Topic #7: Revenue, Expenses and Disclosure

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Revenue, Expenses and Disclosure

Moderator:

Andrew Ness, Mercer Consulting

Panel:

Mary Beth Braitman, ICE Miller

Jayson Davidson, Hyas Group, LLC

Georgette Gestely, City of New York (NY)

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Presented by:Jayson Davidson, CFAPartnerHyas Group, LLC6500 Macadam Avenue, Ste. 300

Portland, Oregon 97239

(503) 416-0957

[email protected]

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Agenda Relationship between Fees and Revenue

• Administrative expense vs. investment expense• Common fund structure• Revenue share types

Plan Pricing• Typical pricing structure• Alternative pricing approach

Plan Sponsor Responsibility Questions

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Administrative vs. Investment-Related Expenses

Administrative Expenses• Provider imposed

Per headAsset based

Investment Expenses• Fund imposed

Per headAsset based

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What is the Mutual Fund Expense Ratio?

Annual Charge Automatically Deducted From a Mutual Fund’s Assets Each Day Prior to the Fund’s Pricing• Consists of:

Management feeRevenue sharingOther expenses

• Automatic deduction from fund often results in a lack of participant awareness of these fund expenses

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What is Revenue Sharing?General Forms of Compensation

Finders Fees* (disclosure in fund prospectus varies)• Paid on new money contributed to the plan• Up to 100 basis points (i.e. 1.00%)• Significant in first year of plan (rollovers)

12(b)-1 Fees* (disclosed in fund prospectus)• Available on majority of funds and usually asset based• 25 – 100 basis points (typically 0.25%)• Included in fund’s expense ratio as provided in the

prospectus* Since these are commissions, a broker-dealer is required for collection

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What is Revenue Sharing?General Forms of Compensation (cont.)

Sub-Transfer Agent (Sub-T/A) Fees (not disclosed in fund prospectus)• Payments made to plan’s record keeper and/or other

administration service provider• Expressed as either a percentage of assets (bps) or a

per participant fee• Payment amounts can vary up to 0.65%. Or, may be

assessed on a per person, per fund position up to $19• Payments are often negotiable

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What is Revenue Sharing?General Forms of Compensation (cont.)

Management Fee Rebates (not disclosed in fund prospectus)• Asset based fee between mutual fund company and

service provider/distributor• Highly negotiable (between 0.03% to 0.60%)

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Typical Estimated Fee StructureAsset Classes

Assets(3/31/08)

ExpenseRatio

Add. Asset Based Fees Total Fees

Total Est. Cost

Stable Value 12,722,783$ 0.44% 0.20% 0.64% 81,426$ FDIC Insured Option 9,374,577$ 0.85% 0.20% 1.05% 98,433$ Short-term US Investment 3,326,536$ 0.95% 0.20% 1.15% 38,255$ Intermediate Term Bond 4,313,904$ 0.68% 0.20% 0.88% 37,962$ High Yield Bond 242,275$ 0.75% 0.20% 0.95% 2,302$ Lifestyle Aggressive 44,256$ 0.89% 0.20% 1.09% 482$ Lifestyle Moderately Aggressive 539,122$ 0.81% 0.20% 1.01% 5,445$ Lifestyle Moderate 3,481,420$ 0.72% 0.20% 0.92% 32,029$ Lifestyle Moderately Conservative 43,202$ 0.72% 0.20% 0.92% 397$ Lifestyle Conservative 44,473$ 0.57% 0.20% 0.77% 342$ Large Cap Index 7,027,397$ 0.05% 0.20% 0.25% 17,568$ Large Cap Blend 6,167,122$ 0.99% 0.20% 1.19% 73,389$ Large Cap Value 8,871,124$ 0.54% 0.20% 0.74% 65,646$ Large Cap Growth 12,595,723$ 0.75% 0.20% 0.95% 119,659$ Mid Cap Index 107,181$ 0.26% 0.20% 0.46% 493$ Mid Cap Value 647,143$ 1.40% 0.20% 1.60% 10,354$ Mid Cap Growth 3,359,302$ 1.10% 0.20% 1.30% 43,671$ Small Cap Index 8,418$ 0.18% 0.20% 0.38% 32$ Small Cap Value 2,489,655$ 0.97% 0.20% 1.17% 29,129$ Small Cap Growth 665,972$ 1.24% 0.20% 1.44% 9,590$ Small/Micro Cap Blend 854,043$ 0.56% 0.20% 0.76% 6,491$ International Value 1,087,263$ 1.16% 0.20% 1.36% 14,787$ International Growth 2,935,182$ 0.90% 0.20% 1.10% 32,287$ Socially Responsible- Balanced 177,384$ 0.95% 0.20% 1.15% 2,040$ Socially Responsible- Equity 47,794$ 1.29% 0.20% 1.49% 712$

81,173,251$ 0.79% 0.89% 722,923$

(avg.) (avg. wt)

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Assessing Revenue

Alternative Pricing Approach• What revenue does the service provider collect from

the total expenses?• Is the amount appropriate given the services?• Are less expensive funds available?• If excess revenue is available, can it be returned to the

Plan to offset expenses?

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Alternative Estimated Fee StructureAsset Classes

Assets(3/31/08)

ExpenseRatio Total Fees

Total Est. Cost

Revenue From Fund

Revenue From Fund

Stable Value 12,722,783$ 0.44% 0.44% 55,980$ 0.25% 31,807$ FDIC Insured Option 9,374,577$ 0.85% 0.85% 79,684$ 0.25% 23,436$ Short-term US Investment 3,326,536$ 0.95% 0.95% 31,602$ 0.25% 8,316$ Intermediate Term Bond 4,313,904$ 0.68% 0.68% 29,335$ 0.30% 12,942$ High Yield Bond 242,275$ 0.75% 0.75% 1,817$ 0.25% 606$ Lifestyle Aggressive 44,256$ 0.89% 0.89% 394$ 0.30% 133$ Lifestyle Moderately Aggressive 539,122$ 0.81% 0.81% 4,367$ 0.32% 1,725$ Lifestyle Moderate 3,481,420$ 0.72% 0.72% 25,066$ 0.32% 11,141$ Lifestyle Moderately Conservative 43,202$ 0.72% 0.72% 311$ 0.33% 143$ Lifestyle Conservative 44,473$ 0.57% 0.57% 253$ 0.33% 147$ Large Cap Index 7,027,397$ 0.05% 0.05% 3,514$ 0.00% -$ Large Cap Blend 6,167,122$ 0.99% 0.99% 61,055$ 0.15% 9,251$ Large Cap Value 8,871,124$ 0.54% 0.54% 47,904$ 0.35% 31,049$ Large Cap Growth 12,595,723$ 0.75% 0.75% 94,468$ 0.25% 31,489$ Mid Cap Index 107,181$ 0.26% 0.26% 279$ 0.00% -$ Mid Cap Value 647,143$ 1.40% 1.40% 9,060$ 0.25% 1,618$ Mid Cap Growth 3,359,302$ 1.10% 1.10% 36,952$ 0.25% 8,398$ Small Cap Index 8,418$ 0.18% 0.18% 15$ 0.00% -$ Small Cap Value 2,489,655$ 0.97% 0.97% 24,150$ 0.40% 9,959$ Small Cap Growth 665,972$ 1.24% 1.24% 8,258$ 0.35% 2,331$ Small/Micro Cap Blend 854,043$ 0.56% 0.56% 4,783$ 0.00% -$ International Value 1,087,263$ 1.16% 1.16% 12,612$ 0.40% 4,349$ International Growth 2,935,182$ 0.90% 0.90% 26,417$ 0.45% 13,208$ Socially Responsible- Balanced 177,384$ 0.95% 0.95% 1,685$ 0.00% -$ Socially Responsible- Equity 47,794$ 1.29% 1.29% 617$ 0.30% 143$

81,173,251$ 0.79% 0.69% 560,577$ 0.29% 235,866$

(avg. ) (avg. wt) (avg. wt)

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Alternate Pricing Approach

• Control Participant / Plan Expenses Three important numbers

• Allows For More Investment Flexibility No requirement for proprietary product Potential for lower cost options

• Tremendous Savings

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What is to Come? More Regulatory Oversight

• Disclosure• Lawsuits• Focus on other plans – OPEB solutions / healthcare

savings Revision to Standard Practice

• Formally separate management fees from administrative fees

• Flat dollar vs. asset based fees Move Away from Daily Valuation?

