By: Frank Armstrong, III, CFP™, AIFA®
Without any thought or planning, the 401(k) has become America’s default pension plan. The days of guaranteed retirement income for life are long gone, and along with them, the financial security the traditional pension plan provided.
The 401(k) solution is deeply flawed, however. Although many plans are excellent, their overall failure to provide adequate retirement income security for American workers has caught the attention of the courts, regulators, the Obama administration, Congress, academics, and plan participants.
These failures include costs that bear no resemblance to the value provided, deeply embedded conflicts of interest, sustained under performance of underlying investment vehicles, inadequate disclosure, inappropriate investment menus, defective plan design, insufficient participant education, and flawed default provisions.
It isn’t unusual, for example, to find 401(k) plans with total participant costs exceeding 3% of the total account value annually, with investment choices limited to subpar proprietary funds, and with payments to the various providers not related to services rendered. Confusion about who provides what service, and whether the various parties are acting in a fiduciary capacity is the rule.
The combined effect on participant accounts and retirement funding is devastating. Taken together, these defects all but guarantee the failure of 401(k) plans to provide meaningful retirement security to many Americans.
BETTER DISCLOSURE REQUIRED
Despite their shortcomings, 401(k) accounts remain the backbone of the American retirement system, and families that open and continue to fund 401(k) accounts have substantially higher net worth than those without such plans. It’s critical, therefore, to improve this vital retirement funding component.
After years of study, thousands of hours of congressional testimony, hundreds of hearings, and innumerable public comments, the U.S. Department of Labor (DoL) issued its final 408(b)(2) and 404(a) regulations, designed to force better disclosure. The hope is that with this improved information, plan providers and participants will make decisions that improve retirement preparation for America’s workers. It appears that they will become effective in the third quarter of this year.
Recently, the DoL released new rules regarding the Employee Retirement Income Security Act (ERISA) 408(b)(2), 404(a), and electronic delivery. Service provider regulations 408(b)(2) took effect July 1, and the new 404(a) participant disclosure rules become effective August 30, with the first quarterly statements under the rules for calendar-year plans due by November 14.
These regulations expand the definition of fiduciary investment advice, so that many consultants who were not previously fiduciaries now are considered fiduciaries. In addition, by mandating significantly higher levels of disclosure, the regulations make key, previously unavailable information available to investors.
The flurry of enacted and proposed “band-aid” fixes will go part of the way toward improving the retirement landscape. But regulations, legislation, and the threat of court action can go only so far. The various fixes provide information and guidance to plan fiduciaries but can’t make the fiduciaries better by themselves. The plan sponsor must either develop fiduciary practices and procedures or delegate them to someone who can.
As a physician, you practice medicine and provide healthcare. Acting as a fiduciary and developing appropriate procedures and practices probably is outside your skill set and a distraction from your primary interest of practicing medicine.
I’m not suggesting for a moment that doctors don’t care. Nobody wants to offer an inferior retirement plan to his or her employees. Most employers want their employees to receive maximum benefits for each dollar set aside. But wishing won’t make it so. And leaving it to a bundled solution provider who “takes care of it all” may not generate a quality plan.
ERISA requires that plan sponsors enter only into agreements with “reasonable” fees and make decisions exclusively in the interest of plan participants. Without disclosure requirements, however, plan sponsors would not be able to determine the reasonableness of their fees or the parameters of the decision-making process. In particular, the bundled product solution—whereby a single company acts as investment adviser, product supplier, recordkeeper, and plan administrator—is appealing, but may lack clarity. If the plan provider does not act as a fiduciary, then the entire responsibility for the plan choices falls to the plan sponsor, the ultimate fiduciary.
THE RISE OF THE BIG INSTITUTIONS
When ERISA became law in 1974, the pension world changed dramatically, and for the better. The act imposed vesting and participation standards, prevented plan sponsors from benefiting from the use of trust funds, and defined actuarial funding requirements. Reporting and recordkeeping became so complex, however, that only giant institutions had or could afford the mainframe computer capacity necessary for managing the accounts. As a result, large insurance and mutual fund companies stepped in to provide the technology and systems that enabled them to become the dominant players in the field.
For a while, the giant institutions had the field all to themselves. The pitch was simple: We will do it all for you—recordkeeping, tax returns, compliance, participant education, investments, and advice. And it’s all free! Free was a pretty compelling price point, and relieving plan sponsors of all those headaches was invaluable.
Of course, it wasn’t really free, because the bundled product solution also provided cover for inflated charges to the participants, and the perfect environment for breeding conflicts of interest. Additionally, bundled product providers seldom acknowledged fiduciary responsibility for their recommendations, thereby placing the entire liability for their decisions on the plans’ sponsors.
The plans’ sponsors, meanwhile, were led to believe that the provider was acting as a fiduciary. Disclosure ranged from opaque to nonexistent. Many plan sponsors and participants simply were ignored when they requested relevant information.
