There have been several articles in the news recently about how mutual fund expense ratios are continuing to drop for 401(k) plan participants. These were based on a report issued by the Investment Company Institute in August 2015 called “The Economics of Providing 401(k) Plans: Services, Fees, and Expenses, 2014”1 . This ICI report pointed out that expense ratios for participants investing in mutual funds have declined substantially since 2000. It states that in 2000, the average expense ratio for 401(k) plan participants was 77 basis points (bps). In 2014, that figure had dropped to 54 bps for a 30% decline. The report also referenced a joint study conducted by the ICI and Deloitte that assessed the mechanics of the “all in” fee for 401(k) plans 2 . This study incorporated all related fees that go into making up the “all in” fee for a 401(k) plan, such as administrative, recordkeeping and investment fees. In 2013 when the study was done, these “all in” fees ranged from 127 bps at the high end to a low of 37 bps of plan assets.
This discussion around “all in” fees for retirement plans got me to thinking of how much employer sponsored retirement plans have changed in the last 25 years. For most of the 1990’s, Delta Data developed defined contribution software for large employers to administer their retirement plans in-house. Back then, employers were much more paternalistic in their approach to providing retirement benefits for their employees. Many large employers had some form of defined benefit plan, but they also provided what we would call a “profit sharing” plan, or more technically, an IRC 401(a) plan. The plan would often have multiple ways for an employee to accumulate retirement benefits. There was usually an annual profit sharing allocation by the employer, based on a company specific profit sharing formula, and usually allocated to participants based on an employees’ wages.
In many instances, the employer would fund the contribution with employer stock. They also often allowed an employee to contribute after tax money into the plan, referred to as IRC section 401(m) contributions. The employer would often match this similar to an employer 401(k) match you see today. In the mid to late 90’s, we started seeing more and more 401(k) contributions along with matching by the employer , which turned out to be what I believe to be the primary driver that changed the typical retirement plan from the paternalistic, company funded and maintained retirement plan to the outsourced, employee funded retirement plan.
There were a number of key differences in these plans when compared to today’s plans. One big difference involved the valuation, which was not daily but monthly or quarterly. Another big difference involved the investments, which were primarily directed by the employer rather than the participant. You might think that getting a paper statement of your account balance once a month or not being able to select your investment choices would be a terrible thing compared to today’s multitude of investment options and on-line access to your daily valued investments. But don’t be too quick to judge those old plans, as there is another side to this story.
I distinctly remember our clients report on their “all in” costs of administering these plans, and it would usually fall in the 30 to 40 bps range. Furthermore, the employer usually paid for most of the administrative and recordkeeping costs whereas the investment related costs were usually paid out of plan assets, so the actual costs to the plan participants was probably under 30 bps. This low cost structure allowed the investments to grow without being pulled down by excessive fees and allowed significant growth in account balances. I remember participant account balances as being very significant, and it was not uncommon to see individual participant balances exceeding $1 million.
In the mid to late 90’s, 401(k) plans really started to take hold. Mutual fund companies were one of the first to see 401(k) participants, with their systematic payroll contributions, as a great new source of investors for their mutual funds. We started getting calls from our clients saying that they were coming off our software because they were moving to a better, more cost effective means of providing retirement benefits to their employees. The way I remember it, the calls went like this: “We are going to be moving our retirement plan and all the assets to ABC mutual fund, so we will no longer need your DC recordkeeping software. They are going to do the administration and recordkeeping for free, we just have to move the plan assets into their mutual funds”.
Now back in the 90’s, mutual fund expense ratios were still geared toward the retail market, and there were no R shares. The expense ratios in many of these funds could easily run from 100 bps to 150 bps. So the question I was asking myself at the time was, since when is 150 bps considered free? The explanation is that the corporation no longer had any costs, as all the costs for this “free” recordkeeping was now borne by the participants via the expense ratios of the mutual funds they were now investing in.
Well, as with most things in life, the pendulum swings back and forth given enough time. It has taken about 20 years, aided by a number of fee related class-action lawsuits, the DOL’s 408(b)(2) and 404(a)(5) disclosure rules and a more competitive, open architecture environment, but 401(k) plan fees have come down. The other big change in the last 20 years, especially with the larger plans, has been a move to more efficient plan investment vehicles. The clients that ran our defined contribution software in the 90’s would be considered large plans and some would even be considered mega plans. Part of the reason they had such low “all in” costs is that they were able to invest in more efficient investment vehicles due to their size. When they moved to mutual funds, those costs went up, but over the years, these large and mega plans have moved to the more cost efficient investments such as collective investment trusts and separately managed accounts.
The ICI and Deloitte report clearly validates the much lower “all in” costs that the large and mega plans enjoy over the smaller plans. In fact, the “all in” cost of these larger plans are now finally getting back down to what they were in the 90’s, around 37 to 41 bps. But now, participants enjoy on-line access and daily valuation of their investments as well as a wealth of financial planning tools to help them with planning for their retirement. These are benefits participants did not have back in the 90’s.
Just one more personal comment on the industry move from employer administered profit sharing plans to the outsourced daily valued 401(k) plans of today. Our defined contribution software business dropped off so quickly that we had to re-invent ourselves. Fortunately, we were building an interface for our recordkeeping system to the NSCC’s Fund/SERV mutual fund trading service back in 1997. It was in 1997 when the NSCC opened up Fund/SERV to retirement plan recordkeepers and bank trust companies. Prior to 1997, you had to be a broker dealer to utilize Fund/SERV. We were able to sell off what remained of our DC software business and started marketing our NSCC interface as a stand-alone application that would interface with any 401(k) recordkeeping software. So where we once viewed the mutual funds as our downfall, we now support the trading of mutual funds for 401(k) recordkeepers and bank trust companies to the tune of over $1.5 trillion in mutual fund assets. Change can be good.
L. Burton Keller was a principal founder of the company in 1985 and currently focuses on strategic initiatives for the company. Mr. Keller is a former member of the Bank, Trust and Retirement Advisory Committee of the Investment Company Institute. He has served on numerous committees and task force groups with the ICI over the last 17 years including Co-chair of the Dividend Distribution Task Force.