The environment for defined contribution (DC) retirement plans has changed enormously in recent years. First came the mutual fund market timing troubles. Then, partly as a reaction to that and as the need for transparency increased, the Pension Protection Act of 2006 (PPA’06) was passed, altering the rules for vesting, automatic enrollment, participant education, employer stock diversification, required disclosures and more. Now, further changes are on the horizon. Many initiatives are gaining traction, including some from the Government Accountability Office (GAO), the Securities & Exchange Commission (SEC) and the Department of Labor (DOL).¹ In addition, legislation has been introduced regarding the disclosure of fees and investment options² and a litany of class action lawsuits could soon be probing how plan sponsors have been handling their fiduciary responsibilities.

As a result, it is clearer than ever that DC plan sponsors can no longer afford to take a laissez-faire approach toward plan management. The plan fiduciaries (typically, either the company itself or a designated committee) must ensure they are doing everything they can to act exclusively in the interest of the plan’s participants. Although fiduciary standards have always been high, greater scrutiny of how those charged with overseeing the plan exercise their responsibility to accomplish all of their fiduciary obligations is expected. These duties include:

• Making sure that participants understand the benefits of participation and eliminating any barriers,
• Understanding all administrative and investment fees paid from plan assets, including those charged directly to participant accounts, and making sure they are at the lowest reasonable levels,
• Making additional plan disclosures in regulatory filings and to plan participants,
• Using appropriate due diligence in the selection of vendors and investment vehicles and in the implementation of contractual service arrangements, and
• Keeping an eye on the DC marketplace to ensure the plan provides appropriate benefits and services at a reasonable cost to the participants.

To stay in control, DC plan sponsors should adopt an ongoing due diligence process that starts by conducting a fiduciary and operational assessment of the DC plan to determine and document its current state. By focusing on the plan’s investments, administration, compliance and communications, the sponsors will be able to determine where any weaknesses lie and take steps to correct them. It is important to conduct this DC plan assessment under the supervision of legal counsel so that technical legal issues can be evaluated properly and, if any compliance problems arise, the analysis can be conducted under the confidentiality of attorney-client communications to the extent available.

Step One: Assess the Plan’s Investments

To assess the DC plan’s investments, plan sponsors need to:

• Review the plan’s overall mission. Its goals and objectives must meet the needs of the participants. One thing that is often overlooked is how the plan relates to other retirement programs that are available to participants. Is this a primary or supplemental program? The answer to that question will affect the plan’s overall mission. As one plan participant once noted: “My defined benefit plan will pay the bills, my DC plan will pay for the boat.” Look at the plan’s investment line-up and related fee structure. It should be tailored to address the range of investment and financial sophistication of the eligible employee group and the demographics of both the active and terminated employee participants.

• Conduct a strategy analysis. The goal here is to find out, “where we are today.” What rationale did the plan’s fiduciaries use to make investment option selections? Check to see if there are unneeded duplications of investment strategies and/or any asset classes that are not represented or investment objectives that are not being met by the funds in the program.

  Plan sponsors need to verify the investment style and measure the risk characteristics of each investment option as well as review its returns and expenses. They should also analyze the extent to which the plan’s investment policies have been carried out and how they have affected the actual results.

  Many DC plans suffer from a duplication of investment strategies — they have more than one fund in the same asset classes or with the same investment goals. This is an easy trap to fall into, given the density of most mutual fund prospectuses and the fact that some funds may do a better job than others at keeping within their stated objectives. For example, how many plan sponsors realize that many large-cap equity funds allow investments in high-yield bonds? A careful analysis may reveal that several of a plan’s funds are, in fact, offering participants similar if not the same investment strategies. This could lead to a lack of diversification among the plan’s offerings.

  One factor that deserves close scrutiny is whether the right participants are selecting the right funds. For example, if 80 percent of the individuals between the ages of 20 and 29 are invested in the plan’s stable value fund, there is a problem that needs to be addressed.

• Check the plan’s investment policy statement. Does it provide a framework for investment decision-making, form a basis for effective communication with the investment managers and clearly define the responsibilities and authority of each party involved in the investment program? It also should offer a documented fiduciary audit trail, identify each party’s responsibilities and indicate the broad array of fund offerings and how they are selected. Finally, the policy statement should detail how fund options should be monitored on an ongoing basis.

