The first DC plans were introduced in the US in 1978-1980 but became popular in 1994 when “safe harbor” legislation, ERISA Section 404(c), was introduced. In Canada, the number of DC plans has also increased as awareness of the perceived economic and competitive advantages increased.  In 2008 approximately 23% of pension plans were DC plans. Sponsors are anxious to extricate themselves from DB plans because they are more costly, represent a potential financial risk, are heavily regulated and are expensive to administer.

Each member has an account in a DC plan to fund their  own unique pension liabity i.e. their personal mini-DB plan. Often, this reality is not understood or is conveniently overlooked or ignored by most sponsors and DC service providers.

In almost all cases DC members do not appreciate the subtly or understand the difficult and complex task of managing and funding their pension liability. Retirement planning and education is presented as an exercise in managing (maximizing) returns rather than the difficult task of funding a pension liability. A benchmark indicating the funded status of each member’s account is also often not provided or understood by members.

A 2007 study in the US concluded that DB plans are less likely to generate very low retirement wealth than a DC plan and also noted that the impact of timing and the type investments used in a DC plan were difficult to assess. A study in the US by Friedburg & Owyan (2002) concluded that DC plan member retirement age increased by two years and that elderly DC plan members were likely to outlive their DC pension assets. The documented and well known problems faced by many experienced administrators and investment professionals in managing DB plans point to the challenges faced by the average unsophisticated DC member. It is therefore hard to understand why governments in Canada and the US are encouraging DC plans as the pension program of choice for individuals given these hurdles.

DC plans can also inhibit members from successfully achieving an equivalent level income due to a long list of problems, including:

a) Members do not understand investment risks and the impact of volatility on returns.

b) Members are not aware of the impact of time and the concept of normally distributed returns with respect to funding.

c) Members focus on achieving high returns vs. adequate consistent returns.

d) Members do not take advantage of other tax assisted savings programs e.g. RRSPs, TFSAs which can boost retirement income.

e) Sponsor contributions in most cases do not adequately compensate members for the investment risk.

f) The risk sharing regarding time and investment timing available in a DB plan is not available in a DC plan.

g) Investment losses in a MMP cannot be made up from additional contributions and tax deductions as is the case in a DB plan.

h) DC members pay high fees from their plan assets which significantly reduces investment asset accumulation before and after retirement.

i) It is difficult to make up for investment losses in the draw down stage of a retirement program because of interest and equity premium risk i.e. timing.

j) Longevity risk is borne entirely by the DC member.

k) Having to sell units of fixed income investments to create a monthly income after retirement increases the member’s exposure to interest rate and duration risk.

l) Investments by pooled (mutual) funds are limited (prospectuses) as to the types of investments that can be used. DB funds can invest in higher yielding alternative /diversifying investments.

m) Most DC plans do not include duration matching products e.g. long bond funds to minimize duration risk.

n) Purchasing an annuity to create a retirement income is an option but dependent upon a sufficient amount of savings and a favorable interest rate environment.

To recover investment loses or increase retirement income MMP members, unfortunately, must take on greater investment risk.

DC plans have only been available in the US since 1974: they have not stood the test of time in either the US or Canada. Given the added limitations and investment hurdles presented  to DC plan members why is it assumed an individual will be successful in managing a funding their personal “DB” plan?

The reliance being placed on DC type plans by governments and employers to generate adequate retirement incomes is perplexing. Perhaps this is just another example of grasping for a “silver bullet” solution to a complex problem. The question remains – are DC plans a new evolving frontier or, fatally flawed?

There are a number of issues that have been overlooked and these may undermine the objectives of the proposed legislation. Before it is enacted, these should be considered. In this blog post, I discuss the major, unintended consequences of the PRPP legislation for Canada.

Unintended Consequences

Section 3 of the proposed legislation states the legislation will provide a framework for a plan accessible to “employees and self employed persons.” Employers already offering a DC or RRSP as a pension program may also participate in the PRPP and transfer an existing DC or RRSP to a PRPP  (i.e., the proposed legislation does not preclude an employer from transferring an existing Capital Accumulation Plan into a PRPP).

Under Section 22 the financial institution becomes the administrator and a trustee of the plan hence the sponsors’ current administrative and fiduciary role responsibilities will be transferred to a financial institution. The transfer of the administrative role and fiduciary role provides a significant legal, financial and competitive advantage: employers are relieved of the onerous and risky administrative, communication, education and fiduciary responsibilities to their employees.

From a corporate governance perspective, an employer would be remiss if it did not transfer its DC or RRSP pension programs to a PRPP to relieve owners and shareholders of the potential legal and financial risk associated with defined benefit or CAPs. Employers will also achieve cost savings given the administrative portion of the fees paid to the PRPP administrator will now be paid by the employee. This combination of factors represents a huge economic incentive for an employer to move their current pension programs to a PRPP.

Is this the real objective of PRPPs?

The inevitable switch to PRPP by employers will result in a significant change in the Canadian pension environment which should be brought to the public’s attention for before enacting the legislation.

“Low-cost” Retirement Savings

The government releases and financial industry lobbying emphasize that PRPPs will provide a low-cost retirement savings opportunity for PRPP members. Other than citing volume of investments, however there is little indication how this will be done or reason to believe it will be achievable.  Many large CAP sponsors have already negotiated fees that are significantly lower than those available to individuals using “retail” RRSPs but this appears to have been ignored.

A close look at the management fees charged in CAPs also reveals that the majority of fees paid by DC and sponsored RRSP members go to the  record-keeper (usually a financial institution) and to financial advisors: fees paid to the actual investment fund managers used in the pension programs generally do not make up the bulk “management fees” paid by members.  In addition, a significant portion of the investment fund management fee actually goes to the record-keeper. Achieving significant fee reductions in a PRPP therefore will not likely come from negotiating lower investment management fees as implied by the government and financial institutions.

Will financial institutions in fact significantly reduce the administration portion of the management fee paid by PRPP members to get fees down?

Section 22 of the proposed legislation states that the administrator  “must administer the PRPP and assets as a trustee for the members.”  What are implications of this?

The administrative, legal and fiduciary roles and responsibilities of the employer will be transferred to the financial instruction(s). The role of a trustee is already considered to be onerous: financial institutions and custodians are very reluctant to take on a trustee role for DB plans because of the inherent fiduciary and financial risks. If they do assume the role of a trustee it comes at a price. The responsibility and administration costs in a PRPP for providing communication, education, and decision-making tools will become a cost of the financial institutions(s). Since there will be several financial institutions providing PRPPs it is difficult to imagine they will individually be able to achieve the economies of scale needed to significantly reduce their administrative costs.

It is not a given that PRPPs will result in significantly lower fees for their members.

Conflict of Interest

Under section 22 and 23 of the proposed legislation, the administrator must act prudently and offer a diversity of investments to PRPP members. Many financial institutions have proprietary investment funds as part of their retail retirement program. These funds are often used in their asset allocation and/or target date products. These products are not necessarily the lowest cost or best performing nor do they necessarily provide optimal diversification. The risk of a financial institution using and promoting its proprietary funds is already acknowledged in the pension industry and will likely become a bigger issue with PRPPs.

To mitigate this area of potential conflict of interest the financial institutions should only be allowed to offer low-cost passive investments in a PRPP.

There are already a number of tax-assisted vehicles similar to the proposed PRPPs (i.e., DC plans, RRSPs, TFSAs available through financial institutions). Perhaps the lack of retirement savings for many Canadians is a shortage of discretionary income rather than a lack of tax-assisted retirement savings opportunities. A Segregated National Annuity Program (SNAP) that invests in federal, provincial and high quality corporate bonds may be more economically sound and a less complicated and less risky approach to providing Canadians with the type of savings approach they need.

A “ready shoot aim” approach often leads to serious and unintended consequences. The federal and provincial governments should take some time, step back and consider some of the potential unintended consequences of implementing the proposed PRPP legislation.

For many years the Canadian pension community has suggested that “safe harbor” legislation, similar to ERISA in the US, is needed in Canada. ERISA-type protection will encourage more employers to offer CAP pension programs in Canada. ERISA safe harbor legislation is prescriptive in nature and outlines nine requirements that must be met in to achieve a safe harbor. The wording of the nine requirements is general in nature and subject to interpretation, hence open to being legally challenged. In the US, the question remains whether the US “safe harbor” legislation really has been effective in reducing litigation.

The Alberta and B.C. Joint Expert Panel on Pension Standards (JEPPS) also considered but shied away from prescriptive ERISA-style safe harbour legislation. JEPPS recommends that a more principles-based approach be used, relying on a “pension judgment rule” to offer protection to sponsors and trustees, similar to the “business judgment rule” approach that protects corporate directors. JEPPS reasons that this will encourage plan sponsors and administrators to follow prudent governance processes and procedures–the emphasis is on due diligence and good governance. JEPPS however recognizes that some areas should be addressed in legislation i.e., a prescriptive approach is appropriate.

Parliament passed Bill C 47 in January 2011 which amended Section 8 of the Federal Pension Benefits Standards Act by adding Subsections 4.3 and 4.4. This change may also be adopted by the provinces for provincially registered pension plans.

