401k Plan Expenses: What You Don’t Know Could Hurt You

Western Pension & Benefits Spring Conference

May, 2005

Today’s Agenda

• Background & Perspective– Philosophy– ERISA & its fee-related requirements– The current marketplace

• The 401k Fee (Expense) Elements– Overview of revenue sharing– How plans get priced– Fee impact on participants

• What Plan Sponsors Can Do About Fees– Understanding & comparing fees– Communicating with your plan providers

Background & Perspective

• Philosophy - Product/Solution/Vendor Agnostic• Fact specific (plan sponsor needs analysis)

– Best “fit” – address current needs and objectives– Durable – can grow with the plan

• Analyze all appropriate solutions– Bundled or unbundled– Banks, insurance companies, investment companies

(mutual funds), independent TPA’s

• Look for net economic value (not simply “cheap”)

ERISA, Regulatory & Marketplace Background

What does ERISA require?

(a) Prudent man standard of care

(1) Subject to sections 1103 (c) and (d), 1342, and 1344 of this title, a fiduciary shall discharge his duties with respect to a plan solely in

the interest of the participants and beneficiaries and—

(A) for the exclusive purpose of:

(i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan;

Note - This doesn’t mean that you must buy the cheapest solution available, but it does mean that you need a rational process of evaluation.

“You should be aware that your employer also has a specific obligation to consider the fees and expenses paid by the plan…Among other things, this means that employers must: Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of service.”

The Department of Labor’s booklet: A look at 401(k) Plan Fees.

What does the DOL say?

Why is this an issue now?

…and the DOL, the SEC, other attorneys general, the plaintiff’s bar, the media, Social Security reform, etc.

This man…

Establishing a Prudent Process

“It’s not what you did, it’s how you did it”

“If you didn’t document it, you didn’t do it”

Process & Proof

Malone’s Laws of Plan Governance

Step 1

Step 2

Step 3

Step 4

Establish Procedures Analyze Fees

& Services Implement Strategy

Monitor &Measure

Establish a prudent process for the selection of investment options and service providers –clearly define the needs & objectives of the plan. Rank attributes in order of importance.

Analyze and benchmark fees and services to determine that overall costs are reasonable in light of the scope and quality.

Select investments that are prudent, appropriate and well diversified –find a provider that offers these

Implement standards, criteria and process for evaluating choices on an ongoing basis, in light of plan and marketplace changes

Refine

Steps in the Process

Suggestions for Sponsors

• Start with the IPS – Investment evaluation criteria

• Types of investment options (ETF, Mutual Fund, etc.)• Ranges of investment expenses

• Write down all of the plan needs & objectives– Must have versus nice to have– Rank by importance

• Rely on experts– Committee member experience– Outside expertise

• Independence & objectivity– Stress test this requirement– The potential “FFF” – Fiduciary Fatal Flaw

Cases on Fees

• No current 401k fee cases in litigation• First Union • Mehling v. New York Life Ins. Co., Civ. No. 99-CV-

5417 (E.D. Pa.)“…Plaintiffs’ central focus is the Defendants’ intentional and/or imprudent and disloyal failure to take advantage of the Plans' considerable bargaining clout to obtain low-cost, high-quality investment management services available through ‘direct’ or ‘separately managed account’ management (offered either by NYL's affiliates or managers unaffiliated with NYL) or other appropriately-priced investment vehicles, and instead to use the far more expensive NYL-proprietary mutual funds…”

Deconstructing Plan Revenues & Expenses

Are Plans Overpaying?

• Many are, a few aren’t, but most don’t know• Why aren’t companies more price aware?

– They’ve had no apparent reason to be• Most companies don’t pay for their plans explicitly• An estimated 85% of all 401k fees are paid by the plan

– Unlike pension plans• No financial statement incentive to scrutinize fees

• Most pricing is simple, but unclear– No common standards or benchmarks

• The 401k Averages Book• 401k Exchange• CFDD

– Revenue sharing has historically gone undisclosed

Core Elements of Plan Expense

15%5%

80%

Investment Management Recordkeeping & Administration Trust/Custody

Also - legal, audit fees, education & advice, investment consultant

Plan Expense = Mutual Fund Expense

• The key to understanding plan pricing is understanding mutual fund pricing– 80% of the overall plan expense– What makes sense and what doesn’t– Correlating cost and value

• Mutual fund expense information is publicly available, but not always easy to understand– Prospectus information

