The Perils of a Multi-Vendor 403(b) Plan. Retirement Plan Consulting

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1 Retirement Plan Consulting

2 The primary issues prevalent in multivendor 403(b) environment include a lack of oversight from a vendor due diligence perspective, use of proprietary investment products, and pricing inefficiencies. Introduction In the second half of 2016, a number of higher education institutions were named in lawsuits surrounding their 403(b) plans. While the complaints varied from case to case, a number of the complaints cited the use of multiple vendors within the 403(b) plan, which led to reduced scale and higher fees for participants. Since the original lawsuits, several more have been filed and the topic has become one of concern for many organizations sponsoring a 403(b) plan. The primary issues prevalent in multi-vendor 403(b) environment include: a lack of oversight from a vendor due diligence perspective, use of proprietary investment products, and pricing inefficiencies. This white paper intends to provide a brief history of 403(b) plans, highlight each of the aforementioned issues and equip plan sponsors with examples of actions committees can take moving forward. History of 403(b)s In order to understand the issues associated with offering multiple vendors in a 403(b) plan, one should look at how the 403(b) plan has developed over time. In many ways, 403(b) plans are the same as 401(k) plans; however, the way they were introduced and used over time has created some stark differences in how they function today. From their introduction, 403(b) plans were prone to offering multiple providers. In 1958, 403(b) plans were introduced as tax-sheltered annuity plans for public sector and some nonprofit organizations. The purpose was to provide employees of these organizations a way to save for their retirement. At that time, 403(b) plans were limited to offering only annuities as investment options. Additionally, providers could only record keep their own annuities; so, if an organization wanted to offer more investment options they had to offer more vendors. It wasn t until 1974 that 403(b) plans were allowed to offer mutual funds (also known as 403(b)(7) custodial accounts). By that point many plans had presumably added multiple vendors to allow choice within the plan and a common practice had been established. Today, it s not uncommon to see multiple vendors still involved in a 403(b) plan. The types of providers can include annuity companies, investment management companies, as well as financial planners or advisors. While each structure has its own benefits it s important to note they have different business models and incentives. Due Diligence Process In a single vendor environment, one of the most important plan governance procedures is a prudent process around vendor oversight. Typically, these procedures include frequent benchmarking of fees and services as well as a defined due diligence process focusing on vendor practices and capabilities. RETIREMENT PLAN CONSULTING ARTHUR J. GALLAGHER & CO. AJG.COM :: 2

3 In a multiple vendor environment, these procedures rarely exist and organizations simply allow several vendors access to the plan. Simply put, the more vendors within the plan, the more difficult it is for the plan sponsor to monitor their fees and products. In addition, many plan sponsors have argued that an open door policy absolves the organization of their obligation to conduct due diligence on each vendor. By taking such a stance, the plan sponsor has made a decision, and that decision is that all vendors are acceptable. Furthermore, this logic does not allow an organization to be a steward for their plan participants and provide them with the advantages provided to participants in the for-profit world as well as others in the nonprofit and governmental space. Proprietary Investments Another prominent issue in multiple vendor 403(b) plans is proprietary investment lineups. In order to understand how proprietary investments come into play, an understanding of a basic plan s fee structure is required. When a vendor provides record keeping services they commonly receive compensation in two forms: an asset-based record keeping fee charged to participants and revenue sharing paid to them by the investment companies whose funds are offered in the plan. Typically, as assets in the plan increase, the vendor relies less and less on revenue sharing from investment companies as the asset-based fee provides enough revenue to support the plan. Since multi-vendor plans spread assets across numerous vendors, the vendors receive less in terms of asset-based record keeping fees and must look elsewhere for additional compensation. It s becoming more common to eliminate asset-based record keeping fees towards flat per-participant fees in order to combat this issue. Coincidentally, charging an asset-based fee as opposed to a per-participant fee is one of the complaints brought against Emory in the case of Henderson v. Emory University. 1 One of the ways vendors generate revenue outside of the record keeping charge is by implementing investment restraints and receiving revenue sharing through agreements with investment managers. In many cases, the vendor restricts the investment lineup to their own proprietary funds to maximize the revenue received. A number of issues exist with proprietary investment options. First of all, there s an inherent conflict of interest with a vendor strictly offering its own funds because it receives a fee for managing the assets. This could cause increased leniency when determining if a fund should be removed from the lineup due to poor performance. Additionally, requiring proprietary investments restricts participants from accessing more suitable funds in each asset class. Pricing Inefficiencies One of the most important considerations a plan sponsor must take into account when offering an employer sponsored retirement plan is fees. When an organization offers multiple vendors, it fails to capitalize on the economies of scale of the plan s assets, which results in participants generally paying higher record keeping and investment fees. Both fees are addressed in the case raised RETIREMENT PLAN CONSULTING ARTHUR J. GALLAGHER & CO. AJG.COM :: 3

