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.
Conclusion
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.
