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Letter from the US: Back from the edge

If there was a clear message from the whole ‘fiscal cliff’ debate, it is that social security will be affected sooner or later. Employees need to realise that company-sponsored pension plans will become an even more important supplement to their retirement income.

But the same companies are trying to cut their expenses for employee benefits. Most have switched from defined benefit (DB) to defined contribution (DC), and are looking for new ways to save money. IBM recently announced that it will contribute only once a year to employee 401(k) accounts in a lump-sum payment. Workers who leave the company before December 15 will not qualify for the match, unless they retire; those who stay will lose the advantages of dollar-cost averaging.

So DC plan members should pay greater attention to costs in the future, taking advantage of rules on fee transparency to be implemented this year. In fact, new regulations approved by the US Labor Department require that plan sponsors give participants quarterly and annual 401(k) statements listing the expense ratios of each investment option and other fees charged to their accounts, including commissions, sales charges, and record keeping.
Moreover, they need to give them information about investment returns compared to a benchmark.

Will this drive members towards low-cost index funds? It is too early to tell.
It is certainly forcing plan sponsors to re-evaluate the cost structure of their services.
“Sponsors may wish to consider not only the reasonableness of plan fees, but the manner in which they are paid,” say the Callan Associates’ DC practice team.

Callan recommends a few action items that should be on every DC plan’s list of priorities in 2013. Sponsors should document their fee evaluation process, and revenue sharing to cover the cost of plan administration versus a flat, per-participant fee.

“Some plan sponsors have even gone so far as to create a fee-payment policy, either as part of their investment policy statement or as a separate document,” Callan notes. In order to minimise fees, sponsors should also consider whether institutional vehicles make sense for the plan. A recent Callan study revealed that, depending on plan size, the use of non-40-Act vehicles over institutional share classes of mutual funds reduced weighted plan fees by 20-35%.

Then there is the issue of the investment policy statement (IPS). According to Callan, while most plans have an IPS, nearly half have failed to review it in the past 12 months. This is risky, because some current fee lawsuits focus on plan sponsor adherence to the IPS.
“The ideal IPS gives clear guidelines, creates a reasonable process, provides a roadmap for making sound, long-term-oriented decisions, and outlines criteria to keep the investment committee on track,” says Callan.

Sponsors should also assess the investment menu. And they should devote special attention to the target-date funds, which many plan sponsors chose as their qualified default investment alternative, after the passage of the Pension Protection Act (PPA) in 2006.

“The present-day appropriateness of the selected target-date funds should be reviewed, because what seemed like a good fit for the plan six years ago might no longer be so,” Callan says. “Plan demographics may have changed, better target-date fund alternatives may have entered the market, even the size of plan assets may have increased enough to make it possible to use a custom target-date fund series.”

Other features to be reviewed are the auto-enrolment and auto-contribution escalation. Callan says that “many plans implemented these auto features very conservatively, resulting in less-than-optimal outcomes.” Good practice in this area would include a minimum default contribution rate of 6%, with auto-enrolment escalating participants to at least 15%, with 1-2% annual contribution rate increases.

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