Taxes Come In All Shapes and Sizes

Jim Lorenzen, CFP®

My thanks to Harold Evensky for the heads-up on this one.  In his newsletter, he cites Jason Zweig’s recent Wall Street Journal Intelligent Invest column, entitled “Watch Out for the Hidden Tax Traps Inside ETFs”  

ETFs are generally very tax efficient and are very low-cost investments, as well, which is one of the reasons I like them so much and do use them in client portfolios; but, in his column, he warns, “… the mad dash in ETFs lately has been into ‘alternative assets’ like currencies and commodities.  The investment researchers at Morningstar track 108 such ETFs… these funds are taxed so differently and at such higher rates than traditional investments, that many investors wish they had looked before they had leaped.” 

According to Zweig, “Wells Fargo Advisors has estimated that many commodity EFTs can be taxed six different ways and currency EFTs in eight!”

It pays to do your homework, doesn’t it?

Trying To Get Back to Even?

Jim Lorenzen, CFP®

You say your investments are down and you’re wondering what it takes to get back to even?  This little story might interest you.

I’m out on the practice putting green near my office,  getting a little fresh air during lunch and shooting the breeze with a few friends, when one of them says, “I had all of my 401(k) in a small cap stock fund that lost 50% during the downturn.  Since then, it’s up 75%!  I should be ahead, but my statement says I’m still down almost 10%!  What gives?”

A lot of people are probably in a similar boat.  Unfortunately, the math doesn’t work that way.  Example:  A $1,000 investment experiences a 50% loss and is now valued at $500.  What does it take to get back to $1,000?  You guessed it:  A 100% gain…. 75% won’t do it.

The table below demonstrates why we, and so many other professionals, focus so much on volatility, not just absolute returnsl.

Down and back to even

-10%  11%

-20%  25%

-30%  43%

-40%  67%

-50%  100%

-60%  150%

-70%  233%

-80%  400%

-90%  900%

Limiting the ‘downside’ just might be worth giving up a little on the upside.  Know someone who’s always `chasing return’ by jumping on ‘hot tips’?  This may be worth their knowing.

The Benchmark Myth

Jim Lorenzen, CFP®

 

We’ve all heard it.  We’ve all read it.  Most managers fail to match, let alone beat, the market.   

Actually, it makes sense!  And, there’s a very simple reason for this, which comes in two parts. 

First, if you believe – probably rightly so – that institutional managers of giant pension plans, mutual funds, etc., actually comprise most of the trading volume, then you begin to realize the managers ARE the market. 

So, if they ARE the market, why is it half of them don’t perform above the average and half below?  That brings us to the second reason:  Expenses. 

Indexes don’t have expenses.  You can’t even buy an index.  You can buy An index mutual fund or exchange-traded fund (ETF) that replicates an index, but not the index.\ 

Managers, however, are judged on portfolio net-asset-value (NAV) – the value after expenses. 

Let’s use an example you experience every day:  Your house. 

Suppose you bought a house for $250,000 and it appreciated in value right along with the overall housing market at 5% per year for 13 years.  Did you tie the market? 

Now, let’s use some assumptions you would have to take into account to report YOUR performance: 

1. Property taxes are and remain at 1% per year
2. Insurance is only 0.5% of value each year
3. Maintenance is less than 1% and rises at 3% per year
4. Final selling costs are only 3%
5. Moving costs, loan interest expenses, and cash flow loss is ignored.

  

 What does your performance look like?

Year	$250,000	Prop Txs	Ins. Exp.	Maint.	Sell	Value
1	$262,500	$2,500	$1,313	$2,400		$256,288
2	$275,625	$2,500	$1,378	$2,472		$269,275
3	$289,406	$2,500	$1,447	$2,546		$282,913
4	$303,877	$2,500	$1,519	$2,623		$297,235
5	$319,070	$2,500	$1,595	$2,701		$312,274
6	$335,024	$2,500	$1,675	$2,782		$328,067
7	$351,775	$2,500	$1,759	$2,866		$344,651
8	$369,364	$2,500	$1,847	$2,952		$362,065
9	$387,832	$2,500	$1,939	$3,040		$380,353
10	$407,224	$2,500	$2,036	$3,131		$399,556
11	$427,585	$2,500	$2,138	$3,225		$419,722
12	$448,964	$2,500	$2,245	$3,322		$440,897
13	$471,412	$2,500	$2,357	$3,422	$14,142	$448,991

The market did 5% per year; but YOUR record was 4.6% per year. 

