Selecting an Appropriate Investment and Administrative Structure for Your Qualified Retirement Plan

Schultz Collins Lawson Young & Chambers
Independent Investment Counsel

650 California Street, 12th Floor San Francisco, California 94108-2716
Telephone (415) 291-3000 Facsimile (415) 421-0737

Individuals responsible for their company's qualified retirement plan face numerous difficult decisions when selecting plan service vendors. As technologies change, and as plan sponsors seek to shift additional responsibilities to external vendors, the complexity of the assignment increases. In selecting providers for your plan, you must weigh each vendor's fees, capabilities and experience in each of several key areas, including:

• Administrative, recordkeeping and trust service capabilities;
• Access to top-performing funds to offer as the plan's investments;
• Ability to insulate you and your company from fiduciary liability; and
• Employee communications and investment education capabilities.

Cost Containment

As a plan fiduciary you have a duty to avoid unwarranted expenses levied against the assets within your company's retirement plan. Yet in your role as a corporate executive, you are expected to minimize "hard dollar" administrative costs paid by the company. Balancing these often conflicting cost containment objectives can be extremely difficult.

Service Provider Evaluation

In evaluating prospective service providers, investment fund performance (net of investment management fees, and sales charges or commissions) should be the plan sponsor's primary focus, since future fund performance will determine the value of employees' retirement benefits. Yet many vendor evaluations tend to focus less on investment performance and more on administrative services and fees, for a variety of reasons, including:

• Lack of a framework for evaluating the merits and weaknesses of various investment products and managers;
• Difficulty deciphering and evaluating multi-layer investment fee schedules;
• A perception that investment costs are not "real", since they are generally paid by employees through an implicit reduction of the fund's net performance.

Given the complexity of operating a qualified retirement savings plan, it is not surprising that "ease of administration" dominates the list of objectives among a broad segment of plan sponsors. However, both government regulatory agencies and the laws governing company sponsored retirement plans will hold the individuals responsible for plan operations to a higher standard. The service configuration you select can significantly impact the fiduciary liability risk borne by you, your co-fiduciaries and your company.

Avoiding the "Sales Claims" Trap

Many plan sponsors make frequent changes to their qualified plan service vendors. A recent survey shows that in 1994 alone, over one-third of 401(k) plan sponsors changed their investment managers, and over one-quarter of plan sponsors changed their trustee and/or their recordkeeper.

Source: Rogers Casey/IOMA 1994 Defined Contribution Survey

This high degree of turnover suggest that many plan sponsors have unrealistic expectations for their service providers. Sponsor expectations, moreover, are generally created during the service provider's sales process. Thus the key to a successful evaluation of any plan service vendor is the ability to differentiate the vendor's sales claims from the vendor's service capability.

Ten Steps to Selecting Plan Vendors

Any plan sponsor can ensure that their retirement plan investment and administrative structures are supported by appropriate vendors, and correctly matched to their employee population and service needs, by implementing these ten steps:

1. Review the investment and administrative service configurations available for your plan;
2. Understand how your selection of an investment configurations impacts the regulatory environment under which your plan operates;
3. Consider your employees' current understanding of investment markets, and ability to digest an investment education program (which impacts their ability to manage their investments within each investment configuration);
4. Decide which configuration best meets your employees' ability to manage their investments and your organization's objectives for regulatory requirements;
5. Identify vendors that offer trust, investment and recordkeeping services in your preferred investment configuration (note: vendors may include integrated, bundled, alliance or unbundled providers--see below for definitions of each service type);
6. Solicit proposals from service providers, using a service and pricing template that permits you to identify each provider's service capabilities and fee schedule for each service that you require;
7. Evaluate vendor proposals, placing a primary focus on net investment return to participant accounts, and services available to participants;
8. Select finalists (generally two to four entities) to make presentations to the administrative committee, and to present a "Best and Final" proposal (note: if finalists include unbundled providers, you will require presentations from finalists for each service area);
9. Notify your selected plan vendor(s) and develop a transition timetable and workplan; and
10. Implement an ongoing participant plan communications/investment education program designed to support the investment configuration selected for your plan.

