Four Essential Steps to Effectively Benchmarking a 401(k) Plan

Copyright 2009 Institute of Management & AdministrationAll Rights Reserved Managing 401(K) Plans

July 2009

HUMAN RESOURCES Vol. 2009 No. 7

1486 words

Four Essential Steps to Effectively Benchmarking a 401(k) Plan

401(k) plan sponsors are all too aware of the need to benchmark plan fees. But what is the best way to do so?

To get some answers, IOMA interviewed Matt Golda, CFA and senior vice president of technology, operations, and product development of Fiduciary Benchmarks Inc. (FBi; Portland, Ore.), and Tom Kmak, CEO and cofounder of FBi. Here's their advice:

To properly benchmark, four steps are key, asserted Golda. First, establish a valid benchmark group. Second, perform a comprehensive review of plan fees. Third, perform a comprehensive review of plan value, and fourth, determine if fees are reasonable.

Establish a Valid Benchmark Group

When plan sponsors look to benchmark their 401(k) plan fees, they often look at plan asset size, number of participants, or similar industries. But much more is involved, Golda said.

Five factors should be considered when building a proper benchmark group, he added.

Plan size and number of participants. Plans included in a benchmark group should be of similar sizes and participant counts to ensure matching economic profiles.

Date of fees and services review. By considering only those plans that have bid or reviewed fees and services recently, the plan benchmarking process will reflect a current, but smoothed, assessment of the marketplace.

Allocation to passive index funds. It would not be appropriate to compare a plan with 100 percent passive investments to one with 100 percent active investments. The passive plan will definitely have lower costs due to the fiduciary's belief in indexing. But those passive costs may be high when compared to other passively managed plans. Therefore, it is important to compare plans with similar active-to-passive investment ratios.

Use of a managed account program. Plans offering a managed account program should be compared with other plans offering managed accounts that have similar utilization. Managed accounts provide participants with an important additional service, albeit at higher structural costs. Thus, plans with similar exposure to managed accounts should be compared to each other.

Plan design provisions. A plan's participation and deferral rates can be directly related to the presence of an employer match or use of "auto" features. Accordingly, grouping plans with similar designs helps establish the context needed to truly determine if additional factors are generating better participant behaviors.

Comprehensive Review of Fees

Once the benchmark group of "apples to apples" plans is established, the next step is to conduct a comprehensive review of plan fees. Four levels of fees should be considered in your review, added Kmak.

Fees at the plan level represent a rollup of underlying service provider fees. This includes fees from recordkeepers, advisers and consultants, investment managers, and any other plan service providers. Also make sure you include fees paid by the plan, as well as those paid by the plan sponsor. "Including all fees related to the plan regardless of who pays the fee is the only way to ensure accurate comparisons," Kmak stressed. Total plan fees as a percentage of assets should be compared against the benchmark group.

Even though fees at the plan level may be reasonable, ERISA requires that you examine fees at the service provider level as well. Fees at the service provider level take the form of investment fees (including service fee credits and revenue sharing, investment management fees, and operating fees), service fees (including recordkeeping, retainer, trust, custody, and other fees) and transactions-based fees (commissions and finder's fees). "Fees should be converted to a percentage of assets to ensure your comparisons are mathematically normalized," Kmak added.

Fees at the investment level represent the fees paid directly through investments in the plan. These fees are charged as a percentage of plan assets. Investment fees are used to pay for investment management services, as well as additional advisory and recordkeeping services. "When investments do not report a fee structure and a related revenue-sharing component (as can be the case with guaranteed fixed accounts) you should apply an estimated fee and fee offset based on similar investments across the benchmark group," he stressed, adding that investment fees should ultimately be compared at the fund level to the benchmark group so fiduciaries can take appropriate action if their fees need to be adjusted.

Lastly, fees at the participant level represent the fees for participant-elected services like loans, distributions, and self-directed brokerage transactions. "These fees," Kmak said, "should be compared against the benchmark group as well since these fees can also have an impact on retirement outcomes."

Comprehensive Review of Value

Section 404(a) of ERISA requires that the responsible plan fiduciary engage in an objective process designed to elicit information necessary to assess not only the reasonableness of the compensation or fees to be paid for services, but also the qualifications of the service provider and the quality of the services that will be provided. "The Department of Labor has specifically stated that fees are important, but they are not everything," added Golda. "Thus, a proper benchmarking exercise should include a review of three important components of value, including participant success measures, plan complexity, and plan services."

Participant success measures evaluate how participants plan, save, invest, and spend related to their 401(k). "This is an incredibly important component of the exercise and it can be proven mathematically that a plan paying higher fees for better participant success measures will ultimately result in better participant retirement outcomes," Golda said, referring readers to an example at www.fiduciarybenchmarks.com/successmeasures.pdf.

Plan complexity is an indicator of how a plan's design compares to other plan designs. Plan complexity is neither good nor bad since every plan is designed to suit each employer's individual situation, he said. What is important to know in terms of benchmarking, however, is that a plan that is more complex can cost more to administer.

"While a core set of services is provided to all plans, differences do exist in the type and amount of services plans use. Services generally fall into two buckets--sponsor services and participant services," Golda added. Sponsor services include functions such as fiduciary oversight and best practices support. Participant services include functions such as administration and participant education and communication. To effectively benchmark services, the type and amount of services provided by each plan service provider should be compared against the respective service providers in the benchmark group.

Balance Fees and Value

"Once you have established your benchmark groups, collected all plan-related fees, and considered the value components of a qualified plan, your next step is how to document all of this information as part of a prudent fiduciary process," Kmak noted.

In particular, fees should be estimated in dollars yet compared in basis points to normalize the data. And they should be normalized on a per-participant basis to put things into perspective. For example, paying $25,000 more per year for a plan with 100 participants (for example, $250 per participant per year) is a lot different than paying $25,000 more per year for a plan with 25,000 participants (for example, $1 per participant per year).

Not all services are equally important to a plan sponsor, Kmak added. "A plan with administrative problems may wish to examine those services versus a plan that is really trying to improve participant investment behavior. Thus, any methodology should allow you to examine the various building blocks of a retirement plan: design, funding, administration, and communication."

Finally, represent findings so everyone on the plan committee, as well as corporate officers, can learn from the fee-review process. Adult learning principles show that some people receive information better via words, others via numbers, and still others via pictures. The best methodology will concisely represent this information all three ways.

In closing, Golda summarized, "Plan benchmarking is more than crunching the numbers or assigning a rating. It requires the thorough collection and consideration of a broad series of relevant plan data. For optimum results, this data needs to be placed in the context of the competitive marketplace and the plan's specific needs, priorities, and history of past decisions."

Kmak noted that the benefits of a comprehensive and informative benchmarking process extend beyond helping plan sponsors meet their fiduciary obligations. "By considering ‘what you get for what you pay,' sponsors are able to allocate plan resources to better meet plan needs, while maximizing participant benefits from the plan."

June 24, 2009