This entry becomes increasingly relevant at a time when corporations continue to shift from defined-benefit retirement plans (pensions) to defined-contribution plans (401k). Corporations are encouraging their employees to self-direct their retirement assets to protect themselves from the possibility of retirement plans becoming under-funded. The issue is similar, on a smaller scale, to the federal government’s current problems surrounding social security and Medicare. It’s logical that a corporation would not be able to anticipate all future events and guarantee that their organization will be financially sound when the time comes to pay benefits. The automobile industry is a prime example of unstable economics (cyclical with high fixed costs) leading to under-funded liabilities stretching way beyond what could have been expected. The solution to an unpredictable corporate climate in terms of retirement planning is improving the quality control of the company 401(k) plan. What employees and employers should focus on is if they are getting the best possible value from their plan provider.
The reason employees elect to defer compensation into a retirement plan is because it provides them with an income source during retirement. Defined-contribution plans, along with social security, will provide the majority of retirement income to current workers. The returns on investment, along with the tax benefits, are the reasons we invest the money rather than leaving it as cash in a checking account. Take the following analysis as an example of the hampered performance fees can cause: the difference between an annual total return of 5% and an annual total return of 7% on a $100,000 investment, net of fees, over a 25-year period, is $204,108. Those two percentage points can make a big difference over the long run. Two percentage points also happens to be an accurate figure of the amount of money deducted for expenses each year in a typical 401(k) plan.
I’ve decided to focus on fees in my discussion rather than on investment options because I truly believe that active management, over the long-run, doesn’t have any certain benefits over passive management. That being said, whoever is the cheapest provider, assuming adequate investment options and reasonable customer service, deserves to service your firm. This is the essence of my argument. The department of labor parallels my sentiment in a study about employee benefits- specifically 401(k) fees. Please reference the article at the end of this entry if you’d like more in depth information. You can also contact me since I clearly enjoy this topic.
Let’s discuss what these 401(k) plan fees are and who ultimately pays them. The first group of fees is related to administration costs. Operating a retirement plan requires prior approval as a “qualified” plan. This refers to the ability of a corporation to adhere to the tax-code necessary to offer plans with the tax-deferred status inherent in retirement plans to its employees. This level of complication requires record keeping, and consulting, from both accountants and lawyers. Administration may also include a portion of the customer service including fielding questions, and providing further advice on retirement.
Investment fees are the next (and generally the most painful) expense. You should note that human resource directors and CEO’s don’t get bills from investment companies. Investment fees are either drained from the funds as a percentage of the total amount of assets invested, or paid in sales loads and commissions. This is why we always want to make a distinction between the total investment return NET of fees and the returns published in brochures and presentations. Investment fees aren’t listed on the monthly statements you receive. They are listed on plan adoption agreements and other expense paperwork which you need to request directly from your plan administrator. It may also be on file with your HR department.
Servicing fees generally detract from the investment return as well. This fee could be required for something as simple as a portfolio rebalancing, or for accessing the loan features of your plan. These are the sort of fees which jump up and bite you because you didn’t even think to ask about them when the plan was established.
It’s important to be able to distinguish how each group of expenses is being paid. Does your plan have a “third party administrator” which deals with the record keeping? If so, is that fee included in the percentage points being deducted for investment fees? These fees can be a grey area for corporations who ultimately will end up paying the fees by means of internal expenses. Sometimes a corporation will even retain their own third party administrator, rather than go through their plan provider. It helps the corporation maintain control and only need to seek fund vendors to use for investment options. This is often a good idea because by “unbundling” the product, it’s easier to track the fees.
Now, I’d like to address a very specific type of management style known as the “separate account” which is often abused in the 401(k) world. This management style can be complicated to explain so I’ll use a very simple analogy. When you’re young, you learn that buying a mutual fund makes sense because you get hundreds of stocks and bonds bundled up into one investment. It gives you both diversification and minimized transaction costs. A “separate account” is similar in that minimizes transaction costs for large pools of 401(k) employees. Rather than combining the fees of hundreds of plan participants, we combine all the money (generally mutual funds) into a pool of assets and manage it as one, larger account. This (in theory) will minimize management expenses and transaction costs. In practice, this only benefits very large corporations. Let me back that up with a quote from the Pension and Benefits Welfare Administration:
“In general, direct use of retail mutual funds or the provider’s institutional funds is the most common investment arrangement among smaller plans, those with assets of $50 million or under. Mid-sized plans, those with assets of $50 million to $500 million frequently add commingled accounts. Finally, separate accounts are found among very large 401(k) plans, those with assets over $500 million.”
The point here is that to recognize the cost savings, the plan has to be big- very big. Yet, we still see separate account management for small and mid-sized firms. Part of the reason for this is the internal management fee which separate accounts charge and is generally not disclosed on plan documents. If you ran a cost analysis on a small or mid-sized firm, you’d probably find the employees are better off with individual mutual funds accounts outside of the separate account.
Every retirement plan has to fit around the corporate culture of the firm. Sometimes a bunch of plans will fit and all accomplish the goal. What’s most important to investigate prior to adopting a plan (or when considering alternative plans) are the fees. If you have questions regarding your personal 401(k) investments, or your company’s 401(k) plan, I’m all ears.
Russell Bailyn
(212) 752-4343 *31
rbailyn@gmail.com
*http://www.dol.gov/ebsa/publications/401k_employee.html
