A plan fiduciary s guide to understanding participant-level fee disclosure under 404(a)5
Overview FOR MILLIONS OF AMERICAN WORKERS who participate in their company s retirement plan, this year s third-quarter 401(k) statements will reveal an unpleasant surprise: Participation in their retirement plan isn t free. As part of a government mandate requiring greater transparency in the way fees and expenses associated with qualified retirement plans are disclosed, plan participants will now receive standardized information, quarterly and annually, on the true costs they pay to participate in their 401(k) plan. In October 2010, the U.S. Department of Labor (DOL) issued regulations to amend section 404(a) of the Employee Retirement Income Security Act (ERISA) to require plan fiduciaries to meet certain standards for providing plan fee information to participants and their beneficiaries. Although the regulations have been amended several times, the DOL has set implementation of the final-final 404(a)5 regulations for August 30, 2012. Since the majority of fee-disclosure reporting will appear on quarterly statements, most plan participants will get their first exposure to the new fee disclosures in their third quarter 2012 401(k) statements. The 404(a)5 regulation is the third-leg of the DOL s effort to provide a clearer picture of the true costs associated with 401(k) plans. The other two legs include 408(b)2, which requires service providers to meet disclosure requirements for fees to plan sponsors, and Form 5500 / Schedule C, which governs disclosure reporting at the plan level. While the other two regulations will impact how sponsors and service providers conduct plan business, 404(a)5 will likely have the most profound impact on the 401(k) industry. The DOL estimates that there are approximately 483,000 participant-directed 401(k) plans in the U.S., with an estimated 72 million participants and nearly $3 trillion in assets (1). Most studies concur that a vast majority of participants are ill-informed about their retirement plans and, especially, about the costs they are paying to participate in them. In a March 2011 report by AARP, 71% of plan participants did not think they were paying any fees for their plan (2), and yet a November 2011 report by Deloitte LLP for the Investment Company Institute revealed that participants, on average, actually bear 91 percent of total plan fees (3). It s not hard to understand the disconnect between what 401(k) participants believe they are paying in costs and fees and what they are really paying. For decades, many retirement plan service providers recordkeepers, third-party administrators, brokers and others have received compensation for their services from the mutual funds and/or annuities offered in the plan. Alternately referred to as revenue sharing, soft-dollar compensation or indirect fees, these expenses are paid out of fund assets rather than billed directly to the plan. While the practice of revenue sharing between service providers is not inherently unethical, historically there has been little disclosure to participants about such arrangements, leading many participants to 2
believe their costs are a fraction of what they really are, or even that there are no costs at all. And plan fiduciaries who are legally obligated under ERISA to act solely in the best interests of plan participants and to understand, monitor and benchmark all planrelated fees and expenses have in the past found it a daunting task to successfully uncover fee-sharing arrangements between service providers. The lack of fee transparency and reporting by service providers over the years has created an environment in which plan participants retirement income security has been jeopardized. Millions of plan participants have experienced shrinkage in their retirement income benefits as a result of excessive fees charged by service providers due to hidden fee payments and inflated fund charges that have annually reduced total returns on their retirement savings portfolios. Over time, excessive fees can have a substantial negative compounding effect on investment results. This issue lies at the heart of the DOL s decision to finally issue comprehensive regulations to expose the true costs associated with 401(k) plans in a uniform manner. The intent of the DOL s three-pronged fee disclosure regulations is to help provide plan fiduciaries and participants an equitable and level playing field in which to compare and compute fees associated with their plan. Of the three regulations, only 404(a)5 specifically requires plan fiduciaries to provide participant-level fee information. And, they must do so in a manner that can be easily understood and acted upon. While that is the intent of the regulation, only time will tell if the DOL has succeeded in providing clear and understandable information that will positively impact participant retirement savings outcomes. Executive Summary Touted by many industry experts as a real game-changer for the 401(k) industry, 404(a)5 is the final in a set of three new fee disclosure regulations mandated by the Department of Labor. The trio of fee regulations is intended to bring transparency and clarity to an all too often murky world of fees and expenses associated with participant-directed retirement plans. While the true effect of the new 404(a)5 regulation is still to be determined, what is known is that for the first time since the establishment of 401(k) plans, plan participants will now have a truer picture of the fees and expenses that impact their retirement savings outcomes. Plan sponsors and plan fiduciaries will be forced to react to a possible backlash to participant inquiries about decisions made on their behalf. Interpreting the new regulations and implementing sound fee disclosure processes will be daunting for most plan sponsors. Many sponsors will seek the help and guidance of qualified plan consultants and advisors to ensure compliance with the regulations and the ultimate success in retirement income security for participants. 3
