jerry thanks for your comment. I agree that the American Funds are by and large a good fund group and have solid fund managers and researchers. The article was not meant to disparage them (and I don’t think that I did that) but rather to illustrate the impact of share classes on costs. American Funds is the easiest to use with their multiple retirement share classes.

      Clearly in the advisory situation that you described the $3,500 fee is a bargain. However for every advisor like yourself there are others in the commissioned space who don’t do much more than “place” the business.

      I am fortunate that all of the plans sponsors whom I advise feel that my services are worth covering from company vs. plan assets. I also realize that not all sponsors have this mentality.

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