Your record looks like it’s 0.4% below market, right?     It’s actually 8% below the market performance (5% – 8% of 5% = 4.6%). 

Your house tied – you didn’t.  

Now you know why my most managers don’t outperform the index.  Collectively, they are the index; but they have expenses, too.

CFP Board Survey Findings Revealed

Jim Lorenzen, CFP®

 

Last week, the CFP Board released their survey findings from 1,002 Americans.  The survey revealed:  

• Nearly two out of three Americans (65 percent) are more concerned about their finances today than they were at the beginning of the financial crisis two years ago.
• A bit more than a third of Americans (37 percent) expect to see their personal finances improve in the next six months, versus less than half (46 percent) who expect to hold onto what they currently have, and 16 percent who expect to lose money.
• 80 percent of Americans say that Congress and regulators have not done enough “to deal with the financial market problems and their impact on American investors.”
• A bright spot in the findings: 44 percent of Americans expect the U.S. economy to improve in the next six months, while only 28 percent expect things to get worse. A smaller group (22 percent) anticipates no change in the economy.
• When asked to describe how they feel about their personal finances, the #1 response from Americans was “cautious” (33 percent), followed by “calm” (26 percent), “concerned” (25 percent) and “hopeful” (25 percent). (Multiple responses were permitted to this question.)
• Interestingly, ethnicity seems to bear on the perception of the prospects for the economy, with just 38 percent of whites expecting the economy to improve, compared to 51 percent of Hispanics and 74 percent of African Americans.

“This survey clearly shows that restoring the trust of Americans in our financial markets is an unfinished work in progress,” said Robert J. Glovsky, J.D., LL.M., CFP^®, 2010 CFP Board Chairman, president of Boston-based Mintz Levin Financial Advisors, LLC, and emeritus director of Boston University’s Program for Financial Planners. “Financial planners across the U.S. hear every day from anxious Americans. After the experience of the last two years, more people want to deal with financial professionals who are able to take a holistic view of people’s finances and who uphold a fiduciary standard that puts their clients’ interests ahead of all others, including their own. This is why CFP^® professionals are going to be more important than ever going forward.”  

The survey found the following about Americans’ attitudes toward financial planners:  

• More than two out of five Americans (43 percent) think financial planners are now “more important in the last two years since the start of the financial crisis,” compared to about a third (36 percent) who see no change, and 14 percent who now see planners as being “less important.”
• Overall use of financial planners by Americans has remained almost unchanged during the first two years of the U.S. financial crisis – starting at 29 percent compared to 28 percent today.
• Of those who have started using a financial planner since the start of the financial crisis, nearly a third (31 percent) say they have done so because “I felt like I needed more financial guidance during these difficult times for investors.” A bigger percentage of those in this group (44 percent) said they have started using a financial planner during the last two years for reasons “unrelated to the financial crisis.”

OTHER KEY SURVEY FINDINGS  

• Only 14 percent of Americans think Congress and regulators have done “much” or “all” of what needs to be done.
• When asked to describe the economy as an animal, they tend towards slow, lumbering animals like sloths, bears, turtles, and elephants; few choose the iconic symbol of confidence, the bull.
• Almost two thirds of Americans (64 percent) say they are “very” or “somewhat” financially prepared for the future.
• The top three financial planning issues for Americans today are retirement goals and planning (30 percent), education funding (25 percent) and savings goals and planning (23 percent).

For full survey findings, go to www.CFP.net.

Do You Remember These Incidents?

