Defined Contributions Insights MagazineJuly/August 2008
Defined Contribution Fees: Considerations for Plan Sponsors and Fiduciaries
A plan sponsor’s decision-making guide.
A Merrill Lynch White Paper
When 401(k) plans first came into being, the question, “Who pays for what?” could be answered fairly simply. Over time, however, fees became more complex. Concern has grown that sponsors and participants alike may not have the information they need to properly evaluate the amount being paid and the way fees impact each participant. Regulators, lawmakers and participants are pressing for greater “fee transparency” as a means of ensuring fairness.
In the early days of the 401(k) plan, before the widespread introduction of mutual funds, 401(k) sponsors typically paid for administrative costs such as recordkeeping and trust services. Participants typically paid for investment management through the fees charged by asset managers for separately managed accounts, collective trusts, and similar vehicles.
Then in the early 1990s, the 401(k) market moved to a bundled model where recordkeeping and other services were “free” or at least low cost. The trend started with proprietary-only mutual fund families where the mutual fund company adapted existing systems that were well-suited to a daily valuation environment and used fund revenue to subsidize recordkeeping costs.
In the mid-1990s, technology was developed to allow trust companies, mutual funds, insurance companies, and plan administrators to exchange trades, settlements, and information each day. This “open architecture” environment created more flexibility among plan investment choices, and was built on a foundation of revenue sharing where the investment manager or fund distributor shared asset-based revenues with recordkeepers and intermediaries to subsidize the cost of servicing the plan and participants.
As these trends developed, few could question their validity. The mutual fund industry had better technology with daily valuation, better transparency with daily publication of the price of the funds in many newspapers, and a single regulated price for admission to the fund. However, in the 21st century, their technological advantage has dissipated. There are many types of investment vehicles now available on a daily valuation basis, and there is widespread use of the internet replacing the importance of “published” fund values. In addition, many fund companies have introduced multiple share classes of the same fund investment portfolio, making it possible to offer the same investments to larger plans at lower costs. While the open architecture environment that is supported by revenue sharing arrangements has served to increase investment choice for plan sponsors and participants, it has created a complex fee structure that is often not understood by plan sponsors, and certainly not understood by most plan participants.
What could be thought of as “free” at the inception of the mutual fund trend has changed to “free to the employer.” In brief, participants began paying virtually all expenses related to their plan, often without realizing that was the case. In addition, different participants within the same plan may be paying fees in a manner that is not transparent, and could be considered by some to be inequitable. These approaches to plan fees are still widely used, but that may be changing in the face of a movement to greater fee transparency.
As the move toward fee transparency gains momentum, sponsors will increasingly face discrete decisions on how to pay the myriad of fees associated with their plan. Sponsors will also need to have a more rigorous governance process in place to deal with these issues and will need a tool to explain their decision process to employees. We believe that the best tool to position plan sponsors to address their fiduciary duties regarding fair and equitable fees is a set of Fee Policy Statements that govern the decisions regarding fees and that can be shared with employees and other interested parties to explain the rationale for the fee decisions.
DOL Guidance on Fees Charged to the Plan
The Employee Retirement Income Security Act of 1974 (ERISA) sets a basic framework for plan fiduciaries to follow. Fees charged to participant accounts must be ‘reasonable’ in amount, relative to the service provided, and “necessary” to the operation of the plan. In addition, the service must be for the benefit of participants. Fiduciaries must make each of these determinations on a case-by-case basis.
The Department of Labor (DOL) has provided guidance on a number of occasions:
· Advisory Opinion 94-32A indicated that some expenses (such as loan processing costs) could be charged directly to a participant’s account, while others (such as QDRO processing) could not.
· Advisory Opinions 97-03A and 2001-01A provided guidance on certain specific expenses, indicating which should be charged to the “settlor” (sponsor) and which may be charged to the plan or its participants (ERISA allowable expenses).
· Field Assistance Bulletin 2003-3 provided expanded guidance on how fees can be charged within the plan (pro-rata, per-participant, transaction-based, etc.). It largely validated the wide range of fee-charging methods which exist today, reiterating that fees must be reasonable and appropriate. This bulletin did, however, reverse the earlier decision that QDRO processing costs could not be charged to the participant.1
1 Bulletin 2003-3 explicitly states that compliance with its guidance does not ensure compliance with the Internal Revenue Code, including the “significant detriment” language in 1.411(a)-11(c)(2)(I).
Who Pays for What?
In Advisory Opinion 2001-01A, DOL provided guidance on whether the plan could bear several specific types of costs and which specific types of fees must be paid by the sponsor. (See below.) Importantly, this opinion confirmed that a plan can pay fiduciary-related expenses even if the payment is for services that incidentally benefit the plan sponsor.
Plan Design Expenses or ‘Settlor’ Costs
(Primarily related to plan design or creation, and must be paid by the sponsor)
· Legal fees for plan implementation and the like
· Communication expenses which benefit the sponsor
· Plan design consulting
Plan Administrative Expenses — ERISA Allowable Expenses
(Primarily related to plan administration or operation, and can be borne by the sponsor or by the plan)
· Legal fees for required, on-going plan amendments and the like
· Recordkeeping and administration fees
· Investment fees (including management fees, operating fees, servicing and sub-account fees, distribution fees, and annuity fees)
· Communication expenses which benefit employees
· Plan design change implementation fees
· Investment consulting
· Auditing fees
If Plan Administrative Expenses are to be charged to plan assets, the Plan Document needs to reflect the ability to do that. The Plan Document, Summary Plan Description (SPD) and Investment Policy Statement (where applicable) should also be consistent with actual expense payment practices.
The Move to Greater “Fee Transparency”
More recently, DOL has taken steps to increase the “transparency” of 401(k) fees, as well as fees associated with de fined benefit and health plans. In theory, better information will lead to better understanding and better decisions.
