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© Copyright 2000 Rogers Media. The following article first appeared in the September 2000 edition of
BENEFITS CANADA magazine.
Focus on Fees
Fees can erode DC plan members' retirement income. Plan sponsors must carefully evaluate this
criteria when selecting their recordkeeper and investment options.
By Colin Ripsman
Jim and Susan are employees hired by X Co. and Y Co., respectively. Both organizations offer a defined
contribution (DC) pension plan that requires them to contribute 4% of their pay to receive a 4% matching
company contribution. Both individuals invest their entire account balance in a balanced fund option, which
earns an annual return of 8% before fees. The manager under the X Co. plan charges an annual fee of 2.5%,
while the manager of the Y Co. plan charges 1% a year. Both employees are hired at age 25 at a salary of
$40,000, are given the same annual salary increases and retire at age 60.
Even though Susan's salary remained the same as Jim's, as did her company's contributions, she will have
accumulated an additional $180,198 or 24% under the plan when she retires--simply because of lower fees.
This fictitious example (see "Tale of two investors," page 60) illustrates that fees are a critical element
in selecting a recordkeeper and investment options for a DC plan. This is particularly important
considering employees bear a significant portion of the fees.
The fees levied under a DC plan fall into two broad categories--recordkeeping and investment management.
The recordkeeping fee covers the costs of a range of services, including: the safe keeping of assets;
managing transactions (allocating contributions, member investment allocations and payment of benefits);
producing and issuing member statements; and member communication.
The fee for these services is recouped in a number of different ways. A basic annual charge is normally
levied, ranging between $25 and $70 per member each year. In addition, the recordkeeper recoups a portion
of the fee as a percentage of the assets invested. This will normally be in the range of 0.3% to 0.6%, or
30 to 60 basis points. This asset-based fee enables the recordkeeper to receive a greater amount of fees as
the plan assets grow.
Additional fees are recouped by the recordkeeper through the interest rate spread on guaranteed investments
(the difference between the rate of return promised and the rate of return earned by the recordkeeper on
the assets backing the guaranteed funds). This is built into the pricing on the guaranteed funds offered by
the recordkeeper.
If an external trustee or custodian is used, the recordkeeper may charge a separate explicit trust or
custody fee in the range of $1,000 to $5,000. In some cases, the provider will structure the fees to
incorporate an element of recordkeeping costs that vary with plan investment transaction levels.
Investment management fees are paid to the investment manager for each plan investment offered. Under a
bundled arrangement, where the plan sponsor contracts with a recordkeeper to provide all of the
recordkeeping, as well as trust, and custody and investment management services, the recordkeeper
negotiates and levies all of the fees. The recordkeeper then directly compensates the investment manager
based on a prenegotiated rate. Under an unbundled arrangement, the plan sponsor negotiates the investment
management fees and contracts directly with the investment manager for its services.
Investment management fees are charged as a percentage of the assets invested in the fund. The investment
management fees may range from 0.5% to 3% of the assets annually.
The type of investment funds offered can have a huge impact on the investment management fee charged to the
members. For example, mutual funds are retail products targeted to individual investors and, accordingly,
individual investors must bear the cost of preparing prospectuses as well as the marketing expenses
associated with the fund.
Pooled funds, however, are institutional products targeted at corporate investors. Since they are not
marketed to individuals, the investment management fees are often significantly lower.
According to the Globe & Mail's Report on Mutual Funds for the period ending June 30,
2000, the median fee level charged on balanced mutual funds is 2.4%. In contrast, the William M. Mercer
Limited Investment Performance Survey of Canadian Pooled Funds for the period ending June 30, 2000
reports that the median investment management fee on pooled balanced funds based on a fund size of $10
million is 0.49%.
Even after factoring in an asset-based recordkeeping fee of 0.5%, the median pooled fund would attract a
fee of 1.41% lower than the median mutual fund fee level. Over a working lifetime of 35 years, the saving
in fees alone, for a typical plan, would result in an increase in a member's plan accumulations of
approximately 23%.
When selecting an investment manager, most DC plan sponsors focus on investment approach and performance.
While these factors should be carefully evaluated, in many cases the potential impact of fees under a DC
plan may have a greater impact on employee investment returns and accumulations than the actual performance
of the manager.
The following is a list of industry accepted annual value-added expectations, or targets, for investment
managers, before fees and typically over a four-year period. The value-added targets will vary, depending
on the asset class in question.
