What's Wrong with Asset-based Fees? Pretty Much Everything!

Asset-based fees are the predominant model of the group retirement plan industry.  For this reason, nobody seems to question this arrangement.  Plan sponsors simply say "Everybody has to make money."  The simple response to this assertion is "No they don't!"If there is no value to a service, then the service provider doesn't deserve any money.  This idea should not be debatable.  However, because plan sponsors don't understand what service providers actually do (and don't do), they are in no position to determine the value of the services they are receiving.The very nature of asset-based fees obscures the plan sponsor’s ability to effectively understand, compare, and effectively negotiate them.  Due to the cash flow and time constraints of running a business, most employers prefer to pass on most or all of the fees to the participants and do not have time to sufficiently understand the details of the retirement plans they offer.   As a result, plan sponsors tend not to look at the fees as closely as they would if they were writing a check instead, meaning they become less price sensitive, just as the withholding tax made us less sensitive to the taxes we pay because we no longer write a check.  This lack of price sensitivity becomes even more apparent when the plan sponsor either has little personal money in the plan.  Yet there are some plan sponsors who do not only have the means to write a check, but also prefer to do so. In these instances, plan sponsors suddenly become far more price sensitive and put more thought into whether the services they are receiving are commensurate with the fees they are being charged. However, the large plan service providers generally do not make it known that plan sponsors can write a check (and some do not even allow for writing a check) for all of the fees because these providers know their fees and services would then face far greater scrutiny.From a psychological standpoint, plan sponsors also do not question the value of the services when the fees are based on a percentage of assets because this percentage gives the appearance of a good deal. Getting an entire package of services for only 1% doesn’t sound like much, but with an account balance of $2 million, that comes out to $20,000, which can be quite excessive for plans with few participants and little work to do. And is it fair if another plan has the same number of participants, but has $5 million in assets and therefore allows the provider to take significantly more money out of the participants’ accounts despite the fact that the plan doesn’t require any more work?  Clearly there is reason to question the fairness of this fee structure, yet plan sponsors rarely feel they have the power to negotiate lower fees and do not realize that some providers are willing to offer a flat dollar fee structure.  On the other hand, plan sponsors who do negotiate often feel they have competitive fees after receiving a reduction in the percentage their participants are being charged when in reality, they are just being ripped off a little bit less.  Less excessive fees are still excessive. When put in terms of hard dollars, however, a plan sponsor may be more inclined to scrutinize the fees instead of being so easily satisfied.Providers often argue that their fees are reasonable by providing fee benchmarking studies showing that a client is paying fees that are in line with other companies of comparable size.  These comparisons are misleading because they simply indicate that fees are similar to other companies, but that does not mean other companies’ fees are reasonable either.  They also primarily disclose fees only terms of percentages rather than hard dollar costs and as a result, do not provide a true understanding of whether or not the fees being charged are reasonable in proportion to the level of services provided.Providers may further argue that all plan sponsors need to see is the total cost and that delving into each component has less importance by pointing out that people only care about the total cost when they buy a car.  Unlike a retirement plan however, you aren’t going to buy the wheels and seats separately from another company – you are getting everything from one place.  With retirement plans, while there are some bundled providers who provide a one-stop shop for all investment advisory, record keeping, administration, and custodial services, many plans have multiple companies performing these tasks with different levels of expertise.  Therefore, only by comparing the cost of each service offering for each part of the plan in hard dollars can a plan sponsor obtain meaningful benchmarking information.Another means providers use to keep plan sponsors and participants in the dark is to charge a flat fee for administration directly to the business and decrease this fee as the assets increase so as to make it appear that they are reducing the fees.  The reason they can reduce the fees is because the revenue sharing or percentage-based fee in absolute dollars increases as the account balance increases.  Plan sponsors don’t think much about this arrangement.  All they see is their fees being reduced, and for this reason they think they are being “taken care of.” A second form of deception some providers employ is to have plans set up so participants receive a credit, which gives the appearance of a refund.  This credit is often simply a return of the revenue sharing payment that a record keeper or financial advisor would have received has they decided to earn their compensation through revenue sharing.  Additionally, the providers who actually charge hard dollar fees may take the revenue sharing payment and issue a credit against the fee they are charging which also gives the appearance that the plan sponsor is getting some kind of discount, but this credit simply means the provider is not charging twice. In many cases, the record keeper and financial advisor often charge a percentage of the account instead which is usually either equal to or more than the revenue sharing payment itself.  This credit often creates confusion because plan sponsors believe providers are discounting their fees. In reality, however, the plan sponsor could have simply purchased the same funds (or very similar funds) without the revenue sharing fee in the first place, so the credit is nothing more than an accounting gimmick.  Furthermore, as previously mentioned, both record keepers and financial advisors often reduce the percentage payment as the assets increase, which also gives the plan sponsor the appearance that they are receiving a discount, when in reality their fees are still increasing, just at a decreasing rate.  In fairness to the providers, some of them may not even be trying to trick the plan sponsors, yet the plan sponsors rarely have a full understanding of how the fees are charged.  As a result, when a competitive provider displays honesty by openly charging a flat annual fee, plan sponsors often view this arrangement as more expensive because they believe their current services are “free” or “discounted” since they either don’t see any fees or see they are receiving a credit.The idea of paying down debt also becomes an issue under asset-based fee arrangements.  While this idea may sound counter-intuitive, the last person to ask this question to should be a financial advisor who has an incentive to advise against paying down debt, as an advisor’s compensation is increased as a result of an increase in plan assets.  Another common participant question is how much to save each year.   Financial advisors tend to advise participants to contribute the maximum affordable amount for the same reason they suggest not paying down debt.  However, participants may already be in a comfortable financial position without having to contribute the maximum affordable amount, so financial advisors’ advice can cause needless sacrifices to their current living standards.  Granted, advisors could argue that they need to raise their fees because their professional liability insurance premiums increase as the plan assets increase.  However, the increase in premiums is generally based on each $1 million of coverage, while the advisors’ percentage-based compensation increases with each dollar in plan assets.  And yes, some advisors do decrease their percentage-based fee as the assets increase, but their fees in absolute dollars still ultimately increase as the assets increase.As a whole, the fees service providers charge bear no relationship to the services they offer. Instead, fees for the providers who dominate the industry are based on factors such as average participant account balance and annual plan contributions rather than the amount of time involved.  This pricing model helps these large providers generate more revenue, but they do not necessarily provide higher quality services in return for this additional revenue. As a result, plan sponsors cannot effectively use providers’ pricing as a means to determine the quality of their services, which is extremely important because providers who lack sufficient expertise can make costly mistakes.  To elaborate, some providers of investment advisory, record keeping, and administration services actually possess a greater level of sophistication than other providers in spite of being able to offer services at a lower price, which suggests that the pricing of retirement plan services is completely distorted.  Until pricing models change to more accurately reflect the value of services provided and plan sponsors and participants gain an understanding of the cost of the services they are receiving, the retirement racket will continue.