Originally designed as supplemental savings programs,

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1 Retirement DC Fiduciary Focus Fees Plan sponsors face ever-increasing scrutiny, pressure and risk associated with their defined contribution (DC) plans. Although participants retirement readiness is influenced by factors beyond the control of plan sponsors, thoughtful management of various plan expenses can both greatly influence participants long-term savings levels and represent a crucial step in successfully exercising fiduciary responsibilities by the plan sponsor. This article focuses on how leading plan sponsors are addressing fees associated with both investment management and administration of their DC plans and how these actions increase the effectiveness of the DC plan overall. by Winfield Evens Aon Hewitt Originally designed as supplemental savings programs, defined contribution (DC) plans have surpassed traditional defined benefit (DB) plans as the primary retirement vehicle for most U.S. employers (Figure 1). 1 Within the private sector, only 3 of workers still have access to a DB plan. 2 A DC plan represents a shared set of responsibilities between the plan sponsor and employees. Unlike a DB plan, where the employer maintains direct control over virtually all decisions regarding the management of the program, with a DC plan, sponsors design a program and individual employees are responsible for decisions such as whether to join, their individual savings rate and their asset allocation. These aspects that are the ultimate responsibility of employees can be influenced by sponsors decisions on plan design and related solutions, such as automatic enrollment, automatic escalation and the plan s qualified default investment alternative (QDIA) choice. 3 For their part, sponsors have direct control over several critical decisions that impact the ultimate financial results for participants, including fees incurred by the plan. It is critical that plan sponsors successfully address issues that are within their sphere of control in order to optimize results for participants. Today, sponsors report a high and increasing level of scrutiny in their role as plan fiduciaries (Figure 2). 4 Establishing a clear approach to expense management that is consistently applied is a key aspect of demonstrating fiduciary oversight of DC plans and is one that can positively impact participants financial security. The benefits of these efforts are real. Over the long term, even seemingly trivial differences in fee levels can greatly impact participants aggregate savings level (Figure 3). Savings passed on to participants accrue benefits akin to increases in savings levels by either the participant or employer but at no out-of-pocket expense to either party. In recent years, the plan sponsor and consultant communities have become more focused on the topic of expenses associated with DC plans, particularly following the fee disclosure requirements instituted in 2012, 5 with over 8 of sponsors reporting that they assess plan fees annually or more frequently. 6 However, in addition to a review of the aggregate fees and how they compare with external benchmarks, many plans would benefit from a detailed exploration of different approaches regarding how plan-related ex- 26 benefits quarterly fourth quarter 2014

2 penses can be incurred and allocated to individual accounts. This article focuses on how leading plan sponsors are addressing fees associated with both investment management and administration of their DC plans and how these actions increase the effectiveness of the DC plan overall. Investment Vehicles As DC plans have a central role in retirement savings, adopting an institutional mind-set and approach regarding the investment structure of the plan is critical. Within a DC plan, the various investment options provide participants the ability to have their retirement savings managed in a comprehensive manner by professionals dedicated to asset management. Due to a confluence of historical factors, mutual funds dominate the majority of the DC landscape. 7 While in the 1980s they provided unique benefits like daily valuation and participantready communication materials, today other vehicles offer the same benefits whenever a leading provider of DC administrative services (i.e., a third-party administrator, or TPA) is utilized. For example, in addition to mutual funds, DC plans can readily employ collective investment trusts (CITs) and separate accounts, which are common in other institutional settings (i.e., DB plans, foundations, endowments, etc.). (See sidebar.) At Aon Hewitt, we have found that when this flexibility is available, plan sponsors readily utilize it. As of December 31, 2013, less than 2 of the DC assets administered by Aon Figure 1 Is DC the Primary Retirement Plan? % 2003 Figure 2 64% 65% Hewitt were held within mutual fund vehicles. By expanding the set of available solutions under consideration for the plan lineup, plan sponsors can obtain greater control over the fees associated 67% 75% 77% Scrutiny Plan Fiduciaries Face Today % 1 None 3% 17% 49% Highly Level of scrutiny over the last two years: Decreased = Remained the same = 18% Increased = 82% with both their investment management and plan recordkeeping. Investment Fee Flexibility CITs and separate accounts are often lower priced than mutual funds and fourth quarter 2014 benefits quarterly 27

