Benchmarking Defined Contribution Plan Fees

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

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. 

Evaluating Plan Service Providers

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Selecting a service provider for a 401(k), 403(b), or 457 retirement plan is one of the most crucial decisions that an employer and plan fiduciary can make in determining the retirement outcomes for its employees.  

The Department of Labor (DOL) has indicated that a plan sponsor has a fiduciary duty to establish and follow a formal review process at reasonable intervals, generally 3-5 years, to ensure the caliber of the selected provider. A client service focused organization will tailor its services to the plan sponsor's needs and have an understanding of the key requirements of the plan sponsor.

The process starts with the Request For Proposal (RFP) which should address the provider’s services, expertise, client commitment and compliance experience at a reasonable cost.  The RFP provides a strong foundation for selection but is not the only factor.  The in-person finalist presentations should highlight the relationship services.

Provider Selection Sub-Committee

It is good practice, in order to facilitate the service provider search, for the plan sponsor to establish a Selection Committee with a range of members with different areas of expertise such as payroll, employee benefits, legal, compliance, investments/finance and technology/systems.  Each member should be responsible for evaluating the provider’s abilities in their respective key areas. 

Use of an Outside Retirement Plan Expert

Many plan sponsors engage an outside consultant to guide and advise them through a methodical process that is well-documented and clearly illustrates the reasons for the decisions made.  The consultant's role is to guide the plan sponsor in establishing goals and objectives, success metrics, and targeting performance standards. The plan consultant can screen candidates, customize the RFP to the plan sponsors needs, conduct the provider search, analyze or score the results and lead the finalists’ presentations.

The RFP consultant will pre-screen candidates based on specific plan sponsor requirements or a set of minimal capabilities.  A retirement plan consultant may expedite the selection process by searching its database of service providers to identify those candidates that offer services that best fit the particular plan's needs.  

The consultant can guide plan sponsors through a large universe of competent service providers and qualify a few candidates that are a strong match for the plan sponsor and the participants.  Service providers have different target markets, service levels and areas of expertise.  The RFP consultant can differentiate among providers and permit the plan sponsor to select the service provider that best meets their specific requirements.

Preparation of the RFP questions is critical for efficiency and thoroughness to prevent receiving vague responses.  Certain questions may serve as differentiators.  The consultant's expertise in understanding the nuances of different levels of service, identifying potential conflicts of interest and understanding the benefits or limitations of certain providers can be extremely valuable to a plan sponsor.  A key benefit in using an expert is that the consultant can provide invaluable insights from having worked directly with the numerous providers under consideration.

One of the best ways for a consultant to present the results of their evaluations is to provide side-by-side analysis and a scoring system to enable the plan sponsor to identify and understand the finalists they would want to interview.  

Investment Oversight Best Practices

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The employer-sponsored defined contribution (DC) plan now represents the primary retirement savings vehicle for most employees.  The increased size, complexity and recent 401(k) plan litigation, demands greater scrutiny of the plan's investment options in addition to enhanced administrative oversight.  These issues are not limited to the 401(k) plans but also 403(b) plans that are under ERISA and DoL.   

Revisiting the Oversight Role

The increased significance of the role of the DC plan now demands additional expert focus on the investment options offered to the participants.  The oversight structure should also adapt to consider the changing relationship between the plan sponsor and the service provider as assets in the DC plan grow.  Additional services may be required as the plan grows and the service providers' ability to deliver those services in a cost-effective way must be evaluated.  Failing to achieve enhanced services or reduced fees as a DC plan grows may result in an unintentional fiduciary breach on behalf of the plan sponsor as recent litigation has shown.  The sponsor may also fail to meet its fiduciary duty to participants if the participation rates, investment selection and education programs are not closely monitored and maintained.

Investment Oversight

The most effective way to increase investment oversight is to include members of the treasury or finance departments in the plan oversight committee.  This is an evolving trend that is spreading throughout the DC market.  Since traditional pension plans or defined benefit (DB) plans directly impact the financial statements, the CFO or Treasurer are typically heavily involved in both the administration and investments in those plans.  In contrast, the DC plan has had minimal impact on the employer's income statement and has historically been overlooked by the treasury group.  Recent litigation on fees and fiduciary breaches have demonstrated that DC plans can have an adverse monetary impact the employer's finances.    Employing the same robust oversight historically reserved for the DB plan to the DC plan will greatly enhance fiduciary compliance and minimize risk.  

