Private Sector: Retirement plan minefields

Tuesday, November 09, 2004
Post-Gazette
By Neil H. Alexander

If you're a 401(k) plan fiduciary, make sure you understand the extra fees you're paying -- before it's too late!

Historically, the retirement plan industry has not offered small businesses many options when establishing a defined contribution retirement plan. Over time, this void was filled by an insurance product called the "Group Annuity Retirement Plan."

Although this type of retirement plan has served the small business market well for many years, the availability of cheaper alternatives is now rendering these options obsolete at best, and in some cases even risky. Fiduciaries of 401(k) plan should take heed -- lawsuits from plan participants to recover unnecessary fees and expenses may become a reality for many unsuspecting company officials.

The Employee Retirement Income Security Act of 1974, known as ERISA, is the federal law that governs how company officials, or "plan fiduciaries" as they are called under ERISA, manage and administer corporate retirement plans.

ERISA imposes numerous duties on 401(k) plan fiduciaries, one of which is to control the fees and expenses that are charged to plan participants. If plan fiduciaries violate this duty, they may be held personally liable for the losses that plan participants suffer as a result.

Under ERISA, plan fiduciaries include anyone who exercises discretionary authority over a plan or a plan's assets, such as a company's board of directors, the corporate officers, the plan trustees, members of the investment committee -- even midlevel human resources managers.

Most 401(k) plans are offered through mutual fund companies that charge plan participants an "internal expense ratio" based on the amount of assets invested in a particular investment option.

For example, a plan participant that invests $10,000 in a large cap mutual fund with an internal expense ratio of 1.1 percent would incur an annual fee of $110.

Because retirement plan providers earn their revenue according to the amount of assets invested in the retirement plan, they have historically not catered to the small business market and plans with fewer assets.

As a result, life insurance companies developed the Group Annuity Retirement Plan model.

Although the design of these plans allowed insurance companies to offer retirement plans to smaller companies, the layers of infrastructure required to operate the plans led to corresponding layers of fees and expenses.

At first, these extra fees were acceptable because there were no other reasonable alternatives for a small company that wanted to offer its employees a retirement plan. Now, however, the retirement plan industry has become more competitive, and the cost of providing traditional retirement plan products to all segments of the marketplace has decreased, thereby making it more difficult for insurance companies to defend the fees they charge for Group Annuity Retirement Plans.

In order to satisfy their fiduciary duty to control fees and expenses inside their 401(k) plans, plan fiduciaries that use Group Annuity Retirement Plans should assess whether these extra fees are reasonable in light of the many alternatives currently available. This, however, won't be easy.

For example, participants in Group Annuity Retirement Plans technically purchase "units" in an underlying pooled investment product, rather than "shares" in a particular stock or mutual fund. As such, group annuities are not considered to be "securities" and are not subject to the uniform disclosure rules set forth by the National Association of Securities Dealers. Because of this, most group annuity contracts are extremely difficult to understand and even more difficult to compare to other retirement plan products.

The two primary fees that group annuities charge are called the "contract charge" and the "separate account fee." The "contract charge" (also called an "administrative fee") can vary by company, and is often open-ended.

It represents the cost of operating the group annuity, such as the insurance agent's commissions.

The "separate account fee" represents the expense of the life insurance company to maintain the underlying group annuity investment portfolio and to account for each retirement plan's share of the pooled account.

Together these two expenses can add as much as an additional 2 percent on top of the internal expense ratio charged by traditional retirement plans. Because plan participants pay these extra fees, they directly curtail the participants' ability to achieve their ultimate retirement objectives, thereby potentially placing the plan fiduciaries at risk.

Group Annuity Retirement Plans are difficult to decipher, and plan fiduciaries have much to consider when evaluating investment vehicles for their employees. Plan fiduciaries should have their current group annuity contract examined by a competent professional to ensure it is still appropriate for their retirement plan.

This due diligence process will not only help establish that the plan fiduciaries have met their fiduciary responsibilities under ERISA, but also will help to improve their 401(k) plan for the benefit of their employees -- a worthy end in itself.

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