Managing Retirement Plan Expenses: A Fiduciary Responsibility

Plan sponsors have fiduciary responsibilities which include monitoring and controlling costs associated with a retirement plan, such as investment and administrative expenses. This issue of Management Briefing discusses some of the basics of 401(k) retirement plan expenses, their fiduciary implications for plan sponsors, and other fiduciary considerations.

Highlights

More and more, employers are making 401(k) plans the retirement vehicle of choice in American

business, with several trillion dollars in assets invested in these plans. This is an astounding accumulation of assets since 401(k) plans were first introduced in 1981. Because participants are taking more responsibility in selecting investments and actively managing their account balances, much attention has been paid to investment offerings, specifically performance and expenses. These are extremely important since the retirement money in participants’ accounts must – literally – last a lifetime.

For plan fiduciaries, ERISA has established five primary responsibilities that are required. These responsibilities are:

• Acting in the interest of plan participants and beneficiaries for the sole purpose of providing benefits to them;

• Carrying out their duties prudently;

• Following the plan documents accurately, unless they conflict with ERISA;

• Diversifying plan investments; and

• Paying reasonable plan expenses.

Let’s take a closer look at this last point – managing plan expenses. Reviewing and managing investment and administrative expenses is extremely important and requires that plan sponsors take an active role with theirinvestment fund providers and plan administrators.

What Are Plan Expenses?

In general, plan expenses fall into two broad categories: investment expenses and administrative expenses. In some cases, investment expenses can account for up to 80% to 90% of overall plan expenses. Administrative expenses may be a smaller portion, but still significant. Investment expenses are made up of several components, including:

• Front-end loads and backend loads

• Operating expense ratios

• Transaction costs

• Asset charges

• Mortality and expense fees

• Surrender charges

Following is a summary of each of these investment components.

• Front-end and back-end loads: Front-end loads, charged at the outset of the investment, are used

to pay the advisor for his or her services. They typically range from 3.50% to 5.75%. Back-end loads, charged when the funds are redeemed within a certain period of time, generally carry a 12b-1 fee1

which is associated with marketing and distribution costs charged by the fund. Both front-end and backend loads can be waived in retirement plans. Back-end loads will not usually be waived for smaller plans.

• Operating expense ratios: The operating expense ratios include charges to

provide investment management services. These include the buying and selling of stocks and bonds, the cost of research, compensation of the manager, the firms profit margin, 12b-1 fees, and other administrative expenses.

• Transaction costs: This is one of the most difficult expenses to quantify without the proper level of expertise and considerable analysis. The transaction cost is created when securities are bought and sold within the mutual fund. It includes the sales commission and must be identified in order to capture all plan expenses. A fund’s transaction cost can easily be greater than its expense ratio. Although it is not published or disclosed, this transaction cost is reflected in the net return of the fund.

• Asset charges: An asset charge is an additional charge incurred to offer outside mutual funds in a

provider’s plan. This expense compensates the provider for offering the extra fund(s). It is in addition

to a fund’s expense ratio.

• Mortality and expense fees: Insurance products, such as annuities, often include mortality and expense

fees built into the product. They range from 0.25% to 2.00% on the total assets in the annuity account(s). These fees are in addition to the usual expenses charged within the underlyingfund offerings.

• Surrender charges: Annuities routinely carry surrender charges that are assessed if the contract is

broken within a specified period of time. Administrative expenses are made up of recordkeeping and administration, and trustee and custodial service expenses. Following is a summary of each of these

components.

• Recordkeeping and administration: Recordkeeping and administration fees are incurred for participant

recordkeeping and fund accounting; Internet, voice response, and customer service access; daily activity processing; participant statement generation; and IRS reporting and compliance services. Recordkeeping

also involves ensuring that the plan is properly operating under ERISA in order to maintain its qualified

status. Recordkeeping and administration is the backbone of the plan, since participants rely on the integrity of the records to make their investment decisions and plan sponsors want quality recordkeeping services so they and the plan participants can be confident that the accounts are accurate and the information reliable. Oftentimes, participant education and communication services are included as part of the recordkeeper’s responsibility, while other times this function is outsourced to

a firm that specializes in these services.

• Trustee and custodial services: Trustee and custodial services are typically provided by banks, trust

companies, mutual fund companies, and insurance companies. The function of the trustee/custodian is to maintain the assets in trust for the benefit of the participants, facilitate the investment of assets as directed, issue checks as required, and handle the appropriate IRS tax reporting. Competitive trustee

and custodial fees normally range from 0.01% to 0.10% of plan assets. The fees are based on the

assets available for investment and usually decrease as assets increase and

meet certain breakpoints.

What Is Fiduciary Responsibility?

ERISA charges plan sponsors with a fiduciary responsibility to act in the best interest of the plan participants. This implies that plan sponsors should know the costs of operating the plan and that they apply due diligence to justify these costs. Plan sponsors are not required to offer a plan at the least expensive cost. They must, however offer a plan with competitive costs, going through a level of due diligence to justify those costs. To assist plan sponsors in complying with ERISA in operating the plan solely for the benefit of the plan participants and beneficiaries, plan sponsors must:

• Establish a prudent process for selecting investmentalternatives and service

providers;

• Ensure that fees paid to service providers and other expenses of the plan are reasonable given the level

and quality of services provided;

• Select investment optionsthat are prudent and adequately diversified; and

• Monitor investment options, plan expenses, and service providers on an ongoing basis. Plan sponsors should have a thorough understanding of plan expenses so they can maximize the return on participants’ retirement investments and fulfill their fiduciary responsibility to the plan participants.

Meeting Your Fiduciary Responsibility

One of a fiduciary’s central responsibilities under ERISA is to act prudently. To meet this responsibility, the focus is on the decision-making and review process. Be sure to do the basics correctly: havea written process in place, follow the process, and remember: documentation is the key.

You can start with a clear and concise investment policy statement. The investment policy statement is your guideline for all decisions regarding plan investments. Always keep it in mind and follow it. Next, create and follow a due diligence process. This involves a number of things, including:

• Holding regular, formal investment/retirement plan committee meetings;

• Identifying benchmarks for fund performance and plan expenses and measuring your funds and expenses against these benchmarks;

• Conducting market searches when necessary for fund providers and administrators; and

• Documenting your findings, meetings, and processes. Awareness of your fiduciary responsibilities and being proactive in carrying out these duties should help you properly fulfill your fiduciary requirements and provide a plan that is compliant, costeffective, and appreciated by your plan participants.