REVENUE, EXPENSES AND DISCLOSURE

Presented by:Mary Beth Braitman, PartnerIce Miller LLPOne American Square, 29th FloorIndianapolis, IN 46282-0200(317) 236-2413 // [email protected]©2008 All Rights Reserved

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AGENDA

• Background

• Fiduciary Responsibilities

• New Regulations

• Litigation

• Congressional Activity

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BACKGROUND

• Ten years ago, the Department of Labor (“DOL”) sponsored a "Study of 401(k) Plan Fees and Expenses" (April 13, 1998). This study found a very large range of fees and expenses, very little understanding of those fees and expenses on the part of plan sponsors, and very little disclosure of those fees and expenses to participants in any meaningful way. In many plans, little has changed in the intervening years.

• In November 2006, the Government Accountability Office (“GAO”) issued a report "Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees." That report again focused on the lack of easily understood and available fee and expense information, and made a number of recommendations to Congress.

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• On February 22, 2008, the Government Finance Officers Association ("GFOA") issued a Recommended Practice for "Monitoring and Disclosure of Fees for Defined Contribution Plans." This report observes that fiduciaries must make decisions in the best interests of plan participants. It further observes that this mandates that fiduciaries have knowledge about all fees and expenses charged to the plan and participants while ensuring that these costs are reasonable, and that participants receive adequate and accurate information about the fees and expenses that affect their account balances.

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FIDUCIARY RESPONSIBILITIES

• The comprehensive powers of a trustee include the power to incur and pay expenses that are:– Reasonable in amount– Appropriate to the purposes and circumstances of the

trust, and– Appropriate to the experience, skills, responsibilities and

other circumstances of the trustee• This power is subject to the trustee’s fiduciary duties:

– Implicit duty to be cost conscious– Duty to act prudently– Duty to act in accordance with terms of trust– Duty to act in accordance with governing state and local

laws

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• The expenses are not limited to solely essential expenses, but can include expenses that, in the exercise of fiduciary judgment, are reasonable and appropriate for the purposes of the trust and serve the beneficiaries’ interest. Examples include:– Education– Website– Investment guides and information– Call center

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DOL REGULATIONS

• On July 23, 2008, the DOL issued new proposed regulations on fee disclosure. Comments are due on September 8, 2008.

• This is an ERISA regulation and therefore not mandatory for governmental plans. However, it may well create a “benchmark” or “best practice” standard.

• Centerpiece of the regulation is a requirement to provide investment related information in a comparative chart.– Performance information on 1, 5, and 10 years– Benchmark performance comparison– Total annual expenses paid indirectly from account– Total fees paid directly from account– Website references for more information

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• Regulations also require regular and periodic (generally annually) notices about participant investment options and instruction rights.– Any limits on investment direction– Any voting, tender or other rights– The plan’s investment alternatives– The plan’s designated investment managers (if any)

• Fee and Expense Information– For plan administrative services – the amounts charged to individual

accounts• Requires quarterly statement of amount actually charged in

preceding quarter to participants’ accounts and a description of services provided for those charges

– For individual expenses – direct charges• Requires quarterly statement of amount actually charged in

preceding quarter and a description of services provided for those charges

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• The regulations also provide that certain information must be available at initial plan eligibility and annually thereafter.– Prospectuses– Financial statements, e.g., shareholder reports– Value of a share or unit– List of assets for each investment alternative and

the value or proportion of the investment alternative in each

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LITIGATION

• On February 20, 2008, the U.S. Supreme Court issued its decision in LaRue v. DeWolff, Boberg & Associates, Inc., et al., which holds that individual participants in retirement plans subject to federal pension laws (the Employee Retirement Income Security Act ("ERISA“)) can sue plan fiduciaries to recover losses in their accounts.– The specific ERISA section at issue provides remedies

for various injuries. (Note: This section does not apply to governmental plans)

– A prior United States Supreme Court decision (Massachusetts Life Insurance Co., v. Russell) had found that a plan participant could not sue for consequential damages. That 1985 decision concluded that certain remedies were only available for "the entire plan" rather than for individual participants.

