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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNERŪ practitioner.
Unbundled pension services free plan sponsors from the strangle hold of the big Wall Street firms, allowing lower costs, easier administration, better investment options, higher quality education, transparency, and accountability in a seamless solution.
Yesterday's Business Model
Back in the dark ages before 1990 computing power was scarce and expensive, computers didn't talk to each other, and there was no internet. Many complex financial services such as pension administration, and investment management had to be delivered by giant institutions. Only those giants had the resources to purchase and program main frame computers, co-ordinate services and distribute information.
Firms delivered pension services through a variety of "bundled solutions" where one company provided consulting, plan design, custody, investments, reporting, tax preparation, testing, and participant education all in one convenient product. The industry was dominated by huge insurance companies, brokerage houses, and mutual fund families.
There were a few giants operating in an unsophisticated marketplace where there was little competition. Alternatives were few, buyers complacent, regulators overwhelmed, and competitive information unavailable, so the system rocked along in a state of torpor.
Employee pensions are not the core mission of many companies. Neither are they a profit center. To put it kindly, most companies see them as a boring staff function, necessary evil, and distraction. Few plan sponsors are aware of their fiduciary liability, or even care about their responsibilities. To a disinterested plan sponsor, all the programs look pretty much the same.
There is no denying the allure of "one stop shopping" in a complex transaction. Plan sponsors are not looking to complicate their lives unnecessarily. At first blush, dealing with one outfit seems preferable to dealing with six.
Finally, the household brand name implies superior quality, permanence, reliability and value to those too lazy to look below the hood. Yet, too often in this industry, the brand name is worth far less than zero. When a plan fiduciary too lazy to do his homework meets an industry that deliberately obscures plan costs, the result is a disaster for the employee that bears the expense.
The predictable result is monopoly pricing, conflicts of interest, opaque disclosure, ineffective investment products, shoddy service levels, and indifferent employee education. In short, a pension plan designed from the ground up for failure.
A key fiduciary obligation is to know what each of the various plan costs are, and whether individually and collectively they are "reasonable". After all, it's not prudent to waste participant's money. But, let's be crystal clear. The often cited "industry standard" cost structure is a license to steal. Fiduciaries should be in a cost containment mode rather than just accept an outrageous standard because everybody else is too lazy to do their own due diligence. Paying for services that add no value is not prudent. Overpaying for services is not prudent.
Bundled plans make it almost impossible to get an idea of the price of the individual components, making it easy to shift, obscure and misrepresent costs. The investment selections are usually either proprietary funds or pay a hefty portion of the operating costs for "shelf space" on the platform ("pay to play" is a very hot item on the SEC's list of concerns). Low cost institutional class shares and/or index funds cannot participate. With choices restricted to proprietary or partner funds (or separate accounts), no true objective performance screening and monitoring is possible.
Insurance companies are the most ingenious in obscuring costs. Many of them actually mark up retail mutual funds by offering a "special" series, then tack on a hefty M&E (Mortality and Expense) charge on top. Not satisfied, they go on to add an additional administrative expense. If anyone can explain to me what benefit a pension plan derives from an annuity wrapper with its accompanying M&E charge, I would sincerely like to know. In my 30 years experience, I have NEVER encountered a plan sponsor that understood the total costs or where the money went in an insurance company pension plan.
Mutual Funds have developed an amazing array of devices to frustrate cost disclosure. Starting with the inexplicable 12(b)-1 fee, directed brokerage, pay to play schemes, and "special" share classes designed to compensate Third Party Administrators (TPA) under the table.
The problem with separate accounts is even more vexing due to their individual nature the unavailability and/or unreliability of comparative performance and cost information.
Wire house separate accounts and wrap fee arrangements rarely discuss their pay to play schemes, directed brokerage, soft dollar arrangements, queuing order, best execution policies, principal transactions, or revenue sharing arrangements. Few plan administrators have the savvy, inclination, or resources to track them down.
All the above can have termination fees, liquidation fees, and back end surrender charges sufficient to discourage migration to more effective providers. This in turn has spawned a cottage industry of litigators assisting plans that finally wise up to break free.
The vast majority of these plans we review have total costs far higher than the sum of the component parts should command. Some of them so high, that it may not make sense for employees to participate. Total plan costs in excess of 3% of the plan balances per year are not uncommon. These obscene cost levels reduce accumulations, defeating the objective of the plan to provide benefits to participants.
Tomorrow's Business Model
That was then, this is now. The advent of cheap computing power and internet communications changed all that. Today unbundled solutions offer sophisticated buyers best of breed components that dramatically improve every part of the pension process. While these components come from different providers, they work together seamlessly, often both enhancing value and reducing costs.
The complete solution includes four providers:
An investment advisor who assists in investment strategy, generates an investment policy statement that reflects the sponsor's needs and strategy, selects appropriate asset classes, screens available funding vehicles whether mutual funds, exchange traded funds, or separate accounts, monitors performance of the funds and reports back to the plan sponsor on at least a quarterly basis. The investment advisor assists the plan sponsor to maintain the highest levels of fiduciary practices. Additionally, they provide educational information for all the plan participants so that they can make informed decisions about the use of the plan to meet their objectives. In most cases they quarterback the efforts of the other providers.
A record keeper or third party administrator (TPA) who assists with plan design, provides the technology solution that enables plan administration, record keeping, compliance testing, reporting, individual account maintenance, loan activity, terminations, vesting, and forfeitures.
Product providers supply the mutual funds, ETF's and separate accounts. These investments are the asset allocation building blocks to construct the portfolios.
Custodians safe keep the plan assets and generate statements and reports necessary to audit fund balances. They provide the "platform" for purchasing and selling plan assets along with an electronic link to the other providers.
State of the art technology links all these functions to the plan sponsor and participants in a seamless package. Each of the various service providers should supply full and clear disclosure of costs, practices, and potential conflicts of interest so that the whole package is transparent, accountable, and readily understood. Plan sponsors should hold each provider at arms length and monitor each for service, costs and effectiveness.
As a crude rule of thumb, total plan costs should fall somewhere at or below 1.5% per year for a typical defined contribution, profit sharing and/or 401(k) or 403(b) plan. This breaks down about 1/3 each for Investment Advisor, Product Provider, and TPA/Custodian. Some variation is allowable, depending on size, complexity, service requirements, and number of participants. Larger plans should expect to benefit from economies of scale. However, if costs are significantly higher, the plan sponsor may have some serious issues to resolve.
This unbundled solution is only possible because of the efficiency of the internet as a means to link freestanding providers to the plan sponsor and participant, lower transaction costs, and provide the seamless solution. All parties involved can look and monitor the plan in real time.
Breaking the strangle hold of the giant Wall Street firms opens up the entire transaction to price and service competition, lowers costs, allows objective advisors to operate free from the traditional conflicts of interest, while bringing transparency, clarity and efficiency to the process. Plan providers can fulfill their fiduciary obligations and participants will have more effective plans.
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