404(a)5 Reporting Requirements AS PROPOSED IN THE NEW DOL REGULATIONS, each 401(k) plan participant will be required to receive, at least annually, specific information about both the plan and the plan s investments. (It should be noted that these regulations apply only to participant-directed plans, not trustee-directed plans.) Plan-Related Information Investment-Related Information 4 Plan sponsors must provide general information about the plan, including investment options and instructions, as well as information on other investment options that might be available (i.e. managed accounts, brokerage windows, etc.). Information must be provided regarding all fees and expenses paid out of plan assets and charged against individual participant accounts. These are normally hard-dollar fees (as opposed to soft-dollar or revenue-sharing fees) which are invoiced directly to the plan. Plan sponsors must also disclose whether fixed fees are allocated to participants on a pro-rata or per-capita basis. An important aspect of the regulation is that, for the first time, participants will be required to receive an accounting of any and all revenue-sharing fees paid between service providers that have been used to reduce the plan s hard-dollar costs. All reporting of these revenue-sharing arrangements must be accompanied by an explanation that some of the plan s operational expenses have been paid from these arrangements that potentially have reduced participant investment returns. Sponsors must provide information on any charge or deduction from individual accounts for an action initiated solely by and for the benefit of the individual. Examples would include charges for loans, domestic-related court orders and brokerage window expenses. Sponsors must provide participants with total operating expenses for each equity investment option available. Investment option expenses need to be reported as both a percentage and dollar amount of each $1,000 invested. For fixed-rate investments, sponsors must provide information on any purchase or withdrawal fee from the investment. Equity investment options must include historic performance of one-year, five-year and 10-year returns, as well as the name of the most appropriate market index used as a benchmark for each option. Fixed-rate investment options must include the annual rate-of-return but benchmarking information is not required. Each plan participant must be provided with information regarding investment terms and their meaning to help participants fully understand the options available to them. While the new disclosure rules require that participants be told whether or not their plan utilizes service providers that engage in revenue-sharing arrangements, participants are not required to be informed about what those dollar amounts are or which service providers are receiving these indirect payments. Approximately 93 percent of all investment companies (mutual funds) providing investment options to 401(k) plans offer some type of revenuesharing arrangement, according to the research firm Cerulli Associates.
Ramifications of 404(a)5 EVEN BEFORE THE RELEASE of the DOL s final participant fee-disclosure rule, there was a heightened awareness that plan fiduciaries could no longer ignore the potential liability of unreasonableness of plan fees, unsubstantiated revenue-sharing arrangements and any possible conflicts-of-interest those arrangements create. Several recent high profile, fee-related court cases over 30 major fee cases according to Fiduciary Benchmarks, a leader in fee benchmarking punctuate the fact that plan fiduciaries cannot turn a blind eye to their responsibility to monitor service provider arrangements to ensure that plan fees and expenses are reasonable for the services provided. The new regulations codify these fiduciary responsibilities in a formal statute. ERISA strongly encourages plan fiduciaries to seek the help and advice of competent third-parties in the operation of their retirement plans. Although they cannot abdicate their responsibilities, plan fiduciaries can mitigate their liability exposure and potentially enhance their participants retirement outcomes by adhering to sound fiduciary principals and best practices. This commitment to sound principals holds true for the monitoring of plan fees and expenses. 5
Guidelines for Complying with 404(a)5 SPONSORS OF PARTICIPANT-DIRECTED 401(K) PLANS should be proactive in approaching the new regulations and establishing a prudent internal process for meeting the requirements of 404(a)5, as well as its companion regulation, 408(b)2. While the requirements of the regulations may seem straight forward on the surface, actual interpretation and implementation of a sound fee-disclosure policy may be daunting for many sponsors. Fortunately, trained plan fiduciary advisors and consultants are available to assist plan sponsors in the implementation process. There are several recommendations that plan sponsors should consider as they begin building their internal fee disclosure policies and procedures: 1. Seek help from professional advisors/ consultants: Most plan fiduciaries have neither the time nor inclination to self-manage the fee disclosure implementation process. Thus, plan fiduciaries should seek out ERISA 3(21) fiduciary advisors who are specifically trained in the understanding of the new fee-disclosure regulations. Working with an acknowledged, fee-only fiduciary advisor/consultant assures the plan sponsor that their advisor is standing feet-to-thefire with them to help fulfill requirements of the new fee disclosure rules. 2. Plan review and analysis: As part of a sound fiduciary process, plan sponsors should conduct a periodic, comprehensive review of their plan s service providers and their associated fees. Normally, this review should be done every two or three years. However, with the advent of the DOL fee disclosure regulations, plan sponsors should strongly consider conducting a comprehensive, third-party fee benchmarking analysis prior to the start date of the new regulations. A good plan benchmarking report will use only current plan information and include an applesto-apples comparison of the plan s current service providers to providers for similar size plans. It will include comparisons of total plan costs, participant success measures and an examination of the plan s fiduciary oversight and best practices. A fiduciary advisor can help facilitate the plan review process. 3. Evaluate plan investment and service provider lineup: After a thorough review and benchmarking analysis has been completed, plan fiduciaries may determine it is in the best interest of the plan and its participants to eliminate any revenue sharing between the plan s service providers. Many service providers that traditionally participated in fee-sharing arrangements, such as TPA/recordkeepers and custodians, will now agree to cease such practices and bill the plan (or plan sponsor) directly for services. Under no circumstances should a plan investment advisor be allowed to accept revenue sharing as this would preclude that advisor from serving as a fiduciary. 6
Guidelines for Complying with 404(a)5 (continued) As most current retirement plan litigation revolves around the investment options, plan fiduciaries might also consider hiring an independent, third-party advisor to assume the responsibility to select and monitor the plan s investment fund lineup. This type of advisor is designated as an ERISA 3(38) investment manager and assumes full discretion for picking the investment lineup for the plan and has sole responsibility for making periodic changes to the lineup when necessary. Hiring an ERISA 3(38) investment manager is an excellent way for plan fiduciaries to mitigate their exposure to liability while enhancing their participant s retirement income security. Since many plan participants are in need of professional help in developing an effective asset allocation strategy to meet their investment goals, the 3(38) manager can provide professionally managed portfolios based on varying age and risk factors. Additionally, some 3(38) investment managers have access to low-cost, institutional funds that help enhance participant retirement outcomes by reducing investment costs. 4. Communicate/educate plan participants: Once the plan has been evaluated and necessary changes have been made to the fund line-up and service providers, plan sponsors should begin a communication campaign to educate participants on upcoming requirements of the new regulations. Starting in the third-quarter, 2012, most participants will, for the first time, receive information on their quarterly 401(k) statement detailing expenses charged against their account balances. Most participants will have difficulty understanding and interpreting this new information. The better educated participants are ahead of time to the changes, the more likely pushback to the plan sponsor will be minimized. The plan s fiduciary advisor should take the lead role in the participant-education process. 7
Summary REGULATION 404(a)5, could be a real game-changer for sponsors of participant-directed 401(k) plans. Although the final outcome is yet to be determined, many industry observers believe plan participants are apt to react negatively upon learning for the first time that fees and expenses are being deducted from their primary and oft-times only retirement income source. Their first stop may well be their HR department for an explanation, and online discussion forums are likely to spring up within the workforces of larger employers. Plan sponsors can minimize any adverse effects that the new participant fee reporting regulation may bring with a little planning and forethought. Plan fiduciaries should begin now to educate themselves about the fee disclosure requirements and how to best fulfill their responsibilities. Most importantly, sponsors should seek out trained professionals to help them interpret, implement and monitor the new fee disclosure requirements. References (1) DOL Fact Sheet Final Rule to Improve Transparency of Fees and Expenses to Workers in 401(k)- Type Retirement Plans February, 2012 (2) 401(k) Participants Awareness and Understanding of Fees AARP March, 2011 (3) Inside the Structure of Defined Contribution/401(k) Plan Fees: A Study Assessing the Mechanics of the All-In Fee Deloitte, LLC for the Investment Company Institute November, 2011 For more information contact: 8