In the 401(k) arena, DOL’s transparency initiative includes three provisions — not all of which are final. DOL has signaled its plans to:
1. Require plan sponsors to disclose all fees paid directly or indirectly to service providers on a revised schedule (Schedule C), which is part of the Form 5500 that must be filed annually for each plan. This requirement is detailed in a final rule which was approved in November 2007 and is in effect for plan years beginning January 1, 2009, or after. It includes fee sharing arrangements and any other “implicit” costs.
2. Require service providers and sponsors to enter into a written contract that provides detailed disclosures of direct and indirect fees (including fee sharing) in order to be considered “reasonable” and otherwise meet the requirements of the exemption from the prohibited transaction provisions of ERISA 408(b)(2). The purpose of requiring such a contract is so that plan sponsors can make informed decisions on the reasonableness of fees before they enter into the agreement. This requirement is outlined in a proposed rule that was issued in December 2007.
3. Require disclosure to participants of fees paid by the plan. Failure to do so could jeopardize the sponsor’s ERISA 404(c) protection. A proposed rule outlining this requirement in more detail has not yet been issued.
Congress has also been considering a number of proposals intended to help sponsors and participants make better decisions regarding 401(k) fees and investments. It is not yet clear whether legislative initiatives or regulatory action will decide the shape and content of new disclosure requirements. Though more information may lead to better decisions, the push for “transparency” may also place a greater burden on sponsors and may cause greater confusion among some participants.
The Case for Creating Sponsor and Fiduciary Fee Policies
As noted previously, costs which primarily benefit the sponsor must be paid by the sponsor, also known as the settlor. The sponsor and/or fiduciary must decide, however:
1. Whether the sponsor or the plan and its participants will pay Plan Administrative costs, which primarily benefit participants or their beneficiaries.
2. How the costs to be borne by the plan and the participants will be assessed, i.e., through forfeited balances, an asset-based fee, a per-participant fee, a transaction-related fee, or a behavior-based fee.
3. How excess investment-related revenue will be allocated among participants or applied to a valid plan purpose.
Sponsors and fiduciaries who have already made some of these decisions essentially have an implicit or ad hoc fee policy in place. In the interest of good governance, these decisions should be formally made, and both the process followed and the outcomes reached formally documented in two “Fee Policy Statements.”
The Plan Sponsor Fee Policy
First, the plan sponsor must decide what Plan Administrative Expenses, if any, the sponsor will bear. There is no requirement for the sponsor to bear any of these costs, but the effect on employee savings and employee relations should be considered.
If a portion of Plan Administrative Expenses is to be paid by the sponsor, decisions must still be made regarding which costs, or what portion of those costs, will be borne by the sponsor and what part will be paid from plan assets. The sponsor might choose, for example, to pay certain types of fees, a certain percentage of all fees, or a specific dollar amount each year.
These decisions should be made by the appropriate body (board of directors, executive committee, or the like) at an official meeting and should be documented in writing in a Plan Sponsor Fee Policy.
The Plan Fiduciary Fee Policy
If any costs are to be borne by the plan and the participants, the plan fiduciaries (often members of the “plan committee,” “investment committee,” or a similar body), should decide and document how those costs will be assessed and how any “excess” investment-related revenue will be allocated — recording the results in a Plan Fiduciary Fee Policy.
Once again, the “reasonableness” and “necessity” standard applies. The amount of fees paid should bear a reasonable relationship to the quality and volume of the services provided. The amount being paid is part of that standard, i.e., fees should be examined for fairness. Generally speaking:
· Asset-based fees provide participants with lower balances a relative advantage, with participants with high balances paying the bulk of the fees. (Using asset-based fees is one form of pro-rata allocation, which FAB 2003-3 addresses.)
· Per-participant fees provide employees with higher balances a relative advantage, and each participant makes an equal contribution regardless of their account balance. However, these fees may deter those with low balances from contributing to the plan. This can be especially impactful in an automatic enrollment design.
· Transaction-based fees such as check fees must be reasonable and proportionate to the service provided.
· Behavior-based fees such as the choice to receive a paper statement rather than an electronic file must be in line with reasonable usage and service costs.
Each of these types of fees may be appropriate within a given plan if they are reasonably associated with a particular cost. Varying fee structures and fee sharing may result in some participants subsidizing others. Fiduciaries may well deem this reasonable, but the implications should be considered.
Other considerations include the impact the Fee Policy may have on an Investment Policy Statement. Available investment vehicles include multiple-share classes of mutual funds, collective trusts, insurance products, separately managed accounts, and others. Each can have different levels of fees and fee sharing arrangements. Not only must the plan fiduciary consider the type of vehicles to be used, but the use of multiple types of investment vehicles, or multiple share classes within the same menu needs to be considered carefully in terms of the impact on different participants. In other words, is the menu itself creating unintended inequities among participants in terms of fees being charged? With each decision along the way it will be important — and difficult — to understand and document if the decisions being made are strictly due to the merits of a particular investment vehicle, or due to the “fit” of that vehicle within the fee policy framework, or both.
Plan fiduciaries must also act regularly to match fees and revenues, since the fees charged to the plan and the revenue collected from investment fee sharing, participant fees, etc. will vary over time. The frequency and method of adjustment should be addressed in the Fiduciary Fee Policy and in contracts between the plan and its service providers. Plan sponsors and service providers are in the beginning stages of developing best practices for managing this process.
Note: This is a Merrill Lynch white paper, and it has been used in its entirety. Merrill Lynch is a member, Securities Investor Protection Corporation.
Sponsor/Fiduciary Decision Tree
The diagram below illustrates the process of developing a Plan Sponsor Fee Policy and Plan Fiduciary Fee Policy.
