The Path Ahead
When she speaks at conferences about the current 401(k) fee scrutiny, attorney Nancy Ross can see the worried look of advisers in the audience.
“Their heads are swirling, because they are very concerned,” says Ross, a Chicago-based partner at law firm McDermott Will & Emery, which represents Northrop Grumman Corp. in its two current 401(k) fee lawsuits. She can hardly blame them.
“I think that advisers are going to take the biggest hit of all of us,” she says. “They are so under the spotlight right now.”
The U.S. Department of Labor (DoL) is reviewing rules for disclosure of 401(k) administrative and investment fees and, in June, the Securities and Exchange Commission (SEC) held a roundtable to discuss 12b-1 fees. In July, Representative George Miller (D-California) introduced legislation that would increase the disclosures about 401(k) fees that are required to be provided to participants. The U.S. Government Accountability Office also released a report urging that participants get more fee information.
The fate of the 401(k) fee lawsuits filed recently against big companies like Northrop Grumman remains unclear, although, in June, the U.S. District Court for the Western District of Wisconsin dismissed a lawsuit against Deere & Co. and Fidelity Investments. In a rejection of key arguments advanced in many of the fee lawsuits across the country, U.S. District Judge John Shabaz contended that Deere, Fidelity Management Trust Company, and Fidelity Management and Research Company (Fidelity is trustee and recordkeeper for Deere’s 401(k) plan) had followed current laws and regulations regarding retirement plan fee disclosures.
The current focus on plan fees by the courts, the DoL, and Congress is “causing a bit of hysteria throughout the country by employers,” Ross says. “The fallout will be that most companies will be taking a good, hard look at their practices. What we do not have any guidance on—and this is the quagmire—is what needs to be done.”
As fiduciaries, plan sponsors have a duty to keep a grasp of expenses paid and services provided. “A lot of plan sponsors have taken their eyes off that ball, or they never had their eyes on that ball,” says Rocco DiBruno, a managing director at Santa Fe, New Mexico-based Thornburg Investment Management. “It is important for service providers and advisers to help plan sponsors to know what they do not know.” Advisers can help a lot, too.
Sponsors and participants need more clarity about fees, believes Don Phillips, a Chicago-based Managing Director at Morningstar, Inc. “There has been a lot of shuffling around of dollars. Fees have gone from being very upfront to being camouflaged and put behind the expense ratio,” he says.
However, the current fee structures have been in place for more than 20 years, and fee clarity has its upsides and downsides. “For some advisers, it is going to be a threat and, for some, it is going to be an opportunity,” DiBruno says. “Some have a drive-by mentality, and others are much more engaged. Advisers today need to be proactive, rather than being defensive and reactive. You can see the sea change, and those who get ahead of the curve and start making the information available now—rather than be forced to do it later—will be in a better position.”
So what should advisers do before the new ground rules get settled? “It is important that they take action now, because we are in uncharted waters,” Ross says. “[The spotlight] also opens up a terrific marketing opportunity for advisers: Those who are secure for the future will be those who make their fees the most transparent. There is no pulling the wool over the eyes of plan sponsors anymore—there is no avoiding this discussion.”
For those in proactive mode, “This is one of the biggest opportunities we have ever seen in this business,” says Wade Walker, an Indianapolis-based financial adviser at Merrill Lynch. “Sponsors are going to be more cost-conscious than ever. It is going to be a great time for new business over the next three to five years.”
A Challenge for Advisers
So far, Ross says, there have been only a couple of cases in this area against advisers, including the Deere lawsuit. The four Deere workers who brought the suit charged that, not only were their plan fees excessive, but also Deere and Fidelity failed to disclose to participants information about a revenue-sharing setup between the two. However, in his ruling, Shabaz asserted that no law or rule compelled Deere or Fidelity to disclose more fee information than they already were disclosing, that participants had to bear some of the responsibility for the Deere plan fees because of their investment choices, and that the safe harbor provisions would, in fact, apply in the case. The judge also contended that the plaintiffs were asking the court to go beyond the applicable laws and rules. Although this ruling was seen as a win by the retirement industry, there are still many cases pending that could have various outcomes, and more continue to be filed.
