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RETIREMENT - Straight-Shooting on 401(k) Fees

Money managers think they have an effective approach to revenue sharing, but the Department of Labor has yet to weigh in.

ARE 401(K) PALNS BEING overcharged? If so, by how much?

These fundamental questions on the economics of defined contribution plans are attracting new regulatory scrutiny that threatens to escalate into an all-out political donnybrook. Prodded by reform-minded Democrats who control the congressional agenda and have held hearings on the subject, the Department of Labor has asked for industry input on how to rewrite the rules on fee disclosure. The industry warns against disclosure standards, citing the costs they’d bring. Meanwhile, class-action lawsuits initiated by the plaintiffs’ bar are making their way through the courts, alleging that the plans and their participants are paying excessive fees beyond the cost of administration.

The stakes in this dispute have climbed along with defined contribution plans’ assets, which increased by $1 trillion, to $2.9 trillion, from 2000 to 2006. With fees generally between 150 and 350 basis points, the gross annual take for the industry surpassed $40 billion in 2006. But the cost of nuts-and-bolts plan administration is only about 25 basis points, plus a bit more in flat fees, says Mark Miller, a partner at the Houston-based law firm Fulbright & Jaworski. The asset-based fees are usually collected by the investment manager, which keeps some for itself and divides the rest among brokerages, consultants and other service providers. Matthew Hutcheson, an independent fiduciary who serves on the boards of plans with assets collectively totaling $5 billion, estimates that the excess fees add up to $25 billion of the $40 billion total.

With regulators and lawyers breathing down their necks, industry officials want to get a precise handle on these fees and on what constitutes a reasonable profit margin for service providers. Complicating defined contribution economics is the fact that when an account is opened, and is in its early stages, asset-based fees do not cover the provider’s costs, and flat fees are imposed to compensate somewhat. As balances grow, service providers earn more than they need to cover their costs. Critics say that plan participants are shortchanged in the long run, with the bundling of fees masking the excess.

Miller advocates creating ERISA fee accounts, where management and service fees would be collected and appropriately distributed in compliance with the Employee Retirement Income Security Act of 1974. This structure is already available to clients of Charles Schwab & Co., Merrill Lynch & Co. and Wells Fargo & Co., which are supporting the new model, though somewhat stealthily. That’s because the Department of Labor has not yet formally approved it. “Several clients have said they wouldn't have an ERISA fee account without clear guidance from the regulators,” says Douglas Murray, executive vice president in the institutional trust division of Wells Fargo, which has about 60 companies using the accounts. Today, after a plan sponsor pays for such ERISA-eligible expenses as educating participants and paying lawyers and auditors, what’s left over generally stays in the fee account. But Miller says he has a corporate client that started returning surplus fee-account balances to its employees and participants as of January 1, 2007.

For Miller, the effort to institutionalize ERISA fee accounts is a second act. A decade ago he played a key role in shaping the current revenue-sharing system when his client, Frost National Bank of San Antonio, obtained ERISA Advisory Opinion 97-15A. Now known as the Frost letter, this DoL ruling permits a bank to keep its share of 401(k) investment management fees as long as it can prove the fees were defraying specific costs.

Miller says that “this leveled the playing field for smaller players” competing against the likes of Fidelity Investments, by far the dominant defined contribution administrator, with a 27 percent market share. (No. 2 Vanguard Group has a 9 percent share.) The giant asset managers that are also recordkeepers “could hang on to their administrative fees without a problem,” explains Miller. The fee-sharing permitted by the Frost letter helped spur the growth of the defined-contribution-plan system.

Miller says he is negotiating an engagement letter with Wells Fargo that will lead to a request for a DoL ruling to let the bank and others implement fee accounts in a standard way. If that succeeds, a Wells Fargo letter will take its place alongside the Frost letter as a defining document of defined contribution economics.