An Investigation of Administrative Fees in Defined Contribution Plans

Abstract

The administration of defined contribution retirement plans is generally outsourced by plan sponsors to third-party financial institutions, resulting in two primary types of plan fees. Although investment fund fees in defined contribution plans have been heavily scrutinized, the administrative fees paid to third-party plan administrators are less well understood. The authors highlight the importance of securing fee reimbursements from third-party plan administrators to avoid excessive administrative fees, as well as situations in which the plan sponsor must be particularly careful to ensure that such reimbursements are secured. The authors’ findings have important implications as the scrutiny of plan fees intensifies with continued regulatory change.

The summary was prepared by Thomas P. Bernardi, CFA.

What’s Inside?

The authors analyze the effect of plan administrative fees charged by third-party administrators (TPAs) on the long-term performance of defined contribution (DC) retirement plans. They find that administrative fees do affect long-term plan performance and that plan participants should be better informed about these effects. There are ways to reduce administrative fees, such as fee reimbursements, that should also be reviewed. TPAs can help by educating investors about plan fees and making retirement plan fee structures as economically suitable as possible.

How Is This Research Useful to Practitioners?

The study determines that administrative fees are an “economically significant” cost of DC retirement plans. On average, administrative fees account for an additional 22 bps in fees annually for each plan. The highest administrative fees reached 234 bps annually. The authors find that investments in proprietary funds of the TPA had significantly lower administrative fees. In contrast, investments in proprietary funds of non-TPAs did not lead to lower-than-average administrative fees.

The authors look into ways DC retirement plans could reduce overall administrative fees. The easiest way is through fee reimbursements. Plans typically receive fee reimbursements when mutual funds share a portion of their revenue (i.e., expense ratios) with the TPA. This revenue is shared because the TPA will take over some of the responsibilities normally attributed to the mutual fund (i.e., recordkeeping). These fee reimbursements should flow back into the plan, but it often does not happen. Fund sponsors should be aware of these situations because they lead to overcharging plan participants.

The authors find that when TPAs provide both the fund administrative services and proprietary investment funds, fee reimbursement is the highest. They observed that TPAs, such as Vanguard and Fidelity, provided higher reimbursements than others.

The study and findings are beneficial to TPAs, plan sponsors, and plan participants. All parties involved should be aware of options to reduce costs that ultimately harm plan participants. TPAs and plan sponsors should work together to educate plan participants on the various aspects of the investment funds available, including fees and reimbursements, if applicable. Plan participants should also educate themselves, beyond what is provided by the TPAs and sponsors, to be aware of how their assets are being invested.

How Did the Authors Conduct This Research?

The authors use a BrightScope database to gather information about 6,809 401(k) plans at the end of 2007. The database provides such metrics as balances, investment fund options, investment fund fees, administrative fees, and plan sponsor and TPA information. The authors focus on DC retirement plans in which plan participants pay the administrative fees. More than half of the plans provide investment funds from one single fund family. When plans have a TPA that also provides proprietary funds, almost 90% of those plans invest in the funds of the TPA.

Regressions are run for a variety of variables to determine which factors lead to lower administrative fees and higher fee reimbursements. It is within these regressions that the authors find that administrative fees posed a significant cost to plan participants. They also analyze the performance of various funds and whether higher expense ratios were offset by superior performance (which was not the case).

Abstractor’s Viewpoint

The study is timely in the current low-fee-focused environment. There have been many studies on investment fund fees and their effect on long-term portfolio performance. This study opens another part of the fee discussion with the introduction of administrative fees. As the authors note, administrative fees, on average, cost funds 22 bps annually, which has an economically significant effect on fund performance over the long run. It is important for sponsors to be cognizant of all costs, including administrative fees, and any reimbursement or cost-saving opportunities available. It is of equal importance for plan participants to be educated in the investments and their costs. This burden should be placed on all three parties involved: administrators, sponsors, and participants.

An additional research development would be to expand the sample outside the realm of DC retirement plans and to provide international evidence to help continue the discussion about the role administrative fees play in plan management.

Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.