3 Figure 3 The Benefit of 25 Basis Points Over Time $250,000 $200,000 $150,000 $100,000 $50,000 $15, years In this example, over the course of a 40-year career, 25 bps of increased return is equivalent to +0.75% of salary saved annually. provide plan sponsors the opportunity to negotiate the fee level charged for a given strategy. This contrasts with mutual funds, which are required to assess $63,500 $212, years 40 years Assumptions: Beginning Pay: $75,000 Salary Growth Rate: 3% Beginning Balance: $0 Savings Rate: 6% EE, 6% ER CAGR: 7.75% vs. 8.0 Types of Investment Vehicles Within DC Plans Each of the following can provide professional investment management, diversification and daily liquidity: Open-ended mutual funds Designed for individual investors Are regulated by the SEC Have relatively high compliance costs. Collective investment trusts (CITs) May be used by multiple institutional investors (e.g., qualified retirement plans) Typically require higher asset minimums than most mutual funds. Separate accounts Managed solely for a given institutional investor (e.g., a qualified retirement plan) Provide maximum control to the client Require higher asset minimums than other options. all underlying shareholders the same level of fees in the same share class, regardless of whether a given investor has purchased $2,000 or $200,000,000 of a fund. Because a DC plan possesses increased purchasing power as the size of the plan and its underlying funds grow, using CITs and separate accounts allows it to benefit from its scale and save participants money. The cost savings can be material. Figure 4 compares the published fee schedules of both CITs and separate accounts with mutual funds in three illustrative asset classes. Note that these published fees may not necessarily represent an investment manager s best and final offer and that it is common for a sliding fee schedule to be utilized so that, as a client s assets increase with a given manager, the average weighted fee continues to decrease. While mutual funds sometimes (but not always) are offered in various share classes that can provide lower total fees when higher investment minimums are reached, true negotiation is precluded. Although institutional options such as CITs and separate accounts will not be appropriate in every situation, it is good practice for plan sponsors to investigate these alternatives when plan assets become sizable. While the consideration of CITs and separate accounts sounds simple, an added complexity is the practice of revenue sharing. Mutual funds often provide revenue that can be used to offset DC plan administrative expenses. This complicates the analysis of both mutual fund fees and DC administration fees, given the wide array of approaches in the industry and the lack of clarity available from some within the retirement industry. The following section will address this issue. 28 benefits quarterly fourth quarter 2014

4 Figure 4 Median Fund Fees by Type of Investment Vehicle Sources: evestment Alliance, Morningstar and Aon Hewitt, as of 12/31/2013. Notes: Peer groups defined by sources and include funds with 3 years of history. Assumes $50m initial investment. Mutual Fund CIT Separate Account Fixed Income U.S. Large Cap Growth International Equity Fund Revenue An additional aspect of investment fund expenses that is crucial for plan sponsors to fully understand is that of fund revenue, most commonly referred to as revenue sharing. Other terms are sometimes used to describe this topic, including rebates, offsets, etc. Because the investment management firm receives a single buy or sell order on a nightly basis and is not responsible for maintaining customer accounts for investors within the plan, mutual funds are willing to return a portion of their total fees to a TPA of the DC plan. In some cases, CITs are offered in share classes that provide fund revenue, but the practice is most common with mutual funds. Today most fund revenue is based on a percentage of assets held in the fund. There are multiple ways mutual funds can source these fund revenues, including from the stated investment management fees, from a 12b-1 fee or from other fund expense categories. In the past, some investment managers also provided fund revenue based on the number of participants invested in a fund, but that practice is less common now. Generated fund revenues are handled in various ways by different TPAs, though the industry best practice is to treat them as clearly identified revenue to the plan, which can then be used by the plan sponsor to offset any Employee Retirement Income Security Act (ERISA)-qualified plan expense. Just as there is variation regarding how these fund revenues are sourced by investment management organizations and how they are treated by DC administrative firms, there is a wide range of payment levels. The level of revenue provided will vary based on both the particular fund/ share class employed and, in some cases, the relationships between the asset management firm and the DC administration provider. Tables I and II detail several common aspects of this variation in fund revenue. Because of the high level of variation, historically it has been relatively rare to encounter a DC plan where all funds provide a consistent level of fund revenue. As a result, the level of contribution a given participant makes toward defraying plan expenses typically varies not just by his or her total bal- fourth quarter 2014 benefits quarterly 29

