Over the past several years the defined contribution plan community has focused on many things, but no topic has received as much attention as fees. The fees assessed for defined contribution plan services have captured the attention of plan sponsors, investment consultants, ERISA Counsel, and the media. Recent headlines have claimed that defined contribution plan participants have paid tens of thousands of dollars in fees during the span of their careers resulting in lost retirement income and additional years in the workforce. While those numbers may be slightly exaggerated, plan sponsors cannot ignore the mechanics and implications of how their defined contribution plan fees are paid.
The Evolution of Fee Analysis: Fee Leveling
The Department of Labor’s recent 408(b)(2) regulation requiring service providers of ERISA retirement plans to disclose to plan sponsors all direct and indirect compensation they receive for services has sparked an unprecedented number of fee benchmarking projects and requests for proposals (RFPs) to determine the reasonableness of plan fees. Such analyses have resulted in lower cost structures for many plans. While such outcomes are indeed favorable, they do not necessarily represent the end of the line when it comes to fee examination.
What are the implications of the fee structure itself? Are all participants paying an equal share? In an effort to further increase fee transparency, many plan sponsors are interested in examining how fees are characterized, and in turn, how they are actually allocated among the participant population.
While the Department of Labor has not given guidance on a prescribed method for allocating fees across participants, it is important to note that it is a plan sponsor’s fiduciary responsibility to be aware of plan fees and how they are allocated. Although it has yet to be tested in a court of law, several experts believe that “fee oversight” including the allocation of plan fees could represent the next wave of lawsuits to affect the defined contribution marketplace – perhaps not a far-fetched conclusion considering the recent fee regulations.
The purpose of this paper is to inform defined contribution plan sponsors about the different fee structures available for plan servicing, and their implications from a participant perspective. The concept of fee leveling will be introduced and discussed – how it can be applied, its challenges, as well as some of the advantages and disadvantages of its implementation.
Defined Contribution Plan Fees – Yesterday and Today
Defined contribution plans have become the main retirement savings vehicle for Americans today. However, in their infancy, defined contribution plans were meant to supplement a person’s retirement income. Defined benefit plans were more commonly the primary source of retirement income, that is, until the late eighties and early nineties, when a fundamental transition began. Defined contribution plan implementation increased dramatically (especially of the 401(k) variety) verses that of defined benefit plans as plan sponsors recognized the advantages of offering a defined contribution plan benefit. In turn, defined contribution assets grew precipitously, more than quadrupling from 1990 to the end of that decade.
The fee structure of early defined contribution plans was fairly straightforward and exemplified the concept of an equitable fee distribution. The plan sponsor would either pay for the plan administration costs or they would pass them along to the participants in the form of hard-dollar fees, paid quarterly. Investment management fees were asset-based charges embedded in the return of an investment vehicle and therefore assumed by the participant. Fee leveling was not a necessary discussion.
Mutual Funds, Revenue Sharing and Effects on Plan Fees
The growth in defined contribution plans fueled the growth of the mutual fund industry, with mutual funds garnering the majority of defined contribution assets. Unlike separate accounts and collective trusts, mutual funds were able to suit the increasing demands of plan sponsors, which included the ability to provide daily valuations. Mutual fund companies were also able to provide something more – a bundled service arrangement, a “one-stop shop” for both investment management and recordkeeping services. In the early days of bundled service arrangements, each mutual fund company offered its own suite of proprietary funds for their clients’ investment menus. Over time, the offering of only proprietary funds became unpopular, as “best-in-class” options could not be achieved in all asset categories through one mutual fund company. That said, mutual fund companies began to offer non-proprietary options in addition to their own fund offerings within the context of the bundled arrangement.
Commensurate with this trend, mutual fund companies started approaching plan sponsors to offer a deal they would find hard to refuse – bundled services for free. The mutual fund company would provide the investment management of the assets via proprietary and non-proprietary products as well as the plan recordkeeping for little or no additional cost to the plan sponsor. However, what was perhaps not clear to plan sponsors at the time was that their mutual fund service providers had existing arrangements with other mutual fund companies which supplied them with additional compensation in the form of revenue sharing.
Most mutual funds are available in several share classes based on plan asset thresholds or other criteria. An agreement may exist in which an investment manager pays a portion of the expense ratio to a recordkeeper. That portion of the expense ratio – revenue sharing – is used to help offset the cost of the administrative services which would otherwise be charged directly to the plan and/or participants in the form of a hard-dollar fee. The investment manager’s payment to the recordkeeper helps cover the costs of recordkeeping multiple participant accounts while the investment manager services one large account. Revenue sharing payments may vary by fund family, share class and recordkeeper according to the agreements in place, which can create imbalances in the amount one fund contributes to the recordkeeper versus another.
