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The coming mandatory disclosure of plan fees could give participants a nasty shock.
Russ Banham, CFO Magazine
December 1, 2011
"Never do anything you wouldn't want seen in a Macy's window." That old saw comes to mind as 401(k)-plan sponsors prepare to prominently display the fees charged by their plans. Many are no doubt worrying whether plan participants will view those costs as unreasonable, or even as a cruel April Fools' Day joke.
Starting next year, the Department of Labor will require plan sponsors to disclose specific plan fees and investment information to 72 million plan participants via two related rules, ERISA 408(b)(2), which governs disclosures that must be made from service providers to plan sponsors, and 404(a)(5), which governs disclosures that must be made from plan sponsors to plan participants. The costs must be presented in an easy-to-read-and-compare format, in dollars and cents. The disclosures must include the types of fees employees paid in the past quarter, who received those amounts, what the payments were for, and the dollar amount of the fees and other indirect expenses charged to participants' accounts. The latter includes the compensation paid by plan recordkeepers and investment firms to third-party service providers.
Plan sponsors that previously made such information available in all-but-invisible legalese on the back pages of an inch-thick Form 5500 should prepare themselves for the reaction from employees. "An enormous percentage of plan participants have no idea they've been paying fees all along, and many of them will be shocked," predicts Joel Shapiro, vice president of ERISA compliance at 401(k) Advisors.
Bracing for a Backlash
Plan pricing is notoriously variable, and there are instances of plans charging participants as much as 400 basis points, "which is egregiously beyond the scope of the reasonableness test," Shapiro says. Future retirees paying, say, 3.5% or more of their retirement assets' value for a money-market fund that could be 1% underwater "makes no sense," adds Chad Parks, CEO of The Online 401(k), a provider of plans for small businesses. "When they realize it, chances are they'll march angrily into their HR office for an answer."
Possible repercussions range from a tattered reputation to class-action litigation against fiduciaries. At least 30 lawsuits have been brought since 2006 on behalf of plan participants alleging that fiduciaries imprudently allowed plan service providers to receive excessive investment-management and administrative fees, according to the Bureau of National Affairs.
And those cases predate the new fee-disclosure rules. "You can bet that plaintiffs' attorneys are clamoring to find out if this is low-hanging fruit," says Shapiro. "If the fees aren't reasonable, people will look back through previous years to get more information. It won't be difficult to drum up support among other employees to bring a class action that could potentially be a large liability for the sponsor."
That said, the majority of 401(k) plans are reasonably priced, says Shapiro. Most recordkeepers have done a fairly good job of making the bidding process competitive, he says, thereby driving down pricing while increasing services and deliverables. Moreover, the vast majority of excessive-fee cases have been adjudicated in favor of the plan fiduciaries, with the courts finding they had undertaken prudent processes in determining the reasonableness of plan fees — the legal standard under ERISA.
Shapiro warns, however, that inexperienced plan sponsors that try to administer the plan without an adviser's help are at risk of having noncompetitive pricing.
In addition to their responsibility to examine fees, plan sponsors have a fiduciary duty under ERISA to prudently select and compensate plan providers, including recordkeepers and investment providers. Sponsors must also engage in an objective process to assess the qualifications of the provider and the quality of services offered.
Before ERISA rule 408(b)(2) was formulated, service providers did not have to fully disclose the fees and other expenses paid to third parties, much less make them transparently clear. Starting April 1, the regulations require the disclosure of investment expenses as both a percentage of assets and a dollar amount per $1,000 invested.
While plan providers like Vanguard and Fidelity routinely provide investment and expense information to plan sponsors, not all sponsors pass it on to participants in an easily accessible and understandable manner. Vanguard, for one, acknowledges the difficulty, stating on its website, "Deciding what's reasonable can be confusing."
In part that's because cost is far from the only difference between plans. One might cost 200 basis points and another 100 basis points, but either one may have more services and different investments than the other, notes Joni Tibbetts, vice president of retirement investor services at Principal Financial Group.
Some help in determining reasonableness is available from for-profit benchmarking firms that compare the fees of recordkeepers and investment-service providers. Another potential recourse is a nonprofit benchmarking service being developed by the Council of Independent 401(k) Recordkeepers (CIKR, pronounced "kicker"), an organization within the American Society of Pension Professionals & Actuaries.
Making fees more transparent is expected to produce changes in the types of investments within 401(k) plans and greater competition among providers. Experts also expect to see less bundling of fees and more fees based on discrete services.
Another likely impact is a reduction in the number of funds available in a typical plan. Over the years, the average number of choices has grown to 26, says Frank Kolimago, a principal in Vanguard's institutional client services area. The options will be compressed into more-logical frameworks like investment tiers, with target-date funds, for instance, in the top tier.
Some plan sponsors aren't waiting for the fee-disclosure rules to kick in before negotiating a better deal with providers. Chesapeake Energy sent out a request for proposal late last year to multiple providers, and leveraged the competition to negotiate lower investment-manager fees with its current provider. The firm also capped the provider's revenue at 14 basis points; anything extra will be used to pay plan expenses, says Lisa Phelps, vice president of human resources at Chesapeake.
The new rules are a good thing for plan participants, but some say sponsors can go further. "They need to measure not just expenses and fund performance, but also individual participant success toward attaining retirement savings goals," says Gerald Wernette, director of retirement plan services at consultancy Rehmann Financial. "This will pressure sponsors to prove they have assessed the value propositions of the providers."
Chesapeake Energy got ahead of the disclosure rules last year, says Phelps, giving participants examples of fees per $1,000 investment. Shapiro calls that a wise move. "For employers that don't get out ahead of this," he warns, "expect some grumbling."
Russ Banham is a contributing editor of CFO.