5 Table I Fund Revenue by Share Class Category Typical Revenue Range Typical Plan Size Advisor-sold 0.5 to 1.25% Micro to small Retail 0.25% to 0.5 Small to large Institutional 0.0 to 0.15% Medium to large Table II Investment Firm Approaches to Fund Revenue Type Even playing field Focused partnerships Captive DC plan administration ance, but also by his or her individual asset allocation. This leaves plan sponsors to wrestle with the question, Should some of my participants pay more or less toward plan administration costs, simply due to their choice of investment options? Many plan sponsors are familiar with the fact that high-balance participants may be contributing disproportionately toward defraying plan costs when fund revenue is used to defray those expenses because it is a percentage of their account balance. But fewer have addressed how some participants essentially may be free riding because of asset allocation decisions. Approach Provide identical level of fund revenue to all TPAs Provide higher preferential levels of revenue to certain TPAs Provide higher preferential levels of revenue sharing to its firm s own DC administration business than provided to outside TPAs Note: In practice, asset managers that take the even-playing-field approach are typically fully transparent with plan sponsors, consultants and TPAs. Only by assessing both aggregate fund revenue for the entire plan to understand total fees paid as well as the rates paid at the individual participant level can a thorough view of this issue be developed. While this is happening with increasing frequency in the market, many sponsors have yet to do this review. Expense Equalization The importance of DC plans and the ever-increasing focus on transparency have begun to raise interest in the topic of expense equalization. Leading plan sponsors are working with their investment consultants and TPAs to better align the fees associated with DC plan administration to the actual services provided. It is most common for DC plans to share the related administrative expenses with plan participants, as they are the beneficiaries of the benefits afforded by the plan. In fact, less than 1 of companies report paying all DC administrative fees directly. 8 Fund revenue embedded within mutual fund options, as described earlier, is the predominant method used to underwrite DC plan administration expenses. Among firms that provide independent TPA services (where the parent organization has no stake in an investment management business), fees for DC plan administration typically are based on factors such as total number of participants, total number of plans and overall complexity of the DC offering. In cases where expenses are to be shared with participants, the plan sponsor is free to employ one of several approaches including: Through fund fees by using mutual funds with embedded fund revenue Through fund fees by adding on basis points fees to a mutual fund or nonmutual fund option Through periodic dollar fee per account by clearly noting and applying a line-item charge to participants accounts, typically on a monthly or quarterly basis. Figure 5 illustrates the trends in how administrative fees are shared with plan participants. 9 The decision to assess plan expenses in either basis point terms or per 30 benefits quarterly fourth quarter 2014

6 person terms can vary from company to company for a variety of sound reasons. While there is no single perfect solution that is common for all organizations, it is important that the plan sponsor understand its options and adopt the approach that best matches the philosophy of its plan. In fact, some plan sponsors will employ a hybrid approach that combines different aspects, for example $10/quarter + five basis points on all funds. Others have instituted minimum and maximum thresholds to ensure that new investors to the plan are not discouraged from participating nor are larger accountholders contributing at an excessive level toward plan expenses. Matching the approach employed with the plan s philosophy is the clear objective. Case Study The topic of fee equalization is best illustrated via a real-life example. Aon Hewitt worked with Company XYZ to help the plan sponsor and its investment consultant better understand how fund revenue was impacting the plan and their participants. As Company XYZ knew, DC plan administration services are a function of factors such as number of participants and plan complexity. Total plan assets and the investment structure do not significantly factor into the cost to deliver DC plan administration, but they do impact the level of fund revenue provided to the plan. Previously, Company XYZ had worked on this topic and determined that total fund revenue was roughly equivalent to annual DC plan administrative expenses. In the aggregate, there was no apparent problem. Figure 5 How Administrative Fees Are Charged to Participants, Among Plans Sharing Expenses With Participants 77% 83% 52% Via mutual funds with revenue sharing 23% 28% Via accruals added to institutional funds Fund Revenue Background Aon Hewitt provided additional detailed analysis that demonstrated how different segments of their employee population were being disproportionately impacted by fund revenue, based upon the structure of their lineup. While from a high level the plan appeared to be in good shape, from a fund revenue % 26% 11% 14% Participants charged discrete $ amount 1 Participants charged discrete % of balance Historically, when a mutual fund is employed within a DC plan, it is common for the investment firm to return a portion of its total expense ratio to the organization providing administrative services. This is done because the mutual fund has budgeted for administrative services within its total expense ratio in order to handle customer accounts. However, when the fund is employed within a DC plan, those shareholder-servicing activities (e.g., maintaining customer records, running a phone center, providing a website, etc.) are done by the third-party administrator providing DC administrative services. perspective, a large number of participants were being subsidized by a relatively small fraction of plan investors. Figure 6 highlights several of the summary findings presented to Company XYZ. Summary findings include: Over 7 of the population paid fourth quarter 2014 benefits quarterly 31

