Unearthing the real costs of 401(k) plans
Remember the six blind men who traveled to meet an elephant? Using their incomplete powers of observation, each firmly declared his own conclusion -- that the elephant was like a wall, a spear, a snake, a tree, a fan or a rope. None captured the true nature of the beast.
In the world of 401(k) plan costs, a similar principle applies: By using a narrow perspective to look at only one facet of a plan, an employer can easily miss the big picture - and may suffer potentially severe consequences for that ignorance.
The scandals and investigations sweeping the mutual-fund industry have made headlines. Recent actions by the Securities and Exchange Commission and New York Attorney General Eliot Spitzer have shed light on the methods by which certain investment companies have benefited themselves and a few select customers at the expense of the vast majority of Americans who invest in mutual funds through their employer-sponsored retirement plans. Similar concerns apply to 403(b) retirement plans sponsored by educational and certain not-for-profit organizations.
What's not well-known, however, is the potential liability that employers -- and the individuals who choose and administer 401(k) and 403(b) plans -- may bear for failing to conduct their own due diligence on the incomprehensible and perhaps inflated fees that their plans have been paying.
The U.S. Department of Labor, which audits 401(k) and some 403(b) plans for compliance with ERISA regulations, has stepped up enforcement since the Enron scandal, says Theresa Mazzullo, principal with EPIC Advisors, Inc. Any fiduciary of a 401(k) plan may be forced to reimburse plan participants for losses stemming from the inclusion of too-costly funds in the plan, Mazzullo says.
And that's not all. Plan participants may sue sponsors whose fund choices for 401(k) or 403(b) offerings are deemed too expensive. Robert Newton, sales consultant at EPIC, points out that anyone named as a plan trustee or viewed as "in charge" of an organization's retirement plan -- be it the owner, CFO, executive director, HR administrator or not-for-profit board member -- may be held personally liable in a lawsuit filed by plan participants.
The whole truth of plan fees
Given the risks, why would a plan sponsor choose funds with high fees?
- The sponsor doesn't comprehend the extent of the fees.
Ask an employer what his or her company's 401(k) plan costs, and many will say "peanuts" or "chump change" Mazzullo and Newton say. That would be accurate only if one considers $250,000 in annual costs on a $10 million plan insignificant. On average, Mazzullo and Newton estimate, employers are paying 2.5 percent to 4 percent of plan assets yearly - whether in direct, stated payments or in asset erosion, as fees are netted from investment funds. Reduce those fees, and investors enjoy higher earnings -- or, in tough times, smaller losses.
Recent surveys bear out Mazzullo and Newton's observations: Few plan sponsors truly understand what their 401(k)s or 403(b)s cost. Given the publicity around mutual-fund fees, Newton says, more employers are starting to pay attention to stated expense ratios -- but few read, calculate and fully understand the dense, obscure sections in a prospectus that describe the ways in which fees are computed. The internal fees paid for frequent buying and selling - an important factor when one realizes that a fund might turn over 400 percent in a year, Newton adds - is just one of many ways that a portfolio's assets can be quietly whittled without attracting attention.
Plan sponsors often remain in the dark - or in denial -- for several reasons. An employer who has a longtime, trusting relationship with a broker or financial adviser may be relying too heavily on this adviser and not asking tough questions regarding costs. Further, investment fees are not the only costs involved. Plan administration, recordkeeping, documentation, compliance and legal counsel all add up - and must be considered, Mazzullo and Newton say.
- The plan sponsor accepts high fees as a necessary cost of providing a retirement plan and may be unaware of low-cost options.
Some plan sponsors assume that, because they've chosen well-known funds or a big-name investment house, they're getting the going rate on investment services. Funds with "stellar" performance ratings, however, often involve so many fees that they end up costing participants much more than their less-hyped counterparts.
Another erroneous assumption is that plans with less than $10 million are stuck with high-cost funds. Newton says that sponsors of small plans can buy some of the lowest-cost Vanguard and Fidelity funds if they shop around for the few channels that offer them.
Further, some not-for-profit organizations that are eligible to participate in the TIAA-CREF system may not be taking full advantage, says Allen Williams, individual consultant at TIAA-CREF in Rochester. The full array of low-expense TIAA-CREF funds and retirement services are available to educational, research, medical and some other not-for-profit institutions. (TIAA-CREF is the acronym for Teachers Insurance and Annuity Association - College Retirement Equities Fund.)
- The plan sponsor is unaware of the consequences of failing to conduct due diligence on plan costs.
Business owners are busy people and, lacking an easy solution and perhaps unaware of the potential consequences, they may avoid or postpone the time-consuming task of deciphering the legalese and running complex calculations or finding an objective adviser who can do it.
Newton and Mazzullo predict that may change once Labor Department enforcement efforts begin making more impact. Further, Williams expects that public pressure and greater awareness will spur more employers to ask more of the right questions and shop for lower-cost options.
Despite the daunting nature of the task, it's becoming increasingly clear that pleading ignorance will not be a successful defense.
What's an employer to do?
- Educate yourself.
First, recognize that excessive fund fees are your problem because, as fiduciary of a 401(k) or 403(b) plan, you have a legal obligation to conduct regular due diligence to protect plan participants' best interests.
Second, understand that investment fees are only part of the picture. Gather data on all the costs that your plan incurs before making fully informed decisions.
- Find an independent analyst, or analyze the costs on your own.
Engaging a skilled, independent professional to analyze your 401(k) or 403(b) plan is easier said than done. Most advisers - whether lawyers, brokers or accountants - know their own areas well but cannot be expected to advise on the whole picture. A good plan analyst is one who can look at all of your costs and highlight areas where fees exceed a benchmark and probably can be trimmed.
What constitutes a reasonable benchmark? Mazzullo and Newton suggest that a large plan aim to pay about 1 percent in total fees. A plan holding less than $10 million in assets might target 1.5 percent to 2 percent.
- Insist that your investment company lower its fees and disclose them clearly.
The longer that plan sponsors remain uninformed, the easier it will be for investment companies to use creative disclosure to disguise fee structures. As plan sponsors start asking better questions and taking their business elsewhere, high-cost funds may be forced to change.
Newton suggests visiting www.Personalfund.com to arm yourself with information. For a fee, the site will calculate all expenses and will illustrate the impact of those costs on the growth of a given investment.
Sponsors of small plans may believe they have limited ability to negotiate reduced fees. But knowing the facts and insisting on transparency may achieve some results. For one thing, the Labor Department will look favorably on documented efforts to reduce plan costs. Further, compounding the pressure being applied by Spitzer and the SEC may accelerate needed changes.
- Shop for plans based on low-fee funds.
Sponsors, especially of small plans, are advised to reject misconceptions and to shop for opportunities to buy inexpensive funds such those offered by Vanguard, Fidelity and, if eligible, TIAA-CREF. In order to maintain their low-cost structures, some of the best funds eschew large ad campaigns; a plan sponsor therefore must conduct more research in order to find them.
Conclusion
Being a responsible employer has never been easy, and the shifting regulatory landscape seems to make it more difficult all the time. Given the popularity of tax-deferred retirement plans as an employee benefit and an indispensable way to encourage savings, however, employers are encouraged to continue providing them.
But employers and certain employees must take the fiduciary responsibility seriously. Rather than wait for a Labor Department action or an employee lawsuit, employers and not-for-profit directors are encouraged to begin now to unearth the true costs of their 401(k) and 403(b) plans and take steps to trim expenses.
