W. Scott Simon
Among the wonderful memories of my childhood were the times when my little brother and I got to cuddle in bed with our father on Saturday mornings. We would run in to our parents’ bedroom and, after Mom got up to go fix us all a big breakfast, take turns crawling into bed to be enveloped by Dad’s strong embrace. Although he wasn’t a large man, his forearms were Popeye-like from the hard physical work he did growing up on his parents’ farm.
One morning, when it was my turn to crawl into bed with my father, Mom yelled something from the kitchen which none of us could hear. My dad told my brother to go and see what she wanted. He did so and came trotting back with his report. “What,” my father asked, “did your mother say?” My brother’s reply, long since immortalized in family lore: “She didn’t say anything, she just talked.”
The same sentiment struck me as I read through the 31-page manifesto issued by the U.S. Department of Labor in the July 23, 2008, Federal Register titled “Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Proposed Rule.” More than half of this document is taken up by explanations of the 39(!) tables provided, which detail the costs ($0.7594 billion) and benefits ($6.8756 billion) of implementing the proposed rule. The proposed rule (§2550.404a-5) itself takes up less than three pages.
Although the estimated benefits of implementing the rule clearly outweigh the estimated costs, about 66.5% ($4.5666 billion) of those benefits consist of reduced participant search time while only 33.5% ($2.3089 billion) of the benefits consist of an actual reduction in fees paid by participants. It remains to be seen how plan participants will be able to transform all those search-time benefits into more dollar benefits for their plan accounts.
According to an accompanying fact sheet released by the Department of Labor, “[a]n estimated 65 million participants are covered by approximately 437,000 participant-directed individual account plans (including 401(k) plans) . . While workers in these plans are responsible for making retirement savings decisions, there is concern as to whether they have access to basic plan and investment information in a format useful to making informed decisions about management of their own retirement accounts . . The proposed regulation requires that uniform, basic disclosures be given to all participants and beneficiaries who direct the investment of assets in their individual accounts, and that investment related information be presented in a format that makes comparisons [among a plan’s investment options] easy.” The rule, as proposed, is to take effect for plan years beginning on or after Jan. 1, 2009.
Basic Plan and Investment Information
Advisors should understand that the essential problem with the Department of Labor’s proposed rule is that it requires only basic (as opposed to complete) disclosure of investment and other costs impacting a plan participant’s account balance. What’s needed under this rule, instead, is full disclosure of the total economic impact that both “visible” costs (e.g., the annual expense ratio of mutual funds) and “invisible” costs (e.g., the bid-ask spreads of mutual funds) have on the accounts of participants in retirement plans. The reality of all costs, not just some, is what participants need to have disclosed to them in order to make informed decisions about their plan accounts.
The rule, for example, fails to require that plan sponsors disclose to plan participants the trading costs associated with the investment options offered by a plan. Yet the Department of Labor is well aware that the trading costs of, say, a mutual fund can be significant. After stating that a “review of the relevant literature suggests that plan participants on average pay fees that are higher than necessary by 11.3 basis points per year[,]” the Department of Labor makes clear its understanding in the accompanying footnote that “[t]his estimate of excess expense does not take into account less visible expenses such as mutual funds’ internal transaction costs (including explicit brokerage commissions and implicit trading costs), which are sometimes [often, more like] larger than funds’ expense ratios.” (My emphasis.)
What the Department of Labor has done in its proposed rule is to require disclosure of a mutual fund’s annual expense ratio with no requirement to disclose, as noted, the fund’s internal transaction costs – which are often larger than the expense ratio. In addition, even though the Department of Labor states, as noted, that studies suggest that participants on average pay an unnecessary extra 11.3 basis points in fees per year, it then proceeds to cite five studies concluding that this assumption is conservative. There can be no doubt that disclosing fee information completely so that markets can be free to function efficiently to lower fees through increased competition will result in cost savings to plan participants of many multiples of 11.3 basis points.
Uniform, Basic Disclosures in a Format Useful to Making Informed Decisions
The Department of Labor’s fact sheet states that “[t]he proposal also requires that investment-related information, including fees and expenses, must be disclosed in a chart or similar format that will help participants easily compare the plan’s investment options.”
No one could argue that uniform comparative disclosures aren’t an excellent idea. But any such disclosures should be complete, not partial. What I mean by “complete” here is not a laundry list of the costs associated with each discrete service provided to a plan such as the $13,095.08 paid to the law firm of Dewey, Cheater & Howe (c’mon, you legal beagles, I’m just joking around here in the waning days of summer). Rather, disclosure of costs would be complete in the sense that all broad categories of costs (e.g., investment-related, including trading costs, and administrative/operational-related, etc.) are set forth clearly with a more detailed breakdown of costs available to plan participants upon their individual request.
The problem with the Department of Labor’s suggested format is that it’s woefully inadequate in actually helping participants get a handle on determining the costs of the investment options offered by their retirement plans. Advisors should consider the case of a plan participant viewing the chart provided by the Department of Labor in the appendix of its proposed rule. The participant sees a format in which a confusing array of percentages and dollars is presented without any real context. This consists of little more than taking partial (not complete) information and repackaging it for delivery to plan participants in the form of a disclosure — at added cost to them — which is not much better than that found in any prospectus.
In addition, plan participants are directed to sources other than the chart in front of them such as Web sites that might have more current information about an investment option’s performance, and fees and expenses. If this is the best that the Department of Labor can do, why didn’t it simply take data from prospectuses and save all of us a lot of time, money and trees? Advisors should understand that the Department of Labor’s proposed rule is simply out of touch with the reality of meaningful disclosure of costs.
Is There Something That They’re Not Telling Us Children?
A basic question, yet unanswered, is why it’s so bloody difficult to get a complete, understandable, and cogent disclosure of the total economic impact that both “visible” costs and “invisible” costs have on the accounts of participants in retirement plans. (A formula for such disclosure was contained in H.R. 3185 – the 401(k) Fair Disclosure for Retirement Security Act of 2007 — but the current Congress failed to pass that bill.)
We’ve all heard, of course, the stock answer to the preceding question which goes something like this: “I’m afraid that disclosure of all these big, old mean costs would just confuse the children; we must protect them from such dangers and keep it simple.” In this context, “simple” is just another word for “conceal and keep ’em confused.” As I noted in last month’s column, this kind of answer makes sense when it comes from entities that profit directly from hiding their high-cost products.
But many of the interest groups that say they represent both companies that offer retirement plans and those participating in them also oppose transparent disclosure of the total economic impact that all costs have on the accounts of participants in retirement plans. As I’ve asked before, why would these interest groups ever want to make it at all difficult for their plan sponsor membership to be able to precisely identify the nature and amount of the costs associated with the 401(k) plans they offer to their employees so that they can disclose them fully to such employees?
Making such disclosures easy and transparent would be of immense help to employee-participants — the end-all of ERISA — and allow the plan sponsor membership in these interest groups to prudently carry out the duties that basic ERISA law prescribes for them. Except for those providing high cost investment options to retirement plans, this helps all concerned: plan participants and plan sponsors, as well as the interest groups that say they represent, both participants and sponsors.
Transparent disclosure of costs will allow markets to function freely and efficiently to lower fees through enhanced competition. The resultant costs savings could very well result in even greater contributions to retirement plans as participants gain greater confidence in the integrity of the cost structures they face. This not only could keep contributions flowing to retirement plans but might even increase them dramatically. It’s backward of the interest groups in question to think that maintaining cost opacity will keep the new contribution taps running and that full disclosure of costs will shut them off. In fact, it would be quite the opposite; such groups may therefore want to reverse their thinking, get on board, and truly support necessary cost disclosure reforms.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.