Monday, December 14, 2015

Benchmarking Defined Contribution Plan Fees

Nicholas Zaiko, CIMA®
Investment Consultant
Bridgebay Financial, Inc.

This article focuses on Defined Contribution (DC) plans such as 401(k) and ERISA-covered 403(b) plans.  The most recent round of legislation has largely focused on increasing transparency regarding the fees charged for these plans by all of the various service providers.  The Department of Labor (DOL) has addressed this issue through increased regulatory disclosure requirements under sections 408(b)(2) for provider to plan sponsor disclosures and 404(a) of the Employee Retirement Income Security Act (ERISA) for plan sponsor to participant disclosures.  These full fee transparency measures were implemented in 2012.    

Some of the unfavorable judgments against plan sponsors stemming from "excessive fee" litigations over the last few years have demonstrated the regulatory and legal reasons to benchmark and document the "reasonableness" of DC plan fees.

Types of Plan Services
Fee structures and arrangements differ from plan to plan in the defined contribution marketplace.  Retirement service providers maintain a multitude of fee arrangements to pay for plan services.  The services that DC plans tend to obtain can be broken down into essentially three major categories.  Those categories are investment management, plan administration and investment or financial consulting to the retirement committee and participants. 

Recordkeeping Services
A variety a service providers may perform recordkeeping services including insurance companies , mutual fund companies, third party administrators (TPAs) or banks.  The services include compliance testing, plan and participant communication, earnings adjustments, posting payroll contributions, plan payments, educational materials and various regulatory requirements.  Each plan is unique and plan sponsors may choose from various levels of recordkeeping service.

A competitive fee review should include: fee re-negotiation with the current service provider, review of plan fees by an independent, retirement plan consultant or a complete vendor search through a request for proposal (RFP).

Fee Arrangements
There are a wide array of fee arrangements to pay for the numerous services used by 401(k) and 403(b) plans.  Administrative service fees, which cover recordkeeping, education, compliance and other administrative functions of the plan, can be charged to the employer, the participant account or directly to the plan itself.  Additionally, these fees can be assessed as variable or fixed costs and  in several different ways including as a percentage of total plan assets, per plan fees or per participant fees.

Asset-Based Fees
Revenue-sharing fees such as asset-based 12b-1 fees, shareholder servicing fees or administrative servicing fees can also be used to pay for some or all of the recordkeeping and administrative services.

Asset-based fees are typically charged by the investment manager and are quoted as a percentage of assets.  Participant fees may vary from person to person depending on the expense ratios of the funds they choose to invest in and the portion of their total amount that they choose to allocate to each selected fund.  The asset management fees make up the majority of the plan's total cost.

Investment options are offered in a variety of vehicles including mutual funds, commingled trusts, separate accounts and insurance products.  In addition to these types of arrangements, some plans may offer company stock or self-directed brokerage windows as investment options.  The fees on each of these options will vary with the share class, asset class, active or passive management and investment vehicle structure.  In certain situations, some of the asset-based fees may also be used to cover some participant services in addition to asset management.  These fees typically cover the investment management, distribution or service fees, and any other fees for the investment option such as custodial, legal recordkeeping and operating expenses.

The various services and all of their associated fees can be structured in a myriad of ways depending on the needs of each plan sponsor.  Several different scenarios may be considered when plan sponsors negotiate for services with their retirement service providers.  Some of the factors considered when negotiating include the number and types of investment options (active vs. passively managed funds), fund fee structures, proprietary vs. non-proprietary investments, and the depth of participant communications and education services  to be provided.

All-In Fee Breakdown
On average, the majority of fees go towards investment management, with a smaller portion going to cover the cost of recordkeeping and administration.  Recordkeeping and administrative fees can be charged directly to the plan sponsor on a per participant basis or may be asset-based.  Administrative fees are used to cover plan audits, 5500 reporting and compliance testing for the plan.

Investment management fees are typically based on asset size and are charged by mutual funds, commingled funds or separate accounts.  These fees may also include a revenue sharing component which pays for compliance testing, plan audit, form 5500 reporting, trustee fees, legal services and other administrative expenses.