The most common fee structure, especially among small to mid-sized plans, continues to be one in which participants pay for plan costs through the expense ratios of the funds offered in the plan. Plan sponsors have been able to affect the plan fees by using a variety of share classes, potentially avoiding any out-of-pocket hard dollar costs. Generally speaking, the share classes offering the higher revenue sharing can aid in offsetting hard dollar costs to a greater degree. However, participants pick up the tab through the higher expense ratios associated with those products.
In light of the new 408(b)(2) plan sponsor and 404(a)(5) participant disclosures, many plan sponsors are challenging themselves to consider new and perhaps more equitable fee designs to characterize their plan administrative and recordkeeping costs. When a plan sponsor is educated about how certain funds subsidize other funds, or that those participants with larger account balances may be subsidizing smaller account balances, it begs the question as to whether or not the existing fee structure is fair.
The basic functions of recordkeeping (account maintenance, statements, call centers, website, etc.) are the same whether a participant has a $1,000 account or $1 million account. However, as it stands today in most defined contribution plans, a participant’s share of the plan administrative and recordkeeping costs is dependent on the investment strategies they choose within the plan as well as the size of their account balance. There are instances in which participants do not contribute to the plan costs when they are invested in strategies that do not participate in revenue sharing (commonly index funds, company stock, or brokerage accounts). Conversely, there are instances in which participants (most commonly with high account balances) are contributing many times over their share of the plan recordkeeping costs.
Exhibit 1.a and Exhibit 1.b are illustrations of two participants at different account accumulation points. Participant 1 (P1) is invested in a mutual fund that provides little revenue sharing offset to defray the recordkeeping cost. Participant 2 (P2) is invested in a different mutual fund that provides a much greater revenue sharing offset to the recordkeeper. Exhibit 1.a represents participant 1 and 2’s share of the recordkeeping cost as a percent of assets. While the percent of assets contribution to recordkeeping costs remains constant throughout the accumulation phases, Exhibit 1.b represents participant 1 and 2’s share of the recordkeeping cost translated into dollars, which increases exponentially as the account value grows.
Exhibit 1.a – Typical fee allocation today
Exhibit 1.b – Typical fee allocation today
Most participants are unaware of the fact that they may be paying more or less than their fair share to participate in their employer’s defined contribution plan. Unless an individual has served on a retirement plan committee, it is highly unlikely that he or she is aware of the composition of a mutual fund expense ratio. The expense ratio is the percent fee assessed on the assets invested in a fund. The components of an expense ratio in their simplest form are the investment management fee and the revenue sharing offset. Rationally speaking, the investment management fee should be identical for every share class of the same fund and often, but not always, is. Conversely, the revenue sharing component should differ for every share class of the same fund to allow the plan sponsor to offset the recordkeeping costs to the extent possible.
Sample Mutual Funds 1 and 2 in Exhibit 2.a illustrate this scenario. However, Sample Mutual Fund 3 in Exhibit 2.a reflects a scenario in which the investment management fee varies from one share class to the next. To add an additional layer of complexity, this example also illustrates that the revenue sharing component can vary from one recordkeeper to the next for the very same mutual fund.
Fee leveling refers to a more equitable allocation of a defined contribution plan’s administrative and recordkeeping costs. It can take one of two forms, pro rata, in which a proportionate share of the costs is allocated based on a participant’s account balance, or per capita, in which each participant bears an equal share of the costs without consideration of account size. Each can significantly impact fees borne by plan participants. Not surprisingly, plan committee discussions regarding these two fee leveling options often take on a political undertone.
The pro rata method treats fee leveling in a manner most similar to how fees are allocated in most defined contribution plans today. In the percent-based, equal revenue sharing example shown in Exhibit 3.a, each participant is proportionately contributing 0.20%, or 20 basis points, of his/her account balance to offset the plan’s administrative and recordkeeping expenses. However, the translation into dollar-terms (Exhibit 3.b) paints quite a different picture. Higher account balance participants contribute a greater total dollar amount of the annual administrative and recordkeeping expenses. Nevertheless, pro rata fee leveling has been considered an effective method, based on the premise that participants will benefit from contributing a smaller dollar-based amount early in their career and will make up the difference as their account balance grows over their career.
