What is an Appropriate Fee that a 401k Plan Should Pay?
Every 401k plan sponsor wants to know the answer to this question. Every plan participant would benefit if their plan sponsor would know the answer to this question. Every industry reporter, analyst and pundit think they know the answer to this question. Every regulator knows there’s no right answer to this question.
Or is there?
With the advent of 408(b)(2) (the DOL’s 401k Fee Disclosure Rule), the discussion of fees – and their appropriateness – has never been higher. Just recently, a letter from two university researchers purporting to threaten to disclose the names of those plans paying “high” fees. Well-known ERISA attorney Fred Reish and others have since rebuked the research methodology that formed the basis in this letter. Still, plan sponsors (and their service providers) are particularly vulnerable – whether true or not – to the charge of “high” fees.
No Help From the DOL
There is no consensus either within the industry or among regulators. The DOL doesn’t help. It does provides information on its web-site regarding fees (see “A Look At 401k Plan Fees”). Unfortunately, while the site does explain the cost of paying 1% too much in fees (“The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent”), it doesn’t identify the base-line underlying that 1% increase. David Brochu, president and CEO of KLEOSSUM advisors in Conway, New Hampshire feels the Rule did “little to assist plan participants with making better choices for their 401k plan investments.” He believes the reason is simple: “the fees are plan specific and the employees cannot choose the plan.”
Pete Swisher, Senior Vice President, National Sales for Pentegra Retirement Services, headquartered in White Plains, NY, sees trying to reach a consensus on an “appropriate fee” is “a loaded question because there is such a wide range of serves and quality.” Swisher adds, “The Department of Labor, if it were to answer this question for you, would probably say much the same thing-something along the lines that the fees must be reasonable based on the going rates for comparable services in the geographic area.” Indeed, the DOL site referenced above says, “Don’t consider fees in a vacuum. They are only one part of the bigger picture including investment risk and returns and the extent and quality of services provided.”
Many looked to the DOL’s 2012 401k Fee Disclosure Rule as a way to get more clarity on what an appropriate fee might be. In the end, the failure on the part of the DOL to provide required reporting guidelines doomed that hope. Braden Perry, Esq, of KennyHertz Perry in Prairie Village, Kansas, says, “As a former Chief Compliance Officer of a global financial firm, including 401k plans, I think anyone that quotes exact numbers for 401k plans would likely be pulling them out of the air and without regard to a number of different factors. ERISA does not put any parameters on plan fees; only that they be ‘reasonable.’”
What Does the Typical 401k Pay in Fees?
That doesn’t stop people from trying. In fact, benchmarking has always been the goals of smart plan sponsors and their fiduciary advisers. There are several popular sources for benchmarking data. Brooks Herman, Head of Data & Research at BrightScope in San Diego, California, provided FiduciaryNews.com with some industry data. For large plans over $100 million (there are 3,470 in the BrightScope database), the average total plan cost is 0.49%; for medium sized plans ($10 million to $100 million – 18,136 in the BrightScope database), the average is 0.87%; and for smaller plans (under $10 million – 29,549 in the BrightScope database), the average is 1.41%. Joe Valletta, author of The 401k Averages Book, pegs the range from 0.87% for larger plans to 1.56% for smaller plans. All benchmarking services suffer from a lack of regulatory consistency in reporting fees. Unlike mutual funds, where all expenses must conform to a rigorous reporting structure, 401k plans have nothing similar.
This may be about to change. The American Society of Pension Professionals & Actuaries recently sent a letter to the DOL suggesting the DOL modify Form 5500 to include a simplified fee reporting schedule. The letter states, “ASPPA’s proposal is designed to reduce or eliminate the opportunity for misinterpretation of the [408(b)(2)] reporting rules.” The proposal further suggests the use of service codes to describe each service provider. The Form 5500 database is publicly available. Changing the fee reporting on the Form would make benchmarking much easier.
Despite the lack of definitive data, many professional advisors cite similar ranges and this data all points to the obvious difference between small plans and large plans. And these are just averages. Some smaller plans pay well more than the average. Gabriel Potter, Senior Researcher at Westminster Consulting, LLC in Rochester, New York, says the range for smaller plans “can be extremely high – as much as 1% to 2% of the plan assets.”
The reason for this difference is simple mathematics. Swisher says “There is a fixed cost to operate a plan that must be spread over fewer participants.” Christopher Sorrow, Senior Portfolio Manager, Probity Advisors, Inc. of Dallas, Texas, says, “Simple math may be applied to fixed costs relative to variable costs. For small plans, fixed costs are the predominant costs, and when divided against the AUM, the fee appears disproportionately large. As assets increase, the fixed costs are spread across more and more assets, to the point where the most important costs are the variable costs, which in most cases are the underlying investment costs. For this reason, plan sponsors of plans in the $3 million range need to start really paying attention to their underlying investment option costs and the revenue share, because starting at that plan size there is a lot of opportunity for plans to switch from a packaged product design (no or low fixed cost, higher variable cost which is perfect for startup plans) to unbundled or brokerage designs (modest fixed cost, much lower variable costs).
“Certain components of a retirement plan require the same amount of work regardless of plan size and are usually billed as a flat fee,” says Kenneth Garrett, Financial Advisor at Garrett Financial Management in Lexington, Kentucky. “Many TPA/Recordkeepers will charge a flat fee of say $1500 for the first 30 participants and then $30 per participant after. In this case, 30 employees in a plan would cost $1500 or $50 per person. As you continue to add participants the average per person fee goes down and makes the overall fees as a percent of AUM go down.” Keep in mind, this is only one set of service fees.