 

   

Jim Lorenzen, CFP®

 

Crisis:  Russia devalued the ruble in August 1998, causing huge losses to international banks, hedge fund bankruptcies, and massive selling on the global financial markets.  

Change:  The Federal Reserve Board cuts interest rates by 75 basis points (0.75%) to provide liquidity.  

Opportunity:  The rate cut restored confidence and liquidity to global markets.  The MSCI World Index (an unmanaged index of world stocks)  from 937 on August 31, 1998 to 1155 on December 29, 1998, a gain of 18% in four months.  

 ————  

Crisis:  Mexico’s economy and government were brought to the brink of collapse by a credit crisis in 1994.  

Change:  The U.S. government lent Mexico $60 billion at the last minute.  

Opportunity:  In less than three months, Mexico’s stock market turned around.  The Mexican Bolsa Index gained 18% for the year 1995 and almost 22% in 1996.  Telefonos de Mexico, the country’s largest stock, fell to $25 a share but doubled in value in three years.  

 ———–  

Crisis:  Europe was rocked by exchange rate turmoil and economic recession in 1992.  

Change:   The UK dropped out of the European Exchange Rage Mechanism resulting in an historic devaluation of the British pound.  

Opportunity:  A cheaper currency stimulated British export industries and made the country more attractive to foreign investment.  For example, Glaxo-Wellcome, the consumer products giant, slumped to about $15 a share during the crisis but has since quintupled in value, rising to a high of $75 a share.  

 ———-  

Crisis:  The U.S. savings and loan industry faced insolvency in 1988.  

Change:  The U.S. government created the Resolution Trust Corporation (RTC), a $500 billion rescue plan.  

Opportunity:  In 1991, still in the midst of a banking crisis, investors could buy Citicorp for $9 a share.  That price appreciated to more than $145 before Citicorp merged with Traveler’s in 1998.  

 ———–  

Crisis:  Chrysler, the nation’s largest automaker, was headed for bankruptcy in the 1970s.  

Change:  The government extended loans to keep the company afloat.  

Opportunity:  Chrysler stock was worth less than $5 until the mid 1980s, but rose to $50 per share as a result of cost-cutting and new products.  Daimler-Benz acquired Chrysler last year for approximately $57 a share.  

————–  

In each of these crises, the media created a public perception of doom.    If there’s a single secret for long-term success, I think it’s this:  Don’t predict and don’t react.  

People who watch television trying to predict will virtually always get it wrong.  Face it, if that worked, Peter Lynch would have managed money that way.   If you’ve ever read anything by Peter Lynch, Warren Buffett, or most other successful investors, you know they didn’t pay much attention to “the market” at all!  I remember Warren Buffet saying he didn’t care if it closed down entirely.  

Remember, don’t confuse education with financial entertainment.

It May Be Time To ‘Manage The Downside’.

Jim Lorenzen, CFP®

 

Are we in a new investment environment very different from what we’ve known in the past?   

Many investors think so.  If true,  this new environment  just might require a different investment model than the one most investors are used to.    

The high volatility of the past seemed to reward being fully invested.   We had high volatility, but it was linked to high average returns.   You were rewarded for remaining fully invested in stocks.     

 This time, the environment might be different:   High volatility linked to lower average annual returns.  If that turns out to be true, the old investment model may not work very well and the real money managers will have to step forward.   

I created a purely hypothetical volatile market (20% moves each year) in Figure A and arranged the returns to begin and end with an `up’ year. I even put two `up’ years back-to-back in years 7 and 8 and even arranged for 3 out of 4 to be `up’ years at the end! The resulting average annual compound return is only 2.03%… below historic inflation figures.   You’re in a bad market, but it looks good enough – enough of the time – to keep you hoping to win.   The key to this market is limiting losses.

