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401(k)plans

Commentary

401(k) PLAN FEES AND EXPENSE STRUCTURE

INTRODUCTION

This section will categorize and describe the fees and expenses that are typically paid by or on the behalf of 401(k) plans. We will also cite the typical range of these expenses as revealed in the literature. In the next section we will identify the ranges and averages of expenses paid by plans of various sizes.

BASIS FOR COMPUTING FEES

One dimension that is useful in understanding fees and expenses is the basis for computing them (Tiemann). Asset-based fees are computed as an annual percentage charge on the total assets of the plan. Census-based fees are imposed on a per capita participant basis and itemized fees specify a fixed charge for a specific service.

A typical price quotation might show fees and expenses of all three types. For example, a mutual fund provider might charge an investment management fee as an expense ratio on the funds (asset-based), a per-participant recordkeeping fee (census-based), and a fixed charge for set-up and conversion (McNabb).

TYPOLOGY OF 401(k) FEES AND EXPENSES

A useful way to classify expenses and fees, for the purpose of this analysis, would relate directly to the services being provided to the 401(k) plan. Therefore the following set of fees and expenses is proposed that focuses on the functions related to each expense category.

• Set-up and conversion fees
• Recurring administrative costs
• Communications expenses
• Investment management fees
• Distribution fees
• Mortality and expense risk fees

401k Fact:

According to Southern California-based (401k) Enginuity (www.401kenginuity.com), twenty-year veteran in developing and running 401(k) administration and 401(k) software and recordkeeping systems, the Internet will be the primary delivery system for 401(k)s by 2007. Many web-based 401(k) plans will run on administration and recordkeeping platforms that plan providers will outsource to 401k specialists and 401k Application Service Providers (ASP).

The advantages of web-based online 401(k) plans are obvious to today's workers, and include use conveniences, real-time monitoring and reporting, and instant re-allocation of their retirement assets. The internet has also dramatically reduce the cost of 401(k) plan administration, saving plan sponsor 50% or more in ongoing fees and costs when compared to the older traditional labor-intensive plans. Outsourcing of 401(k) functions by plan providers will extend the trend towards lower cost, high-quality 401(k) products.

401(k) plan providers of all types, financial institutions including banks, insurance companies, brokerages, mutual fund companies, credit unions, and third-party administrators, are now actively outsourcing 401(k) administration and recordkeeping tasks to 401(k) ASPs --- vendors such as 401k Enginuity, whose sole function is to maintain, updated and supervise software-based 401(k) administration and recordkeeping systems on behalf of plan providers. 401(k) ASP vendors are responsible for all routine day-to-day 401(k) recordkeeping and administration functions, thus allowing the plan providers to reduce internal staff, eliminate the expense and complications of licensing, housing and running hardware and 401(k) administration software in-house. Plan providers can refocus and concentrate their efforts on to the needs of their plan sponsors and plan participants, and rely upon the outsourced ASP 401(k) vendor for the recordkeeping and technical "backbone" supporting providers' Internet-based plans. It is inevitable that some of this 401(k) outsourcing to ASPs will include secondary outsourcing of certain non-critical low-level routine day-to-day tasks to non-US locations, where labor costs are less yet the expertise is abundant.

SET-UP AND CONVERSION FEES

There are one-time costs associated with the establishment of a new 401(k) plan or with the conversion of a plan's records to another administrator's custody. Set-up entails the preparation of a plan document, often by adapting a prototype document, and the enrollment of participants. It also includes entering the participant data on the service provider's computer system, reconciling the existing plan's assets (if any), and setting up existing participant loans.

Set-up costs are relatively fixed, although the typical provider charges a fixed amount plus a variable, participant-based fee. The range of costs for set-up is $500 to $3,000; however, many providers charge a lesser amount and recoup the difference from investment management fees (k(la), (k)form Catalog). In one sample of providers, the range of average set-up charges for plans of 25, 50, and 100 lives was $992, $1102, $1,202 (HR Investment Consultants, Averages Book).

RECURRING ADMINISTRATIVE COSTS

These fees cover trustee services, recordkeeping, compliance, distribution of account proceeds to departing participants, loan processing, and withdrawals.

Trustee expenses typically are the smallest component of the total set of expenses, representing about 3% of fees on a typical plan with 500 participants and assets of $10 million (Stone). Trustee services are often offered at no additional, separate charge when the provider's funds are purchased by the plan.

Compliance costs include the preparation of tax forms (Form 5500) and nondiscrimination testing. When administrative services are separately priced, the compliance expenses are typically included in the base charge rather than being separately priced.

Recordkeeping is the largest component of recurring administrative expenses. This expense category includes enrollment, contribution and investment election processing, loan origination and processing, withdrawal processing, individual account maintenance, and preparation and mailing of account statements and summary annual reports. The 401(k) provider industry has made the investment in computer equipment and software to provide this recordkeeping in an efficient and relatively low cost manner.

The recordkeeping expenses for a small plan can be quite high. Typically recordkeeping consumes about 14% of total expenses for a $10 million plan (Stone). However, providers make their margin on asset management, and where recordkeeping and asset management are done by the same provider, recordkeeping may be viewed as a loss leader, being included with the asset management fees. On a start-up plan, the provider may lose money for two to five years until the average account grows large enough so that the margin on asset-based fees is sufficient to cover the loss on recordkeeping (Richardson, May 1996). Larger funds experience substantially lower cost percentages. For a 500 life plan, for example, recordkeeping costs may be about 7% of total fees and expenses and may be even lower for a much larger plan (Valletta, November 12, 1997).

In bundled mutual fund arrangements, recordkeeping expenses are included in the expense ratios. Where mutual fund providers out-source recordkeeping to third party administrators (TPA) alliances, there is typically a 15-20 basis point transfer from the expense ratio to the alliance for this expense (Rowland).

COMMUNICATIONS EXPENSES

Communications services typically include meetings with employees, printed and video materials describing the plan features and encouraging participation, basic election materials, and newsletters. More elaborate services might include a call center, interactive voice response system, participant asset allocation software, and Internet access. Communications services are valuable to the sponsor in that they encourage employee participation in the plan. They also help satisfy the disclosure requirement contained in section 404(c) of ERISA.

For example, one typical, large full service provider offers all of the communications services listed above except participant software. There is no additional charge for these services except for a $500 setup, $6 per participant charge for the interactive voice response system support (HR Investment Consultants).

INVESTMENT MANAGEMENT FEES

The main purpose of investment management fees is to compensate the provider, who recommends the allocation of funds flowing into a particular 401(k) plan investment option from the universe of financial instruments available for this fund. For an equity mutual fund, for example, the investment management advisor selects the stocks that will be bought and sold. The investment management fee pays for the research that supports these buy-sell decisions. In addition, these fees compensate the mutual fund manager for the pro-rata operating expenses of the fund attributable to each 401(k) plan that buys shares. (These operating expenses include items such as rent, staff compensation, supplies, etc.) In practice, the distinction between investment management fees and other type fees is blurred.

Investment management fees are the largest charges assessed against the plans. In plans where the assets are invested in mutual funds, for example, the investment management fee has been found to exceed 80% of total fees and expenses of a typical plan ("Retirement Planning;" Stone). Valletta found that the investment management fees may be as much as 90% of the total (Valletta, November 12, 1997). However, as will be seen below, these statistics may include certain other expenses such as marketing and distribution costs that are not separately disclosed.

Other investment instruments, typically group variable annuities, include management fees in the "wrap." A wrap fee is an all-inclusive annual fee imposed on the value of total assets in an account. Wrap fees typically include expense elements other than investment management fees.

DISTRIBUTION FEES AND COMMISSIONS

Often, 401(k) providers rely on elaborate distribution networks to market their products. Distribution fees are charged to cover the expense of maintaining this network. For example, a large insurance, full service provider may market its products through one of three modes:

• In-house sales force,
• A network of affiliated third party administrators, and
• Unaffiliated broker/dealers.

Such a provider will establish commission schedules to compensate the sales force at all points in this network. When 401(k) plan investments are purchased through this distribution network, distribution fees are typically charged against the participants' accounts. Distribution fees compensate the distribution network participants for their labor.

In the case of retail mutual funds, the sales commissions are disclosed in the prospectuses. Sales commissions can be collected in two ways: as front-end loads paid on new contributions to the fund (Class A shares) or as 12b-1 fees (combined with deferred contingent sales charges) deducted annually based on the fund's assets and reflected in the fund's net asset value (Class B shares). These sales commissions, whether collected when contributions are received or charged over a number of years against assets, are in the range of 3-4 percent of contributions (Schultz; Tuczak). For class B shares, the mutual fund manager pays sales commissions to broker/dealers up front and then recoups these funds over a number of years in the form of 12b-1 fees (Tuczak). Since the SEC limits the 12b-1 expenses to 100 basis points annually, a contingent deferred sales charge is imposed on the shares, typically for five years, to ensure that the mutual fund can recapture the sales commissions that were paid. A contingent deferred sales charge is only collected when the shares are sole during the contingent period.

