Hidden Costs and High Fees Eat into 401(k) Plan Benefits
Although fallout from the mutual-fund trading scandals still dominates the headlines, some companies with 401(k) plans reserve their greatest ire for another issue: fees.
Complaints focus mainly on the steep fund expenses that are passed on to plan participants — an average of 156 basis points for administration, plus commissions and other transaction costs — and on how hard it is to determine what individual charges the fees include. Both those concerns reflect what plan sponsors say is an historic culture of unresponsiveness among funds to fee-related questions. (Transaction costs are not included in normal shareholder reporting.)
“It’s pretty appalling,” says Jim Price, a Tatum Partners CFO who works for Client Dynamics Inc. He says he has been “told by some providers that the fees would be buried so that none of the participants would ever notice.” That’s not something he wanted to hear, since he was trying to reduce the cost exposure for the company’s 15 employees. After vainly “looking through the fine print” for details of specific charges at various plans, he eventually decided on a Smith Barney administered plan with high returns and a fee structure that was lower and more transparent than competitors’.
Indeed, more than 90 percent of finance executives in CFO magazine’s recent mutual-fund survey thought fees were too high, with more than 70 percent saying they were quite concerned about fee levels — a greater percent even than expressed worries over unethical trading practices.
“If you’ve stayed with one provider for 10 years, that provider doesn’t think it’s part of the job to explain the fees,” says Bruce A. Jackson, CFO of Cedar Fair LP, an amusement-park operator in Sandusky, Ohio. Until recently, he thought high fees were an unavoidable cost of fund investment for the 600 participants in the company’s plan. Then, with the help of one of the growing number of consultants now specializing in fee negotiations, Jackson says he found that “mutual-fund providers are offering a lot of concessions to get money into their fund groups.” By identifying specific components of that fee structure, he adds, “we were able to get a number of discounts.”
Even without negotiations, though, some plan sponsors are beginning to see lower fees. Several funds have reduced fees in the months since the trading abuses began surfacing, and have taken other steps to boost pricing transparency. In some cases, fee reductions have been included as penalties in the settlement terms imposed by regulators. (The Securities and Exchange Commission and the Department of Labor are both reviewing mutual-fund fee structures, but so far both have focused more on trading issues.) Still other funds have made voluntary fee cuts part of a new strategy.
A Blessing in Disguise
Some critics suggest that general market forces — and the tendency for more customers to shun high-cost funds — are responsible for much of the cutting. Those critics add that cuts so far are barely touching the excessive costs that prevail among nearly all funds.
“I think it’s a blessing in disguise that the trading abuses have come to light, because they have caused us to take a look at the whole industry,” says Sen. Peter G. Fitzgerald (R¬Ill.), co-sponsor of the broad Mutual Fund Reform Act of 2004 (MFRA), which seeks to prevent future trading abuses while also improving fee disclosures. Compared to the problem of high fees, “the trading abuses can be addressed relatively easily,” he says. And trading improprieties “are far less costly to mutual-fund shareholders.” Spread over the decades-long life of a plan, he notes, a few excess basis points can cost retirees tens of thousands of dollars.
The senator, a former commercial-banking attorney who now heads the Subcommittee on Consumer Affairs and Product Safety, believes Congress is partly at fault for lax scrutiny of the mutual-fund phenomenon. After all, the industry got its biggest boost when government-created, tax-deferred investment vehicles, including retirement plans, fueled the rapid growth of the mutual-fund industry. “Mutual funds have grown from $115 billion to a $7.4 trillion industry in 24 years,” he says, while regulators “weren’t paying as much attention as they should have been,” and funds “had almost a guaranteed market.”
Over that long haul, mutual funds have not been the star performers they often claim to be, according to testimony before Fitzgerald’s subcommittee. “Eighty-eight percent of mutual funds under perform the market over time,” says the senator, with funds returning only 9 percent on average over the past 20 years, compared with 12 percent for the market in general. “The difference between the 12 percent and the mutual funds’ 9 percent,” he says, “is the fees.”
Beyond the costs represented in the standard expense ratio that funds now disclose, says Fitzgerald, transaction costs often add another 75 to 150 basis points. The MFRA seeks to require transaction-cost disclosure in order to give investors more guidance in deciding which funds to buy, among other benefits. The hidden transaction charges, reflecting commissions and spreads on trades, for example, “are a very real cost, and they eat into investment returns just like any other cost.”
While the act is designed primarily to help independent fund investors, who lack the clout to negotiate fees as corporate 401(k) sponsors might, “the dilemma of plan sponsors is very similar to that faced by individual investors, because it is virtually impossible to get all fee information,” according to the senator.
Confusing and Costly
“Fees are the next wave,” says David Wray, president of the Profit Sharing/401(k) Council of America. After dealing with concerns over the trustworthiness of plan providers, investors “now want to know about the amount of fees, the kinds of fees, and the quality of services those fees purchased.” But plan sponsors must consider that a 401(k) is more complex — sometimes far more complex — than an individual fund investment, he notes. While some of the fee is based on the volume of participants’ assets under management, plan customization also sharply affects the cost. “Employee retirement plans are not just a collection of savings accounts; they’re very different,” says Wray. “The more generic the plan, both in design and investments, the less the expense.”
