A Wake-Up Call & Fee Disclosures for 401(k) Plans
March 14, 2012
Michael D. McNiven, PhD
If you are a provider of services or investment selection to a 401(k) plan, this commentary is a reminder and hopefully not a wake-up call. If you are a trustee, fiduciary or administrator of a 401(k) plan or other retirement vehicle, this commentary will help inform you of the fee disclosures that are now legally required for your 401(k) plan. The implications for fiduciary risk to plan sponsors/companies are large. There is a S&P 500 Index Fund comparison further down in the writing to illustrate the points of fee disclosure and “reasonable” nature of the funds selected in plans. The commentary will take ten minutes to read.
The long-awaited regulations from the Department of Labor regarding fee disclosures and conflicts of interest reporting are now official as of February 3, 2012. (see Federal Register, Vol. 77 No. 23, Friday, February 3, 2012, Rules and Regulations)
You can find the Fact Sheet (roughly two pages) on the Department of Labor website. (or click here http://www.dol.gov/ebsa/newsroom/fs408b2finalreg.html)
The entire rule, which spans 110 pages, can be found on the Department of Labor website. (or click here http://webapps.dol.gov/FederalRegister/PdfDisplay.aspx?DocId=25781)
Other supporting documents, including a sample guide disclosure form, can be found on the Department of Labor website under the Employee Benefits Security Administration subsection. (see http://www.dol.gov/ebsa/)
After many years of testing the waters, the Employee Benefits Security Administration of the Department of Labor has put forward new requirements. The long-awaited fee disclosure rules are meant to provide transparency to an industry that has become convoluted and opaque, and to allow plan fiduciaries the information necessary to assess the real costs of the plans they offer. By laying down these regulations, the regulators are informing the plan fiduciaries of their important role to make sure their plans are “reasonable.” The assessment of what is reasonable leaves room for a lot of personal and industry interpretation; but that will not matter, because these disclosures also go to each individual plan participant in the retirement plan, and the average employee currently thinks he/she is not paying anything. This little piece of information alone should wake up the entire industry, particularly plan sponsors who—many times unbeknownst to them—bear the full fiduciary responsible for the arrangements.
Most participants do not currently think they pay any fees. In spite of this, many plans are structured so that the participants pay all of the fees and the sponsoring company pays nothing. There is no financial magic at work here. Somebody is paying, and plan participants are paying indirectly through the inclusion of more expensive mutual funds that have revenue-sharing arrangements to compensate the advisors and other providers involved. It is a clever arrangement to make people who don’t know pay all of the costs, while keeping the sponsoring company’s cost to zero. Generally this is done through a one-stop, bundled service so that recordkeeping, custody, transactions, third-party administration, and fund selection are performed by the same entity. This in effect simplifies the access point to the company officials by only dealing with one provider. This also creates in effect a monopoly for that provider, who then has the tendencies that all monopolists tend to gravitate toward.
The counter argument for this type of arrangement is its simplicity to the company, in addition to eliminating company cost. A company official or fiduciary can justify some costs by saying that a 401(k) is a benefit and that they are now in the age of austerity where benefits are not free. They may do so even though these arrangements were in place long before the current financial crisis. But those arguments do not change the fiduciary responsibility required of them by ERISA. The law has not changed, and the Department of Labor is starting to put some accountability measures in place that are actionable.
Now consider what the specific ERISA language states regarding retirement-plan fiduciaries (i.e., the companies and their officers who provide the plans for their employees):
“The Employee Retirement Income Security Act (ERISA) requires plan fiduciaries, when selecting and monitoring service providers and plan investments, to act prudently and solely in the interest of the plan’s participants and beneficiaries. Responsible plan fiduciaries also must ensure that arrangements with their service providers are ‘reasonable’ and that only ‘reasonable’ compensation is paid for services.”
(see Fact Sheet, Final Regulation Relating to Service Provider Disclosures Under Section 408[b])
Now people can clearly see the problem. The industry has evolved over time to a model that is at odds with the original ERISA fiduciary mandates. The bundled plan structure mentioned previously yields a plan that costs the company nothing and pushes all costs to the employees. At a minimum this has the appearance of impropriety. And now, later this year, plan participants will begin to see the costs involved, which they are paying almost in full. These disclosures will require a couple of bottles of antacid for HR, benefits personnel, and company officials as they try to answer the questions from employees about the fees they are being charged. Conversely, it seems inevitable that employee-driven class-action lawsuits against employers may increase. Consider these headlines from last year, which likely represent the tip of a litigation iceberg:
“SunTrust faces suit over operation of 401(k),” Atlanta Journal Constitution, 3/18/2011
“ERISA Class-Action Suits Shape U.S. Retirement Future,” Institutional Investor, 2/2011
The new disclosure regulations will begin to force industry providers and plan trustees/sponsors to compress fees and bring transparency to plan participants. As such, plan fiduciaries/trustees need to embrace this opportunity to reduce costs in their plans and to reassess the particulars of the providers, the types of investments being offered in their plans, and the actual value they bring. If this is not done as a voluntary and prudent gesture, then employees and their favorite class-action lawyers may help you along the path.
With these fee disclosures in mind and the fiduciary responsibilities already discussed, let’s ask the loaded question: What is “reasonable”? The answer is that we simply don’t know. It depends. But, nonetheless, here’s an example of a comparison of investments in various plans that easily demonstrates the problem with conflicted fund selection in a plan and the problem with who is making the decisions versus who is paying the fees.
Dear Reader, do a gut check as you read this comparison and determine in your own mind what you think is “reasonable.”
Company A determines it needs a US equity fund in its 401(k) Plan. There is no data that supports the inclusion of expensive, actively managed stock funds as being superior to low-cost indexed funds. In fact, the SPIVA studies from S&P continue to show how hard it is for individual stock picking to outperform the index, in addition to the fact that it is more expensive.
As a result, and for our example, it is quite reasonable that a US equity option be made available in Company A’s 401(k) plan. For simplicity’s sake, let’s say an S&P 500 Index-based mutual fund ought to be included. The next question is, which one? Since all index-based mutual funds are essentially the same (although there is some variation in cash-management policies and trading costs), then it follows that the S&P 500 index fund is the closest thing to a commodity in the available mutual fund arena. Outside of the brand names associated with the various S&P 500 funds, there is very little differentiation in the funds. They all own the same five hundred stocks. All that is left to do is to negotiate the cost, since it is almost an apples-to-apples comparison. Let’s see what our options and costs are, in order to give our participants access to the S&P 500 companies.
This turns out to be a somewhat difficult research project. In 2006, a study by Haslem, Baker & Smith, published in March/April edition of the Journal of Indexes, found 136 S&P 500 Index mutual funds. After digging through all of the costs and revenue-sharing fees, etc., they concluded that the first quartile (top 25%) had an average expense ratio of .27 of 1% (27 basis points per year). The fourth quartile (most expensive 25%) had an average expense ratio of 1.29% (129 basis points per year). This is fairly remarkable, being that these are averages. The least expensive funds on average are only 21% of the cost of the most expensive funds, and these funds have pretty close to the same holdings, with very little differentiation. More to the point, an S&P study of S&P 500 index funds in 2009 revealed this compelling insight:
“The most expensive fund our screener found had an expense ratio of nearly 2.3%. That contrasts with the least expensive fund, which had a ratio of under 0.1%. (see http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDkNZz12BV.s)
So the most expensive S&P 500 index fund was 230 times more expensive than the least expensive one in 2009. This is an extreme example, but the implications are real if you happen to have funds in the upper range of the expense quartiles. Just for interest’s sake let’s compare the different class costs for the Vanguard S&P 500 index funds, long known as an industry cost-cutting leader.
