by: Roxanne Fleszar
from: Journal of Management in Engineering
July/August 1999

Many plan participants don’t realize that increasing the administrative "bells and whistles" in their 401(k) plan may be reducing their rate of return.

A disturbing trend has emerged as plan sponsors increase the fees and administrative expenses paid by plan participants for "bells and whistles" options (personal brokerage accounts, excessive fund choices, etc.). When the costs for these options are taken out of the plan’s assets, it effectively reduces the plan’s rate of return. Nor are employees given a choice of opting for higher investment returns rather than optional services.

The irony is that the trend is occurring when the American employer, in the switch from defined benefit to defined contribution, may be saving up to 40 percent of previous costs of administration. The employer offering a 401(k) plan considers it a benefit for the employee. Should it not then, by definition, be designed and managed in a manner advantageous to the employee?

The 401(k) plan has thrust many Americans into the heart of the investment world with little or no prior experience. So when John sits down to dinner and brags about his 21% investment return, could he tell us if that was gross or net? And if it is net of fees, does he know that he, and not his employer, likely pay those fees?

The 401(k) plan was introduced approximately 17 years ago, and quickly overtook the defined benefit plan as the primary retirement plan option in most companies. Today, nearly 30 million participants have amassed at least $1 trillion in 401(k) accounts.

The popularity of the 401(k) plan among employers comes as no surprise, since it is significantly less expensive to run.

A recent study by the Hay Group states that a company with 10,000 employees can spend 40% less for administrative costs on a 401(k) plan than for a defined benefit plan. So it is surprising that, even with this cost savings, a trend has developed whereby companies pass on more and more fees to participants, effectively reducing their rate of return.

According to statistics compiled in a recent survey by the Pension and Welfare Benefits Administration, participants paid all of the investment management fees in more than half of the plans surveyed and shared the fees in an additional 19% of plans surveyed.

This represents a significant amount - the investment management fees typically constitute 75% to 90% of the total plan expenses. The tendency to shift fees to participants has gone on for years and is expected to continue, with research indicating that the percentage of fees paid only by participants had increased in 8 out of 10 fee categories surveyed from 1991 to 1997.

The Employee Retirement Income Security Act of 1974 (ERISA) mandates that plans disclose the amount of fees and expenses paid by their plan in the summary annual report. However, plans are not required to disclose in this report the amount of those expenses which are passed on to participants. Additionally, quoted net performance returns may still be less than they appear owing to administrative expenses passed on to participants, which are not deducted in performance calculations.

Under ERISA rights, a participant may request and obtain additional documentation from the plan sponsor regarding the plan. This includes the Form 5500, which provides further details on fees paid by the participants. This does not mean that John, the participant mentioned above, will be able to decipher the form to obtain the information he needs.

After all, who among us can honestly make sense of an IRS form? One might argue that a plan sponsor is acting imprudently by not fully disclosing fees to participants. After all, the inherent nature of the 401(k) plan shifts liability for investment decisions to the employee. Shouldn’t they be aware of all information affecting these choices? To comply, plan sponsors should take the following steps toward full disclosure.

• Review and compile a listing of all of the fees and expenses charged to the plan by all of its service providers (third party administrators, financial advisors, etc.). Further clarify those costs based on how they are charged. For instance, administrative fees may be charged in a variety of different ways. They may be asset based or participant based or take the form of a flat fee. This is an extremely important step, since a 1995 study revealed that 78% of plan sponsors were unaware of their total plan costs.
• Communicate this information to plan participants in a clear, concise format. Several companies have designed prototypical forms precisely for this purpose. Your provider will be able to obtain one for you.
• Review methods for reducing fees based on employee feedback. Today’s 401(k) plans can carry a lot of "bells and whistles", but employees may opt for higher investment returns rather than optional services.

Independent pension plan consultants can evaluate options vs. fees vs. rates of returns and help the plan sponsor do what is right for the employees, even surveying the employees to find out their preferences. In an environment when highly skilled employees are looking for more than a good salary package, the administrative details of retirement plans are under increasing scrutiny.