Subsection 4.3 states “if a pension plan permits a member … to make investment choices the administrator must offer investment options of varying degrees of risk and expected return that would allow a reasonable and prudent person to create a portfolio of investments that is well adapted to their retirement needs.”

Subsection 4.4 states “if an administrator offers investment options in accordance with subsection (4.3) and the regulations, that administrator is deemed to comply with the subsection”.

The wording in Section 4.3 “investment options of varying degrees of risk and expected return that would allow a reasonable and prudent person to create a portfolio of investments that is well adapted to their retirement needs” is open to interpretation and legal challenge however it is in keeping with the desire of Canadian pension regulators and JEPPS to have “principles-” vs. “rules-” based legislation.

The amendments to the PBSA Section 8, while not as prescriptive as the safe harbor provisions in the US, do provide a higher degree of safety for Canadian CAP sponsors. The importance of having a strong governance framework and actively using it to manage a pension program is one of the expectations of Canadian pension regulators (see CAPSA consultation paper of Nov 30, 2009 “The Prudence Standard and the Roles of Plan Sponsor and Plan Administrator in Pension funding and Investment”). The amendment to the PBSA Section 8 is in keeping with the pension industry’s and regulators wish for more principle based pension legislation.

Has anything really changed? The answer is yes, in the sense that the underlying principle of a strong governance framework and processes which will assist in making prudent decisions, and which has always existed, is clearly stated in pension legislation.

As a CAP sponsor do you have the necessary strong governance framework in place i.e., a Charter, Terms of Reference, a Statement of Investment Policies and Procedures and a Statement of Investment Beliefs? Equally important – do you have the expertise and a reporting system that highlights issues before they become problems? If the answer is yes then the safe harbor amendments work in your favor.

Many of these issues are overlooked by sponsors while CAP members often underestimate or ignore the significant impact of fees on the accumulation of retirement savings.

CAP sponsors should be aware of the actual amount of fees members are paying to each service provider part of assessing whether or not fees charged are reasonable.

Disclosing the actual fees CAP members pay to each type of service provider on quarterly account statements would be a step in the right direction. It might also encourage members to get more involved in their CAP plan and make greater use of the record keeper and advisor services.

However, there are other broader issues that are also worth considering when looking at the fee structure for a plan or when converting from a DB plan to a DC one.

Fiduciary Responsibility – The Question of Equity

In its consultation paper of November 30, 2009, CAPSA outlines prudence standards and the role of the administrator. Two of the administrator’s basic obligations are to act prudently and treat all beneficiaries fairly, in an even-handed manner. An administrator must also always act in the best interests of plan beneficiaries. Therefore, sponsors and administrators should consider the following with respect to their CAP structures:

• Is it appropriate that all members (with investments where fees are applied) pay for services they may not utilize — e.g. advisor or record keeper fees?
• Is it equitable that members who only invest in GIs or other similar products, where fees are not assessed, pay nothing for the advisor and record keeping services?
• If a sponsor uses the record keeper or advisor to assist in administering the plan, is it appropriate that members essentially pay these administrative costs cost as opposed to the sponsor?
• If balanced funds and/or life cycle funds are provided by the record keeper does the record keeper use also use their own “other” funds in the portfolio and do these funds provide the best fit in terms of risk and return versus cost. Rather, is there any conflict of interest with respect to performance and fees? What level of fee disclosure is appropriate in this type of situation?
• Have all significant direct and indirect fees and costs paid by members been disclosed?
• What does the plan document say about who pays the fees and costs of the CAP?

Fee Issues – DB to DC Conversions

Three recent Canadian court cases (Halliburton, St. Mary’s Cement and Tolko) highlight the importance of disclosing all pertinent facts to DB plan members being offered the opportunity convert to a DC plan. While each of these cases is unique they clearly indicate the importance of clear and concise communication of key information such as conversion formulae, costs and risks. When converting from a DB to a DC plan, there are also some disclosure issues to consider regarding fees paid by members. Questions to ask include:

• Have the members been made aware of the fact that they will be paying the fund manager, record keeper, advisor fees and fund manager administration costs which they would not otherwise pay in the DB plan?
• Have members been provided with an estimate of the total fees and costs they will pay in the DC plan over their working career?
• Have the  fees and costs been explained to the members and factored into the DB to DC conversion discount rate?
• Are the members aware that they may be paying for all or a portion of the sponsors governance costs (i.e., Are the members aware that they may be paying for the services of an advisor whether they use the services or not)?
• Have members been informed that some CAP members may pay minimal or no direct fees or costs for record keeper and advisor services if invested primarily in a guaranteed investment?
• Has the impact of fees on asset accumulation been clearly and simply explained to the members?
• Is the communication to potential DC plan members about fees and costs clear, concise and understandable to less financially sophisticated members?

Conclusion

The issue of CAP fees is complex and has a significant impact on CAP member’s retirement savings.

Sponsors must therefore be diligent in overseeing the costs imposed on plan members. The breakdown of the amounts actually paid to each service provider is a key starting point in assessing the reasonableness of the fees and performance of the service providers.

This is the  fourth installment in my five-part series on fees and performance in defined contribution (DC) plans. In this post I discuss CAP advisor fees and performance. Many smaller plan sponsors use an advisor (an agent or broker of record) to assist their CAP members without understanding what to consider in evaluating performance. Sponsors also need to ensure that the advisor is doing only what has been authorized.

Advisors provide four  basic areas of service:  member retirement planning, assisting with financial education,  investment advice and sponsor governance assistance. Retirement planning support is provided by the record keeper in the form of information and tools that help members in understanding investment concepts, identifying their risk tolerance and selecting an appropriate asset mix. However, sponsors recognize that some members simply don’t have the time and prefer to use an advisor to ensure they have considered all the elements of retirement planning.

Are they offering advice?

Advisors however may also go a step further and provide advice in addition to asset mix recommendations such as which investment option to use and when. Investment advice may benefit some members but results in  additional potential legal and financial risks for the sponsor.  In some cases the sponsor may also rely on the advisor to assist in governance and selecting investment options or provide reporting to assistance  in administering the plan, all of which should also  be considered in the evaluation.

Section 3.4 of the CAP Guidelines recommends that sponsors, in choosing or referring members to an investment advisor should ensure the advisor has an appropriate level of knowledge, expertise and should be independent of any other service providers. Section 6.2 of the CAP Guidelines also recommends that sponsors clearly establish the criteria used in selecting the advisor and periodically use it as information in reviewing an advisor’s performance.

In some cases sponsors are not even aware that the advisor is providing investment advice — a risk from a governance and fiduciary perspective. While offering investment advice may appear to be a good idea, plan sponsors tend to shy away from it because of the added fiduciary responsibilities and legal risks.

The objective in monitoring and assessing the advisor’s performance is important for a number of reasons and should be done formally and on a regular basis to ensure all (and only) the services agreed to are being satisfactorily delivered and at a reasonable cost.

Advisor Fees

The fees for the advisor’s services are applied to all investment options (excluding Guaranteed Investments (GIs) and daily interest investment options) as a part of total composite paid members. Advisor fees of 0.3% to 0.9%, depending on the size of the plan, are not uncommon and often represent a substantial portion of the total cost paid by the members. Members with investments of $100,000 -$400,000 may pay $300 -$3,600 annually for advisory service over their working life.

The advisor fees are paid regardless of whether or not a member uses the advisory service. The amount the advisor receives also automatically increases annually as the amount of the member’s investments increase through contributions, earnings or increases in the market value. The advisor may also earn fees from a group benefit plan if applicable.

Members who only or  primarily invest in GIs or daily interest accounts but make use of the advisor services are getting these services at little or no cost. Conversely members invested in equity and fixed income-type otions may not use the services of the advisor but pay the cost.

Performance

Evaluating an advisor’s service performance can be a difficult qualitative exercise because information on member usage and the type of service provided is often limited or doesn’t exist. Direct feedback from members, the administrator or surveys can be useful in assessing performance but may be costly and difficult to interpret. Assessing the quality of actual investment advice is also a challenging task, which will require specific information and member feedback.

In some cases the advisor fees are not disclosed separately and neither the sponsor nor member is aware of the actual annual cost.

Therefore a good starting point in evaluating advisor performance is to request the amount of fees the advisor actually receives each year and obtain information on the type and quality of services provided to the members. In other words, the sponsor should understand what services are being provided by the advisor and to whom as well as whether or not the costs are reasonable. Providing the advisor with a list of information needs and a reporting format is necessary in most cases. Increases in the amount the advisor actually receives year-over-year should also be explained and justified  (i.e., is there more or better service?).

In summary, there is nothing wrong with providing CAP members investment advice through an advisor but it’s important to understand the additional fiduciary responsibilities, risks and to understand who is paying the cost. Sponsors should ensure that an advisor is not providing CAP members with investment advice unless this has specifically been authorized.

Because of the nature of the relationship with certain service providers it is advisable to have an experienced and impartial consultant assist in evaluating the performance of the record keeper.

In Part V of this series, I will discuss fees and performance issues relating to equal treatment of plan members and  fee issues to consider when converting from a DB to DC plans.

Evaluating record keepers’ performance is often intimidating for plan sponsors because doing so tends to be more subjective and qualitative rather than simply quantitative. Moreover, record keepers often provide numerous services which makes evaluation a complex task.

