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The 401(k) world is abuzz with talk of impropriety in the fee structures of 401(k) plans. So-called revenue sharing is being cast as an evil lurking in the dark shadows, diverting the earnings of 401(k) participants into the hands of service providers and jeopardizing the retirement security of account holders. At this writing there are 14 lawsuits in the works nationwide against large employers claiming that, as the fiduciaries of 401(k) plans, they were ignorant about revenue sharing and, through their ignorance, allowed plan participants to pay too much in fees. The lawsuits also allege that the fiduciaries failed to disclose these revenue-sharing payments to participants, thus keeping them in the dark and unable to question or protest the payments.
The lawsuits serve as stark reminders that plan fiduciaries have a high level of responsibility imposed upon them under federal law and that they need to be diligent in reviewing their investment and service-provider structures. While it is rarely wise to speak in universals, large employers, who have the staff to devote to such matters and the resources to hire qualified professionals, generally understand fee structures and revenue sharing. It is the midsize and smaller employers, where the officer assigned to plan oversight is also the person responsible for myriad other functions, that face challenges brought on by time constraints and relatively limited budgets.
Before we examine fee and fee-disclosure issues in more detail, here is some broad advice to plan fiduciaries: if you think you have done your job by simply picking a plan off the shelf of your financial service provider, think again: You need to be a prudent shopper—to read the label and understand the ingredients. If the ingredients are not listed, ask about them or consider shopping elsewhere. If you are getting a "bonus" or "six extra ounces for free," you need to understand how those extras are being paid for. Remember: getting those extra ounces for free is not necessarily a bad deal. In fact, it may be the best deal available. You simply have to be careful before buying.
Fiduciary Responsibilities under ERISA
When looking for a 401(k) plan provider, the employer is acting as a "fiduciary" under the Employee Retirement Income Security Act of 1974, as amended (ERISA). The plan fiduciary must act solely in the interest of plan participants. The law sets high standards of care and loyalty, and the plan fiduciary can be held liable for losses if those standards are not satisfied.
The U.S. Department of Labor (DOL) is responsible for oversight of ERISA's fiduciary rules. The DOL has expressed its view that, in order to comply with the fiduciary responsibilities of ERISA in choosing plan service providers, the plan fiduciary must follow an objective process that is (1) designed to elicit information necessary to assess the qualifications of the provider, the quality of services offered, and the reasonableness of the fees charged in light of the services provided and (2) designed to avoid self-dealing, conflicts of interest or other improper influences.
In other words, the plan fiduciary must understand the needs of the plan and do some comparison shopping in a thorough and thoughtful manner. The fiduciary also has the responsibility to understand and seek information on the services offered and fees to be charged for those services. In order to do that, the fiduciary must educate itself on investments, service models, fees and related issues. If the fiduciary has neither the expertise for these tasks nor the time to devote to developing that expertise and gathering the information, it may be appropriate to seek professional assistance.
Understanding 401(k) Plan Fees
As part of the selection process, the plan fiduciary must understand fees and fee arrangements and must gather appropriate information on fees as well as on the services offered and the quality of those services.
There are various service models available for plans. "Bundling" is a term often used that can mean many different things. Several services can be "bundled" together and priced on a bundled basis. Also, investments can be part of the bundle. For example, in a bundled arrangement, a financial-services provider may manage the investment funds for the plan, and that same provider, or an affiliate, may provide record-keeping, trust, check-writing, tax reporting and other services. The provider may not break down fees for each discrete service but rather may look to the overall relationship and the fees it receives. These fees might include:
- Investment management fees (from its proprietary funds)
- Revenue-sharing fees (from funds belonging to other fund families)
- Float (interest on outstanding checks issued to participants and beneficiaries)
- Brokerage fees
- Transaction fees
If revenue from these sources is not sufficient to make the overall relationship profitable, the company may charge a per-head "record-keeping fee." If the revenue from investment management and revenue sharing—and other indirect compensation received by the service provider—is healthy, the provider may offer record-keeping services for "free." They are not free, of course, but are merely covered by the revenue received from other sources.
