On Pensions

The Most Important Form Investors Have Never Heard Of

How an obscure proposal from the Department of Labor could make it easier to give solid advice to retirement savers

by Aron Szapiro

Mr. Szapiro is director of policy research for Morningstar. Szapiro is responsible for developing research reports on policy matters, coordinating official responses to regulatory proposals, and providing investor-focused comments on policy issues to clients and the press. Visit Morningstar.com

The Form 5500 Annual Return/Report of Employee Benefit Plan sounds unexciting, at best. Few financial advisors working with clients in 401(k) plans are going to review the voluminous filing.

For their part, most retirement savers probably would rather spend their time reviewing the fine print in their credit card agreements or perusing their iTunes user agreements. The form is meant for regulators, not the public, so perhaps its technical name and dry format should not be a surprise, nor should the fact that the Form 5500 does not have much of a constituency arguing for its improvement.

Yet the Form 5500 tracks the most important sector of the financial industry for ordinary investors. According to the 2013 Survey of Consumer Finance, approximately 75 percent of individual investors in the United States exclusively invest in a retirement account. In that context, the Form 5500, which provides data on more than 685,000 retirement plans, including more than 132 million participating Americans, starts to seem very important. Moreover, the Form 5500 helps track more than $8 trillion in assets held for these plan participants to help support their retirement.

As it stands, the Form 5500, as written, is hopelessly dated and offers only glimmers of information where it could shine an important spotlight. Fortunately, the Department of Labor, when it was under the Obama administration, proposed updating the Form 5500 at the end of last year. Under the new administration, we hope that the Department of Labor will turn the proposal into a reality, vastly improving data aggregators’ ability to evaluate and compare retirement plans, which will ultimately benefit ordinary Americans.

Built for Traditional Pensions

The Form 5500 dates back to 1974, when Congress passed a sweeping set of protections for retirement savers called the Employee Retirement Income Security Act, better known as ERISA. As part of that effort, Congress wanted the departments of Labor and the Treasury, as well as the Pension Benefits Guaranty Corp., to be able to monitor pension plans.

The form was meant mostly for traditional pension plans – and without squinting too hard you can see the actuarial balance equation: Liabilities must equal assets plus the present value of planned future contributions. This made a lot of sense before the 401(k) plan became the dominant type of plan in America. It makes almost no sense whatsoever today. Defined-contribution plans require a completely different set of disclosures.

So, what could the Form 5500 modernization really do?

If the Department of Labor moves ahead with its proposal, investors and advisors would benefit in two ways. First, it would be much easier to compare plans’ investment lineups to each other to see the variety of investment options available to plan participants. Second, it would be easier to see how much of a participant’s hard-earned money goes into investments, how much goes toward investment management or picking which individual stocks and bonds to buy and sell, and how much goes to third parties for related services.

Built in the 1970s for traditional pension plans, the Form 5500 asks for many details on plan investments and holdings. This is modestly interesting for someone trying to assess whether a defined-contribution plan has a compelling investment lineup. However, there is no information on the available funds a 401(k) investor could choose, no information on the fees they would pay, and no explanation for how administrative expenses are charged.

The proposed revisions to the Form 5500 provide data for thousands of 401(k) plans, allowing data aggregators to compare retirement plans to each other. Think about this: Right now, ordinary people can easily compare the cost and quality of mutual funds to each other on Morningstar.com or similar sites. But if someone is trying to assess what their 401(k) plan’s strengths and weaknesses are, no one can tell them because the data is not out there.

What kind of comparative information is missing? All the most important parts: the share classes being offered, the expense ratios for different options, and the administrative fees and who pays them.

The Department of Labor’s proposal would take 401(k) data out of the Dark Ages and make it easy to compare plans. Advisors could assess whether an individual retirement account rollover would be in their best interest using third-party evaluation software instead of pouring over their participants’ statements – if they could even find them. It would dramatically improve the retirement savings experience in the United States.

Schedule C Shouldn’t Get an ‘F’

Tucked under the hood of the Form 5500 lies Schedule C, which contains important machinery that would allow plan investors to move more efficiently toward a secure retirement.