• Overall expense ratio• Read the footnotes

– Morningstar isn’t always right (e.g., asset allocation funds)• Revenue sharing payments & share classes

Median

75th (Fiduciary Threshold)

90th

25th

10th (Reported in bp)Cheapest

Most Expensive

Legend

.42

.80

1.23

1.82

2.11

Large-Cap Blend Mid-Cap Blend Small-Cap Blend

Large-Cap Value Large-Cap Growth Foreign Large

Blend

Intermediate F/I Short-term F/I REITs

.52

.97

1.33

1.95

2.21

.70

.98

1.32

1.90

2.32

.78

1.00

1.32

1.90

2.11

.84

1.11

1.47

2.02

2.35

.83

1.15

1.57

2.30

2.60

.49

.66

.88

1.34

1.75

.39

.55

.75

.97

1.50

.98

1.16

1.50

1.98

2.41

Source: CFS/Fi360 –

as of December 31, 2003

Mutual Fund Expense Ranges

Instrument Cost

Dollar-Weighted Average Expense

0.87%

0.88%

0.89%

0.90%

0.91%

0.92%

0.93%

20032004

Source: Morningstar

Economies of Scale?

99 basis points100 basis pointsExpense

Ratio

$22 billion$345 millionAssets

20041989

Fund: American Century Ultra (TWCUX) Source: Morningstar

Average Expense Comparison

.45%1.62%146Real Estate

.37%1.08%738Intermediate Bond

.33%1.48%357Small Blend

.39%1.70%390Foreign Large Blend

.39%1.25%1216Large Blend

Average 12b-1 Fee

Average Expense Ratio

Total Number of Funds

Category

Source: Morningstar Principia 12-31-2004

What is Revenue Sharing?

• Revenue Sharing – Generally– The transfer of asset-based compensation from investment

management providers to other plan providers• Advantages

– Create price flexibility– Compares favorably with other provider arrangements

• Disadvantages– Can obscure objectivity in fund selection– Often difficult to account for accurately– Results in disproportionate cost allocation

Types of Revenue Sharing

• Finders Fees– Paid on new money contributed to the plan– Up to 100 basis points (1%)– Significant in first year of plan due to rollover

• 12(b) -1 Fees– Available on many funds– Ranges from .25% to 1.0%

• Sub Transfer Agent Fees (Sub TA)– Shareholder service payments– Payments to recordkeepers/TPA’s– Up to 65 bps or $19 per participant

• Share class differences

Share Class Comparison (American Funds Euro Pac)

.92%.22%.25%F

1.70%.25%1.00%C

1.62%.17%1.00%B

.87%.17%*.25%A

Total Operating Expense Ratio

Other Expenses12b-1 FeeShare Class

Source: Morningstar Principia 12-31-2004 Total Management Fee (all classes): .45%

*American Funds still pays Sub TA fees of $12/participant to the TPA for grandfathered plans

Share Class Comparison (American Funds Euro Pac)

.61%.05%0%R5

.92%.10%.25%R4

1.29%.15%.50%R3

1.67%.25%.75%R2

1.71%.10%1.00%R1

Total Operating Expense Ratio

Sub TA Fees12b-1 FeeShare Class

Source: Morningstar Principia 12-31-2004 Total Management Fee (all classes): .45%

Impact on Participant

$2,461$270,714R5

$2,367$260,396R4

$2,277$250,493R3

$2,191$240,987R2

$2,108$231,863R1

Monthly Retirement

Benefit

Lump Sum Amount

Share Class

$50,000 a/c; $3,000 yearly contribution; 6% gross return; 20 year projection; SLA at 65

Plan Level Pricing

Bundled Provider Pricing

• All bundled providers have an internal pricing algorithm for 401k plans

• Competitive goal - “price” a plan so that all needed costs are covered by investment fund revenue– These include both direct (OER) and indirect (partner fund

payments) investment revenues– Ad hoc costs may be an exception (loans, distributions,

brokerage accounts, QDRO’s, etc.) • participant paid fees

• Hard dollar fees are added when investment revenues are insufficient to cover costs

Factors Influencing Price

• Investment Fund Options– Investment managers and share classes

• Proprietary (managed internally by the provider)• “Partner” funds• Outside funds (example, Vanguard)

• Average Participant Account Balance• Total Assets & Net Cash Flow• Case Complexity

