Comparison shopping for the best 401 plan - k - retirement plans

By using two methods - Total Plan Cost and Total Benefit - over various time frames, you can compare the cost of 401(k) retirement plans from different providers.

Choosing a 401(k) plan that best meets your criteria can be a perplexing experience. The marketplace offers many alternatives, as well as varied and confusing price schemes. There are bundled and unbundled arrangements, fixed-cost and variable-cost scenarios, hard-dollar and soft-dollar schemes to choose from. And, further increasing the difficulty buyers have when making comparisons, providers quote services in different ways.

Often this comparison challenge rests with HR executives who, while accustomed to matters of plan administration and participant services, may be less familiar with financial-related issues involving investment options and trustee providers. Trustee and investment issues are often deferred to finance executives, who may not fully appreciate the intricacies of plan administration. This disjointed process only adds to the comparison difficulty.

Fortunately, there is a way to get to the bottom-line cost of various plans. By using two methods - Total Plan Cost and Total Benefit - and considering the length of time of the investment, you can compare 401(k) products on a broad, equitable basis.

The Total Plan Cost of a 401(k) plan is the sum of three basic components: (1) investment management costs, which typically are single-line items for each investment option offered; (2) trustee costs, broadly separated into custody (charged on an asset basis), net asset value calculations (charged on a per-fund basis), and general processing fees (charged on a flat rate basis); and (3) administration costs, which are made up of several components, including record keeping, voice response, call center, communications, investment education, and loan initiation fees.

Investment management costs. These fees are paid to an investment management company for its ability to produce a return commensurate with its stated objectives. Lower fees are paid for investment objectives that do not require tremendous amounts of research, such as index funds or U.S. government bond funds, while those requiring a greater amount of research, such as aggressive equity or international securities, command higher fees. The management fee also covers the costs of customer services, general overhead, and profit for running an investment management business.

The investment vehicle chosen by the plan sponsor affects management costs. Two basic vehicle choices are available: (1) individually managed portfolios and (2) commingled pools.

* Individually managed portfolios are managed separately for an individual client (or retirement plan), but generally in the same style as other portfolios that the management firm controls. They're usually the lowest-cost investment vehicles. Pricing is normally on a sliding scale; the total investment cost decreases as assets in the portfolio increase.

* Commingled pools come in two basic varieties - private or public. Both types have a flat basis-point fee charged to all investors. Private pools may be open only to certain types of investors, for example, ERISA plans. Public pools, also known as mutual funds, are open to any investor - assuming the minimum opening balance criteria (if any) are met.

Among the mutual funds, two classes can be considered for 401(k) plans - retail and institutional. Retail funds, which have been the most common and normally have low initial balance requirements, are priced at the highest end of the spectrum to account for the costs associated with servicing a retail-based product. Institutional mutual funds are a relatively new vehicle. They sometimes have higher minimum initial balances and are designed to be used primarily in qualified retirement plans. Their pricing is discounted to reflect the fact that retail-type servicing will not be required.

Private commingled pools are generally lower cost than public pools (mutual funds), primarily because of the extra amount of compliance involved with publicly traded mutual funds.

Fees for individually managed portfolios do not include trustee fees for custody, daily valuation charges, and so on, whereas fees for most pooled vehicles do. These costs would have to be added to the total cost of individually managed portfolios in a side-by-side cost comparison. Also, a critical mass of assets is needed to begin managing an individually managed portfolio to ensure proper diversification.

Besides the cost of the investment management vehicle, there is the cost of communicating and distributing information about the funds. The individually managed portfolio and the private commingled pool are both essentially private funds. Because these funds are not publicly traded, information about them is not readily available in newspapers and libraries.

Publicly traded pools (mutual funds), however, require the publication and distribution of a prospectus - and most funds have daily pricing quoted in newspapers. Information on these funds and their managers is usually provided through research services available at most public libraries, as well as in business and investment publications.

To the extent that publicly available information is desirable, mutual funds will be the better choice. The higher cost of money management for these vehicles, however, shows that there is a cost for the availability of that information. Some argue that the differential is excessive and can be many times the cost of a high-quality investment education program, which could also be used to inform and educate participants about the funds available in the plan.

Institutional mutual funds may offer the best of both worlds - low in cost with ready access to information. The only downside is that, as with individually managed funds, a high initial asset base is sometimes required.

In summary, individually managed portfolios are the least expensive form of investment management, while retail mutual funds are the most expensive. Individually managed funds require a minimum asset base; therefore, for smaller plans or for new options being offered in any plan, pooled vehicles may be the only choice. Information is publicly available on mutual funds, but not on private funds, a feature that may be reflected in mutual funds' higher costs.

Trustee costs. Trustees price their services differently, so the key is to capture all potential costs in the fee quote. The fees are normally quoted on a flat-rate basis for records processing; on a variable basis for items such as security transactions and check writing; and on an asset basis for custody (if any) of company stock funds or any individually managed funds for which the trustee also acts as custodian. To get as accurate a quote as possible, it will be necessary to estimate the amount of activity for the variable-based fees, or give each prospective provider a "common" set of assumptions to work from.

Administration costs. Plan administration - recordkeeping, voice response systems, call centers, and so forth - is usually quoted on a "flat-rate basis" [TABULAR DATA OMITTED] [TABULAR DATA OMITTED] or on a "per-participant basis." However, a "bundled" provider (normally a mutual fund company or other type of investment management organization) may "wrap" plan administration and, perhaps, trustee costs into the investment management fee portion of the quote. Thus the administration - and/or the trustee - costs may appear to be drastically reduced or possibly even free.

As with trustee fees, some plan administration fees may be activity based, so realistic usage estimates are important. Some providers may estimate the activity themselves and embed those estimates into the overall per-participant fee or flat fee. These providers may be referred to as "partially bundled." Again, with any activity-based fees, it will be important to ensure that realistic assumptions have been used in any bundled type of quote.

Start-up communication and any system set-up costs also need to be considered, but they are usually incurred in the first year or first few years.

Once all line-item costs have been isolated and all activity-based fees have been estimated, one final estimate is needed to determine the Total Plan Cost. An asset allocation estimate or multiple scenarios of estimates for the fund options will have to be created to understand how the investment management fees proposed will affect the Total Plan Cost. This can be either the current allocation, if there are no new options being added, or an estimated allocation based on some type of expected average or survey data.

FIVE STEPS TO CALCULATING THE TOTAL PLAN COST

The following example explains the process for determining the Total Plan Cost of a 401(k) plan. The example has been simplified; each [TABULAR DATA OMITTED] component is broken into only a few subcomponents. In reality, there may be many more line-item costs to consider. Also, for simplicity, system setup and communication costs have been omitted.

Current situation

Quarterly valuation frequency

Approximately 10,000 checks written annually

$500 million in total assets allocated across three pooled type investment options as follows:

* 61% Stable value

* 22% S&P 500 index

* 17% Balanced

New features being added

Voice response system Call center Daily valuation Loans Small cap equity pooled fund International equity pooled fund

Three provider proposals are being evaluated. The bid from Provider A is a partially bundled quote with the administration and trustee subcomponent fees embedded in one overall flat fee. Provider B is a fully unbundled quote. Provider C is a fully bundled quote with all fees reflected in the investment management charges. The services required and their associated fees are listed in the Provider Proposals chart.

Step 1: Estimate asset allocations after adding two funds. According to recent surveys regarding 401(k) plans, the two new asset classes being added - small cap and international equity funds - each receive approximately 5 percent of the total contributions. We account for this by taking a total of 10 percent away from the existing asset classes on a pro-rata basis. The new estimated investment allocation is applied to the $500 million in total assets. The Asset Allocation chart shows the results.

TOTAL TRUSTEE COSTS

TRUSTEE             PROVIDER A          PROVIDER B    PROVIDER C

Processing          included in total     $110,000     no charge
Check writing       included in total       50,000     no charge

Total Trustee Fee            $125,000     $160,000            $0

Step 2: Calculate total investment management costs for each provider. To complete this step, multiply the estimated assets in each fund option by the basis points each provider would charge for investment management. See the Total Investment Management Costs chart for the results of this step.

Step 3: Calculate total trustee costs, including estimated variable costs.

a) Calculate any activity-based charges. Provider B indicated a $5 per-check charge. Records show approximately 10,000 checks are written per year. Therefore, Provider B's total charge for check writing is estimated to be $50,000. Providers A and C have bundled the check-writing charges into other fees.

b) Combine estimated variable costs with fixed costs. See the Total Trustee Costs chart for results of Step 3.

Step 4: Calculate total administration costs. This may seem as obvious as looking at the flat fee quoted or adding up the various component fees. But, as mentioned earlier, a more accurate analysis would also compare fee "assumptions" used by the various providers (i.e., number of call minutes to the voice response system or call center, estimated number of loans, etc.). It is important to understand the volume assumptions used in any activity-based fees, whether bundled or unbundled. Again, to ensure an equitable comparison, ask the providers in the beginning of the process to quote based on a "common" set of assumptions.

TOTAL PLAN COST

COMPONENT           PROVIDER A          PROVIDER B    PROVIDER C

Investment          $2,080,000          $1,992,500    $2,687,500
Management
Trustee                125,000             160,000             0
Administration         500,000             550,000             0

Total plan cost     $2,705,000          $2,702,000    $2,687,500

For this example, we assume that all three providers have been given a common set of assumptions. The Provider Proposal chart lists the administration fees of each provider.

Step 5: Add all component costs for each provider's Total Plan Cost. According to the Total Plan Cost chart, the fully unbundled provider (B) appears to be lower priced than the partially bundled provider (A). Although B's administration and trustee costs are higher, Provider A is charging more for investment management. The fully bundled provider (C) appears to provide the lowest cost. However, the analysis is not yet complete.

TIME IS MONEY

Because the composition of the Total Plan Cost is partly a per-participant and/or per-activity fee and partly (or totally) an asset management fee, a one-year analysis is insufficient. When Total Plan Cost is all or heavily weighted by the assets under management, as assets grow so does the Total Plan Cost. So, an effective analysis adds the dimension of time.

To do this, you will need to estimate asset growth, including net contributions and investment returns. Once these estimates have been determined, a simple spreadsheet can extrapolate future assets. At least five years will be necessary for a realistic comparison, but the analysis might also look at specific times after five years.

The Total Plan Cost method should be applied to each year in the [TABULAR DATA OMITTED] future, and a cumulative total should be calculated as well. It may be that one provider looks less expensive in the first three years, but another provider starts to be less expensive in the fourth. Therefore, the cumulative fee over five or 10 years will be needed for each provider.

Continuing with our example, assume that contributions and investment returns total an average of 15 percent per fund per year. (This is obviously simplified, and a more complete analysis would use different growth rates for each fund option.)

Calculate the asset growth in each fund, using 15 percent per year for each of the first five years, as well as years 10, 15 and 20. See the Fund Assets chart for results.

The Investment Management Costs chart shows the results of recalculating management costs for each year based on the projected asset totals.

Now add the administration and trustee costs for Providers A and B into their yearly investment management fees to arrive at each year's Total Plan Cost. This is not necessary for Provider C, because "all" costs are bundled into the investment management fees. Also, if the trustee and administration fees are not guaranteed, assume these fees will increase at a rate close to inflation. (Our example assumes the fees have been guaranteed, a realistic assumption for the first five years, but not beyond.) See the Total Plan Cost Over Time chart.

The analysis indicates that in the first year, the lowest cost provider (C) was $17,500 less expensive on a Total Plan Cost basis than the highest cost provider (A). But just one year later, and going forward, Provider C is more expensive on a single-year basis. Looking at the cumulative totals reveals an even more interesting discovery.

After five years, the cumulative total cost differential between Provider C (now the highest cost provider) and Provider B (now the lowest cost provider) is more than $1 million. Looking 20 years into the future shows that Provider C will receive $16 million more than Provider B. This analysis demonstrates the power of compounded growth, especially when Total Plan Cost is more heavily weighted on assets under management.

Note that our example does not assume any participant growth, which would naturally cause a growth in per-participant or per-activity fees. Any growth in the number of participants, however, will also bring a growth in assets. Thus, any increase in fees based on the number of participants and activity growth will likely be offset by a decrease in fees based on assets. A more complete analysis may include participant growth as well.

[TABULAR DATA OMITTED]

TIME            PROVIDER A          PROVIDER B         PROVIDER C

Year 1          $2,080,000         $1,992,500         $2,687,500
Year 2           2,392,000          2,291,375          3,090,625
Year 3           2,750,800          2,635,081          3,554,219
Year 4           3,163,420          3,030,343          4,087,352
Year 5           3,637,933          3,484,895          4,700,454
Year 10          7,317,183          7,009,369          9,454,293
Year 15         14,717,468         14,098,344         19,015,959
Year 20         29,602,085         28,356,805         38,247,886

THE TOTAL BENEFIT METHOD

The analysis above shows how to compare the different providers on an equitable basis. But what about the Total Benefit mentioned earlier? The Total Benefit is equal to the total investment return less the total cost. When considering 401(k) plan design (indeed any investment program), sponsors and participants should be most concerned with realizing the highest possible Total Benefit. That goal is achieved by maximizing total investment return and efficiently minimizing costs, without lowering the quality of the services provided.

Selecting investment funds that will perform well in the future can be more an art than a science. But an attempt to maximize the total investment return can be made through fairly standard due diligence procedures, which may include formalizing an investment policy for the plan; defining investment objectives for each of the asset class options; and creating a clearly defined process for choosing, monitoring and, if necessary, dismissing investment managers.

Once these due diligence procedures have been completed and prospective investment funds have been selected, it's fairly simple to compare providers on a Total Benefit basis. To the example above, we will simply add in the total portfolio investment return for each provider.

A few words of caution are needed here. First, the investment returns of public funds are normally reported on a "net on fees" basis, whereas private funds are normally reported on a "gross of fees" basis. It is critical to determine how returns are being reported. If they are "net," it will be necessary to "gross up" the performance returns to reflect the addition of investment management fees and then include those investment management fees on the cost side of the analysis. That calculation is necessary to better understand the effect time will have [TABULAR DATA OMITTED] on the investment management portion of the Total Plan Cost. For our example, we assume the returns are being reported on a gross of fees basis.

Second, and more important, note that although Total Plan Cost will be fairly predictable going forward, total investment returns will not. The investment due diligence efforts referred to earlier will help to complete the overall analysis of any provider.

CALCULATING THE TOTAL BENEFIT

Collect historical investment performance data over certain time frames for each of the funds being proposed by each provider. For our simplified example, we will use a single time frame, three-year annualized performance. A more complete analysis would include performance over multiple time frames (note that risk-adjusted performance can also be used here if desired).

Multiplying those returns by the corresponding weight in the plan of the asset class will yield the "weighted return" for that asset class. Adding each of the weighted returns for a particular provider will result in the Total Portfolio Weighted Return for that provider. See the chart for data on all three providers.

To calculate the Total Benefit, convert the Total Plan Cost for each provider into basis points. (Divide the total dollar cost by total plan assets and multiply the result by 100. In this case we used the Total Plan Cost and assets at the end of three years - $661,250,000 since we used a three-year average investment return in our example.) Then, subtract the Total Plan Cost in basis points from the total investment return.

COMPARABLE TOTAL PLAN BENEFITS

                   TOTAL WEIGHTED           TOTAL           TOTAL
                  PORTFOLIO RETURN        PLAN COST        BENEFIT

Provider A             10.38%               0.51%           9.87%
Provider B             10.77                0.50           10.27
Provider C             10.62                0.54           10.08

The Total Benefit between providers can now be compared. The chart, Compare Total Plan Benefits, shows that Provider B, which has the highest total investment return and the lowest Total Plan Cost, yields the highest Total Benefit. It is interesting to note that while Provider A has a lower Total Plan Cost than Provider C, Provider C provides a higher Total Benefit because of superior investment performance. But again, this analysis was performed using just the Total Plan Cost and assets at the end of three years. Given Provider C's rising Total Plan Cost over time-its fees are weighted entirely on asset management - it may very well be the lowest Total Benefit provider in the future, despite its superior investment performance.

These examples illustrate that when considering 401(k) vendors, sponsors should be most concerned with maximizing the Total Benefit equation. That goal is achieved by maximizing total investment return and minimizing Total Plan Cost without lowering the quality of service provided.

Timothy G. Murphy is a consultant in Hewitt Associates' Lincolnshire, Ill., headquarters.

COPYRIGHT 1997 Society for Human Resource Management
COPYRIGHT 2004 Gale Group