The 401(k) industry is entering a new and "potentially turbulent" period in the next few years as plan sponsors and vendors come to grips with several major, potentially troubling, issues including emerging fiduciary issues associated with plan investments, liability risk management and regulatory compliance, warned William J. McHugh, treasurer at Novartis Corp., Tarrytown, N.Y.
Speaking to the more than 200 attendees at the 1997 Pensions & Investments Defined Contribution/401(k) Conference in New York, Mr. McHugh told participants that methods some plan sponsors use in managing their defined contribution plans might compromise their fiduciary responsibilities.
He said the same due diligence used in managing defined benefit plans should be applied to 401(k) plans, especially in asset allocation, fee issues, diversification and asset management matters.
Mr. McHugh said some plan sponsors might be sidestepping their fiduciary responsibility under the Employee Retirement Income Security Act regarding the selection of 401(k) investments, the appointment of investment managers, the establishment of appropriate investment guidelines and monitoring of investment activities to ensure they are in accordance with "pre-established" investment guidelines.
"A plan sponsor's ability to comply with these fiduciary responsibilities may be sorely tested when the plan offers mutual fund windows and self-directed brokerage options," said Mr. McHugh. "A plan sponsor's ability to fulfill these fiduciary responsibilities may be compromised as a result of the method many plan sponsors have adopted (in) managing their defined contribution plans. It is remarkable how different this approach can be from the approach companies use in managing their defined benefit pension plans."
One of the main differences, he said, relates to the selection of service providers.
"A growing trend in the 401(k) industry over the last five years has been the dramatic increase in the use of full-service or bundled service providers. When selecting these providers, it is not uncommon for some plan sponsors to base their decisions largely on factors related to name recognition, administrative ease and whether or not the service provider's investment funds are listed in the daily newspaper," he said. "In this process, the investment performance and risk profiles of the individual funds selected may become a secondary issue."
This approach, he said, is "very different" from the unbundled approach used by most defined benefit pension funds where plans focus on buying the "best" of each product or service required.
"In the selection of investment advisers for pension plans, issues such as name recognition and administrative ease take a back seat to issues associated with investment philosophy, investment style, buy-and-sell disciplines, portfolio risk and investment results," said Mr. McHugh.
Another contrast between 401(k) and defined benefit pension plan management, he said, relates to plan structure.
"Here the most significant difference lies in the control over the investment process and the establishment of investment guidelines," he said.
When committing 401(k) assets to certain investment strategies with "very broad" investment guidelines, "control over the asset allocation and investment process is largely delegated to the plan's investment manager."
This, he said, is in "direct contrast" to the way defined benefit pension plans are managed where plan sponsors "typically retain tight control" and a manager's failure to follow the sponsor's guidelines "often results in his or her immediate dismissal."
With regard to performance monitoring, Mr. McHugh said most defined benefit plan sponsors develop "very sophisticated, specifically tailored" performance benchmarks and perform detailed analytics on their managers' performance and holdings.
"The opposite is often true for 401(k) plans, where performance is often compared to inappropriate benchmarks that do not reflect the risk profile of the plan's fund," he said.
Much of this year's conference involved discussions regarding fees associated with 401(k) plan services, especially investment management fees, which Mr. McHugh said "are significantly higher" than fees associated with pension plan services.
"In the case of the 401(k) plan, participants generally bear the cost of the services, while for pension plans the corporation sponsoring the plan bears the cost," he said.
Because of the differences found in managing defined benefit vs. defined contribution plans "many plan sponsors should reassess the way in which they manage their 401(k) plans and begin to apply the same disciplined approaches they use in managing their pension plans," said Mr. McHugh.
"This may include moving away from bundled approaches to ensure that they are buying the 'best' of each of the distinct products or services required, gaining control over the investment process and developing specific investment criteria for each investment adviser who manages plan assets, using multiple managers within each fund option to reduce portfolio risk and employing sophisticated techniques for performance monitoring to ensure compliance with guidelines and to ensure participants are receiving attractive risk adjusted returns on their investment," he said.
Mr. McHugh warned conference participants that failure to address the concerns he had specified "may well lead to participant-initiated lawsuits down the road."
"As you consider enhancing your plans, it is imperative that you remember that you are not, I repeat, not overseeing an investment club, rather you are fiduciaries charged with overseeing your corporation's ERISA-regulated retirement plan," he said. "The next five to 10 years will be interesting and important years for the 401(k) industry. The actions you either take or fail to take may very well become the subject of participant-initiated lawsuits. To protect both yourself and your employer, it is important that appropriate care and attention be given to your plan and that you take the steps necessary to ensure you are fulfilling your fiduciary duties."
Several speakers addressed the growing concern over fees and fee management in 401(k) plans and mentioned unitizing defined benefit managers as a method of both reducing fees while acting to fulfill fiduciary responsibilities.
Myra Drucker, assistant treasurer at Xerox Corp., Stamford, Conn., said that since Xerox unitized its defined benefit managers in its $2.2 billion 401(k) plan more than three years ago, the six investment funds have outperformed comparable mutual fund peer groups by an average of 150 basis points annually.
"A lot of that has to do with the lack of fees," she said. "I'm surprised that more companies haven't thought of it (unitizing) or tried it."
Ms. Drucker said plans that use mutual fund families and apply less due diligence than in selecting defined benefit managers "are setting yourself up."
Edward X. Roche, vice president-managing director trust administration at NYNEX Asset Management Co., New York, which oversees NYNEX Corp's retirement assets, said NYNEX has unitized its defined benefit managers into 10 investment funds in the firm's $5 billion savings plan.
He said overall returns have been "similar to our pension plan returns" and with unitizing "our fees are lower" than by using mutual funds. He added that because assets are held in a common trust, it helps with defined benefit liquidity requirements and helps reduce overall transaction costs.
In addition, he said, because NYNEX conducted extensive due diligence in selecting and evaluating defined benefit pension plan managers the company believes it is fulfilling its fiduciary responsibilities "since they (money managers) adhere to the investment guidelines which we established . . . We are much cheaper (than mutual funds). Cheap and will get cheaper in the long term."
IBM Corp. has cut its expense ratio each year for the last five years in its $10.5 billion 401(k) plan, said James H. Rich III, senior investment strategist for the IBM Retirement Fund.
IBM instituted a series of four life-strategy funds last summer in addition to its seven core investment options.
In its core offerings, expense ratios range from nine basis points in its large-capitalization equity fund to 17 basis points in its government bond and money market funds and its international equity fund.
By contrast, Mr. Rich showed figures that indicate comparable mutual funds average 58 basis points for money market mutual funds, 106 basis points in government bond funds, 139 basis points for balanced funds and more than 170 basis points in international equity mutual funds.
"We as plan sponsors have to stand up and say that we can do better," said Mr. Rich.