401 sticker shock? Plan sponsors hope to head off federal rules that would require them to disclose more of their costs. Providers, part 2 - k - includes related article on full disclosure case involving Unisys Corp - CFO Buyer's Guide: 401K

Plan sponsors hope to head off federal rules that would require them to disclose more of their costs.

Last fall, the Department of Labor (DoL) finally took on an issue that has dogged 401(k) plans ever since they began using mutual funds as their primary investment vehicles. That issue is plan costs, including administrative fees, investment expenses, and all other charges paid by either employer or employee. At a hearing last November, Assistant Secretary of Labor Olena Berg said she wasn't convinced that 401(k) plan sponsors and participants "truly understand what expenses and fees they are paying."

With the DoL now paying closer attention to the issue, so are plan sponsors. Like the hangman's noose, the possibility of new pension regulations from Washington aimed at "excessive fees" is concentrating an increasing number of sponsors' minds.

So far, the department has proposed no policy changes. "We're still in the information-gathering phase," says Debra Golding, a pension law specialist at the DoL. Lurking in the background, however, is the possibility that Labor will mandate not only disclosure of all fees, but also the form of disclosure.

The idea behind such a mandate is twofold. If such disclosure were required of sponsors, the DoL believes, sponsors, in turn, would demand it of vendors. "They want it to be apples to apples, as much as it can be," says Peter Starr of Cerulli Associates, a market research and management consulting firm in Boston. Currently,the fees charged by one vendor are not comparable with those of another. As a result, there is a wide variance in what sponsors disclose and how, so that employees have little way of knowing what a plan costs in total, and how much of those costs are deducted from their investment earnings.

That portion is known within the industry as an expense ratio. This consists largely of investment management fees, expressed as an annual percentage of assets and deducted directly from those assets. That means they're borne directly and entirely by participants.

Currently, sponsors are not required to disclose this figure unless plan participants request it. The only costs they are required to disclose are administrative fees, which in any case tend to be lower and are often paid by the sponsor.

Even before Labor began threatening to require more disclosure, some plan sponsors began revamping their plans to anticipate such a change. One example is Aspect Telecommunications Corp., in San Jose, California, a provider of integrated call center products and services. Aspect decided last year to chuck a high-priced 401(k) in favor of a less costly model. The $32 million-in-assets,1,000-participant plan was paying $20,000 a year in administration fees to a plan administrator and record-keeper that Ron Bakis, Aspect's director of compensation, benefits, and HR systems, declined to identify. In addition, Aspect paid a "wrapfee" of 0.76 percent of assets each year to an insurance company. What's more,plan participants paid investment expenses to the six brand-name mutual funds. These ranged from 0.67 percent of assets each year to 1.17 percent of assets each year.

To ensure that total costs for the plan were included in Aspect's bids, Bakis developed a request for proposal (RFP) form based on a model described in the(k)form Catalogue published by (k)la Publishing, in San Francisco. The form helped Aspect understand what to ask for, so that it could make "real comparisons," Bakis says.

He concedes that he tried to anticipate the Labor Department's concerns as the bid and review process went forward. "If DoL looked at the costs, we wanted to make the right moves rather than make changes down the line," says Bakis.

He also called in a consultant - Americh Massena & Associates Inc., of Portland, Oregon - to sort through the mountain of bid data and help pick five semifinalists out of the 19 vendors who submitted RFPs. Bakis further narrowed the choices to three - Fidelity Investments, Vanguard Group, and an alliance between Charles Schwab and Lawrence Johnson & Associates, an Oakland, California, plan administrator - and invited each to make a presentation in early 1998.

Administration fees among the final bidders ranged from $11,000 to $30,000 a year, while expense ratios within the selected mutual funds ranged from 0.26 percent of assets to 1.26 percent. All three could provide Aspect with significantly lower costs, both for the company and for the plan participants. Aspect finally chose Fidelity because, Bakis says, it best understood Aspect's needs, and offered the best technology.

Aspect's experience would support claims in some quarters that the 401(k) provider marketplace is becoming more competitive. Indeed, David Wray, president of the Profit Sharing 401(k) Council of America, a nonprofit advocacy group in Chicago,contends that rising competition has led to multiple providers bidding on smaller and smaller plans, and has enabled large sponsors to negotiate lower fees.

But public data shows that investment management fees are rising. The average expense ratio for a general equity mutual fund, for example, rose from 1.25 percent in 1995 to 1.3 percent in 1997, according to Lipper Analytical Services Inc. A decade ago, it was only about 1 percent.

And the trend toward higher investment management fees may not be limited to mutual funds. According to the 401k Provider Directory Averages Book, published by HR Investment Consultants, of Towson, Maryland, investment fees rose for 122 major vendors of plans with 500 participants from 1.09 percent to 1.11 percent of assets from 1995 to 1997. Yet total 401(k) costs fell from 1.31 percent to 1.25 percent,as recordkeeping and administration fees fell from 0.18 percent to 0.13 percent and trustee fees declined from 0.04 percent to 0.01 percent.

Shifting Costs to Participants

This suggests that despite rising competition among vendors, most plan sponsors continue to shift the cost of their 401(k) plans to participants. And as a result,says David Huntley, a principal at HR Investment Consultants, 401(k) vendors "have chosen not to compete on price." What competition does exist, says Huntley, is over service, as vendors continue to add such features as daily valuations of individual plan assets, 24-hour phone service, Internet access, and an increasing number of investment options. According to a study by Hewitt Associates LLC, the average 401(k) plan now offers eight investment choices, compared with six two years ago.

But increased plan services and investment options can add to the total cost, even with new technology and automation. "Everyone wants providers to provide more services and to do it quicker," says Ed Ryan, senior vice president of the defined contribution operations at Massachusetts Mutual Life Insurance Co., in Springfield,Massachusetts.

And as the statistics indicate, where there is competition on fees, "all the competition is over administrative fees," says Kenny Lee Adams, president of (k)la.The decline here is a consequence of the widespread practice of bundling services- from investment management to recordkeeping to daily evaluations of assets for each account - which are then supplied by a single provider. The incidence of bundling rose from 50 percent of all plans in 1991 to 61 percent in 1996, according to Spectrem Group, a research and consulting firm in San Francisco.

Some plan vendors say that other factors, such as convenience, are the driving force behind bundling. But others disagree. "Smaller plan sponsors are just looking for a single low-cost provider when it comes to administrative costs," says Margaret-Ann Cole, principal at The Kwasha Lipton Group of Coopers & Lybrand, an employment benefits consulting firm in Fort Lee, New Jersey. (For a look at sponsors bucking this trend, see "To Bundle, or Unbundle," October 1997.)

Whatever the cause, bundling has made cost comparisons more difficult. Some mutual fund companies "are so aggressive in capturing market share, they are willing to do it in a way that [eliminates] up-front costs for new accounts," notes Kathleen Hartman, an analyst at Morningstar Inc., in Chicago. That makes for more apples-and-oranges comparisons.

Keeping Costs Down

Yet some sponsors are finding ways to offer more investment options and services while keeping participants' costs down. Consider Warner-Lambert Co., in Morris Plains, New Jersey, which, with 9,000 participants and $1.5 billion in assets in its plan, was bitten by the mutual fund bug in 1993. Before that, the large pharmaceuticals and consumer products firm's 401(k) plan had only three options:company stock, a guaranteed investment contract (GIC) fund run in-house, and an S&P 500 index run by an institutional manager. While investment expenses were nonexistent in the case of the company stock and the GIC and quite low for the index fund, administrative fees for the company were fairly steep, says Sharon Kinsman, vice president for pension investments.

In survey after survey, plan participants told the company they wanted more investment options, including mutual funds that they could follow daily in the press, says Kinsman. So, in 1993, the firm abandoned its unbundled approach and hired a single-source plan provider, T. Rowe Price of Baltimore, to offer more options for participants, as well as to bring down the recordkeeping costs paid by the company.

Recently, the clamor for even more investment options led the company to increase the number of options from 6 to 23. "People love the flexibility," she says. "They love the ability to pick up the phone and talk to T. Rowe Price." And investment costs are low and disclosed. Warner-Lambert notifies plan participants of the administrative costs for the plan in each quarterly statement, and a quarterly prospectus discloses mutual fund fees, Kinsman says.

The company monitors the fees, which range from 12 basis points for an index fund to 85 basis points for an international stock fund, more than the fees participants were paying before they got mutual funds, but well below what similar mutual funds usually cost. Now Kinsman looks back at the pre-1993 plan with disdain. "We were in the Dark Ages then," she says.

Avoid Mutual Funds?

Other companies are attacking the cost question by steering clear of mutual funds.U S West offers its plan participants eight funds managed not as mutual funds, but as separate accounts and commingled trusts. The company stock fund has no investment management fees, while fees on the other seven range from as little as 0.03 percent for an index fund to as much as 0.47 percent for an international fund. And U S West discloses on every quarterly statement both administrative and investment fees taken out of each of the eight funds. Both costs are also reported in the plan's annual report.

Plan participants can invest in any mutual fund through their own brokerage account, although so far only about 1 percent of plan assets has been allocated in that manner. But U S West warns participants that the costs, as well as the risks, might be greater. The plan's administrative fees are spread evenly across all the funds and subtracted from the assets, all of which is disclosed in the plan's annual report, but these typically range from 0.08 percent to 0.11 percent.

GenCorp Inc., of Fairlawn, Ohio, has managed to keep its 401(k) fees to fewer than 10 basis points for combined investment and trustee fees. The company pays all recordkeeping fees. How did this arrangement come about? GenCorp's strategy has been to combine the bargaining clout of the company's $2.4 billion defined benefits plan with that of nearly $500 million in the company's 401(k) plan. Most of GenCorp's defined contribution assets are managed by people who also manage its defined benefits assets, which gives the 401(k) plan greater bargaining power than it would have on its own.

Rely on Index Funds

GenCorp's success in keeping fees low also reflects its reliance on index funds. "We don't offer active management," notes David McNiff, director of investment management. Instead, GenCorp relies on four index funds: an S&P 500 fund, a balanced fund, a bond fund, and an international equity fund. GenCorp also offers three other investment options - a stable value fund, a company stock fund, and a short-term money market fund.

McNiff concedes that some mutual funds could offer higher returns, although index funds have recently beaten most actively managed funds. "The great bulk of returns come from asset allocation," he says.

Yet the structure of these 401(k) plans is unlikely to head off the DoL, so sponsors that aren't doing as much to reduce or disclose their plan costs clearly have cause for concern. And while experts agree that the worst thing smaller firms can do is to adopt a 401(k) plan without getting more than one bid, this is exactly how many have locked themselves into high-cost plans, according to Stephen J. Butler, president of Pension Dynamics Corp., a third-party pension administrator in Lafayette, California.

Butler speaks from experience. When he requested bids for a 401(k) plan with $1 million in assets and 50 participants in 1995, he received cost estimates that ranged from as little as $9,497 to as much as $32,796.

There are reasons for this wide disparity in costs. Start-up plans often cost more to begin with, simply because their fixed costs are spread across meager assets. These costs will be compounded by any sales commissions paid to insurance agents and brokers.

Adds Wray of the Profit Sharing 401(k) Council: "Never buy a plan without getting at least a couple of competing bids."

The McNabb Proposal

While the DoL is not talking about what it might do, pension experts expect a requirement that plan sponsors disclose to plan participants the total costs of all fees charged to the plan, whether paid by the company or the participant. A proposal along these lines was made at last November's hearings by F. William McNabb, managing director at The Vanguard Group. The McNabb proposal suggests having the federal government require plan sponsors to disclose total costs, not just administrative costs, according to a standard formula that includes the expense ratio.

That would make it more difficult for plan sponsors to hide administrative costs in investment expenses, to the detriment of future retirement earnings of plan participants. "A good case can be made that expense ratios ought to be disclosed," says McNabb. But he says total costs should also be broken down to show what part is paid by the company and what is paid by the participant. Ted Benna, president of the 401(k) Association, in Cross Forks, Pennsylvania, would go a step further by requiring sponsors that seek Employee Retirement Income Security Act protection from fiduciary liability to identify the recipients of all fees.

Plan sponsors are expected to object to any new mandated disclosure. To head one off, the Financial Executives Institute is trying to build support for voluntary disclosure of all plan costs in an annual disclosure that would be made available to all plan participants. The draft proposal, formally adopted in April, recommends separate disclosure of each option in the company's 401(k).

All this leads Bill Quinn, president of AMR Investment Services Inc., which manages the pension assets of American Airlines, among others, to predict that 401(k) vendors will finally be forced to compete on price. Full disclosure of fees, says Quinn, will "ultimately lead consumers to press for more reasonably priced options than exist today."

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RELATED ARTICLE: THE CASE FOR FULL DISCLOSURE

Full disclosure of 401(k) fees might help protect you against fiduciary liability,if a recent court case involving Unisys Corp. serves as precedent.

In the case, which reaffirmed a lower-court decision against participants in a Unisys 401(k) plan who had suffered losses, Judge Herbert Hutton of the United States District Court for the Eastern District of Pennsylvania last fall ruled that section 404(c) of the Employee Retirement Income Security Act (ERISA) protected Unisys from liability for those losses. The judge ruled that in selecting three guaranteed investment contracts from Executive Life Insurance Co. in 1987 and 1988 for two of its investment funds, Unisys had acted prudently. But more important,he said that the 404(c) would have offered Unisys such protection even if the choices hadn't been prudent. His reasoning: Unisys had disclosed to plan participants that they exercised control over their investment choices and that by assuming such control, they bore responsibility for financial consequences.

Hutton's opinion is a landmark decision for cases involving "the tanking of investments in 401(k) plans," says Brian T. Ortelere, of Pepper Hamilton LLP, in Philadelphia, who represented Unisys in the case. Granted, a defense invoking the 404(c) section of ERISA has yet to be tested in a situation in which a plaintiff claims losses due to excessive 401(k) fees. Nevertheless, says Ortelere, Hutton's opinion in the Unisys case suggests that at a minimum, "if you disclose all fees, you'll have a good argument" against legal claims involving those fees. - R.S.E.

Robert Stowe England is a freelance writer based in Arlington, Virginia.

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