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The 401(k) Fee Fiasco

As mutual funds go, the Growth Fund of America wins high marks, both from rating firm Morningstar (which accords it four out of five stars) and from the market,
where it has beaten the S&P 500 over the last 10 years. Many Growth Fund shareholders invest through company retirement plans, which enables them to
avoid the sales charge the fund levies on the general public of as much as 5.75%.

A good deal? Maybe for owners of R6 shares, one of seven types of GFA shares in retirement plans (out of the fund's 14 total share classes). They pay a
fraction of what workers at other companies must cough up in annual fund expenses.

Unfortunately for the millions of Americans who are counting on such accounts to fund their retirements, 401(k) plan fees are often absurdly high and
next to impossible to uncover
. Buried in plan literature are kickback schemes (in which fund firms pass on a portion of fees collected to the plan
administrator in exchange for shelf space), custodial, advisory and record-keeping fees, transaction costs and innumerable other charges that few
participants have any clue they're shouldering--or, in many cases, any ability to uncover.

Often, human resources executives are as ignorant about the true costs of 401(k) plans as rank-and-file workers. High, poorly disclosed fees are an
especially big problem among smaller companies.

Now, for better or worse, Congress is getting in on the act with several bills purporting to reform the 401(k) market. All focus on improving fee disclosure.
The most prominent legislation is sponsored by Rep. George Miller, D-Calif., and aims to force 401(k) plans to break down fees based on what they go
toward, and to show participants how much they're paying, either in absolute dollar terms or as a percentage of their invested assets. Miller is also
seeking to require that employees be offered at least one index fund that invests in stocks, bonds or a combination of the two.

"It will give Americans a fighting chance to strengthen their retirement," says Miller, who chairs the House Committee on Education and Labor.

To critics, improved disclosure of retirement plan costs appears long overdue. Under the Employee Retirement Income Security Act of 1974 (ERISA), employers have fiduciary responsibilities to oversee the plans and must provide workers with 401(k) plan summaries. Some list fees; others don't.

ERISA also requires plan sponsors to provide each participant with account statements, which typically include gross costs but little or no disclosure of where
they end up. Employees are also supposed to receive annual reports listing plan expenses for their entire company; employers are not required to break
down the cost of their retirement plans to individual employees, however.

The Government Accountability Office, the research arm of Congress, found that in order to get a clear picture of fees employees must request special documents, perform complicated calculations and even then would face a major challenge in coming up with numbers they can compare with those for alternative investments.

"You cannot, as a practical manner, easily determine the fees you pay in your 401(k) plan," says Mercer Bullard, a professor of securities law at the University of Mississippi and founder of Fund Democracy, a mutual-fund watchdog organization.

Rather than helping employees understand what they're paying, mutual fund companies and plan administrators have come up with some ingenious ways to skim off savings while obscuring which investments are expensive or perform poorly. Some plans do so by subtracting individual fees--such as for making short-term trades or borrowing against your own account--from ending balances without any indication you've been charged at all.

That means the only way an employee can come up with what he's paying is to work out the numbers--first by figuring the rate of return for his entire account and by calculating the difference between that and his ending balance.

Performance disclosure bears scrutiny too. Some mutual funds list historical performance without subtracting expenses, which can drastically overstate how much investors actually earned. Company-wide fees for record-keeping and custodial services are often not disclosed at all but instead bundled into aggregate fund expense ratios.

Supporters of this kind of disclosure argue that it shouldn't matter to employees where their fees are going but only how much they're paying in total. Critics counter that the lack of detailed disclosure provides plan administrators with a dangerous amount of latitude to operate plans in their own interests by, say, including only the funds that earn them the most profit, rather than a menu that best serves participants.

After fighting against added 401(k) disclosure for years, the mutual fund industry has come around, at least in part. Cynics might claim that's because it has seen the political writing on the wall and concluded that it will get off relatively easily, anyway, given that insurers, its main rivals in the 401(k) market, have so much more to hide.

Under the pending proposals from the House and the Labor Department, new hires would receive a list of 401(k) investment options, their objectives, expenses and past returns. Account statements would separately list the different charges. The largest cost for employees, what funds charge to manage their money, would probably still appear as a percentage of assets invested (Growth Fund of America's R6 shares, for example, charge 0.33%). However, plans would also be required to show in dollar terms how much that expense ratio would amount to for an employee with a hypothetical balance of $10,000 or some other figure.

The fund industry hasn't caved in altogether. It is continuing to fight Miller's proposal that it be required to offer all plan participants index funds, which tend to have lower fees, and thus lower profit margins, than actively managed alternatives. The industry is couching its opposition in the claim that 70% of 401(k) plans already include an S&P 500 index fund, which Miller's bill doesn't count as a broad enough stock market index.

Congress itself is unlikely to move on 401(k) reform until after plowing through the health care quagmire. Even then, some observers fear the result will be less than fully illuminating for mom-and-pop investors.

"A participant in the plan isn't going to understand the fees anyway," says Richard Kopcke, a visiting scholar with Boston College's Center for Retirement Research. To Kopcke and other experts, Americans are just too financially illiterate for anything but a basic line of index funds.

Finding out what you're paying right now is tough, but you can get a rough idea and learn how well your employer is looking after your interests. Start by adding up all fees listed in your account's quarterly statements. Get the annual prospectus from your employer (not from the fund's Web sites) for each fund in which you're invested and hunt down the expense ratios. Estimate your average balance in each fund by adding the starting and ending balances for the year and dividing the total by two.

Now comes the tricky part. Company-wide administrative expenses appear in the plan's annual report. You can ask your employer how that charge is divvied up among your employer and fellow workers. There's a good chance your human resources department won't be able to tell you and will instead refer you to your plan's outside administrator, who will probably defer to the annual report.

If the answer isn't forthcoming, you're best bet is probably to divide the total plan cost by the number of plan participants to estimate your personal contribution. If you are told there is no administrative fee charged to employees, it means your provider is including those charges in the funds' expense ratios.

If your plan's fees are too high, an appealing option is a self-directed brokerage account, which some employers allow for inside their 401(k) plans. The beauty of such programs is that they enable workers to opt out of the standard 401(k) fund menu and instead select from among thousands of other low-cost funds, or to own stocks and bonds directly. You'll still have to pick up some administrative costs, but it could save help you shave off most of the fees you're being charged.

Another alternative: Opt out of your 401(k) plan entirely. That's an increasingly sensible alternative, especially in companies that no longer match their employees' contributions.

The Employee Retirement Income Security Act (ERISA) requires plan fiduciaries, when selecting and monitoring service providers and plan investments, to act prudently and solely in the interest of the plan's participants and beneficiaries. Responsible plan fiduciaries also must ensure that arrangements with their service providers are "reasonable" and that only "reasonable" compensation is paid for services. Fundamental to the ability of fiduciaries to discharge these obligations is obtaining information sufficient to enable them to make informed decisions about the services, the costs, and the service providers.

This interim final rule represents a significant step toward ensuring that pension plan fiduciaries are provided the information they need to assess both the reasonableness of the compensation to be paid for plan services and potential conflicts of interest that may affect the performance of those services.


  • The Employee Benefits Security Administration (EBSA) is responsible for administering and enforcing the fiduciary, reporting, and disclosure provisions of Title I of the ERISA.
  • The agency oversees approximately 708,000 private pension plans, including 483,000 participant-directed individual account plans such as 401(k)-type plans.
  • In recent years, the way services are provided to employee benefit plans and the way service providers are compensated (e.g., through revenue sharing and other arrangements) have become increasingly complex.
  • Many of these changes may have improved efficiency and reduced the costs of administrative services and benefits for plans and their participants. However, the complexity resulting from these changes also has made it more difficult for many plan sponsors and fiduciaries to understand how and how much service providers are compensated.
  • Although the Department has issued considerable guidance relating to the obligations of plan fiduciaries in selecting and monitoring service providers, this interim final rule establishes, for the first time, a specific disclosure obligation for plan service providers - a disclosure obligation designed to ensure that ERISA plan fiduciaries are provided the information they need to make better decisions when selecting and monitoring service providers for their plans.
  • The Department published a notice of proposed rulemaking and related class exemption in December 2007 and held a public hearing on March 31 and April 1, 2008.

Overview of Interim Final Service Provider Disclosure Regulation

  • The interim final regulation applies only to defined contribution and defined benefit pension plans and focuses on the disclosure of the direct and indirect compensation certain service providers receive.
  • The interim final regulation applies to plan service providers that expect to receive at least $1,000 in compensation in connection with their services and that provide:

1. certain fiduciary or registered investment advisory services;

2. recordkeeping or brokerage services to a participant-directed individual account plan in connection with the investment options made available under the plan; or

3. certain other services for which indirect compensation is received.

  • The rule focuses on service providers and compensation arrangements that are most likely to raise questions for plan fiduciaries with respect to the amount of compensation being received by a service provider for plan-related services and potential conflicts of interests that might compromise the quality of those services.
  • The interim final regulation also includes a class exemption from the prohibited transaction provisions of ERISA for a plan fiduciary who enters into a contract without knowing that the service provider has failed to comply with its disclosure obligations.

Disclosure Requirements

Disclosure of Services and Compensation

  • Information required to be disclosed by plan service providers must be furnished in writing to the plan fiduciary. The rule does not require a formal written contract delineating the disclosure obligations.
  • Information that must be disclosed includes a description of the services to be provided and all direct and indirect compensation to be received by the service provider, its affiliates or subcontractors. Direct compensation is compensation received directly from the plan. Indirect compensation generally is compensation received from any source other than the plan sponsor, the covered service provider, an affiliate, or subcontractor.
  • Because certain services and costs are so significant or present the potential for conflicts of interest, information concerning those services and costs must be disclosed without regard to whether services are furnished as part of a bundle or package. For example, service providers must disclose whether they are providing recordkeeping services and the compensation attributable to such services, even when no explicit charge for recordkeeping is identified as part of the service contract.
  • Service providers must disclose whether they are providing any services as a fiduciary to the plan.
  • Information also must be disclosed about plan investments and investment options. These disclosure obligations are placed on the fiduciaries to investment vehicles that hold plan assets and on recordkeepers and brokers who, through a platform or other mechanism, facilitate the investment in various options by participants in individual account plans, such as 401(k) plans.

Ongoing Disclosure Obligations

  • Changes: A service provider generally must disclose a change to the initial information required to be disclosed as soon as practicable, but no later than 60 days from the date on which the covered service provider is informed of such change. Reporting and Disclosure Requirements: Service providers also must, upon request, disclose compensation or other information related to their service arrangements that is requested by the responsible plan fiduciary or plan administrator in order to comply with ERISA's reporting and disclosure requirements.

Benefits of Interim Final Regulation

  • The Department estimates that the rule will be economically significant. The non-discounted costs for the first year are estimated to be approximately $153 million.
  • The first year costs are attributable to reviewing and analyzing the regulation, conducting a compliance review to ensure that service providers comply with the regulation, and preparing any new disclosures required by the regulation. Costs in the second and subsequent years are expected to fall to an estimated $37 million.
  • The Department estimates that benefits would result from reduced time and cost for fiduciaries to obtain compensation information needed to fulfill their fiduciary duties, the discouragement of harmful conflicts of interest, reduced information gaps, improved decision-making by fiduciaries about plan services, enhanced value for plan participants, and increased ability to redress abuses committed by service providers.

Failure to disclose revenue sharing arrangement was not breach of fiduciary duty

An employer sponsor of 401(k) plans did not breach its fiduciary duties by failing to disclose to plan participants a revenue sharing arrangement between the plan’s mutual fund providers, the U.S. Court of Appeals in Chicago (CA-7) has ruled in Hecker v. Deere and Company.

401(k) plan investment options

An employer sponsored and administered 401(k) plans for its employees. As the administrator of the plans, the employer had the final authority to select investment options offered under the plans. However, pursuant to an agreement with a mutual fund provider (Fidelity Trust), which functioned as the directed trustee of two of the plans and advised the employer on investments to be included in the plan, the employer (with the exception of an employer stock fund) limited plan investment options to funds offered by a related entity to the fund provider (Fidelity Research). The plans, however, also offered an investment alternative (i.e., brokerage window) which allowed participants to invest in over 2,500 different publicly available investment funds offered by Fidelity Trust and other mutual fund companies. Plan participants were empowered to direct the investment of their individual account assets. However, participants were restricted to investing in options specified under the plans.

The funds for which Fidelity Trust served as an investment advisor charged investors an asset-based fee. The total fee, expressed as a percentage of the assets invested, was reported in each fund prospectus and itemized between management fees, service fees and other expenses. Fidelity Research also shared a portion of the fee revenue with Fidelity Trust, but this revenue sharing arrangement was not disclosed to participants.

Duty to disclose revenue sharing

ERISA does not explicitly require the disclosure of revenue sharing. However, the participants alleged that the employer breached its general fiduciary duty by not informing participants that Fidelity Trust was receiving money from the fees collected by Fidelity Research. The central issue was whether the employer, having disclosed the total fees imposed by the funds, had an additional fiduciary obligation to reveal how Fidelity Research allocated the monies it collected pursuant to the revenue sharing arrangement.

The trial court found that the information disclosed in the reports and prospectuses that were provided to participants accurately reflected the expenses actually paid to the fund manager for fund management. Focusing exclusively on the fact that the failure to disclose revenue sharing did not violate existing ERISA standards for disclosure, the trial court dismissed as without merit, the suggestion that disclosure is required by ERISA’s general fiduciary standards. Disclosure requirements, the court explained, are generally limited to those "expressly prescribed" by ERISA. ERISA provides detailed disclosure requirements, and it would be "inappropriate," the court opined, to "ignore and augment them using the general power to define fiduciary obligations."

The appeals court focused on whether the omission of information about the revenue sharing arrangement was material. Stressing that the total amount of fees, and not the internal post-collection distribution of the fees, was the critical figure in ascertaining the cost and net value of an investment, the court ruled that the omission of the revenue sharing information was not material. As the employer did not deny participants information necessary to prevent them from acting to their detriment, it did not breach its fiduciary duty by failing to disclose the revenue sharing arrangement


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