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Focusing on 401(k) fees

By Rob Smith, Ceridian manager of Government Relations

The 401(k) accounts are the most popular retirement savings option in the United States today. Over 46 million people have invested nearly $2 trillion in the accounts since they first became available in the early 1980s. And, these numbers are sure to grow as the traditional defined benefit pension system continues to fade.

One of the key aspects of 401(k) plans is the flexibility they give account holders. Participants choose their own investment options, as opposed to defined benefit plans that rely on employers to make investment decisions. And, participants have easy access for up-to-the-hour information on their investments' performance. Companies that administer and invest 401(k) funds provide information regarding the investment options available to account holders. Now, the new Pension Protection Act of 2006 will allow plans to give workers tailor-made individual investment advice to help them maximize the earning potential of their 401(k) account. However, a December 2006 study by the Government Accountability Office (GAO), Changes Needed to Provide 401(k) Participants and the Department of Labor Better Information on Fees, found that some of these companies haven't been as generous with other information, and it's costing American workers a lot of money.

What you don't know can hurt you
Like nearly everything that's worthwhile, 401(k) accounts don't come free. As a 401(k) account grows, the employee is charged fees to cover investment expenses, record keeping costs and other activities to maintain the accounts. While these charges are relatively small (often one percent or less) and can be shared between workers and their employers, even a small fee can significantly impact workers' retirement savings over the course of their careers.

The GAO report provides an example of a worker who invests $20,000 in a 401(k) plan. Assuming an investment return of 6.5 percent and an annual plan fee of 0.5 percent, the 401(k) would grow to $70,500 after 20 years. However, if the worker had selected an investment option with an annual fee of 1.5 percent, that same investment would only be worth $58,400.

A one percent difference doesn't seem like much, but it adds up. The basic 401(k) concept is that workers hold their accounts throughout their careers and access the money once they retire. So, over the course of a 30-year career, that "small" one percent additional annual fee would end up costing the investor 30 percent of the funds he would otherwise have for retirement.

The solution to this problem seems simple -- choose low fee investment options. But it's not that easy. Sometimes the higher fee investment funds produce a higher rate of return.

ERISA is not enough
ERISA (Employee Retirement Income Security Act) is the federal law that regulates retirement plans. While it requires 401(k) plan sponsors to provide individual investors with several disclosure documents regarding their plans, there are little or no disclosure requirements regarding fees.

The GAO found that "the information on fees that [ERISA] requires 401(k) plan sponsors to disclose is limited and does not provide an easy comparison of investment options."
Unfortunately, this data is usually provided in a piecemeal fashion or by participant request. Even if a worker knows what to look for, he must collect and wade through numerous documents and plan statements to decipher how much he is paying in fees and then conduct his own comparison of investment options. What's more, participants may be completely unaware they are paying 401(k) fees or that they can direct their investments into lower cost investment funds. In fact, the GAO report cites a 2004 study by the American Association for Retired People (AARP) that found that more than 80 percent of 401(k) participants do not know how much they pay in fees.

Workers aren't the only ones in the dark. Under ERISA, the U.S. Department of Labor (DOL) has the authority to oversee 401(k) fees and business transactions among plan providers. Plan sponsors are required to submit Form 5500 to the DOL each year, which includes sections pertaining to fees. However, the GAO found that the DOL lacks the information it needs to provide effective oversight. The report cites findings from the ERISA Advisory Council Work Group that Form 5500 "does not reflect the way that the defined contribution plan fee structure works, because only those fees that are billed explicitly and are paid from plan assets are deemed reportable." A large portion of the 401(k) fees charged on participants' investments are paid from the investment returns rather than the plan assets, so these costs are never reported to the DOL.

Suggestions for improvement
The GAO recommended several changes to improve fee disclosure and provide investors with a more complete picture of their retirement accounts. First, it suggests that Congress should consider amending ERISA to require all 401(k) sponsors to provide plan participants with a comprehensive, easy-to-understand disclosure of 401(k) fees. The GAO offers that this information could be provided annually in a single document that also displays other information about workers' 401(k) accounts, such as investment performance histories and risks.

The report also states that Congress should consider legislation to require 401(k) service providers to disclose to the DOL the compensation they receive from other service providers. One of the DOL's roles is to ensure that 401(k) holders aren't being charged unnecessarily high fees. Since relationships between service providers aren't reported, the DOL has no way of investigating or monitoring instances when a company may seek to profit from steering a plan sponsor toward an unnecessarily high-priced investment service provider, which in turn can result in higher fees for investors. And, higher fees affect the bottom line value of the investor's 401(k). While such deals are by no means common, this lack of disclosure is a hole in DOL's oversight abilities.

The report also suggests that the DOL should mandate that plan sponsors report annually a summary of all fees paid by participants, regardless of whether they are paid from assets or investment returns. According to the GAO, more robust reporting requirements would provide the DOL with more effective oversight powers and allow them to better protect participants from overpriced plans and services.

What's next
It's a sure bet 401(k) fees will receive a lot of attention in the near future. Pressure to improve plan administration is coming from all fronts. Several recent class action lawsuits based on claims of unreasonably high plan fees have brought the courts in on the issue, and the GAO report makes it clear that Congress and regulators have not kept up with workers' needs for reliable information on their pensions.

Congressman George Miller, who commissioned the GAO study and chairs the powerful House Committee on Education and Labor, has already indicated this year that his committee will hold hearings on 401(k) fees. In a recent press statement, Congressman Miller said: "It's critical that workers' hard-earned savings not be wasted on excessive fees. Workers need complete, accurate and clear information about the total cost of different investment options so they can choose the ones that are best for them."

This position meshes with the DOL's efforts to increase 401(k) fee disclosure and improve its oversight capacity. Most recently, the DOL announced plans to propose reporting changes to promote 401(k) fee transparency. It also has moved to change Form 5500 to require plan administrators to disclose all fees on the plan's annual report.

Activity points to a serious revision of 401(k) fee practices. It is important that any new reporting requirements are not overly burdensome or expensive for employers and investment services companies. And, improved fee transparency and better access to information should be good for 401(k) participants, employers and the investment business. The Pension Protection Act of 2006 made several improvements to 401(k) plans that set the stage for enrollment numbers to explode over the next few years. Plan administrators and investment service companies need a more defined set of disclosure regulations to ensure they are complying with the law.

Most importantly, workers who are making investment decisions that will have a profound effect on their lives in retirement have a right to clear, comprehensive information regarding how much they pay in fees. You wouldn't sign up for something as simple as a gym membership without knowing exactly how much it costs, and 401(k) holders shouldn't have to accept anything less when they invest their retirement money.

The DOL and Congress have started the ball rolling, so look to Ceridian Government Relations for an update on 401(k) fees.