“You get what you paid for” is a common expression, and often this expression is true because when you pay more for something, you’re supposed to get more in return. However, it doesn’t quite work that way in the retirement plan industry for a few reasons. First, unlike the lower cost providers, the most expensive providers primarily charge for their services based on a percentage of plan assets, so as the assets increase, the fees in absolute dollars increase in spite of the fact that the percentage declines. Consequently, these providers will continue to charge more without providing any additional services in return. Second, the large providers include most of their ongoing fees within their “all-in” percentage-based fee whereas the lower cost flat dollar fee-based providers tend to provide an a la carte pricing structure where plan sponsors can choose to purchase additional services if they need them.
Overall, all providers basically provide all of the same services. They just price these services differently. However, large providers who charge asset-based fees still argue they offer more comprehensive services. This claim is simply false. One example is bilingual education services. While these services are clearly important for companies with a non-English speaking population, they are not unique to large providers. In fact, some large providers actually outsource bilingual education services to outside firms even though these services are still branded as being provided by the large providers. Because these same outside firms can partner with any provider, there is no advantage to using a larger more expensive provider. The only difference is that plan sponsors would have greater flexibility in choosing which services they want to pay for with a lower cost provider. Another example is the ability to offer more default investment options. This offering actually harms participants more than it helps as explained in an earlier post entitled Why Most Plans Have too Many Fund Choices.
This flexibility is especially important because almost all plan sponsors wind up paying for services that participants don’t ever use – which occurs mainly because plan sponsors have little understanding of what they are actually paying for as well as how to compare pricing of plans. While providers may tout their statistics on how much participants contribute and how often participants use the website, the bottom line is that participants normally through their money into a fund (or multiple funds) and leave it there without having any idea of what they are doing in spite of the wide array of “educational” services which wind up confusing participants more than helping them. In fact, participants shouldn’t be making many changes to their portfolio anyway, as evidenced by the fact that low cost portfolio models (i.e. conservative, moderate, aggressive) are available at a cost of less than 0.10% and can automatically be rebalanced by any record keeper as often as quarterly at no additional cost.
I admire your commitment to conscious capitalism and your ability to effectively articulate the principles and virtues of the free market. I agree that our healthcare system, for example, as you have stated, would be much more innovative and competitive without burdensome government regulations.
However, you may not be aware of the stifling regulations in the 401(k) plan industry. As a result, we have a far less flexible and transparent retirement plan system that benefits the politically connected retirement plan providers at the expense of the participants and embodies the very crony capitalism you have decried. This lack of transparency prevents companies like yours from applying the same level of scrutiny to your 401(k) plan costs and design as you have applied to your health insurance plan.
To illustrate, you have written in your Wall Street Journal op-ed that Whole Foods Market has established a combination of high deductible health insurance plans and health savings accounts in order to create an incentive for your team members to spend their money more carefully. Similarly, becoming more informed about the inner workings of the 401(k) plan industry will help you develop innovative methods to encourage your team members to invest their money more carefully.
You have also written that you allow your team members to vote on what benefits they most want the company to fund. Unfortunately, however, most plan participants have little if any understanding of the costs and benefits of their plan and how almost all plans are set up for them to fail. Consequently, by learning how to more effectively set up your plan and communicate its features to your team members, you can help them make more informed decisions.
For example, two of the largest holdings in your plan are target date funds through Vanguard. While Vanguard does offer competitive target date funds, were you aware you could have offered risk-based portfolio models (i.e. conservative, moderate, aggressive) with the same holdings at approximately half the cost? And are your participants aware that because the target date funds are meant to be stand-alone options, they may be unwittingly creating unnecessary additional costs and redundancy by choosing additional funds?
As a second example, you have 18 additional fund choices, most of which are likely highly correlated meaning they move in the same direction. Consequently, while you may have the appearance of a diversified investment offering, your plan simply has too many choices, which not only create needless investment costs, complexity, and duplication, but also serves to make participants less likely to contribute because of the confusion that this vast array of choices creates. As evidence to support this claim, Brightscope, an independent retirement plan rating service, has graded your participants’ salary deferrals and account balances as below average and poor compared to other companies in your peer group.
The Vanguard Total Stock Market Index Fund, on the other hand, which is the main component of each Vanguard target date fund, actually contains 3,644 securities, so you can clearly offer a diversified and comprehensive array of investment options without offering so many. In fact, the federal government employee’s Thrift Savings Plan (which has over $400 billion) does just that, offering a total of 10 options including 5 Lifecyle (target date) funds. In a free market, consumers would be more aware of these issues and would therefore have far more simple and lower cost plans.
In summary, I am writing you because I believe that together we have the power to vastly improve and expose the true nature of the 401(k) plan industry by spreading the message of voluntary and mutually beneficial exchange. I have written a research paper entitled The Retirement Plan Racket that focuses on the issues I described above and that I believe will help you provide the best possible benefits to your team members.
Please consider reading my research paper and joining me in promoting conscious capitalism in the 401(k) plan industry.
Paul D. Sippil, CPA
The retirement plan industry, despite the pronouncements of the financial service providers and organizations who support it, is a complete disaster. It is dominated by service providers who not only subject participants to significantly excessive fees and investment complexity, but who also have major conflicts of interest because of the kickbacks they receive from the mutual funds.
However, it actually gets worse because the people who are in charge of the plans either don’t have the aptitude to understand how the plan works, don’t care to understand how the plan works, don’t have time to understand how the plan works, or in many cases, all of the above! Furthermore, there is often a relationship with a close friend or family member that precludes any sort of critical evaluation of the plan because the main goal of the plan is to simply direct business to the friend or family member – at least when the plan sponsor gets to pay these people primarily with other participants’ money (which is how it almost always works).
But what’s most disturbing are two psychological factors which prevent plan sponsors from acting in participants’ best interests. The first is the fact that despite some vague notion that there are costs, the actions plan sponsors take indicate a belief that everything is free. Because of this belief, plan sponsors and participants don’t even bother to consider what plans cost and make irrational decisions. To illustrate, professor Dan Ariely in his book Predictably Irrational, provides an example of how the concept of “free” causes people to behave irrationally. He cites an experiment where people had the choice between purchasing a Hershey Kiss for 1 cent or a Lindt truffle for 15 cents. About 73% of people chose the truffles. However, when the price of each candy was reduced by 1 cent – making the Kisses free – 69% of people chose the Kiss! As Professor Ariely says:
“What is it about “FREE!” that’s so enticing? Why do we have an irrational urge to jump to a “FREE!” item, even when it’s not really what we want?
I believe the answer is this. Most transactions have an upside and a downside, but when something is “FREE!” we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is. Why? I think it’s because humans are intrinsically afraid of loss. The real allure of “FREE!” is tied to this fear. There’s no visibility of loss when we choose a “FREE!” item (it’s free). But suppose we choose the item that’s not free. Uh-oh, now there’s a risk of having made a poor decision – the possibility of a loss. As so, given the choice, we go for what is free.” (Predictably Irrational, p. 54, 55)
Consequently, we always tend to buy things we don’t need when we get something for free. In the retirement plan industry, plan sponsors make decisions to purchase retirement plan services that participants don’t need and don’t use because they think they’re free (this happens because most participants simply throw their money into a fund and leave it there meaning they don’t wind up using many of the services they’re paying for). What’s worse is that these plans are actually not free, but very expensive – at least in proportion to the utilization of the services.
The second factor has to do with a phenomenon known as the bystander effect which refers to the idea that fewer people will help a person in distress the greater amount of people that are present. Granted, retirement plan sponsors are not in a position to help people in distress in the way they would if they were witness to a car accident. However, they are in a position to help participants protect their retirement savings, yet despite my consistently calling many plan sponsors (often over a period of years!) with the simple request of doing nothing more than picking up the phone and calling their provider to negotiate their fees, they often refuse to take any action whatsoever. I believe the reasons are that they believe that everyone else is doing the same thing and that if nobody else is taking any action, then there must not be anything wrong. So many times have plan sponsors said to me: “Our fees are in line with other plans in the industry.” Statements like this one perfectly exemplify plan sponsors’ abdication of responsibility as a result of feeling proportionally less responsible because of the belief that their actions are visible to others who are behaving the same way.
What ultimately has to change is not making new rules that represent more “reform” that so many people clamor for, but the mindset of central planning which ultimately results in plan sponsors serving the goals of politically connected service providers rather than the participants who they have a fiduciary obligation to protect. As a consequence, plan sponsors spend most of their time and energy following a set of arbitrary bureaucratic rules instead of looking for ways to fill the unique retirement needs of each participant.
Unfortunately, those in power who benefit most from this system won’t give up their power any time soon. To stimulate change, we need to strike at the root which perhaps can only be done with a full scale consumer rebellion.
Asset-based fees are the predominant model of the group retirement plan industry. For this reason, nobody seems to question this arrangement. Plan sponsors simply say “Everybody has to make money.” The simple response to this assertion is “No they don’t!”
If there is no value to a service, then the service provider doesn’t deserve any money. This idea should not be debatable. However, because plan sponsors don’t understand what service providers actually do (and don’t do), they are in no position to determine the value of the services they are receiving.
The very nature of asset-based fees obscures the plan sponsor’s ability to effectively understand, compare, and effectively negotiate them. Due to the cash flow and time constraints of running a business, most employers prefer to pass on most or all of the fees to the participants and do not have time to sufficiently understand the details of the retirement plans they offer. As a result, plan sponsors tend not to look at the fees as closely as they would if they were writing a check instead, meaning they become less price sensitive, just as the withholding tax made us less sensitive to the taxes we pay because we no longer write a check. This lack of price sensitivity becomes even more apparent when the plan sponsor either has little personal money in the plan. Yet there are some plan sponsors who do not only have the means to write a check, but also prefer to do so. In these instances, plan sponsors suddenly become far more price sensitive and put more thought into whether the services they are receiving are commensurate with the fees they are being charged. However, the large plan service providers generally do not make it known that plan sponsors can write a check (and some do not even allow for writing a check) for all of the fees because these providers know their fees and services would then face far greater scrutiny.
From a psychological standpoint, plan sponsors also do not question the value of the services when the fees are based on a percentage of assets because this percentage gives the appearance of a good deal. Getting an entire package of services for only 1% doesn’t sound like much, but with an account balance of $2 million, that comes out to $20,000, which can be quite excessive for plans with few participants and little work to do. And is it fair if another plan has the same number of participants, but has $5 million in assets and therefore allows the provider to take significantly more money out of the participants’ accounts despite the fact that the plan doesn’t require any more work? Clearly there is reason to question the fairness of this fee structure, yet plan sponsors rarely feel they have the power to negotiate lower fees and do not realize that some providers are willing to offer a flat dollar fee structure. On the other hand, plan sponsors who do negotiate often feel they have competitive fees after receiving a reduction in the percentage their participants are being charged when in reality, they are just being ripped off a little bit less. Less excessive fees are still excessive. When put in terms of hard dollars, however, a plan sponsor may be more inclined to scrutinize the fees instead of being so easily satisfied.
Providers often argue that their fees are reasonable by providing fee benchmarking studies showing that a client is paying fees that are in line with other companies of comparable size. These comparisons are misleading because they simply indicate that fees are similar to other companies, but that does not mean other companies’ fees are reasonable either. They also primarily disclose fees only terms of percentages rather than hard dollar costs and as a result, do not provide a true understanding of whether or not the fees being charged are reasonable in proportion to the level of services provided.
Providers may further argue that all plan sponsors need to see is the total cost and that delving into each component has less importance by pointing out that people only care about the total cost when they buy a car. Unlike a retirement plan however, you aren’t going to buy the wheels and seats separately from another company – you are getting everything from one place. With retirement plans, while there are some bundled providers who provide a one-stop shop for all investment advisory, record keeping, administration, and custodial services, many plans have multiple companies performing these tasks with different levels of expertise. Therefore, only by comparing the cost of each service offering for each part of the plan in hard dollars can a plan sponsor obtain meaningful benchmarking information.
Another means providers use to keep plan sponsors and participants in the dark is to charge a flat fee for administration directly to the business and decrease this fee as the assets increase so as to make it appear that they are reducing the fees. The reason they can reduce the fees is because the revenue sharing or percentage-based fee in absolute dollars increases as the account balance increases. Plan sponsors don’t think much about this arrangement. All they see is their fees being reduced, and for this reason they think they are being “taken care of.” A second form of deception some providers employ is to have plans set up so participants receive a credit, which gives the appearance of a refund. This credit is often simply a return of the revenue sharing payment that a record keeper or financial advisor would have received has they decided to earn their compensation through revenue sharing. Additionally, the providers who actually charge hard dollar fees may take the revenue sharing payment and issue a credit against the fee they are charging which also gives the appearance that the plan sponsor is getting some kind of discount, but this credit simply means the provider is not charging twice. In many cases, the record keeper and financial advisor often charge a percentage of the account instead which is usually either equal to or more than the revenue sharing payment itself. This credit often creates confusion because plan sponsors believe providers are discounting their fees. In reality, however, the plan sponsor could have simply purchased the same funds (or very similar funds) without the revenue sharing fee in the first place, so the credit is nothing more than an accounting gimmick. Furthermore, as previously mentioned, both record keepers and financial advisors often reduce the percentage payment as the assets increase, which also gives the plan sponsor the appearance that they are receiving a discount, when in reality their fees are still increasing, just at a decreasing rate. In fairness to the providers, some of them may not even be trying to trick the plan sponsors, yet the plan sponsors rarely have a full understanding of how the fees are charged. As a result, when a competitive provider displays honesty by openly charging a flat annual fee, plan sponsors often view this arrangement as more expensive because they believe their current services are “free” or “discounted” since they either don’t see any fees or see they are receiving a credit.
The idea of paying down debt also becomes an issue under asset-based fee arrangements. While this idea may sound counter-intuitive, the last person to ask this question to should be a financial advisor who has an incentive to advise against paying down debt, as an advisor’s compensation is increased as a result of an increase in plan assets. Another common participant question is how much to save each year. Financial advisors tend to advise participants to contribute the maximum affordable amount for the same reason they suggest not paying down debt. However, participants may already be in a comfortable financial position without having to contribute the maximum affordable amount, so financial advisors’ advice can cause needless sacrifices to their current living standards. Granted, advisors could argue that they need to raise their fees because their professional liability insurance premiums increase as the plan assets increase. However, the increase in premiums is generally based on each $1 million of coverage, while the advisors’ percentage-based compensation increases with each dollar in plan assets. And yes, some advisors do decrease their percentage-based fee as the assets increase, but their fees in absolute dollars still ultimately increase as the assets increase.
As a whole, the fees service providers charge bear no relationship to the services they offer. Instead, fees for the providers who dominate the industry are based on factors such as average participant account balance and annual plan contributions rather than the amount of time involved. This pricing model helps these large providers generate more revenue, but they do not necessarily provide higher quality services in return for this additional revenue. As a result, plan sponsors cannot effectively use providers’ pricing as a means to determine the quality of their services, which is extremely important because providers who lack sufficient expertise can make costly mistakes. To elaborate, some providers of investment advisory, record keeping, and administration services actually possess a greater level of sophistication than other providers in spite of being able to offer services at a lower price, which suggests that the pricing of retirement plan services is completely distorted. Until pricing models change to more accurately reflect the value of services provided and plan sponsors and participants gain an understanding of the cost of the services they are receiving, the retirement racket will continue.
Mark Twain once said “It’s easier to fool people than to convince them they have been fooled.” Too bad more retirement plan sponsors don’t heed his words. If they did, it might one day occur to them that broker’s commissions are not free. Unfortunately, I don’t see this happening any time soon.
To illustrate, I recently had a conversation with a woman in charge of overseeing a company’s 401(k) plan. I tried explaining to her that the $37,109 commission payment that her broker received in 2012 was paid for by the participants despite her insistence that the mutual funds paid this commission and that it was free to the participants. I tried explaining the concept of a share class to her which is the means by which a broker determines the level of compensation. Plan sponsors have no idea what this means, so brokers always have complete control over the compensation they take from participants’ accounts. The reason for the availability of different share classes is to allow the broker and plan sponsor to discuss different levels of compensation. Of course this never happens nor does the broker ever remember (or perhaps conveniently forgets) to reduce the percentage-based compensation as the assets increase.
So this situation naturally begs the question: If mutual fund payments to brokers are free, and the broker has the ability to select the share class without asking permission from the mutual funds, why would mutual funds bother offering different share classes? Since everything is free to the participants, why wouldn’t every broker just continue to select the share class that pays the most? And why would the Department of Labor bother having a fee disclosure requirement?
If any plan sponsor ever bothered going on the Department of Labor’s website in order to verify what should have already been obvious, they would find the following:
“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.”
Sadly, the plan sponsor’s only response to this was: “I need to do more research.” Even more sadly, this response was not the exception, but the norm. If common sense requires research, a broken and corrupt retirement plan system is the least of our worries.