Do Common Benchmarks Mislead the 401k Fiduciary?
(The following is the first of two articles addressing an issue of growing importance in the 401k industry)
Benchmarking 401k plans seems to come down to two metrics: fees and investment performance. Measuring mutual fund performance has become a cottage industry (or bigger, q.v. Morningstar). With the advent of 408(b)(2), fee analysis has suddenly become the dimension de jour. Too often, analysts declare certain metrics “significant” simply because they can be measured, not because they measure the relevant objective. If we are to believe academic research and industry thought leaders, fees and investment performance might not be the most important 401k benchmarks. What are the real important benchmarks and how much of a burden do they have on the fiduciary duties of the 401k plan sponsor? The answers are at once both easier and more complicated than one would think.
In terms of complication, some, like Fred Reish, feel ERISA strictly limits the fiduciary liability of the 401k plan sponsor to matters pertaining to the care and handling of the employees’ money. This argument has merits in such a confined legal sense. Yet, in the broader sense of fiduciary duty – that of placing the interests of the beneficiaries first – the matters of relevance go beyond merely acting as the good custodian of other peoples’ moneys. Here, the definition of fiduciary duty comes from trust law, not ERISA. This may or may not have relevance in the court of law, but it speaks volumes in the court of common sense. Just because it might be hard to measure these metrics doesn’t mean they lack importance.
Readers might also be interested in: “401k Fees That Matter”
We begin with the current state of benchmarking – what some might call the overemphasis of fees and investment performance. The former suffers from subjectivity. Again referring to Reish, we are reminded of his conclusion regarding the hysteria surrounding the apparent threats of a law school researcher to publicly identify those plan sponsors who are paying “high fees.” Reish had the perfect comeback. Consistent with everything the DOL has said and published regarding Rule 408(b)(2), without knowing the level of service received, it’s impossible to determine if any fee is fair or high.
“Fees should always be examined in conjunction with cost-drivers and value-factors,” says Tom Kmak, CEO of Fiduciary Benchmarks in Lake Oswego, Oregon. “For example,” says Kmak, “employee meetings are a common cost-driver and an advisor providing 3(38) fiduciary advice is a well-known value-factor. Both of these items are specifically designed to help participants retire and if they generate higher savings rates or better investing behavior, that improved behavior can be proven to mathematically dwarf almost any reduction in fees. In summary, examining Fees without examining value is a meaningless exercise. It is like knowing only half the score of a football game.”
Investment performance has its own problem. “The industry turned 401k plans into investment plans many moons ago,” says Steve Wilbourne, CEO of Questis Portfolio Partners LLC in Charleston, South Carolina. Aside from the usual differences in investment discipline, there is the issue of the importance of investments themselves. The summer of 2012 offered a one-two punch sending investment performance down a peg or two. A month after Rule 408(b)(2) became effective, a Wharton study came out declaring investment allocation had less relevance than at least three other factors. Could those other factors provide the clue to better 401k benchmarks?
Readers might also be interested in: “New Study Reveals Three 401k Strategies More Important than Asset Allocation”
Wilbourne points out “a 401k plan is first and foremost a savings plan. Investment firms have attempted to sell fund performance and costs as differentiators, but with pension plans dying and/or dead in America, and 401k being the primary means toward retirement, then participation and savings are the most important thing. The reason participation and savings rates are superior to returns and costs is fairly obvious. A percentage of nothing is nothing… if individuals aren’t educated and incentivized to first participate, then second, contribute, returns and subsequent costs to access returns take a back seat.”
“Of course we continue to offer traditional benchmarking metrics regarding plan fees, mutual fund expenses, and mutual fund performance; however, that is only a sliver of the pie,” says Bradley K. Arends, CEO, Senior Consultant at Alliance Benefit Group Financial Services, Corp. in Albert Lea, Minnesota. He looks at three primary metrics: participation rate, contribution rate and percentage of employees using either asset allocation funds or individual advice. Arends believes “Americans are critically behind on their retirement savings path when looking at the end-goal, a successful retirement.” He says, “Progressive retirement advisors are implementing process, procedures, and benchmarks to help their clients get America’s workforce back on track.”
When it comes to participation, there’s another metric that has garnered increased attention in recent years: the number of options on a plan menu. “Studies have shown that 401k plans with too many investment choices results in lower participation due to uncertainty in making the right choice,” says Joyce Morningstar, Senior Wealth Manager at Dynamic Wealth Advisors in Scottsdale, Arizona. “Most 401k plans contain an overabundance of equity options – far more than is required to create a diversified portfolio.”