Insurance company providers (and other providers using a wrap fee) can collect distribution fees at two levels. On the first level, 12b-1 expenses are charged against the annual value of an individual mutual fund and transferred to the distributor. On the second level, part of the wrap fee imposed on the value of all instruments included in the group variable annuity may be used to pay for distribution costs. The amount of each 12b-1 fee is disclosed in each fund's prospectus, but the portion of the wrap fee that is devoted to distribution charges is not disclosed.

Sales commissions for insurance products, including group and individual annuities, may be structured with two components. Deposit commissions are paid on balances transferred from other providers as well as periodic contributions into the plan. Trail commissions are paid on assets under management, including the growth from investment returns, and continue as long as the plan continues with the same insurance provider. The direct and trail commissions are typically combined and incorporated as part of the wrap fee.

MORTALITY AND EXPENSE RISK (M & E) FEES

Insurance products, such as group and individual annuities, bear costs that are unique to these products and that reflect the insurance risk of each product. These risks include the mortality and expense guarantees inherent in the annuity contracts. (See Section II, Insurance Industry Products, for a discussion of these guarantees.) The M & E fees pay these costs.

M & E fees are highest for individual variable annuities, generally ranging from 100 to 200 basis points (Hack). However, since distribution fees are often grouped with M & E fees, the total wrap fee for individual annuities might be in the range of 200 to 300 basis points.

In the case of group variable annuities, the M & E fees are usually based on plan size (Hack).

• For very small plans, less than 50 participants and $500k assets, 100 to 200 basis points, • For small plans, more than 50 participants and greater than $500 k assets, 75 to 150 basis points, • For medium sized plans, greater than 500 participants and $5MM assets, 30 to 75 basis points, and • For large plans, greater than 1,000 participants and $15MM assets, less than 50 basis points. M & E fees are typically imposed as wrap fee based on the total assets in the annuity accounts.

APPROACHES USED TO ASSESS THESE EXPENSES

The preceding discussion related administrative fees and expenses to the functions that they support. The following subsection describes the structure of fee payment modes.

• Invoiced expenses
• Sales charges
• Expense ratios
• Wrap fees
• Net asset value computations

INVOICED EXPENSES

Invoiced expenses are generally for recordkeeping and administration. They are often charged on an itemized basis, and may be paid by the sponsor, by the plan, or shared. There should not be any issue concerning disclosure by service providers to plan sponsors, for the sponsor can read the charges from the plan contract or from the periodic invoices or statements from the provider. Examples of invoiced expenses that would be paid by the sponsor or the plan are start-up fees, annual base fees, trustee fees, tax form filing, and recordkeeping for company stock purchases. Examples of invoiced expenses that might be paid by individual participants (or the plan) are loan origination, loan maintenance, and distributions.

Some invoiced fees are census based, i.e., fees charged as amounts per participant. These fees are similar to itemized expenses in that they are charged for recordkeeping and administration and in that there should be adequate disclosure of their extent to sponsors. Census-based fees, charged as a fixed amount per participant, are typically paid from plan assets or by the sponsoring firm. Examples of census-based fees are a per-capita addition to the annual base fee, additional fees for communications options that are not in the basic package, adding investments from outside providers, and the use of non-electronic data inputs. Some expenses are charged as itemized expenses by some providers and as census based fees by other providers.

SALES CHARGES

Regulated securities, such as mutual funds, may impose sales charges on purchases and/or reinvested dividends. Where up-front sales charges are imposed, they are disclosed to the sponsors and participants in the prospectuses. Contingent deferred sales charges combined with 12b-1 expenses may be used to assess sales charges (as described above). These charges are also fully disclosed.

EXPENSE RATIOS

Mutual funds impose asset-based administrative fees and expenses that are disclosed in the form of expense ratios. Expense ratios, which are incorporated in the prospectuses and published in the financial press (for retail funds), show the amount of fees and expenses that are deducted from the assets of each fund annually. Since expense ratios reflect deductions from the assets of a fund, these expenses are borne by the individual participants in a plan by a charge against net asset value of the funds in their individual accounts.

The Securities Act of 1933 requires the disclosure of the magnitude of fees imposed on mutual funds. The industry has developed a standard display of expense ratios:

• Management fees
• Marketing and distribution fees
• Other administrative expenses

Management fees represent a percentage of the fund assets paid to the fund's investment manager. These fees include the costs of research, the manager's compensation, and the firm's profit margin, among other costs. The identity of items included in the management fees for any fund is typically not disclosed. Mutual funds charge additional fees to support the marketing and distribution costs of the fund. These fees are authorized by the Securities and Exchange Commission as section 12b-1 expenses. They may not exceed 100 basis points. There is a trend, however, to use 12b-1 fees for other purposes. One such use involves the transfer of a portion of the marketing and distribution fees to consultants through 12b-1 fees; one author suggests that this may be as much as 25 basis points (Richardson, January 1997). Bundled providers are also observed to be out-sourcing recordkeeping services and charging plan sponsors 15-20 basis points in 12b-1 fees that are rebated to the recordkeeping provider (Rowland). Other administrative expenses is a category that primarily includes the servicing of shareholder accounts, such as providing statements, reports, dispersing dividends, as well as custodial services.