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Canadian bonds: 0.25% to .5%;
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Canadian equities: 1% to 1.5%;
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U.S. equities: 0.75% to 1.25%;
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International equities: 1.5% to 2%.
Using the mid-points of these ranges for a typical balanced fund (based on the median asset mix as
identified in the William M. Mercer Limited Investment Performance Survey of Canadian Pooled Funds
for the period ending March 31, 2000), this would provide a value-added target expectation of 0.9%. The
potential fee differential between the most and least expensive manager available may exceed this 0.9%
performance expectation.
Looking at the impact of performance in a different light, the above chart illustrates the difference
between first-quartile performers and third-quartile performers (50% of the universe) over different time
periods ending June 30, 2000 (see "Comparing performance," above).
The difference in performance decreases as the time period increases. For example, over a five-year period
the range is 2.9%, but over 10 years this range falls to 1.1%, dropping to 0.7% over 15 years.
Data is not readily available in Canada for periods longer than 15 years, but in other jurisdictions these
annualized differences in performance narrow further over longer periods. Any fee saving negotiated
continues to have the same impact, for as long as it remains in place.
While the manager should not be selected solely on the basis of the fees, it is critical to negotiate a
reasonable fee on behalf of plan members. When choosing between two managers, the plan sponsor should
evaluate its confidence in the ability of the more expensive manager to outperform the second choice by an
amount in excess of the difference in fees over the duration of the mandate.
In the event that members challenge this decision, the company may be called upon to defend the rationale
for this expectation. As the fee differential increases, the likelihood of the more expensive manager
outperforming the less costly one decreases, and the fee distinction will become a larger factor in the
selection process.
Fees cannot be avoided, only re-allocated between parties. Normally, the pricing model will target a
certain average annual fee per member. The recordkeeper can tailor the manner in which this target is
achieved, by increasing the fixed per member administration fee or increasing the asset-related fee.
Generally, the higher the per member fee charged, the higher the pricing will be in the earlier years.
However, since asset growth should greatly exceed growth in membership in most plans, this type of fee
option becomes cheaper over time. Pricing options that allocate more to asset-related fees start out
cheaper when assets are small, but become relatively more costly over time as asset growth exceeds the
growth in membership.
Plan sponsors that allocate a larger portion of the fees to members typically do this by reducing the
explicit per member recordkeeping fee and increasing the asset-related fee built into members' investment
returns. In fact, there are some plans where no fee is charged to the plan sponsor for recordkeeping--all
of the fees are allocated to employees in the form of higher investment management fees.
While this is a valid practice, the plan sponsor should take steps to ensure that the asset-related fee is
reasonable and competitive. In some cases, the asset-related fees can be significantly higher, both
initially and over time, than what a competitive fee structure would yield under a more traditional
cost-sharing arrangement.
As a plan fiduciary, it's important to focus on controlling the DC fees charged to the plan (see "Cost
containment," page 60). By taking simple steps to understand fee arrangements and benchmark fees, employers
can greatly enhance the value of the benefit to members.
Colin Ripsman is a senior investment consultant and head of the DC consulting group at the Toronto office
of William M. Mercer Limited. colin.ripsman@ca.wmmercer.com.
*** ***
Cost containment
Four ways to control DC-related fees.
1. Provide accurate data. The recordkeeper will normally present its quote based on the following pricing
information: expected plan membership; expected annual cash flows; initial asset balances under the plan;
and the ratio of guaranteed funds to market-based investments. An accurate estimate of this pricing data
will help to obtain fair initial pricing and reduce the likelihood of significant future fee increases.
2. Benchmark fees. When selecting a provider, obtain and assess quotes from three or four different
record-keepers, while ensuring the services are compatible. It may also be helpful to select more than one
recordkeeper that can offer the same investment manager, in order to evaluate the asset-related fee levied
on the account.
3. Pay only for the services required. Many recordkeepers bundle services and may offer features that you
don't need, such as group meetings with employees at each location, call centre capabilities or individual
financial counselling. Identify the service elements that you do not require and eliminate the associated
costs.
4. Continually monitor fees. Your plan profile may change over time through an increase in membership, cash
flows or a transfer of assets. These changes may improve the profitability of the plan and justify a
reduction in fees. In addition, pricing in the market may improve. Ensure your present pricing is
competitive.
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