Statement of Mary Podesta
Senior Counsel - Pension Regulation
Investment Company Institute

Working Group on Fiduciary Responsibilities and Revenue Sharing Practices

Before the ERISA Advisory Council

September 20, 2007

The Investment Company Institute¹ is pleased to provide its views to the ERISA Advisory Council as it considers fiduciary responsibilities and revenue sharing practices. This is the third time in four years that we have testified to the Council on improving the ERISA regulatory regime in the interests of plan participants.

November of last year was the 25th anniversary of the birth of the 401(k) plan.² The Institute marked the occasion with a research retrospective that demonstrates that the 401(k) plan is a success story for Americans' retirement security.³ As of year-end 2006, 401(k) plans held $2.7 trillion in assets, an amount greater than that held by private defined benefit plans.⁴ And this does not count assets that have been rolled over into IRAs. Estimates suggest about half of the $4.2 trillion in IRAs in 2006 came from 401(k) and other employer plans. The number of 401(k) plans grew from fewer than 30,000 in 1985 to around 450,000 in 2006.⁵

Our research also shows that the assets of 401(k) plans are being effectively deployed to accumulate retirement wealth. Collaborative research by the ICI and the Employee Benefit Research Institute (EBRI) demonstrates that participants generally make sensible choices in allocating their investments⁶ and that a full career with a 401(k) plan can produce adequate replacement rates at retirement.⁷

Plan fiduciaries play an essential role in assuring that workers can rely with confidence on 401(k) plans for retirement saving. Although 401(k) participants make their own investment decisions in most plans today, fiduciaries are charged with selecting an appropriate investment menu and entering into reasonable arrangements for the provision of administrative services to the plan. Often, plans contract to receive access to plan investment options and administrative services in a full service, or "bundled," arrangement in which a service provider offers the entire range of administrative services.

ERISA imposes clear responsibilities on fiduciaries in entering into any service arrangements. Under ERISA section 404(a), the fiduciary must act prudently and for the exclusive purpose of providing benefits and defraying the "reasonable" expenses of administering the plan. Under section 408(b)(2), fiduciaries must ensure that a service contract is a reasonable arrangement for necessary services and that "no more than reasonable compensation is paid therefor." If a service arrangement does not meet these standards, section 4975(d)(2) of the Internal Revenue Code imposes an excise tax against the service provider.

As we testified in 2004,⁸ effective disclosure by service providers to plan sponsors is essential to enabling plan fiduciaries to enter into and maintain reasonable 401(k) service arrangements. The purpose of disclosure should be to allow plan fiduciaries to compare service options and monitor arrangements over time. The Institute has called upon the Department of Labor to require plan fiduciaries to obtain information from service providers on the services that will be delivered, the charges the plan will incur, and the extent to which service providers receive compensation from others in connection with providing services to the plan. To assist plan fiduciaries in entering into service arrangements, the Institute and others created a disclosure tool, discussed in more detail below.

Table of Contents

Use of bundled arrangements and asset-based fees
Monitoring and reviewing services and fees over time
Mutual funds in 401(k) plans

Department of Labor section 408(b)(2) project
Disclosure tool

The Institute's testimony today focuses on why plans may choose to obtain both investment and administrative services through a single service provider and how to meet a plan sponsor's need for information in entering into and monitoring these service arrangements.

401(k) Service Arrangements
Use of bundled arrangements and asset-based fees
While a wide variety of practices exist, many plans contract with a recordkeeper to receive both administrative services and access to an array of investment products from which plan fiduciaries construct the menu of investments offered. The recordkeeper is compensated for its services to the plan, in whole or in part, by asset-based fees (such as sub-transfer agency or distribution fees) paid in connection with the plan's investment choices. These payments to recordkeepers from investment providers commonly are called "revenue sharing." Using a single full service provider eliminates the cost to a plan sponsor of dealing with and monitoring multiple providers, and provides a single responsible party for all aspects of the arrangement. A recent survey by Deloitte Consulting and others found that 75 percent of plan sponsors used a bundled arrangement.⁹

Using asset-based fees of plan investment options to defray the cost of recordkeeping and other plan administrative costs does not violate ERISA so long as a fiduciary does not use its discretion to cause itself to receive revenue sharing.¹⁰ ERISA does not require flat charges for recordkeeping services. As the Department stated in testimony to the Working Group on July 11, "many of these arrangements may serve to reduce overall plan costs and provide plans with services and benefits not otherwise affordable."

