Asset levels continue to peak in defined contribution plans, driving fees tied to asset levels higher in the investment management as well as recordkeeping and administration marketplaces. However, after three straight years of material compression in recordkeeping and administration expenses, the market may have found equilibrium.
Multnomah Group’s 2014 Fee Benchmarking Study has been concluded and fees for recordkeeping and administration experienced little change from 2013 levels. However, Multnomah Group has seen four significant changes in how fees are being structured across the industry that will likely expand in 2015 and beyond.
Plan sponsors are increasingly paying attention to how fees are calculated and how expenses are being allocated to plans. This level of scrutiny, aided significantly by the Department of Labor’s fee disclosure requirements, has expanded four primary market trends.
Across the industry, fees for recordkeeping and administration services continue to be overwhelmingly oriented to asset levels. Either plan sponsors have negotiated with their providers a “revenue requirement” calculated as a percentage of assets, or vendors’ revenues are determined based on revenue sharing paid by the investments available in the plan.
The challenge with both models of asset-based pricing is that investment options often provide disparate levels of revenue sharing. Fund A may provide revenue sharing to the recordkeeping provider of 0.40% as part of its expense ratio, while Fund B may provide no revenue sharing offset to recordkeeping. As a result, participant-specific recordkeeping costs differ dramatically based on asset allocation. An increasing number of plan sponsors and providers have developed solutions to “equalize” revenue sharing amounts. Vendors add additional wrap expenses to investment products that do not generate recordkeeping subsidies and may credit additional earnings to products that pay revenue sharing in excess of the negotiated target.
Below, you can see how a simple three fund investment menu might be structured differently assuming a revenue requirement of 0.20%.
In the example above, a transition to fee equalization does create winners and losers at a participant level. However, after transition all participants share equally in generating the 0.20% revenue requirement. In addition to creating fee equity within the plan, it also alleviates instances where fund changes are dictated by revenue sharing rather than investment merit. For instance, in the above example if Stock Fund A needs to be removed for performance, the available universe of replacements may be bound to other equity products that provide a 0.40% revenue share to the provider. Situations like these can put plan fiduciaries in a difficult position. For a more detailed explanation of fee equalization, please review our white paper Trending Toward Fee Equalization.Per Capita Fee Structures
Investment management may become the last bastion of asset-based pricing. For years, independent consultants have negotiated fixed fee structures with clients acknowledging the reality that the recordkeeping and administration service workload has a low correlation to plan assets.
From January 1, 2009 through September 30, 2014 the S&P 500 Index has delivered a nearly 150% return - a major contributor to the growth in plan assets and the corresponding fee compression among retirement plan service providers. Plan sponsors and vendors looking to more clearly tie revenue to costs are negotiating per capita fee structures where service providers are compensated based on the number of account holding participants in the plan. In many cases, expenses are calculated based on participant count, while revenues are still being generated by revenue sharing paid by the funds in the plan. This seems to be changing as well.
Plan sponsors wishing to remove revenue sharing from the cost discussion entirely are migrating to per capita fee structures with their providers, where all investments are reduced to their lowest cost share class. These true institutional products share no revenue with the recordkeeper. Plan costs are being directly allocated to participant accounts as a quarterly fee.
This approach carries the benefit of being the most transparent method for expenses to be paid, and additionally benefits longer-tenured participants with larger account balances as their per capita fee is lower than fees allocated on a percentage of assets. Conversely, whether a directly allocated $100 annual fee will reduce the likelihood of a new participant enrolling in the plan continues to concern plan sponsors.
Increasing Transaction Fees
The fee compression trends and migration to per capita fees, which reduce the “upside” for recordkeeping service providers, has vendors examining much more closely transaction fees being charged for participant initiated transactions. When provider margins were larger, vendors would waive, or process at a loss, fees for a number of items.
While fees at the plan level have been receiving additional scrutiny, transaction fees not included in the “bundled” cost of service are frequently ignored. Our 2014 fee survey, detailed the following trends.
These fees are generally not material in the scope of the full financial engagement, however, plan sponsors should continue to monitor these expenses to ensure that they are cost recovery items not new revenue levers for your service provider.
Vendor Focus on Cross-Sell Opportunities
Margins for retirement plan service providers are tight and will likely remain thin as fiduciaries fulfill their responsibilities to manage and monitor expenses to their participants. Despite shrinking margins, financial service firms are as eager as ever to write new retirement plan business. Why?
The answer is the additional opportunities to drive high margin revenue when providers maintain a relationship with participants. The revenue opportunities are plentiful.
Recordkeepers with proprietary investments are still very successful at gaining share among the plan’s investment options. Investment management continues as an asset-based, high-margin revenue opportunity. Specifically, target-date funds used as a Qualified Default Investment Alternative (QDIA) can capture a significant share of the contribution flow.
Returns on money market funds have been near, or at, 0% for the last five years. Insurance companies providing recordkeeping services to defined contribution plans have been very successful in using general account fixed annuities as the alternative to money market funds. General account fixed annuities have no stated expense, but generate revenue and profits to the insurance company as they earn a return on the invested assets in excess of the crediting rate they pay investors. General account fixed annuities remain one of the least understood and least transparent investments in defined contribution plans, but can provide significant cash flow to vendors who provide them.
For service providers that are not primarily investment management organizations offering a competitive QDIA solution, we are seeing significant interest in integrating managed account solutions within their product offering. The managed account programs in the marketplace are largely computer generated portfolios of the plan’s underlying fund array that are allocated and rebalanced based on a participants age, risk tolerance, and financial means. The cost of the managed account solution is low, but firms generally receive a percentage of assets from participants who are defaulted into, or opt into, a managed account solution.
Little definitive evidence exists as to whether managed account solutions provide better participant outcomes than a target-date default, but vendor interest in adding managed accounts is very high.
The one market segment that continued to see compression in our fee benchmarking study was for plans with large average account balance (>$100,000). As the baby boom generation ages and begins the transition into retirement, average account balances in retirement plans are on the rise. Among the most attractive plans in our peer group were plans with average account balances >$300,000. In this market segment, service providers are able to write recordkeeping business at cost or even at a loss. Vendors are willing to do this because the greater revenue opportunity is in providing a broad suite of financial services to these participants nearing retirement.
The most successful of the retirement plan providers may achieve rollover conversion rates nearing 50%. For plans with a large number of participants with high average account balances, vendors have the opportunity to identify and build relationships with affluent investors. These participants convert from retirement plan participants to direct clients of the financial services firm where margins are likely to increase with the use of proprietary investments and managed account solutions.
Periodically, the Department of Labor has expressed concerns about how the revenue motive may impact the guidance participants are provided around retirement, but deccumulation revenue remains a holy grail for many financial services juggernauts.
Fee disclosure regulations resulted in substantial fee compression in the marketplace. This trend has created huge opportunities for plan sponsor to define how fees should be paid in the plan, to more equally share the costs among participants. With markets at near all-time highs, and vendors eager to compete for a shrinking volume of proposal opportunities, plan sponsors have significant leverage to define cost, negotiate services, and drive vendor accountability.
Multnomah Group, Inc.
Phone: (888) 559-0159
Fax: (800) 997-3010