New Fee Disclosure Regulation Magnifies Fiduciary Risks for 401(k) Plan Sponsors

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1 Fiduciary Insights New Fee Disclosure Regulation Magnifies Fiduciary Risks for 401(k) Plan Sponsors COST ASSIGNMENT DECISIONS EXPENSE CONTROLS CONFLICTS OF INTEREST INVESTMENT SELECTION CONSTRAINTS FEE TRANSPARENCY INVESTMENT POLICIES June 2011

2 CONTENTS STEP 1: Understanding 401(K) Fees & Investment Revenue 2 STEP 2: Developing a Cost Assignment Model 3 STEP 3: Developing Investment Policies 5 Introduction: Using This Report This report is the first in a series designed to assist plan sponsors in understanding fiduciary issues related to retirement plan administration. The goal is to identify areas of fiduciary concern and to introduce best practices that can be incorporated into governance frameworks. This report focuses on guidance available through the institutional consulting practice of the Allen Investment Group of Raymond James. Raymond James does not provide legal or tax advice. CONCLUSION 6 Overview: Fiduciary Risks Magnified by 404(a)(5) For more information on this report, please call us toll-free or send questions via . The material that follows identifies fiduciary risks for plan sponsors that will be magnified by the new Department of Labor (DOL) Regulation under the Employee Retirement Income Security Act of 1974, as amended (ERISA), Section 404, which requires the disclosure of certain plan and investment-related information. 1 Under the new regulation, plan administrators are required to regularly disclose to defined contribution plan participants, among other information, a wide variety of expenses and fees that can be charged to or deducted from their accounts. For the first time, the expenses and fees that participants pay each quarter for their 401(k) plan will be explicitly listed on their statements in hard dollars. At issue is how plan sponsors pay for the cost of their plans important decisions that may significantly constrain the investment selection process and disproportionately allocate costs. Frequently, plan sponsors design investment menus to specifically offset plan expenses by incorporating investment options and share classes that contribute revenue from their internal expenses back into the plan. At issue is how plan sponsors pay for the cost of their plans important decisions that may significantly constrain the investment selection process and disproportionately allocate costs. As a result of cost assignment decisions, plan sponsors may have failed to consider the complete universe of investment choices, share class options, and implementation scenarios available on their 401(k) platforms, inadvertently increasing expenses and reducing investment returns. Plan sponsors should be prepared to justify their decisions to participants in light of the new regulation. 1 For additional information on 404(a)(5) and 408(b)(2) regulations, please visit

3 STEP 1: Understanding 401(k) Fees & Investment Revenue There are a number of fees and expenses involved in providing a 401(k) plan to employees. Plan sponsors have a fiduciary responsibility to control and account for and these costs, which can be grouped into four broad categories: Plan Administration Fees These fees cover the day-to-day operation of the plan such as recordkeeping, accounting, legal and trustee services, access to customer service (telephone/online), and statements. Investment Advisor Fees These fees cover consulting services provided by an investment advisor for plan design guidance, investment policy development, investment manager research and due diligence, enrollment meeting support, investment advice, portfolio management, vendor selection, and other services. Investment Management Expenses Underlying investment options within the plan have internal investment management expenses. These fees are charged indirectly against participant account balances and are deducted directly from investment returns. They vary widely based on investment structure and share class. Individual Service Fees These fees cover optional plan features such as self-directed brokerage options and loans. They are generally charged separately to participant accounts. Historically, these administrative costs have been collectively assigned to plan participants in the form of higher investment management expenses. In simplest terms, some investment managers (but not all) share a portion of their internal investment management expenses in the form of 12b-1 fees and revenue sharing dollars, which funnel back into the plan. Plan sponsors use this revenue to reduce or eliminate their out-of-pocket costs. Under these arrangements, investment managers with specially designed retirement share classes and/or large numbers of assets under management may be able to return larger portions of their expenses back to the plan, compared to many of their boutique, no-load, and institutional peers one of the main reasons why the same investment managers appear on the investment menus of countless 401(k) plans. Fiduciary risks emerge whenever plan sponsors use revenue from investment management expenses to offset costs within their 401(k) plans Conflicts of interest in the investment selection process Revenue needs may limit the universe of investment alternatives to a limited subset of choices that kick-back revenue to the plan in the form of 12b-1 fees or revenue sharing dollars. Failure to control and account for expenses Investment menus with inconsistent share classes can unfairly distribute plan expenses among participant accounts. Revenue in excess of plan expenses, unless explicitly controlled (e.g., fee caps, ERISA budgets, etc.), may be retained by the advisor and vendor as additional compensation rather than rebated to participants. Plan sponsors should make sure they have not overlooked viable investment alternatives due to revenue constraints or disproportionately allocated plan expenses via mismatched share classes.

