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Obfuscation Nation: 401(k) fee disclosure laws still don't give the true cost of plans and may well cause more agita for would-be retirees

The new DOL rules are far from ideal but may give fee-based advisors an edge in the small-plan market

Tuesday, August 28, 2012 – 4:37 PM by Tom Gonnella
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Tom Gonnella: It makes no sense to place the burden on individuals to figure out how much their nest egg is costing them.

With financial markets in constant flux and the economic recovery still uncertain, advisors and their clients have enough to worry about with their retirement accounts. Now they must brace for another change: At the end of this month, 72 million 401(k) participants will, for the first time, receive required disclosures about their plans’ underlying investment expenses. See: A 401(k) plan dethroning deferred: The DOL-mandated disclosures may not set any legacy palaces on fire near-term.

Investors should expect these reports on an annual basis going forward, as long-awaited Department of Labor rules to promote fee transparency go into effect.

There’s only one problem: They don’t go far enough.

At best, the new rules give participants and plan sponsors a tiny window into costs. At worst, they provide just enough information to thoroughly confuse participants and employers.

Fee-based edge

This lack of clarity provides new opportunities for both established retirement plan advisors and those new to the market. Established players need to reach out and communicate early and often with existing plan sponsor clients, while those new to the 401(k) market can potentially build new business by helping plan sponsors and participants understand the new fee disclosure. See: Fidelity reports 57% boost in 401(k) sales as it sets its sights on smaller plans and advisors.

Fee transparency — even the slightly opaque version that goes into effect Aug. 30 for plan participants — gives fee-based advisors a competitive advantage, particularly in the small-plan market where product providers have sold bundled 401(k) plans that may be layered with investment fees. It will be up to advisors to educate plan sponsors and participants about the “reasonableness” of not only the investment costs, but the overall costs, of their 401(k) plan.

One simple number

The key for advisors is to consolidate information from multiple disclosure reports and provide a simple number to participants that represents the true cost of a 401(k) plan. Only then can plan sponsors and employees make accurate and meaningful decisions about their retirement plan.

Instead of receiving an explicit, hard-dollar breakdown of all fees and expenses, including management fees for underlying funds, would-be retirees will actually have to wait for their next quarterly statements (which will be the first statement that is required to disclose hard-dollar fees deducted from participant accounts) and then break out an Excel spreadsheet to do the math. Participants will have to add the hard- dollar expenses from their quarterly statement with the investment expenses that they will need to calculate using the expense ratios provided in the annual notice. See: Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors.

The high cost of costs

According to a study by Deloitte and the Investment Company Institute, investment expenses account for 84% of a plan’s cost, thus this is an important and impactful calculation. The new disclosure statement requires listing the expense ratios of a plan’s underlying funds, and the amount per $1,000 it costs to be invested in those funds.

That’s it.

Nowhere in the statement are 401(k) providers required to say “You paid this amount of dollars to this fund manager.” Instead, if the participants want to figure out how much of their hard-earned deferred income was paid to the managers with whom they invest, they have a very interesting math problem on their hands. To make matters worse, ancillary fees associated with plan administration are NOT required to be disclosed in this annual statement. See: After years of DOL bluster, new 401(k) rules appear to make RIAs’ low expenses look higher than those of brokers.

For the sake of argument, suppose a saver has a $100,000 retirement balance equally split between two funds, with a 0.50% annual expense ratio for one fund, and 1% for the other.

Doing some quick back-of-the-envelope math, the total estimated annual expenses to those fund managers should come to $750. Throw in a hypothetical 0.10% fee to the recordkeeper for administration costs, and 0.15% for investment advisory services and the total comes to $1,000 a year. On the surface, total annual expenses as a percentage of this retirement plan — at Lincoln Trust we call this the Personalized Expense Ratio (PER) — are 1%. See: 9 things advisors to 401(k) plans must do to keep clients out of hot water.

While that math seems fairly easy to do, it is misleading. First, the listed fund expenses come from one statement, while the plan administration costs come from another. In addition, that $100,000 balance is only a snapshot number on an arbitrary day. That balance does not take into account how the funds have been bought, sold, rebalanced, and fluctuated with the markets over the previous year. So unless a sponsor has a mechanism to calculate the average daily balance of the underlying investments throughout a calendar year, any well-meaning, manual fee calculation is usually inaccurate, not to mention time-consuming. Even math Ph.D.s could easily get this wrong.

Let Siri do it

So is there any good news at all? Actually, yes.

Technology and automation can do this math so that you don’t have to. There is no reason for this NOT to be the industry standard, and it makes no common sense for the burden to be placed on individuals to figure out how much their nest egg is costing them to maintain.

There’s one more thing: Plan sponsors must show how their funds have fared against their respective performance benchmarks. But they are NOT required to benchmark their funds against fees, let alone providing a benchmark for the “all in” cost to a participant!

What’s to be done?

While fees are the main enemy of investment returns, fund managers and plan sponsors have to pay their rent and eat too. However, retirees should have a right to know explicitly how much they are paying for the privilege, just like any other service in life they would pay for so they can make informed decisions. See: Fidelity tries out new DOL-influenced 401(k) fee disclosures on clients — and gets plenty of response.

The Department of Labor rules for fee disclosure should go an extra step in requiring the following:

1. Plan sponsors should provide personalized annual statements that give more than just snapshot balances and theoretical fee information. They should be required to keep an average daily balance of their participants’ investments, which will allow for more accurate calculation of investment-related expenses.

2. Investment options of a given plan should be benchmarked to both performance and fees.

3. Explicit hard-dollar expenses associated with plan administration should be included on the annual statement. Savers should not have to gather this information from two different sources.

4. Sponsors should aggregate all expenses related to each individual’s account — both administrative and investment-related — and provide one simple, overall expense, expressed as both a dollar figure and percentage.

Without these changes, true transparency will never be achieved, and cause savers more headaches than necessary.

Tom Gonnella is senior vice president of corporate development for Lincoln Trust Co., a Denver-based recordkeeper servicing more than 2,700 qualified plans and over $3.7 billion in assets under administration.

Elmer Rich III

Elmer Rich III

August 28, 2012 — 7:17 PM

Let us offer and additional perspective.

- The 401k (DC) system is brand new in societies around the world. The 1st generation of folks is getting ready to retire using it.

- No one EVER expected it to be so big an successful. In fact, most financial services firms and leaders dismissed it as a joke when it started. I know, I was in those meetings.

- It has gotten very big and complex and fast growing and with increasing velocity.

- Disclosure issues with so many options, at an individual level, balanced to the penny, everyday are really complicated.

- It’s going to take some trial and error to find approaches that work.

As financial services always does, instead of testing different approaches before releasing them to the market, the industry approach is throw a bunch of stuff out and see what works or doesn’t. It would make sense to thoughtfully and carefully test approaches across firms and the industry then stepwise release and pilot in the market — but that ain’t gonna happen in the US.

There is certainly a common utility approach that could be developed using the latest educational and learning, communications science, etc. But that ain’t gonna happen either.

It’s dum to take a hodgepodge, jury-rigged approach to fee communications but that’s the legacy (sales-driven) culture of our industry.

In fact, we have a pilot start-up where we are applying the best science to education on retirement matters with retirees, of all ages. You can learn more at www.retirementscholar.com. Disclosure in retirement is no different from in medicine, and other professional matters. Stay tuned.

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