Private Pensions: Increased Reliance on 401(k) Plans Calls for Better Information on Fees
Published: 2007-03-06T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over the past two decades there has been a noticeable shift in the types of plans employers are offering employees. Employers are increasingly moving away from traditional defined benefit plans to what has become the most dominant and fastest growing type of defined contribution plan, the 401(k). As more workers participate in 401(k) plans, they bear more of the responsibility for funding their retirement. Given the choices facing participants, specific information about the plan and plan options becomes more relevant than under defined benefit plans because participants are responsible for ensuring that they have adequate income at retirement. While information on historical performance and investment risk for each plan option are important for participants to understand, so too is information on fees because fees can significantly decrease participants' retirement savings over the course of a career. As a result of employees bearing more responsibility for funding their retirement under 401(k) plans, Congress asked us to talk about the prevalence of 401(k) plans today and to summarize our recent work on providing better information to 401(k) participants and the Department of Labor (Labor) on fees. GAO's remarks today will focus on (1) trends in the use of 401(k) plans, and (2) the types of fees associated with these plans.
section_title: What GAO Found
paragraphs: There are an increasing number of active participants in 401(k) plans than in other types of employer-sponsored pension plans, a trend that has accelerated since the 1980s. Now, 401(k) plans represent the majority of all private pension plans; they also service the most participants and hold the most assets. These plans offer a range of investment options, but equity funds--those that invest primarily in stocks--accounted for nearly half of 401(k) assets at the close of 2005. Most 401(k) plans are participant-directed, meaning that a participant is responsible for making the investment decisions about his or her own retirement plan contributions. Inadequate disclosure and reporting requirements may leave participants without a simple way to compare fees among plan investment options, and Labor without the information it needs to oversee fees and identify questionable 401(k) business practices. The Employee Retirement Income Security Act (ERISA) of 1974 requires 401(k) plan sponsors to disclose only limited information on fees. Participants must collect various documents over time and may be required to seek out some documents in order to get a clear picture of the total fees that they pay. Furthermore, the documents that participants receive do not provide a simple way to compare fees--along with risk and historical performance--among the investment options in their 401(k) plan. The information reported to Labor does not identify all fees charged to 401(k) plans and therefore has limited use for effectively overseeing fees and identifying undisclosed business arrangements among consultants or service providers. As a result, participants may have more limited investment options and pay higher fees for these options than they otherwise would.

section_title: Letter
paragraphs: I am pleased to be here to discuss American workers’ increased  participation in 401(k) plans and the potential effects of the fees  associated with these plans on their retirement income. Over the past two  decades there has been a noticeable shift in the types of plans employers  are offering employees. Employers are increasingly moving away from  traditional defined benefit plans to what has become the most dominant  and fastest growing type of defined contribution plan, the 401(k).
As more workers participate in 401(k) plans, they bear more of the  responsibility for funding their retirement than they do when covered by  traditional defined benefit plans. Under 401(k) plans, participants are  responsible for choosing how much of their pretax income to contribute,  how to invest their contributions in the choices offered by the plan  sponsor, and how to manage their 401(k) investments upon retirement.   Given the choices facing participants, specific information about the plan  and plan options becomes more relevant than under defined benefit plans  because participants are responsible for ensuring that they have adequate  income at retirement. Although information on historical performance and  investment risk for each plan option are important for participants to  understand, so too is information on fees because fees can significantly  decrease participants’ retirement savings over the course of a career.  As a  result of employees bearing more responsibility for funding their  retirement under 401(k) plans, you asked us to talk about the prevalence  of 401(k) plans in the private pension system today and to summarize our  recent work on providing better information to 401(k) participants and the  Department of Labor (Labor) on fees. My remarks today will focus on (1)  trends in the use of 401(k) plans, and (2) the types of fees associated with  these plans and the information available to participants and Labor.
To describe the current trend toward the increased use of 401(k) plans, we  relied on our previous work on the nature of the private pension system  and information from Labor and industry research. Regarding plan fees,  we also relied on our previous work that looked at the types of fees  associated with 401(k) plans, who pays these fees, how information is  disclosed to participants, and Labor’s oversight of fees and certain related  business arrangements. We conducted our review from February 2007  through March 2007 in accordance with generally accepted government  auditing standards.