– Plan document, distinct payrolls, contribution formulae

• Education and Delivery– Locations, non-English, materials

Revenues & Expenses

• The Services (expenses)– Enrollment & education

materials & meetings– Daily Recordkeeping– Administration &

compliance– Web services & call center– Trading & execution– Distributions & reporting– Amortization of fixed costs– Profit Margin

• Expense = $175/particpant

• The Revenue– Average $43,750 account

balance– Average margin on

investment management = 40 bps (.40%)

• $43,750 times .40% = $175/participant

Impact on Participants

• Participant with more than $43,750 in their accounts subsidize those with less than $43,750

• Example: high account balance– $300,000 account times 40bps (.40%)– Revenue generated = $1,200– Excess revenue over cost $1,025 ($1,200 minus $175)

• Example: low account balance– $20,000 account times 40bps (.40%)– Revenue generated = $80– Deficit revenue against cost $95 ($80 minus $175)

Measuring & Benchmarking

Plan Sponsor

Trustees

Record Keeping

Administration Directed Trustee

Custody

Consultant

Investment Options

Bundled Vendor

Participant Education

Fees likely to be paid direct from plan assets

Fees likely to be paid indirectly from plan assets

oror

Bundled Structure

Plan Sponsor

Trustees

Record Keeping

Administration Directed Trustee

Custody

Consultant

Investment Options

Bundled Vendor

Participant Education

Fees likely to be paid direct from plan assets

Fees likely to be paid indirectly from plan assets

oror

Unbundling Fees

Cost of fund options plus

3 bps up to 12 bps

$1500 to $7500 per year

$25 to $125 per head plus

$1500 per day plus costs

Bps charge or flat $ per qtr.

35 bps up to 200 bps $1500 to $7500

Case Study

• Bundled Solution with MFS• Approximately $20 million total assets• Approximately 400 participants• Broker sold and maintained

Current Provider

Asset Class Incumbent Manager Ticker AssetsAllocation

PercentageExpense

Ratio Amount 12b-1 12b-1 $ Sub-TA Sub-TA $Large Cap MFS Mass Investors Trust R2 MIRTX $1,153,125 6.00% 1.34% $15,452 0.50% $5,766 0.25% $2,883

First American Equity Index A FAEIX $1,345,312 7.00% 0.62% $8,341 0.25% $3,363 0.00% $0

Mid/Small Cap MFS New Discovery R2 MNDRX $576,562 3.00% 1.81% $10,436 0.50% $2,883 0.25% $1,441MFS MidCap Growth R2 MCPRX $384,375 2.00% 1.76% $6,765 0.50% $1,922 0.25% $961

International MFS Global Equity R2 MEQRX $768,750 4.00% 2.00% $15,375 0.50% $3,844 0.25% $1,922MFS Research International R2 MRSRX $576,562 3.00% 2.05% $11,820 0.50% $2,883 0.25% $1,441

Real Estate Scudder RREEF RRRRX $576,562 3.00% 1.25% $7,207 0.47% $2,710 0.25% $1,441

Bonds MFS Bond R2 MBRRX $960,937 5.00% 1.30% $12,492 0.50% $4,805 0.25% $2,402MFS Research Bond A MRBFX $960,937 5.00% 1.30% $12,492 0.35% $3,363 0.25% $2,402

Stable Value Gartmore Morley Stable Return N/A $2,306,249 12.00% 0.75% $17,297 0.25% $5,766 0.00% $0

Asset Allocation MFS Conservative Allocation R2 MCARX $960,937 5.00% 1.50% $14,414 0.50% $4,805 0.25% $2,402MFS Moderate Allocation R2 MARRX $2,882,812 15.00% 1.63% $46,990 0.50% $14,414 0.25% $7,207MFS Aggresive Allocation R2 FFFEX $3,843,749 20.00% 1.78% $68,419 0.50% $19,219 0.25% $9,609MFS Aggressive Growth R2 MAWAX $1,921,874 10.00% 1.88% $36,131 0.50% $9,609 0.25% $4,805

TOTAL $19,218,744 100% 1.31% $283,630 $85,350 $38,918Recordkeeping & TrustPer Head Recordkeeping $0.00 $0

Trust, Custody, Trade Platform 0.00% $0Administration & Compliance $0 $0

Employee Education 0.00% $0Total $0

438 Participants

Comparative Solution

Asset Class Possible Manager Ticker AssetsAllocation

PercentageExpense

Ratio Amount 12b-1 12b-1 $ Sub-TA Sub-TA $Large Cap Vanguard S&P 500 Index VFIAX $1,153,125 6.00% 0.12% $1,384

