Nicholas Zaiko, CIMA®
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.
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).
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.
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.