The old investing adage — you can’t control the markets, but you can control costs — underscores the importance of consistently monitoring a retirement plan’s expense structure. Recent developments, including government prodding, pending participant litigation and the volatility of the financial markets, have made cost management an even higher priority for defined contribution (DC) plan sponsors.
The current urgency around DC plan expense structures notwithstanding, plan sponsors have long had strong motivation for keeping costs in check as much as possible. Expenses — including costs such as investment management, most areas of plan administration, financial advice and certain consultant-related activities — have a significant impact on participants’ abilities to accumulate sufficient retirement savings.
A March 2010 study by Towers Watson, “Quantifying the Effect of Target Date Fund Fees,” highlights how fees can erode retirement income. The study evaluated the expense impact on target date fund (TDF) investors using various fee and salary levels as well as saving scenarios. As seen in Table 1, fees of 0.2% may eradicate as much as three years of retirement income, depending on savings rates. Meanwhile, fees of 0.5% to 1% could eliminate as much as 15 years of potential retirement income.
Because participants could potentially lose a significant amount of retirement income to fees, it is imperative that plan sponsors understand the expenses incurred and to control these costs as much as possible. In addition, plan sponsors need to formulate appropriate policies and disclosures to communicate fees and expense structures to plan participants.
Ultimately, three essential questions must be answered with regard to DC plan costs:
- Who pays them?
- How may they be subsidized through plan assets?
- How can they be controlled?
Who Pays the Costs?
According to Deloitte Consulting’s 2009 “Defined Contribution/ 401(k) Fee Study,” participants pay most of the fees for their DC plans. Investment expenses are typically 70% or more of overall fees.
As seen in Table 2, within the universe of plans in the study, participants pay 83% of total plan fees while employers cover 13% and the plans cover 4% (generally achieved through forfeited employer contributions).
Of course, expense allocations varied based on the size of the plan. For example, the study found employers having plans with less than $10 million in assets on average carried a larger share of plan fees than employers sponsoring plans having $10 million or more. Plan sponsors of plans with less than $10 million in assets paid about one-third of their plans’ “all-in” fees, compared with about 10% of “all-in” fees paid by sponsors with larger plan assets.
This break in behavior across plan size may reflect plan sponsors’ covering the fixed costs of running the plan in the small plan space, where there are fewer participants and assets over which to spread certain fixed costs. Economies of scale are one of the main contributing factors to fee distribution. An increase in the number of participants or their average balance decreases overall fees because there is a larger base of participants and assets to share the fixed costs.
Because participants could potentially lose a significant amount of retirement income to fees, it is imperative that plan sponsors understand the expenses incurred and to control these costs as much as possible.
In addition to plan size, fees vary significantly according to the asset classes represented by plan investments. As seen in Table 3, within investment management fees, fixed-income assets have a 0.44% median plan-level average expense ratio, whereas equity has a 0.77% ratio. This difference reflects the fact that equity investments are generally more costly to manage than fixed-income. According to the Deloitte study, equity-oriented investments generated higher average asset-based fees versus other investments. Thus, as plan allocations to equities increase, total investment costs tend to rise correspondingly.
Investments that combine equity and fixed-income assets, such as target date and balanced funds, are somewhere in between depending on their allocation among the various asset classes.
How Are Costs Subsidized?
There are a number of ways that plan sponsors are permitted to pay expenses from plan assets. Depending on the vehicle for delivery of a plan’s investment options, some or even all of these asset-based fees may be embedded in fund expense ratios:
- Commissions or 12b-1 fees
- Shareholder servicing
- Sub-transfer agency (Sub-TA)
- Mortality and expense fees
- Surrender and transfer fees
- Wrap fees
- Proprietary investment subsidies (common to bundled arrangements)
12b-1 and Sub-TA fees are two of the more common fees. In addition, apart from fees stated in a prospectus or fund declaration, if the plan recordkeeper is also an investment manager, it is not uncommon for fee considerations or concessions to have been made depending on the assets under management (AUM) in a recordkeeper’s proprietary funds.