But monitoring and assessing a record keeper’s performance is very important and ought to be done formally on a regular basis to ensure that all services agreed to are being delivered in a satisfactory manner and that member costs are reasonable.

Below are they key areas plan sponsors should focus on and some suggestions for how to approach the evaluation of record keepers.

Record Keeper Role

Record keepers have a critical role in a CAP and they provide a variety of services and information to both sponsor and members. It is important to understand how the record keeper earns income from a plan and how they get paid. Record keeper fees are applicable to all investment options (excluding Guaranteed Investments (GIs) and Daily Interest type accounts)  and their fees are  paid by members regardless of whether or they use certain services (i.e., tools, information, helps lines etc.). Record keepers earn income from fees, direct charges and the interest spreads on GIs and Daily Interest Accounts (if applicable) and they also receive a portion of the fund manager fee paid by the plan members. If the record keeper is an insurance company they may also provide benefits services from which they earn revenue.

Evaluating record keeper performance should be at least a partially quantitative exercise that is focused on a variety of services and can utilize the statistics the record keepers collects ( i.e., web site usage, phone assistance, fund manager performance statistics, demographic reporting capability, the  types and number and strength of investment funds available, support personnel and account reps, tools and information for members). Direct feed back from members and the administrator and surveys can also be collected and used as qualitative information.

The value of Information and reporting flexibility provided by the record keeper about the demographics and member transactions should also be assessed since it is critical information in administering the plan in areas such as  risk and return performance statistics, and detailed demographic information.

Again, record keepers generally have a wealth of information about the plan and members that can be used to understand and assess performance. The administrator should also try to keep abreast of what other record keepers provide their sponsors and plan members. The key is to ask the right questions.

Sources of Revenue

If the record keeper provides the GIs then the competitiveness of the interest rate and premiums paid should also be part of the assessment. Plan sponsors should also consider the credit rating of a record keeper that provides GIs because it is a risk for plan members in the event of a default.

Another other issue that must be considered is for potential conflicts of interest if the record keeper also provides investment options used in the plan or as part of the asset allocation or target date funds. The fees and relative risk and return performance of the record keeper’s investments should be scrutinized to ensure they are reasonable and appropriate and that members are getting diverse choices with acceptable performance at a reasonable cost. Most sponsors only look at the investment options available in the plan and have little awareness of the funds that may be used within an investment.

Total Service Package

In looking at the record keeper fees and performance, plan sponsors should consider the total package of services and total dollars actually received from the fee package — namely, the fund manager, record keeper, and advisor, the GIs rates and premiums, communications and education, and the decision-making tools for members as well as any costs paid by the sponsor. In some cases the sponsor will use the record keeper as the plan governance advisor as well.

Once you have a breakdown of the record keeper services, and costs and corresponding actual amount paid by the members, you have a better base on which to better assess performance.

In assessing record keeper performance and costs you have to appreciate that there is a qualitative aspect to the assessment which may require you to develop unique cost measurement statistics or qualitative performance benchmarks. A checklist approach with a comprehensive list of services and details is a good start. From a governance perspective the key is that you are regularly monitoring the record keeper’s performance on behalf of the members who are paying most of the cost.

Because of the nature of the relationship with certain service providers it is advisable to have an experienced and impartial consultant assist in evaluating the performance of the record keeper.

In Part IV fees of these articles performance issues relating to advisors will be discussed.

First, a bit of international context: there is an overwhelming consensus that the costs in DC schemes in the UK should be clear, simple and comparable.  In July, Global Pensions reported that emphasis is needed in the UK on the value service providers offer to sponsors and DC members. Fee transparency is also a major issue in the US: there have been a series of lawsuits related to plans that charged members excessive or undisclosed fees.

In Canada, Section 4.4 of the CAP Guidelines recommends that the component of the fees paid by the members be disclosed. Section 6 of the CAP Guidelines also recommends that the sponsor establish criteria for reviewing these service providers, however this requirement is often overlooked or forgotten once the manager is hired.

Plan sponsors, by choice, may pay certain administrative costs but have a fiduciary obligation to review the fees and costs paid by the member.

Members generally pay fees to the fund manager, record keeper and advisor. Record keeper and advisor fees (if applicable) are generally the same for each investment option while fund manager fees usually vary.

The fees are deducted from each investment option — and those fees reduce return performance. The amount a CAP member pays is based on the total fund manager, record keeper and advisor fee rates applied against the market value of each investment.

The amount of fees paid automatically increase as the amount of a member’s investments increase through contributions, earnings or increases in the market value.

Sponsors must monitor not just fee rates but also increases in the actual amount paid annually to the fund managers, record keeper and advisor to ensure any increase is justified by expected performance, improved service or new features.

