Service Provider Due Diligence

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Selecting and effectively monitoring defined contribution plan service providers is an essential fiduciary duty of the plan sponsor which influences retirement outcomes for its employees.  The plan sponsor or Committee overseeing the defined contribution plan shares this responsibility for the prudent management of the plan for the benefit of the participants.

Fiduciary Reasons for Conducting a Provider RFP

In the ERISA Section 408(b)(2) fee disclosure rules, the Department of Labor (DOL) assumes that a prudent plan sponsor has a fiduciary duty to establish and follow a formal review process at reasonable intervals, generally three to five years, to ensure the caliber of the selected DC provider and that the services are being delivered at a "reasonable" cost.  Typically, a plan sponsor can conduct this due diligence review by issuing a service provider RFP.

Types of Service Providers

There are a full range of DC plan service providers that are either independent or affiliated with different types of institutions that include:  TPAs (third party administrators) or independent recordkeepers, mutual fund companies, insurance companies, banks, and brokerage firms.

Bundled or Open Architecture 

In order to properly operate a qualified DC plan, an array of services are necessary.  Those services include recordkeeping administration, trustee/custodian services, compliance testing, investments, legal update of plan documents, government reporting and participant education.  Bundled service providers offer the full spectrum of services necessary to operate a qualified plan under one contractual arrangement.  A bundled provider includes plan administration, recordkeeping, trustee, legal, investments, participant communication and education. Defined contribution plans, such as 401(k), 403(b) and 457, that are open architecture may use multiple service providers that perform each role.  In such a situation, the plan sponsor would issue RFPs for each of the various services.

Multi-Purpose RFP

A well-documented due diligence review enables plan sponsors to fulfill their fiduciary duty to prudently monitor their service plan providers.  A multi-purpose RFP covers the services of key providers necessary to operate a 401(k) or 403(b) retirement plan.  The design of the questionnaire is the first step in the evaluation process when benchmarking providers.

The process starts with the Request For Proposal (RFP) and should elicit information about the provider’s services, expertise, client commitment and compliance experience with clearly detailed costs.

Independent Benchmarking

The RFP process can be a benchmarking tool to assess the quality of the plan’s services, potential upgrades to the plan and serve as a resource to evaluate the reasonableness of plan fees.  Periodic, unbiased benchmarking documents the plan sponsor's fiduciary process to monitor the quality of plan services and fees.

Open Architecture

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

As fiduciaries, plan sponsors must act for the sole benefit of their plan's participants. Decisions born of the need for corporate convenience may lead to less-than ideal arrangements or investment options for plan participants. Sponsors need to evaluate whether the convenience of one-stop shopping is worth the potential fiduciary risk of foregoing open architecture.

The conventional wisdom regarding bundled service providers is that the convenience offered by an all-in-one solution is particularly attractive to smaller 401k plan sponsors who might not have the scale or staffing necessary to administer the plan in-house. These types of companies are typically spread thin already, with many individuals wearing many hats. Tight resources tend to push plan sponsors to make the easy choice of working with bundled service solutions. These service providers come in several forms. They can be a broker, a mutual fund firm, a payroll processor or an insurance company.

Truly open architecture goes well beyond the simple ability to add non-proprietary funds to a plan's line-up. In a open architecture, all of the service providers are either unbundled or entirely separate entities. The goal of open architecture is to have the flexibility to monitor and trade out each individual component, independent of the other services with a minimal amount of disruption to the plan. The primary service providers to a typical DC plan include the recordkeeper, investment or fund managers, custodian or trustee, plan investment consultant, managed account provider, and the education/communications provider. Ideally, each of these service providers is a separate, unaffiliated entity without any vested interest in the actions of any of the other providers.

The key is to then take a "best-of-breed" approach and select only the best recordkeeper, TPA, mutual funds and investment consultant. A recent study which compiled the characteristics of an ideal 401k plan supported this approach and demonstrated that such plans do not use bundled providers. By managing each component individually, the sponsor maintains the flexibility to replace any element that may suffer from poorer or declining quality service without disturbing any of the other services. The modular nature and the ability to use best-in-class providers are the major strengths of open architecture.

In contrast, bundled service providers typically rely on investment products to drive revenues, making other peripheral services an afterthought and generally a loss leader. Ancillary services such as plan administration and recordkeeping tend to suffer when pushing investment products is the primary source of revenue.

Additionally, by obscuring the actual cost for each service in the bundled fee, such providers make it difficult to accurately benchmark total plan fees. Independent providers bring with them a built-in check-and-balance mechanism regarding the quality and fees of other service providers. Though many bundled providers may tout the benefits of the "economies-of-scale" that come with their arrangements, the inherent conflicts of interest may actually result in higher fees than a truly open architecture solution.

In recent years we have seen numerous lawsuits brought against plan sponsors for various breaches of fiduciary duty. In 2011 we witnessed the result of the high-profile class action suit against Walmart for breach of duty regarding the investment choices in the 401k plan. The plaintiffs discovered that het plan's bundled service provider had placed high-fee funds into the plan and the broker was receiving trailing commissions for having placed those funds in the plan.

The mere fact that it took plan participants so long to discover the breach of fiduciary duty indicates how well high fees can be hidden within the bundled arrangement. 2012 promises to be a year of greater disclosure and transparency on behalf of bundled service providers. The new fee disclosure requirements outlined under sections 408(b)(2) for provider to plan sponsor disclosures and 404(a) of the Employee Retirement Income Security Act (ERISA) offer to shed light on the bundled service provider. This has the potential to reshape the bundled provider industry and reinvigorate plan sponsors' interest in pursuing open architecture.

While a bundled solution may work for plans of a relatively small size, the modular and best-in-class approach afforded plan sponsors by using open architecture and the potential for lower, more competitive fees must not be ignored.