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The GRABot BAG
by Sherrie E. Grabot, CEO

November 2009
Throwing a Wrench in the Fee Machine

Less is more in these days of the New Frugality. And corporate America certainly isn’t enjoying much public goodwill, especially in the financial services sector. Put the two trends together, and what do you get? A hue and cry about management fees, once more.

The latest event in the ongoing drama regarding fees and fee disclosure involves Fortune 500 #44 – Caterpillar, Inc. (NYSE: CAT). As one of the nation’s most successful heavy-industrial firms, the corporation rather resembles its own product: a huge, implacable machine. A recent legal settlement, however, has stopped the company in its clanking tracks.

Crawling Toward Fee Transparency
As a recent article in Investment News describes, Caterpillar has agreed to pay $16.5 million to settle charges that participants in its 401(k) plans were charged excessive fees. Making matters worse, some of the fees in question were pocketed by a subsidiary of the corporation, set up specifically to manage plan funds.

This case is not recent development – or an isolated one. The suit was filed in 2006, back in the distant, pre-crash past before financial firms became the villains in a national morality play. It was one of more than a dozen lawsuits filed at once by a law firm specializing in personal injury, pharmaceutical, and pension litigation. And they did not act alone; a Forbes article published at the time describes a wave of similar suits directed at large companies such as Boeing, Kraft, and International Paper.

Fees and More Fees
These actions are not identical, of course. As the Investment News piece points out, the Caterpillar settlement is unique because an affiliate of the company was profiting from the fees charged. This pretty clearly violates ERISA’s requirement that plans be run “solely in the interest of participants.” Other cases argue that disclosure of expenses was buried in pages of fine print, or disguised with language such as "Compensation scale: Dep./asset 100/25 standard H." And some claim that management fees and sales commissions, while perhaps not out of line with industry practice, are simply too high to be in employees’ best interest.

Taken together, the suits are probably not a threat to 401(k) as we know it. But they do represent a significant trend toward transparency. And they highlight the fact that as these DC plans have evolved, they’ve come to occupy an awkward middle ground between an employee benefit and a consumer product.

Who Pays Retail?
As part of the settlement, Caterpillar also agreed to stop using retail funds as part of the investment mix. There is some sense to this. After all, a major advantage of employee benefit plans in general is that they offer health coverage and various types of insurance at group rates and with streamlined eligibility. Employees are essentially buying wholesale, and it’s not unreasonable to expect their retirement plans to offer a similar deal, especially given the volume and leverage enjoyed by big-company plans.

On the other hand, one of the core promises of 401(k) is that participants have the freedom to make their own choices. Employees have criticized plans in the past for offering too narrow a range of options. And mutual fund companies have spent vast sums promoting their brands to retail customers. So perhaps it’s not unreasonable to give employees access to brand-name funds?

Never mind that branded funds, much like bottled water compared to tap, don’t necessarily differ from the generic equivalent in any way besides price. And never mind that having too many choices can significantly impair decision-making, as psychologist Barry Schwartz describes in fascinating detail. Powerful market forces are at work, so I don’t expect this one to be settled any time soon.

You Better Shop Around
Speaking of market forces, just what is a reasonable fee, anyway? Part of the problem is that consumers don’t have a sense of what 401(k) investments should cost. It’s relatively easy to shop for a burger or a car based on price. But intangible, highly technical services are much less straightforward. In a world in which Google gives software applications away for free, but your phone company gouges you for every text message over the limit, it’s difficult to know how much is too much.
 
Complicating matters is the fact that while participants may put up most of the money, employers buy the plan itself. Sadly, many are not much better informed: when Plansponsor conducts its annual survey, they no longer ask employers about fees because too many have trouble figuring out what they pay. Whatever those costs might be, employers often still pass them on, while they achieve the benefit of payroll tax savings and employee goodwill. But this only works if the fees are opaque enough that nobody notices.

Taking Notice
People are starting to notice, and not just lawyers. A recent article in USA Today, for example, looks at the issue in some detail. Citing a Hewitt survey, it reports that 58% of plan sponsors passed on administrative fees to their participants in 2007, up from just 33% in 2001. The article also correctly notes that fees for large-company plans are usually reasonable, ranging from 0.4% to 0.9% according to Hewitt. Small firms, however, lack the leverage to negotiate, don’t have access to quality providers, and can wind up paying much more.

Lawmakers have also taken notice. Various bills have been meandering their way through the Congress for quite a while now. Considering that the latest version is the fifth iteration, one can only guess whether it will be legislative action or public awareness that eventually brings some order to the jungle of plan fees. But as I’ve discussed before, fee transparency is ultimately in everyone’s best interest, and it is very likely that change will come.

Shining a Light
In the meantime, there’s BrightScope. Using public Form 5500 data and other sources, this startup gathers the information, crunches the numbers, and assigns single-number scores to the 401(k) plans of more than 4,500 companies. Their calculations include much more than fees. Ratings take into account factors such as investment menu quality and plan design, as well as performance issues like participation rate and average account balance which are of interest mostly to professionals like ourselves.

Their site even analyzes the difference between a given plan and the highest-rated plan in its corporate peer group, expressing the gap in terms of years of work and dollars of savings. This represents a radical step toward simplification and transparency.

Some would say it’s far too radical to rate a complex financial program the same way you would a movie or a book. But in an Internet society in which massive data resources morph seamlessly into “free” information, this kind of user-friendly comparison tool is inevitable. Providers had better start doing what BrightScope claims they’re in business to help with: Improving their offerings to meet the demands of well-informed customers.

~~ Sherrie