Investment and Service Configurations

Generally there are four primary investment configurations available to the plan sponsor: closed menu; open menu; managed portfolio and unrestricted. Additionally, plan administrative services are offered in four primary configurations: integrated; bundled; alliance and unbundled. Hence, there are theoretically sixteen primary combinations of administrative service and plan investments, although certain service and investment configurations are generally closely associated with each other, narrowing the range somewhat. Further complicating potential plan structures, a single administrative service configuration can include more than one investment configuration.

The primary administrative investment and service configurations are described in the following tables:

Investment Configuration Impacts Fiduciary Liability

Every qualified retirement program is operated by fiduciaries -- generally, executives or officers of the organization sponsoring the program. Fiduciaries are responsible for operating the plan solely for the benefit of plan participants and beneficiaries, and can be sued by participants, beneficiaries and the Department of Labor for not adequately fulfilling their fiduciary responsibilities. In any potential litigation under the Employee Retirement Income Security Act of 1974 (ERISA, the federal law governing the operation of retirement plans), that asserts a breach of fiduciary duty, plan fiduciaries will be held to the "prudent expert" standard (i.e., the fiduciary's conduct of the plan's affairs will be deemed to be negligent if the fiduciary's performance is not at the same standard as would have been provided by a retirement plan expert).

In selecting vendors for their plans, there are two primary pitfalls facing plan fiduciaries:

• poor or inadequately documented selection of investment management providers; and
• lack of appropriate distinction between a vendor's administrative service pricing and capabilities, and their investment management pricing and capabilities.

Prudent Investment Selection

In very general terms, fiduciaries must be sure that their plan complies with the general prudent investment standards established under ERISA section 404(a). If the plan permits employees to choose how their account will be invested, fiduciaries must also be sure that their plan complies with the participant direction rules established under ERISA section 404(c).

Prudent Man Rule (ERISA 404(a))

Every plan must adhere to the general rules of ERISA section 404(a). These rules are commonly referred to as the "Prudent Man" rules and are best articulated in Restatement of the Law: Trusts (As Adopted and Promulgated by The American Law Institute) (1992). This work is the consensus opinion of the legal community with regard to the fiduciary duties of trustees and pension sponsors for the operations pertaining to and management of trusteed investment assets.

Section 404(c) and Participant Directed Accounts

As of January 1, 1994 final U.S. Department of Labor regulations relating to participant-directed retirement plans went into effect. The regulations, promulgated under Section 404(c) of ERISA, outline the requirements employers must meet in order to avoid being held responsible for their employees investment decisions. The regulations establish basic standards under which employees are deemed to have effective control over the investment of assets in their account. The regulations outline:

• how frequently participants must be permitted to make investment elections;
• how many, and what type of funds must be offered;
• what information about the investment offerings must be provided to participants; and
• special language that must be included in the official plan documents and participant summaries.

If a plan meets the ERISA 404(c) standards, fiduciaries are not responsible for asset allocation decisions made by participants. However, fiduciaries are still responsible for selecting the plan's investment options. Note that in a participant directed plan that does not meet the ERISA 404(c) standards, fiduciaries would be responsible for both selecting the plan's investment options and for participant asset allocation decisions.

Menu Plans

Menu plans are generally designed to comply with ERISA section 404(c). Although not a "safe harbor," 404(c) compliance indicates that the plan offers a diversified menu of investment choices with a sufficiently broad range of risk/return characteristics such that participants can implement an appropriate portfolio. Likewise, it indicates that the employer has provided each participant with investment information (including account statements) sufficient to allow for timely and well-informed investment decisions. In order for a sponsor to use 404(c) as a defense against a participant complaint, the plan must be in complete compliance with all provisions of the regulations. It would be potentially extremely dangerous for fiduciaries of a menu plan to assume that their plan satisfies the 404(c) standards, only to find out later that the plan did not comply, and that consequently they were responsible for each individual participant's investment selection decision.

Further, 404(c) does not insulate fiduciaries from their general responsibilities codified in section 404(a). These include:

• selecting appropriate investment options to make up the plan menu;
• monitoring the performance of the menu selections;
• evaluating investment performance to determine the ongoing prudence of the menu selections; and
• evaluating all fees, charges, commissions and other costs which adversely impact the investment performance of participant accounts.

