Center for American Progress on fee disclosure

On April 11, 2014 the Center for American Progress (CAP) released a report “Fixing the Drain on Retirement Savings – How Retirement Fees Are Straining the Middle Class and What We Can Do about Them.”

The report is important for a couple of reasons. First, CAP – “an independent nonpartisan educational institute dedicated to improving the lives of Americans through progressive ideas and action” – is a fairly important voice in the progressive wing of the Democratic Party. Its current chair (and former president), John Podesta, is a senior counselor to President Obama. And second, the policy proposals in this report – e.g., cigarette-label type ‘warnings’ about high fee funds in 401(k) plans – are innovative and may get traction with some policymakers.

Findings

The CAP report begins with what is becoming a basic ‘anti-fee’ talking point:

On average, American workers’ 401(k) plans charge fees of approximately 1 percent of assets managed – which covers fund-specific fees such as the expense ratio, as well as other administrative fees …. Even worse, many workers pay more. In fact, small-business employees typically face significantly higher fees: A 2011 study found that plans with fewer than 100 participants have an average fee of 1.32 percent.

To understand how fees affect an individual, consider, for example, that a worker has a choice of investing in a mutual fund with an expense ratio of 25 basis points – 0.25 percent, which is in line with available, low-cost retirement options – or another with fees of 100 basis points – 1 percent.

This 75 basis point spread between what 401(k) funds ‘actually’ cost and what an ‘available, low-cost option’ would cost is a key data point in this and in other anti-fee literature.

The report then discusses the impact of a 75 basis point drain on returns over different time periods. Much of this discussion is uncontroversial and simply illustrates the power of compound interest:

Assume this worker is 25 years old, earns the median income of $30,502 for workers in her age group, and saves 5 percent of her salary annually in a retirement plan, which in turn is matched by her employer for a 10 percent contribution amount. That seemingly small 0.75 percent difference would cost her almost $100,000 in fees over her lifetime …. In fact, to retire with the same account balance as she would have had with lower fees, that worker would have to work more than three additional years.

This analysis sets up the basic concern CAP wishes to address: the need to get participants and sponsors to understand the significant impact, over time, of seemingly small differences in fees. There are, as CAP sees it, two problems: fees are ‘too high;’ and their impact is not well understood. Thus, “a central challenge is that even when fees are disclosed, the fees themselves can seem very small because the disclosures are not good enough at providing consumers the information they need to make an informed decision.”

Policy proposals

Rather than proposing, e.g., some sort of direct regulation of 401(k) plan fees, CAP is advocating changes in the way fees are disclosed to participants and sponsors. (One is tempted to exclaim: ‘What, again!?’) While the ERISA 408(b)(2) and participant disclosure regulations are “an important step forward,” CAP is recommending better marketing of the low-fee message. In that vein, CAP makes three proposals:

1. A cigarette warning-type label for high fee funds

CAP “imagine[s] a simple ‘Retirement Fund label’ … visible on all literature:”

We assume this label would be required wherever the offending fund is mentioned, e.g., in the description of funds available in the plan and in the quarterly statement. The objective of the label is obvious: scare participants away from certain ‘high fee’ funds. More elaborately, CAP ‘imagines’ four effects:

First, it will help educate investors on a simple, critical metric, leading investors to think more about fees as a part of their investment decision.

Second, it could lead plan sponsors (employers) to switch their offerings to include lower-fee funds as well.

Third, it could lead retirement fund providers to lower their fees to avoid unflattering comparisons given heightened competition and scrutiny.

Fourth, by highlighting such a blatant failing of the current retirement system, it may foster conversations about the broader changes that are needed to ensure that all Americans can have a secure and dignified retirement.

2. Lengthening the time horizon/increasing the account balance with respect to which the impact of fees is shown

CAP believes that, if the effect of compounding were made more explicit, the significance of fees would be better understood by participants and that, as a consequence, participants would make better choices. Current ERISA fee disclosure requirements for investment funds focus on the expense ratio (in effect, a 1-year charge) and require an illustration based on a $1,000 account balance. CAP ‘imagines’ what it calls a 20/20 rule “showing the impact of fees on $20,000 over 20 years.” It believes that the longer period/larger account balance will more vividly illustrate the high fee ‘problem.’

Obviously, looking at fees over a longer time period will show the effect of compounding. If a participant is earning 75 basis points a year less than she would in a ‘similar’ fund, the year-one cost is only 0.75%. The year-20 year cost is more like 15%.

3. Special rollover disclosure

Given the long-term consequence of selecting an IRA provider in connection with a rollover, CAP would require 401(k) plan sponsors and IRA providers to provide a similar 20/20 disclosure to workers “at the point of their separation from employment.” This approach responds to growing concern about the consequences of sub-optimal rollover decisions by participants.

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While these disclosures would generally target participants, as indicated above, CAP also hopes to change sponsor fund choices: when sponsors have to put warning labels on funds and see how costly a 75 basis point spread in fees is, they may change fund menus.

We know that, in connection with the participant fee disclosure regulations, DOL struggled with the issue of how best to communicate fee issues to participants. DOL may find the focus of the CAP report on how to market the ‘high fee’ issue useful. We can ‘imagine’ (to use the rhetoric of the CAP report) DOL adopting CAP proposals 2 and 3. Those proposals are not particularly radical – they more or less tweak current rules, simply changing, for fee disclosure purposes, the size of the account and the time period over which fees are projected. (Although providers, and sponsors, may not be happy with having to, once again, re-program their systems for the new disclosures.)

CAP proposal 1 – the cigarette label – is more problematic. It purports to identify a ‘similar option’ (an investment fund which is similar to the ‘high fee fund’) that has lower fees. The assumption here is that, e.g., a ‘low-cost’ S&P500 index fund is ‘similar’ to a higher cost actively managed large cap equity fund. That is an equivalence that a lot of active managers would contest. All of the citations for this proposition in the CAP report are from the ‘passive’ side of the active vs. passive debate. That debate is by no means settled. It seems unlikely that DOL (with no particular expertise on the issue) would want to inject itself into that debate.

More broadly, a fundamental issue in the debate over 401(k) fund management fees is how you determine whether a given manager’s higher fees are ‘too high’ or are compensation for producing better returns. The CAP report cites (copiously) arguments and data from index-fund advocates and the (widespread) evidence that there are funds that do overcharge for returns that are ‘similar’ to (or, even, worse than) what an index would produce. But, clearly, managers exist who do produce above-market returns and charge extra for doing so. The CAP report does not grapple with this issue: how to distinguish high-priced ‘good’ (e.g., high return) managers from high-priced bad managers.

In our next article we are going to discuss recent work that does address that issue more directly and in more detail.