UNDERSTANDING 401(k) PLAN FEE STRUCTURES AND INVESTMENT TRENDS Presentation for the Plan Sponsor Council of America s 68th National Conference Holly Verdeyen, CEBS, Director, Defined Contribution, Russell Investments Robert E. Pike, CFA, AIF, President & Chief Investment Officer, Stratford Advisors Inc. Ty Parrish, C(k)P, CIMA, GFS, Managing Partner, Blue Prairie Group OCTOBER 15, 2015
Ty Parrish Blue Prairie Group
Retirement plan fee basics and best practices Discussion topics Understanding your responsibility as a fiduciary Fee trends A review of fee components and price drivers of your plan Pricing structure considerations Benchmarking your fees 3
What are the duties of a fiduciary? Original text: Fiduciaries have important responsibilities and are subject to standards of conduct because they act on behalf of participants in a retirement plan and their beneficiaries. These responsibilities include: Acting solely in the interest of plan participants and their beneficiaries with the exclusive purpose of providing them benefits Carrying out their duties prudently Following the plan documents (unless inconsistent with ERISA) Diversifying plan investments Paying only reasonable plan expenses Source: www.dol.gov/ebsa/publications/fiduciaryresponsibility.html 4
What does the DOL say about 401(k) fees? Fees need to be reasonable, not low Fees should not be considered in a vacuum This determination needs to be made at the Service Provider Level 5
Factors to consider Quality of Provider Fees Cost Drivers vs. Value Factors 6
Lessons learned from Tibble vs. Edison ERISA fiduciaries have a continuing duty to review the investments in the plans for which they are responsible Fiduciaries should regularly benchmark the fees to insure reasonableness Fiduciaries should document their decisions and the rationale for such decisions 7
Components of plan costs Administrative Fees Investment Fees All costs associated with managing the investments Almost Always paid for by plan participant Services to operate the plan: Recordkeeping, Trustee, Compliance, Communications Paid for by plan sponsor and/or participant Plan Consulting Fees Advisory fees paid to a registered investment advisor or commission paid to a broker Paid for by plan sponsor and/or participant 8
How fees are being charged across the industry? Source: Transamerica Report on Retirement Plans- 2013 9 9
Pricing drivers Primary Average account balance Total plan assets Total head count Secondary Use of auto features # of locations Higher participant and employer contributions Other business with service provider Allocation in stable value/fixed income vehicles 10
Basis points fee charged through plan investments Based on account balance & investment allocation Revenue sharing vary by vehicle/share class Higher account balance participants may subsidize lower account balances Participants in higher revenue share investments may subsidize participants in lower revenue share investments 11
Basis point fee charged through plan investments Pro-rated based on account balance Fee Levelization All investments have the same revenue share/wrap fee Higher account balance participants may subsidize lower account balances Keeps fees reasonable for new employees/lower account balances 12
Flat dollar fee charged to participant s account Option #1: Evenly distributed per employee Allows for use of investment manager s lowest cost structure Eliminates participant subsidization Full fee transparency New and low balance participant considerations Option #2 Pro-rated based on account balance Allows for use of investment manager s lowest cost structure Higher account balance participants subsidize lower account balances Full fee transparency 13
Benchmarking Best Practices 14
Benchmarking Best Practices Hire third parties to conduct benchmarking Compare fees to third party benchmarks annually including: Investments Administration Advisor fees Total costs Conduct RFI every three years Save documentation to fiduciary vault Know the minimum required revenue needed from your recordkeeper Recapture excess revenue in ERISA bucket Look for opportunities to move to a lower investment share class 15
Holly Verdeyen Russell Investments
