Laying it on the line

Lisa Pyne, the director of benefits and compensation programs at Philips Electronics’ U.S. division, likes to call a spade a spade.

Lisa Pyne, the director of benefits and compensation programs at Philips Electronics’ U.S. division, likes to call a spade a spade.

By Jinny St. Goar
May 2001
Institutional Investor Magazine

Lisa Pyne, the director of benefits and compensation programs at Philips Electronics’ U.S. division, likes to call a spade a spade. “When we have employee meetings, a big section at the front of our handouts describes the fees in our 401(k) plan,” she says.

Pyne is the rare straight shooter. In the 401(k) business, fee disclosure, whether to plan participants or sponsors, has been a notoriously murky affair. “There is so little comparability between vendors,” says Jag Alexeyev, a consultant with Strategic Insight, a mutual fund research and consulting firm. And even within an individual vendor’s fee structure, the price tags on separate services are not obviously marked.

That’s because the lion’s share of the payment for 401(k) services is collected as investment management fees, calculated as a percentage of assets. That pot of money is then shared by the investment manager (typically a mutual fund company), the plan’s recordkeeper and its trustee. Sometimes two or three managerial functions are bundled together, in the industry jargon, and handled by one institution.

The picture is further complicated by the fact that fees are sometimes levied at three levels: first, on assets under management; second, on a per-participant basis; third, as an administrative fee paid by the plan as a whole.

Certainly, fees vary widely. At the expensive end of the spectrum, a small plan (less than $10 million in assets) that is administered by an insurance company might pay expenses totaling 350 basis points on total assets. At the cheaper end, at a large company like Philips, which uses the services of Vanguard Group, the expense ratio for the plan is about 29 basis points. Of course, bigger plans command a break on pricing. But this also makes it difficult for a small plan to evaluate its pricing structure. How much of the substantial fee differential reflects actual economies of scale, and how much is something more akin to price gouging?

Vanguard, whose low fees are one of the fund company’s major selling points, has tried to galvanize the industry to improve fee disclosure. Its “All-in Fee Report,” issued to plan sponsors annually for the past two years, lays out precisely what an individual plan pays for which services.

Charles Schwab & Co. and Strong Capital Management are also well regarded for their clarity about fees. Schwab, for example, starts its discussion of fees with plan sponsors by analyzing the investment options that a plan might consider. During the sales pitch, says James McCool, senior vice president at Schwab’s Retirement Plan Services division, “we lay out what revenues each fund will kick off to Schwab and which costs that will cover.

“We don’t require the choice of actively managed Schwab funds,” McCool adds, referring to the category of funds that brings the highest-margin revenue to Schwab.

“For us this [report from Vanguard] clearly identifies what the company pays and what the participant pays,” explains John Stamatiades, manager of benefit plans for Alcan Aluminum Corp., which, like Philips, relies on Vanguard for the bundled trio of defined contribution services: investment management, recordkeeping and trusteeship. Particularly useful, Stamatiades believes, are the projections showing the impact of various fees over the course of a 25-year investment.

Says Ward Harris, managing director and founder of McHenry Consulting Group, “Some participants are paying between 20 percent and 200 percent more than they need to be paying.” The disparities lie in the inherent differences between the plans, some of which may seem similar at first glance.

For example, the Philips defined contribution plans have approximately $940 million in assets and close to 19,000 participants, for a sizable average account balance of roughly $48,000.

The Alcan plans have approximately $380 million in assets and about 5,600 participants, for an average account balance of roughly $68,000. Given that the largest share of fee income is taken as a percentage of assets, the Philips fund throws off a larger fee in absolute terms, but per participant, its fees are only 70 percent of Alcan’s.

At Philips, where parts of the defined contribution plans have been accumulating assets since their inception in the 1970s, some of those relatively high account balances belong to sophisticated participants who rely on the Web (at little cost) to manage their 401(k) accounts. Meanwhile, the relatively low-balance account holders of Philips demand more time and attention (at a higher cost) from the plan provider. If the two plans - Alcan’s and Philips’s - were priced on the same criteria, Alcan’s would be much more profitable to vendors.

“Sophisticated providers are pricing each client individually,” reports Paul Heller, who heads defined contribution services for Vanguard. The same holds true at Schwab. Says McCool, “Our ‘no-cookie-cutter-pricing approach’ lessens the likelihood of cross-plan subsidies.” In addition to basing pricing on average assets per participant, Vanguard and Schwab factor into the equation administrative complexity (that is, how many plans and how many payrolls); the mix of investment options, including what percentage of assets are invested in outside funds or in company stock; and how heavily participants rely on ancillary services, such as education. Vanguard generally offers a two- or three-year contract, with a commitment not to raise fees beyond a certain percentage. “Of course, if any material assumptions change substantially, the fees could be repriced,” explains Philips’s Pyne.

But not all vendors price their clients so systematically, and, in many cases, the basic confusion about how to price makes the jobs of plan sponsors like Pyne more difficult.

Furthermore, inequities exist within individual plans. Effectively, middle-aged executives with account balances approaching $300,000 could be supporting as many as ten low-balance account holders. In even the lowest-cost plan, which is paying an average of 20 basis points on assets, that large-balance person accounts for $600 in fees, while a person with a $10,000 balance accounts for only $20 in fees.

This indirect subsidy is particularly hefty if the large-nest-egg holders are not actively trading or don’t use the educational services. So far most higher-balance account holders have not objected to the imbalance in fee structures.

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