Saturday, February 07, 2009

"Spreading" the Wealth

In one of the more memorable sound bytes of the Presidential campaign just past, candidate Obama tried to explain the rationale underpinning his economic philosophy as a belief that we should “spread the wealth.”

Of course, it remains to be seen just how much wealth will be spread, and to whom (and from whom) – but, like it or not – there are also certain redistributive principles at work in our retirement plans. And while I think it’s fair to say that no new ground was broken, a recent paper, “The Structure of 401(k) Fees,”,published by the Center for Retirement Research (CRR) at Boston College, highlighted the potential inequities that current fee structures may be imposing on plan participants (see “Disclosure not the Only Issue with 401(k) Plan Fees”).

Setting aside for a moment whether the fees charged are fair, the paper highlighted a fact that, while obvious, is not always intuitive: When asset-based fees are the order of the day, as they surely still are for most retirement plans, participants with larger balances pay more.

The rationale behind asset-based fees has long been a sense that larger accounts benefit more from the services associated with those fees, notably investment management. And, certainly, there is an appealing simplicity and efficiency to a process that simply takes from each investor a fixed and identical percentage of their account balance.

Still, the CRR paper offers an example with a plan where the costs amount to 0.8% of assets, costs that include marketing and administrative costs of $100 per year for each participant, as well as investment management expenses, which range from $200 a year for a participant with a balance of $20,000 to $400 a year for a participant with a balance of $80,000. In the example, the plan’s 0.8% expense ratio means that a participant with a balance of $80,000 would pay a fee of $640, even though this participant would account for only $500 of the plan’s costs – while a participant with a balance of $20,000 would pay a fee of $160 while accounting for $300 of the plan’s costs.

Twice, Told


Indeed, the CRR paper notes that “participants with twice the balances of others are not likely to entail twice the management cost, although they pay twice the management fee. Thus, a constant expense ratio is a deceptively simple method of pricing, which, by decoupling fees from costs, reduces the return credited to higher balance accounts while boosting that on lower balance accounts.”

This type of discrepancy is often acknowledged but discounted because we tend to see it as a positive thing that the participant with a larger balance – who is generally assumed to be an executive – effectively subsidizes the individual with the smaller account balance, who is generally assumed to have a smaller income. Certainly this is true in some cases – and surely discrepancies in pay can, and do, account for disparities in account balance.

Still, what is frequently overlooked is that there are some – perhaps many - $80,000 account balances that belong to workers who simply have been saving longer, or perhaps just more diligently, than those with those $20,000 balances.

Moreover, how much of the imbedded costs of “running” retail mutual funds are effectively being spread to and across retirement plan balances “proportionately,” muted only (in some cases) by a “better” class of shares? How much of the costs we don’t see – the trading costs in the funds, for example, which can be significant – are generated by retail investors with relatively modest balances…but spread across to the accumulated “wealth” of retirement plan investors?

It’s one thing to truly spread wealth – and another altogether to simply take it.

- Nevin E. Adams, JD

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