Defined contribution (DC) plan sponsors are subject to many risks, including vendor-management risk, financial risk, administration and compliance risk, plan design risk and reputational risk, according to the authors of a Sibson Perspectives article.
Defined contribution plans use many vendors, including recordkeepers, investment managers, banks and legal counsel. The authors of “Mitigating Risk in DC Retirement Plans: The Time to Act Is Now” say plan sponsors need to thoroughly vet new vendors and develop a process to monitor all vendors on an ongoing basis.
One thing the authors suggest is a rigorous administrative audit of the recordkeeper every three years. This should include a careful review of the vendors’ annual SSAE 16 reports, trustee and custodial reports, ratings agency reports and analysis of actual plan administration compared with the requirements contained in the plan document.
Rick Reed, vice president and defined contribution practice leader with Sibson Consulting in Boston, who co-authored the article with Pirie McIndoe, Sibson vice president and defined contribution practice director, tells PLANADVISER this administrative audit is different from a request for information (RFI) or a request for proposals (RFP). With an RFP, a plan sponsor is taking its plan to market to see if it should hire a new vendor, but with an administrative audit, the plan sponsor is looking to see that all parties involved in plan administration are communicating well with each other.
For example, Reed notes, a plan sponsor’s human resources (HR) and payroll departments may not be communicating well about the definition of compensation to be used for plan contributions or nondiscrimination testing purposes. HR may be communicating to employees and other departments that compensation as defined by the plan is one thing, while payroll may have a different compensation coded in its system. If this incorrect data is passed to the plan’s recordkeeper, the plan will have compliance issues.
“Many plans must perform an audit with their annual Form 5500 filing, but that’s not enough,” Reed says. “That audit only reconciles plan assets, but an administrative audit makes sure there is data integrity and the plan is being administered according to the plan document.”
The Perspectives article points out that improper administration of a defined contribution plan can drive up costs. Higher costs from inadequate retirement readiness and/or Internal Revenue Service (IRS) or Department of Labor (DOL) penalties represent preventable financial burdens. Moreover, as recent litigation has demonstrated, retirement plan fees that are too high, that are collected inequitably or that are not transparent enough can result in significant legal fees and settlement costs.
To reduce financial risks, the article suggests that plan sponsors take four steps:
- Set up a custom charter to guide the retirement committee in the administration and oversight of the plan and ensure ongoing compliance and improved fiduciary governance;
- Review all fees and benchmark them on an ongoing basis to ensure the plan and its participants pay reasonable fees for the services provided;
- Recognize that plan fees should be allocated equitably among the participants; and
- Document policies and procedures to ensure accurate ongoing administration of the plan.
On the point of fees being allocated equitably among plan participants, Reed explains that, traditionally, fees have been paid by plan participants through investments. He adds that a stock fund has a higher fee than a bond fund, and an active equity fund typically has larger investment expense than a passive or index equity fund. Some investment expense goes back to the plan’s recordkeeper to offset administrative costs—referred to as revenue sharing. If one participant has assets in an index fund, that participant is not picking up as much of the recordkeeping expense as someone who is in an actively managed equity fund; it can be interpreted as an inequitable allocation of expenses, Reed observes. “An equitable allocation would be to strip out all revenue sharing and keep it clean by saying, for example, that everyone pays 35 bps [basis points] for expenses—taking variable costs by fund and saying everyone should pay the same amount,” he says.
Administration and Compliance Risk
Defined contribution plan sponsors do not always follow all the provisions of their plan document and investment policy statement (IPS), according to the Sibson Perspectives article. Many plans become noncompliant when they make impermissible loans or hardship distributions, exclude eligible employees, fail to replace investment options in accordance with the IPS or use the incorrect definition of compensation.
The article gives the example of a large technology firm vice president who was surprised to discover the company’s plan had several violations for delayed loan repayments and for allowing multiple loans—even though the plan had been amended to allow only one outstanding loan at a time. The correction process took more than half a year to complete and cost more than $60,000 after legal fees. Unfortunately, these errors were not discovered during the plan’s routine annual audit.
Initiating the start of payments on time in accordance with the recordkeeper’s loan amortization schedule would have avoided the delayed loan repayments. The recordkeeper had allowed multiple loans because it had never received a copy of the signed amendment from the plan sponsor that limited loans—a simple but costly mistake.
Reed says a plan sponsor should check at least annually to make sure all provisions of the plan document are being administered correctly. This may be a difficult goal, but it is also important for proving adequate monitoring of processes. “Because the plan document governs administration, if there is a discrepancy, the plan sponsor will have a compliance issue with the DOL,” he warns.
Plan Design Risk
A major risk for defined contribution plans is not meeting the goals of the plan for employees and plan sponsors. The Sibson article notes that if an organization’s DC plan fails to meet its goals, employees may not have sufficient retirement assets and, as a result, may delay retirement. In addition to having a direct negative impact on employees, this can hurt the organization when indirect ancillary costs—such as retention, recruitment and health care—rise. An unsuccessful plan also makes it difficult for the organization to hire and develop talent.
Retirement readiness of participants is the pinnacle of plan success, Reed says. He suggests plan sponsors use both qualitative and quantitative measures of success. “Qualitative measures include determining whether the plan is meeting the goals of participants and the plan sponsor, whether there are strong employee communications resulting in strong employee knowledge, whether there is strong plan governance in place and whether employees are engaged,” Reed explains.
Quantitative measures include participation rate, average deferral rate, reasonableness of fees, and proper asset allocation by employees. “Plan sponsors need numbers and want to be able to compare numbers, but they need to drill down more,” Reed contends.
Proper plan governance and administration, and making sure the plan is successful, can help to manage a plan sponsor’s reputational risk. Failing to manage all the other risks can lead to negative publicity when a plan is cited by the IRS or DOL or is sued by its participants for breach of fiduciary duties. The Sibson article points out that polishing a reputation after a problem has occurred takes time, effort and resources that are better deployed elsewhere.
“It would be nice to have a hierarchy of risks to manage, to be able to say one is more important than the other, but they are so interrelated,” Reed says. “If a plan has a compliance issue, there is a financial risk; a plan design issue can lead to a compliance risk. One is not more important than the other.”
He adds that if a plan sponsor implements best practices and uses the right experts to help in plan administration and compliance, it can address all DC plan risks at the same time.
The Sibson’s Perspectives article can be read here.