April 1, 2012 looms as a date that may live in infamy for some 401(k) service providers. That's when the DOL’s new 408(b)(2) regulation takes effect. This regulation requires all plan service providers to disclose their compensation to 401(k) plan sponsors. Service providers include anyone acting as a fiduciary, registered investment advisers, brokers, recordkeepers, third party administrators and consultants. But that’s not the surprise.
What 401(k) plan sponsors might find shocking will appear in the compensation section of the service provider disclosure (services and a declaration of fiduciary status must also be disclosed). Compensation is defined as anything received directly and indirectly. Indirect compensation can include cash or non-cash items the service provider receives as a result of providing a service to the plan. Most plan sponsors will already know the amount of direct compensation. This indirect compensation may startle them.
Prior to 408(b)(2), service providers had no requirement to disclose indirect compensation (we’ll leave it up to ethical philosophers to determine if they had an obligation to disclose). Many 401(k) plan sponsors, who are paid to specialize in their company’s product, not in their retirement plan, simply don’t have the experience or know-how to ask the right questions of service providers in order to uncover these hidden fees. This all changes as of April 1, 2012, and that might just scare some 401(k) service providers.
It won’t be surprising, then, if 401(k) plan sponsors might have a greater focus on fees next spring. Indeed, this has already been the subject of media reports (see “Study Reveals Five Factors That Help Lower 401(k) Fees,” October 11, 2011). Still, while fee disclosure might reveal hidden fees, the downside is it might create some false choices for plan sponsors. Here are a couple of examples.
There fees that matter and fees that don’t matter. If one recordkeeper charges twice as much as another recorder, does that fee matter? This is a trick question. If the service (remember, that’s the other thing that needs to be disclosed) justifies the higher fee, than the higher fee doesn’t matter. Of course, the quality of service can’t be disclosed, it can only be experienced. If the stated services between the two recordkeepers are the same but the quality of the low-cost alternative is extremely poor, then, again, the higher fee doesn’t matter.
It is this focus – or, specifically, the lack thereof – on quality that might prove the Achilles’ Heel of 408(b)(2). It’ll be too tempting to just look at the number generated by the fee disclosure. Indeed, it’s almost guaranteed some vendors will try to sell their service based on lower fees. Remember, such a sales strategy only works for commoditized products and, right now, the only commoditized products are index funds. There is no real difference between two S&P 500 index funds. Both should be managed in the same manner and yield the same return, so the only difference will be the fee. In this case, the fees do matter. (One can argue custody and recordkeeping should also be considered a commodity, but there’s too large a service component in both those activities to justify placing a “commodity” label on them.)
But here’s the potential pitfall. There’s a lot of emphasis on the categorizing mutual fund expense ratios as “fees.” We all know equity-based mutual funds have much higher expense ratios than bond-based mutual funds. A quick and dirty method for lowering overall 401(k) fees is to move all the assets to lower cost bond-based mutual funds. But we also know (and one of the reasons why the 2006 Pension Protection Act was drafted the way it was) the best long-term investment remains equities, not bonds.
In cutting fees, will 401(k) plan sponsors accidentally cut off their nose to spite their face?