The form was meant mostly for traditional pension plans – and without squinting too hard you can see the actuarial balance equation: Liabilities must equal assets plus the present value of planned future contributions

Schedule C seeks to measure all the indirect compensation that different retirement plan providers receive. For example, when a firm offers recordkeeping, advisory, or consulting services to plans, it might also collect money from revenue-sharing agreements with mutual funds. The practice itself might work well—or it might not—but without accurate and comprehensive disclosures, it’s very difficult to identify fees and arrangements that might be questionable.

Not only that, these arrangements make it difficult to figure out what percentage of the management fee is actually used for management. A participant might like to know if part of the expense ratio for investing in a particular fund is going to pay administrative costs that benefit other people in the plan – even those that invest in other funds.

As is, Schedule C, and its companion, Schedule H, is a mess. It’s difficult to figure out if there are questionable third-party payments, what administrative fees participants are responsible for, and how those costs are allocated. Since reducing expenses is a surefire way to increase returns, all else being equal, this is critical information.

Luckily, the Department of Labor’s proposal dramatically improves the transparency of these disclosures. The proposal would make it much easier to figure out who pays for what inside a plan. This would immediately benefit participants, who could better understand what they get for their money – management of their assets or revenue-sharing for administrative costs. Their advisors could help them avoid funds with higher expense ratios set up to cross-subsidize the administrative costs of the 401(k). Over the long haul, it would help plans compare themselves to others and it would put pressure on them to get rid of questionable arrangements.

Opposition to the Proposal

Given all the benefits from the Department of Labor’s proposal, one might expect the new disclosure rules to sail through the regulatory process. Of course, these kinds of proposals face a typical political problem: They convey broad benefits to people who are largely unaware, while imposing some costs on a narrow group of people who are more knowledgeable. Of the hundreds of comment letters the Department of Labor received in response to its proposal, most were negative, and there were a few key themes to criticisms.

First, critics argued that the costs of the new disclosures would greatly outweigh the benefits. The modernization proposal is 700 pages long, and some of the new disclosures may impose more burden than they are worth; however, the key adjustments highlighted would cost almost nothing to disclose. That information is already collected by law from the 404(a)(5) and 408(b)(2) regulations. It would be relatively easy for plan sponsors to take that information and plug it into a revised Form 5500.

The second argument is that the new disclosures increase the risk of litigation for retirement-plan sponsors by making it easier to compare their investment lineups to other plans. This charge may be true, but it is not a reason to avoid having this kind of disclosure. Indeed, if a large number of plan sponsors think they are lagging behind their peers, this would be a great way to make it easier to offer better lineups with lower fees to participants.

Finally, critics have argued that disclosing expense ratios and fund lineups publicly is unnecessary because participants can find such disclosures for their plan. That would be like saying that mutual funds shouldn’t disclose their expense ratios to anyone other than current investors. It seems obvious that retirement savers should be able to benchmark their plan against others and have an easy basis for comparison when they ponder rollovers into an individual retirement account (IRA) or a new employer’s 401(k).

Going Forward

The Trump administration has frozen new rulemaking and regulations while his administration figures out its next step. We are hopeful that the Form 5500 will be revised, bringing the disclosures on it out of the their 1970s-era framework.
In the meantime, we at Morningstar believe that record-keepers and other financial institutions should remember that investors own their data. As long as they do, retirement investors will be able to easily share their investment and plan lineup data with their advisor – human or robo – electronically.

Such sharing is more efficient for everyone than requiring clients to dig around for a paper copy of their 404(a)(5) disclosure and will mean advisors can give high-quality, holistic advice to their clients more easily and much faster. Some firms have argued that facilitating electronic access to these records violates retirement savers’ privacy, but we believe they are using privacy as an excuse to serve narrower interests. Financial advisors should tell financial institutions that block such data that access is essential for advisors to give timely, quality advice to their clients.

Of course, many in the retirement industry will oppose these changes, but many in and outside of government support efforts to increase transparency and competition. If the Department of Labor moves forward with its proposal, then we will quickly wonder how we ever thought about retirement planning and advice without a clear picture of a plan’s strengths and weaknesses relative to other plans and other options. ◊