Fixing ERISA to Protect Against High Plan Fees

Cash dollars slipping down a drain.The Employees Retirement Income Security Act (ERISA) was created to protect and promote the interests of pension plan participants and their beneficiaries. Unfortunately, ERISA, in its present form, falls far short of such goals. Fortunately, the changes needed to make it meaningful in protecting plan participants and their beneficiaries are relatively easy.

Defined contribution plans have become the predominant form of pension plans for American companies, especially so-called 401(k) plans. 401(k) plans can elect to become so-called Section 404(c) plans by complying with various requirements. If a 401(k) complies with Section 404(c)’s  twenty to twenty-five requirements, then the plan sponsor is not liable for any losses suffered by the plan’s participants and beneficiaries.

Fred Reish, one of the nation’s leading ERISA attorneys, has publicly stated that many plan sponsors mistakenly believe that they have complied with ERISA in general and Section 404(c) in particular. ERISA establishes certain minimum standards for ERISA fiduciaries, including a general duty of acting prudently, which includes the duty to avoid unnecessary costs and the duty to diversify a plan’s investments in order to minimize the risk of large losses. One of the requirements for achieving 404(c) status is that a plan be set up so as to allow plan participants and their beneficiaries to exercise “meaningful control over the assets in their account.”

In my opinion, two of the areas that most plan sponsors and other ERISA fiduciaries fall short are of 404(c)’s “meaningful control”  requirement are the use of investment options with excessively high fees and the failure to provide plan participants with “sufficient information to make informed decisions.” A plan’s failure to comply with these requirements can have serious financial consequences  for plan participants and their beneficiaries.

Actively managed mutual funds have higher annual fees and have been shown to generally under-perform comparable to passively managed, or index funds. Nevertheless, 401(k) plans often limit investment options within the plan to actively managed mutual funds. In some cases, the funds choice of actively managed mutual funds may be due to a plan’s ability to participate in revenue sharing arrangements with a chosen fund.

However, the impact of fund fees on a plan participant’s return cannot be overstated. A Department of Labor study reported that each additional one percent in fees and costs reduces a participant’s end return by approximately seventeen percent over a twenty year period. Given the same scenario over a ten year period, a participant would suffer a nine percent reduction in the end return.

The effective impact of fund fees may be even more significant. Many actively managed mutual funds have chosen to invest in such a way as to closely track the performance of appropriate market indexes, so as not to deviate too far from such indexes and avoid losing clients. The combination of these  “closet” index actively managed funds and their usual higher fees result in effectively higher costs for plan participants.

The effective impact of the combination of “closet” index funds and high fees can be seen by using two metrics that measure such costs. The Active Expense Ratio (AER) was created by Professor Ross Miller. By examining both a fund’s fees and the extent to which a fund tracks an appropriate market index, the AER can provide a more meaningful assessment of the effective cost of a fund’s active management component. Professor Miller’s study found that an actively managed fund’s AER was often at least three to four times higher than its stated expense ratio.

The Active Management Value Ratio™ (AMVR™) is a proprietary measure that I created to perform a simple cost/benefit analysis of a plan’s investment options. To get a more meaningful picture evaluation,  the AMVR™ uses a fund’s incremental cost and incremental benefit in computing a fund’s score. As with the AER, a fund’s AMVR™ often finds that the cost of a fund’s active management component is significantly higher that it’s stated expense ratio.

Next – ERISA’s “meaningful control” and “sufficient information” requirements.

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