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– In the LaRue case, the Justices stated that the Russell decision's "emphasis on protecting the 'entire plan' from fiduciary misconduct reflects the former landscape of employee benefit plans. That landscape has changed." (Emphasis added.) The Justices note that "defined contribution plans dominate the retirement plan scene today," while in 1985, the defined benefit plan was the "norm" … "the dominant paradigm for the provision of retirement income.“

– The LaRue opinion further explained that the "entire plan" language in Russell was in the context of defined benefit structures – but "are beside the point in the defined contribution context."

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– Consequently, the Justices held that ERISA § 502 "does authorize recovery for fiduciary breaches that impair the value of plan assets in a participant's individual account.“

– Just how broad this decision is remains for “other courts in other cases” to decide.

• Beginning in the fall of 2006, a number of class action lawsuits have been filed alleging excessive fees and that fiduciaries do not understand why the fees are being charged and who is receiving the fees. In some cases, the plaintiffs are also raising conflict of interest issues.

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• These cases generally involve 401(k) plans. However, there are some cased involving governmental plans. Examples include:– A class action complaint in state court asserting violations of

state consumer protection laws and state securities laws, as well as claims for unjust enrichment and breach of fiduciary duty. Based on security law claims, case was removed to federal court. In June 2008 the court denied motion to dismiss with leave to refile motion at conclusion of discovery.

– A class action on behalf of public employers sponsoring 457(b) plans against a vendor, alleging breach of fiduciary duty and unjust enrichment due to purported revenue sharing payments. The district court dismissed the action based upon preemption by the Securities Litigation Uniform Standards Act ("SLUSA"), but noted that an action could be re-filed based upon SLUSA or an individual action could be filed in state court. Plaintiffs filed a motion to vacate judgment and amended complaint in October 2007 which remains pending. Note: other courts based dismissals as well on SLUSA preemption.

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– A class action concerning commissions and revenue sharing payments.

• The DOL amicus brief in one case argues that the Secretary of Labor’s longstanding interpretation is that in participant directed accounts, fiduciaries are not immunized against claims of losses stemming from imprudent or disloyal selection of investment options, including those with excessive fees.

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CONGRESSIONAL ACTIVITY

• As might be expected in the light of the explosion of claims and complaints, Congress has turned its attention to fees.

• HR 3185 (“401(k) Fair Disclosure for Retirement Security Act of 2007”) passed the House Education and Labor Committee on April 16, 2008. The bill requires information on historical risk, returns and fees, as well as requiring at least one low-cost index fund option.

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NAGDCA Annual Conference:

Running Your Plan Cost Effectively

Georgette Gestely

September 17, 2008

Running Your Plan Cost Effectively

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Running Your Plan Cost EffectivelyThe discussion has been going on a long time:

“78% of plan sponsors do not know how much their costs are largely because there are about 80 different ways in which vendors charge fees.”1998 Department of Labor

10 years later… A CIEBA committee on Investment of Employee Benefit Assets conducted a survey and found that only 58% of plan sponsors are confident of their understanding of plan costs. It would be preferable if they were confident that they were able to control plan costs!

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The 1st Big Decision is Recordkeeping

Bundled vs. UnbundledPro

Bundled plans, where the investments and recordkeeping are with a single vendor through a single contract, are EASIER, one stop shopping for plan sponsors.

ConBundled recordkeeping means less control over the program. Bundled programs do not allow plan sponsors to hire best in class vendors for every aspect of the program including the lowest costs.

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Bundled vs. UnbundledProBundled providers often offer FREE recordkeeping as long as all, or most of the assets remain with them.

ConThere is no such thing as a free lunch, so “free” translates into “invisible” to the plan sponsor. Bundled recordkeeping fees are reflected as asset-based fees incorporated into the investment management fees. That makes it impossible to see how much either recordkeeping or investment management actually costs participants. Since the recordkeeping fees are added to the investment management fees, they directly reduce the investment returns of participants.

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Bundled vs. Unbundled

More Cons Since the fee is charged on the investments, the larger theparticipant’s balance the more he is paying for recordkeeping, without an increase in services provided.

When the markets go down, the asset-based fees paid to the bundled provider go down with them. This might translate into reduced services being provided by the bundled recordkeeper to participants.