Plan sponsor fee initiatives in 2015 WHAT STEPS AROUND FEES ARE YOU MOST LIKELY TO ENGAGE IN NEXT YEAR? Very likely Somewhat likely Somewhat unlikely Very unlikely REBATE PARTICIPANT FEES 24.7 11.8 22.5 25.8 CONDUCT A FEE STUDY 31.5 20.2 21.2 42.4 RENEGOTIATE RECORDKEEPER FEES 20.5 23.9 26.1 29.5 SWITCH TO LOWER FEE SHARE CLASSES 12.2 34.4 20 33.3 CONDUCT A RECORDKEEPER SEARCH 11.4 11.4 12.5 64.8 CHANGE THE WAY FEES ARE PAID 10.3 13.8 25.3 50.6 CONDUCT A TRUSTEE/CUSTODIAL SEARCH 9.3 7 14 69.8 Source: 2015 Callan DC Trends page 47
Be deliberate in your choice of investment vehicles Separate accounts Commingled funds Mutual funds Guideline flexibility Negotiable fees Handle limited scale Brand recognition
The attraction of institutional fees 100 US equity fees 90 Fee (bps) 80 70 60 50 Retail Gap Institutional Gap Mandate Aggregation Future Growth Mutual Fund Universe Median Mutual Funds Used By 401(k) Plans* 40 Commingled Fund Universe Median 30 0 50 100 150 200 Mandate Size ($M) *ICI Research Perspective, August 2015, The Economics of Providing 401(k) Plans: Services, Fess and Expenses (Domestic stock, asset weighted average) Data Source: evestment, LLC, September 2014 (US large cap core equity) unless otherwise noted
How do I know which vehicles my plan is eligible for? Mutual fund (institutional shares) TYPICAL MINIMUM INVESTMENT: I share $10,000 Y share $10 million R share none CONSIDERATIONS: Minimums may be assessed on plan level or platform level Collective investment trust TYPICAL MINIMUM INVESTMENT: $5-10 million CONSIDERATIONS: Minimums may be flexible or waived Your recordkeeper or consultant may have special arrangements Separate account TYPICAL MINIMUM INVESTMENT: $25-$50 million CONSIDERATIONS: Additional costs such as custom fund accounting p.20
Investors are paying less for target date funds Average of Industry s Asset-Weighted Expense Ratio 2008-2014 Target-Date Mutual Funds Percent [VALUE]% [VALUE]% [VALUE]% [VALUE]% [VALUE]% [VALUE]% [VALUE]% 2008 2009 2010 2011 2012 2013 2014 Source: Morningstar 2015 Target-Date Fund Landscape Report, April 7, 2015. Historical asset-weighted expense ratios of the 57 target date fund series included in Morningstar s database.. p.21
Fiduciary risk and lawsuits are the top reasons sponsors go passive, but is passive actually the safe option? 60% 48% 40% 26% 20% 17% 9% 0% Alleviate threat of lawsuits Fiduciary concerns Do not believe that active managers outperform Cost of investments is the most important factor -20% Source: Cerulli Retirement Markets 2013 22
All passive DC plans: Whose interest do they serve? Current fee scrutiny is not generally about fee levels, but appropriate fee monitoring and benchmarking Investment objective must remain primary focus - make the active/passive decision at the asset class level, not the plan level Focus on a fund s value in terms of meeting retirement income objectives, not on absolute fee levels Most institutional investors mix active and passive management why would you not do the same for participants? There is no such thing as a total passive solution Source: Russell DC Practice 23
Important Information THIS CONFERENCE MATERIAL WAS CREATED BY RUSSELL AS AN EDUCATIONAL TOOL, AND IS NOT FOR FURTHER DISTRIBUTION Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Copyright 2015 Russell Investments. All rights reserved. This material is proprietary and may not to be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. First Used: September 2015 USI-22930-09-2016
Robert E. Pike Stratford Advisors Inc.
IMPORTANT LEGAL INFORMATION This presentation is intended solely for information purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or sell or trade in any securities herein named. Information is obtained from sources believed to be reliable, but is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted. In no event should the content of this presentation be construed as an express or implied promise, guarantee or implication by or from Stratford Advisors, Inc., or any of its officers, directors, employees, affiliates or other agents that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. All investments are subject to risk which should be considered prior to making any investment decisions. The firm may hold for its clients, Principals or employees, positions in any securities mentioned herein, and may buy or sell such securities at any time without prior notice.