Measuring fund manager return performance can be relatively straightforward. Performance is usually evaluated against specific return and risk benchmarks (market indices) after fees and outlined in the Statement of Investment Policies and (SIPP). The fund manager’s performance is expected to exceed the bench plus fees for specific time periods.

In assessing the fund manager’s performance the actual fee paid for each specific investment option should be used: it should not include any applicable record keeper or advisor fee. In other words the fund manager’s performance should be assessed on return performance and their portion of the total fee — not the portion of the total fees paid to the record keeper and advisor.

Equally important in assessing fund manager performance is monitoring risk (tracking error). Since the risk performance is likely looked at against the risk performance of the benchmark the tracking error before fees is a reasonable indicator of risk performance. Fund managers that achieve high returns but have tracking error exceeding the benchmark should be reviewed in relation other investment options available to members, the plan objectives, and the level of risk expected of the fund over specific time periods.

Assessing a fund manager’s performance therefore is a two step processing: return performance after fees and tracking error before fees.

If the CAP investment options include balanced funds or life cycle type funds (e.g. target date funds) other investment funds of the provider may be used that also charge fees. The CAP Guidelines recommend that all fees and operating expenses paid by the members should be disclosed.  If the fees applicable to balanced or life cycle fund managers do not reflect the fees for funds used within the balanced or life cycle fund portfolios, then the sponsor should ensure they are disclosed as part of the investment option operating expenses.

The objective in monitoring fund manager performance is to ensure that each fund manager is performing as expected on an after fee basis and that the fees are reasonable.

Guaranteed Investment Investments

In offering guaranteed investment (GI) type options the record keepers do not levy fees based on the value of the members investment in the GIs as they do for other CAP investments: the members pay no manage, record keeper, or advisor fees. The provider does however earn income on GIs based on the spread between the guaranteed interest rate when the GIA is acquired by the member and prevailing future interest rates.

In other words, if a member invests in a five-year GI paying 2.5% and interest rates increase to 3.5% the provider benefits from paying the lower interest rate. Conversely if Interest rates decrease the provider may suffer a loss.  Most record keepers also offer a premium of 0.3%-0.4% above the current market GIC rates offered by banks.

A sponsor can not monitor fees in the case of GIs but should monitor the current bi-weekly or monthly market interest rates paid to members to ensure they are competitive and, the CAP members are getting the GI rate premium promised by the provider. .

Fund manager fees are just one components of the fees paid by CAP members. The expectations regarding fund manager performance on an after fee basis should be outlined in the fund manager’s mandate in the plan as well as the risk performance expectations  Fees are not applicable to guaranteed investment type investment s however the rates of interest and any premiums to be paid should be monitored .

The next blog will review the role of fees in monitoring record keeper and advisor performance as well as issues relating to treating the equal treatment of CAP members with respect to fees and costs.

In Canada the CAP Guidelines recommend that sponsors disclose the nature of any costs paid directly or indirectly by members i.e., fees paid to an investment fund manager, record keeper, investment advisor fees, and operating costs charged directly to a fund. The CAP Guidelines also recommend sponsors establish criteria and monitor the performance of all service providers, including record keepers, advisors, fund managers, or other consultants.

Fees have a significant role in a plan sponsor’s evaluation of the services rendered by service providers on behalf of the CAP members. It is noteworthy that one of the key objectives of the recent Pooled Registered Pension Plan (PRPP) proposal is to substantially lower the fees that members pay. Whether this is feasible, given the involvement of financial institutions in the PRPP is questionable. Breaking down and understanding the nature and amount of the fees paid by members is therefore prudent from a fiduciary perspective.

CAP members and sponsors often complain that the fees paid to fund managers are too high. Let’s have a closer look at some of these costs and see if this is true or just a case of not understanding the fee structure.

What fees do members pay?

CAP members generally pay fees to both the record keeper and fund manger. This is usually reported as single amount, e.g.  1%, which is applied against the market value of equities, bonds etc. (marked to market) and deducted from the members’ accounts weekly, monthly or quarterly.

In addition, the investment manager uses money directly from the fund to pay administrative costs for things like accounting, audit, reporting, and transaction costs. If these costs weren’t paid out of the fund (in short, paid for by the members) the total assets and the returns would be higher.

The fund manager administration costs are disclosed annually, on a retrospective basis, and generally range from 0.01% to 0.25%. Since these costs can vary from year to year they should be disclosed separately from the record keeper and investment management fees.

In the case of record keeping fees the entire fee may go to the record keeper. In other cases, however, a portion of the fee may be paid to an agent of record, say 0.25% – 0.45%, who provides member services on behalf of the record keeper. However, the record keeper’s fees are usually the largest component of the total fee paid by a CAP member, often representing 40% to 60% of the total.