If the plan fiduciary were unaware of the revenue-sharing payments received by the service provider, it certainly could end up agreeing to a record-keeping fee when such a fee could have been negotiated away. Alternatively, the plan fiduciary could find itself in a position in which, for the same overall fee, an investment fund with a lower management fee, but with lower or no revenue sharing, could have been selected. As noted, an uninformed plan fiduciary is a poor shopper and being uninformed can spell legal trouble.
Whether record-keeping fees are paid by revenue sharing or by a per-head administrative charge that is assessed against participant accounts, the fees are, in effect, borne by the plan, although not necessarily in the same way within the plan. Reasonable record-keeping fees can be charged to participant accounts within the plan, and while this is not popular from a human resource perspective, it is legal and becoming increasingly common. Almost all plans are drafted to allow fees to be charged against the plan and participant accounts, even though the plan sponsor may step in and pay the expense before it hits the plan books. Again, to be a good shopper, the plan fiduciary must understand the impact of revenue sharing on participants within the plan.
None of this is to suggest that revenue sharing is intrinsically bad and to be avoided. A reasonable plan fiduciary may well conclude that having a per-head record-keeping fee assessed against participant accounts is a less desirable than paying for record-keeping with revenue sharing. However, if the fiduciary agrees to a fee structure that includes revenue sharing, in order to demonstrate prudence, it would do well to at least seek a reduction in other fees in an effort to recapture some of the costs to the plan introduced by the revenue–sharing arrangement.
Here again, the plan fiduciary should avoid taking action with a lack of knowledge and information. ERISA requires that an informed and thoughtful decision be made. It does not dictate any particular decision.
Impact of Participant Disclosure Requirements
Another concern contributing to the current buzz about 401(k) fees relates to requirements that sponsors disclose any fees to plan participants. ERISA specifies that participants be informed about fees that are assessed directly against their accounts (such as loan-processing fees and distribution fees) and that participants be informed of the expenses that reduce the rate of return of a given investment fund (such as fund-expense ratios). However, comprehensive disclosure of revenue sharing and other indirect compensation are not explicitly required by ERISA.
That may be changing under upcoming DOL revisions to regulations governing participant-directed plans under ERISA, although what those revisions will entail remains to be seen. Solid arguments can be made that disclosure of revenue sharing received by a plan service provider offers little, if any, useful information to a plan participant in making investment decisions. After all, isn't the disclosure of the rate of return and expense ratios sufficient? Such arguments, of course, start from the premise that the purpose of such disclosure is only to provide information useful to a participant in making an investment decision. A broader goal, however, may be to allow participants access to all information necessary to oversee the actions of the plan fiduciary during the service-provider selection process.
A plan fiduciary who is comfortable with the decisions made in the selection process should not mind disclosing those decisions to plan participants, including a financial analysis of expected revenue sharing and other indirect compensation. Certainly such information has the potential to confuse and mislead. However, in the current 401(k) environment, disclosing more rather than less may be wise risk management.
Seeking Help from the Service Provider
Service providers function in competitive markets and must earn a profit on the services they provide. The form in which a service provider is compensated—by fees or revenue sharing or a combination of both—is of concern to that provider only to the extent that one model or another puts it at a competitive advantage or disadvantage. As courts, legislatures and the public push for greater disclosure of fee arrangements related to 401(k) plans, a plan fiduciary should look for a service provider that is helpful in satisfying the fiduciary responsibilities spelled out in ERISA. If the plan fiduciary cannot receive the information from a service provider needed to satisfy those responsibilities, the fiduciary may need to shop elsewhere.
While revenue sharing is currently being cast in a bad light, it is not revenue sharing per se—but rather the perception (correct or incorrect) that fiduciaries are not knowledgeable about revenue sharing—that appears now as a target for correction by regulation or litigation. Ultimately—and legally—it is the responsibility of the plan fiduciary to be a well-informed shopper.
Best Practices/Recommendations
To meet its legal obligations with respect to 401(k) plan fees, a plan fiduciary should:
- Become educated on service models and fees.
- Follow an objective, thorough and thoughtful process in selecting service providers, obtaining and reviewing all necessary information to assess the qualifications of the provider, the quality of services provided and the reasonableness of fees received, further ensuring that the plan finally chosen is not tainted by conflicts.
- Be mindful of disclosure obligations and best practices, including disclosure both to participants and the government (Form 5500).
- Keep abreast of legal and regulatory developments related to 401(k) plans.