In principle, fee transparency and investment disclosure should make the world a better place. That's certainly the intent of the Department of Labor's (DOL) new disclosure rules for all 401(k) and other self-directed defined contribution plans. The rules mandate many of the current best practices of the top mutual fund, insurance, and investment companies and third-party record keepers. As most plans already follow most of the new requirements, the benefits will be felt by participants in those mostly small and mid-sized plans still in the ERISA Dark Ages of poor disclosure, high fees, and hidden charges.
But other aspects of the regulations will affect big and small plans alike. First, there is the little-noticed, new requirement that administrators report to each participant the actual total fees paid from his or her account. Seeing this charge in black and white may result in a positive sea change in how fees are viewed and split among participants. But, the rules also impose burdensome and costly obligations on separate accounts and other non-mutual fund investment vehicles designed to be lower cost and participant friendly. And, by making disclosure an ERISA fiduciary duty, the DOL has increased the likelihood of class action lawsuits, which ultimately may increase overall fees and administrative costs.
THE BASICS
The new rules, found in DOL Regulations Section 2550.404a-5 and DOL Regulations Section 2550.404a-5-c, cover all defined contribution (DC) plans that allow participants to choose their investments. The rules apply whether or not an employer wants to take advantage of liability protection under ERISA Section 404(c) for participants' own poor investment decisions, essentially replacing Section 404(c)'s voluntary safe harbor with a new set of fiduciary obligations.
Thus, starting with the 2012 plan year (or November 2011 for plan years that start in November), plan administrators must furnish all participants (including non-contributors with zero balances) with a schedule of expense ratios and other investment fees; service charges for processing loans, withdrawals, QDROs, and the like; and planlevel charges for legal and administration costs that are not otherwise covered by investment fees. In addition, participants must be informed of their investment choices; investment performance history (including benchmark comparisons) over one-, five- and ten-year periods; an investment glossary; "Bogle-like" (the Vanguard founder and patron saint of low-cost investing) comments on the impact of fees on retirement savings; and access to a Web site with additional details.
This information must be provided before a participant starts investing in the plan and annually thereafter. And, in what can only be described as wanton bureaucratic cruelty, participants must be notified within 30 to 90 days prior to any change being made. For example, if a plan's holdings in a particular mutual fund grow large enough to qualify for a lower share class, the fees cannot be lowered until participants have had at least 30 days to digest this information. However, in a burst of generosity, the DOL does not require separate breakdowns of any revenue sharing or 12b-1 fees included in a fund's expense ratio. Instead, participants need only be told that some of the plan's administrative expenses are paid from some of the fund fees. This is a fair requirement that will not confuse participants with information overload over how the expense ratio is divvied up among plan vendors.
WILL PARTICIPANTS NOTICE THE CHANGES?
My own unscientific but broad-spectrum survey of record keepers used by clients and colleagues reveals that most of the required information disclosure was already widely available online to plan participants. For many participants, the new rules will change only the format, timing, and location of the disclosure, not its scope. However, not all of it is necessarily included in the paper statements and, even on the Web, it may require multiple clicks to dig into details such as expense ratios and investment benchmarks. The new rules do usefully require providing all this information in one place, directly to participants without their having to ask for it (or even know it exists). Folks who take the time to study this information will discover an array of basic investment information is now at their fingertips. However, for the many participants who routinely toss or delete their quarterly statements, the added convenience of the new format will be meaningless.
WHAT INFORMATION IS TRULY NEW?
Come 2012, there will be one huge difference in participants' quarterly statements that should jump out to anyone paying attention: a participant's total investment fees. This is important because of the way most participants perceive their plan costs. To many employees, a 1 percent expense ratio doesn't sound like much and may not even be viewed as an out-of-pocket expense. In contrast, informing someone with a $400,000 plan account balance that he's paying $1,000 in quarterly investment charges is likely to register loud and clear.
How folks will react to this additional fee information is anyone's guess. The DOL is hoping participants will start haranguing their employers and record keepers over the fee levels and move their savings into low-cost index funds. Indeed, an unstated intent of the new rules is to steer participants toward index funds and away from more expensive, actively managed products. While this may conform to the thinking of many academics and professionals, others may question whether it's within the DOL's role or expertise to favor a particular investment strategy.
Once total fees start showing up in quarterly benefit statements, many employees may realize that their retirement plan is not "free"— rather, they are paying for the toll-free number, Web site, investment education, and general 24/7 access to account information plus the costs of complying with the myriad of tax and ERISA regulations. The loudest screams may come from higher-paid, longer-tenured employees with substantial account balances. These participants may realize that not only are they paying significant amounts, they are subsidizing fellow plan participants with smaller balances or in lower-cost funds. After all, it doesn't cost any more to maintain records on a $1 million account than one of $10,000. And, because index funds and some other plan investment offerings may not engage in revenue sharing, people investing in these funds do not contribute at all toward recordkeeping.
This eye-opening disclosure could pave the way to alternative fee arrangements in which recordkeeping and investment costs are charged separately. Investment fees could be lowered, while each participant's account would be debited a quarterly recordkeeping charge—say the lower of 15 basis points (.15 percent) or $20. Each participant would thereby pay his or her own way, with any 12b-1 fees or revenue sharing being returned to the participants' accounts investing in the funds that generated these amounts. Ironically, imposing a 15bp recordkeeping charge would actually increase costs for those investing in index funds, which typically do not engage in revenue sharing. Until now, employers found this type of alternative structure difficult to impose because participants believe their 401(k) program is free. By correcting this common misperception, the DOL will make it feasible for employers to consider an "everyone pays his or her own way" system and other equitable and reasonable methods of sharing administrative costs.
Unfortunately, the new rules also will give some participants only enough new information to be dangerous to themselves. For example, employees participating in a new or small plan (where the fees are likely to be higher) may be discouraged from contributing. Or, some former employees will mistakenly try to avoid their DC plan fees by withdrawing their money or rolling over their accounts to IRAs which—because they aren't required to disclose fees in this manner— may appear to be "free." Similarly, the DOL did not impose fee transparency on certain guaranteed investment contracts and other interestgenerating, guaranteed insurance, or annuity products, which may also seem fee free and a better investment deal than other funds.
PLANET WASHINGTON
Before getting to the bad news, I'd be remiss in my editorial duties without reporting that the DOL projects that better disclosure will save participants an astonishing 54 million hours now spent searching for this same information, adding $14.9 billion to the US economy. Perhaps this would be the case in an alternative universe, where most participants had actually bothered to look up this information, and will now devote their newfound free time to economically productive activities.
THE BAD NEWS
Alas, the new rules are destined to increase plan costs in at least two ways. First, according to the DOL's own estimate, it will cost record keepers over $2.7 billion to reprogram computers, reformat benefit statements, and make other administrative changes. I'd suggest adding to this total the "hidden" costs of delays, and confusion in notifying participants within the 30–90-day window allowed for fee and other changes. I wonder how many fee reductions will be delayed to give the mandatory 30-day advance notice.
The costs of retooling will likely be even higher for the many plans that offer separate accounts or commingled investments. The new rules were written as if all plan investment vehicles were mutual funds. But many of the larger plans and some financial institutions have created their own investment offerings by selecting money managers, developing investment guidelines, and building a custodial/ recordkeeping infrastructure. These vehicles allow more control, access to a wider array of investment professionals, and reduced fees, among other possible benefits. Because the new DOL guidance is "mutual fund–centric," it will take extra money and effort to build the necessary systems and Web sites for these other investment vehicles.
The other new costs are more insidious: increased litigation and the wasteful "defensive" practices that employers, investment firms, and record keepers will adopt to reduce their exposure. The DOL has effectively elevated a disclosure error to a violation of the ERISA fiduciary duties of prudence and loyalty. Yet the reality is that plan administration is extraordinarily complex and mistakes inevitably are made. Now, when a statement or notice is late, a fee or performance data is miscalculated, a schedule is omitted, or a similar glitch occurs, the plaintiff's bar will be ready to argue (especially if the plan is large) that the mistake caused his or her clients to invest too aggressively or conservatively, depending on the particular investment market. The DOL disingenuously maintains that the regulations aren't intended to make it easier to sue, but in fact they create an entirely new fiduciary obligation and give class action lawyers another legal weapon in their arsenal.
PARTIAL DO-OVER
The DOL has added a number of sensible requirements to enable participants to get a better understanding of the fees they are paying and their DC plan investments. This good is largely undone by the higher costs of compliance for non-mutual fund investment vehicles and, more significantly, the litigation Pandora's box opened by the DOL turning a simple disclosure mistake into a full-blown ERISA fiduciary violation. As the government well knows, these costs ultimately will be reflected in higher recordkeeping and administrative fees and passed through to participants. Although the regulations are final, it's not too late for a partial "do-over" to correct these policy errors. Otherwise, the DOL will have given participants a better view of the higher fees they'll certainly be paying.
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