  A plan’s investment policy statement is usually written by an independent investment consultant who incorporates the plan’s mission along with specific types of investments. It is reviewed by the sponsor’s counsel and, after modifications if desired, endorsed by the plan’s fiduciaries, making it a working document whose goal it is to keep everybody on the same page.

• Review the plan’s mutual fund offerings and how they are selected. Plan sponsors should use a “best in class” approach, independently reviewing and identifying the best funds available in each asset class. This will provide the performance the plan’s participants need and make it easy for them to allocate their investments.

  First, analyze each fund’s key quantitative factors: Return performance relative to appropriate benchmarks; risk metrics on both an absolute and a benchmark-relative basis; a rolling period analysis; and fees. Then look at the key qualitative factors: the portfolio manager’s tenure; the stability of the organization; the depth of investment resources; and the fund’s physical location. It is interesting to note that according to various studies, these qualitative assessments are often a better predictor of investment results than is past performance.

• Monitor the plan’s ongoing performance. Plan fiduciaries should do this at least annually, preferably quarterly. First, those responsible for the plan need a good understanding of the overall economic and general market conditions. Take, for instance, the current volatility of large-cap value funds caused by the problems with certain financial stocks. It would be impossible to evaluate a plan’s value managers without understanding what is happening in this part of the market.

  Plan fiduciaries then need to compare each potential investment option’s return and risk metrics to appropriate market indices and universes of similarly managed vehicles. Look at the fund’s historical performance with a focus on consistency. Make sure the fund’s management has not undergone major changes. Analyze the extent to which investment policies have been carried out and how they have affected the actual results.

• Check the fees. Plan sponsors need to look carefully at their vendor contracts and service agreements to make sure they are getting what they pay for. The first step is to ensure that they are receiving full disclosure of all fee arrangements. Many plan managers mistakenly believe that their DC plan vendor “charges nothing for recordkeeping and administration.” In fact, high expense ratios could be covering the administration costs, but plan managers need to understand that and how it could affect participants’ returns. The figure below lists the various fees, charges and expenses that these vendors can charge and provides a brief description of each one.

   

  

  Source: Segal Advisors, Inc.

  
  

  As an example of just how much these charges can vary, sub-transfer agency fees can range from 10 basis points to as high as 50 basis points. Moreover, while 12b-1 fees may be appropriate for smaller mutual funds that do not have a marketing or distribution group, many larger funds still charge them only as another source of revenue.

  Finally, plan sponsors need to renegotiate fees periodically as the plan matures. One factor that often gets overlooked is that many mutual funds peg their charges to the amount of assets in the plan. As the plan grows, so do the fees. But if the size of the plan doubles, does the fund manager really deserve double the fee? That is negotiable. The lesson here is that expense ratios that may have made sense two or three years ago may not be acceptable in the current environment.

Step Two: Assess the Plan’s Administration

Quality assurance is important. Plan fiduciaries need to make sure that the various services, systems and tools that are being used or provided by the vendor are functioning appropriately. Of course no system is perfect and vendors intervene manually every day, but any manual intervention must be done correctly and each plan’s provisions must be met meticulously.

Plan fiduciaries also need to review their vendor’s security and disaster-recovery program. In particular, be sure backup records are stored in a safe and secure location that’s far removed from the main records. Also look at the delicate issue of how well the vendor processes and monitors loans and hardship withdrawals. Another key administration issue is the responsiveness, tenure and talent of the vendor’s staff. The people in these positions will change from time to time. Plan fiduciaries need to be sure their replacements are well trained and understand the nuances of their particular plan.

Fiduciaries should also ask these questions:

• How do the participants view the plan’s ongoing administration?
• How efficient is the data interface between the vendor and the plan sponsor’s payroll department?
• Is there a clear delegation of fiduciary responsibility for providing administrative and investment functions for the plan?
• Does the plan sponsor receive proactive advice from sources other than the DC plan provider about the impact of new legislation and current marketplace administrative offerings?
• Is there complete documentation of how the various vendors were selected along with supporting implementation documentation?