In summary, there are more active participants now in 401(k) plans than  other types of employer-sponsored pension plans, a trend that has  accelerated since the 1980s. Now, 401(k) plans represent the majority of  all private pension plans; they also service the most participants and hold  the most assets. These plans offer a range of investment options, but  equity funds—those that invest primarily in stocks—accounted for nearly  half of 401(k) assets at the close of 2005. Most 401(k) plans are participant- directed, meaning that a participant is responsible for making the  investment decisions about his or her own retirement plan contributions.
Inadequate disclosure and reporting requirements may leave participants  without a simple way to compare fees among plan investment options, and  Labor without the information it needs to oversee fees and identify  questionable 401(k) business practices. The Employee Retirement Income  Security Act of 1974 (ERISA) requires 401(k) plan sponsors to disclose  only limited information on fees. Participants must collect various  documents over time and may be required to seek out some documents in  order to get a clear picture of the total fees that they pay. Furthermore, the  documents that participants receive do not provide a simple way to  compare fees—along with risk and historical performance—among the  investment options in their 401(k) plan. The information reported to Labor  does not identify all fees charged to 401(k) plans and therefore has limited  use for effectively overseeing fees and identifying undisclosed business  arrangements among consultants or service providers. As a result,  participants may have more limited investment options and pay higher  fees for these options than they otherwise would.
subsections: section_title: Background
paragraphs: Roughly half of all workers participate in an employer-sponsored  retirement, or pension plan. Private sector pension plans are classified as  either defined benefit or defined contribution plans. Defined benefit plans  promise to provide, generally, a fixed level of monthly retirement income  that is based on salary, years of service, and age at retirement regardless  of how the plan’s investments perform. In contrast, benefits from defined  contribution plans are based on the contributions to and the performance  of the investments in individual accounts, which may fluctuate in value.  Examples of defined contribution plans include 401(k) profit-sharing and  thrift-savings plans, stock bonus plans, and annuity plans.
Labor’s Employee Benefits Security Administration (EBSA) oversees  401(k) plans—including the fees associated with running the plans— because they are considered employee benefit plans under ERISA.  Enacted before 401(k) plans came into wide use, ERISA establishes the  responsibilities of employee benefit plan decision makers and the  requirements for disclosing and reporting plan fees. Typically, the plan  sponsor is a fiduciary. A plan fiduciary includes a person who has  discretionary control or authority over the management or administration  of the plan, including the plan’s assets. ERISA requires that plan sponsors  responsible for managing employee benefit plans carry out their  responsibilities prudently and do so solely in the interest of the plans’  participants and beneficiaries.
The law also provides Labor with oversight authority over pension plans.  However, the specific investment products commonly contained in  pension plans—such as company stock, mutual funds, collective  investment funds, and group annuity contracts—fall under the authority of  the applicable securities, banking, or insurance regulators:    The Securities and Exchange Commission (SEC), among other  responsibilities, regulates registered securities including company  stock and mutual funds under securities law.
The federal agencies charged with oversight of banks—primarily the  Federal Reserve Board, the Treasury Department’s Office of the  Comptroller of the Currency, and the Federal Deposit Insurance  Corporation—regulate bank investment products, such as collective  investment funds.
State agencies generally regulate insurance products, such as variable  annuity contracts. Such investment products may also include one or  more insurance elements, which are not present in other investment  options. Generally, these elements include an annuity feature, interest  and expense guarantees, and any death benefit provided during the  term of the contract.
section_title: An Increasing Number of Employees Participate in Defined Contribution Plans, and This Trend Has Been Increasing Since the 1980s
paragraphs: The number of defined contribution plans has increased since 1985, while  the number of defined benefit plans has declined dramatically. Figure 1  shows the growth of defined contribution plans relative to that of defined  benefit plans from 1985 to 2005.
In 2005, more workers were covered by defined contribution plans than by  defined benefit plans. In 1985, defined benefit plans covered  approximately 29 million active participants, compared to 33 million active  participants in defined contribution plans. By 2005, the difference in the  numbers had become more pronounced, with roughly 21 million active  participants covered by defined benefit plans and approximately 55 million  active participants in defined contribution plans. Figure 2 shows the shift  in active participants from defined benefit to defined contribution plans  since 1985.
With the growth in plans and participants, the majority of private pension  plan assets are now held in defined contribution plans. As shown in figure  3, defined benefit plan assets decreased from $2.0 trillion in constant 2006  dollars, or about 66 percent of total private pension assets, in 1985 to $1.5  trillion, or just over 40 percent of the total, in 2005.
Similarly, the number of 401(k) plans grew from less than 30,000 in 1985,  or less than 7 percent of all defined contribution plans, to an estimated  417,000 plans, or about 95 percent of all defined contribution plans in 2005.  During this same time period, the number of active participants in 401(k)  plans increased from 10 million to 47 million, and plan assets increased  from $270 billion to about $2.5 trillion in constant 2006 dollars.
Based on industry estimates, equity funds accounted for nearly half of the  401(k) plan assets at the close of 2005. Equity funds are investment  options that invest primarily in stocks, such as mutual funds, bank  collective funds, life insurance separate accounts, and certain pooled  investment products (see fig. 4). Other plan assets were invested in  company stock; stable value funds, including guaranteed investment  contracts; balanced funds; bond funds; and money funds. Several of these  options can be held in mutual funds, which in total represent about 51  percent of 401(k) plan assets. Common plan features, like the type and  number of investment options provided to participants in their 401(k)  plans, is a topic being studied under other GAO work on plan sponsor  practices requested by this committee.
With the growth in 401(k) plans, more workers now bear greater  responsibility for funding their retirement income. According to the most  recent data from Labor, the majority of 401(k) plans are participant- directed, meaning that a participant makes investment decisions about his  or her own retirement plan contributions. In 2003, about 88 percent of all  401(k) plans—covering 93 percent of all active 401(k) plan participants  and 92 percent of all 401(k) plan assets—generally allowed participants to  choose how much to invest, within federal limits, and to select from a  menu of diversified investment options selected by the employer  sponsoring the plan.
While some participants have account balances of greater than $100,000,  most have much smaller balances. Based on industry estimates for 2005,  37 percent of participants had balances of less than $10,000, while 16  percent had balances greater than $100,000. The median account balance  was $19,328, while the average account balance was $58,328. Participants’  account balances also include any contributions employers make on their  behalf.
Fees are charged by the various outside companies that the plan  sponsor—often the employer offering the 401(k) plan—hires to provide a  number of services necessary to operate the plan. Services can include  investment management (i.e., selecting and managing the securities  included in a mutual fund); consulting and providing financial advice (i.e.,  selecting vendors for investment options or other services); record  keeping (i.e., tracking individual account contributions); custodial or  trustee services for plan assets (i.e., holding the plan assets in a bank); and  telephone or Web-based customer services for participants. Generally  there are two ways to provide services: “bundled” (the sponsor hires one  company that provides the full range of services directly or through  subcontracts) and “unbundled” (the sponsor uses a combination of service  providers).
Fees are one of many factors—such as the historical performance and  investment risk for each plan option—participants should consider when  investing in a 401(k) plan because fees can significantly decrease  retirement savings over the course of a career. As participants accrue  earnings on their investments, they pay a number of fees, including  expenses, commissions, or other charges associated with operating a  401(k) plan. Over the course of the employee’s career, for example, a 1  percentage point difference in fees can significantly reduce the amount of  money saved for retirement. Figure 5 assumes an employee who is 45  years of age with 20 years until retirement changes employers and leaves  $20,000 in a 401(k) account until retirement. If the average annual net  return is 6.5 percent—a 7 percent investment return minus a 0.5 percent  charge for fees—the $20,000 will grow to about $70,500 at retirement.  However, if fees are instead 1.5 percent annually, the average net return is  reduced to 5.5 percent, and the $20,000 will grow to only about $58,400.  The additional 1 percent annual charge for fees would reduce the account  balance at retirement by about 17 percent.
