The Price of ‘Free’ Retirement Plans

By Richard M. Todd

Retirement plan sponsors often believe they are getting their retirement plan for “free.” The author’s evaluation of more than 40 retirement plan providers, however, indicates a wide range of “free” plan providers. An extensive database of provider services, features, and costs has been developed through a request for proposal (RFP) process for over 25 different plan sponsors over the last three years. Plan sizes ranged from under $5 million to over $400 million. The survey revealed a number of key dimensions on which plan providers can be evaluated.

Comparing Free Plans

Revenue sharing. Many providers are completely reliant on their array of mutual funds to provide their compensation. The differences in what mutual funds pay in revenue sharing can be staggering. The amount is generally related to the internal expenses of the underlying mutual fund; higher expense-ratio funds generally provide more revenue sharing. If a provider can position higher-cost mutual funds for its client, it means increased revenue sharing for the provider. Therefore, the participant often ends up bearing the cost of mutual fund revenue sharing through higher internal expenses.

Plan profitability varies. Generally, the higher the average participant account balance, the higher the profitability to the provider. Large participant balances allow the plan sponsor to force its provider to utilize lower-expense ratio products and institutional share classes. They also require the provider to improve employee communication or offer something else to improve the plan. In addition, the provider can send the plan sponsor a “rebate” to cover other plan costs, such as consulting, legal fees, or employee communication. However, there cannot be renegotiations with the provider without cost and revenue-sharing quantification. The onus is on the plan sponsor to understand the details.

Commodification of the plan. A common sales pitch used by insurance companies is, “Let us handle your health, life, and disability, and we’ll throw the retirement plan in for free.” Experience says that the plan usually ends up being expensive rather than free. Retirement plan providers’ services and costs vary widely and must be looked at differently than other benefits.

Advisors. Brokerage commissions always make plan costs higher, and should be paid for separately from expert advice. Benchmarking is flawed when a “broker” lines up numerous products for comparison, because all the options are usually drawn from the expensive tier of commissionable solutions.

Expanding options. Even the largest mutual fund families are loosening their grip on their own funds. For reasonably profitable plans, providers are allowing plan sponsors to opt out of the proprietary product lineup and expand to outside funds. Plan sponsors must ask for this flexibility.

Based on the author’s research, the median universe size now offered by plan providers is over 1,000 mutual funds. Plan trustees can design their own options, such as 10 to 15 “best of class” choices that form a custom program. They can unplug and replace mutual fund options easily and seamlessly. The more choices and flexibility, the better the program, for both participants and fiduciaries.

Fiduciary responsibilities. The fiduciary standards for defined contribution plans are identical to those of a pension plan. The process of ongoing evaluation is a fiduciary requirement. This process should continue after the provider has been chosen and as the plan grows. Develop an investment policy statement, and document the processes and activities. Because of the losses participants have suffered over the last three years, the likelihood of litigation has increased. Prudence hinges on process, not performance.

Increased Scrutiny

With the terrible recent stock market performance, participants are beginning to hold their employers over the fire. Similarly, it may be time for plan sponsors to look more closely at their providers. The better providers appreciate an evaluation that sets them apart and establishes their credibility; only poor providers complain. When “free” is properly unraveled, scrutinized, benchmarked, and then acted upon, participants get a better plan, plan sponsors get relief, and quality vendors extend their relationship with happier clients.

Richard M. Todd, CIMC, is a consultant and principal of Innovest Portfolio Solutions, Greenwood Village, Colo. He can be reached at (303) 694-1900 or richt@innovestinc.com.