As plan assets grow, plan sponsors may consider retaining the services of an independent, retirement plan consultant that has the benefit of working with many different plan providers, investment funds/managers and plan sponsors.  Many bundled 401(k) plans have relied on the affiliated investment consultant provided by the recordkeeper that is an employee of the recordkeeper's parent organization.  Periodically, a plan sponsor should seek a deep-dive review of the investment recommendations by an independent third-party advisor to ensure that the investment line-up is best in class with reasonable fees.

The expertise of a retirement plan advisor will assist the plan sponsor in ensuring that plan fees and services are competitive with other plan providers.  An independent consultant can also point out any deficiencies in the administration of and the investments in the plan. 

The Plan Committee

Plan sponsors should pay close attention to the size and composition of their investment committee.  The cornerstone of an effective committee is ensuring that all members represent experts in their particular field of focus.  The best committees are well rounded, drawing from several different departments.  Each member should focus on a particular area of the plan which aligns with their particular expertise and take the lead in major decisions.  For example, the ERISA attorney should have greater direct input and authority on providing fiduciary and compliance advice.  Similarly, the Treasury professional should focus on the investments, leaving legal compliance issues to the ERISA attorney.  The administrative requirements of the plan should be provided by the benefits manager and Human Resources representative.  Additionally, an advocate for the participants and employees should also provide input to the committee.  Well defined roles and segregation of duties is crucial for an efficient and effective oversight committee.

The committee should be sufficiently small as to avoid getting bogged down in procedure and scheduling conflicts and allow sufficient time for proper oversight by each member.  Exceedingly large committees may have problems assembling enough members at any one meeting in order to establish a quorum and thus inadvertently delay crucial plan decisions. 

Investment vs. Administrative Decisions

Investment and administrative timelines tend to differ dramatically and can often conflict.  Many challenges arise when trying to fit investment decisions into administrative timelines.  The conflict may become so great, that investment decisions end up being made based on administrative pressures rather than investment priorities.  These types of decisions can potentially represent breaches of the plan sponsor's fiduciary duty to the plan participants.  For example, leaving an underperforming fund in the plan because of administrative restrictions after the committee has decided to remove or replace the fund may open the door to fiduciary liability.  On the flipside, the plan investment policy should not be written in such a way as to rigidly trigger automatic action regarding a fund.  The policy should reflect a structure of monitoring that involves the evaluation of numerous important factors.  Any action taken regarding a fund should be reviewed and documented by the committee.

Investment Review Process

A well-designed and methodical investment review and search process is the hallmark of the top institutional DC plans.  Any changes made to the plan should be done so in a well thought out approach which takes into account investment considerations.  While administrative considerations are omnipresent, they should simply inform but never interfere with critical investment decisions.  There are some steps that can be taken to reduce administrative burdens such as utilizing a multi-manager framework and using asset class specific funds.  This makes it significantly easier to simply replace an underperforming fund with a similar fund with better performance.  The best plan sponsors also have an established search process in case a fund change is required at any time, rather than relying on a pre-determined periodic review.  This allows the committee to act swiftly in the case of an unexpected event.  Though periodic review is important, searches should be conducted in response to external events and not simply be restricted by the calendar.

Conclusion

Now rivaling the traditional pension or defined benefit (DB) market in scale, DC plans have taken center stage in employees' retirement future.  As such, professional, expert scrutiny of the investments offered to plan participants is becoming increasingly important.  The plan committee composition and size are crucial to providing diligent and effective oversight in order to protect against fiduciary risk.  Engaging the broad knowledge and specific expertise of an independent investment consultant to share the burden of co-fiduciary status affords the sponsor further protection and market insight.   A detailed and methodical review and search methodology, coupled with a comprehensive pattern of documentation is the one of the best ways to fulfill the sponsor's fiduciary duties to the plan participants.

Implement an Education Strategy

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The best way to implement an effective education strategy is to create an Education Policy Statement that establishes an overriding framework for deploying and measuring the effectiveness of participant communications.  The process of formally documenting the strategy in a policy statement helps ensure that the program will be focused, effective, and quantifiable. 

