How Conversations with Plan Sponsors Typically Go

Here is a typical interaction I have with a plan sponsor:

Financial Advisor:  I’m calling to quickly figure out if some of the research I’ve done and work I do is relevant.  If not, you’re welcome to hang up on me.  I just wanted to see if you had a minute.

Plan Sponsor:  What kind of research?  If it’s about the 401(k) plan, we’re all set.  We’ve done an extensive amount of due diligence recently.

Financial Advisor:  I am not concerned with whether or not you are “all set.”  I am simply trying to change the way in which the industry does business and help plan sponsors understand what’s actually going on without their knowledge.  More specifically, I am trying to explain to plan sponsors that they should only be passing on flat dollar fees to their participants for all record keeping, administration, and advisory services.

Plan Sponsor:  We just addressed what you mentioned.  We have a broker and XYZ Company and only pay flat fees.

Financial Advisor:  A broker by definition can only earn a percentage-based kickback paid by the mutual fund companies to retirement plan service providers and ultimately coming out of the participants’ pockets, which means a broker can only make money by directing you towards certain funds and investment platforms and away from others.  And yes, you may be paying a flat fee for the administration, but administration is the smallest portion of the fees.  XYZ’s business model is primarily based on revenue sharing, which by definition is also a percentage-based kickback.  If they reduce their fee, it only means they reduced the percentage, and that percentage only gets reduced once the account balance grows, so paying a lower percentage on a higher balance is NOT a reduction in fees at all.

Plan Sponsor:  Our broker does a good job.  He comes out regularly to meet with the participants.

Financial Advisor:  As I just mentioned, a broker can’t make any money unless he steers you towards certain platforms and funds.  Furthermore, a broker cannot legally provide advice.  Only a registered investment advisor can provide advice and charge a flat fee that is commensurate with how much actual work there is to do.  Consequently, you need to keep him as far away from your participants as possible.

Plan Sponsor:  I understand what you are saying, but we’re happy with our arrangement.

Financial Advisor:  How can you be happy knowing that your providers are consistently getting significant raises (and therefore subjecting participants to continually higher fees) without doing any more work?  And do you realize what administration and record keeping services actually entail and the difference between the two services?  Administration is nothing more than giving plan design advice, preparing a tax form, and performing discrimination testing and other compliance services, while record keeping is nothing more than sending out statements, providing a website, and keeping track of participant balances.  Can you honestly tell me that any advisor, broker, administrator, or record keeper is actually doing more work simply because the assets have increased?  How can you justify any provider taking more money out of participants’ accounts just because the assets are greater?

Plan Sponsor:  We have a good handle on things.  We understand how our fees work.

Financial Advisor:  Did you know that your provider’s primary pricing structure is a percentage-based fee or kickback based on cash flow contributions and the average participant account balance?  What do any of these factors have to do with how much actual work there is to do?  Did you know that there are many providers such as Vanguard, Ascensus, Aspire Financial, and Alliance Pension who only charge a flat dollar fee for all record keeping and administration services solely based on how many participants there are in the plan or how much actual work there is to do regardless of how much the plan has in assets?

Plan Sponsor:  I’m really busy.  I don’t have time to address this now.

Financial Advisor:  I don’t doubt you are busy, but unfortunately, based on the fact that the vast majority (or perhaps all) of the fees retirement plan service providers charge are deducted out of participants’ accounts and therefore don’t affect the bottom line, the retirement plan will likely always be a back burner item which dis-incentivizes plan sponsors to scrutinize fees as closely as they would if they were instead writing a check.

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Why most plans have too many fund choices

I recently looked up some information on my old dentist and saw he was on a news program called “Drilling for Dollars.”  The story was about how he diagnosed a patient with a bunch of cavities when another dentist who the patient sought a second opinion from said he didn’t have any cavities at all.  Needless to say, I was a bit disturbed after I just had a tooth drilled myself.

The more I thought about this issue, however, the more I realized that diagnosing patients with problems in order to provide unnecessary revenue-generating services was not unique to the dental profession.  This issue also applied to the retirement plan industry, as financial advisors (mostly commission-based brokers, but also registered investment advisors) will often recommend an excessive number of fund choices and asset classes in order to create unnecessary additional complexity to use as justification for their unnecessary additional fees.

