The Wall Street Journal published an article July 6 entitled, “Percentages vs. Dollars — a Battle for Investors' Attention.” Basically, the article contends that, “percentages don't seem like real money to many people. In particular, some experts worry that investors don't fully grasp the magnitude of risks and expenses when they see them in percentage form.”
It would seem that there is little argument as to how investors experience a percentage-based versus a dollar fee expense. The former requires an extra mental step to calculate what one is being charged, while the latter is experienced much like 99% of the products and services consumers buy every day.
In the DC industry, this issue impacts essentially three types of providers: money managers, investment advisors and record keepers.
In terms of money management, the practice of charging an asset-based fee is a deeply imbedded practice. Few expect this to change. Flat-fee providers such as Folio Investing and Motif Investing, the former being around for 15 years and the latter being recently established, have not, as of this writing, been shown to pose a significant challenge to asset-based pricing in the money management industry.
Investment advisory is a bit of a different story. In the large and jumbo DC market, it has been the practice for large companies to hire investment consultants on a time-and-expense basis to help plan sponsors create an investment policy statement (IPS), establish an investment committee and recommend fund lineups. In the midsize and particularly the small DC segments, however, asset-based fee pricing structures are more common. This is especially the case if the investment advisory firm is serving as a 3(38) and/or performing asset allocation services.
In terms of a trend, however, it appears that the flat-fee model continues to drift downward from the large to mid-market. That said, it seems certain that it will take some time for flat-fee based pricing to become the dominant model in the mid-market — and a very long time before it hits the small market. This will be the case because without an increase in compensation, few plan advisors will be willing to take on extra fiduciary risk as plans become larger.
So while the money management fee structure is not under any significant pressure to change and investment advisors are getting pressures to do so at the larger end of the mid-market, the record keepers are experiencing it at all levels. The logic seems to be that a record keeper’s risk/reward should not change as the plan assets increase. However, if the record keeping fees are paid out of plan assets (which most are in the low end of the market), a flat fee can create challenges for the plan sponsor.
Given that small plans costs are significantly greater on a per-participant basis, it is challenging to charge a per-participant fee to DC investors. Here is the challenge: a participant contributes $1,000 to a DC plan and gets charged $100 for an annual record keeping fee. That is experienced as a 10% investment loss in year one. An asset-based fee helps to ameliorate this problem by charging a fee on a pro rata basis tied to assets held in the plan. This is essentially what happens in the majority of small plans in which the fees are charged against the plan versus being paid for by the plan sponsors — either through an investment product or by allocating expenses based on assets held.
Conclusion
The Journal article is spot on as it relates to the psychological aspects of how investors experience a fee when expressed as a percentage of assets versus a dollar amount. However, this may be somewhat irrelevant in the DC space for the various providers — money managers, plan advisors and record keepers. Though most providers prefer the asset-based approach to fees (plans generally become larger over time), the major limiting factor will be the way in which providers are willing to charge their fees in the various market segments. In other words, competition will drive much of what happens as it relates to how fees are charged.
While many money managers and plan advisors bemoan the fact that most record keepers (on an asset-weighted basis) in the small market charge an asset-based fee, which is often imbedded in a group annuity product, few want to enter the razor-thin business of keeping participant records on a purely unbundled basis (and making no money on money management or advisory services). No doubt the most challenging segment of this business from a profitability standpoint is to be an independent record keeper that is continually being “spread-sheeted” against its competitors, many which have asset-based fees. There seems to be no mad rush to enter this space, with the exception of a few private equity firms who believe this model will change someday.
Be that as it may, the DC industry, although buffeted by the forces of DOL regulation and threats from the plaintiff’s bar, it is still mostly a market-driven business.