Why have so few revenue-sharing lawsuits named advisers up to now? Probably, in part, because the suits so far have targeted very large companies that tend to utilize advisers less and plaintiffs may believe that the plan sponsors and providers have deeper pockets. The difficulty in proving fiduciary status with respect to such activity also explains a lot, Ross says. “My own view is that they are not appealing defendants because there is nothing illegal per se in revenue-sharing, so the cases have to focus on inadequate disclosures, and the duty to disclose business practices of an adviser to plan participants is too attenuated to support a claim,” she says. “Put that together with the difficulty in showing direct harm to participants caused by revenue-sharing, and plaintiffs have a very uphill battle.”
However, the possibility of future suits naming advisers “is another shoe that is potentially waiting to drop,” says Donald Stone, President of Chicago-based Plan Sponsor Advisors, LLC, “I doubt it will be a fee-based consultant but there are situations where a broker has directed business to a particular place, and that could get ugly.”
With the spotlight on fees, Ross says, some employer clients want an audit of their fee-disclosure practices. “Traditionally, employers have had a good sense of expense ratios. What they have only been somewhat aware of is any behind-the-scenes revenue-sharing,” she says. “We are seeing companies going back to their service providers, changing their RFPs, or engaging for the first time in an RFP. They are asking, “Are there 12b-1 fees? Are there recaptures?””
“Now, clients will understand fully what is being delivered for the compensation that is being paid,” says Nick Della Vedova, President of Aliso Viejo, California-based 401(k) Advisors, Inc. ’[Some advisers] are going to have a hard time justifying the fees they are receiving for the services they are providing,” says Tom Pittman, Chief Marketing Officer at Heathrow, Florida-based The Newport Group.
In reality, mutual fund fee structures have been developed to make it easy for the mutual fund industry to get paid. “The compensation is built in: The way that a mutual fund gets paid, and the adviser gets paid through the mutual fund, is all designed to make it very easy, and for no one to ask any questions,” Stone says. “There is no correlation between the fee charged and the service provided. They may be getting a lot of service for the money paid, and they may be getting very little service.
“[As a result of the opaque fee structure,] participants have no earthly idea what fees are paid—and they may be very unhappy when they find out that adviser A is getting a lot of money,” Stone says. “Once this information is disclosed, you are going to have to justify your fee. It is going to drive people out of the business who have written up plans, then nobody ever sees them.”
Advisers can expect to be challenged by sponsors with raised service expectations, Walker says. “They may be paying all this money, and all an adviser is doing is showing up for the investment reviews,” he says. “I believe this will be the writing on the wall for the adviser who is not truly dedicated to this business.”
Winning Business in a Fee-Conscious Era
Advisers who are proactive about fee transparency may have a big advantage in winning new business and maintaining existing clients.
Stone sees a couple of areas where advisers can play a vital role in helping sponsors understand whether fees are reasonable. One, they can provide the employer with data on what other, similar plans pay. “Getting a number as to what actually is being charged is the first step,” he says. “The conundrum for plan sponsors has always been: “If I know what the number is, what do I relate that to?””
Second, Stone says, an adviser can take the lead on getting answers about providers’ actual costs. “Ask them, “What does it actually cost you to administer this plan? Break it down for us,”” he says. “You may not be able to peel the onion completely, but you can get it down by a number of layers.”
In addition, advisers can break down their own fees very clearly. Advisers would be smart not only to reveal the fee amounts to sponsors and participants, but also to spell out clearly what they get because of those payments. “Advisers ought to be looking at the role they have played, and asking themselves whether they have any exposure—and, if they do, what they can do to mitigate that exposure,” Stone says.
With sponsors, start the disclosure before they even become clients, and keep it ongoing. “An adviser’s marketing materials should, front and center, disclose the fee arrangements and explain why the adviser is working with these particular providers,” Ross says. “Advisers need to show that plan participants will not be harmed by revenue-sharing.”
