As 401(k)s become the primary retirement savings vehiclefor more and more workers, the need to keep plan costs from cutting into investment returns intensifies. And in today's competitive market, plan sponsors may be in a better position to do just that than they have been for a while.
The stakes are high. The Profit Sharing/401(k) Council of America reports that 420,000 401(k) plans are in place, with more than 44 million participants and $2 trillion in assets.
While the cost of a 401(k) plan to an employer is, on average, half that of a defined-benefit pension plan, 401(k)s entail substantial expenses. More than half of the plans surveyed by Hewitt Associates have an annual total plan cost (TPC) of between 0.31 percent and 0.70 percent of plan assets. The median TPC is 0.59 percent, and the average is 0.62 percent. To make a dent in TPC, the finance function must identify total plan costs, structure the plan to control those outlays, create a paper trail to satisfy Labor Department requirements, evaluate fee disclosure and make appropriate cost projections. It's not an easy job, given the relative obscurity of total plan costs and the unwillingness of many vendors to clarify expenses.
"Companies are more concerned about monitoring all of their 401(k) plan costs than they were 10 or even five years ago," says Michael Weddell, retirement consultant at Washington, D.C.-based Watson Wyatt Worldwide. "Now if a provider promises a $0 per participant fee, that marks just the beginning of the discussion. Companies strive to measure total costs including investment fund costs and other administrative charges. As the 401(k) plan becomes the primary retirement plan for an increasing number of employers, those employers realize that they need to keep plan costs down for those plans to generate as much retirement savings as possible."
New interest in total plan costs also derives from the renewed focus on compliance with fiduciary requirements under the Employee Retirement Income Security Act (ERISA), according to Paul Bracaglia, a partner in PricewaterhouseCoopers LLP's investment advisory group in Phil-adelphia. "Part of the ERISA requirements entail ensuring that the costs associated with the plan are fair and reasonable and understanding that the retirement plan committee is obligated to act in the best interest of plan participants," he says.
"At the same time, the competitive environment among 401(k) plan providers is continuing to heat up," Bracaglia points out. "The growth in the number of new plans being introduced has slowed considerably, so the only way for a provider to grow market share is to win existing business from their competitors. With this as a backdrop, astute retirement plans are using this buyer's market to look for opportunities to reduce their plan costs."
The first step in any cost evaluation is to develop an effective procedure for comparing fees charged by a range of providers. Weddell notes that any competitively bid 401(k) provider search should include a fee template in the request for proposals so that all bidders' fees can be collected in a single format and readily compared. Total costs can be computed on a spreadsheet and compared for each provider based on estimates of the volume of participant transactions and the amount of assets in each investment fund.
"The bidders may be a relatively small number of providers who have a serious chance of winning the search, they but should include at least one bidder with a reputation for low costs or who is especially eager to grow their market share in order to increase the cost pressure on the other bidders," Weddell says.
Weddell advises CFOs to be aware of the following pitfalls when comparing fees:
•Some bidders base their fees on a minimum number of plan participants at or near the current number. If the number of participants increases, the bidder's fees increase. But if it drops, the bidder's fees remain the same. The fee comparison should penalize these providers. Alternatively, the minimum participant number should be negotiated to a much lower level.
•Different providers' total fees will grow or shrink more rapidly as the amount of plan assets varies. Plan sponsors need to take this into account instead of simply taking a snapshot of the fees based on current plan assets.
• Bidders may impose restrictions related to plan assets. These can include market value adjustments, redemption fees and surrender charges. These restrictions and fees most often arise in connection with annuity products and stable value funds. CFOs should bear in mind that a company's 401(k) buying power depends on its ability to move its plan assets to a different provider. If the funds can't be transferred readily, the company will not be able to negotiate competitive fees.
Bracaglia says that there are two significant areas where plan sponsors can look to reduce costs. The first (and usually the largest cost component) is the investment expense of operating the underlying investment vehicles. "For most plans, this means the expense ratios for their mutual funds," he says. "Although expense ratios cannot typically be negotiated with the mutual fund provider, a plan can and certainly should look to see if [these] funds are competitively priced relative to the average peer fund."
From a fiduciary standpoint, a pro-vider should be careful if the expense ratios of the funds offered are higher than the average of their respective peers. "Frequently, plan costs can be reduced substantially just by focusing on a less expensive share class of the same fund," Bracaglia notes. "This is particularly true if the fund offers a passive index fund option."
The second cost area is the assessed per-participant charge. This fee is usually expressed as a flat rate based on the number of employees enrolled in the plan. As plan assets grow, the revenue that the provider derives from the underlying investments also increases. The increased revenue should be offset, at least to some extent, by a reduction or elimination of the per-participant charge.
Notes Bracaglia: "A retirement committee that understands the relationship between plan assets and revenues should be in a position to monitor plan costs going forward to ensure their plan remains competitively priced and, as a result, improve their ability to continue to control costs in accordance with their ERISA requirements."