Included in the investment expense is the external investment consultant or financial advisor to the plan.  These consultants are typically hired by the plan sponsor to guide the plan design, fund search and selection process and assist with other advisory services.  Many service providers offer their own investment consultants that may tend to select proprietary investment funds or share classes of nonproprietary funds with attractive revenue sharing for the recordkeeper.  In order to avoid potential conflicts of interest, best-practices dictate that the plan consultant be independent of the recordkeeper and asset management.   

Investment fees represent the majority of the plan's expenses.  This trend has steadily grown over the last few years.  As assets accumulate and grow, the investment management component of the all-in fee will also expand.  This portion of the fee will increase in rising markets as total dollar expenses for asset-based management fees grow.  This partially explains the overall increase in plan fees.  It is imperative that plan sponsors monitor the increase in absolute fees charged and periodically re-negotiate with the providers for fee reductions.

Economies of Scale
All-in fees, as compared to total plan assets may vary greatly especially between plans of dramatically different sizes.  Plan fees are heavily dependent upon the total plan size, which determines the ability to access institutional level share classes which typically carry lower fees.  Periodically, plan sponsors should revisit the share classes of selected funds and negotiate reduced fees as plan assets increase.

Factors Affecting Fees
Numerous variables affect any particular plan's all-in fees.  Some of the major factors include total plan size, number of participants, average account balance, participant contribution rates, and levels of participant services and communication.  Larger plans tend to benefit from economies of scale which lead to lower fees.  As a percentage of assets, plans with larger average balances and larger numbers of participants pay lower investment fees.  Plans with smaller total assets typically have smaller average account balances than larger plans, which contributes to the higher relative fees as a percentage of assets for smaller plans.  Additionally, studies have indicated that plans with more participants have lower all-in fees than plans with fewer participants. 

The correlation between large plan size and lower total fees is largely a function of the interaction between the variable and fixed costs associated with the plans.  The specific service provided and the fee arrangement with the service provider dictates whether the fee is variable or fixed.  While fixed costs remain fairly flat, variable rate costs, such as per participant or asset based charges vary as the plan grows or shrinks.  Variable costs include investment management expenses while plan audit fees, document services and regulatory filing expenses would be examples of fixed rate costs.  As the defined contribution industry has matured and become the primary retirement savings vehicle, variable costs have increased while fixed costs have decreased as a percentage of total plan costs.

Defined contribution plans have evolved dramatically since their creation and now represent the majority of Americans' retirement savings.  Along with this colossal growth has come a renewed sense of scrutiny, especially in the wake of the financial crisis and market turbulence of late.  Fiduciaries need to make the extra effort to properly asses the fees associated with their defined contribution plans and ensure that they are competitive and appropriate for the level of services the plans receive.  The increase in "excessive fees" litigation brought against plan sponsors over the last few years has made benchmarking and periodic fee reviews all the more important for prudent fiduciaries. 

Monday, November 16, 2015

Best Practices in Benchmarking 403(b) Plans

Barbara Williams, CFA
Managing Director
Bridgebay Financial, Inc.

This article addresses some of the best practices in benchmarking 403(b) plans as a guide for plan sponsors.

Periodic benchmarking of your 403(b) plan is a normal due diligence process that should be conducted by an independent retirement plan advisor or consultant that is well-informed and has experience working with multiple service providers.  This broad experience allows the third-party advisor to properly benchmark your plan against other plans and service providers in the defined contribution market, namely, ERISA-covered and non-ERISA plans. 

The Department of Labor (DoL) has signaled that such a review should be conducted every 3-5 years.  Plan sponsors should conduct a request for information (RFI) through an independent retirement plan consultant to benchmark plan services, fees and administration as a best-practice and document good fiduciary practices.  Refreshing plan features and services assists nonprofit retirement plan sponsors who are dedicated to their participants' ability to have positive retirement outcomes.

Ideally, the independent retirement plan advisor conducting the benchmarking study should not be associated or affiliated with the current or prospective plan provider.  Also, the advisor should not have any conflict of interest or be able to benefit financially from selecting or recommending any specific provider. 

A critical element of the benchmarking process is proper and thorough documentation.  The evaluation criteria must be specifically defined in order to unequivocally demonstrate that an impartial, balanced, and comprehensive review was conducted and that the final decision is rational, defensible and free of any potential conflicts of interest.  Such documentation will definitively exhibit the prudent process for the DoL and demonstrate that the chosen solution was for the benefit of the plan participants. 