A second way fees can be subsidized that also potentially enhances DC plan sponsor reporting transparency to participants is to permit expenses to be paid solely based on a per-participant basis. Using this approach, the cost of plan administration, on a per-head basis and separate from any consideration of plan assets under management, is deducted from plan assets. By severing the relationship between assets under management and plan administration expense, cost can be more simply disclosed to participants and controlled in a more streamlined manner.
Our experiences with DC plan clients indicate that enhancements to fee disclosure and reporting transparency generally are well received. Many plan sponsors we work with simply see this as good policy and part of their ongoing effort to educate participants. In addition to providing information about contribution rate and investment options, plan sponsors also can use participant statements to inform plan members about the difference in expenses between index and actively managed funds. Plan sponsors that have moved to a more direct fee model reported that participants viewed the appearance and communication of this information on statements as useful. Specifically, participants found the information beneficial to their longer-term retirement planning.
How Can Costs Be Controlled?
In addition to understanding the fees and expenses associated with offering a DC plan, it is important to use tools and best practices to control costs and thus minimize the erosion of participants’ retirement savings.
Perhaps the best way to control costs is to optimize the efficiency of investment options. Often, this entails enhancing access to index management and/or seeking other cost-efficient vehicles to implement investment strategies, such as collective investment trusts, separate accounts and institutional mutual fund share classes.
Many DC plan clients have recently undertaken fee reviews in conjunction with a review of their investment framework. This analysis helps to separate, even under a bundled arrangement, revenue required for administration versus investment management. This is especially helpful to the extent that investment revenues subsidize plan administration costs.
These efforts have led plan sponsors to more distinct reporting of administrative and investment management costs. Often, this type of “unbundled” approach requires additional participant communication to help explain what fees are included in plan administration.
We believe this type of analysis and participant education effort should become part of an ongoing governance process. Within administrative provider revenue, it is important to analyze asset-based, per participant and transaction-based fees. Within investment manager revenue, plan sponsors should analyze fund management, 12b-1 and Sub-TA fees.
Plan sponsors should analyze all expenses, fees and revenue — both direct and indirect — at least every three years. The frequency of this analysis might fluctuate because of changes in plan dynamics, such as significant expansion or contraction of the plan population or plan design changes, including automatic enrollment and automatic contribution escalation.
Still, other factors continue to expose plan assets to high fees, including:
- Low plan asset balances that force sponsors to use higher fee products
- Dependence on the recordkeeper’s products, due to administrative or relationship considerations
- A bias toward actively versus passively managed products
The Towers Watson study cited earlier suggests plan sponsors could consider other tactics to lower TDF fees, such as:
- Asking existing vendor to reprice TDFs annually
- Bidding the TDF assignment or entire vendor relationship
- Moving from active to passive investment strategies
- Developing customized solutions (managed accounts or TDFs) that incorporate passive strategies and lower administrative costs
Better Disclosure, Better Decisions
Disclosure to participants should use basic language along with standardized terms and format, to help educate participants on the impact of fees on long-term accumulation goals. Fees should be disclosed upfront at the point of decision-making — prior to enrollment. In addition, participants should be kept abreast of their fees on an ongoing basis through their statements and annually as they reassess their existing investment elections.
According to an International Centre for Pension Management 2008 study, “Fee disclosure to Pension Participants: Establishing Minimum Requirements,” when consumers do not know the costs of different options, they tend to over-consume expensive items and underconsume inexpensive ones. Similarly, with DC plan investment options, participants may assume that the cost of investment management is an indicator of the quality of the fund (investment experience, performance, etc.).
It is clear a thorough understanding of DC plan expenses is critical to both plan sponsors and participants. Plan sponsors could better manage costs, and participants could decide whether higher fees for active management are justified or whether they can achieve as good or potentially better long-term performance through lower cost index management.