By establishing specific goals in the policy, educational campaigns can be more easily assessed and positive results measured against identified criteria.  The process of creating the policy turns nebulous notions of improving participant financial literacy into specific, discrete goals that can be used to guide the educational efforts of the program.

An Education Strategy guides the development of ongoing participant communications and education.  The strategy focuses on specific demographics or employee segments that need targeted education and messaging.  The strategy should identify specific types of desired results and include a calendar for delivering the education, milestones and how the program’s success will be measured.

Getting Started

An Education Strategy can document the objectives of the education program, content of the educational meetings, webinars, seminars, topics to be covered, and feedback or survey results.  There are several plan statistics that can be helpful in identifying areas for improved participant communications which include participation rates, average deferral rates, asset allocation among funds, and average participant balances.  All of this data can be provided by the recordkeeper and sliced by age, income group or geographic location.   Different savings patterns can be further evaluated by employee salary levels, divisional location, experience level and age.  These statistics, supplemented with employee surveys, can be utilized to identify certain populations of employees that face similar challenges in retirement plan savings. 

Once some of the challenges have been recognized, relevant goals, objectives, action plans and an education program can be developed to achieve stated goals. 

Employee Surveys

A well designed employee questionnaire or survey can be instrumental in identifying misconceptions about the retirement plan, employee benefits and areas of interest to employees.  The results of this survey may highlight areas for increased participant communication and educational needs. 

Plan sponsors can also benefit from industry data available through the recordkeeper and plan advisor that compares the plan to peer groups with similar workforces.  These industry surveys and benchmarking studies can be helpful in designing the plan and the communications program to enhance participant satisfaction and employee retention.

Setting Goals

Different measures of success can be used to establish specific goals.  Some typical milestones include increasing participation levels among a specific demographic, growing balances among certain salary levels, increasing contributions for participants stuck at a low percentage, broadening overall savings, improving asset allocation for participants in one undiversified fund, or improving personal returns.

Determining the Goals

The Education Strategy should focus on the issues or communications gaps that must be addressed.  Not participating in the retirement plan, inadequate deferral rates or excessive loan taking can all be areas for further education.  Employee groups to be targeted with specific educational topics can be prioritized in the annual education plan. 

The communications objectives should be stated to provide a clear message in the educational campaign.  Document the education campaigns to be delivered for the year by topic, targeted group, frequency, and delivery method.  Establishing an annual communications calendar that highlights the specific schedule for the various educational programs is critical for a well-orchestrated program that is measurable and repeatable. 

Finally, define the annual goals and objectives and how they will be evaluated and measured.  This is an opportunity to define the key metrics to be used to monitor the plan’s effectiveness and identify areas for modification. 

Means of Delivering Education Program

The methods by which the education will be delivered is an integral part of the strategy and planning process.  The use of in-person small group sessions, webinars, seminars, online tools, and participant feedback should be part of the annual plan.

The sequence of educational topics for the general audience as well as more targeted communications for specific employee demographics is important.  Certain topics may address the unique financial wellness and planning for women while other topics may be more relevant to young parents or recent graduates or new hires.  The topics should be segmented by stages in life and unique needs.

Topics to Be Presented

The education strategy should have a process for the review of all educational materials to be presented to the participants to screen for sales pitches or other services that would be a conflict of interest.  The annual plan should include a list of presentation materials that have been reviewed by the plan sponsor in advance for relevance and educational value. 

Measure Milestones and Education Success

Metrics for measuring the success of specific educational campaigns should be established in advance and should be used to evaluate the factors that contributed to the session’s success or help explain why the program missed the mark with participants.  Later sessions can be modified to absorb the feedback from participants.  By setting expectations in advance, results can be measured to determine the effectiveness of the program and set standards for future improvements. 

The effectiveness of a program can be measured by changes in participation rates, deferral rates, fund changes, or increased usage of service provider services following an educational program.  Follow up may also include a participant survey which can provide actionable information. 

Educational programs should be developmental and sequential.  They should target different participant groups by topic and interest.  Simply providing introductory and enrollment meetings does not educate participants nor do they gain financial literacy.  Educational plans should provide a foundation upon which to progressively build the participants’ knowledge of financial topics that are relevant to them.