The due diligence process should incorporate a review of the recordkeeper's financial strength, delivery of services, plan compliance, reporting services, plan sponsor services, participant services including education, quality of investment choices and fees.  Fortunately, recently mandated disclosure requirements now enable the plan sponsor to receive better information and greater transparency concerning services and total costs.

On the investment side, many plans rely on the recordkeeper's affiliated investment team to provide investment reviews quarterly.  From a fiduciary perspective, it is also a best-practice to conduct a deep-dive of the investments using an independent third-party investment consultant at least annually to provide an impartial review of the quality, diversification and cost of the investments.  By conducting an annual deep benchmarking review of the plan by an independent consultant the sponsor can still benefit from the recordkeeper's quarterly investment input while also enhancing fund, plan and provider oversight.  This third-party perspective is a tremendous fiduciary benefit that the plan recordkeeper simply cannot provide.

Multiple Providers
When compared to 401(k) plans and other defined contribution plans, 403(b) plans offer many more investment options to their participants on average.  Typically, when multiple vendors are used, many of the investment options are redundant and may not necessarily be best-in-class.  This redundancy in investment options can lead to participant confusion, inertia, poor asset allocation and higher costs for participants.  The use of multiple providers can present complications when trying to evaluate a particular 403(b) plan with regards to its peers. 

Nonprofit plan sponsors with multiple providers with different investments and embedded costs may require retaining an experienced retirement plan consultant to streamline the plan.  Many 403(b) sponsors find it advantageous to move to a single provider with an efficient cost structure and investment offerings that best benefits the participants. 

Understanding Plan Fees
The implementation of 408(b)2 in 2012 represented a major step in assisting plan sponsors in understanding plan fees, re-negotiating those fees and gaining a better understanding of the costs associated with the services being provided.  In many cases, providers have updated the services and expanded their platforms to better serve their clients in an effort to retain existing business.  All of these developments are positive for the discerning 403(b) plan sponsor.

Enhancing Plan Features
There are numerous features in plan design that sponsors can employ to increase the success of their plan and participants' retirement outcomes.  Some key design features include auto-enrollment of current and new employees, auto-deferral, auto-deferral increase, and selection of a Qualified Default Investment Alternative (QDIA).  Providing enhanced participant information on projected retirement savings and income replacement by retirement age are also important participant incentives to increase the success of the 403(b) plan.

The current trend is to de-emphasize participant education and focus on plan design features that optimize participation, asset allocation, and maximize deferrals.

Planning for the Future
When using independent third-party consultants, it is important that the retirement plan adviser have specific experience in an ERISA environment, even if the 403(b) plan is non-ERISA.  This experience and background will ensure that the plan sponsor is attaining the highest standard of prudent care and is implementing best practices.  The advisor should be able to draw from the practices of a wide range of providers so that if the plan services are determined to be limited, outdated, or overpriced, the advisor will be able to recommend better solutions.

Retirement plans offered at different nonprofit organizations are at different stages of development.  Advisors that are familiar with more evolved retirement plans can "see the future" and are able to lay out a blueprint for success.

Many qualified retirement plan advisors that have historically advised 401(k) plans can contribute significantly to 403(b) plan sponsors.  Their expertise and fiduciary knowledge gained from operating in a ERISA world can benefit nonprofit organizations that are now progressing into an ERISA fiduciary environment.  An advisor well-versed in ERISA standards can effectively apply that same level of due diligence, prudence and fiduciary standards to the 403(b) plan of a nonprofit organization. 

Fiduciary oversight of a 403(b) plan has become a challenging role for many plan sponsors, especially if their administrative responsibilities are still burdened with multiple vendors.  Periodic plan benchmarking is a critical function for all plan fiduciaries, regardless of the retirement plan type or size.  Benchmarking helps plan sponsors upgrade plan services, plan design and participant services at a competitive price.

Friday, October 9, 2015

Economic Review 3Q 2015

Nicholas Zaiko, CIMA®
Investment Consultant
Bridgebay Financial, Inc.
US Federal Reserve
At the September 17, 2015 FOMC meeting, the Fed left rates unchanged after the much anticipated rate hike that the market had long awaited.  The rationale was that it would restrain US economic activity.

