Okay, you should get the picture about 401(k) and 403(b) fee litigation trends. Large organizations are getting sued (and often losing/settling) because of fee mismanagement. Meanwhile, the pace of litigation is increasing. Here’s a key point to keep in mind: big companies are losing lawsuits despite having large, sophisticated HR and finance teams that you’d think would be knowledgeable and effective in this area. But if they have been making major mistakes, what’s the likelihood a small company is doing a better job without the same resources?
What Are The Risks To Your Company?
Let me state that I think the industry overhypes the risk of fee litigation, especially for smaller plans, even though there have been a couple of instances where these types of plans have been targeted. I call this "fiduciary fearmongering". While it’s possible for plans of any size to be sued, it’s not probable. As long as you take the right steps, the risk of litigation is likely to be very low. Consider driving a car. Whenever I drive, I’m always at risk of an accident. But if I drive safely and obey traffic laws, the possibility that I’ll be involved in a serious crash is reduced by a wide margin.
However, the threat of litigation isn’t the only risk companies face if they don’t negotiate wisely. A second risk for companies is related to human capital and talent management. That’s because it’s the employees who bear the brunt of high fees when plan sponsors contribute little direct cost. Unhappy, dissatisfied employees have both a direct and indirect cost on company culture and company performance.
Most companies pay little attention to retirement plan fees for one of three primary reasons.
- Most fiduciaries don’t realize the significance of their legal responsibilities under ERISA. In many cases, they may not even know that they are fiduciaries. For example, a 2014 survey by AllianceBernstein found that 37 percent of the 1,000 plan sponsors surveyed were unaware of their fiduciary status, and 6 percent were unsure. Here’s the catch: every single person surveyed was actually a fiduciary!
- They don’t see/feel the impact of most fees because they never hit the company’s bottom line. This creates little incentive to reduce costs. In my experience, more than 95 percent of fees are paid through the plan, not directly by the plan sponsor.
- They aren’t aware of the devastating impact fees can have on long-term retirement savings.
The DOL has made it clear that companies have an ongoing legal obligation to understand and evaluate plan fees to help their employees achieve a secure financial future. In “Understanding Retirement Plan Fees and Expenses,” the DOL states:
Understanding and evaluating plan fees and expenses associated with plan investments, investment options, and services are an important part of a fiduciary’s responsibility. This responsibility is ongoing. After careful evaluation during the initial selection, you will want to monitor plan fees and expenses to determine whether they continue to be reasonable in light of the services provided.
A failure to understand, monitor, and control fees put plan sponsors at risk for legal action by employees for potential breach of fiduciary duty.
What Are The Risks To Your Employees?
There are four primary variables that contribute to the retirement equation.
- The total amount of money that goes into a person’s account, including their own contributions plus any employer contributions. Studies have shown that this is the most important variable, and most experts recommend total savings rates of 10 to 20 percent depending on age and income level.
- The total amount of money that comes out of their account or "leakage". This includes things like fees, loans, cash-outs, hardship withdrawals, etc.
- The rate of return they earn on their investments. Most people think this is the most important driver of retirement security, but it’s not, and it’s also the one people have the least control over. Furthermore, a person can’t invest their way out of a savings deficit. This is why sufficient funding is so important (i.e., high savings rates).
- The last variable is time. The earlier someone saves, the lower their long-term savings rates typically need to be and the higher the probability of achieving a successful retirement experience. Delaying retirement saving by even five to ten years can have a devastating impact.
Let’s focus on how high fees can impact that equation. The DOL has estimated that high retirement fees can reduce a person’s account balance by 28 percent over the course of a working career.
Let’s assume you began your career at twenty-five and made a starting salary of $40,000, receiving an annual pay raise of 3 percent. Let’s also assume you saved diligently and contributed 10 percent of your salary to your 401(k) plan each year and received a 3 percent matching contribution from your employer for a total annual savings rate of 13 percent. Finally, you earned an average annual return of 7 percent on your investments after fees. Guess how much you would have retired with at age sixty-five? About $1.8 million. Now imagine you worked for a company that had a 401(k) plan with expenses that were 0.50 percent higher, reducing your after-fee returns to 6.5 percent. Instead of retiring with approximately $1.8 million, you retire with about $1.6 million (11 percent less) because high fees were eating away at your balance year after year. Want to know how much additional income you could have had for the rest of your life with that $200,000? $948 per month.* Ouch!
What could one of your employees do with an additional $948 per month in income? How much would that impact their living situation? Their ability to pay for healthcare expenses? How often they could see their grandchildren? Or the chance to leave a legacy to organizations they care about? That $948 in monthly income could be the difference between retiring in dignity or with despair. It also could have systemic implications. What if that $948 per month could have been the difference between being financially independent and being a financial burden to their family? What if they had to move in with their children, or their children had to pay for their long-term care? Which meant they couldn’t save enough for retirement, and the cycle continued to their children and their children’s children?
Low fees alone will not save your employees’ retirement prospects, but they can have a significant impact and help them keep a lot more of what they save. However, your employees have very little control over the fees they pay because they don’t select the vendors that service the plan, the investments that are offered, or the overall fee structure. Those things are all chosen by the plan fiduciaries. That means your employees are highly dependent on you to make wise decisions.
Let me state clearly - there's a cost to offering a great retirement plan. The DOL has made it clear that it's prudent to engage experts. And leveraging the right team of specialists to implement many of the strategies and solutions in my book The Fiduciary Formula can yield tremendous outcomes. As Warren Buffett has said, cost is what you pay and value is what you get. Sometimes paying a little more is well worth it. It's important not to be penny-wise and pound foolish. But often, plan sponsors focus too much on relationships and not enough on results when evaluating their service provider relationships. Too many plans fail to engage in a thorough due diligence process and ask the hard questions from their services providers to ascertain whether they are generalists or specialists. If you want to know what questions to ask and how to evaluate the answers properly, download these guides for interviewing prospective advisors, recordkeepers/TPAs, and plan auditors.
Quantifying The Impact From A Corporate Finance Perspective
It’s in the best interest of companies to gain control of retirement plan fees, both to manage corporate risk and also to enhance employee goodwill. I’ve already quantified the estimated financial impact on employees. But since most plan fees aren’t paid by the company, reducing costs isn’t often seen as high a priority from a corporate finance perspective because it doesn’t affect the bottom line. The best way for companies to get motivated is to quantify the long-term impact of high fees, at both the plan level and at the employee level.
Most CFOs can create a present value (PV) formula in Excel in their sleep. So that’s a great place to start. Think of retirement plan fees like any other potential business expense, even though very little direct cost may hit the company’s P&L statement. Just in case you slept through your finance class in college, let me refresh your memory about present value. Present value is what a future sum of money or a stream of cash flow is worth in today’s dollars. You determine present value by taking a future sum of money and then using an interest rate (called the discount rate) to factor in the time value of money. The higher the discount rate, the lower the present value of that future sum of money.
At the plan level, one way to think about the long-term impact of high fees is to project the impact over a period of time (e.g., ten years). So put on your CFO hat. Let’s assume you have a $20 million 401(k) plan with 200 participants, and the current total annual fees equate to 0.80 percent of plan assets ($160,000/year). Also, let’s assume that participants pay all plan fees, so there is no direct cost to your company.
If the plan grows at 5 percent over the next ten years there will be roughly $31 million in the plan. For simplicity, I will assume this includes market growth plus annual contributions, such as employee deferrals and employer contributions. With annual plan fees of 0.80 percent remaining constant over that period, the cumulative fees paid would be $2,013,601.
However, consider if you had negotiated plan fees of 0.40 percent during that same ten-year period. The plan would have only paid $1,029,394 in fees, which is a difference of $984,207! Look at this chart to see the difference:
Now, using a discount rate of 4 percent, the present value of that $984,207 in additional fees is worth $664,895 in today’s dollars. This is like depositing that amount of money in the plan today. With 200 participants, that’s like giving each one of them $3,324 in additional retirement assets ($664,895 ÷ 200) just from fee savings!
Remember that you’re still wearing your CFO hat. If you were projected to spend more than $2 million on IT services over the next decade and someone told you they could save you nearly $700,000 in today’s dollars, would you listen? I expect you would jump at the chance to save this kind of money for your company. Otherwise, you may not be CFO for long! The difference is that the cost of IT is a direct expense that hits the bottom line of your company’s P&L, while retirement plan fees do not since they are paid through the plan and absorbed by your employees. Because of a lack of awareness, a lack of concern, just sheer laziness, or a combination of all three, companies rarely have the same level of commitment to reducing plan costs as they do other types of business expenses.
From a fiduciary perspective (and for the good of your employees’ financial futures), that kind of thinking needs to change. This example illustrates the importance of thinking about retirement plan fees like any other corporate expense and applying a similar decision-making logic to the process. If you're interested in having this type of analysis done on your plan, please feel free to reach out to schedule a discovery call.
*Fidelity Investments Guaranteed Income Estimator, male, starting at age 65, single life immediate annuity (no increase option or death benefit), state of Maryland, 10/9/2020. $200,000 in assets would purchase $948 in monthly income for life.