An industrious Gen Yer a few years out of college was excited about her new job at a fast-growing tech start-up. And to make the position even more attractive, her employer promised a 401(k) retirement plan with a company match. Looking to sign up for a couple of inexpensive index fund options, the new employee was confronted with a menu of 17 mutual funds from a single asset manager. They were all actively managed, with the exception of a money market fund, and laden with management fees that ranged from 1.5 percent to 1.85 percent; additional fund fees were not clearly stated.
An aberration? Retirement plan advisers think not.
When it comes to the 401(k) plans of companies with fewer than 200 employees, “the plan is structured for the sponsor, not the participants,” says Brett Goldstein, director of retirement planning at American Investment Planners in Jericho, New York. High-fee plans with no index funds are also structured for the brokerage firm whose revenues are derived from them. “The problem is, the owner is relying on a broker to pick funds from a universe of 100 funds, and he might not have the same objective as the owner,” notes Reed Fraasa, a managing director at Highland Financial Advisors in Riverdale, New Jersey.
The fee burden — and accompanying questions about plan choices — that thousands of employees take on when they are encouraged to defer part of their salary into company-offered retirement plans is not likely to go away any time soon. But it’s not just employees who are feeling in the dark. According to an April 2012 report by the U.S. Government Accountability Office in Washington, nearly 90 percent of employers surveyed either had not assessed their plan fees using Department of Labor resources or did not know their fee levels. Plan costs encompass charges for investment management, advisory expenses, recordkeeping, communications and marketing.
The impact of fees on long-term savings has been well documented. In a simple GAO example (see chart), a 45-year-old employee has $20,000 in a 401(k) account. If the investment earns 7 percent annually and the plan charges 0.5 percent in fees, the return is reduced to 6.5 percent and the investment is worth $70,500 after 20 years. But with the same gross rate of return and if annual fees are 1.5 percent, the average net return is reduced to 5.5 percent. After 20 years, the account that opened with $20,000 has $58,400. That extra 1 percent in fees means a 17 percent lower account balance.
This is not how things were supposed to be after the DoL brought out its fee disclosure regulation, effective July 1, 2012, following years of criticism about high fees from a range of stakeholders, including investor groups and the GAO. This latest regulation is likely to be just another step on the long journey to a rationalized retirement income system in the U.S., which dates back to the Employee Retirement Income Security Act of 1974. The new rules, which will be enforced by the DoL’s Employee Benefits Security Administration, require plan fiduciaries to ensure that fees are “reasonable.”
Louis Harvey, founder, president and CEO of Dalbar, a financial services research and consulting firm headquartered in Boston, spends a lot of time evaluating the reasonableness of defined contribution plans for employers. He has seen disclosure documents prepared by plan vendors of as many as 300 pages, filled with unnecessary costs such as checkbook covers. “What they’re delivering is useless,” he says. According to Harvey, the DoL indicated it would give employers time to get used to the new regulations before the department would enforce them in full. “[Plan vendors] thought they could get away with murder,” says Harvey, who has been vetting advisers and brokers since he launched Dalbar in 1976.
Small employers, including many start-ups, are more likely than larger companies to have high-fee 401(k) plans. They lack the scale to access big, lower-cost, pooled accounts. In addition, smaller plans are often sold by stockbrokers who are held to a different standard of care, says Winfield Evens, director of outsourcing investment strategy for Aon Hewitt in Lincolnshire, Illinois. For them, “good enough is ‘standard versus best,’” he adds.
The DoL has been working on the standard-of-care issue for years and has finally gotten closer to a ruling on who can be considered a plan fiduciary with prudence and loyalty obligations, says a department official who requested anonymity. Employers have tended to trust plan vendors as if they were fiduciaries. But if they are not fiduciaries — and stockbrokers still are not — as plan providers they are able to act first in their own financial interest when selling products. This concern has been one of the financial industry’s most contentious issues and its resolution is of the highest importance to the DoL, notes the official. The department is also working on creating a guide that small employers can use when working with brokers to evaluate fees and indirect charges in defined contribution plans.
It has been only 18 months since fee disclosure was formalized, but there have been some signs of change. Oppenheimer Funds, for example, has created “I shares,” or institutional shares, geared toward retirement plans. (Other fund companies call them R6 shares.) I shares have no 12b-1 marketing fees and an expense ratio of 0.50 percent. “Many plan sponsors don’t know what 180 basis points means,” says Kathleen Beichert, director of retirement marketing at Oppenheimer in New York. To comply with the fee disclosure rule, her group works with plan sponsors and advisers to benchmark plans for fee comparison. Noting the problem with high fees in legacy plans, Beichert says that industry consolidation among retirement specialist advisors is moving fees in the right direction.
Although Dalbar’s Harvey acknowledges the creation of low-cost plans for small employers, the trouble is that the plans are bought, not sold, he says, meaning that an employer has to know enough to ask for the lower-cost plan. Even in the large-plan market things aren’t entirely sanguine. “I keep coming across plans with 1,000 people who are not getting a good deal,” notes Aon Hewitt’s Evens. They tend to still be using mutual funds and could be better negotiated.
Chip Castille, head of BlackRock’s U.S. retirement group in New York, is looking for competition among plan advisers to bring fees down for smaller plans. The firm, the world’s largest asset manager, does not offer plans directly to employers, preferring to go through advisers. “The big wave we’ve seen set up by fee disclosure will reach the small end of the market last,” says Castille. “We’re putting our bets there.”
There’s nothing preventing the evolution of the overall defined contributions model from a supplemental savings plan to something else, Evens observes. The wheel is turning, he says, and every once in a while, “there’s a French Revolution.” The retirement industry will get there, he adds, through steps like fee disclosure.
