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Courting Disaster

Confusion over 401(k) plan fees is triggering lawsuits and congressional inquiries. What can plan sponsors do to head off trouble?
Russ Banham, CFO Magazine
May 1, 2008

See this year's 401(k) Buyer's Guide.

Last summer, when a federal judge dismissed a suit brought by employees of John Deere & Co. alleging that they were charged unreasonable and poorly disclosed fees in their 401(k) plans, companies may have been tempted to breathe a sigh of relief. A number of such suits have been brought over the past two years, making companies acutely aware of a fiduciary responsibility that few seem suitably prepared to address.

Turns out that relief was short-lived. In March, the Department of Labor (DoL) lent its weight to the employees' side of the case, filing a brief in support of their claim as they pursue an appeal. It's the latest salvo in the battle over 401(k) fees, namely how to accurately assess and communicate them to employees.

Over the years, as more providers have gotten into the defined-contribution business, their fees and behind-the-scenes revenue-sharing arrangements have become so complex that plan-expense comparisons are virtually unattainable. And that's a problem. If plan sponsors can't ascertain the true cost of their defined-contribution plans, they certainly can't explain fees to plan participants, who pick up many of these expenses. The upshot has been litigation against more than a dozen plan sponsors and intense scrutiny of 401(k) fees by Congress and the DoL. The latter is in the midst of receiving public comment on proposed guidelines to make fees more reasonable and transparent.

Rather than wait for the DoL to issue new regulations, some companies have called in retirement advisory firms to analyze and benchmark the hodgepodge of fees that they and their employees pay for the services rendered by 401(k) providers.

Doubts about the suitability of fees affect a wide swath of plan sponsors. According to a study released in March by Chatham Partners, while 79 percent of plan sponsors believe understanding their 401(k) plans' overall costs is important, only 58 percent feel confident they do. Thirty-four percent said they found it difficult to compare one plan's fees with another's, and only 38 percent say their provider discloses its revenue-sharing arrangements with partner firms.

Were these respondents able to obtain full disclosure of what they're really paying for — many providers give out only a bottom-line number — they would find wide disparity. According to data compiled by HR Investment Consultants, for a plan covering 500 participants with average account balances of $50,000, the shared fees paid by plan sponsors and participants ranged from $211 to $822. "Given today's legal climate, employers should be wary if they are paying more than the average cost [$599]," says Joe Valletta, a principal and co-author of the investment advisory firm's 401(k) Averages Book.

Wariness, indeed, makes sense given the lineup of companies alleged to be in violation of the Employee Retirement Income Security Act of 1974 (ERISA). Companies ranging from Boeing to RadioShack are embroiled in litigation filed by employees over the reasonableness and disclosure of the 401(k)-related fees they have paid.

None of the cases have been settled, although a lawsuit filed by employees of Deere & Co. against Fidelity Investments, the company's trustee and record-keeper for its $2.5 billion 401(k) plan, was dismissed last July. (However, as of March, the DoL has become involved and is asking the judges to reconsider.) Nevertheless, increased due diligence seems in order, given sponsors' fiduciary obligations to protect the interests of employees. "If a sponsor doesn't know how the bundled fees are broken down into different buckets, it cannot compare them with the fees charged by other providers," says Pamela Hess, director of retirement research at Hewitt Associates. "Yet sponsors have a legal obligation to make sure their contracts are reasonable."

Nobody's Business
When defined-contribution plans came on the scene in 1978, after Congress amended an Internal Revenue Code to permit them, plan fees were easy to interpret. That's because the original providers were third-party administrators (TPAs), such as Hewitt or Mercer, that charged a single fee to employers for the administrative services associated with the three or four investment options presented. On top of that, the plan sponsor might pay an investment manager to handle the portfolio. "It was pretty basic when defined-contribution plans were new and few," says Leslie V. Smith, senior vice president of Aon Consulting's retirement practice. "When 401(k) plans took off they also became extremely convoluted from an expense standpoint."

Once the mutual-fund companies realized they had the technology in place to handle the record-keeping themselves, they gave the TPAs stiff competition. The companies offered "free" record-keeping — the administrative services that sponsors paid for.

The major drawback for plan participants was that investment options were limited to the mutual-fund company's proprietary products. Realizing this, the TPAs brokered a truce with the fund companies. The TPAs offered to include the companies' funds in the menu of investments they provided, linking the parties' technology so participants could execute trades. They also provided record-keeping and other administrative services, which would still be "free" to sponsors. In the background, the partners would share revenue. "They essentially joined hands," Smith says.


TPAs now had leverage over the mutual-fund companies because they could offer an array of mutual-fund families — say, a T. Rowe Price large-cap fund here, a Vanguard international equity fund there. The mutual-fund companies became lesser players, a situation they remedied by creating revenue-sharing arrangements with one another, opening up their technological architecture to permit trades out of one fund family into another, while providing their own recordkeeping services or hiring the TPAs to do it for them.

This had the good effect of permitting plan participants to significantly diversify assets across several funds and fund classes. On the down side, all the complicated side deals obscure actual plan costs. Not that the bundled fee isn't listed in the prospectus — it is. But the components of this fee (administrative expenses; trustee, audit, and legal costs; consulting expenses; statement fees; trading costs; potential performance bonuses; and the actual fund or investment fees) are unclear. "The difficulty is in peeling back the onion," says HR Investment's Valletta.

Moreover, under current ERISA law, the behind-the-scenes revenue sharing is essentially nobody's business, explains Robyn Credico, national director of defined-contribution consulting at Watson Wyatt Worldwide. "If all the fees are paid through revenue-sharing arrangements," she says, "technically you don't have to disclose anything." The Labor Department is looking to change the law by making revenue-sharing arrangements completely transparent.

The point is to find the best deal, not necessarily the lowest cost. "Plan sponsors have to understand what they're getting to make an informed decision — the lowest fee is not always the best value," says Jim Morris, senior vice president of institutional solutions at SEI Investments.

Shooting Blind
Sounds easy enough, but many plan sponsors are ill-equipped to peel the onion. In such cases, retaining an advisory firm like Resources for Retirement, Aon Consulting, or Watson Wyatt to pare fees down to their essentials offers recourse. Morris has another solution. "Demand to know what you're paying and how that compares with what others are charging," he says. "Many providers have already had themselves benchmarked and will hand over the results if requested."

Such was the case for RLI Corp. "Our recordkeeper, Principal Financial Group, itemized every source of revenue it would earn from our 401(k) plan and ESOP: management fees for its mutual funds, service fees it earned on outside mutual funds, and direct payments from our company," says Jeff Fick, vice president of human resources at the Peoria-based specialty-lines property-and-casualty insurance company. "We then compared those total fees with the services it would provide to our employees. Principal provided us with complete disclosure, which then helped us negotiate the best deal." Some companies feel more confident in turning to an outside party for such analysis.

Southwest Power Pool Inc. hired an outside firm to objectively examine all facets of its 401(k) plan. "It was just too much for us internally," says CFO Tom Dunn. "They did the spadework and were able to give us the net return on each fund after the fees were extracted. As a fiduciary, if you don't have the skill sets, you're just taking a shot in the dark."

And in these litigious times, a blind shot might ricochet.

Russ Banham is a contributing editor to CFO.


Employees are less confident about their prospects for a comfortable retirement.


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