The record keeper also generally charges plan members a higher fund management fee than the fee the record keeper actually pays the fund manager: the fund management fees members pay don’t all go to the fund manager. The CAP investors will often be charged the higher fund manager’s fee associated with the current (low) level of investment in the fund in their specific plan. At the same time, because the fund manager is managing a larger pool of funds on the record keeper’s platform, they are paid a lower fee (amount) based on the total larger pooled fund investment they are managing.

For example, if the fund manager is managing $300 million on a record keeper’s platform in a specific fund the record keeper will negotiate a lower fee, say 0.35%, to be paid to the manager based on the total $300 million (fees paid to the fund manager decrease as the size of the investment increases) whereas the member will pay the higher fund manager fee, say 0.55% based on say, $20 million invested in that fund in that  plan. Fees paid to investment managers therefore are generally not the largest component of the fees paid by plan members.

In the US, the Department of labour (ERISA) now requires detailed provider-to-sponsor disclosure and sponsor-to-participant disclosure. In addition, the dollar amount of fees per $1,000 of investments must be disclosed and must be presented in a way that allows the members to compare fees between investment options. The new ERISA requirements are intended to level the playing filed for record keepers, fund managers and consultants and provide members with a better idea of what they are paying for–and reduce fees through increased competition.

Fee transparency is obviously an issue in Canada as well and it is unfortunate that more emphasis was not put on better fee disclosure in the recent proposed CAPSA revisions to the CAP Guidelines.

The CAP Guidelines recommend that plan sponsors describe and regularly monitor not only the performance of the investments but that of the service providers. From a fiduciary perspective it therefore is important that plan administrators request a breakdown of fees from the record keeper that explains the nature and amount of each component of fees.

The issue of fees is a bit more complex than it appears at first.  It is therefore critical that the sponsor, administrator, and the pension committee clearly understand, monitor and disclose fee costs to CAP members.

In subsequent installments on this blog, I will cover other types of hidden fees and the issues relating to fees for different forms of life cycle funds. In addition, I will discuss ways to monitor investment manager fees and performance and how to reduce fees.

There are many factors that have contributed to the demise of private sector DB plans. I’ve listed a few major ones below.

a) Employers gave benefit increases away “like candy at Halloween”. Correspondingly, unionized employees often insisted on better pension benefits and early retirement with no appreciation for the eventual cash funding required and risk to the employer.

b) Many plan sponsors had no idea of the concept of risk (volatility) in terms of the impact of volatility of interest rates and equity returns on funded ratios nor did they have the time or resources to do this and, hence, they relied on someone else to look after this vital financial interest.

c)  For many years interest rates and equity returns were high (a version of “fat tails”) masking the potential for financial issues.

d) Somehow the concept of liability and asset matching got lost. Liability Driven Investing (LDI) should have been a basic principle and a legislated requirement right from the beginning. The actuaries should have beaten the drum harder about liabilities.

e) Boards and Pension Committees accepted the advantages of diversification without recognizing the limitations and, the risk of “fat tails” i.e., diversification does not work when it is needed most. Focusing on returns and “labels” i.e., value vs. growth, active vs. passive etc. etc.  was also far easier to accept than understanding the underlying risk concepts.

f)  The accountants and auditors who focused on a short term view of expenses, liabilities and deficits for a long-term obligation. Having different methods for calculating the accounting and funding liability and, different discount rates added to the cost, confusion and frustration.

g)  Equity managers and financial advisors  managed to emphasize the potential gains of investing vs. the risks. Funding requirements also played a role in this by delaying “paying the piper”. The common theme was “invest 60% in equities and 40%in fixed income and everything will be fine over the long term”. Unfortunately solvency funding is determined on a short term basis. Was this ignorance or intentional?

h) Organizations didn’t have the time or resources to understand DB pension liabilities and the actuarial and accounting implications. HR vs. financial people was often administrators and bought into the actuarial approach – but it wasn’t the whole story- not by a long shot.

i) A fragmented and piecemeal approach to managing the DB was common i.e., relying on actuaries, financial advisors and auditors rather than having a competent financially experienced administrator to oversee both sponsor and member interests. This resulted in confusion, wasted resources, and higher costs.

j) The financial advisors were often weak in the area of liabilities and accounting and focused primarily on assets. They tended to focus on relative returns (market based benchmarks) rather than on focusing on a primary return objective e.g. CPI +4% and absolute return strategies.