Herman says, “Small plans have always been expensive. All the services that go into setting up and maintaining a 401k plan like handling the recordkeeping, making payroll deductions, managing investment allocations, compliance, and support can be quite costly in terms of net assets. Typically, Insurance Carriers have been the ones supporting this small market as other service providers did not find this space cost effective. As plans get bigger, plan sponsors have more resources to spend to examine their 401k plan, and do things like put it out to bid for new services at a lower rate. The very big plans even have whole departments of people devoted to their 401k plans. Compare this staffing with a small startup with the plan sponsor might also be doing payroll, accounting, human resources, hiring, and buying office supplies!”
Valletta adds one more parameter to consider when determining the true cost of smaller plans versus larger plans. He says there’s a “big difference in the distribution and service models for these two plans given that they would represent small and large market providers. Economies of scale impact the pricing models of each. Another important variable would be the size of plan’s average account balance. The smaller the average balance, our data indicates typically the higher the expenses given same total plan assets.”
What’s a Small 401k Plan To Do?
Smaller 401k plan sponsors do have options, but, first, they must recognize there’s a problem and, second, they must recognize what part of the problem they can control (their vendors) and what part they can’t control (their lack of economies-of-scale). Simon Roy, President of Jemstep in Los Altos, California, says, “Lower cost solutions for smaller plans exist that offer a more do it yourself, cost-effective approach. It’s important for a plan to determine the level of service they require and can afford based on the participant population.”
There are several options, some including using a different form of retirement savings plan, some include making the existing 401k plan more efficient and one includes partnering with other related business to achieve economies-of-scale that could rival even the largest plans. “All else being equal, a smaller plan will tend to pay higher fees but it doesn’t have to be significantly higher fees,” says Garrett. “Many small plans don’t necessarily need to be set up as a standard 401k plan. In many cases a SIMPLE 401k or SIMPLE IRA would be sufficient and usually less costly. A small 401k could look at paying several thousand dollars per year in administrative fees (TPA/Record keeping) while a SIMPLE IRA administrative fees can be in the hundreds of dollars per year, it just depends on which plan is the appropriate fit for the company and its participants.”
“There are a few things that a plan sponsor of a super small plan can do to dramatically reduce the overall cost of a voluntary retirement (particularly a ‘start-up’) plan,” says Porter L. “Buddy” Ozanne, President of Probity Advisors, Inc., who also likes the Simple Plan. On the other hand, Ozanne says, “If the plan sponsor still wants all of the higher contribution limits and options that come with a ‘real’ 401k plan, consider a very standardized ‘plan in a box.’ There are a few service providers (primarily insurance companies, which own their own mutual fund family) that offer ‘turn-key’ 401k plans with a very narrow choice of options. This standardization helps reduce costs. Yet, the employee is still likely to pay more for participating in this type of plan than if he/she were participating in a much larger plan. The (possible) third way to reduce plan administrative costs is to adopt ‘safe harbor’ provisions for your plan. These ‘safe harbor’ provisions require a specific and stated employer match or a minimum 3% of participant payroll profit-sharing contribution to the plan; however, they eliminate the ‘top heavy’ testing requirement, which in turn reduces administrative costs. This third method of reducing costs only seems to work when the income tax savings for the top executive(s) exceeds the cost of the employee matching contributions.”
Swisher suggests smaller 401k plan providers “look into Multiple Employer Plans (“MEPs”); they will not necessarily be your cheapest option but they offer genuine economies-of-scale that make them a good deal for the level of outsourcing that is offered, though not all arrangements pass the savings through to the adopting employers.”
This is What Matters Most
Fees, to echo our earlier quote from the DOL, shouldn’t be viewed “in a vacuum.” “A plan sponsor can shop around and look for lower cost service providers,” says Herman, but “scraping a 401k plan all together prevents participants from getting two key benefits of a 401k plan: company matches and tax deferred growth that should help them get to retirement.” It’s more than that.
“Plan sponsors are required to determine the reasonableness of fees,” says Potter, “but they aren’t required to pick the cheapest plan. The addition of services depends on the specifics of the individual plan.”
Ozanne says, “A larger company with its own robust Human Resources department would most certainly rely on its own resources for certain plan services. However, all smaller companies with plans need to access some of the same services, for which they don’t have their own in-house resources. Those companies, in order to reduce fiduciary and likewise liability exposure should most certainly hire the services of a third party provider. In our experience, most plan sponsors in the under $50 million plan size range need help determining the options that best fulfill the needs of their employees and the budgets of their companies. Most employers need to rely on an independent third party to help offload some of the fiduciary responsibilities of determining which investment options are the most appropriate for their particular plan and employee team. Most plan sponsors need to enlist the services of an experienced ERISA attorney to periodically and regularly review the plan documents and Investment Committee procedures to make certain that all rules and regulations are being complied with. Most employers want and need someone to present to employees verbally and in-person the features, benefits and options provided in the plan. These services not only increase participation in the plan, but they also improve employee morale and satisfaction. For the value received from these services, many employers are willing to factor into their budgets the necessary costs. For many businesses, 401k plans serve as an incentive to retain and attract employees.”
“Better service typically equates to a better experience for participants, and can also reduce the work required by the employer to support the plan,” says Roy. “An employer with less financially sophisticated employees might be well served with a plan that provides managed accounts and advisory services as long as they are aligned with the interests of the employees. A more valuable service can also increase the attractiveness and talent retention of an organization. The key to fiduciary responsibility is ensuring that the service being used is worth the fees being charged and appropriate for the participant pool.”
In a way, 401k fees that are too high are like pornography: You’ll know it when you see it. Given that, what’s an “appropriate” fee for any particular 401k plan? There’s only one correct answer to this question: “It Depends.”
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