7 Figure 6 Summary Analysis of Fund Revenue 37% 33% 53% 39% less than the annual per participant fee associated with DC plan administration. Less than 2 of the population provided over 8 of the plan revenue used to defray DC plan administration. As a result of the analysis, summarized in part here, Company XYZ has elected to restructure its investment approach to remove fund revenue and to defray DC plan administration in a more equitable manner. Conclusion The era of DC plans being a side benefit for employees has long since passed. When plan sponsors do not pay attention to fees, costs may be misaligned with services, ultimately decreasing 36% 11% 27% % Level of Fund Revenue 64% % of Plan Fund Options % of Plan Assets % of Plan Revenue participant balances for individuals who accumulate large balances and/or choose to invest in specific funds that pay the TPA higher fund revenue. 10 The optimization and governance of DC plans are critical to their long-term effectiveness. While the attention focused on DC plans as well as the requirements placed on plan fiduciaries are high, the market has responded with an increasing array of solutions. Today, asset managers are offering investment strategies designed for the DC marketplace that eliminate fund revenue in both non-mutual fund and mutual fund vehicle structures. For example, share classes that denote zero revenue sharing, such as R6 and Institutional, are becoming much more prevalent. 11 Competition among asset managers for new business and the utilization of institutional vehicles can be leveraged to help lower costs to participants and thus increase long-term savings levels. Further, plan sponsors have much greater control over how administrative fees are assessed to the plan than they may have had in the past, as the TPA industry has responded to the need for more refined solutions. It is prudent for plan sponsors to decouple their investment plan design decisions from considerations related to how DC administrative services are paid. Today, plan sponsors have additional solutions at their disposal beyond simply employing a set of mutual funds with embedded revenue sharing. Mutual funds remain appropriate for a portion of the funds, or all of the funds, for many plans. But in all cases it is appropriate for plan sponsors to work to ensure a relatively consistent level of fund revenue across the lineup, regardless of the types of investment vehicles employed. Best Practices As plan sponsors focus on fees within their DC plans, best practices include: Fully understand plan expenses (including investment and administrative fees). Leverage institutional vehicles and pricing where possible. Share plan expenses across the plan population in an equitable manner that matches the plan s philosophy. Maintain a thorough ongoing governance process. 32 benefits quarterly fourth quarter 2014

8 Aon Hewitt believes that it is prudent for plan sponsors, along with assistance from their trusted advisors serving in a fiduciary capacity (such as investment consultants and attorneys), to design and use the investment structure and the approach to addressing plan administrative expenses that best meet the needs of the plan and its participants. Endnotes 1. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 2. Bureau of Labor Statistics, National Compensation Survey, March For additional considerations regarding how sponsors can improve the design and utilization of their DC plans, see the white paper Improving DC Plan Investment Governance, A Call to Action, Hewitt EnnisKnupp, May 2013, available at DC-Governance-A-Call-to-Action_FINAL_0620.pdf. 4. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 5. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 6. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 7. Cerulli, Investment Company Institute and Aon Hewitt. 8. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 9. Aon Hewitt s 2013 Trends and Experience in Defined Contribution 10. PLANSPONSOR s 2013 Defined Contribution Survey indicated that 26.6% of respondents did not know the average expense ratio of all investment options in their plans. PLANSPONSOR.com, April Emile Hallez, Revenue-Sharing Fees May Join Endangered Species List, Ignites, January In 2008 there were 24 mutual funds in an R6 share class; that had expanded to over 400 funds by AUTHOR Winfield Evens, CFA, is director of outsourcing investment strategy and a partner at Aon Hewitt in Lincolnshire, Illinois. He is responsible for investment strategy and retirement research groups. As the primary creator of DC Nexus, he leads that team s efforts. He also is an investment consultant for Hewitt EnnisKnupp, an Aon Company, where he provides investment counsel to a group of DC plan fiduciaries. Evens previously was vice president of analysis and client relations at Vision Capital Management and an equity analyst at Jensen Investment Management. He holds a B.S. degree in labor and industrial relations from Penn State University and an M.B.A. degree in finance from the University of Chicago Booth School of Business. International Society of Certified Employee Benefit Specialists Reprinted from the Fourth Quarter 2014 issue of BENEFITS QUARTERLY, published by the International Society of Certified Employee Benefit Specialists. With the exception of official Society announcements, the opinions given in articles are those of the authors. The International Society of Certified Employee Benefit Specialists disclaims responsibility for views expressed and statements made in articles published. No further transmission or electronic distribution of this material is permitted without permission. Subscription information can be found at iscebs.org International Society of Certified Employee Benefit Specialists fourth quarter 2014 benefits quarterly 33