section_title: Investment and Record-Keeping Fees Account for Most 401(K) Plan Fees, but Information on These Fees May Be Limited or Unavailable to Participants and Labor
paragraphs: Various fees are associated with 401(k) plans, but investment and record- keeping fees account for most 401(k) plan fees. However, inadequate  disclosure and reporting requirements may leave participants and Labor  without important information on these fees. The information on fees that  plan sponsors are required to disclose to participants does not allow  participants to easily compare the fees for the investment options in their  401(k) plan. In addition, Labor does not have the information it needs to  oversee fees and identify questionable 401(k) business practices. Labor  has several initiatives under way to improve the information it has on fees  and the various business arrangements among service providers.
subsections: section_title: Investment Fees Account for Most 401(k) Plan Fees and Are Usually Borne by Plan Participants
paragraphs: Investment fees account for the largest portion of total fees regardless of  plan size, as figure 6 illustrates. Investment fees are, for example, fees  charged by companies that manage a mutual fund for all services related  to operating the fund. These fees pay for selecting a mutual fund’s  portfolio of securities and managing the fund; marketing the fund and  compensating brokers who sell the fund; and providing other shareholder  services, such as distributing the fund prospectus.
Plan record-keeping fees generally constitute the second-largest portion of  plan fees. Plan record-keeping fees are usually charged by the service  provider to set up and maintain the 401(k) plan. These fees cover activities  such as enrolling plan participants, processing participant fund selections,  preparing and mailing account statements, and other related  administrative activities. Unlike investment fees, plan record-keeping fees  apply to the entire 401(k) plan rather than the individual investment  options. As shown in figure 7, these fees make up a smaller proportion of  total plan fees in larger plans, indicating economies of scale.
There are a number of other fees associated with establishing and  maintaining a plan, such as fees to communicate basic information about  the plan to participants. However, these fees generally constitute a much  smaller percentage of total plan fees than investment and plan record- keeping fees.
Whether and how participants or plan sponsors pay these fees varies by  the type of fee and the size of the 401(k) plan. Investment fees, which are  usually charged as a fixed percentage of assets and deducted from  investment returns, are typically borne by participants. Plan record- keeping fees are charged as a percentage of a participant’s assets, a flat  fee, or a combination of both. Although plan sponsors pay these fees in a  considerable number of plans, they are increasingly being paid by  participants.
section_title: Required Disclosures Provide Limited Fee Information to Assist Participants in Comparing Investment Options
paragraphs: ERISA requires that plan sponsors provide all participants with a summary  plan description, account statements, and the summary annual report, but  these documents are not required to disclose information on fees borne by  individual participants. Table 1 provides an overview of each of these  disclosure documents, and the type of fee information they may contain.
ERISA also requires 401(k) plan sponsors that have elected liability  protection from participants’ investment decisions to provide additional  fee information. Most 401(k) plan sponsors elect this protection and  therefore must provide, among other information, a description of the  investment risk and historical performance of each investment option  available in the plan and any associated transaction fees for buying or  selling shares in these options. Upon request, these plans must also  provide participants with the expense ratio—a fund’s operating fees as a  percentage of its assets—for each investment option.
Plan sponsors may voluntarily provide participants with more information  on fees than ERISA requires. For example, plans may distribute  prospectuses or fund profiles for individual investment options in the plan.  Although not required, plan sponsors may provide record-keeping or other  information on fees in participants’ account statements.
Although participants are responsible for directing their investments in the  plan, they may not be aware of the different fees that they pay. In a  nationwide survey, more than 80 percent of 401(k) participants report not  knowing how much they pay in fees. Some industry professionals said  that making participants who direct their investments more aware of fees  would help them make more informed investment decisions.
Participants may not have a clear picture of the total fees they pay because  plan sponsors provide this information in a piecemeal fashion. Some  documents that contain fee information are provided to participants  automatically, such as annually or within 90 days of joining the plan, while  others, such as prospectuses, may require that participants seek them out.
Furthermore, the documents that participants receive do not provide a  simple way for participants to compare fees among the investment options  in their 401(k) plan. Industry professionals suggested that comparing the  expense ratio across investment options is the most effective way to  compare fees within a 401(k) plan. The expense ratio is useful because it  includes investment fees, which account for most of the fees participants  pay, and is generally the only fee measure that varies by option. However,  as noted above, not all plan sponsors are required to provide expense  ratios to participants.
section_title: Labor Has Authority Over 401(k) Plan Fees and Certain Types of Business Arrangements, but Lacks Information for Effective Oversight
paragraphs: Labor has authority under ERISA to oversee 401(k) plan fees and certain  types of business arrangements involving service providers, but lacks the  information it needs to provide effective oversight. Under ERISA, Labor is  responsible for enforcing the requirements that plan sponsors (1) ensure  that fees paid with plan assets are reasonable and for necessary services;  (2) be prudent and diversify the plan’s investments or, if plan sponsors  elect liability protection, provide a broad range of investment choices for  participants; and (3) report information known on certain business  arrangements involving service providers. Labor does this in a number of  ways, including collecting some information on fees from plan sponsors,  investigating participants’ complaints or referrals from other agencies on  questionable 401(k) plan practices, and conducting outreach to educate  plan sponsors about their responsibilities.
However, the information plan sponsors are required to report to Labor is  limited, and the lack of information hinders the agency’s ability to  effectively oversee fees. Many of the fees are associated with the  individual investment options in the 401(k) plan, such as a mutual fund;  they are deducted from investment returns and not included on the annual  reporting form plan sponsors submit to Labor, Form 5500. As a result, the  Form 5500 does not include the largest type of fee, even though plan  sponsors receive this information from the mutual fund companies in the  form of a prospectus. In 2004, the ERISA Advisory Council concluded that  Form 5500s are of little use to policy makers, government enforcement  personnel, and participants in terms of understanding the cost of a plan  and recommended that Labor modify the form and its accompanying  schedules so that all fees incurred directly or indirectly can be reported or  estimated. Without information on all fees, Labor’s oversight is limited  because it is unable to identify fees that may be questionable.
Labor and plan sponsors also may not have information on arrangements  among service providers that could steer plan sponsors toward offering  investment options that benefit service providers but may not be in the  best interest of participants. For example, the SEC released a report in  May 2005 that raised questions about whether some pension consultants  are fully disclosing potential conflicts of interest that may affect the  objectivity of the advice. Plan sponsors pay pension consultants to give  them advice on matters such as selecting investment options for the plan  and monitoring their performance and selecting other service providers,  such as custodians, administrators, and broker-dealers. The report  highlighted concerns that these arrangements may provide incentives for  pension consultants to recommend certain mutual funds to a 401(k) plan  sponsor and create conflicts of interest that are not adequately disclosed  to plan sponsors. Plan sponsors may not be aware of these arrangements  and thus could select mutual funds recommended by the pension  consultant over lower-cost alternatives. As a result, participants may have  more limited investment options and may pay higher fees for these options  than they otherwise would.
In addition, specific fees that are considered to be “hidden” may mask the  existence of a conflict of interest. Hidden fees are usually related to  business arrangements where one service provider to a 401(k) plan pays a  third-party provider for services, such as record keeping, but does not  disclose this compensation to the plan sponsor. For example, a mutual  fund normally provides record-keeping services for its retail investors, i.e.,  those who invest outside of a 401(k) plan. The same mutual fund, when  associated with a plan, might compensate the plan’s record keeper for  performing the services that it would otherwise perform, such as  maintaining individual participants’ account records and consolidating  their requests to buy or sell shares.
The problem with hidden fees is not how much is being paid to the service  provider, but with knowing what entity is receiving the compensation and  whether or not the compensation fairly represents the value of the service  being rendered. Labor’s position is that plan sponsors must know about  these fees in order to fulfill their fiduciary responsibilities. However, if the  plan sponsors do not know that a third party is receiving these fees, they  cannot monitor them, evaluate the worthiness of the compensation in view  of services rendered, and take action as needed.
section_title: Labor Has Several Initiatives Under Way to Improve Information It Has on Fees and the Various Business Arrangements Among Service Providers
paragraphs: Labor officials told us about three initiatives currently under way to  improve the disclosure of fee information by plan sponsors to participants  and to avoid conflicts of interest:    Labor is considering promulgating a rule regarding the fee information  required to be furnished to participants in plans where sponsors have  elected liability protection. According to Labor officials, they are  attempting to define the critical information on fees that plan sponsors  should provide to participants and what format would enable  participants to easily compare the fees across the plan’s various  investment options.
Labor has proposed changes to the Form 5500 Schedule A and  Schedule C to improve reporting of fees.
