Ray of Light
Ever wonder how much your retirement savings plan is really costing? You're not alone. Plan sponsors and employee participants alike often scratch their heads when deciphering fees, charges and expenses associated with 401(k) accounts.
But transparency is coming--soon.
"Employers often had no idea what they were really being charged. Employees never considered they might be charged, because their statement usually didn't show any fees. Many employers may be surprised what the true cost of their plan is, and employees might be shocked to discover that they are, indeed, paying fees," says Rebecca Davis, director of the National Pension Assistance Resource Center. It's affiliated with the Pension Rights Center, a national consumer advocacy organization.
"It's extremely difficult to find out any fee information. I liken it to ordering a meal from a menu without prices. In the end, the money is taken out of your 401(k) account in some way, but how do you decide what investment options to choose if you don't know what they cost?" says Jill Gianola, owner of Gianola Financial Planning, a fee-only firm.
Tougher U.S. Department of Labor (DOL) fee disclosure rules will soon solve the mystery. Plan participants and their employers (generally the plan sponsors) will see exactly what expenses they're incurring and what for. The rules impact participant-directed retirement plans such as 401(k)s and 403(b)s, which are governed by the Employee Retirement Income Security Act of 1974 (ERISA). The rules apply to plan years that began Nov. 1, 2011, so compliance for calendar-year plans starts Jan. 1.
"The DOL took a two-prong approach and we believe they struck a good balance," says Davis. "Employers will receive additional information from the plan's service providers that will help them offer the best possible 401(k) investment options to their employees. Plan sponsors are responsible for providing employee-participants more fee, expense and investment information that's meaningful and easy to understand."
The DOL estimates 72 million American workers have socked away a combined $3 trillion in self-directed retirement plans. Proponents say the enhanced fee disclosures will help investors make better-informed decisions. And since 401(k) plans have all but replaced traditional pension plans, wise investing is critical for retirement security.
"It was the hunch of the DOL that plan sponsors and employee-participants were paying too much. The DOL decided it was time to bring market forces to bear and have all of the fees disclosed," says Steve Haxton, a certified public accountant and president and principal of Jacob, Haxton & Boord, a firm specializing in third-party administration.
When the rules take effect, plan providers will face an onslaught of questions about their pricing, employers will field inquiries from employees about fees that are no longer hidden, and investors will have to figure out how to make sense of all the new information.
Service Provider Disclosures
As fiduciaries, ERISA requires 401(k) plan sponsors to act prudently and solely in the best interests of the plan's participants and beneficiaries. "ERISA allows the plan to pay what's called ‘reasonable' fees. Many fees were hidden, and often the employer hasn't really been able to comply with that regulation the way they'll be able to now," says Brian Hanna, senior relationship manager for Everhart, an independent retirement plan advisory firm.
"Fee disclosures from service providers were considered best practices before. Now that they're required, it's not entirely new, but rather a re-emphasis of existing ERISA regulations," says Hanna, an Accredited Investment Fiduciary.
A 401(k) plan's covered service providers--fiduciaries, investment advisors, record keepers and brokers--each must disclose significantly more information to their clients, the plan sponsors. Many of them aren't exactly embracing the new mandate. "Those previously invisible fees, charges and expenses won't be invisible anymore. As you can imagine, there's squawking in the industry," Gianola says.
Some plan providers may soon find themselves justifying the fees they're charging for their services. "It can be quite challenging for a plan sponsor to identify and understand the plan's overall expenses. Many times, service providers hide fees within the investment themselves. I think the new rules will open a lot of eyes. Clients are getting their arms around exactly the services they're getting for what they're paying," says Kyle Pifher, principal at human resources consultant Findley Davies.
When a retirement plan provider anticipates receiving at least $1,000 in direct or indirect compensation, it must provide the sponsor with formal, written disclosures describing the plan's investments and options. The provider also must describe the tasks it will perform, including any fiduciary duties. That's one area where financial advisors say higher fees may be worthwhile.
"Whenever possible, the plan sponsor should shift fiduciary liability to the service providers to help mitigate risk. When a service provider takes on fiduciary responsibility, the higher fee it charges can be justified when compared to an advisor that's only advising on the plan," Haxton says.
Disclosures should document direct and indirect compensation, transaction-based charges and expenses associated with bundled service arrangements. Because of their business model, fee-only financial advisors will have an easier time divulging their expenses. Brokers paid by commission must explain their many and often complex compensation methods, including revenue-sharing arrangements.
The new rules may help plan sponsors compare apples to apples when choosing a retirement plan. "Bundling makes comparisons difficult. Fee disclosures level the playing field for service providers who've been disclosing their fees, but who were competing against firms that did not," Pifher says.
Employers can use the disclosures to identify conflicts of interest as well as to assess service providers' compensation. "The rules don't say you need to have the cheapest plan. They say you need to have reasonable expenses relative to the services provided," Pifher says.
"It's been difficult for CEOs and other decision makers to make the best possible 401(k) choice, because of the limited information they had to work with. Now they can do better comparison shopping and get the best plan at the best price. That benefits the company and the participants, from the executives on down," Gianola says.
Plan sponsors should receive service providers' new fee disclosures by April 1. Each should be closely inspected upon arrival. "The employer gives de facto approval that the fees are reasonable when the disclosure is put in a file," Haxton says. "If, as a fiduciary, you're challenged in court about reasonableness, you'll have to justify why you're paying that higher fee."