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Bundled vs. UnbundledProOften times, a family of investment funds is offered to participants by the bundled provider, which SAVES TIME for the plan sponsor who would otherwise need to:

– issue individual investment management RFPs– review proposals– conduct oral presentations– draft contracts with individual investment managers– hire investment advisors to help with all of these

ConThe investments within a family of funds, by definition, cannot ALL offer participants best in class investments with respect to performance and fees.

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Bundled vs. UnbundledMore ConsThe investments within a family of funds have not been selected through a competitive bidding process, so the plan sponsor has not exercised due diligence in their selection. Most likely the investment funds are also not being reviewed regularly against their benchmarks and peers. ProThrough open architecture, a bundled recordkeeper can offer outside investment funds in addition to its own family of funds.

ConIn this case, the relationship of the outside investment manager will be with the bundled recordkeeper rather than with the deferred compensation plan sponsor. That will translate into a charge to the participant in the form of a recordkeeping overlay.

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Bundled vs. Unbundled

ProBundled recordkeeping allows for efficiencies of scale that lower costs.

ConIf costs cannot be broken out and compared to the universe, how can anyone tell whether or not they are lower and the plan participant is indeed benefiting from these economies?

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Bundled vs. UnbundledProBundled recordkeepers often offer their own off-the-shelf, proprietary target date portfolios which gives plan sponsors an easy way to incorporate these into their plans.

ConTarget date strategies can be off-the-shelf or custom built, using an unbundled plan sponsor’s own investment funds.

The more hands-on you are in building your target date portfolios, the more you will be in control of both their cost and the monitoring of their performance.

As is the case with a family of investment funds, off-the-shelf target date portfolios offer the plan sponsor little opportunity to “look under the hood”.

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The 2nd decision is the Investment ProgramUsing the best investment vehicles for your plan

Mutual Funds, which once made sense in deferred compensation plans when assets were low and it was important for participants to find their investments in the newspaper, no longer make sense.

• Rather than expensive, retail mutual funds, plan providers can offer participants any number of lower cost, institutionally priced vehicles

• Yet a recent Callen survey found that over 50% of large plans use nothing but mutual funds as their investment vehicles.

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Using the Best Investment Vehicles for your Plan

What if the mutual fund manager offers you a rebate? Isn’t that the same as having lower cost institutional funds?

• No. Lower cost funds affect the participant accounts directly: the higher the fee, the lower the return. Rebates, on the other hand, are paid to plan sponsors, while participants continue to pay the higher fee on their investments.

• Rebates are typically used to offset plan expenses. Since the rebates of a single investment fund are being used for servicing all plan participants regardless of their investment options, the validity of their use is questionable.

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Use the power of your aggregate DB and DC dollars tonegotiate the most favorable terms through investment vehicle types:

– Retail Mutual Funds– Institutional Mutual Funds– Super Institutional Mutual Funds– Co-Mingled Funds– Collective Trusts– Separate Accounts

Separate accounts need a master custodian to hold the assets,trade the shares and calculate the NAVs on a daily basis. That information is transferred to the recordkeeper.

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Why Separate Accounts?• Minimizes expenses• Allows control over investment managers and investment policy• Maximizes returns• Keeps it simple for the participant. They only need to determine if

they want to be in this asset class. The evaluation of the manager and underlying holdings is done by the Board, staff, and investment consultants.

• Underlying fund managers can be changed without any disruption to the participants (funds keep the same values and there is no blackout period)

• Prevents trading abuses: not open to outside investors• Allows for securities lending

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How do the NYC Plan fees compare to the universe?

The City’s average participant pays $.26 on $100; the median cost of average institutional fund is $.54 on $100; the median cost of a retail fund in an IRA is $.83 on $100.

Fund (all separate account) DCP Expense Ratio

Stable Income Fund 0.17%

Bond Fund 0.26%

Equity Index Fund 0.04%

Socially Responsible Fund 0.46%

Mid-Cap Equity Fund 0.57%

International Equity Fund 0.38%

Small-Cap Equity Fund 0.42%

Pre-Arranged Portfolios 0.26%

The change from mutual funds to separate accounts has resulted in a cost savings of approximately $3 million annually for NYC Plan participants

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Using the Best Investment Vehicles for your PlanWhat is Securities Lending?• When a plan sponsor is invested in separate accounts, it is the

“owner” of those securities (rather than the investment company) • Since the plan sponsor owns the securities, it can lend them

through a lending agent (its custodian or other institution)• A securities lending policy details what can be lent and how the

loaned securities are compensated and collateralized• If you think that your plan’s securities – those held by investment

companies in institutional mutual funds or commingled investment trusts- are not being lent, think again!