Labor proposed to add a check box on Schedule A to improve the  disclosure of insurance fees and commissions and identify insurers  who fail to supply information to plan sponsors. According to a 2004  ERISA Advisory Council report, many employers have difficulty  obtaining timely Schedule A information from insurers.
Consistent with recommendations made by the ERISA Advisory  Council Working Groups and GAO, Labor proposed changes to the  Schedule C to clarify that the plan sponsor must report any direct  and indirect compensation (i.e., money or anything else of value) it  pays to a service provider during the plan year. Plan sponsors also  would be required to disclose the source and nature of  compensation in excess of $1,000 that certain key service providers,  including, among others, investment managers, consultants,  brokers, and trustees as well as all other fiduciaries, receive from  parties other than the plan or the plan sponsor, such as record  keepers. Labor officials told us that the revision aims to improve the  information plan sponsors receive from service providers. The  officials acknowledge, however, that this requirement may be  difficult for plan sponsors to fulfill without an explicit requirement  in ERISA for service providers to give plan sponsors information on  the fees they pay to other providers.
The third initiative involves amending Labor’s regulations under  section 408(b)(2) of ERISA to define the information plan sponsors  need in deciding whether to select or retain a service provider.  According to Labor, plan sponsors need information to assess the  reasonableness of the fees being paid by the plan for services rendered  and to assess potential conflicts of interest that might affect the  objectivity with which the service provider provides its services to the  plan. This change to the regulation would be intended to make clear  what plan sponsors need to know and, accordingly, what service  providers need to provide to plan sponsors.
To ensure that participants have a tool to make informed comparisons and  decisions among plan investment options, we recommended in our  previous report that Congress consider amending ERISA to require all  sponsors of participant-directed plans to disclose fee information of  401(k) investment options to participants in a way that facilitates  comparison among the options. To better enable the agency to effectively  oversee 401(k) plan fees, we recommended that the Secretary of Labor  should require plan sponsors to report a summary of all fees that are paid  out of plan assets or by participants. To allow plan sponsors, and  ultimately Labor, to provide better oversight of fees and certain business  arrangements among service providers, we also recommended that  Congress should consider amending ERISA to explicitly require that  401(k) service providers disclose to plan sponsors the compensation that  providers receive from other service providers. In response to our draft  report, Labor generally agreed with our findings and conclusions.  Specifically, Labor stated that it will give careful consideration to GAO’s  recommendation that plans be required to provide a summary of all fees  that are paid out of plan assets or by participants. Labor and SEC also  provided technical comments on the draft, which we incorporated as  appropriate.
section_title: Conclusions
paragraphs: The pension plan universe has changed: 401(k) plans have emerged to  cover most plan participants and the majority of plan assets. With this  shift, participants now bear more responsibility for ensuring they have  adequate income in retirement, emphasizing the importance of having  sufficient information to make informed 401(k) investment decisions.  Information about investment options’ historical performance is useful,  but alone is not enough. Thus, giving participants key information on fees  for each of the plan’s investment options in a simple format—including  fees, historical performance, and risk—will help participants make  informed investment decisions within their 401(k) plan. In choosing  between investment options with similar performance and risk profiles but  different fee structures, the additional provision of expense ratio data may  help participants build their retirement savings over time by avoiding  investments with relatively high fees.
Regulators, too, will need to have better information to provide more  effective oversight, especially of the fees associated with 401(k) plans.  Amending ERISA and updating regulations to better reflect the impact of  fees and undisclosed business arrangements among service providers will  help put Labor in a better position to oversee 401(k) plan fees.  Furthermore, requiring plan sponsors to report more complete  information to Labor on fees—those paid out of plan assets or by  participants—would put the agency in a better position to effectively  oversee 401(k) plans.
section_title: Contacts and Acknowledgements
paragraphs: For further information regarding this testimony, please contact Barbara  D. Bovbjerg, Director, or Tamara Cross, Assistant Director, Education,  Workforce, and Income Security Issues at (202) 512-7215 or  bovbjergb@gao.gov. Individuals making key contributions to this  testimony include Daniel Alspaugh, Monika Gomez, Michael P. Morris,  Rachael Valliere, Walter Vance, and Craig H. Winslow.
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