Participants have the right to challenge 401(k) plan fees. If a challenge results in the DOL ruling that the fees are unreasonable, the sponsor must make appropriate adjustments. Otherwise, participants could sue. The employer also risks the Internal Revenue Service disqualifying the plan, which could cost big bucks come tax time.
Plan Sponsor Disclosures
Under the DOL's new rulebook, plan sponsors are required to clarify certain aspects of the retirement plan. Participants should receive a list of the investment and brokerage options and categorizations (Is it a mutual fund? A bond fund?), as well as explanations about how and when to execute investment instructions.
The administrative costs of operating the 401(k) plan will now appear on participants' quarterly statements. "Even if the employer is covering the cost, it must be disclosed. Participants will start to see things like commissions, administrative fees, surrender charges, brokerage fees and recordkeeping fees," Gianola says.
Additionally, participants will see fees and expenses that are directly charged to or deducted from their account based on their own actions. Examples include loan fees or processing costs of a qualified domestic relations order.
For fixed rate or stated rate of return investment options, the annual rate of return and investment term must be disclosed. Mutual fund and other variable rate disclosures will include historical performance data for one, five and 10 years, as well as corresponding securities indexing benchmarks. The total annual operating expense for each variable option should be expressed both as a percentage of assets and as a dollar amount for each $1,000 invested. "Seeing the historical averages will tell the employees if the plan's investment choices are lagging or beating the averages," Gianola says.
"Now you have potentially thousands of people, the participants, who are reviewing the plan, its investment returns and the fees against benchmarks. It'll shine a bright light on the retirement plan," Pifher says.
Standard methodologies must be used when calculating and disclosing fee, expense and return data. Don't expect to get away with formulas that require investors to remember high school calculus. "The comparison data using specific methodology must be easy to comprehend," Gianola says. "The data must be formatted in such a way that [participants] can easily make an apples-to-apples comparison. DOL even created a template."
Employee-investors must be given any material regarding shareholder rights, such as tender or voting, related to a specific investment option. When asked, plan sponsors must furnish prospectuses, financial reports and statements of valuation and assets held.
Calendar-year plan participants must receive the new fee disclosures by May 31. The deadline to provide quarterly statements showing fee and expense deductions is Aug. 14. Participant disclosures can be provided in writing or electronically.
In cases where information disclosed to employees is incomplete or inaccurate, the DOL shields employers from liability if a service provider failed to comply with the new disclosure rules.
All of this newfound data won't come cheap. "You can't push a button and get all of this information. It's a real undertaking that will take time and money," Hanna says. The DOL estimates the total cost of implementing the new rules will reach $425 million in 2012.
Because 401(k) participants aren't accustomed to seeing plan costs, many won't automatically know how to use the information. Questions, confusion and maybe even anger may result.
"The natural reaction is, ‘If you give me more information, I'll ask more questions,' " says Dwight Montgomery, a Certified Financial Planner with Montgomery & Associates, a wealth advisory firm affiliated with Ameriprise Financial Services.
Advisors caution investors not to make choices based solely on fees. Doing so could be penny-wise but pound-foolish. "They'll definitely have better information to make better investment decisions. However, they also can use that information to make bad decisions if they don't utilize it properly," Montgomery says. "For example, you might allocate money solely on cost or performance based on the fees. It's then an emotional decision, rather than an informed decision. Sometimes you have to live with a costlier option to get the right diversification mix."
While the DOL requires distribution of the new disclosures, it doesn't mandate that plan sponsors educate participants about them. But smart employers are developing a proactive communications plan. "It can avoid potentially difficult questions," Pifher says. "Share with the employees what the company has done in the past as the plan fiduciary to control costs. It will help participants understand their 401(k) was not free to begin with."
Employees shouldn't abdicate their role in managing their 401(k). "They have the responsibility to review their statements and become better informed using these new tools. They have to pay attention to what's happening in their account," Gianola says.
It's too soon to tell whether increased transparency will ultimately lower the cost of 401(k) and other participant-directed retirement plans. Some predict increased competition among service providers could drive down prices. "The competitive advantage will go those providers with the technology and the larger firms. They can more easily incorporate the new rules into their existing reports and systems," Gianola says.
"Egregiously priced plans will come down because of the increased transparency and resulting competitive environment," Hanna says. "I expect service providers to ask ‘How can we do this effectively without increasing plan expenses?' Because the industry will be tightening, raising fees will be harder to do. Margins will tighten, because of the additional work and the pressure to keep expenses in check. I'd expect fewer margins for vendors rather than increased fees to plan sponsors."
Hanna also anticipates industry consolidation. "Small shops might not be able to absorb the increased workload with fewer margins. If it's an ancillary business, the company may not be able to satisfy the regulations and determine it's no longer an efficient business model," he says.
Haxton predicts more legal wrangling as a result of the rules. "They'll create a more litigious environment, because participants might talk to lawyers about these new fees that aren't necessarily new at all. They're just seeing them for the first time because of the disclosures," he says.
Lisa Hooker is a freelance writer.
Reprinted from the January 2012 issue of Columbus C.E.O. Copyright © Columbus C.E.O.