4 against Duke University. 2 Regarding record keeping fees, the complaint notes the plan offered four vendors and failed to use the Plan s bargaining power, causing the Plan to pay unreasonable and greatly excessive fees for record keeping, administrative, and investment services. Regarding investment fees, the complaint mentions the plan offered too many investment options and didn t consolidate like investments. The lack of consolidation meant the plan failed to qualify for lower cost share classes of certain investments. Another example occurs in Cassell v. Vanderbilt University 3 where the lineup included retail share class mutual funds, despite the massive size of the plan, which are identical in every respect to institutional share class funds, except for much higher fees. As a result, the opportunity to efficiently manage the plan s fees was missed, nor could the plan achieve any economy of scale because it offered multiple vendors and too many investment options. Small decreases in fees, can lead to a significant impact in an individual s retirement account balance. In the following scenario, Individual 1 and Individual 2 both start their career earning $40,000, saving 6 percent and receiving a 3 percent company match. The only difference is in the fees they are paying. Individual 1 pays an all-in cost of 0.89 percent while Individual 2 pays 1.09 percent. As illustrated, a mere 20 basis point difference in fees can generate an additional $36,000 during a participant s working lifetime. Illustration is based an individual beginning their career at $40,000 with 2 percent per year salary increases. The individual contributes 6 percent of pay and receives a 3 percent employer match. The investments return 7 percent annual reduced by the expense of 0.89 percent and 1.09 percent for Individual 1 and 2, respectively. Return for annual contribution is assumed to be made mid year. $1,000 Account Balance after x years Thousands $900 $800 $700 $600 $500 $400 $300 $200 $100 Individual 1, Total Expense: 0.89% Individual 2, Total Expense: 1.09% Difference $13K $4K $371K $359K $161K $158K $768K $36K $733K Moving Forward Interestingly, in the Cassell v. Vanderbilt University case, the complaint acknowledges Vanderbilt consolidated its record-keepers, but there was no loyal or prudent reason that Defendants failed to engage in such process long before April 2015, and before 2009, hinting the university took too long to take action. Additionally, the complaint highlights the process of assessing the reasonableness of plan fees saying, prudent fiduciaries of large defined contribution plans put the plan s record keeping and administrative services out for competitive bidding at regular intervals of approximately three Years RETIREMENT PLAN CONSULTING ARTHUR J. GALLAGHER & CO. AJG.COM :: 4

5 years. Since the timing of the issue is important, here are some suggested courses of action for beginning the process of benchmarking your plan. The first step should be to evaluate the current state of the plan and conduct a comprehensive vendor review. An example of the steps: Conducting an independent review of each vendor s financial strength, investment product mix, employee approach and any litigation and consumer complaints Comparing plan and cost structure to industry benchmarks to assess the reasonableness and value of the services being provided by the vendors Every plan sponsor and every plan looks a little different. By knowing and reviewing your options, you can feel more confident in determining the best approach and meeting your related fiduciary duties. Reviewing the types of investments available and benchmarking the fees and performance to determine the reasonableness of the funds offered Based on the findings of the vendor review and the philosophy of the organization there are multiple routes for moving forward. If the organization decides they are comfortable with the findings and assuming the risks of offering multiple vendors, then maintaining the status quo is an option. Other organizations might decide they are not comfortable with the risks of continuing to operate in a multi-vendor manner. In this case, the organization could choose a limited number of preferred vendors to offer in their plan and institute procedures to continually monitor and review the vendors at appropriate intervals. The final option would be to take the same route as Vanderbilt and move to a single vendor. While this process is the most tedious and complicated, it offers the most protection from the risks associated with offering multiple vendors when paired with proper governance and vendor review procedures. Additionally, it may provide the most fee savings to participants. Every plan sponsor and every plan looks a little different. By knowing and reviewing your options, you can feel more confident in determining the best approach to meet your fiduciary duties and support the financial wellbeing of your employees. When considering a retirement plan consultant, choose a partner to help ensure you are acting in the interests of your employees, protecting their assets and your organization from risk. An advisor who acts in your interest, giving you the guidance, research and market insights you need to develop your overall benefits strategy. 1 HendersonvEmoryUniversityOrder1.pdf 2 ClarkvDukeUniversityComplaint.pdf 3 CassellvVanderbiltUniversityComplaint.pdf RETIREMENT PLAN CONSULTING ARTHUR J. GALLAGHER & CO. AJG.COM :: 5

6 About the Practice The Retirement Plan Consulting team of Arthur J. Gallagher & Co. helps you maximize your total benefits and compensation by aligning your retirement philosophy and plans with your organization s goals. The team helps you manage plan selection, design and structure, regulations and filing requirements, employee education, and long-term retirement planning for employees. For more information, visit > Solutions > Retirement Plan Consulting. This material was created to provide accurate and reliable information on the subjects covered, but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Gallagher Benefit Services, Inc., a subsidiary of Arthur J. Gallagher & Co., (Gallagher) is a non-investment firm that provides employee benefit and retirement plan consulting services to employers. Securities may be offered through Kestra Investment Services, LLC, (Kestra IS), member FINRA/SIPC. Investment advisory services may be offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Certain appropriately licensed individuals of Gallagher are registered to offer securities through Kestra IS or investment advisory services through Kestra AS. Neither Kestra IS nor Kestra AS is affiliated with Gallagher. Neither Kestra IS, Kestra AS, Gallagher, their affiliates nor representatives provide accounting, legal or tax advice. GBS/Kestra-CD(257191)(exp092018) 2017 Gallagher Benefit Services, Inc. RETIREMENT PLAN CONSULTING ARTHUR J. GALLAGHER & CO. AJG.COM :: 6 17GBS32195B