Spring 2007

Do You Know…Understanding Plan Costs and Revenues Paid to Your Providers

By Fred Reish, Bruce Ashton and Stephanie Bennett

Media and public attention has increasingly focused on the expenses borne by the participants in participant-funded retirement plans. While much of the attention centers on private sector 401(k)'s and 403(b)'s - arising out of fiduciary litigation regarding fees, expenses and revenue sharing, Congressional hearings on the costs charged to plans and the revenues paid to providers, and efforts by the U.S. Department of Labor ("DOL") to re-write the rules for disclosure of those costs and revenues - the fallout from these efforts will almost certainly impact public sector 457(b) and 403(b) plans as well.

The consequence of this attention will be greater scrutiny of fees, costs and indirect payments received by providers, sometimes referred to as "revenue sharing." That scrutiny will inevitably lead to more transparency and additional disclosure by service providers. Further, regulatory changes expected this year, affecting private sector plans governed by the Employee Retirement Income Security Act of 1974 ("ERISA"), will almost certainly affect the expectations of participants, the responsibilities of fiduciaries, and the costs of public sector participant-funded and invested plans. As a result, the officials responsible for these plans (e.g., members of a municipal retirement board) need to be aware of the costs associated with the administration and investments of the plans.

While any analysis of costs and revenues includes the charges made directly to plans, it also includes indirect payments from the investments to service providers. In turn, that means that fiduciaries must understand and evaluate who receives the benefit of the indirect payments. By following the "money trail," the plan sponsor and its fiduciaries may discover a variety of indirect payments, such as finder's fees, 12b-1 fees, administrative service fees, bonus payments and awards, transfer agency fees and even gifts. That trail also reveals the recipients of those indirect payments, which may include consultants, advisers, plan providers, recordkeepers, broker-dealers and third party administrators.

Most plan officials understand direct fees charged to their plan. For example, plans that work with investment advisers to select the investments for their 457(b) plan may pay the investment adviser's fee themselves or through plan assets. That fee is typically a fixed dollar amount or a fixed percent of the plan assets. The flat fee is straightforward and transparent, since a description of the services rendered along with the amount of the fee is usually included in the agreement with the adviser and later documented by an invoice. However, the investigation into the plan costs and the payments to advisers (or other providers) cannot end there, because it is possible for an adviser to receive additional compensation from other sources, such as investment managers or mutual funds or their affiliates that may or may not be adequately disclosed - or even mentioned - in the advisory agreement.

For example, a plan adviser may receive compensation that varies depending on the investments that are selected for the plan. This form of compensation is usually either a commission or a bonus paid by a provider of investments to a plan, such as a mutual fund or its management company, or an affiliate. However, it may also take the form of a gift, such as an expensive trip or vacation. If the consultant or adviser is a broker, the payments may include finder's fees for new deposits into the plan (such as transferred amounts from a prior provider, new contributions and deferrals, rollovers to the plan, and so on), together with an ongoing 12b-1 fee-most often ¼ of 1% per year (sometimes referred to as 25 basis points), but sometimes as high as 1% per year. (A broker may also be known as a registered representative, financial adviser or financial consultant. The compensation is usually split between the broker and the broker-dealer with whom he or she is associated.)

An example of the type of information that public sector fiduciaries should seek from their advisors is the information reported for private sector plans in Schedule C of the Form 5500. (The Form 5500 is an annual report filed by private sector plans with both the IRS and DOL.) The instructions of the proposed Schedule C for 2008 indicate that the following must be reported:

[M]oney or any other thing of value (for example, gifts, awards, trips) paid by the plan or received from an entity other than the plan or the plan sponsor by a person who is a service provider in connection with that person's position with the plan or services rendered to the plan. [F]inder's fees, placement fees, commissions on investment products, transaction-based commissions, sub-transfer agency fees, shareholder servicing fees, 12b-1 fees, soft-dollar payments, and float income. Also, brokerage commissions or fees (regardless of whether the broker is granted discretion) are reportable whether or not they are capitalized as investment costs.

Providers are developing information based on this framework. Even though this information may not be required to be disclosed to them by law, it would be prudent for public sector plan fiduciaries to ask for information similar to that reported on Schedule C.

Uncovering the costs and revenues to providers is the first step, but once that information is collected, what should the fiduciaries do with it?

That question leads to the next step, which is an evaluation of the information. In evaluating the information, the fiduciaries should focus on whether the plan costs are competitive and whether the participants are receiving equivalent value for the cost. To determine competitiveness, fiduciaries may wish to hire a consultant to perform a request for proposal and compare the costs of other provides' services for plans of a similar size (i.e,. number of participants and total assets). To determine value, fiduciaries should ask the following two questions: What does the plan receive in exchange for the expense paid? Is the service worth it? For example, if a service is provided to participants and the plan pays all associated costs but no one uses the service, no matter how minimal the fee, it would be unreasonable because no one is using the service.

If the plan officials do not understand those concepts and have not traced the "money trail," it is possible that they are unaware of additional compensation being paid to one or more of their plan's service providers, compensation that may impact the advice or services being received from that service provider. In order to protect the plan and themselves, plan officials need to take precautions. The DOL's ERISA Advisory Council offered practical advice to all plan officials about the information they should obtain from service providers:

"The Advisory Council makes the following recommendations in an effort to further educate plan sponsors and fiduciaries:
  1. Plan sponsors should avoid entering transactions with vendors who refuse to disclose the amount and sources of all fees and compensation received in connection with plan.
  2. Plan sponsors should require plan providers to provide a detailed written analysis of all fees and compensation (whether directly or indirectly) to be received for its services to the plan prior to retention.
  3. Plan sponsors should obtain all information on fees and expenses as well as revenue sharing arrangements with each investment option. Plan sponsors should also determine the availability of other mutual funds or share classes within a mutual fund with lower revenue sharing arrangements prior to selecting an investment option.
  4. Plan sponsors should require vendors to provide annual written statements with respect to all compensation, both direct and indirect, received by the provider in connection with its services to the plan.
  5. Plan sponsors need to be aware that with asset-based fees, fees can grow just as the size of the asset pool grows, regardless of whether any additional services are provided by the vendor, and as a result, asset-based fees should be monitored periodically.
  6. Plan sponsors should calculate the total plan costs annually."

That advice is consistent with the DOL's interpretation of ERISA's fiduciary responsibilities. While ERISA does not govern the operation of public sector retirement plans, the basis for ERISA's rules is the same as for the state fiduciary laws controlling public plans. For example, the prudent man rule for California, found in the state's Constitution, is virtually verbatim the same as the ERISA provision:

The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.

As a result, the DOL interpretations of ERISA's fiduciary rules are important guidance for the officials of government-sponsored plans.

The DOL has a long-held position that fiduciaries have an obligation to know, understand and evaluate all of the fees and expenses being charged to a plan, as well as the compensation of all plan providers. In that regard, the DOL stated in its Advisory Opinion 97-16A:

"…the responsible Plan fiduciaries must assure that the compensation paid directly or indirectly by the Plan to [the provider] is reasonable, taking into account the services provided to the Plan as well as any other fees or compensation received by [the provider] in connection with the investment of Plan assets. The responsible Plan fiduciaries therefore must obtain sufficient information regarding any fees or other compensation that [the provider] receives with respect to the Plan's investments in each….Fund…to make an informed decision whether [the provider's] compensation for services is no more than reasonable.

While that DOL guidance refers to plan providers (i.e., recordkeepers), it also applied to any other person or entity that provides services to a plan, such as advisers and consultants.

Unfortunately, it is easy for the DOL to say that ERISA requires that fiduciaries obtain all of the information on fees and expenses, but it is often difficult to do. In fact, it is hard to even figure out the right questions. However, the recommendations made by the Advisory Council are a great starting point. In fact, that guidance can be re-written as questions and then submitted to each of the plan providers, advisers and service providers for answers. A good adviser can help the plan fiduciaries prepare and submit the questions-and then evaluate the answers.

A recent consultant agreement we reviewed for a private sector plan contained the following:

Consultant agrees to undertake the following obligations and responsibilities with respect to the Funds for the Client:
  1. Consultant agrees to serve the Funds as a fiduciary and to assume the standard of care imposed on a fiduciary under the Employee Retirement Income Security Act of 1974 ("ERISA")
  2. Consultant agrees not to accept or receive any commission or other soft dollar payment from any source with respect to the Funds.
  3. Consultant warrants that it receives no compensation, soft dollar-based or otherwise, from any investment manager or mutual fund, and that it will continue to refrain from receiving such income during the course of this agreement.
  4. Consultant agrees not to sell any services to managers, including but not by way of limitation, banks and investment advisory companies. The purpose of this limitation is to ensure the Client receives objective advice.

The representations and disclosures in this agreement are helpful to fiduciaries by providing them the information they need to know and evaluate in order to appreciate the true costs associated with retaining the adviser. Although plan providers and advisers are not required to make a statement like this, if they cannot, they should at least be able to explain to plan officials why they cannot.

In the final analysis, the public officials charged with responsibility for operating a participant-funded 457(b) or 403(b) plan and overseeing its operations owe a duty to the employees who defer a part of their pay into the plan. A part of that duty is to make sure the employees are receiving fair value for the costs that come out of their retirement savings account, to make sure they are receiving a fair return on their invested dollars compared to the revenues being generated by the investment provider and the plan's advisors. The task is not difficult - it just requires attention and a willingness to do a little probing.