Step Three: Assess the Plan’s Compliance with All Applicable Laws

Given all the changes that have resulted from PPA’06 and other sources, sponsors need to be sure that pending legislation and regulations are monitored and plan operations and terms are updated as necessary. It is very important that plans with §401(k) arrangements pass applicable nondiscrimination tests and meet the detailed rules governing how much employees can defer and how possible excess amounts are corrected. Sponsors will also want to review for potential prohibited transactions and check the plan’s fidelity bonding and fiduciary insurance. In addition, all required notices must be reviewed and distributed.

Plan documentation is of great consequence from a compliance standpoint. The plan document, the summary plan description (SPD) and minutes of all meetings of the plan’s board or committees all need to be carefully maintained.

Plan limits must be monitored. In one case, a plan sponsor thought that its payroll department was monitoring the §402(g) annual individual deferral limit while payroll thought the vendor was doing it. Corrective distributions had to be made.

Also important are benefit claims and appeals procedures and processes. These must be set up so that all claims and appeals are handled similarly and properly.

Finally, in addition to assuring that participant communications are clear and effective, the laws and regulations increasingly emphasize “transparency,” adding a myriad of detailed reporting and disclosure requirements that have to be satisfied faithfully.

Step Four: Assess the Plan’s Communications

Every DC plan assessment should include a review of the plan’s communications, from enrollment materials through distributions processing. Participant benefit statements and educational materials need to be complete, compliant, consistent, timely and responsive to the needs of the participants.

One key test takes into account industry practices and standards. For example, sponsors may want to consider how the plan’s communications, message and delivery compare with those of similar plans in the marketplace.

In Summary

Conducted correctly, this fiduciary and operational assessment will identify any deficiencies associated with the ongoing operations of the plan and, if necessary, formulate the basis for corrective actions. In addition, it will provide a platform for review of all processes and procedures with a focus on optimization of the DC plan as a retirement vehicle for the participants and as a workforce management tool for the plan sponsor. A well-formulated and documented ongoing fiduciary process is an essential component in support of these objectives.

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¹ In brief:

• The GAO issued a report in November 2006 which concluded that fee disclosure requirements under the Employee Retirement Income Security Act (ERISA) do not provide participants with enough information to make informed decisions about investments. It recommended legislation requiring plan sponsors to provide such information and disclosure of revenue-sharing arrangements between service providers and other vendors. In October 2007, GAO testimony before the U.S. Senate’s Special Committee on Aging reviewed how fee information should be disclosed to participants. In addition, the DOL recently announced safe-harbor relief for plan sponsors for default investments under ERISA §404(c).
• The SEC is investigating possible conflicts of interest among investment advisors to pension funds. They are looking into fee disclosure to plan sponsors, investment consultants who receive payments from investment managers and middle-man fees in brokerage arrangements.
• The DOL has proposed changes in annual reporting and additional information about and disclosure of fees. They also have two projects in place: The Employee Contributions Project would review plan sponsors and their plans regarding timely deposits of contributions into the plan. The Consultant/Advisor Project is similar to the SEC’s conflict of interest investigation.

² H.R. 3185, the §401(k) Fair Disclosure for Retirement Security Act of 2007 (July 2007), would require: detailed fee disclosures from service providers to plan sponsors and from plans to participants; additional specific requirements on the selection of investment options by §404(c) plan sponsors; an annual statement of fees assessed during the plan year; an investment offering of at least one lower-cost balanced index fund; and annual DOL review of compliance with representative sampling. H.R. 3765, the Defined Contribution Plan Fee Transparency Act of 2007 (October 2007), would impose tax penalties on DC plan administrators who fail to provide prescribed information on plan fees and expenses to participants and on plan service providers who fail to provide this information to DC plan.

About the authors:

Richard DeFrehn is a vice president and administration consulting practice leader in the Princeton office of Sibson Consulting. He has more than 30 years in benefits consulting, administration and actuarial technical experience. He can be reached at 609.520.2762 or rdefrehn@sibson.com

Gino Reina, CFA, is a vice president and consultant in the New York Office of Segal Advisors, Inc. His primary responsibilities and expertise include providing advice on asset allocation and investment policy, assisting clients in the selection of investment managers and evaluating investment performance. He can be reached at 212.251.5910 or greina@segaladvisors.com

Copyright © 2008 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved.