Roundtable. Retirement. Plan Investment Vehicles: How Fee Disclosure is Changing the Conversation

Transcription

1 Retirement Moderator: Greg Jenkins, CFA Senior Director, Consultant Relations, Invesco Roundtable Defined Contribution Plan Investment Vehicles: How Fee Disclosure is Changing the Conversation Contributor: Scott Faris, CFA, JD Senior Consultant, Hyas Group Contributor: Betsy Warrick Vice President, Invesco National Trust Company Understanding the pros and cons of different investment vehicles and mutual fund share classes has always been an important consideration for defined contribution (DC) plan sponsors, but fee disclosure and communication has been a catalyst for additional focus on the topic. As DC plan sponsors are now called to gather, analyze and communicate the fees in their plans by the Department of Labor s regulations 408(b)(2) and 404(a)(5), plan sponsors are having renewed interest in their options and considering new approaches to paying plan expenses. We ve asked two industry experts to share their insights and perspectives on investment vehicle options as well as approaches that plan sponsors and their consultants may want to consider when evaluating fees and revenue sharing investments within their plan. Greg: Scott, as you have discussions with DC plan sponsors about the challenges of developing a fair and sustainable model for paying plan expenses, what are you hearing? Are there any trends that you re seeing? Scott: I thought it might be helpful to first define which plan expenses we re really talking about here because the question relates to the oversight and administration of DC plans and not to the investments. It s important for plan sponsors to distinguish between those two, primarily because administrative cost is generally a fixed cost. Typically, the number of participants determines the cost to turn the recordkeeping crank, so to speak. Investment costs, on the other hand, are variable in nature. There s no investment that I know of that charges a flat fee. They re all based on assets under management. Brought to you by: So in principle, the goal is to try to match the method of paying with the type of expense. In the retirement plan context, this means paying administrative fees on a per-head basis and investment fees on an asset basis. We ve seen a trend towards charging per-head participant fees, but still I would say the overwhelming majority of plans pay their fees on an asset basis. Essentially, there s no big difference between the services that the recordkeeper provides from participant to participant, so everybody gets the same experience with some minor variants. Ultimately the goal is to treat all participants similarly.

2 The goal is to try to match the method of paying with the type of expense. In the retirement plan context, this means paying administrative fees on a per head basis and investment fees on an asset basis. If I had to point out one big trend that s rapidly gaining traction in the marketplace, it is for asset managers to offer investment vehicles with no revenue-sharing built into the fee structure. We re seeing almost daily or at least weekly fund managers announcing that they ve come out with a new share class that has no revenue-sharing or shareholder servicing cost. This is primarily on the actively managed side because passive funds, as a rule, have no revenue-sharing built in. One big trend that s rapidly gaining traction in the marketplace is for asset managers to offer investment vehicles with no revenue-sharing built into the fee structure. From my perspective, and what we ve been communicating to our clients, is the practice of offering investment vehicles that have no revenue-sharing benefits all parties. 1. It benefits the manager because it reduces their performance hurdle. One of the main reasons that active managers underperform, if they do, is their revenue sharing costs can knock 15 to 50 basis points off of their performance. That can be the difference between beating their hurdles and not beating their hurdles, so it s important for them to focus just on investment management without this additional cost burden. 2. It benefits the participant by reducing the cost, since revenue-sharing is a drag on performance for the participant. Performance ultimately impacts how much money participants have for retirement, their ability to retire, and the comfort of their retirement. You can associate a portion of the comfort index to the cost of the investment products they invest in over their working career. 3. It benefits the plan sponsor by reducing or eliminating the inherent subsidy of revenue-sharing that varies by fund. For example, in a typical medium sized or larger plan, index funds generally have no revenue-sharing, and other funds may pay a moderate amount of revenue-sharing, say 5 to 15 basis points, while still others may pay more, such as 25 to 35 basis points. It could be even more in a smaller plan. When participants make their own investment decisions, oftentimes they don t know what the revenue sharing cost is because it s not disclosed, ironically, under the new ERISA Section 404(a) rules. Even though the overall cost of the product is disclosed in a document that most people aren t paying attention to, revenue sharing is still not evident to the participant. They would really have to be sophisticated and know what questions to ask in order to understand this whole revenue-sharing thing. The reality is, there are winners and losers among the participants. If you have a participant whose account is allindex, for example, and all of the administrative costs of the plan are borne by the investments, they re free riders, so to speak. And to the extent that somebody is invested all in investments with the highest revenue share, they re probably paying a disproportionate share of the administrative cost. So the real question is why should a participant s investment choice impact the cost of having an account when that administrative cost is basically the same for everyone? Why should a participant s investment choice impact the cost of having an account when that administrative cost is basically the same for everyone? Plan participants pay a majority of investment management and recordkeeping fees Percentage of total fee paid Plan Participants Company Plan Participants and Company Communication to employees Investment management fees Investment consultant fees Legal fees Plan recordkeeping fees Trustee fees Audit fees Source: Plan Sponsor Council of America s 55th Annual Survey of Profit Sharing and 401(k) Plans. Data reflects plans with 5,000 or more participants.

3 Greg: Scott, what potential remedies to revenue sharing are you presenting to your clients for consideration? Scott: The remedies for this revenue-sharing issue can be obtained in a number of ways, but there are compromises to consider. For example, if you have a flat fee that s $50 per participant to have an account balance in their 401(k) or 457 or 403(b) plan, that structure significantly benefits the highdollar account participant versus the low-dollar account participant. In other words, if I m charged $50 on a $10,000 account balance, that s a whole different proposition than $50 on a $300,000 balance. Now if the opposite is true, meaning if it s an asset-based structure instead of flat dollar-based fee, then the small account balance gets the benefit and the large account balance pays a bigger share. We ve recently restructured one of our large 401(k) clients to include changes to the menu, the cost structure, and the recordkeeper. One of the outcomes of this was changing how participants were paying for things by going to an explicit fee that is part asset-based fee and part flat-dollar fee. It s assetbased in that everybody pays the same 10 basis points or same percentage of their account, but it s capped. The fee cap was around $150. So even if you have a $200,000 account, you re only going to pay $150. This was the compromise we came up with to make things fair. It s not perfect, but it s a way to address the problem. The culture of the organization will also drive how fees are paid. If it s a self-service type of organization where participants are expected to pay everything this could be an influence. If they re very egalitarian and try to treat everybody the same, there may be a different structure. It also depends on their definition of fairness. Is it fair for large account holders to pay a higher amount versus small account holders? How do you balance that equation as an organization? This issue about how fees are being paid has become one of the key considerations in the restructuring process. Greg: Scott, fee leveling seems to be a relatively new topic of discussion among plan sponsors. It sounds like a very appealing concept. Please walk us through the rationale for it, the type of plans that are considering this, and any challenges this might present. Scott: The rationale, I believe, is multifaceted. There are three important reasons to consider this. One is the fairness issue. We ve talked quite a bit about the fairness to participants. Given these considerations, it just makes sense to apply a more rigorous separation of administrative costs and investments as you would do in a defined benefit plan. There s no defined benefit plan that I know of that uses their investment structure to subsidize anything on the administrative side. It s just not done. It just makes sense to apply a more rigorous separation of administrative costs and investments as you would in a DB plan. There s no DB plan that I know of that uses their investment structure to subsidize anything on the administrative side. The second question is what types of plans are considering fee leveling? I would say essentially all types. It is not just the corporate market, but it s also very applicable to the governmental 457(b) market. It resonates to a lesser extent in the nonprofit sector because of some unique things about the 403(b) market. But corporates and governments are both looking at this issue. Challenges to implementation include the willingness and capabilities of the recordkeeper. The plan s governance resources are another consideration. Communicating to the participants is also a challenge, especially if you re going from an investments-pay-all structure to an explicit fee. Even though participants may be better off in that they re ultimately going to have more money in retirement, it may be a huge issue for them if they are not used to seeing a fee charged to their account. Communicating to the participants is a challenge, especially if you re going from an investments-pay-all structure to an explicit fee. Even though participants may be better off in that they re going to have more money in retirement, it may be a huge issue if they are not used to seeing a fee charged. A second rationale is transparency. Even though it s not required that revenue sharing be disclosed, there s a major focus on transparency. The third rationale is fiduciary prudence. We ve been seeing lawsuits for years related to fees, some of which have been successfully defended and some of which haven t. Most recently, the Tussey vs. ABB case raised a lot of eyebrows.

4 The other big challenge is the fund choice. As I stated earlier, even though a lot of fund managers are offering no revenueshare funds, not all fund managers have adopted this. There are still some popular funds in 401(k) plans that haven t gotten that message yet, or for one reason or another, it s difficult for them to change their structure and eliminate revenue-sharing. Typical Fee Components for Large DC Plans Fees as a % of Assets Investment Revenue Share Administration Auditor Legal Consulting Revenue Share Model Source: Hyas Group, LLC. For illustrative purposes only. No Revenue Share Model Greg: Scott, you mentioned the two top areas where you re seeing adoption or interest in non-revenue sharing investments, and that was in the corporate and government plan markets. Can you discuss some differences among corporate and public plan sponsors on this issue? Are there different challenges for these two different types of plan sponsors? Scott: We work with clients from the corporate and public markets, so we have exposure to and meet with both of their committees. Interestingly enough, there s a keen interest from both types of plans. Because of ERISA and its fiduciary standards, you would think corporations would be more concerned than governments because governments are not subject to ERISA. But the reality is, government plans nevertheless use ERISA as their standard by and large. And in some cases, an ERISA-like statute is built into the regulatory structure at the state or local level that has ERISA type language in it, such as the so-called prudent expert rule, for example. Another thing about the government market is that they re under a lot more public scrutiny. Their meetings are often open and they have potentially more bargained employees versus the corporate market. Meeting minutes are often posted on the Internet and their decisions could be secondguessed by anybody. There are some other differences that are important to address. In the corporate model, there is only one recordkeeper. And the trend is definitely towards consolidating into a single recordkeeper in the public sector, but not all plans are there. So there are still a lot of cases where government plans have multiple vendors. In this case, one vendor might have one capability and another vendor might have a different capability. Plan sponsors might not be able to implement fee structure changes as easily in a multi-vendor environment as with a single vendor. There are also important differences among the vendors themselves. The government market is dominated by insurance companies, whereas the corporate market is dominated more by mutual fund companies. Greg: How is plan size affecting these discussions and considerations? Are you seeing substantial differences in the approach to this issue across the spectrum from mid, large to mega plans? Are there different considerations or just different levels of feasibility? Scott: Plan size has a significant impact on the feasibility of separating administrative cost and investment cost. Even the available universe of funds that don t pay revenue sharing can be very different from a smaller plan to a larger plan. Absolute cost is significantly different by plan size. As I mentioned, plan administration tends to be of a fixed cost in nature. If one plan is about the same cost to administer as another plan, the more assets or the more people you have over which to spread that cost, the lower the per-unit cost. So in other words, fees tend to be higher for small plans and lower for large plans. In the smaller plan market, you also have a difference in who the advisor is and how they get paid. Small plans are typically served by an insurance agent or a financial advisor who primarily gets paid through the assets, versus the mid, large and mega markets where consultants typically get paid a flat fee. Eliminating revenue sharing from a small plan therefore might have a material impact on the amount and methodology of compensation to the advisor. There would be no impact to a fee-only consultant. The primary differences based on the size of the plan are investment product availability and plan governance budget. There are material differences between a $200 million plan and a $1 billion plus plan. As you go up that spectrum, investment choice expands, fees are reduced and there are more people and assets to spread them over. Customized solutions become more and more available as assets increase. For plans that are $500 million and up, sponsors can start to think about unitizing separate accounts which oftentimes are the lowest cost, most pure investment products available. With regards to plan governance, across the size continuum, there is a different balance emerging between the HR and finance functions. We re seeing more finance or treasury involvement with the DC plan, whereas traditionally they were more involved in the pension side. They re starting to take a much more visible role in the governance structure of the plan and it s migrating from strictly an HR function to a blend of HR and finance.

5 Greg: Betsy, Scott mentioned a trend in movement away from revenue sharing classes of mutual funds and trends with recordkeepers adapting to the current environment. In your position with Invesco National Trust Company and your expertise with collective trust funds (CTFs), how have these trends and renewed focus on fee transparency affected collective trusts? Betsy: Let me first start off by providing a brief background. CTFs are designed exclusively for qualified retirement plans and are basically the functional equivalent of a mutual fund. One of the biggest differences is that CTFs are only distributed through banks and trust companies. National banks are regulated by the Office of the Comptroller of the Currency (OCC) instead of the Securities and Exchange Commission (SEC), with state banks regulated by their state examiners. The movement toward fee transparency has actually been a good thing for the CTF market. For example, our participation agreements required to invest in CTFs have always offered full disclosure of all fees. And plan sponsors really appreciate this level of transparency. Think of CTFs like a stripped-down version of a typical mutual fund, but with the ability to eliminate revenue sharing. Additionally, plan sponsors have the flexibility to build in revenue sharing if needed. Certain CTF providers allow plan sponsors to even elect the revenue sharing payments to be paid to two different parties if the plan sponsor requires this type of payment structure. Again, all CTF fees are laid out in the participation agreements, so there is no ambiguity with the plan sponsor or their consultant. Also, certain CTFs have been offering non-revenue sharing classes long before R6 mutual funds became available. And many CTFs, from the onset, have been cheaper due to their non-registered and streamlined infrastructure. Collective trust funds have been offering non-revenue sharing classes long before R6 mutual funds became available. Greg: Scott, with regards to collective trust funds, have you seen any changes or additional considerations of these types of funds as it relates to this issue? Scott: Definitely. We re seeing new product creation and clones of mutual funds in the collective trust space. We have conversations with managers all the time about what they have available. You don t have to be a billion dollar plan to have a collective trust product. One of the issues is communication to the participants. You can t go to retail online sources such as Morningstar and look up anything on a collective trust fund. So sponsors are more dependent on the manager themselves providing information that otherwise would be easily discoverable by the participant. There has to be a material benefit to using collective trust funds, and there usually is. Here is a case in point: we looked at a large-cap blend manager whose institutional mutual fund product was 60-plus basis points. But that same strategy in their collective trust fund was half the price. And if you re looking at a 30-plus basis point difference, that s enough to justify any kind of hassle you have communicating to participants. We looked at a large-cap blend manager whose institutional mutual fund product was 60-plus basis points. But the same strategy in a collective trust fund was half the price. At a 30-plus basis point difference, that s enough to justify any kind of hassle you have communicating to participants. Lastly, the biggest change we ve seen, as a result of the need for more fee transparency, has been an increased adoption and growing familiarity of recordkeepers with CTFs. They re becoming more comfortable and open to the idea of including CTFs as available vehicles to their plan sponsor clients. That s certainly good for our business, but, more importantly, the lower cost and transparent fee structure ultimately benefits the participants and how much they ll accumulate in their accounts by the time they retire.

6 Greg: Betsy, it s no secret that mutual funds have historically been the vehicle of choice for the majority of defined contribution plans. What are some current trends you re seeing in the CTF market? What are some of the obstacles that collective trusts have experienced in the past? What has changed over time and how has your team responded to some of these challenges? Betsy: We have seen an uptick in the DC market over the last five years. CTF market share in DC plans increased from 10% in 2006 to 20% in Since it s not easy to quantify true CTF market share, I suspect this percentage may be higher. If you re familiar with the US Federal Government Thrift Plan which is the largest government plan their entire fund lineup consists of CTFs. Collective trust fund market share in DC plans increased from 10% in 2006 to 20% in Since it s not easy to quantify true CTF market share, I suspect this percentage may be higher. Again, as I ve mentioned already and depending on the provider, there is much greater flexibility in pricing than with mutual funds. In fact, CTF providers can provide lower fees as assets increase. Pricing can also be further customized by client level or relationship. CTFs are worth a second look as an alternate means for a plan sponsor to eliminate revenue sharing or add flexibility to the plan s pricing structure. Collective trust funds hold almost a third of target date fund assets within large DC plans Percentage of target date/lifecycle funds by investment vehicle Mutual Fund 59 Collective Trust 27 Separately 14 Managed Account One of the obstacles we ve experienced is the misperception that CTFs are only for medium to large plan sponsors. In fact, many smaller plans can include CTFs in their fund line-up. For example, we work with a large recordkeeper that adopted an omnibus structure so they could offer CTFs to 3,000 of their small plan clients, whose average balance is less than $10,000 in CTF assets per plan. So, the myth that CTFs are exclusively for large plan sponsors is not always the case. CTFs have come a long way over the last several years, and DC plan sponsors may not be aware of the progress that s been made supporting these vehicles. For example: Daily liquidity has become the norm. Website reporting both for plan sponsors and participants has become more robust. There is increased capability with electronic trading. Fund companies and recordkeepers are advancing their technology and working together to ensure increased administrative efficiencies are in place (e.g. using account access on websites, linking to fact sheets directly rather than creating their own and receiving pricing electronically). Source: Plan Sponsor Council of America s 55th Annual Survey of Profit Sharing and 401(k) Plans. Data reflects plans with 5,000 or more participants. CTFs are worth a second look as an alternate means for a plan sponsor to eliminate revenue sharing or add flexibility to the plan s pricing structure.

7 Greg: How are you seeing collective trust funds used within custom target date and target risk funds? Betsy: Custom target date funds are taking off in the large and mega plan market. According to Cerulli Associates, 2011 asset levels topped $46.4 billion and are expected to increase to $218 billion by We are seeing growth in this area at Invesco as well, particularly with larger plans. Collective funds have several advantages over other types of vehicles as components within custom target date and target risk funds, including: 1. The flexibility to eliminate revenue sharing. 2. Better pricing than mutual funds. 3. The ability to use stable value and alternative investment strategies not available in a mutual fund structure. 4. Built-in daily valuation and daily liquidity. Greg: How does this tie-in to the revenue sharing issue? If one investment within a custom fund has a higher percentage of revenue sharing and it s receiving the bulk of the allocation, there could be a perceived conflict of interest. This problem may be avoided by using CTFs with no revenue sharing. Greg: I d like to thank our distinguished contributors for their insightful remarks. We hope this roundtable provides some additional perspectives on plan fees, what is fair and equitable for plan participants, and how certain investment vehicles such as collective trust funds and R6 mutual fund share classes offer revenue-sharing neutral alternatives that may help level the playing field. Betsy: I would say one of the predominant benefits of using non-revenue sharing investment vehicles within custom funds is that it may eliminate a conflict of interest for plan fiduciaries. For example, since the asset allocation and glide path are determined by the investment committee and/or consultant, if one of the investments within a custom fund has a higher percentage of revenue sharing and it s receiving the bulk of the allocation (i.e. equity funds), there could be a perceived conflict. This problem may be avoided by using CTFs with no revenue sharing.

8 Invesco s Defined Contribution Institute is dedicated to helping DC plan sponsors and consultants build better plans with insights from Invesco and industry experts. For more information about this and other timely topics relevant to defined contribution plans, please contact your Invesco representative, us at IDCI@invesco.com or visit us at invesco.com/dc. Note: The Hyas Group, LLC is an independent organization and not affiliated with Invesco. Collective Trusts are available exclusively to qualified retirement plans. Material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This does not constitute an offer or solicitation of any security or product, nor constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco distributors, Inc. is a U.S. distributor for retail mutual funds, exchange-traded funds, institutional money market funds and unit investment trusts. It is a wholly owned, indirect subsidiary of Invesco LTD. Not all products, materials or services available at all firms. Advisors, please contact your home office. invesco.com/dc IDCIRR-BRO-5 11/12 Invesco Distributors, Inc