Sinkorswim

03/06/09 - Insult to Injury in Your 401(k)

By: Robert J. Gordon, MBA, CFP®, AIF®

Perhaps, like many others, your 401(k) has become more like a 201(k) in the last 12 months. It has been painful for everyone and especially those who, over the years, have religiously contributed to their defined contribution plans which would include 401(k), 403(b) and 457 plans. Diversification has offered little protection during this market downturn as the correlation between asset classes has converged to 1. As if a market‐imposed haircut is not enough, the companies which provide the investment products and services for retirement plans continue to charge a confusing jumble of fees which frequently go undisclosed. These expenses are commonly categorized as "revenue sharing" in the financial services industry. While not necessarily illegal, it can reasonably be argued that this practice places an unnecessary surcharge on the long term performance of the plan. In times like these, when the unavoidable market correction challenges our efforts to save and invest for a comfortable retirement, it is important to focus on the things we can control and plan expense is one of them.

What is revenue sharing? Revenue sharing refers to payments that are sourced from a plan's investments and are paid to providers without going through the plan.¹ Common examples include 12b‐1 fees. While some of these fees offset real expenses, for the most part, they are marketing or market access fees. This is why your plan ends up with the 10 to 50 mutual funds or other investment options shown on the list of available investments despite the fact that there are thousands of mutual funds in existence.

The process used to select the funds included in a plan is based on a combination of demand and incentive. The demand is theoretically driven by the expected future performance though favorable brand identification and availability are also important factors. Incentive is the other key ingredient. In fact, it is fair to say that incentive IS the key ingredient. Hell bent on gaining market share, qualified retirement plan providers (typically insurance led financial services conglomerates) joined forces many years ago with traditional Wall Street and Main Street brokerage firms and large mutual fund companies to serve the qualified retirement plan needs of the public and their employers. The brokerages, through their long established sales teams, had access to the investing public. The large mutual fund complexes, typically offering mostly actively‐managed mutual funds, wanted to build their assets under management. The plan providers act as matchmakers and toll collectors in this arrangement. Plans which have the third party administrator (TPA), record keeper, investment advisory and investment products offered by one company or a group of affiliated companies are typically referred to as "bundled" solutions. Solutions which include unaffiliated firms are referred to as "unbundled."

Let's look at an example of the cost difference between a bundled and an unbundled plan.

The large insurance company plan provider of a plan such as this has average mutual fund operating expenses of 1%. However, you must add on the fee that is paid ultimately by the plan participant for the funds that are offered through the plan. It is called a platform access fee and it averages 0.375%. The plan provider charges it to the plan's assets even though it was really due from the mutual fund company. There is also typically a separate charge for the recordkeeping services of approximately 0.15%. Now we come to a category of charges which come under the heading "indirect costs". Typically, these costs are not broken out or disclosed in any detailed manner. Recently, at a defined contribution conference organized by industry publication Pensions & Investments, Scott Parker, a Senior Manager with Deloitte in their Pension Consulting group said, "Indirect costs may represent up to 1/3 of a plan's total annual costs and they are typically not fully detailed or disclosed." So that gives us a total cost of approximately 2.31%.

Now let's do the same breakdown for an unbundled plan using institutional class, index mutual funds. Average fund operating expenses under this scenario are 0.50%. The recordkeeping and TPA fees are a fixed annual amount as long as the number of employees remains the same. For a plan this size, they represent approximately 0.60% of the total plan assets. Custody charges at a discount brokerage average 0.10%. The investment advisory fee for the RIA is 0.50%. That gives us a total 1.70%. In dollar terms, this is an annual savings of $9,150.

With the market down almost 40% since January 2007, savings in any amount are certainly welcome. We are optimistic about the growth in global economies over the long term. Reducing all drags on that future performance, especially excess costs, improves the long term performance for all participants.

If only the rest of the industry thought similarly.

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