Companies can choose from several methods for valuating costs and negotiating reductions, "but nothing completely replicates the competitiveness of a full search complete with finalist meetings and fee negotiations," Weddell says. "However, unless there are reasons for dissatisfaction with the current 401(k) provider beyond just a desire to check if fees are reasonable, most employers do not want to start a full 401(k) provider search."
Employers may choose to hire a consultant who regularly performs 401(k) plan searches to conduct a fee benchmarking study for a fraction of the cost of a provider search. "It's essential to provide the consultant with recent competitive proposals for 401(k) plans of similar size, in terms of both plan assets and number of participants. Quick methods, such as looking at Morningstar averages of mutual fund expense ratios, can lead to inflated estimates of the competitive fee levels charged to 401(k) plans," Weddell asserts.
"Also, let your current provider know that you've retained an outside consultant to benchmark its fees," Weddell advises. "It shows the provider that you are serious about measuring current fees and negotiating for a reduction if necessary. It also gives the provider a stronger incentive to show competitive fees, knowing that if its fees are too high it risks not being included in future 401(k) searches conducted by the outside consultant."
Savings From Institutional Funds
Part of the new interest in 401(k) plan expenses stems from the frustration plan sponsors feel with their retail mutual funds and their greater recognition of institutional funds, according to Pam Hess, a senior investment consultant with Hewitt Associates in Lincolnshire, Ill. The key benefit of institutional funds is their substantially lower fees. That translates to significant savings -- and higher account balances -- for participants. Sponsor costs are approximately the same for retail and institutional funds.
Hess recommends that "CFOs should investigate institutional funds because they make 401(k) plans a more meaningful retirement program." A Hewitt Associates study found that institutional funds accounted for 45 percent of all funds in 401(k) plans in 2005, up from 40 percent in 2003.
5 Action Steps To Control Plan Costs
1. Add a total plan cost (TPC) calculation to your periodic fiduciary checklist. Make sure you understand all fees associated with your plan.
2. Create a paper trail for plan fees to illustrate your company's decision-making process.
3. Begin an internal dialogue regarding fee disclosure to plan participants.
4. Make a commitment to keep all costs -- especially investment management fees -- as low as possible during plan evaluation. Remember, employers have the greatest cost control over fund fees, so the selection of funds is a key component of any strategy aimed at keeping costs low.
5. Include future asset and participant growth projections in your TPC projections, because different fee types grow at varying rates.
Source: Hewitt Associates
The concerns that many plan sponsors have about switching to institutional funds are often overblown, according to Hess. "The idea that these funds require greater due diligence is more perception than reality," she notes. "Also, the hurdles for asset minimums are lower than many employers realize. We would hope to see even more growth in the institutional funds because the fees are so much lower."
Given the substantial cost reductions available through institutional funds, it's hard to explain why their growth has not been even more rapid. "Mutual funds are more profitable for plan providers, so they may be reluctant to have a conversation about institutional funds," Hess notes. "The employer may have to initiate the conversation by asking questions and pushing for answers." If an employer has a defined-benefit offering as well as a defined-contribution plan, switching to institutional funds can reduce fees for both. "Mutual funds will continue to perform well for smaller plans," adds Hess, "but larger plans will increasingly move toward institutional funds."
Communication is key. "Participants need to know that the move means savings for them," says Hess. "They may believe that if you are replacing a well-known fund with a no-name fund, there is some sort of take-away involved. The employer has to explain the lower fee and how it affects the participant's account balance. Often, the institutional fund is exactly the same fund with the same manager, but simply a different vehicle."
"Understanding total plan costs must also go beyond a simple interpretation of administrative and investment expenses," says Tal Diekvoss, midwest regional director of the private client wealth management practice at professional services firm BDO Seidman LLP in Chicago. "Plan sponsors need to have an intimate understanding of the amount of revenue sharing their plan is generating and how, if at all, this revenue is being utilized to reduce plan expenses."
Diekvoss advises plan sponsors to consider an independent fiduciary review of the plan that identifies total plan expenses, including investment fees, administrative fees and revenue-sharing allocations. It should also include an analysis of plan investment performance and the diversification of plan investment options. (According to the Profit Sharing/401(k) Council of America, the average 401(k) plan offers 18 investment options.) In addition, "the review should examine the plan's employee education procedures and provide a comprehensive review of the plan's investment policy statement," Diekvoss says. "This type of review will help plan sponsors maintain proper organization of the plan and will also demonstrate procedural prudence in the event that the plan is examined by a regulatory agency."
Weddell advises CFOs to make the administrative provider responsible for delivering all core services -- recordkeeping, participant communications, trustee services and access to investments -- so that one firm is responsible for any operational problems. This also tends to minimize trustee fees. He recommends that CFOs should reserve the flexibility to change investment funds, although the plan sponsor may need to tolerate some restrictions for smaller 401(k) offerings.
The cost evaluation is not complete when the fee negotiations are concluded. "A new service agreement should be reviewed carefully by the employer, the outside consultant and legal counsel to make sure that no hidden charges or uncompetitive provisions are included," Weddell says.