A brief review
In the previous article, we highlighted the disparity in fees when using traditional revenue sharing arrangements to pay for the administrative and recordkeeping costs of a retirement plan. Today, let’s focus on solutions.
First solution: fee equalization using existing revenue sharing
Let’s go back to our example of John Doe Computers 401(k), which has $12 million dollars, 100 plan participants, and generates 50 basis points in revenue sharing (or $60,000) – which, by design, is the exact amount of revenue required by XYZ Bank for administrative services. Currently, participants with high allocations of active investments end up paying for the plan’s total costs. Another way to split of the plan cost is to allot them to plan participants based upon their percentage of total assets. 401(k) fee equalization determines the total fees paid by the plan and splits it proportionally among plan participants, using rebates or additional hard dollar fees as necessary. Employees with cheap index funds will get charged additional hard-dollar fees from their account. Employees with expensive active funds will get a rebate or refund to compensate them for overpaying.
For example, Sam Smith is the big executive at John Doe Computers; Sam has $1,000,000 in the plan, so you’d think he’s paying for much of the underlying costs, but since he primarily uses passive investment options in his personal 401(k) account, he generates minimal revenue sharing - only 5 basis points or 0.05% - to pay for the administrative costs of the plan. In contrast, Walt Whitman the technician has $75,000 in the plan, but he invests in actively-managed investments which contribute 120 basis points (1.2%) of revenue sharing fees, far above the average rate.
If we split the total administrative costs ($60,000) to participants proportionally, you would calculate that Sam Smith owes $5000 of revenue sharing to the costs of the plan (i.e. 1M/12M * $60k). Sam Smith currently contributes a mere $500 to plan costs, so he has to pay a hard-dollar fee of $4500 to equalize his fees. In contrast, Walt Whitman should owe $375 of revenue sharing to the total plan costs (i.e. 75K/12M * $60K). Since Walt is currently paying $900 in revenue sharing (1.2% * 75K) so he should get a refund of $525 to equalize his fees to the correct amount.
Second solution: fee levelization per participant
Fee equalization is a workable solution, but it is a little complicated because it’s based on the existing revenue sharing structure. In contrast, the Department of Labor and Department of Justice both seem to dislike the common revenue sharing model as a payment method. The fiduciary rule, drafted by the DOL, promotes zero revenue sharing models while DOJ lawsuits often focus on neglect regarding share class selection, often established as retirement plan sponsors mold their plan to accommodate the revenue sharing requirements of service vendors. While the actual implementation of the proposed fiduciary rule is an ongoing quarrel between the White House and government watch dogs, the guidance included in the drafted legislation has clearly indicated the preference of the DOL and DOJ.
Is there an alternative payment structure which avoids the inherent complications of revenue sharing? Certainly there is. Plan sponsors can remove all revenue sharing arrangements from the plan. They can convert every investment, active or passive, to the cheapest available share class which, typically, creates no revenue sharing. Available breakpoints for retail investors, like you or I, are generally based upon the amount of available to invest. In contrast, retirement plans – even small retirement plans – often have access to minimal cost share classes.
Of course, the plan still has to cover administrative costs. So who pays and how do they pay? If the retirement plan sponsor itself, say John Doe Computers, pays and their payments do not come from plan assets (which is reserved for the participants’ benefit), then the fiduciary duty has largely been met. However, the plan sponsor can still make plan participants pay for administrative costs, and there are two ways to do it.
Pro-rata participant fees
A pro-rata payment system would look quite similar to the fee equalization example we already discussed, but it is even simpler. Commonly, there will be overall cost savings by switching to a simpler per-participant payment plan, through cheaper share classes or smaller administration fee requirements. Using our going example, the $60,000 of fees generated for John Doe Computers might be high given the simpler approach of an updated plan without revenue sharing. However, just to maintain a constant, apples-to-apples comparison for this article series, let’s presume the total administrative costs remain steady at $60,000.
Under the pro-rata system, Sam Smith still owes $5,000 for administrative costs to the plan (i.e. 1M/12M * $60k) and that amount is deducted from his balance annually. Walt still owes $375 for administrative costs (i.e. 75K/12M * $60K) and that amount is deducted from his balance annually. Neither Sam nor Walt gets additional credit since no investments generate any revenue sharing.
Per-capita participant fees
The pro-rata system is straightforward, but Sam Smith and other highly compensated individuals at John Doe Computers might complain about it. Recall Sam started originally paid $500 for plan costs invisibly through an indirect expense ratio and now he sees $5000 direct deduction from his 401(k) balance.
Sam makes this argument: “Why are retirement plans cheaper than a comparable IRA? The answer: pooled money. The more money in the pool, the better the economies of scale, and the cheaper the plan is for everybody.”
Sam reasons John Doe Computers’ retirement plan is inexpensive because of his large pool of money (and from other large investors like him) have lowered the total costs for everyone. Since the large asset pools are creating cheaper costs for everyone, large and small investor alike, why not make everyone pay the same amount?
Sam argues that the costs of managing the plan are actually the same for each participant. XYZ Bank sends each of the participants a quarterly statement and offers each participant the same type of investment education on the phone, so shouldn’t the fees be the same for everyone as well? If participants get the same service, shouldn’t they pay the same amount? If two people order a hamburger, you don’t change the price of the burger based on how wealthy each customer is.
Sam proposes a level fee per person. Under the per-capita system, Sam and Walt would pay the same amount. There are 100 participants in the plan and the combined plan costs are $60,000. Thus, Sam and Walt (along with every other participant) pays a hard dollar fee of $600 taken from their 401(k) balance every year.
A per-capita payment system often penalizes the small investor and benefits the large investor, but large investors suggest that the plan costs are as low because of their existing presence within the plan. Why should large investors be forced to do double-duty? Why subsidize access to the retirement plan for the least engaged participants?
Advocates of the pro-rata payment system counter this argument by noting the disproportionate expense to smaller plan participants will discourage small investors from investing into the plan at all since so much of their initial, smaller balance is taken in fees. The subsidization of smaller investors encourages more people to invest, making the plan larger (which ultimately lowers total plan costs again), employees’ retirements more secure, and healthier company turnover.
No matter how the retirement plan committee chooses to approach changes to plan payment structure, asking these questions, and interacting with your service providers can often significant cost savings. Going through these exercises with an engaged investment consultant with a fiduciary duty to your plan can reduce committee liability and create cost savings benefits for employees.