Using asset-based fees to cover administrative services also effectively spreads the costs of acquiring necessary services over a shareholder or participant base. All mutual fund investors, whether in a 401(k) plan, IRA, or taxable account, experience "mutualization." Some costs of administering a mutual fund shareholder's account are relatively fixed, such as the costs of printing prospectuses and sending shareholder statements. Because mutual funds charge asset-based fees, shareholders with larger investments subsidize smaller accounts. Similarly, wrap fees in brokerage accounts and M&E charges in insurance products mutualize certain costs in those products.

Under the Internal Revenue Code, a 401(k) plan and its services must be available to employees on a nondiscriminatory basis. Asset-based fees allow new participants and those with lower wages or smaller accounts to participate in plans without the cost of administration falling disproportionately, as a percentage of account balance, on them.

Asset-based fee arrangements also help pay for start-up or service provider transition costs. Service providers experience significant start-up expenses in servicing a newly created plan or beginning a client relationship with an existing plan that is moving from a previous provider. To avoid the plan incurring all those expenses in the first year, asset-based fees allow the provider to recoup its expenses over several years as assets grow. Absent these arrangements, employers would be less willing to establish new plans or switch service providers.

Monitoring and reviewing services and fees over time
Plan fiduciaries should monitor and review plan service arrangements from time to time to assure that they remain reasonable arrangements. In a bundled services arrangement where a plan recordkeeper receives asset-based compensation to defray the cost of recordkeeping, one aspect of the review will involve looking at the level of fees if the plan and participant accounts grow in size.

If the growth of plan assets supports a revision of the arrangement, the plan fiduciary and service provider have a number of options. One is to lower total plan costs by replacing existing plan investments with lower-cost options or share classes. Another is to provide the plan and participants with additional services that were not originally affordable. For example, as a new plan grows, it may become possible to provide participants with access to investment advice. A third option for plan fiduciaries might be to negotiate with the recordkeeper to share some of the recordkeeper's revenue with the plan.¹¹ Finally, the plan fiduciary can put the service contract out for bid to determine whether other service providers might offer comparable services at a lower cost. According to one recent study, plan sponsors, on average, evaluate their recordkeeper about every four years.¹²

Mutual funds in 401(k) plans
Of the $2.7 trillion in 401(k) assets at year-end 2006, $1.5 trillion, or about 55 percent, are invested in mutual funds. As a percentage of total 401(k) assets, mutual fund investment has increased significantly. In 1994 only about 27 percent of 401(k) assets were invested in mutual funds.¹³

Institute research suggests that plan fiduciaries are cost conscious when selecting mutual funds for their 401(k) plans. Attached to this testimony is just-released research on the fees incurred by mutual fund investors in 401(k) plans. This research updates, with 2006 data, research we released last year, which married for the first time our extensive research on trends in mutual fund fees with our tracking of 401(k) plan holdings of mutual funds. Our research studies mutual fund fees in 401(k) plans because comparable information for other products offered in 401(k) plans is not readily available.¹⁴

In the competitive mutual fund market, 401(k) savers tend to concentrate their assets in low-cost funds. In 2006, the average stock mutual fund had an expense ratio of 1.50 percent. This is the simple average that does not reflect investment concentration: 77 percent of stock mutual fund assets in 401(k) plans were invested in funds with a total expense ratio of less than 1.00 percent. On an asset-weighted basis, the average expense ratio incurred by all mutual fund investors in stock mutual funds was 0.88 percent. And the asset-weighted average expense ratio for 401(k) stock mutual fund investors was even lower: 0.74 percent. Similar results can be seen in each broad type of stock fund, as well as in bond funds. Overall, the asset-weighted average expense ratio across all mutual funds in 401(k) plans was 0.71 percent in 2006. These expense ratios include any revenue sharing that a fund pays to defray the cost of 401(k) plan administration.

401(k) Mutual Fund Investors Tend to Pay Lower-Than-Average Expenses
Percent of assets, 1996-2006

¹The industry average expense ratio is measured as an asset-weighted average.

²The 401(k) average expense ratio is measured as a 401(k) asset-weighted average.

Note: Figures exclude mutual funds available as investment choices in variable annuities and tax-exempt mutual funds.

Sources: Investment Company Institute; Lipper; Value Line Publishing, Inc.; CDA/Wiesenberger Investment Companies Service; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/ www.crsp.com); Primary datasource; and Strategic Insight Simfund

There are several factors that contribute to the relatively low average fund expense ratios incurred by 401(k) plan participants. Plan sponsors play a vital role in selecting and regularly evaluating the plan's investment line-up to ensure that each option's fees and expenses provide good value. Easy access to comparable and transparent mutual fund fee information helps employees in selecting investments for their accounts.¹⁵

Because the costs of trading a mutual fund's portfolio affect total shareholder return, but are not included in fund expense ratios, the Institute also examined portfolio turnover ratios of mutual funds used in 401(k) plans.¹⁶ Our research found that 401(k) plan participants tend to own stock mutual funds with low turnover rates. The average turnover rate in stock mutual funds held in 401(k) plans was 46 percent in 2006, which is lower than the simple average turnover rate in stock mutual funds generally (86 percent) and about the same as the industrywide asset-weighted average rate of 47 percent.

Average Portfolio Turnover Rate¹ of Stock Mutual Funds
Percent of assets, 2001-2006

¹The turnover rate for each fund is calculated by dividing the lesser of purchases or sales of portfolio securities for the reporting period by the monthly average of the value of the portfolio securities owned by the fund during the reporting period.

²Average portfolio turnover rate experienced by stock mutual fund shareholders is measured as an asset-weighted average annual turnover rate based on the assets held in each fund (reported as a percentage of fund assets).

³Average portfolio turnover rate experienced by 401(k) stock mutual fund shareholders is measured as an asset-weighted average annual turnover rate based on 401(k) plan assets held in each fund (reported as a percentage of 401(k) fund assets).

Note: Figures exclude mutual funds available as investment choices in variable annuities. Stock mutual funds include hybrid funds.

Sources: Investment Company Institute and Strategic Insight Simfund

Meeting Plan Fiduciary Needs for Information
Department of Labor section 408(b)(2) project
The Institute believes that we can make certain that plan fiduciaries are equipped to enter into reasonable service arrangements by assuring that they have the information they need to make informed decisions. The Institute supports the Department's initiative to revise its section 408(b)(2) regulations to clarify the information that fiduciaries should obtain in order to enter into and monitor plan service arrangements. We urge the Department to move quickly on this project and to take a commonsense, straightforward approach.

The Department should require plan fiduciaries to obtain information from service providers to the plan on

Disclosure should focus on the cost to the plan of acquiring services, not the cost to the service provider of delivering the service. ERISA does not require plan fiduciaries to assess service provider profitability, but rather to enter into contracts that provide for reasonable compensation.

A service provider that offers a number of services in a package should be required to identify each of the services but not to separately break out the fee for each of the components of the package. If a recordkeeper, for example, provides a comprehensive array of services, including maintaining participant-level accounts, providing custody, and making educational materials and other services available to participants, it should not be forced to assign prices to each component. If the plan sponsor understands the services that will be performed and the total cost of the service arrangement, it will be able to compare overall cost and quality of the bundled provider's offer with an unbundled arrangement available to the plan, and fulfill its responsibility to enter into reasonable service arrangements.

