Guest Article

Make Sure You Focus on What Really Counts: the Investment Expenses

Recently there has been a constant blur of conferences, articles and promotional material about 401(k) plans. The subject matter has run far and wide but has generally centered around improving the plan for the participants. All things considered, it is appropriate that the focus is on assisting employees in maximizing the value of their plan. After all, most sponsors use retirement plans as a primary tool to recruit, retain, reward and ultimately retire their employees.

The sheer volume of material testifies to how important the subject is and how interested all parties are in improving their programs. Perhaps the last place people would look for meaningful guidance is the federal government. Interested parties will be pleasantly surprised by two publications just released from the Department of Labor's Pension and Welfare Benefits Administration. A Look At 401(K) Plan Fees and Study of 401(k) Plan Fees and Expenses can be accessed at the DOL's web site www.dol.gov/dol/pwba/public/pubs.

To the Government's Credit

The former piece is directed to participants in self directed defined contribution plans. It does an admirable job of alerting employees to many of the issues they need to understand in order to determine if their employer's plan(s) is competitive. In this sense, successful plans are defined in the context of direct and indirect costs associated with the plan. The fundamental point is people need to determine the total expenses of running the plan and who is paying for them. Only after this arduous task is done can employees decide if the arrangement is acceptable or not. It is an unfortunate fact that participants have been innocent bystanders when it comes to this most important facet of their financial future. However, that state of affairs may soon irreversibly change if folks heed the information in these DOL publications and selected other published material.

Not only does A Look at 401(K) Plan Fees help the average person gain a better understanding of major expenses in their plans but it also explains the responsibility of their employers in managing the plans as fiduciaries. It will no doubt come as a shock to many parties involved with the plans that certain members of management are charged with a standard of conduct the likes of which they just barely understand. Based on the commentary at the end of Section 1, Why consider fees?, employers should prepare themselves for poignant questions from participants about how they are managing the plan and discharging their fiduciary responsibility. As a matter of fact, this booklet is probably the first place the DOL has outlined an investment process that defines the standard of care and diligence contemplated by ERISA. Fiduciaries would be well served to conduct an audit of the programs investments and the practices and procedures surrounding the management of the trust's assets.

The good news is that companies can use A Study of 401(k) Plan Fees and Expenses as guidance in determining if what has been and is being done to manage the plan is proper and represents good business judgment. The report titled A Study of 401K Plan Fees and Expenses does a good job of deciphering the convoluted elements that comprise self-directed defined contribution plan costs. In section 3.6 it points out that investment management fees are customarily 75%-90% of total plan expenses. Sponsors need to focus their attention on investment related charges if they are to materially lower their plans operating expenses.

The "blocking and tackling"

The conventional method of lowering investment fees is to simply select the lowest cost investments. The use of index funds is a straight forward way of buying a diversified portfolio of securities for rock bottom prices. Unfortunately, most plans don't have index funds available and aren't prepared to change their entire program just to access index funds. Furthermore, it may not be prudent to commit all your money to passive management. Therefore, companies need to utilize other techniques to reduce existing charges. One practical approach is to negotiate lower commissions or "wrap fee" costs.

Commissions are sales expenses paid to licensed insurance agents and stock brokers as an inducement for selling a vendors product. Wrap fees are add on bills, so to speak, that give certain vendors additional marketing revenue. Various insurance companies offer different commission schedules agents can pick from. Human nature being what it is, too many agents select the option that results in maximum money to them. If an agent is truly providing a meaningful service to the plan, some commissions may be justified. However, all too often their pay is not reasonable in light of what they are doing for the plan. Wrap fees can often be reduced as well. As strange as it may sound, investment sales people can often waive part of their compensation. If this proposition is put to a vendor in an effective manner, lower investment costs often result.

In the case of mutual funds with commissionable 12b-1 charges, another technique can be used with amazing results. There is an arrangement in the financial services market place called a "commission recapture program". Under this scenario, a plan sponsor simply designates a special type of broker/dealer to receive the commissions from the mutual funds. What makes these parties unusual is that they, by routine business practice, agree to return a significant portion of the commissions they collect to the plan. This transaction may be thought of as a type of rebate to the participants. Many of these special broker/dealers refund 80%-90% of the concession they receive from the mutual funds. As you might imagine, your existing broker won't be pleased with this idea. However, the reality is that commissions are an asset of the retirement plan and need to be managed in a prudent and businesslike manner. If that means such an arrangement is in the better interest of the employees benefiting from the plan, then the fiduciaries are mandated to execute the transaction.

So you don't leave any "change on the table", take steps to recover any sub transfer-agent fees. These are expenses that mutual funds customarily pay to service individual investors. When a person buys a mutual fund through a retirement plan the mutual fund doesn't have to service that account. The money the fund would have expended for account maintenance is now available to be paid to the Third Party Administrator to help defray the cost of running the plan. When available, these reimbursements customarily run from $3.00-12.00 per participant per year. The actual amount varies based on multiple circumstances. However, it is easy to see that this item can add up to meaningful revenue that is available to cover plan costs

Professional Help

It is highly unlikely a plan sponsor will be able to benefit from these and other cost reduction techniques without the support of an independent, experienced consultant.. An important criteria in finding and using a consultant is to be sure they are compensated solely for a fee (hard dollars). Only if this rule is meet can a sponsor be certain that recommendations are not a function of compensation and are free of conflicts of interests and other hidden agendas. Not only can a skilled and knowledgeable consultant guide you through the many permutations of commission recapture programs and fee negotiations but they can also help you adopt and execute an investment process that is in accordance with the standard of conduct contemplated by ERISA and anticipated by the Department of Labor.

The end result should be a meaningful reduction of plan costs and a significant improvement in participants retirement benefits. These cost savings as well as all expenses paid from the plan need to be thoroughly and completely disclosed to employees. The conventional method of doing this is to include them in the Summary Annual Report, a document given to participants and beneficiaries at the end of the year after the IRS 5500 form is filed. As part of this effort, some plan sponsors are reporting to participants the Plan Rate of Return. As you can probably understand, the various credits and debits in the form of rebates and charges will alter the returns stated in the financial media. The ultimate step is to calculate for the employees their net effective return, taking into consideration the company's contribution. As competitive pressures and government mandates ultimately force more disclosure people will want to see the "big picture" so they can understand the full and exact financial reward from their employers plan.

One of many reasons for stating the Plan Rate of Return is to counteract a potentially damaging but innocent statement routinely made by well meaning companies. How often have you heard someone in management say a 50 cent match on a dollar invested is a 50% "return on the employees savings". That statement is likely only true for the first deferral a new enrollee makes. The effect of a matching contribution is greatly diluted as account balances grow. It is logical and justifiable for a company to skew their contribution towards a new participant as a way to motivate them to enroll. It is just as rational for a sponsor to properly manage their plan so the program is cost effective. Then the company won't be reluctant to tell the full story about the plan's financial aspects to the employees.

By: Stephen J. Lansing CLU, CIMC, CEBS
Gabriel, Roeder, Smith & Co.
605 Delaney Avenue
Orlando, FL 32801
Email: slgrs@gte.net