4 Regardless of who ultimately pays for the 401(k), plan sponsors should be able to articulate how they are assigning costs within the plan, control and account for expenses, and establish an investment selection process unconstrained by revenue needs. STEP 2: Developing a Cost Assignment Model These potential fiduciary risks can be mitigated by developing cost assignment models, investment policies, and recovery mechanisms that widen the investment opportunity set, improve cost controls, and promote transparency. Plan sponsors can use one of three models: - Employer-Paid Model - Participant-Paid Model - Shared Model (% Employer / % Participants) Under the Employer-Paid Model, plan sponsors assume responsibility for costs associated with the retirement plan. With the employer paying for plan expenses out-of-pocket, investment selection would not be limited to a subset of investment options that share revenue from their internal investment management expenses. In this way, the investment committee can research, identify and select investment alternatives from the entire universe of options available on their respective 401(k) platforms. In addition, plan sponsors would be able to offer participants access to investment managers and strategies in the lowest expense structure, as revenue is not required from internal investment management expenses. Management should vet these decisions and confirm that they are consistent with corporate objectives, budgets, and compensation. Under the Participant-Paid Model, participants assume responsibility for costs associated with the retirement plan. Historically, plan sponsors have implemented this model by building a menu of investment options with inflated investment management expenses. Revenue to offset plan expenses is deducted indirectly from participant balances and reduces investment returns. The new disclosure regulation requires that these expenses, previously disclosed as a percentage, now be disclosed in real dollars. Whenever plan sponsors indirectly deduct revenue from investment management expenses, conflicts of interest can arise. Specifically, plan sponsors may have inadvertently narrowed their investment selection to a subset of choices that share revenue on their respective 401(k) platforms, rather than evaluate the entire universe of alternatives available.

5 STEP 2: Developing a Cost Assignment Model continued Many plan sponsors are unaware that they can incorporate investments in their plan without regard to revenue sharing under the Participant-Paid Model. Transparent cost recovery mechanisms such as wrap fees can uniformly allocate costs to participants and allow plan sponsors to evaluate no-load and institutional investment options that may offer little, if any, revenue sharing. Uniform wrap fees are typically expressed as a percentage of total assets in the plan and charged directly against participant accounts. Since the wrap fee is the mechanism by which revenue is collected, plan sponsors can provide investment options to participants with the lowest-cost expense structure. The wrap fee essentially represents the portion of the investment management expenses that would have otherwise been collected indirectly by the plan through 12b- 1 fees and revenue sharing agreements. In this way, plan sponsors can avoid potential conflicts of interest during investment selection, explicitly manage costs, and fairly allocate expenses across the plan. Under the Shared Model, both the employer and the participants assume responsibility for costs associated with the retirement plan. Corporate budget and compensation considerations should be evaluated in determining the proportion of responsibility. Although some share classes do not have 12b-1 fees, they may still return a portion of their investment management expenses to the plan through revenue sharing agreements. Plan sponsors can capture this excess revenue and rebate participants in order to further reduce expenses and improve performance. Transparent cost recovery mechanisms in concert with updated investment policies can ensure that investment selection is independent of revenue requirements, helping to mitigate fiduciary risks in this model. Regardless of who ultimately pays for the 401(k), plan sponsors should be able to articulate how they are assigning costs within the plan, control and account for expenses, and establish an investment selection process unconstrained by revenue needs. By employing transparent cost recovery mechanisms and developing prudent investment policies, plan sponsors can design more inclusive investment menus, improve participant performance, and effectively manage costs.

6 STEP 3: Developing Investment Policies Incorporating a cost assignment model into the fiduciary framework is just one part of the solution to mitigate certain risks. Plan sponsors should also develop investment policies to guide the implementation of these models within the plan as well. The primary purpose of an investment policy statement is to outline the process that a plan sponsor intends to use in selecting and monitoring investments within the company s retirement plan. Every investment policy should clearly outline the investment selection process and detail qualitative and quantitative evaluation criteria and their relative importance. As a best practice plan sponsors should consider adopting explicit language within their policies to mitigate the potential fiduciary risks discussed in this report. Specifically, plan sponsors should: 1) Prohibit revenue sharing from being a primary selection factor How much revenue an investment option shares with a plan is largely irrelevant. Plan sponsors have transparent mechanisms that can be used to directly offset plan costs and avoid this potential conflict of interest. The investment selection process should be inclusive by nature and consider the widest range of choices available on the platform. In addition, plan sponsors should be wary of selecting investments managed by the platform vendor (i.e., ABC Growth Fund when the plan is on the ABC platform) so as to avoid any perceived or real conflicts of interest related to expenses and revenue sharing. 2) Evaluate investment options in their lowest-cost share class or expense structure Investment options often come in numerous share classes or expense structures. Plan sponsors should ensure that their selection process evaluates investments on uniform basis. 3) Ensure that share class and expense structures are consistent wherever possible Plan sponsors should ensure that share classes or expense structures are consistent to avoid disproportionately allocating costs to participants wherever possible.

7 CONCLUSION The DOL adopted the new 404(a)(5) regulation to ensure that all participants have the information they need in order to make informed decisions about their retirement plan accounts. One of the regulation s aims is to provide transparency to the indirect fees that many participants are paying through their investment returns. As a result, plan sponsors must be prepared to explain their decisions from both cost and investment perspectives. Plan sponsors should undertake a comprehensive investment, cost and service analysis to ensure that they are fulfilling their fiduciary obligations under ERISA and to identify potential risks that will be magnified by the new regulations. For additional information, please contact us. Joseph C. Allen, AAMS WMS Senior Vice President--Investments Joshua H. Anderson, AIF Financial Advisor Allen Investment Group of Raymond James & Associates, Inc. 223 North Sycamore Street Newtown, Pennsylvania (215) Telephone (866) Facsimile ABOUT THE AUTHORS The Allen Investment Group of Raymond James helps plan sponsors engineer robust retirement plan solutions that can improve participant benefits and mitigate fiduciary liability. The group provides top-level guidance on many aspects of retirement plan operations: plan design, governance, service providers, investments and education. Consulting as fiduciaries, the team focuses on delivering total retirement solutions for defined contribution, defined benefit, profit sharing, deferred compensation and executive benefit plans.

8 2011 Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC