By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist
Summary:
Under the new rules, plan sponsors will be required to disclose fee and expense information to plan participants, and covered plan service providers will need to give detailed information about all forms of compensation—direct and indirect—and any possible conflicts of interest.
Because of the way the rules are written and will likely be enforced, plan sponsors may limit the number of investment options available through their plans.
An unyielding focus on cutting fees would likely result in inferior plan design, which is hardly consistent with the idea that plans are to be created and managed for the benefit of plan participants.
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The Department of Labor (DOL) isn’t shy about hiding its intentions with the new 408(b)(2) and 404(a)(5) rules. In fact, the DOL has made it apparent that it wants to lower fees for retirement plans. It has also expressed concern that plan participants either don’t have, or don’t understand, fee and expense information. As a result, 404(a)(5) requires plan sponsors to disclose fee and expense information to plan participants, and 408(b)(2) requires covered plan service providers to give detailed information about all forms of compensation—direct and indirect—and any possible conflicts of interest.
Will the new disclosure regime result in plan participants agitating for lower cost options in their retirement plans? Or, will the new rules have about as much effect as New York City’s law requiring calorie labeling on menus has had on the incidence of obesity? While the ultimate effect is open to debate, it is almost inarguable that there will be some effect. Because of the way the rules are written and will likely be enforced—based on the DOL’s guidance—plan sponsors may limit the number of investment options available through their plans. The DOL has indicated that if as few as five or more plan participants choose the same investment option, a plan sponsor may have to treat that investment as though it were a designated investment alternative. The additional due diligence associated with designated investment alternatives may lead plan sponsors to eliminate additional choices, which could spell the elimination of brokerage windows or nondesignated investment alternatives from covered plans.
The burden on small plans
Small plans may find that it is overly arduous to gather and analyze the additional data from covered service providers. In a Government Accountability Office (GAO) survey, 55% of all employers with a covered plan used a bundled solution for creating and managing the plan. The most popular reason why a service provider was chosen was for its “one-stop-shop” solution. Considering 408(b)(2) requires plan fiduciaries to assess the reasonableness of total compensation received by covered service providers, its affiliates, and subcontractors, that could create additional administrative burdens on already time- and resource-stretched small plan fiduciaries. As a result of the additional burdens, small employers that attempt to start their own plans may find it more practical to join multi-employer plans instead.
Whether the new fee disclosure rules result in a “race-to-the-bottom” in terms of plan features depends on how plan fiduciaries interpret the rules. It may be tempting to think that the safe route is to simply choose plan features or service providers that offer the lowest bid. However, I believe that would be a mistake. The new rules require the contracts and fees to be “reasonable,” not necessarily the “lowest.”
The DOL has clarified that what is a “necessary service, a reasonable contract or arrangement, and reasonable compensation” is inherently a factual question. Therefore, determining the reasonableness of a contract, arrangement, or fee requires looking at the value the service or feature brings to the plan relative to the fee. Some considerations in evaluating the value of a service can include whether the service increases the success of the plan in meeting its objectives, whether the service meets the needs and preferences of plan fiduciaries and participants, and whether the service protects the plan fiduciary from liability.
The plan’s investment policy statement can be consulted to determine the objectives of the plan. A financial planner or advisor can determine whether his or her services map directly into a stated objective of the plan. Many plans will indicate that a diverse set of investment options and participant investment education is required. This could require looking at various passive and actively managed investments as well as assessing the quality of investment communications coming from the various investment firms used to manage plan assets. Those features can add value. Whether plan features or services meet the needs and preferences of plan fiduciaries and participants can be determined during the interview or request for proposal process. Participants could also be asked periodically (for example, annually) through short, online surveys whether they prefer certain plan features or not, which could help build a relationship with plan fiduciaries as well as plan participants.
The liability issue
Protecting the plan fiduciary from liability could be done in a variety of ways, including having the planner or advisor assume some of the liability. In addition, a financial planner or advisor could assist in the aggregation and interpretation of the new disclosure information. Although the DOL has focused on cutting fees, the real purpose of the new regulations should be to ensure that the fees and expenses are commensurate to the value of the plan features and services and to give a clear picture of what those fees are.
The views expressed are as of 7-18-12 and are those of Chief Portfolio Strategist Brian Jacobsen, Ph.D., CFA, CFP®, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
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