Plan sponsors can’t rely solely on the product providers to overcome deeply embedded conflicts of interest and fix their plans. Those sales entities have little interest in—and strong disincentives for—exercising proper fiduciary behavior. Most of them prohibit their agents from accepting fiduciary responsibility.
Several questionable practices quickly emerged:
limiting investment choices to funds that shared management fees with the provider;
using proprietary funds where better-performing, lower-cost alternatives existed;
levying mortality and expense charges—a charge to guarantee conversion to an annuity at a future date—with no economic benefit to the participants who, in most cases, will never convert their account to an annuity;
using special class funds with additional fees over retail costs;
using retail funds where lower-cost institutional class funds were available;
assessing per-account and per-position fees at each participant level; and
charging termination fees that effectively prevented plan sponsors from changing providers.
Individually and cumulatively, these fees easily may exceed “reasonable” standards, and the decisions regarding revenue sharing, n product selection, performance monitoring, and administrative costs often violate the requirement that they be made exclusively in the best interests of the participants.
Today, of course, most personal computers could easily handle recordkeeping for hundreds of plans, and the Internet provides the infrastructure for seamless communication between remote providers. The stranglehold that the giant institutions had on the market has been broken, and many excellent providers exist who can dramatically lower costs and improve every aspect of plan design.
Even the best-intentioned, most diligent retirement plan sponsors and participants may have had difficulty extracting critical information from plan providers. That situation is about to change, however. The new DoL disclosure regulations could greatly benefit both plan sponsors and participants.
CHANGES YOU CAN EXPECT TO SEE
So what can you expect? If you are a plan sponsor, each service provider must supply you with a revised service agreement that includes:
a complete description of the services it provides;
full disclosure of the costs of each service;
disclosure of any direct or indirect compensation it receives from associated providers;
whether the provider assumes fiduciary responsibility for each function (hint: If the service agreement does not specifically assume fiduciary responsibility for a function, the provider is unable or unwilling to assume that liability); and
any potential conflicts of interest and how they are managed and mitigated.
Under the companion 404(a) regulations, you are, in turn, responsible for sharing most of this information with your plan participants. By July 1, responsible plan fiduciaries, such as plan committees and plan sponsors, should have developed processes and procedures for reviewing the disclosures they receive. This disclosure is not optional. If your providers don’t or won’t supply you with the required information within 90 days after you request it, the responsible fiduciary must terminate the relationship “as expeditiously as possible,” consistent with its duty of prudence.
The expectation is that more and better information inevitably will lead to selecting better plans to provide to your workforce.
But the benefits of disclosure depend on the willingness to review the provided information and then act on it appropriately. If you are a plan sponsor, you are a fiduciary, and reviewing the quality of your retirement plan is not optional. Failure to comply with the many requirements of ERISA generates personal liability for the plan sponsors/fiduciaries.
Unfortunately, the new regulations suggest no appropriate benchmarks other than “reasonable” for costs and a general prohibition against undisclosed or unresolved conflicts of interest. Fiduciaries must, therefore, either test the market occasionally through an open request for proposal process or hire an independent fiduciary adviser to do it for them.
Warning signs of unreasonable costs might include:
a total cost for all services including investment advice, recordkeeping/administration, fund fees, transaction costs, custody or trustee fees, and any mortality and expense charges that exceed 1.5%;
any single fee that is disproportionate to services rendered or economic value;
direct or indirect compensation between the parties that might cause conflicts of interest;
revenue sharing not fully accounted for and credited back to the plan;
failure to specifically assume fiduciary status by investment advisers, consultants, and other plan providers; and
use of retail class fees rather than the lower-cost institutional shares.
YOU CAN DELEGATE
Fortunately, if you are a plan sponsor, you can delegate most of your responsibility—and transfer much of your liability—to an outside independent investment adviser who will accept fiduciary status in writing. As long as you select that adviser and monitor him or her prudently, and as long as he or she is willing to accept fiduciary responsibility in writing, you can turn over almost all of the responsibility—and liability—for investment design, fund selection, cost control, disclosure, resolution of potential conflicts of interest, and participant education. In fact, unless you have investment expertise and are willing to accept potential personal liability, ERISA requires you to delegate fiduciary responsibility to a prudent expert.
Given that doctors don’t all practice ERISA law or have finance degrees, even with the additional information, you may not believe you are qualified to perform a plan audit or make comparisons. A qualified fiduciary investment adviser, however, will provide you with a comparison at nominal or no cost. Hiring a competent plan fiduciary adviser will relieve you of significant personal liability while bringing discipline to the process of providing quality benefits at reasonable costs to your workforce.
When engaging a prudent expert, expect reduced costs, improved investment results, higher participant satisfaction and plan utilization, greater accumulations, and reduced personal liability for fiduciaries. If not, the courts, your employees, the Securities and Exchange Commission, and/or the DoL may administer a particularly costly and painful lesson.