The net effect of these expense ratios is that it is difficult to separate the investment management fees from the administrative fees using the published information. For example, there has been a dramatic increase, 44%, in the total expense ratio of the average diversified stock fund since 1980. However, if we look at the detail in the ratios, we see that the cause of this increase has been the shifting of sales charges from a front-end load to the 12b-1 segment of the expense ratio. "Other expenses" have fallen while the 12b-1 share of the expense ratio has increased. The real increase in investment management expenses (apart from marketing and distribution) since 1980 is closer to 17% than to 44% (Sheets).

WRAP FEES

A wrap fee is an all-inclusive annual fee imposed on the value of total assets in an account. Originally developed to use with separate account money managers to pay the manager's fee as well as transaction costs, wrap fees are often associated with funds that still have internal expense ratios (Stone). For example, one large insurance company provider offers a variety of mutual funds to smaller 401(k) plans. Each of these mutual funds contains its own expense ratio. In addition, this provider charges an asset based wrap fee on the overall value of all of the mutual funds in the plan participants' accounts (Ryan).

Wrap fees are typically charged by insurance providers, who package their 401(k) investments in the form of group or individual annuities. In these plans, wrap fees typically include M & E expenses and distribution fees in addition to the cost of plan services and investment management fees. Wrap fees may also be charges by some bank and investment management company providers. The magnitude of wrap fees (as a percentage of the 401(k) fund) is observed to be inversely proportional to the value of assets in the 401(k) plan (HR Investment Advisors).

The magnitude of the wrap fee in any plan is disclosed to the plan sponsor (and, in some plans, to the plan participants). However, information about the portion of the wrap fee devoted to the elements of expense (M & E, distribution, services, investment management) is generally not disclosed (HR Investment Advisors). Since the typical wrapped account is an annuity, it is qualified as an insurance investment and not required to be registered nor to disclose fees in the detail required of mutual funds under the Securities Act of 1933 (Hack).

NET ASSET VALUE COMPUTATIONS

Certain investment products do not directly disclose any of the fees and expenses imposed on the plan participants. Instead, these charges are netted into the periodic net asset value (NAV) computations. Stable value accounts, such as GICs and BDAs use this technique to impose fees. In such accounts the provider guarantees a specified annual rate of return on each account. However, the fees and expenses are converted into a percentage charge against the assets in the account and are built into the formula for crediting investment returns. The plan sponsors and participants will be provided with the NAV and may be given the net rate of return used to compute the NAV, but the percentage devoted to fees and expenses will not generally be disclosed (Hack). (This is in contrast to mutual funds where fees and expenses are netted into the NAV but where the magnitude of fees and expenses are disclosed in prospectuses.)

ISSUES AFFECTING EXPENSES

The plan sponsor seeking to minimize the fees and expenses imposed on a 401(k) plan is constrained by a number of issues that bear on the magnitude of fees and expenses. An important strategy for minimizing costs is to obtain competitive bids from a number of 401(k) service providers. Other considerations related to costs of services are:

• Plan size
• Plan features and investment options
• Behavior of plan participants
• Portfolio turnover

PLAN SIZE

Plan size is clearly an important dimension in the amount of fees and expenses a plan will absorb. This is largely a result of the fact that there are certain fixed costs of providing services to a plan that are not highly sensitive to the number of plan participants, and the fewer the participants, the higher the per-capita expenses. More and more vendors, especially mutual funds, focus only on the larger plans, those with 200 or more lives (Richardson, July 1997).

Another consideration related to plan size is that many small plans are new accounts with few assets. Access Research is reported to be encouraging technology companies to set up automated service bureaus that would handle administration for multiple 401(k) service providers as a cost savings for small plans (Richardson, July 1997).

Some sponsors may remain too small to easily afford a 401(k) plan. For firms with substantially less than 100 employees, the SIMPLE IRA plan or a profit-sharing arrangement may be a more affordable solution. Also, those small firms with higher than average income workers may prefer the higher maximum contribution limits in 401(k) plans over the SIMPLE IRA.

