Palm Harbor, Fla. - Pay attention to fees.
If attendees at Pensions & Investments' 10th annual Defined Contribution/401(k) Conference took one message home with them, that was it.
It started with Jim Rich, chief investment strategist for IBM Corp.'s pension plan, noting in his keynote address how IBM had whittled plan fees to eight basis points after the restructuring of its $20 billion defined contribution plan.
The conference ended with a cost-reduction workshop lead by Ira Hoffman, operations manager for portfolio investments of The Dow Chemical Co., Midland, Mich., who told the plan sponsor audience to stop paying retail fees.
In the middle, plenty of speakers sang the same tune.
Use will grow
David J. Katz, managing director for investment consulting at Darien, Conn.-based Barra RogersCasey, said that, according to data gathered by the firm, use of institutional vehicles in defined contribution plans will grow to 41% in 2003 from 24% in 1996. Institutional mutual funds have been the fastest growing segment, followed by separate and commingled accounts, he said.
Of 250 plan sponsors responding to a 1999 study by Cerulli Associates Inc., Boston, 44% used retail mutual funds in their defined contribution plans, 58% had institutional mutual funds and 22% included separate accounts, he noted.
Some 16.3% of 401(k) plan sponsors included separate accounts. This reflects $254 billion in defined contribution assets invested in separate accounts, and that number is expected to grow to $437 billion by 2003, Mr. Katz said. "There's a real need for non-retail-oriented investment vehicles. Even moving from retail to non-retail mutual funds will make a huge difference for participants' retirement."
According to a sample of expense ratios provided by Mr. Katz from Morningstar LLC and InvestWorks data, a large-cap domestic equity mutual fund would cost 1.22%, compared with 0.71% for an institutional fund and 0.62% for a separate account. The expense ratio for an international equity mutual fund is about 1.86%, compared with 1.21% for an institutional fund and 0.67% for a separate account. An emerging market mutual fund would cost 2.12%, while an institutional fund's expense ratio is 1.5% and a separate account, 0.88%, he said.
This trend toward institutional-type investments is driving money managers to create institutional investment vehicles for defined contribution plan sponsors, Mr. Katz said.
However, the growth in separate accounts is mainly for plans with $1 billion or more in total assets or $100 million in one investment discipline, said Douglas Foreman, group managing director and chief investment officer of The TCW Group, Los Angeles.
Mr. Katz said he has seen separate accounts with "as little as $20 million in a certain fund."
This trend toward separate accounts is being spurred on by the increasing use of consultants, said Mr. Foreman, whose firm is re-entering the defined contribution plan market with an investment-only strategy.
"Consultants are good at beating up on managers for fees and are bringing that to the contribution plan market," said Mr. Foreman, who shared the podium with Mr. Katz.
Consultants can guard against style drift and help ensure consistency of funds, Mr. Foreman said.
The U.S. Department of Labor did its part to try to clarify the fee issue in the waning hours of the Clinton administration, said Mark J. Ugoretz, president of the Washington-based ERISA Industry Committee, during a panel discussion on the agency's crackdown on plan expenses.
After a year of sometimes-heated discussions, the Department of Labor, in a move contrary to the view of its own auditors, clarified its position on plan fees, Mr. Ugoretz said. Some six years ago, the Kansas City office began cracking down on defined benefit plans in a series of "exacting audits," and some of the offices soon began expanding the crackdown into the defined contribution area, he said. The issue was which expenses must be borne by the plan sponsor and which can be charged to the plan.
"Lesson one is that plan sponsors who are better prepared fared a lot better in the audit process. They had to pay less and the audit process itself was abbreviated," Mr. Ugoretz said.
If the expense allocations are not documented, the department's position was that the burden is on the plan sponsor to demonstrate that the expense should not be borne solely by the plan sponsor, he said. At the same time, the DOL took a hands-off approach and left enforcement up to the regions, he explained.
The opinion letter released by the DOL gave six hypothetical situations to help plan sponsors distinguish when they could charge expenses to the plan.
Basically, there are two approaches, he said. One is to set a limit on what fees ought to be and the other is simple disclosure pursuant to the guidelines. Congress may clarify this area further but probably not this year, he added.
`Keep careful records'
"We view (the hypotheticals) as helpful but they leave questions as to how to allocate things," said Marla J. Kreindler, chairwoman of the employee benefits department of the Chicago-based law firm, Katten, Muchin Zavis.
"The important thing is to keep careful records on how you are allocating expenses and so you can show good faith and reasonableness in following the Department of Labor's many advisory opinions," she said.
The incredible inefficiencies in the 401(k) market could pose a problem in a world where plan sponsors have a fiduciary responsibility to disclose fees accurately to participants, said Dow Chemical's Mr. Hoffman.
"Charging fees is a real creative exercise," Mr. Hoffman said. "The largest element and most expensive element of fees are investment management costs, which can be between 75% and 90% of total fees, but it's difficult to separate investment management fees from total fees."
And who pays the fees, he queried. Participants pay everything for retail funds.
"If you are a large plan and use institutional funds, the expense can be a quarter of retail," he said. "Why in the world would a 401(k) plan pay retail?"