k) Legislation and regulators and sponsors did not keep up with the changing nature and requirements of DB plans. In the US however the regulators also added to the admin costs and confusion with ERISA, PBGC, TEFRA, DEFTA, PPA, EGTRRA, PFEA, OBRA, and TAMERA. In Canada, having 11 different sets of legislation and regulators was a sufficient hurdle.

l) Plan sponsors felt that transferring investment and longevity risk to employees through DC plans or RRSPs was a good idea.  They did not consider the impact on the employees’  retirement savings  and,  the new and daunting fiduciary roles, responsibilities and legal risks they were assuming with DC/401k plans.

m) The final point that has been over looked is that governance has been ignored in most plans as an effective management tool: the focus has been asset performance. DB plans if properly managed provide what most employees claim they want: very limited or no involvement in vesting, and a guaranteed pension income i.e., minimal risk represented by the risk of employer defaulting. 

The demise of the private sector DB plan is the result of many outside factors and to a large degree, a lack of attention by sponsors. The employer simply has more control of the retirement income outcome in a DB plan. The investment and return issues and problems related to DC/401K plans and members are no longer key issues: sponsors realize that encouraging the average CAP member to effectively become an informed balanced fund manager is extremely difficult and unproductive.  It is really a question of providing a pension program that is most effective in attracting and retaining employees i.e., DB vs. DC. Perhaps the best approach is to offer both types of programs or a hybrid plan and give the employees the option to select the one they are most comfortable with.

Pension governance is a process which focuses on having a prudent delegation process and approach to overseeing the pension program in place which has often been overlooked.  A good pension governance framework and internal compliance is the sponsor’s best defense if something ends up in court. How many sponsors fail in this regard – and will be eaten alive by lawyers who will point out the sponsor’s shortcomings from a fiduciary perspective.

Spending a small amount now to put in a governance framework for your DB or DC plan then monitoring the plans in an appropriate manner will mitigate the potential for costly legal risk and is money well spent.

It’s generally recognized that getting employees involved in planning and saving for retirement is difficult and can be costly. Retirement planning and investment education and communication programs have also had limited success. TDFs address many of these concerns and situations, which gives them the following advantages:

• Plan members are automatically slotted into a “one size fits all” family of balanced funds;
• Asset mix and investment options are automatically selected and managed professionally;
• The asset mix is automatically adjusted over time;
• Each TDF fund is rebalanced regularly;
• The TDF can provide better diversification if a wider range of asset classes and options are used than are otherwise available to members in the plan;
• There is no minimum investment requirement;
• Management fees are lower versus retail funds;
• The members can still make use of the other investment options available and the planning tools and information provided by the sponsor and record keeper;
• Employees can opt out of the TDF and start to manage their own investments in whole or part;
• Employees can become more involved when it suits them (in the meantime, they will be invested in a reasonably prudent manner); and,
• TDFs can be customized in some cases to better fit the sponsor and member needs.

TDFs do provide plan members with a convenient, diversified CAP investment portfolio where the issue of too much vs. too little risk is addressed for them. For plan members who feel intimidated by having to make investment decisions (or who are too busy or not interested) TDFs are often seen as a “set it and forget it solution” allowing them to focus on other things.

At the same time, TDFs pose challenges for the plan sponsors and administrators – that leads to a series of disadvantages that they need to consider. Specifically, some of the issues that need to be addressed in providing TDFs are:

• Members may become reliant on the TDF and, hence, disengaged from retirement planning and investing;
• Members often believe that TDFs include guaranteed returns or safety of capital;
• The plan sponsor is entering a long-term relationship with a single supplier making it difficult to change if things don’t work out;
• The Administrator is still responsibly for overseeing the TDF provider and funds;
• There is general a lack of transparency with TDFs;
• One family of TDFs may not be suitable for all plan members;
• The TDF manager may use other investment funds not available in the plan, which are  not part of the SIPP. That means monitoring and overseeing the TDF program is  more difficult;
• Managers who use only or primarily in-house funds which perform poorly or are costly may represent a conflict of interest;
• Benchmarking and/or ranking of each TDF fund and a family of TDF funds is difficult;
• The philosophy with respect to retirement dates (“to” or “through“ ) may not be appropriate;
• TFDs are exposed to market volatility (a concern for retired members or close to retirement);
• CAP Guidelines still require you to provide member education and communication, etc.
• TDFs are often quite different – it is difficult to assess and compare fees and costs;
• Assessing performance is complex and there is no practical recourse if the TDF underperforms;
• There is minimal regulatory supervision or guidance with respect to TDFs; and,
• Fiduciary responsibilities are the same or more complex with TDFs.

The increased governance and administrative burden and complexity of issues related to TDFs are significant and need to carefully examined.

A summary and conclusion on the appropriateness of TDFs will appear in the next post.