• Your securities are being lent by the trust or fund who “owns” the securities, though not necessarily for your optimal benefit

• Through separate accounts, your plan can control that function and get your full share of revenue

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Securities Lending offers plan sponsors another important revenue source to either offset administrative expenses or offer additional plan services. If you do not use separate accounts, but commingled trust funds, for example, you might talk to your provider about sharing the securities lending revenue on the plan’s assets with your plan.

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Helping Plan Participants with Financial Decisions What did DC communications look like at the

beginning? • a brochure listing the plan rules• an enrollment form listing the investment choices,

and• a quarterly statement with account information

The 3rd Decision is Employee Education

This was pretty basic stuff! It was important to get employees enrolled. But beyond whatever it took to get participants invested and get out that all important quarterly statement, not much else was going on.

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Helping Plan Participants with Financial Decisions

What did employee education look like in the middle phase of DC plans?

It was the uphill battle of teaching employees the fundamentals of investing for the long term, diversifying their portfolios, remembering to re-balance their portfolios….the list goes on.

Printed Matter: glossy, 8th grade level materials did not work– people hate to read stuff they MUST read– people hate to read stuff they don’t understand– and more and more, as images overtake the written work,

people just plain hate to read.Our hearts went out to all the busy and overwhelmed would-beinvestors.

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How About Electronic Communications? How did electronic advice fare?

We tried making everything interactive; allowing participants to play with “what-if” scenarios so that they could make better investment decisions with their ultimate retirement goals in mind.

Findings: Few participants used electronic advice and even fewer used it and then followed the advice.

Communications in the middle phase of DC plans, which has lasted all the way up to the present, has been a dismal failure.

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Helping Plan Participants with Financial DecisionsTarget Portfolios are being adopted at break neck speed and solve the investment problems for both:

The plan sponsor: What investment choices should I offer? And

The plan participant: How should I invest my money?

So, in our new DC world of “automatic” everything (automatic enrollment, automatic escalation, automatic default), is the Plan Sponsor done? Can we forget about communications? Has the Plan Sponsor lost a voice as chief communicator with employees?

Just the opposite! This is the opportunity for more communication, not less.

New

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What will DC employee education look like in the future?

It will be holistic financial planning to fight financialilliteracy

Defined contribution participants have a history of making badfinancial decisions. Here’s an example:

• Workers who are laid off are 47% less likely to roll over their defined contribution distributions to an IRA.

• Workers who relocate to obtain new jobs are 50% less likely to roll over their accounts to their new employer or an IRA.

• And workers who leave work to care for a family member are 77% less likely.”


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In all aspects of their financial lives, employees are becoming more economically insecure. Without a rudimentary understanding of budgeting or debt management or insurance planning, they will have a harder time making ends meet in retirement.

Financial education now will make a tremendous difference later, because it helps participants make the most of what they have while they are working.


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The MethodA call center to answer all financially related questions?While it seems like a good idea, people have little patience to talk forlong periods of time to a faceless voice on a telephone about theirfinancial problems.

Face-to-face communications is more expensive but much moreeffective.As every salesman knows (and the reason why people hatevideoconferencing), the only way to truly communicate is to

– look someone in the eye– make a connection– build trust

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Helping Plan Participants with Financial DecisionsWhether the method is group seminars or one-to-one consultation, nothing beats face-to-face communication.

It’s one reason why retail IRAs are successful at getting employees to roll over their assets from their low cost employer 401(k) plans to much more expensive retail investments. This even works when a participant knows that the person advising them to do just that will receive a direct commission from that move.

Financial planning educational programs are the best way to keep participants in the plan after termination of employment, and throughout their retirement years.

Keeping participants in the plan is cost effective for them and cost effective for the plan as a whole.

Questions?

Topic #7: Revenue, Expenses and Disclosure

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Transcript of Topic #7: Revenue, Expenses and Disclosure