Most financial advisors will justify this complexity with the argument that using a financial advisor to help participants navigate through a complex investment world is the only way to ensure that participants are consistently diversified and invested in a portfolio that is in line with the goals and risk tolerance.  However, what they fail to mention is that this same or often a greater level of diversification can be achieved by offering only five or six risk-based portfolio models (i.e. conservative, moderate, aggressive) consisting of two to five funds, which are automatically re-balanced at no additional cost and without the assistance of an advisor.  Because these models can potentially contain 9,000 securities or more, it is clear that diversification is not about the number of mutual funds offered, but the number of securities in each fund.   Furthermore, many of the additional and unnecessary mutual funds that are offered are actually very highly correlated meaning they move in the same direction and are therefore redundant.  With regard to the so called need to offer funds in each asset class, this is another deceptive practice because you can cover the small, mid, and large cap asset classes entirely with the Vanguard Total Stock Market Index Fund which costs only 0.05% while passively managed funds in each of these asset classes cost 0.24% or more.  Why spend more money on each pie slice when you can buy the whole pie at a much lower price?  And how do you know which area (small, mid, or large cap) will outperform?  These types of arrangements with excessive funds choices encourage redundancy, needless cost and complexity, and market timing.  Unfortunately, because participants tend to buy after a fund has gone up and sell after a fund has gone down, they tend to be very poor market timers.  Perhaps most importantly, having all of these different fund choices encourages participants to try and “pick the best funds” and chase returns rather than continually monitor their goals and risk tolerance.

In the case of offering solely risk-based portfolio models, however, the only responsibility participants would have is to periodically review a risk assessment questionnaire to ensure they are investing properly.  In fact, the federal government’s Thrift Savings Plan already uses this approach:

http://www.cbsnews.com/8301-505123_162-37741476/thrift-savings-plan—the-model-for-all-401k-plans/

Here are some highlights:

•   Simplicity – Five core investment options.

•   Diversification – Four of those five options give exposure to the entire U.S. stock market, most of the international stock market, and the U.S. aggregate bond market.

•   A special government fund that yields longer term bond returns without any loss of principal.

•   Ultra low costs – Less than 0.03 percent annual costs.

•   Lifecycle funds that own all five core investments, rebalance automatically, and become more conservative over time – all for no additional costs.

I agree with Walter Updegrave of Money Magazine that this is the retirement plan that Uncle Sam has right. It is the simplicity of this plan that makes it particularly effective, because studies show the more choices that are offered, the less likely people are to choose. And the diversification of this plan protects investors from chasing the part of the stock market that has recently gone up.

Costs really matter – the 0.03 percent annual expense ratio compares to the 401(k) industry average expenses of 2.00 percent, as noted by a recent LA Times article by fellow blogger Kathy Kristof. To put the costs in perspective, the average 401(k) plan costs 67 times the amount of the TSP, and even my own portfolio is about five times more expensive. Hence the envy I have for this plan.

As compelling as the TSP is, the final proof that this is the model for all 401(k)s is the fact that the financial industry hates it. The Investment Company Institute, the trade organization for mutual funds, published a paper questioning the TSP as a model for 401(k)s. You can bet that anything that threatens the mutual fund industry’s profits is probably a good thing for investors.

I’m with advisor and author Dan Solin that the TSP is the model to stop the great 401(k) rip-off. I’m not making a political statement when I say that I would jump into the TSP if I were offered the opportunity. It would simply lower my costs and increase my returns. It’s unfortunate that I’m not making a political statement, because getting elected to political office would be my only chance to get access to the TSP.

My advice to Federal employees is to keep your money in the TSP plan, in spite of many of my fellow planners telling you to dump it as soon as you can. I’m happy to say that, according to TSP spokesperson, Thomas Trabucco, that’s exactly what most former Federal employees are doing.

Consequently, because participants’ goals can be achieved with such simplicity, there is no need to pay a financial advisor excessive percentage-based “management fees”.  Instead, plan sponsors should be advisors a flat dollar fee based on the value of their time – which not surprisingly is always significantly less than a percentage-based fee.

Why companies should never use a broker to “manage” their plan

A broker cannot legally provide advice or act in a fiduciary capacity.  Rather, a broker can only earn percentage-based kickbacks known as 12b-1 fees from mutual funds which creates a major conflict of interest because some mutual funds don’t have any kickbacks – which means a broker can only make money by recommending certain funds.  Only a registered investment advisor can act in a fiduciary capacity and provide actual advice because this type of advisor does not receive any kickbacks.  This short video also illustrates the difference:

Butchers v Dietitians Brokers v Advisors Suitability v Fiduciary:

https://www.youtube.com/watch?v=AfSaENxAe0M

This article further explains:

Conflicts of Interest Cost Retirement Plan Investors Billions:

http://www.benefitspro.com/2013/04/09/conflicts-of-interest-cost-retirement-investors-bi?eNL=5166db72140ba03f7900005d&utm_source=RetirementAdvisorPro&utm_medium=eNL&utm_campaign=BenefitsPro_eNLs&_LID=80852648

•   By using affiliated mutual funds, brokers are not acting in the client’s best interest. This is the focal point of the fiduciary standard. Eliminate the conflicts of interest in terms of giving advice, and investors will immediately benefit.  It doesn’t mean eliminating brokers, it just means eliminating the claim that brokers are giving advice. They are not.  Advice requires a fiduciary duty.  Brokers don’t (and shouldn’t) have to operate under the regimen of a fiduciary duty.  Brokers don’t give advice.  They trade.

 Furthermore, many plan sponsors are actually under the impression that a broker somehow helps them meet their fiduciary responsibilities.  This is simply not possible, as a broker is not only not a fiduciary, but a party whose very existence inherently places plan sponsors at greater risk.

First, a broker can only get paid a percentage-based kickback that is deducted out of participants’ accounts, so if plan sponsors wanted to limit their expose to excessive participant fees by writing their broker a check, they would not be able to do this.  Second, a broker can typically only make money from more expensive actively managed funds (or index funds which are significantly more expensive that the least expensive available index funds such as the Vanguard Total Stock Market Index Fund – VTSAX – which has a cost of only 0.05%) which require significantly more monitoring than less expensive passively managed index funds.  This additional required monitoring makes an investment policy statement (a written description of a plan’s investment related decision making process) more difficult to follow.  Third, because a broker can only charge a percentage-based fee rather than a flat fee based on how much actual work there is to do, there is a greater chance that the broker’s fees will not be considered reasonable in light of the services provided.

Unfortunately, everyone still continues to falsely believe that a broker is “free” because the mutual funds pay the broker.  This belief isn’t true as explained below:

“The first form of revenue sharing, 12b-1 fees, is used for the cost of the sale, or distribution, of investments. The fee is deducted from the assets of the mutual funds and thus is charged directly to the participants invested in that fund. The fee is ordinarily paid to a broker-dealer as a part of the distribution of the mutual fund. However, for small plans funded with group annuity contracts, it may be paid to subsidize the recordkeeping costs.

The second form of revenue sharing, subtransfer agency fees (or sub-TA fees), are also deducted from the mutual funds’ assets. A mutual fund must maintain records of its shareholders and may properly pay for that service. Where an intermediary, like a record keeper, maintains those records, the mutual fund pays the record keeper for that service. Sub-TA fees are typically fixed fees on a per-participant basis or asset-based fees, or a combination of both. [Pozen, Robert C., The Mutual Fund Business. Boston: Houghton Mifflin Company, 2002.] The transfer agent also provides other shareholder services, such as administration, compliance, communications, and other operational services; the fees for these services, in the aggregate, are referred to as shareholder servicing fees.

The third form is that the mutual fund investment management firm, or an affiliate, may pay a portion of its management fee to a third party as a form of revenue sharing. For example, a mutual fund manager or affiliate may pay a bonus payment to a broker/dealer based on a specified sales goal or total volume of business retained. The source of this money is the fee for managing the portfolio of securities held by the mutual fund that is charged to the fund by the investment manager. Management fees are also charged directly to the mutual fund’s assets, thereby reducing participants’ benefits.”

http://www.401k-fees.com/revenue.html

“Mutual funds also may charge what are known as Rule 12b-1 fees, which are ongoing fees paid out of fund assets. Rule 12b-1 fees may be used to pay commissions to brokers and other salespersons, to pay for advertising and other costs of promoting the fund to investors and to pay various service providers of a 401(k) plan pursuant to a bundled services arrangement. Some mutual funds may be advertised as “no-load” funds. This can mean that there is no front- or back-end load. However, there may be a 12b-1 fee.”

http://www.dol.gov/ebsa/publications/401k_employee.html#section4

Why most plans should not have an investment policy statement

An investment policy statement (IPS) is a written description of a plan’s investment related decision-making process.  While not required, the prevailing view is that any company offering a retirement plan should have this document in place because it will help provide protection from fiduciary liability.  In fact, the Department of Labor will regularly ask for this document in the event of a plan audit.

However, it is actually a bad idea for most companies to have an IPS because they likely will either not follow it or not sufficiently document the process.  The reason is that most companies have a large number of asset classes and fund choices, most of which are actively managed.  As a result, the process becomes extremely complicated to follow.  Here are some examples of questions that come up:

  1. Under what circumstances will the fund managers be replaced?
  2. What happens if the style of the fund changes?
  3. How should the performance standards of the fund managers be determined?
  4. How should these decisions be documented?

There are likely many more questions that companies need to answer, but the idea should be clear:  most plans are set up in a way that makes it extremely difficult to follow and document the steps in an IPS.   Consequently, it’s safer not to have one at all.