The Stark Reality of DC Plans

No matter what their motivation, plan sponsors must be aware that their responsibility does not end once a DC plan is put in place. It is a certainty that, if sponsors do not meet their responsibilities on a voluntary basis, the regulators will move from “guidelines” to “rules and requirements” which will entail greater costs to plan members.

What are these responsibilities? Simply put, any sponsor of a DC plan must carefully think through and monitor the elements of the plan that are mandated by the sponsor and provide the members with the tools to help members make informed decisions where members are given options.

For example, most sponsors will offer the members some investment options. This usually means that members are able to direct their contributions to one or more of five funds. This presumably lets the sponsor off the hook so far as investment returns are concerned. The sponsor monitors the results of each of the funds and is prepared to replace any fund that underperforms.

There are two aspects of this decision that must be considered. First is the sponsor’s responsibility. Is the sponsor avoiding responsibility by offering five funds rather than just one fund? I don’t think so. Surely the sponsor retains responsibility as soon as the offering is restricted to fewer than the universe of funds. Also, the sponsor must now take responsibility for educating plan members so that they are able to make informed choices. If, indeed, 85% of members make choices that result in investment returns of less than would have been attained in the balanced fund on offer (See A paternalistic approach. for more), maybe the sponsor’s investment education is not very effective. This is why underutilization may be good.

Then there is the cost aspect. Offering a range of funds costs more than offering only one fund. The added administration costs (tracking several funds and movement from fund to fund as well as the cost of the education) are readily quantifiable. The costs, in terms of lost investment income, differ from member to member and are not so easily determined.

A basic, bare-bones DC plan will require an investment manager to invest the money, a custodian to hold the money and recordkeeping/administration. In Ontario, if plan assets exceed $3 million, the fund will require an annual audit. Most sponsors will want to engage a professional to advice on governance to ensure that the sponsor is fulfilling this obligation.

Some costs are a function of the size of the fund, other costs are a function of the number of records being kept (in other words, the number of members) and some costs are pretty well flat per plan. Unfortunately, it seems that far too much of the cost is expressed as a percentage of the fund.

In the comparison below, I have looked at two plans. One plan has 100 members and $6 million in assets and the other one has 500 members and $50 million in assets. I have allowed for investment/custodial costs, recordkeeping costs, member statements and an audit. In the bare-bones approach (called the Base Plan in the table below) I have allowed for a special fee for an outside advisor’s help with governance. All of these were converted to a percentage of the fund.

In the following table, I have assumed that the fund will earn 6% per annum after base expenses and expenses in excess of the base will reduce the actual return to something less than 6% per annum. For the smaller plan I allowed for an excess expense charge of 0.71% per annum and for the larger plan I allowed for an excess of 0.75% per annum. I allowed for contributions (employer and employee) of 10% of pay with the contributions increasing by 3% each year. Three percent per annum assumes salaries will increase by 2% for inflation and 1% for productivity.

Given the similarity of the offerings of most investment/custodian providers, a change to a new provider sometimes appears to serve only the advisor who is promoting the change. While the costs of the change are seldom highlighted, we know that there is usually a direct charge in the range of 0.5% to 1% of transferred assets. The illustration assumes that there was one such change and that the commission paid was 0.75%. The starting fund for each person was based on the fund balances of members at the various ages from an actual plan.

These figures should be an eyeopener for anyone involved in, or responsible for, plan governance. One might wonder how plan members (including those who have a say in the “services” being provided) would react if they were made aware of what it costs to get options, frequent statements and internet access? A few basis points here and there does not sound like much but over time it will equal serious money.

Fred Thompson is an actuary and has practiced in the pension area since 1963 from within the insurance industry and as an independent consultant. He is the senior partner at Thompson Tomev Actuarial, an actuarial consulting firm based in Toronto.