Price vs. Value: Separate all costs first Source: The Adviser Lab, LLC. Fund expenses are manufacturing costs which produce a common product: return on investment Service costs include many components that are not easily captured in return on investment
Every basis point matters Small changes in returns can equal the entire starting value or more over time Costs savings and return enhancements can improve retirement readiness
Expense ratios of actively manage & index funds (in basis points) Source: 2015 Investment Company Fact Book. NOTE: Expense ratios are measured as asset weighted averages; excludes mutual funds available as investment choices in variable annuities and mutual funds that invest in other mutual funds. Trend towards lower fees has been very consistent over time, across all vehicles Active funds cost more than passive, and their fee reductions have not been proportionately as great
All-in expenses represent true cost Source: The Arithmetic of All-In Investment Expenses John C. Bogle, Financial Analysts Journal, Vol. 70, No. 1 (Jan-Feb 2014) Active fund portfolio turnover a good indicator of transaction costs Active funds must always hold cash to meet shareholder redemptions Sales charges/fees include advice, consulting, anything outside the investment vehicle
Shift to passive funds is clear Morningstar.com Active funds have over $3.8 trillion in assets Passive funds currently have $2.5 trillion in assets and are expected to reach parity with active
Expense ratios are the best predictor of future performance If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile. Russel Kinnel, Director of Fund Research, Morningstar How Expense Ratios and Star Ratings Predict Success, 08/10/2010 Consider only lowest quintile/quartile funds for inclusion in DC plans Can be applied to both active and passive funds
Percent of active funds underperforming benchmark Source: S&P Dow Jones Indices, SPIVA U.S. Scorecard YE 2014 Vast majority of active funds fail to deliver excess return after fees Certain fund categories offer better probability of success
Is beating the benchmark the right measure of success? Passive funds reflect the entirety of declines/drawdowns Cost savings dwarfed by amount of decline Participants need help
Gap between fund and investor returns Source: Research Affiliates based on Kinnel (2014) Emotionalism and market timing are the participants worst enemies Can seriously and directly impair retirement readiness
Few participants are equipped to manage their retirement investments It s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals You d no more require employees to make those kinds of decisions than an automobile maker would dump a pile of car parts and a technical manual in the buyer s driveway with a note that says Here s what you need to put the car together. If it doesn t work, that s your problem. Robert C. Merton, The Crisis in Retirement Planning, Harvard Business Review, July-August 2014
Participants using help are better off Source: Help in Defined Contribution Plans: 2006-2012 (Financial Engines/Aon Hewitt) Help is defined as target-date funds, managed accounts, or online advice Average annual performance advantage net of fees was 3.32% per year Custom solutions emerging (MACS, TDF 3.0, CIT)
Core/satellite approach common for institutions Source: First Eagle Funds Blend of passive & active with unconstrained (go-anywhere) mandate Utilizes both short term (tactical) and long term (strategic) positioning
Real 10 year expected risk and return Source: Research Affiliates Today s core investments offer poor prospects going forward
US University endowment s asset allocation 1900-2013 100.0 90.0 80.0 70.0 Percent 60.0 50.0 40.0 30.0 Alternatives Real Estate Common Preferred Bonds 20.0 10.0 0.0 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 Year Source: British Origins of the US Endowment Model Elroy Dimson & David Chambers, Financial Analysts Journal, Vol. 71, No. 2 (March-April 2015) The smartest guys in the room already know this
This is the challenge for everyone Source: Research Affiliates Historical returns unlikely to be repeated over next 10 years Imperative to provide DIA s that alleviate these types of outcomes
Expanded opportunity set allows for higher real returns Source: Research Affiliates Non-traditional/non-core asset classes have healthier return profiles Investment vehicles growing but industry still in nascent phase
Alternative strategies can provide ballast during bear periods Source: EMC Capital Advisors LLC Higher costs more than offset by return differential Sophisticated strategies unavailable to retail saver/investor Diminishes primary risk to retirement savers of timing, magnitude, and length of drawdowns
Alternative growing rapidly Source: Strategic Insight, Forward, and Morningstar as of 6/30/14. Inflows into liquid alts were over $20 billion in 2014 according to Morningstar Total assets now over $300 billion, up from $25 billion in 2005 Wide variety of vehicles and strategies, not a uniform category
Evolution of target design Source: Alliance Bernstein, Designing the Future of Target-Date Funds: A New Blueprint for Improving Retirement Outcomes, June 2015 First generation TDF s still dominate DC plans DOL encourages inquiry around custom or non-proprietary TDF s
Conclusion Benchmark plan fees annually and save documentation Conduct RFI every three years to gain true gauge of competitiveness Look for opportunities to move to a lower share class or collective investment trust on Investments Consider a thoughtful blend of active and passive to manage overall plan cost Offer a well diversified, institutionally-priced, TDF suite to help participants navigate the complexities of global markets Participants want and need help to navigate market complexities Passively managed funds are not necessarily the safe fiduciary option Poor return prospects going forward suggest an urgency to adopt more institutionally based (risk controlled) solutions 46