Figure A Amount Invested: $100,000         Market Portfolio Year Return      A 1 20% $120,000 2 -20% $96,000 3 20% $115,200 4 -20% $92,160 5 20% $110,592 6 -20% $88,474 7 20% $106,168 8 20% $127,402 9 -20% $101,922 10 20% $122,306

Figure B shows the same market if an investor gives up 40% of each `up’ year and captures only 25% of the downside moves. The result is $38,463 more, despite having no big `up’ years to brag about.   So, capturing only 60% of the upside and only 25% of the downside would look like this:

Figure B:  Amount Invested:   Up Cap> 60%    $100,000     Dn Cap> 25%     Market Portfolio Portfolio            Year Return B Return       B Difference 1 20% 12% $112,000 -$8,000 2 -20% -5% $106,400 $10,400 3 20% 12% $119,168 $3,968 4 -20% -5% $113,210 $21,050 5 20% 12% $126,795 $16,203 6 -20% -5% $120,455 $31,981 7 20% 12% $134,910 $28,741 8 20% 12% $151,099 $23,697 9 -20% -5% $143,544 $41,622 10 20% 12% $160,769 $38,463

This is purely hypothetical, of course;  but it does seem to illustrate that if those experts are right, those who manage the downside will be the ones making money.   No more riding the waves.  

Will the real managers please stand up.

Amazing! – But, Depressing…

Jim Lorenzen, CFP®

I found a few interesting pieces of data from the Journal of Financial Planning:

• 54% of Americans do not have a retirement plan.  They don’t know how much income they’ll need or where the money will be coming from.
• 10,000 – The number of baby boomers becoming eligible for Medicare and Social Security EACH DAY for the NEXT TWO DECADES!
• $13,700 – The average cost of family healthcare coverage per year for a small firm.
• 1.86% – The median annual return increase for employees who use the 401(k) financial advice offered by their advisor over those who don’t.   What does that mean?  A young person getting help  and investing $2,000 per year for 20 years could have $47,923 more at retirement!  Hmmm.  1.86% isn’t so small, after all.

But, not everyone’s smart.

RegisteredRep magazine recently published their list of the 2010 Worst Managed University Endowments.   The Ivy League schools didn’t look so good:  Harvard was the worst, followed by Yale!  Brown was 4th!  Who were the three best?  Washington State, Virginia Tech, and the University of Utah.

Do You Know Your Mutual Funds’ True Costs?

Jim Lorenzen, CFP®

 It’s a safe bet that most investors, and indeed even many financial advisors, have no idea how much they’re really paying for the investments they hold.            

This wasn’t something investors paid attention to when the stock market was roaring along at a double-digit pace and bonds were paying high yields; but times have changed, haven’t they?            

Since mutual funds might arguably be considered the most popular vehicle for individual investors, it might be worth looking ‘under the hood’ to see where your money is going.            

Most funds fall into one of three broad categories:  Stocks, bonds, or so-called `balanced’ funds – I say ‘so-called’ because these funds vary widely in characteristics and, frankly, I’ve always felt there are just too many variables to know what your allocations really are.            

For the sake of illustration only, let’s assume you have a stock fund with annual expenses of 1.4% – you can look in your own funds’ prospectuses to find yours.             

Is that 1.4% your total expense?  Not at all.  It does not include trading costs!  That’s right, the fund’s trading costs are not included in annual expenses.  They’re actually hidden in the price of the fund, it’s net asset value (NAV).  You see, when a fund manager makes trades, s/he pays commissions just like you do; and what the fund realizes after the trade are the ‘net proceeds’ of the transaction, which becomes part of the NAV.  John Bogle – is he still President of Vanguard? – estimated in his book, ‘Bogle on Mutual Funds’ that these hidden costs were probably around 0.6% per trade.   That ‘per-trade’ verbiage is important, as you’ll see.             

So, now we have a hypothetical 1.4% in annual expenses, plus 0.6% per trade.  Is that all?   Okay, like the broker in the Scottrade commercial asks, `What else?’             

 Have you ever heard of market-impact costs?            

Huh?           

As we know, fund managers rarely make ‘round-lot’ 100-share transactions.  They are known for moving large blocks of securities on a single trade!    Whether it’s a buy or a sell, it can affect the stock’s price when they trade.    Market-impact costs have to do with the effects a fund’s trading actually has on the price of a stock.    A BusinessWeek article I read ten years ago estimated that these costs range from 0.15% to 0.25%.   I doubt much has changed, but we can I think we can conservatively use the low-end.    Okay, our hypothetical fund has 1.4% in annual expenses, 0.6% in trading costs, and let’s say 0.15% in market impact costs.            

Now, let’s look at turnover.  How often does the manager turnover the portfolio?  Again, examine the data for your own funds; but, let’s assume our hypothetical stock fund has a turnover of 120% – not an unrealistic assumption for a growth fund, to be sure.  What does that mean?      

Annual Expense Ratio	1.40%
Trading Turnover: 2.2 x 0.6%	1.30%
Impact Turnover:  2.2 x 0.15%	0.33%
Total	3.03%

           

Oops!  We’re not paying 1.4%; we’re really paying 3.03% – more than double what we thought!   And, it gets worse.  That percentage doesn’t go down as (if) you grow your assets.  The investor with $1 million is paying the same percentage as the new investor who’s beginning with an initial $1,000 deposit!             

Yes, I promised to come back to the importance of ‘turnover’ in the portfolio. Did you notice that the 120% turnover is computed with a 2.2 factor?  That’s because you have to `establish’ a position before you can turn it over.  That’s two trades.  The 120% turnover means that all positions are established and replaced, and it happens yet again to 20% of the fund’s portfolio!   Now, trading costs and market impact costs – all hidden in the NAV – become even more important.  As you can see in our hypothetical, the trading costs alone almost equal the fund’s annual expenses.             

Okay… we’ve got annual expenses, trading costs, market impact costs and then we’ve got turnover….  WHAT ELSE?     

How about 12B-1 fees?      I think this is when the broker drops his head in disgust.  12B-1 fees were, in my opinion, foisted upon the public by the industry claiming it would pay advertising and marketing expenses and help keep overall expenses down.   Yeah, sure, okay.  The truth is they primarily provide residual income to brokers – and if you have a good broker, there’s nothing wrong with that.  That compensation is what allows them to spend time on client service issues.  My issue with 12B-1 fees arises when an investor is paying them and isn’t using a broker.  The fund company is, in my opinion, just pocketing the money that would be going to a broker.     

Oh, yeah,   if you’re using a broker there are likely commissions.   Despite all the bad things you may have heard about commissions, they do have their place.   My own view is that the existence of commissions is what allows brokers to handle smaller accounts – people who otherwise wouldn’t be able to access professional help.   Fee-only planning and advisory practices like mine, for example, generally need higher asset-level  minimums to generate the revenue required to support the infrastructure our clients expect and deserve.   One might think you only need add more clients; but the reality is that service and manager oversight issues take time, and time is a finite commodity.  For this reason, many seasoned advisors – after nineteen years, I may fit that description – generally ‘cap’ their client list at one hundred in order to make sure no one is being neglected.  It’s simple math.  Financial objectives must be met within the 100-client cap.   But, I digress.   

Quick recap:   It’s not that any of these charges are necessarily good or bad; but, it’s important for investors to know what they’re paying in order to assess true net value – and to form realistic expectations.            

Hope this helps!

Are We in Depression, Recession, or Recovery?

Jim Lorenzen, CFP®

 

Hope you had a great 4^th of July!  It’s one of my favorite holidays and I always enjoy seeing the ‘Capitol Fourth’ celebration on tv; I lived in the Washington DC area for eight years – back before the barricades, when you could park your car almost anywhere and walk into virtually any building.  I used to drive past the Pentagon, cross the Lincoln Memorial Bridge, and pass by many of those monuments on my way to work every day.  Good memories. 

Unfortunately, the jobs report on Friday was disappointing – again.   And, all the Keynesian[i] economists that usually populate Washington and never having made a payroll see still more stimulus spending as the answer.  

As the divide widens between the parties and Obama feels pinched between the economy on one side and oil spills on the other, you can expect his attention will likely turn to immigration as the November elections draw closer. 

Double-Dip? 

If your neighbor is out of work, that’s a recession.  If YOU are out of work, that’s a depression. 

–       Ronald Reagan 

Someone asked me just last week if we were really in a depression.  When I asked him what made him think we might be, his answer didn’t surprise me:   His wife had been laid-off from her staff position at a major drug company five months ago and she can’t find work in her field anywhere.  In the meantime, his income isn’t enough to support the beautiful home they purchased a little over two years ago when no one expected the economic melt-down that ensued.   Since they don’t have any equity in the house, they’re on the verge of losing everything and wondering where they’re going to go. 

Not an unusual story. 

Lourdes and I know of another who’s been out of work for two years with still no prospects; and another couple who are being forced to leave their second house (this time as renters) because their landlord is being foreclosed on by the bank!  I could go on – and you no doubt know people yourself. 

Businesses aren’t hiring because of a number of negatives, as well as unknowns all related to the inability to project and forecast the cost of doing business over the next three to five years, i.e., health care, taxes, regulatory issues, etc., all have attendant costs that reduce profit, narrow margins, and take expansion capital off the table. 

Strange as it may seem, all of this news – while sounding bad for the markets – may just be ‘par for the course’ as recoveries out of recessions go. 

Doug Short’s analysis[ii] of the first 500 days of sixteen recoveries in the Dow Jones Industrial Average (DJIA) since it’s creation in 1896.  He analyzed all the Dow rallies following a 30% or greater decline[iii]  At any rate, as of the Dow’s close on June 29^th, the current recovery places 9^th compared to the other 15.  The volatile recovery after the Crash of 1929 leads the pack by a wide margin.    Some of the historic 500-day rallies went on to substantially higher gains – the Roaring Twenties, the Boomer Era that stated in 1982.  However, some of the earlier rallies (1903, 1907, 1914) would soon falter, as did 

the rallies of 1962, 1970, and 1974.  When the recoveries are adjusted for inflation, the picture becomes even more obvious. 

What’s Next? 

Mr. Short didn’t say; but, let’s give him a break, who does?  I watched the ‘financial block’ on FoxNews this past Saturday morning and heard just as many people say the market was terrible and they didn’t like anything about it as there were people saying this was a great buying opportunity.   It only confirms that’s what makes a market:  Bulls and Bears.    After all the dust has settled, I think those that kept their eyes on the lighthouse – stuck to their plan – will be the ones that best weather the storm. 

Some Inside Baseball 

There are a couple of new additions to the IFG website:  

–       Jim’s Blog has been added.  This will contain most of my memo content and will have additional posts not contained in memos; however, ‘Clients Only’ memos will not be posted. 

–       A new initial data gathering tool has been added.   This is primarily for new clients, but current clients are able to use it, too[iv].    I’ve been looking for some time to find a quality, credible third-party vendor in the industry that  could integrate with our MoneyGuide Pro platform and we now have them in place.  There’s a ‘generic’ demo on the site, as well as the tool itself.  Clients will find the tool in the Clients Only section. 

In addition, we now have an online  ‘meeting room’, which is just what it sounds like.  It allows me to conduct introductory meetings for new prospective clients, as well as online meetings with existing clients.  If you can be on the phone and the internet at the same time, you can do it.  These days, most everyone is on internet through cable, DSL, or some other broadband platform.  The only question is whether you have access to a nine-year-old – they’re the only ones who REALLY understand all this stuff.  It’s a Webex-hosted meeting room, some of you may be familiar with Webex, already.  

---

[i] John Maynard Keynes (1883-1946) was a British economist and government advisor who came into prominence in 1935 when he took issue with classical economists like Adam Smith, who believed economies worked best when left alone.  Keynes believed in active government intervention.  His approach could be called ‘demand-side’ economics.  He believed that government manipulation of government taxation and spending could pump money into the economy, creating spending by consumers.  This approach remained popular in America from the Great Depression until the 1980’s when, after repeated recessions, high interest rates, and high unemployment, ‘supply-siders’ began to promote the idea that government was the problem, not the solution. [Barron’s Finance & Investments]. 