The Department should address revenue sharing disclosure by requiring that a service provider disclose to plan sponsors information about compensation it receives from other parties in connection with providing services to the plan. This information will allow the plan fiduciary to understand the total compensation a service provider receives under the arrangement. It also will bring to light any potential conflicts of interest associated with revenue sharing payments, for example, where a plan consultant receives compensation from a plan recordkeeper. The service provider that receives revenue sharing payments should be the entity required to disclose these amounts.

When services are provided to a plan by affiliates of the service provider, a plan fiduciary should understand all the services provided by the service provider and its affiliates and the aggregate compensation paid for those services. The service provider should not be required to disclose how payments within its organization might be allocated among affiliates. In economic terms, transactions between affiliates are not market transactions, and therefore the pricing of these transactions is necessarily artificial and should be of no value to plan sponsors. The reason a firm would choose to organize as a fully integrated firm rather than contract with third parties is that the firm believes it is more efficient to do so. The goal of resource allocation within an integrated firm is to allocate resources in a manner that produces the final bundled product as efficiently as possible, not to ensure that costs can be accurately tracked and allocated to the production of any one product component. In this model, any allocation of revenue, costs and profits among affiliates or business lines has nothing to do with the services provided by the respective affiliates to the plan, but instead is designed for budgeting, accounting and other purposes.

Disclosure tool
To assist plan fiduciaries in discussing service arrangements with providers and to help inform the Department's consideration of new 408(b)(2) guidance, the Institute, together with the American Benefits Council, the American Council of Life Insurers, the American Bankers Association, and the Securities Industry and Financial Markets Association, developed a disclosure tool and submitted it to the Department in July 2006. Plan sponsors can use the tool to better understand plan services and fees and appreciate any potential conflicts of interest that might arise, and any additional compensation providers will receive, through revenue sharing. The tool was developed with significant input from the plan sponsor, service provider and consultant communities to reflect best practices used by sponsors, providers and consultants in today's marketplace.

The tool lists service- and fee-related data elements and is intended, essentially, to help plan fiduciaries satisfy their obligations under ERISA sections 404(a) and 408(b)(2) to understand what services will and will not be provided, and the fees for those services. It can be used regardless of the arrangement, whether a particular provider is offering only one service or a package of services. A service provider offering several services for a single fee would show the single fee and make clear what services are included. The tool also can be used when a plan sponsor works with a consultant in engaging providers and selecting investments and when it does not.¹⁷

The tool takes the approach to revenue sharing disclosure discussed above. It includes a section for plan fiduciaries and service providers to discuss the extent to which a service provider receives compensation in connection with its services to the plan from other service providers or plan investment products. For payments received from unaffiliated parties, the tool recommends that plan sponsors and service providers discuss:

For payments from affiliated parties, service providers would identify the affiliate, state whether the payment received from the affiliate has any impact on the aggregate revenue received by the firm in connection with services to the plan, and provide non-proprietary information about the nature of the payment.

Conclusion
There is no single "reasonable" fee and service arrangement for a 401(k) plan. A plan fiduciary must consider all the services and investment options being provided, the size and characteristics of the plan, and the services and fees available from other providers. Full-service arrangements that use asset-based fees can be an effective way to deliver the services that 401(k) plans need. The key is that fiduciaries have a process to collect information, compare and monitor providers, and consider any potential conflicts the arrangements might present. The Department should act to increase transparency by requiring service providers to describe the services offered, the charges to be paid, and payments from other parties in connection with providing services to the plan. We are pleased to testify to the Council about improving 401(k) disclosure and look forward to working with the Council and the Department to continue strengthening the 401(k) system.

ATTACHMENTS

1 ICI members include 8,803 open-end investment companies (mutual funds), 671 closed-end investment companies, 457 exchange-traded funds, and four sponsors of unit investment trusts. Mutual fund members of ICI have total assets of approximately $11.140 trillion (representing 98 percent of all assets of U.S. mutual funds); these funds serve approximately 93.9 million shareholders in more than 53.8 million households.