American Funds ICA R5 RICFX $1,345,312 7.00% 0.36%

Mid/Small Cap DFA US Small Cap Portfolio DFSTX $576,562 3.00% 0.42% $2,422Harbor Small Cap Growth HRSGX $384,375 2.00% 1.08% $4,151 0.25% $961

International American Funds EuroPacific R5 RERFX $768,750 4.00% 0.61% $4,689 0.05% $384Thornburg International Value TGVIX $576,562 3.00% 0.99% $5,708

Real Estate Morgan Stanley Instl US RE MSUSX $576,562 3.00% 1.00% $5,766

Bonds Vanguard Total Bond VBTIX $960,937 5.00% 0.10% $961PIMCO Total Return PTTRX $960,937 5.00% 0.68% $6,534 0.25% $2,402

Stable Value Gartmore Morley Stable Value n/a $2,306,249 12.00% 0.50% $11,531

Asset Allocation Conservative n/a $960,937 5.00% 0.45% $4,324Moderate n/a $2,882,812 15.00% 0.47% $13,549Aggressive n/a $3,843,749 20.00% 0.50% $19,219Maximum Growth n/a $1,921,874 10.00% 0.53% $10,186

TOTAL $19,218,744 100% 0.49% $90,424 $3,363 $384Recordkeeping & TrustPer Head Recordkeeping $45.00 $19,710

Trust, Custody, Trade Platform 0.075% $14,414Administration & Compliance $4,500 $4,500

Employee Education $1500 per day $7,500Total $46,124

438 Participants

Overall Comparison

% % %1.48% 0.47%0.00% 0.075%0.00% 0.10%0.00% 0.02%

-0.02%0.04%0.20%

1.48% 0.65% 40%

438$19,218,744

Average Balance $43,878

$390.95

Employee Education

($256.60)$171,238

$19,710$4,500

Per Head RecordkeepingAdministration & Compliance

$100

3 years

Participants

3 yearsAssets$19.95

$20 per participant/yr$75

Loan Processing - Annual Maintenance $25 $0$75 (per loan)

$25$5 after initial enrollment

$50$120

$$193,206($14,414)

$112,392

($19,710)($4,500)

($3,748)

($38,437)

$3,748

$24.95

$647.56

$150 (one-time)

$70

$50

$75included

included

SDA - Online Cost per TradeFee Guarantee

QDRO ProcessingSDA - SetupSDA - Annual Participant Charge

included$75

Online Advice Hardship Withdrawal Processing

Annual recurring costs $$90,424$14,414

$$283,630Investment Management

Trust, Custody & Trade Platform

Less Revenue Share Recapture

Distributions (of any kind)Enrollment Kits

Loan Processing - Setup

Investment Consultant (RIA)Total Recurring CostPer Participant

Plan Conversion $0 $5,000

$283,630

Non-recurring (ad hoc) costs

$38,437

Net Savings

$0

$7,500 ($7,500)

$0$0

Current Provider Benchmarked Solution

Points from the Study

• Deconstructing plan expense elements can result in savings– Asset based savings increase over time, grow each year

• This may allow for a more equitable distribution of fees to participants– All employees pay $45 annual administrative costs– Investment costs are same % for all

• This is not a case for unbundled versus bundled– Importance of service and investment comparisons– Qualitative, not just quantitative

• Know what you’re paying– Request full disclosure

• Must be able to identify the significant fee elements• Don’t necessarily need to know how internal costs are allocated

– “The finders fee was there for you to find”• Avoid conflicts in evaluating fees

– Who is analyzing and do they have a stake in the outcome?• Benchmark plan fees

– Reasonable cost versus comparable cost• Be prepared to act

– Failure to act on a report could lead to trouble

What can Plan Sponsors do?

What can Plan Sponsors do?

• Best benchmarking may be an RFP• Look at the 3-year rule

– Amortized start-up costs– Plan growth

• Participant communication issues– Gross versus net pricing– Line item expenses

• $10 versus 40bps

• Rich plan - Poor plan– “demographically rich”– $35,000 average account balance?

• At 40 bps this is $140 per participant

Other Tools for Sponsors

• Fee disclosure worksheets– http://www.dol.gov/ebsa/pdf/401kfefm.pdf– www.psca.org

• Articles & guides– http://www.401khelpcenter.com/401k/uncovering_hidden

_fees.html– McHenry Consulting Group – Revenue Sharing Report

Thank You