401(k) Reform – How to Make Plans More Transparent

On October 27, the Ways and Means Committee Chairman Richard E. Neal (D-MA) and Ranking Member Kevin Brady (R-TX) introduced the Securing a Strong Retirement Act of 2020 to “help a greater number of Americans successfully save for a secure retirement.” In general, I like this bipartisan bill – which builds upon the SECURE Act of 2019. My favorite provision would require 401(k) plans to benchmark the investment returns of Target-Date Funds (TDFs) based on Department of Labor (DOL) standards.

Under current law, 401(k) providers have broad discretion when choosing TDF benchmarks. This discretion can be used to make the returns of underperforming TDFs look good. Setting standardized benchmarks should help poor TDF returns stand out.  While the proposed legislation is a welcome improvement, I think there are more reforms we can pursue.

I love 401(k) reform that makes plans more transparent. 401(k) plans should offer objective value for participants and straightforward fiduciary responsibilities for business owners. Too often, they deliver neither. I think some common sense 401(k) transparency reform can help turn that around. Here are my proposals.

Define a “qualified” 401(k) investment menu

Believe it or not, ERISA imposes few investment-related fiduciary responsibilities on business owners. They boil down to picking – and maintaining - enough “prudent” investments to allow plan participants to diversify their account “so as to minimize the risk of large losses.” Prudent 401(k) investments are simply funds that meet their investment objective for reasonable fees.

The problem? Most 401(k) providers have little – if any – incentive to help business owners to pick prudent investments. In fact, the opposite is true. They can grow their profits by steering business owners towards “imprudent” investments with excessive fees and/or inferior returns – in short, give conflicted investment advice. The worst part? It’s perfectly legal for them to do so.

To help business owners avoid this trap, I'd like to see the government define a Qualified Investment Alternative (QIA) menu (100% my invention) for 401(k) plans. Qualified Default Investment Alternatives (QDIAs) offer business owners a fiduciary safe harbor for “prudent” default investment selection today. I think expanding this safe harbor concept to a QIA menu would boost the investment returns of many 401(k) plan participants.

A QIA menu could be modeled after the Federal government’s Thrift Savings Plan (TSP). The TSP’s menu delivers market returns with index funds and professional investment advice with target-date index funds. If 401(k) fiduciaries want different funds, no problem – they could use QIAs as performance benchmarks. 

Ban “hidden” 401(k) administration fees

401(k) plans are NEVER free. All 401(k) providers charge fees for administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and professional investment advice. These administration fees can either “direct” or “indirect” in nature: 

• Direct fees – these fees can be paid from either 1) plan assets or 2) a corporate bank account. They are highly transparent. Their dollar amount must be explicitly reported in invoices in 408b-2 and 404a-5 fee disclosures, participant statements, and invoices. 
• Indirect fees – these fees are paid from investment returns. They’re often called “hidden fees” because they lack the transparency of direct fees. Their amount can be buried in the fund expense ratios of 408b-2 and 404a-5 disclosures, and not appear at all in participant statements or invoices. The two most common forms are revenue sharing and variable annuity “wrap” fees.

I think indirect 401(k) fees should be BANNED (full stop) for three reasons:

• All 401(k) fees paid from plan assets reduce the investment returns of plan participants dollar-for-dollar. Indirect fees are harder to keep in check than direct fees because they are less transparent.
• Indirect fees are always based on a percentage of assets. That means their amount will grow automatically with assets - making excessive fees more likely.
• 401(k) providers can limit their investment options to funds that pay indirect fees – making many top 401(k) investments unavailable.

Standardize 408b-2 Fee Disclosures

When final 408b-2 regulations were released in 2012, they were a big step forward in improving the transparency of 401(k) provider fees – making it easier for business owners to protect the interests of their 401(k) plan participants and avoid fiduciary liability. However, these rules had a major shortcoming - they did not mandate a standard disclosure format. Many 401(k) providers have taken advantage by burying their administration fees in fund expense ratios and/or multi-page documents.

To fix this shortcoming, 408b-2 reform is necessary. I think a standard one-page summary that totals a 401(k) provider’s administration and investment fees into a single “all-in” fee would do the trick. That way, business owners can quickly learn the full cost of their 401(k) plan – not to mention, compare their 401(k) provider’s fees to competing providers on an apple-to-apples basis.

Reform the Form 5500

Most 401k plans – except certain one person plans – must file a Form 5500 annually. The goal of the Form 5500 is to help the government and other stakeholders perform 401k-related research.

For decades, the Form 5500 has done a poor job at meeting this goal for two reasons:

• Small plan 5500 filers do not report indirect administration fees at all. while the Schedule C that large plans must file does not disclose 100% of them.
• Small plan 5500 filers are not required to report plan investments, while large plan filers report investments on paper attachments that are difficult to data mine.

These 5500 shortcomings harm both 401(k) plan fiduciaries and participants. When 401(k) market information is not readily accessible, it’s more difficult for plan fiduciaries to benchmark their plan fees vs. comparable plans – making excessive 401(k) fees, and fiduciary liability, more likely.

I think Form 5500 reform is needed to make 401(k) plans more comparable. Reform was proposed years ago, but it went nowhere. 

You don’t have to wait for a transparent 401(k) plan!

401(k) plans todays can be a black box of hidden fees and underperforming funds. That’s too bad given their important role in helping Americans save for retirement. I think some basic government reforms can make 401(k) plans much more transparent. 

In the meantime, reform is not necessary to have a 401(k) plan with no “hidden” administration fees and top index funds today – business owners just need to hire the right 401(k) provider.  If they want different investments or more personalized participant support, they just add a fiduciary-grade financial advisor to the mix.