401k plan Fees and Reporting on Form 5500
The 2004 Advisory Council on Employee Welfare and Pension Benefit Plans ("Advisory Council") created a Working Group to study 401k retirement plan investment management fees and expenses as they are currently reported on Form 5500. The Working Group was charged with studying whether plan sponsors adequately understand the total fees and expenses they are paying and whether those fees are reported on the Form 5500 in a manner consistent with the Department of Labor's reporting objectives. In particular, the Working Group was interested in determining whether the Form 5500's fee reporting requirements (along with the accompanying Schedules) meet the Department of Labor's objectives with regard to the data that is collected. The Working Group was also interested in determining whether plan sponsors currently receive adequate data from the service providers in order to both understand and report the fees. Finally, the Working Group studied whether new reporting methods should be adopted in order to increase the plan sponsor's understanding of overall plan fees and to improve reporting.
The first task of the Working Group on Plan Fees and Reporting on Form 5500 ("Working Group") was to determine what fees and expenses are currently reported by plan sponsors on Form 5500 and to determine whether there are other fees and expenses that should be reported, but currently are not. In general, each plan document has specific provisions stating whether the plan sponsor/employer will pay the expenses, or whether the expenses will be paid from plan assets. The plan settlor makes the decision as to how the expenses will be treated when establishing the plan.
In the circumstance where the plan is required to underwrite its expenses and the fiduciaries contract separately with different service providers that are billed explicitly, it is clear that the billed or explicit charges of the plan provider paid from plan assets are reportable on the Form 5500. However, with the evolution of 401(k) and 403(b) plans using mutual funds as a popular investment option,(1) the investment management fees and expenses of the mutual fund are netted from the mutual fund's performance and are not reported to the plan sponsors; as a result, these expenses are not reported on the Form 5500. Additionally, many plan fiduciaries enter into bundled arrangements with plan service providers for record keeping or other administrative services which typically do not entail explicit charges to the plan. Rather, in a bundled arrangement plan service providers such as record keepers and trustees often are compensated for their services to the plan from the underlying mutual fund investment through either (1) "sub-transfer agent fees," 12(b)(1) fees, or other administrative fees, or (2) through "revenue sharing" arrangements whereby the mutual fund's advisor compensates the provider directly from its profits for the services provided. In either case, the fees and expenses are not paid from "plan assets", but rather from a portion of the mutual funds operating expense which is shared with the plan's service provider. These fees also are not reported on the Form 5500.
The Working Group Proceedings
The Working Group received oral and written testimony at a series of public hearings. The Working Group also received and discussed research and material from public sources that related to the topic of study.
At the hearing on August 4, 2004 , Donald Stone, President of Plan Sponsor Advisors, Inc., reviewed the type of revenue sharing arrangements engaged between plan providers at mutual fund companies and reviewed various surveys of plan sponsors which demonstrated that many plan sponsors are largely unaware of the various revenue sharing arrangements between the vendors and mutual fund companies. The Working Group also heard testimony from John J. Canary, Chief of the Division of Covered Reporting and Disclosure in the Employee Benefit Security Administration Office of Regulations and Interpretations, concerning the current requirements regarding the reporting of fee and expense information as part of the Form 5500 annual report. Additionally, Mr. Canary briefly commented upon the need to employ rule-making if the Department of Labor decided to amend the Form 5500. Additionally, the Working Group heard from Scott Albert, Chief of the Division of Reporting Compliance Office of the Chief Accountant of the Department of Labor, regarding reporting compliance with Form 5500.
At a hearing on September 21, 2004, the Advisory Council received testimony from Elizabeth Krentzman, General Counsel of the Investment Company Institute, who testified that plan sponsors need to receive information from prospective service providers concerning the provider's receipt of compensation, including "revenue sharing" in connection with their services to the plan, but that Form 5500 was not an appropriate vehicle for reporting that information. The Working Group also heard testimony from two representatives of The Vanguard Group, Inc., Mr. Dennis Simmons and Mr. Stephen P. Utkus, who testified in favor of encouraging transparency in fee arrangements between 401k retirement plan providers and that greater transparency will foster sharper competition in the marketplace which will contribute to lower overall costs for 401k retirement plans.