The Fed cited recent global financial and economic developments that could impact and restrain US economic growth and keep inflation low.  The Fed focused on the adverse impact of global economic and market developments and lowered its inflation forecast.  The Fed lowered its long term projection of the rate from 3.8% to 3.5%. 

European Central Bank
The ECB kept the main policy rate unchanged in August, 2015 as growth and inflation expectations were revised downward.  The inflation rate is expected to be negative in 4Q2015 due to low oil prices.  Eurozone inflation fell below zero in September for the first time in six months, potentially bolstering the argument for the European Central Bank (ECB) to stave off deflationary concerns with additional stimulus. The Euro area’s consumer price index fell 0.1% from a year ago. The previous negative reading came in March, when the ECB launched its bond-buying program.

US employers added a disappointing 142,000 jobs in September, raising questions over whether slowing global growth is taking a toll on the US expansion and if the Fed will raise rates this year.

August monthly figures were revised lower and wages were sluggish, adding to the downbeat tenor of the report. While the unemployment rate held at 5.1%, the labor force participation rate fell further, remaining near its lowest level since the 1970s.

The jobs report for August was 173,000 lower than the average 200,000 per month required.  The economy added less jobs than anticipated.  The unemployment rate dropped to 5.1% and the U6 underemployment rate dropped to 10.3%.  The labor force participation rate was 62.6% and  2Q GDP was revised to 2.7% which is below the median forecast of 3.2%.

In September, US manufacturing activity expanded at the slowest pace since May 2013, according to the Institute for Supply Management (ISM), a sign that the strong US Dollar and tepid overseas demand is weighing on manufacturers. The ISM index fell to 50.2 in September, down from 51.1 a month earlier, dragged lower by production, new orders, and employment indicators. However, readings have remained above 50—which separates expanding from contracting activity—for nearly three years.

In September the investment grade, corporate bond market totaled $21 billion in new supply across 14 issuers including Gilead, Marriott, and Lowe’s.  Corporates outperformed Treasuries as a result of strong demand.

Liquidity in the US bond market has changed dramatically from the period before the financial crisis.  Historically, broker-dealers carried securities inventories on their balance sheets and were willing to make markets in securities and take market risk.  The change in making markets, and the record corporate issuances and low interest rate environment have made it difficult for broker-dealers to make markets and inventory securities.  Fixed income trading has become less liquid. 

Fixed income investors face longer holding periods than they would have considered in the past.  Lower turnover strategies have a lower impact on transaction costs on portfolio especially when there are changes in market liquidity.  Trading now requires a more deliberate approach to minimize transaction costs.  Conversely, there are attractive prices for buyers when there are forced sellers in the market. 

The liquidity in fixed income markets has changed across all sectors including Treasuries.  The ability to trade in large blocks has changed.  Primary dealers that purchase directly from the Fed have been buying fewer Treasures and volume has fallen.  The size of the Treasury market has doubled since 2008.  US and foreign investors have purchased a higher percentage of Treasuries sold by the Fed than the dealer community. 

Puerto Rico
They released a 5-year plan to restructure and reduce the $28 billion financing gap.  This involves losses on $72B in Puerto Rican debt. 

Global financial markets were volatile in August following China’s devaluation of its Yuan currency that triggered fears of a Chinese and global economic slowdown.  Chinese economic weakness impacted commodity demand, emerging markets that are commodity based, and drove fears of deflation.  Crude oil fell below $40 per barrel.  Global growth concerns highlighted by continued weakness in China weighed on global markets in September.

China is at an inflection point as the services sector overtakes industrials as the largest part of its economy. Countries ranging from Brazil to Indonesia to South Africa saw their currencies plunge either to multi-decade or record lows, underscoring the tumult facing emerging-market currencies.

The Fed’s new focus on non-US developments underscored China’s far-reaching implications.  The volatility in Chinese equities, an unexpected depreciation of the Renminbi, and another round of disappointing activity data.

USD Currency
The Fed’s decision to postpone a rate hike may put downward pressure on the USD at first.  Higher US yields may support a trend to a stronger USD against global currencies.  US companies with international sales have usually not benefited from stronger USD although US consumers have with lower prices.  If the USD weakens, commodity prices may rise temporarily. The excess crude oil supply and weaker Chinese demand for commodities, prices will continue to trend downward, regardless of the Fed action.