2 On November 10, 1981, IRS issued proposed regulations under the new section 401(k) of the Internal Revenue Code added by Congress in 1978 that clarified the most important interpretative issues under the new law, including whether ordinary wages and salary could be deferred into the plan.

3 Holden, Brady and Hadley, 401(k) Plans: A 25-Year Retrospective, ICI Perspective, vol. 12, no. 2 (November 2006).

4 Brady and Holden, The U.S. Retirement Market, 2006, ICI Fundamentals, vol. 16, no. 3 (July 2007).

5 U.S. Department of Labor, Employee Benefits Security Administration, Private Pension Plan Bulletin Historical Tables (March 2007); Cerulli Associates, "Retirement Markets, 2006," Cerulli Quantitative Update (2006).

6 For example, in 2006, participants in their 20s allocated 59.7 percent of their accounts to pooled equity investments and company stock, and only 18.4 percent to GICs and other fixed-income investments. Participants in their 60s allocated 35.6 percent to GICs and other fixed-income investments. See Holden and VanDerhei, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2006, ICI Perspective, vol. 13, no. 1, and EBRI Issue Brief, Investment Company Institute and Employee Benefit Research Institute, August 2007. The 2006 EBRI/ICI database contains 53,931 401(k) plans with $1.228 trillion in assets and 20.0 million participants.

7 See Holden and VanDerhei, Can 401(k) Accumulations Generate Significant Income for Future Retirees? and The Influence of Automatic Enrollment, Catch-Up, and IRA Contributions on 401(k) Accumulations at Retirement, ICI Perspective and EBRI Issue Brief, Investment Company Institute and Employee Benefit Research Institute, November 2002 and July 2005, respectively.

8 See Statement of Investment Company Institute on Disclosure to Plan Sponsors and Participants Before the ERISA Advisory Council Working Group on Disclosure, September 21, 2004.

9 Deloitte Consulting, LLP, International Foundation of Employee Benefit Plans and the International Society of Certified Employee Benefit Specialists, Annual 401(k) Benchmarking Survey 2005/2006 Edition.

10 See Advisory Opinion 97-16A (May 23, 1997) (Aetna) and Advisory Opinion 2003-09A (June 25, 2003) (ABM-AMRO).

11 In its testimony on July 11, the Department made clear that an arrangement where a recordkeeper shares some of its revenue with the plan does not violate ERISA and plans have a number of options to address the allocation of revenue sharing proceeds.

12 Deloitte Consulting, LLP, International Foundation of Employee Benefit Plans and the International Society of Certified Employee Benefit Specialists, Annual 401(k) Benchmarking Survey 2005/2006 Edition.

13 Brady and Holden, The U.S. Retirement Market, 2006, supra note 4.

14 We are not aware of any similar cost analysis for other products held in 401(k) plans such as insurance company separate accounts, collective trusts, or separately managed accounts.

15 For other factors that contribute to the relatively low expense ratio incurred by 401(k) plan participants investing in mutual funds, see Holden and Hadley, The Economics of Providing 401(k) Plans: Services, Fees, and Expenses, 2006, ICI Fundamentals, vol. 16, no. 4 (September 2007).

16 The SEC requires a mutual fund to report its turnover rate, which is broadly speaking a measure of how rapidly the fund is trading the securities in its portfolio relative to total fund assets. Funds also report information on brokerage commission costs in the fund's Statement of Additional Information. Although brokerage commissions are not included in the expense ratio, a mutual fund reports its net return, which reflects all fund trading costs.

17 Using the tool is not the only way a plan fiduciary could meet its obligations under section 408(b)(2). We do not believe the Department should adopt a particular form in connection with the 408(b)(2) regulations that always must be used. A mandated form would not recognize the variety of service arrangements that might exist, would become outdated over time, and could stifle innovation in the marketplace.