IT’s a GIVEN THAT THE COSTS of executing securities sales or purchases cut into investment performance. Quantifying these costs has become critical to active traders and executing brokerages as they struggle to turn a complex and constantly evolving analytical process into a science.
Now the pension industry is getting into the game of transaction cost analysis, or TCA. It’s under pressure from the Department of Labor, which enforces ERISA and its requirements for prudent investment management and reasonable service charges, and from the ever-opportunistic plaintiffs’ bar, which has identified allegedly excessive investment-related fees as a target for class-action suits.
The DoL, which is drafting rules on the matter, has not publicly commented but is asking plan sponsors to examine all manner of direct and indirect costs, says Jan Jacobsen, senior counsel for retirement policy at the American Benefits Council, a trade group representing many Fortune 500 companies and their service providers.
Defined contribution plans, like 401(k)s, are particularly in need of such scrutiny because “trading costs take money directly out of the participants’ pockets,” notes Steven Glass, head of Plexus Plan Sponsor Group, a consulting subsidiary of New York–based brokerage Investment Technology Group. (Defined benefit plans are less affected because they promise a certain benefit regardless of investment results.)
The administration costs that concern DoL — recordkeeping, transfer agency, trust and custody — are red meat for class-action law firms. St. Louis–based Schlichter, Bogard & Denton, for one, has filed more than ten suits accusing plan sponsors, such as ABB and Deere & Co., and providers, such as Fidelity Investments, of overcharging.
Big plan sponsors are, of course, the choicest targets — their transaction costs can be disproportionately high because of the market impact of their large trades — but they also have the clout to negotiate lower fees and employ sophisticated managers who understand TCA. Plans with less than $1 billion in assets may not get sued, but Jerome Schlichter, managing partner of Schlichter Bogard and lead attorney on several of its suits, stresses that “it is possible for plans of all sizes to control transaction costs.”
Plan sponsors have some benchmarks available to determine what costs are reasonable. The Securities and Exchange Commission has come up with an average transaction cost for equity funds of 75 basis points. However, that’s based on commissions and bid-ask spreads and does not take into account such key TCA variables as market impact (price movements caused by large trades), slippage (price changes between the time an order is communicated and when it gets executed) and opportunity costs (missing out on a positive outcome, which can have many causes). But the SEC has also drilled deeper, calling in consultants such as Harvard Business School finance professor Peter Tufano to calculate the costs of the mutual fund trading abuses of earlier in this decade. Tufano says that he can’t disclose specifics of the TCA methodology he came up with, but it is in the regulatory tool kit and could make its way into examinations and enforcement.
A readily available starting point for plan sponsors as they press their providers for better TCA is the turnover rate, or the dollar volume of net purchases or sales as a percentage of the average value of a portfolio. The SEC requires mutual funds to disclose their turnover rates.
Turnover in a retirement plan can vary widely and is not perfectly correlated to costs. Gregory Kasten, president of retirement plan consulting firm Unified Trust Co. in Lexington, Kentucky, surveyed portfolio trading at almost 11,000 equity mutual funds during 2006 and found an average annual turnover rate of 93 percent, within a range of 58 to 182 percent. He estimates that each 100 percent measure of turnover translates into 147 basis points of costs. That would put turnover-related expenditures somewhere between 85.26 and 267.54 basis points. High turnover in efficiently traded stocks can be more expensive than low volumes in less-liquid issues.
Switching from one recordkeeper or adviser to another can further complicate the cost structure. Plexus’s Glass says these “supercharged” circumstances, involving high trading volumes under tight deadlines, raise transaction costs. That’s just more fuel for regulators and class-action attorneys. “It’s only a matter of time” before all firms will have to wake up to the cost issue, says Glass. But clearly, the heat is already on.