Thornburg Investment Management currently is working on a fee-disclosure template and a service-value proposition template that advisers can use with sponsors. It will give them a way, among other things, to disclose 12b-1 fees and to communicate the value received, DiBruno says. “Why does it still make sense to pay a 12b-1?” he asks. “I look at that more as an adviser’s service fee. There could be a lot of time spent by the adviser servicing the plan: meetings with the plan sponsor, and enrollment meetings and education for participants.’ With participants, keep the fee explanation simple to help them understand the reasonableness of fees. DiBruno recommends breaking down the overall basis-point charge into three main components: the investment-management fee paid to the mutual fund company, the adviser services/12b-1 fee, and the recordkeeping cost.
The only meaningful disclosure for investors would break it down into the dollars-and-cents impact on them, says Richard Phillips, a San Francisco-based Senior Partner at law firm Kirkpatrick & Lockhart Preston Gates Ellis LLP. In other words: What does it cost if I buy an A share and pay a sales load today, compared to paying for it this way? “Detail is the enemy of effective disclosure,” he says. “More words would be meaningless to investors.”
The bottom line? Remember that there is nothing inherently illegal—at least for now—about revenue-sharing and commission recapture, according to attorney Ross. “The problem is that it needs to be disclosed,” she says. “Advisers need to be sure they can document and explain why they are utilizing the other providers they are dealing with. When it gets into trouble for advisers is when they do a “You scratch my back and I’ll scratch yours” deal with a provider, and they are not making the best choices. Cronyism without explanation is going to be over.”
SIDEBAR:
Taking a Snapshot of Clients’ Profitability
The new era of fee clarity also offers opportunities for advisers. For those who, in the past, have not had a firm grip on the profitability of their 401(k) plan clients, it means they can get a much better handle on that.
Registered investment advisers (RIAs) bill fees on a client-by-client basis, so the adviser and sponsor both know how much money is involved, says Jeb Graham, a retirement plan consultant at CAPTRUST Financial Advisors in Tampa, Florida. “In the commission model, it has to be run through a broker/dealer. You, generally speaking, do not get any type of itemized report breaking down mutual fund commissions at the individual plan level,’ he says. “If you are a broker, you want to figure out what is 401(k) business and what is not, and that is hard to do.” These advisers know what they should get paid, he says—the challenge comes in figuring out whether they actually get paid that amount. Broker/dealers apparently can help to varying degrees.
Some advisers already analyze sponsor profitability, and they offer a sense of how to do it. Wade Walker and his team at Merrill Lynch use a spreadsheet to figure out the profitability of existing clients to the team. “We take a snapshot every month, and we break that out by investment and by provider,” he says. “Then we look at our calculations versus the team’s actual compensation to determine accuracy.”
Of course, profitability is an equation with two sides, and Walker’s team also does a lot of legwork with prospective clients to get clarity on both sides of the ledger. They collect information upfront about factors such as how many locations an employer has, so they can figure out the cost of doing educational meetings. “As a team, we determine the profitability of a plan prior to ever taking it on,” Walker says. (For those that do not meet their profitability criteria, they bow out of trying to get the business.)
Why do a lot of extra work on a sponsor that may go with another adviser? “The last thing that any adviser wants to do is make a commitment to service an account, and realize a year later that you are losing money on that account,’ Walker says. “You may have wasted a lot of time getting the plan through the conversion, and we all know that the first year of service is the hardest.”
Morgan Stanley’s Aaron Hagwood looks at several factors when taking on a new 401(k) client: The size of the plan, number of participants, and number of locations all have an impact on the service model that The Hagwood Tomoda Group outlines to the client. Based on the above factors, The Hagwood Tomoda Group has one of four service models it could put in place.
Which model a plan falls into determines activities such as the frequency of investment reviews with sponsors and educational meetings with employees the advisers conduct each year. “We are very much upfront with our clients as to what they can expect from the Group,” says Hagwood, a Wellesley, Massachusetts-based Vice President at Morgan Stanley. “We explain our service model and clearly state, “This is what you will get from us.””
Before bringing on a new client, Hagwood and his colleagues also provide full disclosure to their client as to how they will be compensated. “Our compensation is derived from 12-b-1 fees,” explains Hagwood. “We are pretty upfront about how we get paid, and nobody at this point has had a problem with it. It is the financial advisers who do not provide the support or ongoing education who might not be able to justify the 12b-1 fee compensation.”