Readers might also be interested in: “Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu”
Some believe participation rates can indicate a greater problem with the plan. “Employees should be strongly encouraged to participate,” says Michael A. Edberg, Managing Partner at J.M. Edberg Investment Management LLC in Washington D.C. “Low participation rates are a sign that the company does not care about employees’ retirement and/or a sign that plan is not well structured.”
Indeed, these under emphasized benchmarks can help 401k plan sponsors fulfill their (traditional) fiduciary duty to serve the best interests of the beneficiaries of the plan. “Benchmarks on income replacement and participation rates provide more information and enable the plan sponsor to be in better position to enhance their fiduciary oversight and take action to influence participant behavior,” says Tim Slavin, Senior Vice President of Defined Contribution at Broadridge in Edgewood, NY. “Based upon this information, sponsors could choose to implement features such as automatic enrollment, deferrals rates greater than 5%, and auto increase of deferral rates – all of which can positively impact their employees’ ability to achieve a comfortable retirement.”
“If the metrics mentioned above are not tracked and monitored, then the plan sponsor will not be aware of any shortcomings and cannot implement strategies to help their employees succeed, such as automatic enrollment, automatic increases, and automatic re-enrollment,” says Mark Sulpizio, Partner at Innovative Investment Fiduciaries, LLC, in Cinnaminson, New Jersey. “Ultimately, if participants are not contributing to their retirement plan, then the plan fees and investment performance hold no bearing on their overall outcome. Employees need to take the first step to start contributing to their future and determine what is needed today in order to have a successful retirement.”
Readers interested in benchmarking might want to buy this book: 401k Fiduciary Solutions
Much like what the Wharton study suggests, many professionals see participation rates and savings rates as more useful benchmarks than either fees or performance. That being the case, why don’t we see more discussion of this in the broader media? “Fees and investment performance are typically easier to see,” says Nicole Offerman, Qualified Plan Specialist at Innovative Investment Fiduciaries, LLC, in Cinnaminson, New Jersey. Administrators and recordkeepers have been disclosing investment performances on an ongoing basis and with the new fee disclosures in place, the plan fees are starting to be transparent and more straightforward to plan participants. Many administrators and recordkeepers lack the technology to illustrate the participation metrics listed above to even the plan sponsor, let alone plan participants.”
How do these other benchmarks differ between large and small plans? “The benchmarks themselves are not different between large and small plans,” says Slavin, “but the performance against these benchmarks are. Generally speaking, larger plans tend to have higher participation rates and sponsors often spend more time educating participants to take advantage what can be an important employee benefit.”
Kmak, whose firm looks at the benchmarks discussed here (and then some), offers several insights. Although he’s in agreement that participation is a good metric, he supplied data that suggests the real difference isn’t between large and small firms, but between industries. For example, the industry with the highest participation rate (utilities) ranges generally (25th through 75th percentile) from a 78% to a 92% participation rate. Contrast this to the Accommodation and Food Service industry, which has a similar range from between 12% and 53%. In general, most industries range from between 50% and 85%.
In terms of deferral rates, Kmak warns this is not always an apples-to-apples comparison. He says it “has to be as a percent of salary versus someone using Form 5500 absolute dollar amounts which can be very misleading.” For example, Kmak offers this: “2 people contribute $8k each to their 401k plan. One is a lawyer making $400k per year, the other a blue collar worker making $40k per year. The dollar amounts are the same but the blue collar worker is in a much better position to retire well.” Public Administration has the highest average deferral rates among both HCE and non-HCE workers with the 75th percentile exceeding 10%. Once again, the Accommodation and Food Service industry fairs the worst, with a range of between 1% and 3% for the non-HCE employees and between 2% and 5% for the HCE employees.
This just proves how difficult it is not only to obtain data on these more proper benchmarks, but how to incorporate them into any significant analysis. Perhaps now it’s clear why regulators tend to focus on the measurable, not the meaningful. It also might suggest why 401k plan sponsors, if they really want to look out for the best interests of their employees, can be misled by placing undue emphasis on fees and investment performance.
Yet, for all the statistical maneuverings, there remains one ultimate benchmark that we haven’t mentioned. We’ll reveal that next time in “The One True 401k Benchmark Every Fiduciary Should Measure.”
Interested in learning more about benchmarking and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on benchmarking, including how to create an plan “report card” to better evaluate its effectiveness.