Last year, the Investment Company Institute analyzed 401k plan fees and expenses in a paper entitled, The Economics of Providing 401k Plans: Services, Fees and Expenses. As full participant fee disclosure gets closer, plan sponsors will be under greater pressure to reduce fees or justify the higher ones.

For what it's worth, the ICI spotlighted five areas to focus on in order to help lower per-participant fees:

1. Competition among all investment products
2. Plan sponsors shouldering at least some portion of 401(k) costs - this would allow them to select cheaper funds from unbundled (open architecture) platforms
3. Utilizing lower cost share classes - 401(k) plans should leverage their economies of scale
4. Proactive fiduciaries - 401k plan sponsors should make cost-conscious and performance conscious decisions
5. Reduced role for investment advisors providing individual advice.

You can download ICI's paper here.

 

Obviously, the easiest way to lower expenses is to cut services and benefits.  For example, note #5 above. While some studies suggest that individual investment advice can help participants achieve superior investment performance, it's not a free service; and, in fact, there are several low-cost third-party service providers who are 'geared-up' to provide this service in a very cost-effective manner, charging only those participants who elect to utilize the service.

 

Due to economies of scale, smaller plans will normally pay a greater percentage in fees than larger plans for the same service. Since smaller plans may have fewer attractive fee options, plan sponsors must make sure they compare their plans to others who are roughly the same size, not the average 401k plan. In addition, it's really helpful if, in your benchmarking, you can access 'live data' to see what those plans are actually paying, instead of data obtained from 5500 forms, which can be inaccurate and fraught with errors, or an RFP approach, which contains only estimates, sometimes low-balled.

 

It should be noted, too, that some methods of achieving lower fees may not be in the best interests of 401k investors. Remember The Pension Protection Act, which was passed back in 2006? The act was passed, in part, to dissuade 401k investors from placing too great a percentage of their assets in low return vehicles. Problem is the high return vehicles tend to have higher fees. So, if 401k plan sponsors and participants focus too much on fees, they may select inappropriate investments that won't help them reach their long-term goals.

 

How will this impact the ultimate liability exposure for the 401k plan fiduciary? With the focus on reduced fees, inappropriate investment choices could become a concern.

 

Meanwhile, Congress has been arguing the fiduciary debate for some time. Both sides have their lobbyists with the investment sellers (brokers) arguing it would increase costs while the fiduciaries (RIAs) argue for a tightening of the fiduciary standard.

 

If the brokers are right, then there should be many examples where they were able to win business from RIAs simply because they were able to provide advice at a lower real cost to the retirement investor.

 

This argument was actually tested in the real marketplace by Fiduciary News. While the test was unscientific, it was interesting: They asked 401k and IRA investment professionals to provide specific examples of situations where they won business either from RIAs or from brokers based on offering lower fees.

 

The results: Not one was able to provide an example of a broker winning business based on lower fees.  Many respondents seemed to echo this prevailing opinion expressed by a CPA answering the survey:

 

Brokers are compensated based on product commissions or transactions. RIA advisers are compensated based on a fee that is typically a certain percentage of assets. The difference between the two models is that one is being paid for investment advice and the other is being compensated for selling a product or executing a transaction. Being compensated as part of the deal means a broker is not independent and therefore cannot serve as a fiduciary, whereas an RIA adviser is only being paid for his advice and has no interest in the transaction, so can serve in a fiduciary capacity. Depending on how you frame the debate, you can make an argument either way that one way or the other is more costly.

 

The Fiduciary News, January 19, 2011) a new National Economic Bureau of Research (NBER) study concludes that directly-purchased funds tend to outperform broker-sold funds by about 1%, which seems to indicate that even if one ignores the actual savings in fees, retirement plans utilizing funds selected by a fiduciary vs. those selected by a broker should see better investment results over the long-term.

 

What Fees Matter?

 

According to the Department of Labor (DOL), investment fees are "by far the largest component of 401k plan fees and expenses." (For an excellent breakdown of all fees, see the DOL publication A Look At 401(k) Plan Fees.) The 401k plan sponsor using a bundled service provider, of course, has the chore of determining exactly what compensation is received by each service provider from all sources and breaking them down as to how much is received from all sources for each service provided. Obviously, the of justifying fees becomes more difficult not because of the raw size of the fee, but because it's very difficult to really indentify what fee is being paid for what service.

 

You can download the DOL's publication here.

 

One huge problem with the 'bundled' approach: Investment choices have both direct fees and indirect fees. Complicating the issue is that professionals, academics and regulators don't agree on how to reconcile the difference and a vested interest in certain investment vehicles results in a conflict of interest.

Direct fees are relatively easy to see because they're transparent: Plan sponsors simply authorize their payment (either out of fund assets or by the plan sponsor directly).  These fees, usually sales charges, brokerage commissions, fiduciary consulting fees, etc., however often become obscured or hidden by 12b-1 fees, shareholder servicing fees, and others, like those embedded within annuities and other brokerage products.

 

Did you notice what's missing? In last week's White Paper, I discussed the one expense - often the largest - that isn't even included in the direct or indirect fees: The expense ratio of the mutual funds that make up the plan's investment lineup!

Why not a 'clean' platform approach?

 

I wouldn't be surprised if close to 90% of all small plans are in solutions they should never have purchased in the first place. I also wouldn't be surprised if 90% of those plans contain one or more easy-to-spot fiduciary breaches, many related to prohibited transactions.  

 

Why not this approach:

• Open-architecture platform - featuring low-cost no-load funds and ETFs.  All investments are directly-purchased and no one makes commissions
• No 12b-1 fees
• No revenue sharing between/among service providers
• Fully-disclosed direct billing - All service providers direct-bill the plan or plan sponsor for the services they provide - none receiving indirect or hidden revenue from any source
• Recordkeeping
• Third party administration
• Investment management
• Fiduciary advisor
• A fiduciary advisor - A 'pure' fee-only Registered Investment Advisor charging for itemized (and calendared) services on a direct-billing basis and receiving no compensation from any other source.

Do you think fees would be easy to understand and disclose then?

 

 

 

 

James Lorenzen, CFP, AIF

Founding Principal

THE INDEPENDENT FINANCIAL GROUP

A Registered Investment Advisor

805.265.5416