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.financial-services401k.com

SELECTION OF PLAN FEATURES AND INVESTMENT OPTIONS

Decisions by the plan sponsor have a considerable influence on the magnitude of fees and expenses that will be charged. These decisions involve the specification of services that will be provided to the plan as well as the selection of investment options that will be offered to the participants. An extensive set of services is available to 401(k) plans, and many of them are more elaborate than the minimum requirement mandated by law and regulation. When the plan sponsor chooses to include more elaborate services than the minimum requirement, albeit in response to employee demand, the administrative costs are increased. For example, the sponsor might specify that the plan allow employees to change their investments daily, and the service provider would quote an incremental price for this additional service (Quinn, January 1998). Increasing the frequency of compliance testing is an example of another service for which most providers would charge an additional fee (HR Investment Consultants, 401(k) Provider Directory).

Another significant influence of plan sponsors' decisions on plan fees and expenses is in the selection of the suite of investment options that will be offered to participants. The plan that offers a wide spectrum of investment choices is likely to include investment options that have a higher than average expense ratio. For some investment options, for example employer stock and instruments purchased from institutions other than the full service provider, the provider will charge an additional itemized or census-based fee (HR Investment Consultants, 401(k) Provider Directory). Finally, including investment instruments that impose sales commissions on their purchases will increase the expenses being charged to participants who select these options.

Plan sponsors influence the magnitude of fees and expenses when they select a service provider that only offers investments loaded with sales charges or that packages investment options in a group annuity. An example might be the typical major insurance provider that offers a set of investment options that feature choices among mutual funds. These funds are included in a group annuity wrapper and an asset-based wrap fee is imposed (except for the larger plans) (HR Investment Consultants, 401(k) Provider Directory). A similar set of investment options could be provided by a non-insurance provider, absent the group annuity. This does not suggest that the group annuity does not have value, only that it comes with an additional cost. Similarly, the plan sponsor that selects a full service mutual fund provider that offers only loaded retail funds, could find another provider that offers a set of no-load funds with similar risk-return characteristics.

BEHAVIOR OF PLAN PARTICIPANTS

Participant behavior directly affects transaction costs. The typical plan provider charges additional fees for transactions such as withdrawals and loans. In the case of loans, there are charges for both loan origination and monthly maintenance (HR Investment Consultants, 401(k) Provider Directory).

Participant behavior selection of the investment instruments also drives the level of fees and expenses. To the extent that participants understand the investment management fees imposed on alternative investment choices (mutual fund expense ratios, for example) they have the opportunity to influence the amount of expenses that will be charged to their accounts. This does not suggest that the rational choice is always the lowest cost fund.

The participant's selection of actively managed versus passive investments will have an effect on investment management fees. The average expense ratios for particular fund categories encompass wide ranges from low to high expense ratios across individual funds (Fortune, December 23, 1996).

One key factor in this wide range of expense ratios is the notable difference in expense ratios generally observed between indexed (or passive) funds and actively managed funds. In an indexed fund, the investment manager seeks to maintain a portfolio closely tracking an appropriate market performance indicator. For example, a U.S. large company stock fund might be benchmarked to the Standard & Poor's 500; a small company stock fund to the Russell 5000; an international stock fund to the Morgan Stanley EAFE (Europe, Australia, Far East) Index. Other fund categories have similar benchmarks meant to capture the overall performance of particular segments of stock and bond markets. In actively managed funds, the investment manager expends more costs on research, investment selection, and buying and selling.

Similarly, the choice of equity versus fixed income investments affects expenses. Inspection of mutual fund expense ratios reveals that bond fund expenses are significantly lower than are those for equities (Sheets).

PORTFOLIO TURNOVER

Portfolio turnover is another factor affecting expenses. Higher portfolio turnover increases the transaction costs of buying and selling the individual securities in a mutual fund or other investment account. These transaction costs are not usually separately identified but are netted with the investment return, so it is difficult to observe them. Portfolio turnover results from decisions made by the investment manager, and is not under the direct control of the plan sponsor nor of the participants. However, portfolio turnover is often disclosed in the case of mutual funds and thus is indirectly controlled by sponsors and participants who select certain investment options in spite of the knowledge that the managers of that option are active traders. Portfolio turnover is an issue that should be considered by plan participants in choosing between actively managed and passive investments, as discussed in the preceding section.

WHO PAYS 401(K) PLAN FEES AND EXPENSES?

The evidence shows that the largest element of expense for 401(k) plans is the investment management fees that are imposed principally as expense ratios in the case of mutual funds or as wrap fees imposed on assets in group annuities. It has been shown that investment management fees typically range from 75% to 90% of the total administrative fees and expenses imposed on a plan. The participants in a typical plan bear the mutual fund expense ratio and annuity wrap expenses.