Unrestricted Investment Structures

Unrestricted investment structures insulate fiduciaries from liability due to adverse investment performance in participant accounts simply because there are no constraints or limitations put on plan participants' ability to select their investments. Fiduciaries for plans with unrestricted investment structures still have four significant concerns:

• their responsibility to select a service provider which is competent in qualified plan administration and record keeping functions;
• their responsibility to ensure that costs charged to participant accounts are reasonable. Generally, an unrestricted investment structure plan requires that each participant have their own brokerage account, which generally includes a flat annual account fee. Although this fee is small relative to a large account balance, it may represent a significant drag on earnings for a small account balance.
• the ability of lower paid participants to trade in their accounts with the same frequency as higher paid participants. Many brokerage accounts have minimum purchase requirements. A highly paid participant's semi-monthly contribution is likely to be sufficient to meet the minimum purchase requirement, while a lower paid participant may be required to allow their semi-monthly contributions to accumulate in a money market account for several payroll cycles, until sufficient funds have accumulated to meet the minimum purchase requirement. Thus a lower paid participant with the same investment selection as a highly paid participant will have a different (and probably lower) rate of return, because they are restricted as to the timing of their investment purchases. This discrimination in operation could cause employee relations issues, and possibly IRS or DOL issues.
• the ability of all plan participants to make appropriate investment decisions. Many unrestricted investment structure plans find that significant numbers of participants are paralyzed by the sheer volume of investment possibilities, and consequently their accounts remain invested in the money market option. Menu plans, which restrict choices to about ten or fewer options, may provide a more manageable investment decisionmaking forum, and provide a reasonable framework for an ongoing investment education program.

Managed Portfolio Structures

Managed portfolio structures (which include mutual funds known as "life style" or "life cycle" investments) offer participants a wide range of choice without requiring that the plan fiduciaries adhere scrupulously to the many requirements of 404(c). Briefly, each managed portfolio represents a balanced account which is both prudent and diversified. The plan fiduciaries then select or construct several managed portfolios with varying investment approaches, from conservative to aggressive. The plan participant cannot make an imprudent investment selection, since each portfolio is designed to be implicitly prudent. As such, these portfolios offer sponsors a separate path to compliance with qualified plan regulations which is readily defensible because of its conformity to the "Prudent Man" investment rules.

Distinguishing Between Administrative and Investment Capabilities

Perhaps the most common pitfall for a plan fiduciary is failing to distinguish between a vendor's administrative service pricing and capabilities, and their investment management pricing and capabilities. There are many reasons for this conundrum, including:

• investment fees are generally paid directly from fund assets, through an implicit reduction in the fund's Net Asset Value (NAV). Administrative fees are generally paid by the plan sponsor, and hence receive greater scrutiny. Further, excluding the possibility of ERISA litigation, the plan sponsor bears no direct cost from offering a poor performing fund relative to offering a top performing fund.
• investment performance, management fees, commissions and other costs are difficult for the layman to evaluate, due to the varying performance measurement approaches, and the multitude of fee schedules used by investment providers. Administrative services and related fees are generally easier to evaluate objectively.
• fiduciaries responsible for the vendor evaluation will generally be working closely with the selected provider, and will rely on the provider for administrative support for functions such as distribution of participant statements, processing of benefit payments, etc. If the vendor's administrative services are deficient, the fiduciary can expect to receive numerous complaints and questions from disgruntled plan participants.

Although these reasons for placing a greater weight on a vendor's administrative service capabilities than on their investment capabilities appear to be legitimate, ERISA does not permit fiduciaries to neglect their responsibility to ensure that participants have the opportunity to invest in top performing funds. More than any other single factor, investment results will have the greatest impact on a participant's ability to retire at a suitable and sustainable standard of living.

Balanced against the plan sponsor's reasonable desire for "ease of administration" is the need to ensure that the plan's investment performance is adequate, thereby protecting the plan's fiduciaries against potential ERISA litigation. Poor investment results represent the "open door" through which litigation against plan fiduciaries may be introduced.

