Last week the Department of Labor published its final rule on participant fee disclosure, which is the last step in the Department’s three pronged, multi-year approach to increasing fee transparency in the defined contribution marketplace. Before we dive in to the participant fee regs, lets quickly review the Department’s first two fee disclosure initiatives:
- Disclosure to Government: The first step towards fee transparency was the new Schedule C disclosure requirements that went into effect last year. The new, expanded Schedule C requires enhanced reporting of indirect compensation (revenue sharing) received by service providers. The extension filing deadline for the Form 5500 was last Friday October 15th, so we expect to begin reviewing and incorporating the additional Schedule C information into our plan fee calculations and products in the next few weeks. Of particular interest with the new Schedule C will be enhanced disclosure of service providers who only receive revenue sharing payments (some brokers, TPA’s and recordkeepers) as well as listings of service providers who failed to make the disclosures in time for sponsors to file the Form 5500. Industry watchers currently believe that failure to comply with the new Schedule C disclosure requirements will likely lead to an immediate DOL audit.
- Disclosure to Plan Sponsors: The second step was the enhanced disclosure to plan sponsors by service providers. This interim final regulation, called 408(b)(2) by the industry, was published in the Federal Register on July 15th and is due to go in to effect July 16th of next year. Among other things it requires advance disclosure to plan fiduciaries of a services provider’s expected direct and indirect compensation from the retirement plan.
So, the Department has been busy, but the real fireworks have not begun yet. Enhanced form 5500 disclosures and enhanced disclosures to plan sponsors are important, but disclosures to plan participants is the critical piece that ties the system together and ensures a strong accountability link between the participants, the plan sponsor fiduciary and the service providers. Here are some highlights of the final rule, called the “Fiduciary Requirements for DisclosureÂ in Participant-Directed Individual Account Plans”:
- Effective Date: The new rule goes into effect for plans with year ends after November 1, 2011. This is much faster than what would have been accomplished via the legislative approach and is thus a big win for fee disclosure proponents. If the Miller bill had passed it likely would have had an effective date 12-24 months after this rule’s effective date.
- Plan Coverage: The Department has decided that participant fee disclosure should occur for all participants regardless of the size of their plan. Currently only plans with more than 100 participants are required to fill out the new expanded Schedule C and obtain an annual plan audit. Requiring equivalent levels of fee disclosure for small plans is critical to ensure benefit adequacy for those working for smaller companies.
- Administrative Expenses: Importantly, fee disclosure in individual account plans extends beyond the fees charged within the plan’s investment options and includes general plan administrative services like recordkeeping, legal and accounting. The disclosure also addresses fee equity issues that we have addressed previously, requiring disclosure of whether fees are charged pro rata or per capita. This is important because it will likely come to light that some participants are bearing a higher burden of administrative charges based upon the size of their accounts or the types of investments they hold. How participants might react to this information is hard to guess, but I think many will be surprised by the types and quantities of fees they are paying.
- Disclosure Timing: Although many of the expenses charged against the plan are annual in nature, the rule requires quarterly disclosure to participants. The lumpiness of some administrative fees over the course of the year (legal and accounting bills typically are paid out of the plan once a year and at the same time) might create some confusion from investors and need to be explained by advisors and sponsors. Their is the potential that quarterly disclosure might create an incentive for more plans to pay these fees with revenue sharing recapture or ERISA spending accounts so that they can be deducted slowly over the course of the year rather than in a single lump sum. It remains to be seen what the impact will be on the billing practices of service providers with the knowledge that their fees will now show up on a quarterly participant disclosure.
- Revenue Sharing: The Department has taken the stance that fund-level revenue-sharing detail need not be disclosed to participants, but that participants should be aware that that revenue-sharing exists and that administrative services are not free. The argument that fund-level arrangements would be costly to disclose and may not help participants make fund decisions was accepted by the Department. This is one area where the Department dialed back the disclosure a bit and compromised with the industry.
- Investment Labeling: The Department struck the requirement to include a label of whether or not an individual investment option is “actively” or “passively” managed. Many commentors felt the disclosure was duplicative, as most passively managed options have the word “index” in their name. The Department agreed with this logic and removed the requirement.
- Investment Benchmarking: The Department retained the requirement to compare investment returns to a broad-based market index that is unaffiliated with the investment firm. In the case of funds that have a mix of equity and fixed income exposure the rule permits the blending of multiple market indexes. Of particular interest here will be seeing which target date index becomes the industry standard and is widely adopted by service providers in participant-level disclosures.
- Dollar-Based Disclosure: In addition to expense ratios the disclosures will also feature dollars per thousand as a way to communicate the cost of the plans. The hope is that dollar-based disclosures will do a better job of helping participants understand their fees than percentages.
