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KEYWORD:
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EMPLOYEE BENEFITS MEMORANDUM
You may have read in employee benefits newsletters that the Department of Labor (DOL) has been taking an interest in 401(k) plan fees and expenses. DOL is concerned that plan sponsors may not have enough information about fees, and that plans and their participants may be paying too much in fees. Anyone who has read a mutual fund prospectus knows, though, that the problem many 401(k) plan sponsors face is not a lack of information but a jumble of information. A study submitted to the DOL by Economic Systems, Inc. (ESI) in April of this year confirms that, although in most cases adequate information appears to be available about 401(k) plan fees and expenses, employers may have a difficult time assimilating the information and using it to judge the overall reasonableness of plan fees and expenses. The difficulty comes from two sources: (i) the wide variety in mutual fund expense ratios and (ii) the different ways in which 401(k) plan fees and expenses are calculated and expressed. When a plan sponsor selects mutual funds that will be made available to plan participants as investment alternatives, the sponsor is engaging in fiduciary activity. This means that the plan sponsor must exercise an appropriate degree of care, skill, and prudence with respect to the selection of the funds. Mutual fund fees and expenses are particularly important issues since, in most cases, they are netted out of a fund's return and are paid for by the plan's participants. The ESI study concludes that, for 401(k) plans purchasing mutual fund shares, 75 to 90% of total plan costs are investment management fees and related expenses imposed principally through mutual fund expense ratios. Fund expense ratios are disclosed in prospectuses and in commercial reports such as Morningstar and Value Line. Within different fund categories, expense ratios show significant variation, as illustrated by the following table:
Part of the wide variation in expense ratios results from distinctions between (i) actively versus passively managed funds and (ii) retail versus institutional funds. Passively managed funds, such as index funds, are significantly cheaper than actively managed funds. Institutional funds are generally 50 basis points (1/2 of 1%) cheaper than retail funds. Allowances for these differences, however, do not account for all of the wide variation in mutual fund expense ratios. The ESI study postulates that differences in the quality of services and name brand recognition may account for the remainder of the variation, as well as inefficiencies in the mutual fund market brought about by plan sponsors who do not adequately understand the nature of the fees and expenses that the plan and its participants are being required to pay. In other words, some plan sponsors or plan participants may be paying too much for mutual funds and not know it. To compound the difficulties facing 401(k) plan sponsors, other types of plan fees and expenses, such as recordkeeping and administrative expenses, are often expressed on a per participant or per transaction basis, making it difficult to combine these costs with investment management costs in order to get a complete picture of plan costs. Assuming that you, as a plan sponsor, are able to find a satisfactory way to combine all of your 401(k) plan costs and express them as a percentage of plan assets, the following table can give you some idea of where you stand in relation to other employers who sponsor 401(k) plans (note that larger plans enjoy an economy of scale here). Comparison of Estimated Total Plan Costs 401(k) Provider Directory and Butler Survey Costs as Basis Points Applied to Plan Assets
(Sources: Butler, Pension Dynamics Corporation, as reported in Wang, Money, April 1997; H.R. Investment Consultants, 401(k) Provider Directory Averages Book, 1997) A fair question to ask is this: Why should a plan sponsor care about mutual fund expense ratios so long as the fund's net total return is acceptable? It is, after all, the total return of a fund that should really matter. Or another fair question is this: So long as expense ratios are disclosed to participants, why should it matter that one fund is more expensive than another? Participants will take this information into account when they self-direct their 401(k) plan accounts. Although both questions raise valid points, the DOL clearly takes the position that an employer has the specific obligation to consider fees and expenses when selecting plan investment options, and to determine that the fees and expenses are reasonable in light of the level and quality of services provided. Where does all of this leave us? My suggestion would be that you take the DOL seriously. Keep this letter handy. Use the averages from the ESI study to help you determine the reasonableness of mutual fund fees and other 401(k) plan expenses. Note that there is nothing wrong with paying higher than average fees and expenses so long as you decide that the plan and its participants are getting valuable services or better than average performance in return. Document your review of these issues. Finally, you might also want to get a copy of a brochure that the DOL published on July 1, 1998, called A Look at 401(k) Plan Fees. It is written for employees, but employers should read it too. The best way to get it is to go to www.dol.gov/dol/pwba/public/pubs/401kfe~1.htm.
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