Exhibit 3.a – Pro Rata Method
Exhibit 3.b – Pro Rata Method
The per capita method of fee leveling reverts back to how fees were assessed in the early days of defined contribution plans. As illustrated in Exhibit 4.a., each participant is assessed an equal dollar-based fee regardless of the size of his/her account balance. However, as a percent of their account balance (Exhibit 4.b), participants with the smallest account balances are adversely impacted. This often raises concern among plan sponsors, as plan participation could suffer if the fees are considered prohibitive by the participants who are not able or willing to contribute a greater amount toward their retirement – commonly, younger employees who have just entered the workforce and are in the early stages of contributing to their retirement. Similar to the pro rata rationalization, it is thought that the effect of a dollar-based flat fee will balance out over the time horizon of an individual’s career.
Exhibit 4.a – Per Capita Method
Exhibit 4.b – Per Capita Method
Actionable Avenues for Fee Leveling
Defined contribution plan committees must understand their respective plan’s fee structure and its impact on plan participants. A fee leveling exercise is the first step to increase the plan sponsor’s awareness about who in the plan is paying for the services all participants receive. Once the findings have been prudently reviewed, the committee members should thoughtfully discuss their philosophy regarding the allocation of fees.
There is no one “correct” way to implement fee leveling, and in many cases, execution is not perfect. Plan committees should consider alternate fee methodologies, with that philosophy in mind, carefully weighing the options and potential outcomes and document their decisions. One approach is a transition from the most expensive funds to less expensive share classes, reducing the range of any inequality. In an effort to maximize transparency, some plan committees have transitioned into the lowest cost share classes for all funds offered, eliminating revenue sharing to the greatest extent possible. In such cases, participants are then charged an annual administration fee to make up the shortfall to the recordkeeper. Moving in this direction is one step closer to equalizing plan fees.
For the most part, larger defined contribution plans have been able to avoid these complexities because their asset size allows them to offer less expensive collective trusts or separate accounts within their plans. There is no revenue sharing associated with these investment products. That said, a flat hard dollar participant charge is often the more common fee design in these plans.
Mutual fund companies are recognizing an increased interest in fund share classes which eliminate the revenue sharing component entirely. In the last few years, an increasing number of mutual fund companies have launched new share classes to meet this demand. We anticipate that this trend will continue.
One other approach to fee leveling which is still in its infancy is to have the recordkeeper either “wrap”, or assess an asset-based fee on a fund- by- fund level, or credit part of the fee back to the participant. To explain, assume a plan sponsor chooses a basis point fee structure with the recordkeeper, with a basis point requirement of 0.20%, or 20 basis points. Any investment option offering revenue sharing less than 20 basis points would have an additional fee “wrapped” to the existing expense ratio to bring the total revenue sharing to 20 basis points. Investment options that generate more than 20 basis points would be credited back the difference. While this approach is not widely available at this time, there are some recordkeepers in the process of enhancing their systems to offer this service.
Careful consideration is necessary, as the service may involve additional fees. As one would imagine, communicating the mechanics of this method to plan participants creates an additional layer of complexity. Of particular issue is the timing of the fee assessment or credit. Quarter-end balances are typically used to determine which participants are assessed a credit or a debit to their accounts.Opportunistic participants could trade in and out of certain funds to gain unfair advantages. Given such possibilities, those recordkeepers currently providing the service are working to fine tune their capabilities so that such activities are not permitted. Soon, some may be able to apply the wrap or the credit on a daily basis, mitigating the participant timing issue.
On a final note, company stock offered within in a defined contribution plan poses its own unique challenges, which is many times exacerbated by the fact that it is often one of the plan’s largest holdings. As an investment option that in most cases does not contribute to the administrative and recordkeeping costs, but is factored into the pricing of the plan, management frequently struggles with the concept of a fee associated with company stock. The discussion is primarily around the competing goals of encouraging company ownership and finding an equitable way to share the administrative and recordkeeping costs.
There is no doubt that defined contribution plan fees have received unprecedented attention over the past few years. In light of several high profile class action lawsuits surrounding excessive fees and revenue sharing agreements, plan sponsors have become especially aware of their fiduciary responsibilities and exposure. The lack of fee transparency within the bundled service model has garnered the attention of the Department of Labor and other government agencies as well. Such entities have been demanding greater fiduciary accountability and disclosure for years. New regulations that took effect last year reflect the culmination of these efforts.
Many plan sponsors may not fully understand the fiduciary risks in the current legal and regulatory environment, but they cannot avoid the issues concerning the fees paid by their plan participants. We encourage all plan fiduciaries to look closely not only at the fees paid on an aggregate level, but also at the participant level to determine reasonableness.