- Turnover Disclosures: BrightScope has consistently advocated for more transparency around fund management costs arising from the buying and selling of underlying securities. The Department seems to agree on this issue, re-enforcing its opinion that trading costs matter: “trading costs are not included in an alternative’s expense ratio, yet the cost of trading on a portfolio level does have an effect, on the alternative’s rate of return.” For more information on this issue we recommend reading BrightScope’s Transaction Cost White Paper. The good news is that the DOL has required turnover disclosures for all investment options, not just those currently subject to SEC rules. This means that collective trusts, separate accounts and other non-registered vehicles will have to calculate and disclose portfolio turnover in a manner consistent with SEC Form N-1A or N-3. Employer stock funds and “fixed” funds are exempted from this requirement. The one problem will be helping participants understand how the turnover rate impacts them from a fee perspective. Our transaction cost algorithm converts turnover metrics into a transaction cost estimate expressed in % form making it easier for investors to compare it to the expense ratio. Without this additional analysis a pure turnover comparison may not add a lot of value to participants.
- 404c Redundancy: The final rule eliminates references to 404c disclosures that are now encompassed in the new 404a language. The aim was for the final rule to establish “a uniform disclosure framework for all participant-directed individual account plans.” So, at least from a fee disclosure perspective, all plans are held to the same disclosure standard and additional fee disclosure to obtain 404c coverage is effectively dead.
The impact of this new rule will be substantial and the effect of the trio of new government, plan sponsor and participant level fee disclosures will dramatically enhance the ability of companies of all sizes to benchmark their fees and determine if their fees are reasonable. In light of these new disclosures, plan fiduciaries should re-new their understanding of their ERISA duties relating to maintaining reasonable fees and selecting and monitoring service providers. What will you do with this new fee data? How will you use it to evaluate your service providers? Now that you know what your fees are, how will you ensure your fees are reasonable? Constructing a process to deal with this issue will be critical and having the data in hand removes all doubt that the data is unavailable or hidden.
No discussion of the DOL’s approach to the issue of retirement plan fees is complete without an evaluation of their motivation for pursuing fee disclosure in the first place. As a part of their final rule on participant fee disclosure, the Department shored up its economic justification for enhanced disclosure. The Department cites two primary benefits of the rule: (1) reduced time for plan participants to collect and compare investment-related fee and performance information; and (2) improved investment results for plan participants. The Department quantifies the first benefit (savings of between $7 and $30 billion) but does not quantify the second benefit, yet it is the second that is perhaps most interesting from an economic perspective.Â With enhanced information on fees will participants be able to better select investment options? Will the increased transparency strengthen competition between investment products and drive down fees? The Department believes this to be the case, but updated its economic logic a bit to ensure they stood on solid footing. To make their case the Department made several points, of which I will highlight the two that provide the most insight into the Department’s thinking:
- Expense Sensitivity: The Department believes that more sophisticated investors are more sensitive to fees and that many individual investors, including DC plan participants, historically have not factored expenses optimally into their investment choices. Hard to argue with this logic, especially given results like AARP’s 2007 survey in which 65% of surveyed participants believed their retirement plans had no fees. When these investors find out that they are paying fees they will probably develop some level of sensitivity to the fees, seeking lower cost options or putting pressure on plan fiduciaries to offer lower cost options.
- What Expenses Buy: The Department points to research that looks at the links between investment costs and “observable attendant financial benefits such as performance” and finds that much of the fee markup in mutual funds pays for distribution expenses rather than expenses that lead to higher returns. But, the Department doesn’t take a firm stance here saying that market conditions that may lead to inefficiently high prices – namely imperfect information, search costs and investor behavioral biases – “likely exist to some degree in particular segments of the DC plan market.” But, the Department goes on to say that “there is a strong possibility that at least some participants pay inefficiently high investment prices.” Again, in a world where most economists accept that no market is perfectly efficient and the field of behavioral finance is burgeoning, this isn’t exactly the Department going out on the limb to make the case for the need for full disclosure. The test will be whether or not bottom-up pressure from newly empowered participants will encourage a more thoughtful conversation about the role of fees in retirement plans. When that conversation occurs, it will likely lead to the same conclusion that fund ratings firm Morningstar drew about fund performance; fees are the single most important factor, more important than the Morningstar Rating.
It has been a busy year for the DOL on the fee disclosure front. Now the onus is on the industry to implement and comply with the new regulations. There will certainly be winners and losers from fee transparency, but the hope is that the net effect is superior retirement outcomes for plan participants.
Links for further reading and research: