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The environment for defined contribution (DC) retirement plans has changed enormously in recent years. First came the mutual fund market-timing troubles. Then, partly as a reaction—and as the need for transparency increased—the Pension Protection Act of 2006 (PPA) was passed, altering the rules for vesting, automatic enrollment, participant education, employer stock diversification, required disclosures and more.
Now, further initiatives are gaining traction, including from the U.S. Government Accountability Office, Securities & Exchange Commission and Department of Labor (see DOL Proposes Rule To Increase 401(k) Fee Disclosure, Reveal Conflicts of Interest). In addition, legislation has been introduced regarding the disclosure of fees and investment options (see 401(k) Fee Disclosure Hearings Warn of New Burdens), and a litany of class action lawsuits could soon be probing how plan sponsors have been handling their fiduciary responsibilities (see 401(k) Fee Litigation: Assessing the Complaints, Plan Sponsors' Duties).
As a result, it is clearer than ever that DC plan sponsors can not afford to take a laissez-faire approach toward plan management. The plan fiduciaries (typically, either the company itself or a designated committee) must ensure they are doing everything they can to act exclusively in the interest of the plan’s participants.
Fiduciary ResponsibilitiesAlthough fiduciary standards have always been high, greater scrutiny of how those charged with overseeing the plan exercise their fiduciary obligations is now expected. These duties include the need to:
• Understand all administrative and investment fees paid from plan assets, including those charged directly to participant accounts, and to make sure they are at the lowest reasonable levels.• Make additional plan disclosures in regulatory filings and to plan participants.• Use appropriate due diligence in the selection of vendors and investment vehicles and when implementing contractual service arrangements.• Keep an eye on the DC marketplace to ensure the plan provides appropriate benefits and services at a reasonable cost to the participants.• Ensure that participants understand the benefits of participation, and eliminate barriers to their participation.
To stay in control, DC plan sponsors should adopt an ongoing due diligence process that starts by conducting a fiduciary and operational assessment of the DC plan to determine and document its current state.
By focusing on the plan’s investments, administration, compliance and communications, the sponsors will be able to determine where any weaknesses lie and take steps to correct them. It is important to conduct this assessment under the supervision of legal counsel so that technical legal issues can be evaluated properly and, if any compliance problems arise, the analysis can be conducted under the confidentiality of attorney-client communications to the extent available.
Step One:Assess the Plan’s Investments
To assess the DC plan’s investments, plan sponsors need to:
• Review the plan’s overall mission.Its goals and objectives must meet the needs of the participants. One thing that is often overlooked is how the plan relates to other retirement programs that are available to participants. Is this a primary or supplemental program? The answer to that question will affect the plan’s overall mission. As one plan participant once noted: “My defined benefit plan will pay the bills, my DC plan will pay for the boat.”
Look at the plan’s investment line-up and related fee structure. It should be tailored to address the range of investment and financial sophistication of the eligible employee group and the demographics of both the active and terminated employee participants.
• Conduct a strategy analysis.The goal here is to find out “where we are today."What rationale did the plan’s fiduciaries use to make investment option selections? Check to see if there are unneeded duplications of investment strategies and/or any asset classes that are not represented or investment objectives that are not being met by the funds in the program. Verify the investment style and measure the risk characteristics of each investment option as well as review its returns and expenses. Analyze the extent to which the plan’s investment policies have been carried out and how they have affected the actual results. Many DC plans suffer from a duplication of investment strategies — they have more than one fund in the same asset classes or with the same investment goals (see Most 401(k) Plans Fail to Provide Adequate Mix of Asset Classes).A careful analysis may reveal that several of a plan’s funds are, in fact, offering participants similar if not the same investment strategies. This could lead to a lack of diversification among the plan’s offerings (see What's on the 401(k) Menu? Do More Funds Help Participants Diversify?).One factor that deserves close scrutiny is whether the right participants are selecting the right funds. For example, if 80 percent of the individuals between the ages of 20 and 29 are invested in the plan’s stable value fund, there is a problem that needs to be addressed.
• Check the plan’s investment policy statement.Does it provide a framework for investment decision-making, form a basis for effective communication with the investment managers and clearly define the responsibilities and authority of each party involved in the investment program? It also should offer a documented fiduciary audit trail, identify each party’s responsibilities and indicate the broad array of fund offerings and how they are selected. Finally, the policy statement should detail how fund options should be monitored on an ongoing basis (see Developing a 401(k) Investment Policy Statement).A plan’s investment policy statement is usually written by an independent investment consultant who incorporates the plan’s mission along with specific types of investments. It is reviewed by the sponsor’s counsel and, after modifications if desired, endorsed by the plan’s fiduciaries, making it a working document whose goal it is to keep everybody on the same page.
• Review the plan’s mutual fund offerings and how they are selected.Plan sponsors should use a “best in class” approach, independently reviewing and identifying the best funds available in each asset class. This will provide the performance the plan’s participants need and make it easy for them to allocate their investments.First, analyze each fund’s key quantitative factors. Review performance relative to appropriate benchmarks, such as category-peer funds and indices that track the same asset class as the fund. (Example: do not compare a fund focusing on small company stocks with the S&P 500 index, which tracks the largest U.S. companies. Instead, compare it to an index of small capitalization U.S. stocks, such as the Russell 2000). Analyze the fund's risk on both an absolute and a benchmark-relative basis, over a variety of rolling periods. Compare fund fees. (Some of these factors are discussed at greater length below) Next, look at the key qualitative factors, such as the portfolio manager’s tenure, the stability of the fund provider and the depth of its investment resources. According to various studies, these qualitative assessments are often a better predictor of investment results than is past performance.
• Monitor the plan’s ongoing performance. Plan fiduciaries should do this at least annually, preferably quarterly. First, those responsible for the plan need a good understanding of the overall economic and general market conditions. Take, for instance, the current volatility of large-cap value funds caused by the problems with certain financial stocks. It would be impossible to evaluate a plan’s value managers without understanding what is happening in this part of the market.Again, in comparing performance over time, plan fiduciaries need to compare each potential investment option’s return and risk metrics to appropriate market indices and universes of similarly managed vehicles. Look at the fund’s historical performance with a focus on consistency. Make sure the fund’s management has not undergone major changes. Analyze the extent to which investment policies have been carried out and how they have affected the actual results.
• Check the fees.Plan sponsors need to look carefully at their vendor contracts and service agreements to make sure they are getting what they pay for. Start by ensuring that full disclosure of all fee arrangements is being received. Many plan managers mistakenly believe that their DC plan vendor “charges nothing for recordkeeping and administration.” In fact, high expense ratios could be covering the administration costs, but plan managers need to understand that and how it could affect participants’ returns. The figure below lists the various fees, charges and expenses that these vendors can charge and provides a brief description of each one.
Defined Contribution Plan Fees, Costs And Charges
Fee, Cost or Charge
Management/operating (expense ratio)
Ongoing charges for managing the assets of the fund
Sales charges (loads or commissions)
Transaction cost for buying and selling shares
Charges for variable annuity programs offered by insurance companies that bundle together a suite of services
Sub-transfer agency fees
Payments to record keepers from mutual fund companies related to account servicing
Brokerage of record fees
Asset based fees paid to broker/dealer for providing plan services (i.e., mutual fund selection, education/ communication
Contingent deferred sales charges (CDSC)[primarily for §403(b) plans]
Sales charge or load that mutual fund investors pay when selling Class-B shares within a specified number of years of the date on which they were originally purchased
Mortality risk and administration expenses (M&E)
Fees for providing an annuity product and life insurance
Fees paid by broker-dealers for fund distribution, marketing,
service support and recordkeeping
Source: Segal Advisors Inc.
As an example of just how much these charges can vary, sub-transfer agency fees can range from 10 basis points (.10 percent of the value of assets in the portfolio) to as high as 50 basis points (half a percent). Moreover, while 12b-1 fees may be appropriate for smaller mutual funds that do not have a marketing or distribution group, many larger funds still charge them only as another source of revenue.
Finally, renegotiate fees periodically as the plan matures. One factor that often gets overlooked is that many mutual funds peg their charges to the amount of assets in the plan. As the plan grows, so do the fees. But if the size of the plan doubles, does the fund manager really deserve double the fee? That is negotiable. The lesson here is that expense ratios that may have made sense two or three years ago may not be acceptable in the current environment.
Step Two:Assess the Plan’s Administration
Quality assurance is important. Plan fiduciaries need to make sure that the various services, systems and tools that are being used or provided by the vendor are functioning appropriately. Of course no system is perfect and vendors intervene manually every day, but any manual intervention must be done correctly and each plan’s provisions must be met meticulously.
Review the vendor’s security and disaster-recovery program. In particular, be sure backup records are stored in a safe and secure location that’s far removed from the main records. Also look at the delicate issue of how well the vendor processes and monitors loans and hardship withdrawals. Another key administration issue is the responsiveness, tenure and talent of the vendor’s staff. The people in these positions will change from time to time. Be sure their replacements are well trained and understand the nuances of their particular plan. Ask these questions:
• How do the participants view the plan’s ongoing administration? • How efficient is the data interface between the vendor and the plan sponsor’s payroll department? • Is there a clear delegation of fiduciary responsibility for providing administrative and investment functions for the plan? • Does the plan sponsor receive proactive advice from sources other than the DC plan provider about the impact of new legislation and current marketplace administrative offerings? • Is there complete documentation of how the various vendors were selected along with supporting implementation documentation?
Step Three:Assess the Plan’s Compliance with All Applicable Laws
Be sure that pending legislation and regulations are monitored and plan operations and terms are updated as necessary. It is very important that 401(k) plans pass applicable nondiscrimination tests and meet the detailed rules governing how much employees can defer and how possible excess amounts are corrected (see Clearing the Annual 401(k) Compliance Test Hurdle). Also, review for potential prohibited transactions and check the plan’s fidelity bonding and fiduciary insurance. In addition, all required notices must be reviewed and distributed.
Plan documentation is of great consequence from a compliance standpoint. The plan document, the summary plan description (SPD) and minutes of all meetings of the plan’s board or committees all need to be carefully maintained.
Plan limits must be monitored. In one case, a plan sponsor thought that its payroll department was monitoring the section 402(g) annual individual deferral limit while payroll thought the vendor was doing it. Corrective distributions had to be made.
Also important are benefit claims and appeals procedures and processes. These must be set up so that all claims and appeals are handled similarly and properly.
Finally, in addition to assuring that participant communications are clear and effective, the laws and regulations increasingly emphasize “transparency,” adding a myriad of detailed reporting and disclosure requirements that have to be satisfied faithfully.
Step Four:Assess the Plan’s Communications
Every DC plan assessment should include a review of the plan’s communications, from enrollment materials through distributions processing. Participant benefit statements and educational materials need to be complete, compliant, consistent, timely and responsive to the needs of the participants.
One key test takes into account industry practices and standards. For example, sponsors may want to consider how the plan’s communications, message and delivery compare with those of similar plans in the marketplace.
Conducted correctly, this fiduciary and operational assessment will identify any deficiencies associated with the ongoing operations of the plan and, if necessary, formulate the basis for corrective actions. In addition, it will provide a platform for review of all processes and procedures with a focus on optimization of the DC plan as a retirement vehicle for the participants and as a workforce management tool for the plan sponsor. A well-formulated and documented ongoing fiduciary process is an essential component in support of these objectives.
Richard DeFrehn is a vice president and administration consulting practice leader in the Princeton office of Sibson Consulting. He has more than 30 years in benefits consulting, administration and actuarial technical experience. Gino Reina, CFA, is a vice president and consultant in the New York Office of Segal Advisors Inc. His primary responsibilities and expertise include providing advice on asset allocation and investment policy, assisting clients in the selection of investment managers and evaluating investment performance.
This article is adapted and reposted with permission from The Segal Group Inc.
© 2008 by The Segal Group Inc. All rights reserved.
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