Recent surveys provide information showing that, apart from the investment management fees, participants are bearing a substantial fraction of the costs of administering 401(k) plans. Plan participants are more likely to pay non-mutual fund/group annuity investment management fees, while plan sponsors are more likely to pay other fees and expenses. Buck Consultants report that, in 51% of plans surveyed, participants paid all of the investment management fees; while sponsors shared in these fees in 19% of plans. The Profit Sharing/401(k) Council of America survey indicated that in 62% of plans participants paid all of the investment management fees. Hewitt Associates reported that, in 1997, participants paid 56% of non-mutual fund investment management fees.

The opposite is the case with administrative fees (non-investment management fees). RogersCasey reports that, on average, 54% of plan sponsors pay all of these administrative fees, while 28% share these costs with participants. Larger plans (>10,000 lives) are more likely to shift administrative fees to participants. The Profit Sharing/401(k) Council of America survey results mirror these findings.

The following table shows the results of a 1997 survey that asked plan sponsors how administrative fees and expenses are paid.

Table III-1 Who Pays Plan Expenses?

Percent of Plans1                         

Participant Pays  Employer Pays  Shared   Expense 
Audit fees  24%  73%  3%
Internal administrative staff compensation  4%  93%  3%
Employee communication  14%  75%  11%
Investment education:

Seminar/workshops

 9% 83%  8%

Other media 

10% 82%   8%
Non-mutual fund investment management fees 56% 39% 5%
Legal/design fees  9% 85% 6%
Recordkeeping fees 35%   58% 7%
Trustee fees  40% 55% 5%
Other administrative fees 24% 61% 15%
 (Source: Hewitt Associates, 1997)
1 (441 plans reporting)

The trend in recent years has been for plan sponsors to shift administrative and non-mutual fund expenses of the plans to plan participants (Hewitt Associates, 1997). The following table illustrates this trend.

Table III-2

Plan Expenses Paid by Participants Only

Percent of Plans1                  

1991 
Survey
1993 
Survey
1995 
Survey
1997
 Survey
Audit fees 16%  17% 18% 24%
Internal administrative staff

compensation 

4% 3% 4% 4%
Employee communication 5% 10% 10% 14%
Investment education:

Seminar/workshops

--  --  --  9%

Other media

-- -- -- 10%
Non-mutual fund investment 

management fees

44% 50% 56% 56%

Legal/design fees

 9%  7% 10% 9%
Recordkeeping fees 22% 27% 29% 35%
Trustee fees 27% 32% 33% 40%
Other administrative fees 14% 17% 18% 24%

(Source: Hewitt Associates, 1997)
1 (656 plans reporting in 1991; 486 plans reporting in 1993; 429 plans reporting in 1995; and 441 plans in
1997)

Another survey research study conducted over a four year base yielded comparable results. Table III-3 displays the results of this study.

Table III-3

Plan Expenses Paid by Participants Only

Percent of Plans1          

1992
Survey
1994
Survey
1996
Survey
General Recordkeeping 11.6%    13.1% 22.0%
Compliance 10.4% 8.9% 12.3%
Communications 5.2% 8.8% 13.8%
Asset Management 35.8% 34.4% 53.9%
Investment Education 18.7%
Loans 46.4%
(Source: Spencer Associates, 1996)
1 (229 plans reporting in 1996)


The evidence that there is a trend to shift expenses from plan sponsors to plan participants is reinforced by a survey conducted in 1996 that asked plan sponsors to indicate their intentions for the future. This survey indicated that a modest but significant number of respondents intended to pay a lower percentage of such fees in the future. Table III-4 displays the results of this survey.

Table III-4

Future Payment of Administrative Fees

Percent of Plan Sponsors      

Participant
Pays
Employer 
Pays
  Shared
Expense
In 1996 in 1996 in 1996
Company will pay a higher percentage of fees  1%   0%   2%
Company will pay a lower percentage of fees 7% 15% 24%
Company will pay the same percentage of fees 91% 85% 73%
Number of respondents  (82) (245) (128)
(Source: RogersCasey)

ARE PLAN SPONSORS AND PARTICIPANTS ADEQUATELY INFORMED ABOUT FEES AND EXPENSES?

The adequacy of the disclosure of fees and expenses to both plan sponsors and participants has been introduced as an important issue. (This was the focus of the public hearing held by the Department of Labor on November 12, 1997.) It is clear from evidence in the literature that not all investment products disclose the fees and expenses charged to a 401(k) plan, nor are all of the fees and expenses charged by service providers disclosed. For example, we have demonstrated that the fees imposed on stable value accounts are not usually identified and that other charges, such as sales fees, are often not disclosed. Adequate disclosure of fees and expenses should be important to sponsors as they select 401(k) service providers and monitor their performance. The disclosure of fees and expenses is also important to plan participants as they select among available investment options. ERISA charges DC plan sponsors with a fiduciary responsibility to act in the best interests of the plan participants. This implies that plan sponsors will know the costs of the services they procure and will apply due diligence to minimize these costs in the light of the level of services desired.

There is evidence, however, that there is a lack of information about costs that may affect the level of some administrative fees and expenses. A Dalbar study in 1992 shows that 78% of plan sponsors did not know how much their costs were, largely because there are about 80 different ways in which vendors charge fees (Benjamin). Some observers have suggested that some plans absorb as much as 100 basis points in higher fees and expenses presumably due to ignorance about the extent of fees being charged (Butler, November 12, 1997). The logic supporting this assertion is that, absent knowledge of the fees and expenses, many plan sponsors will select a higher cost provider than would be selected with detailed cost information.

The existence of such a large number of service providers suggests that competition in the marketplace should serve to minimize 401(k) plan fees and expenses. However, some observers believe that sponsors are not especially price sensitive in their purchasing decisions (Butler, November 12, 1997). Perhaps this is due to a lack of knowledge about the total fees and expenses being assessed. It also appears that some segments of the market are more efficient than are others. It is asserted, for example, that competition makes the market for large corporation plans very efficient (Barry). However, a valid distinction can be made between competitiveness in the market for services to large and small plans. This suggests that smaller plans do not benefit from this price competition (Cronin).

Another issue related to whether sponsors need a greater disclosure of fees and expenses is the costs of the many plan features that are now characteristic of a typical plan. More services are being provided to plan participants today than was the case ten years ago - indeed - many did not exist ten years ago (interactive voice response systems, for example) (Saxon). The provision of these services is driven by demand. A valid question is: if participants knew how much optional features of their plans cost, would they demand so many (O'Brien). In a recent study conducted on the Internet, 85% of the 1000 respondents voted for greater investment returns versus more services from their plans (Butler, November 12, 1997).

The imperatives for a greater disclosure of fees and expenses to participants are less clear. In one opinion, given in testimony at the public hearing before the Department of Labor on November 12, 1997, additional information would not benefit plan participants (Barry). They have one of two choices to make among the inventory of options offered by their plan. These decisions are yes or no for each investment option, and all they really need to know is now disclosed including historical rates of return and investment objectives. This argument would be much more persuasive if the evidence showed that plan sponsors have complete knowledge of fees and expenses and are acting responsibly on this information to minimize costs.

An opposing view is that employees deserve the same access to information that the plan sponsors should be receiving when they select plan providers and investment vehicles. This argument starts from the construct of the DC benefit and especially of 401(k) plans in relation to an employee's retirement income security. Responsibility has been placed on employees to direct their own investments and to assume the risk of making bad decisions. Thus, they are entitled to all of the relevant information bearing on these decisions (Fink). Another factor arguing for the disclosure of information about plan costs to participants is that they have influence on the decisions of the plan sponsors in many firms. This influence may be exerted through employee advisory committees, their bargaining units, or through informal channels of communication. Thus participants deserve access to the information they need for informed participation in the sponsor's selection process.

ERISA requires that participants receive information about the amount of fees and expenses charged against their plan in the summary annual report. In addition, plans are encouraged by section 404(c) (the ERISA safe harbor provision) to provide full disclosure of fees and expenses. However, except for investments covered by the Securities Act of 1933, for which a prospectus must be furnished to participants, there is generally no requirement in the law or Federal Code for a complete disclosure of investment expenses to plan participants (Fink).

The disclosures required by plans seeking to comply with section 404(c) do not always display the full range of expenses charged to participants. Only that information relevant to the participant's capability to make rational choices among the investment options must be included. Thus, items such as the wrap fee and internal computations of the net asset values for stable value accounts would not necessarily be disclosed.

What do the stakeholders in the 401(k) universe think about the adequacy of available information about fees and expenses? Testimony before a public hearing held by the Department of Labor revealed differing perspectives on this issue by industry and advocacy group representatives. The mutual fund industry appears to be solidly for a full disclosure of all fees and expenses to both plan sponsors and participants (McNabb; Fink).

The Vanguard representative presented a model for a disclosure format that would appear to be acceptable to the mutual fund industry (McNabb; Fink; Tiemann). However, the industry's position on disclosure may be somewhat self-serving. The Securities Act of 1933 already requires them to disclose their administrative and investment management fees in a prospectus. Therefore, under current law, they are somewhat at a competitive disadvantage because they are subject to more stringent disclosure requirements than are insurance and bank investment products that are not similarly regulated and whose fees and expenses are often concealed in the net asset valuation computations. The Vanguard model disclosure would combine the asset-based, census-based, and itemized expenses into one "all-in" cost expressed as an expense ratio on total plan assets (McNabb). (This model disclosure is included in Appendix B, where several such models are displayed.)

Representatives for the banking industry stated their support for adequate disclosure of information about fees and expenses but believe that such information is now available (Barry; Dudley). Strong sentiment was expressed that no actions should be taken to mandate what fees and expenses could be charged (Barry). Such an action would disrupt the structures that have been created to service the 401(k) industry. There was additional comment opposing the establishment of mandatory disclosure requirements (Barry; Saxon).

The insurance industry was underrepresented at the hearing; the one insurance firm offering testimony operates in a niche market that offers mutual fund products wrapped in a group annuity to mostly small plans (Ryan). Anecdotal evidence was offered that some insurance companies would object to changes in their disclosure procedures that would separately identify their fees and expenses, such as distribution and M & E fees incorporated in the annuity wrap fees, to plan sponsors or participants (Butler, November 12, 1997; Snyder; Schultz).

Testimony from individuals representing participants in 401(k) plans strongly advocated the need to provide participants with detailed information on the fees and expenses being charged against their accounts (Benna, O'Brien, Snyder).

SECTION IV

COST ANALYSIS FINDINGS

INTRODUCTION

Systematic and reliable measurements of the fees and expenses incurred by 401(k) plans and their participants are difficult to establish. Within the 401(k) plan universe, the mechanisms through which recordkeeping and administration services are delivered, the manner in which expenses are charged for those services, and the expenses associated with the management of plan investments all vary widely. Additionally, there are difficulties in measuring the differences between the total expenses involved in administering plans and the expenses actually paid by the plan participants.

Most 401(k) plans purchase all or most of the essential plan administrative services from external providers, or alliances of multiple providers. For such plans, there are some data available regarding the structure and level of the fees quoted by the providers. However, at least three factors restrict the use of these data in this research effort.

First, complete quantitative documentation of the major service providers' fee structures is not available for this study. A limited sample of fee structures was presented at the Department of Labor's public hearings (Valletta, November 12, 1997).

Second, providers' fee quotes may reasonably be regarded as typical "asking prices" within the 401(k) marketplace. They do not necessarily reflect the actual "buying prices" that emerge after negotiations between plan sponsors and the providers.

Third, many plans purchase some plan services from outside vendors, but provide other services using internal staff and resources. While there is some limited survey data suggesting which types of services are more likely to be provided internally, there is no systematic basis for identifying the expenses incurred in doing so.

Another major difficulty in assessing the types and levels of major plan expenses results from the wide variations in products and fee structures. Two examples are particularly noteworthy. Providers may offer identical arrays of plan services - investment management, recordkeeping, loan administration, trusteeship, and so on - under very different fee arrangements. For example, one provider may offer comparatively low investment management fees, but charge separate and additional fees on a per capita or per transaction basis for all other services. A second provider may offer many administrative services at no charge, but generate revenue to finance these services by charging comparatively high investment management fees. As a result, it is difficult to establish benchmarks for individual fee components.

Information reported by plan sponsors on Forms 5500, 5500-C, and 5500- R provide a measurement of some of the plan expenses that are charged against plan assets. Here however, there are significant uncertainties about the significance and implications of the data. First, the expenses reported on the Form 5500 do not include investment management expenses debited directly from the earnings that accrue in participants' accounts. Depending on plan size and participants' asset levels, these "hidden" fees may comprise 75% to 90% of total plan expenses (HR Investment Consultants, Averages Book).

Second, expenses reported on the Form 5500 include only the portion of other expenses that plan sponsors charge against the plan assets. They do not include the portion of the expenses paid out of general corporate funds, and therefore do not provide a reliable indicator of the actual total expenses involved in administering the plan. An preliminary analysis of the Form 5500 data shows promise for further investigation, but did not merit inclusion in this report.

Within this ambiguous context, the project team has attempted to develop a "best sense" notion of the general range and tendencies of 401(k) plan administrative expenses. The findings are based on multiple sources from the available literature in the area and the limited body of somewhat systematic data about provider fees

COMPONENTS OF PLAN EXPENSES

There are various ways to categorize the components of total plan expenses. The following discussion is based on four categories that capture distinct sets of service functions.

1. Costs associated with the investment and management of plan assets (not including trading costs);

2. The costs of plan administration and recordkeeping;

3. The charges incurred for processing participant loans; and

4. Trustees' fees.

For each functional area, plan sponsors typically either provide the services internally or purchase them from outside providers.


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