Carol Geremia, president of the MFS Retirement Services Co. unit of Boston-based fund giant MFS Investment Management, contends that plan sponsors “do understand the operating expense of a fund,” which they see in the reported expense ratio. “Now they need to understand how that correlates to recordkeeping and other expenses” — costs that are not included in the ratio, but reflect the plan sponsor’s specific 401(k) management needs. “That’s where the transparency, in my opinion, has gotten muddy,” says Geremia.
In February, MFS settled improper-trading cases filed against it by the SEC and New York and New Hampshire regulators, agreeing to reduce management fees by about $25 million a year over five years on the funds it advises. And more recently, it agreed to pay a $50 million fine — which fund shareholders will receive — to settle SEC charges that MFS secretly made payments to brokers who promoted MFS products. Still, MFS also has been among the more-aggressive funds in changing fee-related practices, including by beefing up its fund-expense reporting, and offering expense-ratio numbers on a single report so that plan sponsors don’t have to “go prospectus by prospectus, which is a pain in the neck,” as Geremia puts it.
MFS recently eliminated the use of “soft-dollar” commission payments to third-party brokers, a technique that lumps fund research and other expenses in with trading costs — and, say critics, often leads brokers to inflate commissions on trades and kick back credits to fund managers in return. By breaking out the research expense separately, MFS “will ultimately end up paying hard-dollar research amounts between $10 million and $15 million per year,” says Geremia.
Overall, she believes the movement toward disclosure will help rather than hurt. “If the plan sponsors have a better idea what the fees are,” she says, “it’s going to be much better for our business.” As for breaking out transaction costs, Geremia says, “the more transparency of additional expenses that are borne in managing a portfolio, the better.”
The existence of soft-dollar payments — which are charged against assets and are thus not part of the formal fee structure — only hints at how daunting it can be to deconstruct all the components of the total mutual-fund costs for which participants pay. Senator Fitzgerald’s subcommittee describes such often-consolidated elements as broker confirmations; advertising costs; costs from portfolio turnover; and various revenue-sharing arrangements with brokers, financial planners, or other advisers. Other fund-administration staples include postage and printing, audit and legal services, and costs listed in reports as “other.”
Many funds also incur costs when they shift assets on a temporary basis under the SEC’s Rule 12b-1, a measure designed to allow investors to capture savings from economies of scale within their funds. Critics say that this asset movement is often overused and misguided, however, and rarely produces net savings. Rather, 12b-1 costs can become something of a disguised load.
Send in the Consultants
Geremia is among the fund-company executives who lately have seen plan sponsors become more aggressive in demanding information about fees. “And ironically, it began happening before any of the scandals hit,” she says.
In some cases, plan sponsors have turned to consultants to act as intermediaries with funds.
One such consultant, Brent Glading of Montclair, New Jersey based Glading Group, says that by analyzing a 401(k) plan and negotiating with the provider, his firm can “recapture the excessive profits from the administrator, and generate them back to the plan participants.” In just over a year of operation, he says, about 20 private-and public-sector sponsors have used the firm’s services. In the extreme case of one client, with an average participant balance of $100,000, Glading says he was able to shave 30 basis points by identifying excessive revenue sharing between the investment manager and the recordkeeper. He negotiated an annual return to the plan’s 650 participants of about $460 each, for a total savings of $330,000. “This is a gross example,” he says, “but it certainly is a return that can happen.”
The idea at Barrington, Illinois-based Clark Consulting is to “first conduct a fiduciary assessment that includes an analysis of its client’s plan expense components” where excess costs are identified, says Harold Small, vice president for Clark’s human-capital practice, based in Atlanta. Then, Clark shows them “how much of their investment dollar is really going into the management process.” In a typical plan with assets of $500 million, he says, total reductions of 5 to 15 basis points are not unusual. Five points on a $500 million plan equals $250,000 a year.
Jackson of Cedar Fair, which spent two years as a Clark client, is happy with the lower fees his company won, although reductions vary from fund to fund in his plan, and he hasn’t calculated the total savings. “It’s a meaningful amount,” he says. One low-cost stock-index fund even had its fee shaved by 10 basis points, according to Jackson.
“In some respects, it helps to have an outside adviser,” he adds. “It can be the tough guy to get mutual funds to listen to you.”
Of course, many finance executives tend to pay much more attention to returns than to fees in choosing a mutual fund for their company’s 401(k) plan. When Putnam Investments recently announced it was cutting fees voluntarily, Treasurer Alan Hartley of Shari’s Management Corp., a Beaverton, Oregon, restaurant operator, says he hardly noticed. “I didn’t think their fees were that high, and the returns are very good” on the single Putnam fund Shari’s has in its plan.
To counter any apathy, Harold Small says Clark Consulting subjects its 65 corporate and other clients to the pitch “that the plan sponsor has a responsibility not only to pick good investment options, but to pick efficient ones.” And they must also ask, “Is what we’re spending appropriate for a plan that size?”
With plan sponsors bearing the fiduciary responsibility for participants, Senator Fitzgerald says such questioning is a crucial legal strategy as well. “Plan sponsors that are interested in being protected from lawsuits ought to make it their business to carefully investigate the fees for their funds,” he says.