On September 23, 2004, the Working Group heard testimony from Lawrence R. Johnson, CPA, of Lawrence Johnson and Associates, concerning the specific fee information that is currently required on the Form 5500 as well as need to improve disclosure of all fees including investment management fees, 12(b)(1) fees, revenue sharing, commissions, "pay to play" arrangements, sales charges, administrative fees, trustees fees, etc. Later that day, Mr. Mark Davis of Mark A. Davis Consulting testified that there exists a significant difference in the disclosure patterns concerning revenue sharing in the different sectors of the market; the larger and more sophisticated plans tending to require candid and clear disclosures, with mid-size and smaller plans receiving significantly less disclosure. Mr. Lawrence R. Johnson of Lawrence Johnson and Associates testified that 70% to 80% of all 401(k) costs are represented in the internal expense ratios of the mutual fund but are not reported on the Form 5500. Mr. Michael Olah of Schwab Corporate Services testified that Schedules A and C of Form 5500 are an attempt at identifying fees and expenses paid from a plan to a service provider directly out of plan assets (i.e., "hard dollar" payments). However fees intrinsic to specific investment products (i.e., investment management fees and administrative expenses) are not discloseable on Form 5500 because they are not paid with "plan assets". While transparency in fees is important, Schwab does not believe the Form 5500 is appropriate for this task because it is filed too late to be of help to the plan fiduciary in selecting a provider or investment option. Instead, Mr. Olah recommended that existing Department of Labor worksheets be employed. The Working Group also heard from Mr. Edward Ferrigno, Vice President of Profit Sharing / 401k Council of America, who testified that the Form 5500, as currently structured is not useful to government policy makers, plan sponsors, and plan participants, because it does not begin to capture the expenses of many 401k retirement plans. Additionally, Ms. Laura Gough, Chair of the Securities Industry Association Retirement and Savings Committee, testified that the Form 5500 is not an appropriate vehicle for the disclosure of embedded fees to plan sponsors and further described the difficulty in accurately accounting for investment management fees and expenses incurred at the mutual fund level at the 401k retirement plan level. Finally, the Working Group heard testimony from Mr. Thomas M. Kinzler, of the Massutual Financial Group, who recommended that fee and expense information be reported and monitored on a periodic basis and include explicit as well as imbedded fees and expenses.
Contributions by the company are based on the amount contributed by the employee, with XYG matching 30% of the employee's contribution. As with employee contributions, taxes on company contributions and their related earnings are deferred until distribution from the plan. Company contributions are not fully vested to the employee until after a five-year period; employee contributions are fully vested from the time of contribution. Target Labs (www.targetlab.com) makes a 30% contribution, and sees an 85% participation rate company-wide.
Currently the Form 5500 fee reporting requirements do not meet the Department of Labor's objectives with regard to the data collected. There are numerous pooled investment vehicles in which the fees are intrinsic to the underlying investment and are not reported to (or known by) the plan sponsor nor reported on Form 5500. Additionally, fees paid to plan service providers such as record keepers and trustees out of these asset-based fees, in the form of revenue sharing, sub-transfer agency fees, 12(b)(1) fees or the like are not reported on Form 5500 or the accompanying Schedules. While some more sophisticated plan sponsors are cognizant of the overall fees, both explicit and embedded, as well as the revenue sharing arrangements between various providers, many plan sponsors simply do not understand the total fees paid to service providers, nor the revenue streams between them. The fiduciary responsibility provisions of ERISA require that plan sponsors know the amount of fees paid in relationship to the services provided and to understand the revenue sharing arrangements between plan providers. Therefore, the Department of Labor should consider amending the Form 5500 and the accompanying Schedules and, through its rule-making authority, solicit the input from the industry as to the appropriate methodology for capturing that information. In particular, the Department of Labor may wish to consider use of a proxy in order to estimate total fees in light of the significant difficulties of capturing exact information at the plan level. The Department of Labor may also wish to modify its existing worksheet for plan sponsors in order to provide a tool to help plan sponsors understand the true nature of the non-explicit fees and revenue sharing arrangements among the plan's providers prior to choosing the provider or an investment option.
Relevant General Fiduciary Requirements
ERISA imposes certain obligations on plans and their fiduciaries. For example, a plan fiduciary must discharge its duties solely in the interest of the plan and its participants and beneficiaries for the exclusive purpose of providing plan benefits and defray reasonable plan expenses.
A fiduciary must also act with the care, skill, prudence and due diligence under the circumstances then prevailing that a reasonably prudent person acting in a like capacity (and familiar with such matters) would use in the conduct of an enterprise of like character and with like aims. The highlighted terms distinguish ERISA's prudence rule, often described as the "prudent man standard," from the traditional common law "good faith" standards. The prudent man standard means, among other things, that the level of care imposed upon a fiduciary may vary with the complexity of the plan involved.
What is clear however, is that the Department of Labor has consistently held that under Section 404(a)(1) of ERISA, the responsible plan fiduciaries must act prudently and solely in the interest of plan participants and beneficiaries both in deciding whether to enter into or to continue a particular arrangement with a plan service provider and in determining which investment options to utilize or to make available to plan participants. This is true even for fiduciaries of plans where investments are self-directed by the participant and the ultimate benefit is tied to his or her account balance, as is the case with many 401(k) and 403(b) plans. In such cases the fiduciary is responsible for selecting and monitoring the investment options that are available to the participants, as well as the service providers to the plan. In this regard, the responsible plan fiduciary must insure that the compensation paid directly or indirectly by the plan to the service provider is reasonable, taking into account the services being provided to the plan as well as other fees or compensation received by the provider in connection with the investment of plan assets. The Department has repeatedly emphasized its view that the responsible plan fiduciary must obtain sufficient information regarding any fees or other compensation that the service providers receive with respect to the plan's investments and to make an informed decision as to whether or not the service provider's compensation for services is no more than reasonable. See, Department of Labor Advisory Opinion 97-15A and Department of Labor Advisory Opinion 97-16A.
Initially, when ERISA was passed in 1974, the pension world was a very different place than it is today. In an environment populated by defined benefit plans, fees and expenses of the 401k retirement plans were explicit and were paid by the plan sponsor or, alternatively by the plan from plan assets. Additionally, according to generally accepted accounting principles ("GAAP"), these fees and expenses paid by the plan were reported in the expense section of the 401k retirement plan's Income and Expense Statement so that actual fees paid by the plan matched the fees reported both in the plan's audit report and the Form 5500.
The emergence of defined contribution plans in the 1980s, in particular 401(k) and 403(b) plans, with the heavy reliance on pooled investment vehicles such as mutual fund investments, has caused a dramatic change in the way fees are charged. In particular, the pricing methodology has evolved from the explicit charges billed to and paid by the plan (or by the plan sponsor) into an asset-based fee model. Under such an arrangement the investment management fees and expenses of the mutual fund are netted out of its performance on a daily basis in arriving at the mutual fund's net asset value (NAV) and as such, those fees and expenses are intrinsic to the investment and not easily identifiable by the plan sponsor. Likewise other pooled investment vehicles have migrated to the asset-based fee model and suffer from the same reporting deficiencies. To further complicate matters, many plan sponsors have moved to "bundled" arrangements with plan providers whereby other costs of administration such as record keeping or trustee fees are offset, in whole or in part, by revenue sharing arrangements with the mutual funds and other investment vehicles with asset-based fee structures. In many cases the plan sponsor's decision to choose one particular investment vehicle or another is driven by its desire to reduce or eliminate its costs through the revenue sharing devices inherent in such bundled arrangements. Indeed, the testimony established that explicit charges in many plans have been substantially reduced or nearly completely eliminated and the majority of costs associated with administering many 401k retirement plans are now embedded in the form of asset-based fees and borne by the plan participants.
One problem that has emerged is, that as a result of this evolution in how fees are collected, the Form 5500 as currently structured is outdated and simply no longer reflects the way fee structures work in the industry. As noted, many explicit fees have all but disappeared and many very large plans have little or no explicit fees whatsoever. Because the asset-based fees are netted from the investment funds performance (and as such not paid with "plan assets"), the actual costs of operating the plan are reflected only indirectly in the 401k retirement plan's income statement.(2) Thus the current Form 5500 does not provide plan sponsors, participants, or governmental regulators adequate information to understand true cost of the plan. While the evidence suggests that some of the larger and more sophisticated plan sponsors do in fact understand the totality of fees and expenses, the vast majority of plan sponsors have not calculated and do not know the actual cost of running the plan.(3) This "out of sight, out of mind," mentality of some plan sponsors is particularly dangerous in asset-based fee arrangement because as the account balances grow, so do the fees regardless of whether additional services are provided. Yet one of Department of Labor objectives in requiring the Form 5500 is to ensure that plan fiduciaries monitor the operations of the plan, including costs. This is consistent with the overarching fiduciary responsibility provisions of ERISA which require plan fiduciaries to review and monitor fees for reasonableness on a periodic basis.
The Advisory Council respectfully suggests the present reporting requirements are inconsistent with the stated goals of ERISA, which was to provide full and fair disclosure with respect to the fees and costs associated with a 401k retirement plan. A great number of Form 5500's filed by defined contribution plans are of little use to government policy makers, government enforcement personnel, plan sponsors and participants or other interested persons in terms of understanding the cost of the plan. The Advisory Council believes that by capturing indirect fee and expense data on Form 5500, plan fiduciaries will be forced to calculate and therefore fully appreciate the true costs of the plan. Additionally by requiring the reporting of cost information on Form 5500 which is a publicly available document, a data bank will emerge which will undoubtedly be used as a tool by competing providers to drive down overall plan costs. Finally, governmental policy makers and enforcement personnel will have access to more meaningful information regarding plan fees and costs.
However, capturing accurate fee information is a complicated task and in some respects not feasible in light of the current state of the art in record keeping. First, it is unclear to the Working Group as to whether accurate data can be captured concerning exact revenue sharing payments between the mutual fund and plan service providers at the individual plan level. If the information can be accurately gathered at a reasonable cost, it should be reported on Schedules A and C. If the information can not be accurately and economically captured, it should be estimated and reported. However, the task is even more complicated when it comes to investment management fees and expenses of the mutual fund which are calculated and subtracted on a daily basis to arrive at NAV. The testimony from a wide variety of witnesses suggested that, as a result of the way the mutual fund industry record keeping is currently configured, the industry is unable to account for mutual fund investment management fees and expenses at the plan level. The Advisory Council is also concerned that the costs associated with requiring an informational system overhaul that would allow the differing record keeping platforms of the mutual fund industry and record keeping industry to coordinate information exchange (if feasible) would be excessive and outweigh the benefit of exactitude. However, the Advisory Council does believe a proxy could and should be developed which would fairly approximate the fees and expenses of the plan by taking a snapshot of plans holdings at a given point in time and extrapolating from the mutual funds known operating expense ratio.
The shift to asset-based fees coupled with the proliferation of revenue sharing devices between mutual funds and plan service providers has also made it very difficult for plan sponsors to fully understand the fees that are paid indirectly to various service providers such as record keepers, trustees, etc. The evidence before the Working Group established that there exists an asymmetry of information which impedes plan sponsors from knowing how much the plan provider is paid outside of the explicit or billed fees. A study by Grant Thornton that was provided to the Committee and which included a broad survey of plan sponsors, indicated that 81% of the plan sponsors did not know what the vendors were receiving for sub-transfer agency fees, 69% did not know what the vendor received in 12(b)(1) fees, and 80% of the plan sponsors did not know what the vendor was receiving in placement fees, (i.e., marketing fees, finders fees, etc.). Although a vast majority of 401(k) plans utilize these bundled arrangements,(4) the evidence shows that the flow of money in such arrangements is often not disclosed and is accomplished by a variety of revenue sharing devices, that are to say the least, confusing. The lack of transparency in this area has led to an inefficient market where it is extremely difficult for the plan sponsor to determine either the absolute level of fees, or the flow of fees, i.e., who is getting paid what. The latter point is particularly important for a plan fiduciary selecting various investment options; the testimony indicated that certain vendors have steered plan sponsors to mutual funds which pay a high revenue share and de-emphasize funds with little or no revenue share. Alternatively, providers have recommended a particular class of a mutual fund, where a different class (with a lower revenue share) might be more appropriate. Thus we think it is critical that plan sponsors obtain full and complete information concerning all revenue sharing arrangements for each individual investment option, along with alternatives, in order to serve as a check upon the service provider's self-interest in promoting one investment option over another. We believe such a requirement would be consistent with the Department of Labor's repeated admonitions that it is part of the plan sponsors' fiduciary responsibility to ensure that they fully appreciate the amount of fees, both direct and indirect, that are being paid to the providers.
Unfortunately the Form 5500 is not the best vehicle to promote such practices as the Form is filed well after the plan sponsor has already engaged the provider and selected the investment options. While Form 5500 would be helpful in monitoring performance, we believe plan sponsors need a tool to help them understand the revenue sharing arrangement at the point of sale.
As earlier noted, ERISA places substantial responsibilities on plan fiduciaries charged in overseeing the administration and investments of pension plans to understand the total amount of fees paid to a service provider to ensure reasonableness and also to understand the revenue sharing arrangements between various providers. However, many plan sponsors simply do not have sufficient experience or an appropriate source of information concerning industry practice to deal with and understand revenue sharing arrangements. Therefore, the Advisory Council has concluded that educational information would be very useful for all plan sponsors and other fiduciaries, and would be particularly beneficial to fiduciaries of small and medium size pension plans. The Advisory Council notes that as a result of hearings in 1997 and an independent study commissioned by the Department of Labor on 401(k) fees and expenses, the Department developed a pamphlet for plan sponsors, "A Look At 401(k) Plan Fees for Employers" which was later replaced with a brochure entitled Understanding Retirement Plan Fees and Expenses which is available on the Department of Labor's web site. While these pamphlets advise plan sponsors in general terms of the fiduciary responsibilities in determining that 401(k) plan fees are "reasonable," the Department of Labor web site includes a detailed worksheet that enables plan sponsors to evaluate and compare fees of potential 401(k) vendors. The witnesses testified that the worksheet is widely used by plan sponsors in selecting service providers. While this form is an excellent tool to analyze explicit fees, it does not attempt to capture the revenue sharing streams that are prevalent in the industry today. The Advisory Council respectfully recommends that the Department of Labor update this worksheet in order to provide tools for fiduciaries to understand the revenue sharing and total fees received by the service provider for each investment option under consideration prior to its selection.
Recommendations For Regulatory Change
The Advisory Council concludes that the Department of Labor should initiate rule-making in order to modify the Form 5500 and the accompanying schedules so that total fees incurred either directly or indirectly by the plan can be reported or estimated. Additionally, the Advisory Council believes that all fees paid to plan providers either directly or indirectly through revenue sharing devices should be reported or estimated. As a result of the significant accounting (and audit) difficulties that might arise through the use of estimation techniques, the Department of Labor may wish to consider developing a new schedule which includes a uniform proxy formula designed to capture the information.
Additional non-profit websites that include relevant unbiased information about 401k plans include: www.affordable-401k-plans.com and www.401kcosts.com .
Recommendations Involving Plan Sponsor Guidance
The Department of Labor should amend its worksheet for plan sponsors of 401(k) plans in order to provide a tool which will help them fully appreciate the true nature and magnitude of non-explicit fees as well as revenue sharing arrangements. Moreover the Department of Labor should advise plan sponsors that good fiduciary conduct requires the use of the worksheet (or some similar tool) before selecting the service provider or the investment options for the plan.
The Advisory Council makes the following recommendations in an effort to further educate plan sponsors and fiduciaries:
A. Plan sponsors should avoid entering transactions with vendors who refuse to disclose the amount and sources of all fees and compensation received in connection with plan.
B. Plan sponsors should require plan providers to provide a detailed written analysis of all fees and compensation (whether directly or indirectly) to be received for its services to the plan prior to retention.
C. Plan sponsors should obtain all information on fees and expenses as well as revenue sharing arrangements with each investment option. Plan sponsors should also determine the availability of other mutual funds or share classes within a mutual fund with lower revenue sharing arrangements prior to selecting an investment option.
D. Plan sponsors should require vendors to provide annual written statements with respect to all compensation, both direct and indirect, received by the provider in connection its services to the plan.
E. Plan sponsors need to be aware that with asset-based fees, fees can grow just as the size of the asset pool grows, regardless of whether any additional services are provided by the vendor, and as a result, asset-based fees should be monitored periodically.
F. Plan sponsors should calculate the total plan costs annually.