401(k) Mutual Funds – Choose Low-Cost Share Classes to Maximize Returns

When choosing investment options for their 401(k) plan, employers often overlook one crucial detail: the share class of mutual funds. While all share classes of a mutual fund offer the same underlying investments, they often come with varying fees. Over time, the cumulative effect of higher fees on employee savings can become massive. Selecting the least expensive share class can maximize employee returns and ensure you meet your fiduciary responsibilities as a plan sponsor.

In this guide, we’ll explore why mutual fund fees matter, break down the impact of different share classes, and provide actionable steps to help you optimize your 401(k) investment options.

Why Mutual Fund Fees Matter for Your 401(k) Plan

Fees directly reduce the returns of 401(k) investments dollar-for-dollar. Even small differences in fees can lead to significant differences in savings over time due to compound interest. The table below demonstrates the cumulative effect of fees over time. Just a 1% annual fee would reduce a hypothetical participant’s account balance by $403,343 after 40 years of saving, assuming a $25,000 starting balance, $5,000 in annual contributions, and 7% annual rate of return.

Mutual fund fees generally fall into two main categories: shareholder fees and operating expenses. Fund companies are required by law to disclose these fees in their prospectus, which often includes all available share classes for the fund. These factors simplify the comparison process, allowing employers to make informed decisions about share class options.

Understanding Shareholder Fees

Shareholder fees cover costs associated with individual transactions and account maintenance. They are generally categorized as follows:

• • Sales Loads: A commission paid to a broker or salesperson. There are two types:
    • Front-End Load: Deducted from the initial investment amount, reducing the funds available for purchasing shares.
    • Back-End Load: Deducted when selling fund shares, reducing the final proceeds.
  • Redemption Fees: Charged when shares are redeemed and paid to the fund company. This fee helps cover the administrative costs of redemptions.
  • Purchase Fees: Deducted at the time of purchase to cover fund-related expenses.
  • Exchange Fees: Imposed when shares are exchanged for the shares of another fund.
  • Account Fees: Imposed if the account balance falls below a minimum threshold.

Understanding Operating Expenses

Operating expenses cover ongoing costs. They are generally categorized as follows:

• • Management Fees: Fees paid out of fund assets to the investment adviser for managing the portfolio.
  • Distribution and/or Service 12b-1 Fees: Charged to cover marketing and selling expenses, including compensating brokers. Named after an SEC rule, these fees are the primary indicator of an expensive investment, but the easiest to recognize because all such fees must be disclosed in the prospectus and cannot be hidden.
  • Other Expenses: Expenses not included in the other two categories. Examples include custodial expenses, legal expenses, accounting expenses, transfer agent expenses, and other administrative expenses.

Revenue Sharing Increases Operating Expenses

Revenue sharing is a common practice where 401(k) administration fees are embedded in the fund’s operating expenses and distributed to outside service providers. Revenue sharing increases the cost of a 401(k) plan, ultimately reducing participant returns. There are two general forms:

• • 12b-1 fees: Paid to a broker for selecting investments. They increase “Distribution and/or Service Fees” in fund prospectuses. 401(k) providers must disclose their rate in a 408b-2 fee disclosure when they apply.
  • Sub-Transfer Agency (sub-TA) fees: Paid to a 401(k) provider for participant recordkeeping. They increase “Other Expenses” in fund prospectuses. 401(k) providers must disclose their rate in a 408b-2 fee disclosure when they apply.

Revenue sharing is more common in actively managed funds than passively managed funds, such as index funds or ETFs.

How Much Share Class Affects Returns

Different share classes can have a significant impact on the returns of 401(k) investments. To illustrate the impact, check out the two tables cut from the latest American Funds Growth Fund of America prospectus. The first table discloses the different operating expenses of each class, while the second discloses their investment returns over specific periods of time.

401(k) plans most commonly use one of the eight “R” share classes. R-1 shares pay the most revenue sharing, while R-6 shares pay none at all. Unburdened by revenue sharing, the R-6 shares delivered 1.21% (12.20% - 10.98%) higher average annual returns over the 10-year period ending December 31, 2023 compared to R-1 shares. This difference might seem small, but over time, compound interest can lead to substantial additional earnings.

Annual Operating Expenses by Share Class:

Average Annual Returns by Share Class:

Steps to Choosing the Best Share Class

To ensure you’re selecting the least expensive share classes for your 401(k) plan, and thus more profitable to plan participants, follow these steps:

1. 1. Evaluate Your Plan’s Share Classes: Start by reviewing the fund’s prospectus to compare share class fees, focusing on both operating and shareholder fees as well as any revenue sharing structures.
   2. Consult Your 401(k) Provider: Contact your provider to discuss your options. Some plans qualify for lower-cost share classes based on plan size or assets under management.
   3. Document Your Efforts: Regardless of whether you’re able to secure a lower-cost share class, it’s essential to document your process. This action demonstrates that you’re fulfilling your fiduciary duty.
   4. Schedule Regular Reviews: Share class options and associated fees can change over time. Schedule periodic reviews with your 401(k) provider to ensure you’re consistently offering the best options to your plan participants.

Maximize 401(k) Savings by Choosing Low-Cost Share Classes!

Choosing low-cost share classes is a powerful way to enhance participant returns while fulfilling your fiduciary responsibilities. This job can easily seem overwhelming, but it doesn’t need to be. Knowing how to compare share classes is the key.

Think your 401(k) plan qualifies for a lower-priced share class? Ask your 401(k) provider. Be sure to document the discussion. Even if you’re wrong, you can prove you met your fiduciary responsibility.