Once upon a time, defined contribution plans seemed to be "set it and forget it" tools for plan participants. Organizations would decide to offer a vehicle for retirement savings and put the plan in place for employees to defer money. From that point on, not much was done by way of changes or monitoring.
Fast-forward to 2017: The retirement industry has matured dramatically and, in the wake of the Pension Protection Act of 2006, the fee-disclosure movement and an ever-growing number of lawsuits, it is now under a nationwide microscope.
There are various aspects of a retirement plan that require ongoing review (i.e., plan design, participant communication and education efforts, record-keeping tools and services), but investments and fees continue to make headlines. While many of the cases featured in the news involve large plans (with $100 million or more in assets), smaller retirement plans with less purchasing power face similar challenges.
Imagine for a moment that an organization has a billion-dollar retirement plan with thousands of participants. If a per-head fee is charged for plan services, the cost is spread across many participants, many of whom may not even notice they're paying for those services. If revenue sharing is being used, the investment lineup may even generate enough revenue to cover the cost of plan services with the balances of just a few funds.
Due to size and economies of scale, the required revenue for the plan can be lowered and the weighted average expense can be reduced constantly. Why? The general rule of thumb in the retirement industry is that the larger a plan gets, the more attractive it becomes to record keepers, and as a result the more competitive the pricing becomes. The plan has purchasing power.
Now, take the same concepts and apply them to a $1 million plan with 100 participants. The record keeper still needs to make enough money for the plan to be financially viable, and the adviser has to be paid as well. The demands on the plan may decrease in terms of absolute dollars, but because the plan is smaller the expense represents a larger percentage of the plan assets.
For example, for a $100 million plan the required revenue for plan services may be 0.15%, or approximately $150,000 per year. On the other hand, the required revenue for a $1 million plan may be 1%, or $10,000 per year. In terms of dollars paid, the latter scenario represents a lesser amount of money, yet it's a dramatically higher percentage of the plan assets each year.
What are an adviser's options? The most common is to utilize a fund menu provided by the record keeper that includes share classes with enough revenue sharing to cover the cost of the plan. The problem with this option is that the additional revenue share leads to a higher weighted average expense for the participant.
The intricacies of retirement plan economics are not often explained to the average investor, and many feel as though any fund with an expense ratio greater than, say, 0.30% is too high. The economy of scale achieved by larger plans is simply not present. However, many participants do not feel as though the lack of the plan's size should cause more expensive funds, despite the fact that the money has to come from somewhere.
The next option is to convince the organization to cover the cost of the plan. By paying for the record-keeping services and the possible adviser fees, less revenue is required from participants and the investment expenses can be reduced. The problem for many smaller organizations is that the cost to create the plan, and possibly provide matching contributions for employees, makes it difficult to contribute more to something they may view as an excess benefit.
One final option is to change the way the fees look to participants. Instead of using a share class loaded with additional revenue and high expense ratios, a smaller plan sponsor could use low- or zero-revenue-sharing funds and then charge a basis-point fee or a hard-dollar, per-head charge for record-keeping and other plan services. By assessing fees in this way, a participant's weighted average expense ratio is reduced and, simultaneously, fee transparency is increased.
While there is no perfect solution for smaller retirement plans, the best solution often combines features from the methods described above. One thing is clear, though — lower fees and fee transparency are here to stay.
Tim Irvin is a consultant at Cammack Retirement Group, a retirement plan consulting firm overseeing more than $75 billion in assets.