The Open Option
If you’ve been reading the benefits literature lately, you’ve heard a lot about 401(k) plan fees. Are legislators, regulators and industry leaders creating much ado about nothing? Hardly. Consider a typical plan with $100 million in assets and 2,000 participants. Total investment and record-keeping fees might approach 1 percent of assets, or $1 million per year. Certainly, a lot goes into providing investment management and servicing participant accounts, but when you’re dealing with this much money, and no one is directly responsible for writing the check, it’s easy for a hundred grand to get lost here or there. For larger plans, the stakes are even greater.
This “fee awareness” movement has spurred an increased interest and demand for open investment architecture, an arrangement where administrative costs are established independent from the investments offered. Once administrative costs are fixed, usually on a per-head basis, plan sponsors can freely choose any reasonable investment lineup without affecting administrative fees. Plan sponsors can also decide how administrative costs are paid and by whom. So why haven’t we utilized open architecture all along? To understand, we need some background on how the currently prevailing bundled arrangement works, and the challenges facing plan sponsors.
Ignorance is bliss: But it’s also expensive! Bundling services promotes efficiency and convenience under a single provider and combines plan administration cost with investment management cost, both being paid from plan assets. Bundling also passes the cost of administration along to those holding the assets: the participants. The problem here is that participants are largely unaware of these costs. They never see them because industry practice is to net fees against income before publishing investment returns. We all know that when the person footing the bill is unaware of the costs, things can get sloppy.
The only constant is change: Businesses hire or downsize (or make acquisitions), plan accounts grow, technology marches forward, and companies shut down defined-benefit plans and start pouring more money into defined-contribution plans. While it’s possible for plan assets to shrink, as defined-contribution plans have matured and taken on greater importance, their assets have mostly been growing, and in many cases growing a lot. This has given service providers a growing source of revenue (a set percentage of a growing asset pool) while the costs being offset by this revenue (mostly dependent on the number of participants) have grown at a much slower rate. You don’t need a degree in accounting to realize how quickly this can put fees far out of line with costs.Click here for a chart that shows what can happen
No two snowflakes are exactly alike: Neither are any two defined-contribution plans. Plan differences that complicate efforts to benchmark fee levels include:
Size: With tremendous economies of scale, size can make a huge difference.
Demographics: Turnover, utilization of technology, average age and sophistication all affect cost.
Complexity: Provisions vary tremendously from plan to plan.
Investments: Flexibility in lineup, asset allocation and investment structure.
Average account balance: How much revenue-generating assets are there per cost-producing participant?
Service requirements: Some plan sponsors want the car wash and wax, plus an oil change, while others simply want a full tank of gas.
These differences make meaningful benchmarking of fees a huge challenge, especially when administration fees are bundled together with investment fees.
Fee disclosure: Meanwhile, the regulatory focus has been primarily on disclosing fees, with less discussion about the level of fees. While better fee disclosure to participants is warranted and overdue, it’s not really a solution. Assuming you do get their attention, how are participants to know how to evaluate fee information when even plan sponsors are having difficulty?
Fee disclosure to plan sponsors is likely to be more useful. In particular, disclosure of administrative fees separate from investment fees would provide plan sponsors the information needed to judge the appropriateness of fees.
Investment independence: In response to increased demand for open fee disclosure, some providers are offering open architecture, which provides a form of investment independence, with fixed administrative costs and the ability to offer any investment option. This makes sense for a number of reasons, including:
Fee transparency: What you see is what you get (billed for). Open architecture forces vendors to determine their administrative costs, an important first step toward fee disclosure. Once those costs are known, any revenue sharing derived from plan investments can be used to offset the fixed administrative costs at the plan sponsor’s direction. And if the plan sponsor requests additional services, a business case can be developed around the cost and value of what will be provided.
Cost control: If investment revenue sharing is insufficient to cover administrative costs, plan sponsors may pay the difference or allocate this cost to participants in an equitable fashion. If revenue sharing exceeds administrative costs, an account is set up to hold excess funds for payment of eligible plan expenses. Ideally, excesses can also be credited back to participants. The bottom line is that plan sponsors have control over cost allocation and sharing.
Fiduciary investment oversight: Besides providing plan sponsors with the ability to better manage plan expenses, open architecture allows plan fiduciaries greater freedom in their selection and oversight of the plan’s investment lineup. No more required number of proprietary funds, or having to choose between continuing with underperforming funds or going through the time, expense and hassle of switching administration.
Keeping up with the Dow Joneses: Probably the best feature of open architecture is its ability to keep pace with change. If assets grow faster than participant counts, the additional investment revenue is automatically passed on to the plan sponsor or participants as increased fee offsets or spending credits.
Benchmarking: When investment fees and administrative fees are clearly separated, it removes a major hurdle to benchmarking. Each investment option can be compared with other top-tier investment alternatives within each investment category, while fee comparisons are based on the level of assets invested in that investment category. Administrative fees can be benchmarked against pure administrative fees, without reference to investment architecture or flexibility.
I’m not calling for yet another change in the regulatory environment to promote open architecture. I don’t think additional regulation is required beyond what is currently proposed. As plan sponsors gain greater awareness of their fiduciary risks and responsibilities relating to plan oversight, and become better educated about the advantages of open architecture, they will be more assertive in demanding this option. Meanwhile, proactive providers will find there is a competitive advantage in making open architecture available to their clients.