Liability Where Administration Drives Investment Decision

Closed menu investment structures in integrated or bundled service arrangements present plan fiduciaries with the greatest potential exposure to fiduciary litigation. Generally, in these arrangements the only funds that may be considered are funds offered by the investment provider also responsible for delivering the administrative service. Funds can't be selected or replaced for the plan, unless they are available through the investment provider. Although these plans tend to have relatively low "hard dollar" administrative costs, they often bear significantly higher that average investment expenses. In a September 18, 1995 article, the Wall Street Journal provided the following estimate of the relationship between administrative fees and investment expense:

There's a good rule of thumb for 401(k) costs: a typical bundled, one-stop shopping approach to investments and administration will, at a minimum, double the employees' cost for every 25% reduction in the plan sponsor's administration fees.

Further, few (if any) investment providers offer top performing funds in every asset class. Thus, in selecting the integrated or bundled service provider, the plan fiduciaries implicitly select certain mediocre funds for their plan.

There are many instances where the selection of integrated or bundled service providers may be prudent and defensible. For small or new plans that have limited assets, and where plan administrative expenses would be borne by plan participants, the low administrative costs of an integrated or bundled service provider might outweigh the expected differential in investment performance between the provider's mediocre funds, and funds available in a more open investment structure with higher administrative costs. In this instance, fiduciaries should select the integrated or bundled service provider offering the best combination of administrative services and investment options, and should be sure to document the rationale for their provider selection decisions.

The failure or success of the plan as a valued compensation benefit may depend on the participants' perception of how well or poorly their account accumulates wealth. If the participants' investment choices consist of a "basket full of mediocrity," the plan will not achieve its basic employee benefit goals.

Summary

There is no "right" or "best" formula for determining the type of investment structure for a company's retirement program. Rather, final selection should be based on the objectives of the plan sponsor and the wishes of the participant group. Indeed, two or more different investment structures may be "blended" within a single plan so that a more complete spectrum of choice is available to participants. Whatever the selected path to compliance, the crucial point in fiduciary liability management is complete, written documentation of the decision making process and of the objective criteria used for all evaluations (both initial and ongoing) of products, vendors, and service providers.

Selecting Vendors for Your Company's Retirement Plan: A Complex Task

The RFP: Assessing Vendor Capabilities

Once you have completed your review of administrative and investment structures, and reached some preliminary decisions regarding appropriate structures for your organization, you are ready to proceed with vendor selection. This is generally accomplished through a formal Request for Proposal (RFP) process, where a cross section of service providers are asked to respond to a set of questions in a standardized format. This permits the plan sponsor to rate the vendors in a reasonably consistent manner. Note that most organizations sending out RFPs don't restrict the pool to providers offering the same administrative and investment structures. Often, RFP responses will provide additional ideas or information that change the sponsor's initial concept of the preferred service configuration. However, if you have ruled out a particular service configuration (e.g., you know your employees are not sufficiently sophisticated to manage their accounts in an unrestricted investment structure), you should make this clear in your RFP, and avoid sending RFPs to vendors that only offer that service configuration.

In structuring your RFP, you should ask questions that will permit you to gauge vendor's capabilities in each of the following areas:

Administrative Issues

• Adequacy of the vendor's recordkeeping and administrative systems;
• Ability to respond promptly to changing IRS and Department of Labor rules and regulations;
• Capability to permit your company to outsource burdensome administrative functions;
• Willingness to contain administrative expenses to a reasonable level;

Fiduciary Liability Management

• Willingness and ability to accept applicable fiduciary liability;
• Ability to comply with recently enacted Federal regulations;
• Capability to assist you to implement appropriate risk mitigation strategies;

Investment Capabilities

• Ability to provide plan participants with suitable investment choices and immediate access to their account information;
• Access to top-performing funds to offer as the plan's investments;
• Ability to provide accurate and unbiased historical performance information to facilitate the initial selection and ongoing monitoring of plan investment vehicles.

Building a System for Evaluating Responses

A successful RFP process rates vendors separately in three primary areas:

• Service capabilities and responsiveness;
• Administrative fees, expenses and pricing structure; and
• Investment offerings, performance, diversification and fee structure.

Service Capabilities

Qualified plan service vendors have varying strengths and weaknesses. Responses to your RFP will permit you to assess each vendor's relative strengths. This is generally accomplished through a "point" system (i.e., score one to five points for each vendor's response to each RFP question). To further customize your evaluation, once you have decided which vendor capabilities are most important to your organization, you can develop a point weighting system for grading the responses, with more points allocated to questions addressing capabilities in those areas deemed most crucial for your company. For example, if local service delivery is important for your company, you could allocate additional points to providers geographically proximate to your company headquarters. With this structure in place, you can build a spreadsheet template for evaluating vendor responses. This will permit you to assess which vendors offer the most appropriate range of administrative services for your organization, without considering fees and expenses, or investment product offerings.

Fees and Expenses

You may also want to develop a separate spreadsheet for comparison of the fees and expenses applicable to each possible alternative, as vendors will have different fee schedules and costing methodologies. By creating a reasonable and consistent set of assumptions for plan experience (i.e., number of participants, number of benefit payments, loan applications, inter-fund transfers, etc.), and applying the same assumptions to each vendor's fee schedules, you should be able to evaluate each fee schedule in a reasonably equivalent manner. Your spreadsheet should also consider implicit costs, such as administrative expenses subsidized by investment management fees and any contract or surrender charges. These costs are often significant, in some cases greater than the aggregate explicit "hard dollar" fees.

Evaluating Investment Offerings

As indicated earlier, rating investment products may be the most difficult part of the vendor evaluation process. However, investment selection is the most important component of the vendor search. Selecting substandard investment options could cost the plan two to three percentage points in "lost" annual returns, an amount that dwarves any potential administrative fee savings. A properly designed Investment Policy Statement can be an invaluable tool for evaluating fund offerings from various investment providers.

Causes of Sub-Par Performance

Loads and Sales Charges

Funds may be subject to front-end sales charges. This means, for example, that $100,000 invested in a fund with a 3% sales charge is immediately worth $97,000. The $3,000 is paid to the selling agent.

In place of, or in addition to, initial sales charges, funds may levy 12B-1 fees, generally ranging from 0.15% to 0.35% of assets. The 12B-1 fee is subtracted annually from the fund's total return. (This fee is generally passed on to the selling agent as well.) True no-load funds do not charge front-end loads or 12B-1 fees.

Mutual Fund Expenses

All mutual funds incur a variety of expenses including management fees, marketing and distribution costs, etc. These expenses are quantified in the fund's annual expense ratio. In general, equity fund expense ratios range from less than 0.50% to over 3.00% of assets. Fixed income fund expense ratios generally range from less than 0.20% to over 1.50%.

The Investment Policy Statement: A Key Liability Management Document

An investment policy is a "blueprint" used in the design and implementation of an investment program. The policy outlines the plan's principle objectives and the procedures to be utilized in making and documenting investment decisions.

An investment policy statement should include:

• A well formulated statement of the plan's objectives;
• A framework for achieving diversification within and among asset classes;
• Criteria for selecting and retaining investment vehicles;
• A system for monitoring investment performance;
• A protocol for making determinations concerning the ongoing suitability of the plan's investment alternatives; and
• A set of established procedures for making and documenting your investment decisions.

A formal investment policy is a critical factor in demonstrating the prudence of the fiduciary's investment decisions. For each investment decision, the investment policy sets forth a set of criteria against which the propriety of a specific investment's inclusion can be measured. These criteria may include:

• management's experience and track record;
• historical volatility and past return performance;
• fees, charges and other investment-related expenses;
• technical risk measurements; and
• comparability with performance of applicable indexes and averages; and so forth.

Your investment policy provides a defensible methodology for all investment decisions. The policy helps you make decisions based on facts rather than on opinions, and provides sound approach to the selection of investments which in turn provides plan participants with a higher probability of realizing anticipated returns.

Communicating Your Investment Options

Helping Employees Meet Their Goals for Retirement

The success of an organization's retirement plan is ultimately determined by the employee's perception of the plan, as measured by factors such as:

• The degree to which participants understand and utilize the investment alternatives offered under the plan
• The participants' ability to allocate their accounts in a manner appropriate to their individual circumstances and objectives
• The perceived performance of the plan's investment alternatives
• The employee's capacity for developing a long-term investment strategy and for adhering to that strategy during adverse political, economic or market conditions

Sponsoring a retirement savings plan represents a substantial investment for your corporation. Capitalizing on that investment will depend on your employees ability to utilize the plan to meet their financial objectives.

Customize Your Investment Communications to Your Investment Structure

In designing an investment education and ongoing investment communication program, you must match the communication/education program to the needs of the participant group and to the investment options offered by the plan.

Depending on the level of income and investment experience of the plan participants, the program may focus on different factors that could motivate them to participate in the plan. These could include:

• illustrating potential current tax savings;
• demonstrating the need to save to provide for a comfortable retirement;.
• explaining early retirement opportunities;
• explaining the plan's attractive investment opportunities; or
• describing the sense of independence and self-reliance that comes through wealth accumulation.

The Investment Decision: A Key Determinant of the Plan's Success

Surprisingly, even those plans offering the most generous matching contributions are vulnerable to negative sentiment caused by a participant's sub-standard investment experience. Yet, the participant's investment decision is something neither the plan sponsor nor fiduciary can control. For this reason, plan sponsors and participants alike understand the value of information that results in an informed and productive investment decision.

Numerous studies have shown that the primary determinant of a portfolio's rate of return is the asset allocation decision. The seminal work in the field is the study of 82 large pension plans over the period 1977 through 1987 This study concluded that the asset allocation policy is the major determinant of investment performance. The choice of individual investment securities and the decisions concerning when to be in or out of the market had relatively little impact on the plans' returns. The importance of the asset allocation decision may be illustrated graphically:

Source: Financial Analysts Journal (May-June, 1991)

Investment Education

Depending on the level of investment knowledge among the participants, an effective investment education program may be required to permit them to participate more productively in the plan. Education can take much of the fear out of investment decisions. It can help participants focus on their retirement income needs, on their risk tolerance, and on their planning horizon and economic circumstances.

For all levels of investors, an effective education program should provide insight into the basic principles of portfolio selection including investment volatility, historical and expected returns, asset class characteristics, and asset allocation decisions. Additional levels of educational programs should be tailored to the concerns and interest of the plan participants and may extend beyond 401(k) basics to more advanced or specialized topics (Socially Responsible Investing, Active vs. Passive Management, Planning for Retirement Distributions, etc.).

Conclusion

Selecting an appropriate investment and administrative structure for your company's qualified retirement plan is a significant, yet crucial task. The administrative structure you select has a direct impact on the degree of fiduciary liability borne by you and the other plan fiduciaries. And the selection of investment and administrative vendors has additional implications, from operational, liability management and employee relations perspectives. Following the procedures outlined in this article may represent a significant expenditure of time and energy, but provides an essential framework for:

• demonstrating procedural prudence in your vendor selection process;
• ensuring that your investment and administrative configurations and service vendors are appropriate for your employee population; and
• avoiding the "sales claims" trap that leads to frequent turnover among plan service providers.

About the Authors

Schultz Collins Lawson Young & Chambers is an independent Registered Investment Advisory firm. The firm specializes in the analysis, design and implementation of investment programs for corporate retirement plans. We focus on assisting human resource and benefits departments to develop efficient and successful plan administrative structures, while helping plan fiduciaries fulfill their responsibilities and mitigate their risk.

Our areas of service include:

• Assisting with the development of streamlined, effective plan administrative systems and procedures
• Vendor searches, requests for proposal and service provider fee analyses
• Mitigating fiduciary liability for plan operations
• Employee communications and investment education
• Fund selection, performance monitoring and investment policy statements

Independent Counsel

Schultz Collins Lawson Young & Chambers is not affiliated with any vendor of investment products or services. Nor does the firm offer advice with the expectation of receiving commissions, finders' fees or other similar forms of remuneration. Rather, the firm is compensated by its clients on a fee basis, with fees calculated as a percentage of assets or at an hourly rate.

Copyright 1998, Schultz Collins Lawson Young & Chambers