Minimums for all classes:
. . . . . . . . . . . . . . . . . . . . . . . . . .Minimum Initial Investment Expense Ratio (12/31/2010)
500 Index Fund Inv – VFINX $3,000 0.17%
500 Index Fund Signal – VIFSX Advisors 0.06%
Inst Index Fund Inst – VINIX $5,000,000 0.04%
Inst Index Fund Inst Plus – VIIIX $200,000,000 0.02%
(taken from https://institutional.vanguard.com/VGApp/iip/site/institutional/investments/productoverview?strategy=1342558128 on March 13, 2012)
The investor-class S&P 500 fund is available to anybody in the open market and costs 17 basis points (.17 of 1% per year). Any employee can find this out easily with a quick internet search. For 401(k) plans, an advisor should be involved in selecting the funds and can access the Signal-class shares at 6 basis points (.06 of 1% per year). Thus, the comparison expense-ratio unit for an S&P 500 Index-based mutual fund in 401(k) plans should be 6 basis points.
Now consider the S&P 500 index fund that is included in your current plan. It has to compare against an expense ratio of 6 basis points. Is the expense ratio of your S&P 500 index fund higher than that? Is this “reasonable”? Would an employee who figured this out find solace in the friendship of a friendly class-action attorney?
Maybe this has got somebody’s attention. For an industry that moves along at a glacial pace, any thaw? Anybody?
In the event of any awakenings out there, here are some important dates that you should note regarding the fee disclosures this year:
July 1, 2012: Covered service providers (CSPs) must furnish in writing the fees they receive either via direct or indirect (revenue-sharing) sources to the responsible plan fiduciaries/trustees. This is an actual deliverable that, if ignored, will open up great liabilities. Note who is considered a covered service provider in the rule: investment advisors registered under federal or state law; record keepers or brokers who make designated investment alternatives available in a plan; or any of the following who receive compensation in a “indirect compensation” (i.e., not paid directed by the plan/plan participants) related to a retirement plan: accounting, auditing, actuarial, banking, consulting , custodial, insurance, investment advisory, legal, recordkeeping, securities brokerage, third-party administration, or valuation services. Providers not supplying this disclosure will be subject to the prohibited transaction rules of ERISA section 406 and Internal Revenue Code section 4975.
August 30, 2012: “The initial annual disclosure of ‘plan-level’ and ‘investment-level’ information—including associated fees and expenses—must be furnished no later than August 30, 2012” to plan participants.
November 14, 2012: The first quarterly statement containing the fees and expenses actually deducted from the participant’s or beneficiary’s account must be sent or made available to the plan participant.
(information taken from Fact Sheet February 2012, found at Department of Labor website. http://www.dol.gov/ebsa/newsroom/fs408b2finalreg.html)
At Cumberland, we are an independent advisor to 401(k) and pensions plans. We see our role as being completely independent in helping guide fiduciaries of any type of plan toward lower fees and “reasonable” offerings. We currently advise on all types of 401(k) plans and pension plans as an independent voice and do share some investment fiduciary risk in certain situations. We prefer open-architecture record-keeping systems that allow the advisor to select the best funds available in the market. There are reasons to keep bundled providers, even though they may currently be more expensive. Each plan has to be assessed independently. We feel that a “reasonable” all-in annual fee for 401(k) plans is less than 1% of assets. For example, an employee with an account balance of $100,000 would pay less than $1000 in annual fees. This includes all fees for record keeping, custody, third-party administration, advisors for fund selection and management, expense ratios of funds, etc. All of the elements are available in the market in unbundled form to provide such cost-effective plans.
Finally, please note that Cumberland Advisors is not an ERISA attorney, and the information provided in this commentary is that of an independent investment advisor and not legal advice. The new rules are lengthy and can be complicated reading, particularly with regard to possible exemptions or other possibilities. We advise 401(k) market participants to call their investment advisors and/or consult with an experienced ERISA attorney for more detailed information.
Michael McNiven is a senior vice-president and portfolio manager and heads the 401(k) section at Cumberland.