[ii] Advisor Perspectives, June 30, 2010 

[iii] Bear markets usually are defined by a 20% or greater decline, but the charts would have been so busy as to lose any meaningful analysis. 

[iv] Please note that planning fees, which are separate from advisory management fees, will apply.

Do You Know Your 401(k) Costs?

  

Jim Lorenzen, CFP®

 

  

Believe it or not, many experts estimate 85% of retirement industry revenue is never billed directly or even disclosed.      

This is because most 401(k) plan distribution and record-keeping costs are subsidized by the funds themselves in the form of fund-marketing fees, shareholder-servicing fees, sub-transfer agent fees, and finder’s fees that compensate the sales and distribution effort.  Many of these costs are unknown to a great many employers who provide retirement plans for their employees.  In some cases, these costs are paid by the employer; but, in many – if not most – cases, they’re paid by the plan participants themselves through hidden deductions.    

    

Revenue Sharing    

Ever hear of it?  It’s quite common.  Many legitimate plan expenses are paid through revenue sharing arrangements, but often they’re hidden.   Many providers ‘bury’ costs in the investment side in order to reduce costs on the administration side.  It makes the plan look less expensive – or even `free’ – to the employer.  In some cases providers overpay for brokerage services so that they can receive ‘research’ and other services from the brokerage firms, which is legal as long as it benefits the plan.  But, few employers sponsoring plans know what those fees are or how to account for them.     

Are You Paying Too Much in Fees?    

Here’s a little checklist of ‘Warning Signs’ your company should be looking for:    

>  Low plan administration fee.   If that fee is low, or even ‘zero’, just remember that nothing is free and a ‘zero’ hard-dollar fee means the plan is paying for administration based on plan assets (either through an asset-based charge or higher fund expense ratios that subsidize the record keeper – or both).  Fees that don’t cover the cost of administration obscure the cost of the service – and, asset-based fees result in substantially higher fees as assets grow.    

>  Average participant balance is over $25,000.   Since over 80% of vendor revenue is asset-based, high average balance plans are more profitable.  The economics of the industry make plans with average balances below $20,000 not very profitable for the vendors, while plans with average balances over $25,000 become attractive.  If the average plan balance is over $50,000 it’s a virtual certainty the vendor is being overpaid and you can negotiate a lower fee.    

>  Vendor compensation from funds is unknown.   Most mutual funds pay compensation to record keepers because they do the accounting work the fund would otherwise have to do.  These fees are asset-based.   Many employers have no idea how much the plan vendor is earning in these sub-transfer agent fees or shareholder service fees.    

>  Heavy reliance on proprietary funds.   A good rule of thumb is that service providers make 0.70% (70 basis-points) or more on equity funds they manage.   Requiring proprietary funds may be good for the vendor, but may not be prudent from either a fee or investment perspective for your plan.    

>  12-(b)(1) fees are kept by the vendor.  12b-1 fees pay account representatives to service the plan.  If your plan doesn’t have an advisor providing services, either the vendor or the fund manager is keeping those fees.  Consider either getting an advisor to help with the plan or ask the vendor to offer lower expense ratio funds to the plan without this fee.    

>  Unknown stable-value management fee.  Stable value funds are a favorite place to bury additional fees.  Insurance companies often minimize more visible fees by raising the management fee of the stable value product.  The management fee for the same product can vary from as little as 0.30% to 1.25%.  Since assets in this type of fund are typically high, it can be very profitable for the service provider and practically invisible to the employer/sponsor and plan participants.    

>  Unknown advisor fees.  In the small to mid-market (plans between $2-50 million), advisor fees can have a major impact on fees.  Advisors often choose the fee they want and the vendor builds it into the total fees the client is charged.  Some vendors even tie additional fees for themselves to advisor compensation.   There are even some plans that are paying the advisor more than twice as much as similar plans.  If you don’t know what compensation your advisor is getting, you may be overpaying.    

It pays to watch your pennies.   Like mom said, they grow to nickels, dimes, ….. well, you know.