Dealing with Back-End Charges in Service Agreements

Clients often ask us to review agreements related to their 401(k) plans. Unfortunately, we are sometimes consulted only after a problem has come up.

Nearly half the problems we see revolve around back-end charges. The charges have various names: surrender charges, contingent deferred sales charges (CDSC), market value adjustments, etc. So long as they are reasonable, we see nothing inherently wrong with them; but all too often, that’s not the case.

The justification for a surrender charge or CDSC is that the provider has incurred a cost at the outset that it expects to recoup through its normal contract charges over time. However, if the contract is terminated early, the provider needs to recoup any unrecovered expenses at that time. Thus, in the reasonable situation, the amount of the back-end charge should decline over time and ultimately disappear, for example, within three years or so.

Market value adjustments arise in the context of an investment with a guaranteed fixed rate of return. If interest rates change and the plan surrenders the guaranteed contract, the investment provider may lose money on the transaction, if interest rates have increased and, therefore, the value of the underlying bonds has decreased, so the market adjustment charge is designed to protect the provider from that change, since they are liable for the agreed-on fixed return.

The issue for plan sponsors is whether the charges or adjustments are reasonable. We seen situations in which the back-end charge is perpetual and applies to each new dollar coming into the plan. In our view, there is no reasonable justification for this type of charge. Where the plan sponsor is entering into a new relationship, to avoid the problem, it needs to take three steps:

• Find out if there are back-end charges, and if so, how they are structured.
• Negotiate with the provider to either remove the charge entirely or have it apply on a more reasonable basis.
• If the provider is unwilling to negotiate, seek a different provider.

If the plan sponsor does not have the experience, time or expertise to take these steps, it should employ an experienced adviser to assist it.

With respect to market adjustment charges, the plan sponsor should understand whether or not they will be imposed and under what circumstances and seek to negotiate with the provider over whether the adjustment works both ways - that is, will the plan’s investment go either up or down depending on how interest rates fluctuate? Is the amount of the adjustment reasonable or too much for the purpose of protecting the provider from interest rate swings? Is the formula for the adjustment in writing or does the provider have discretion? If the provider will not negotiate reasonable terms, the plan sponsor should seek investments from a different provider.

The key point is to be aware that these kinds of charges may be imposed. They are not necessarily bad but can be under some circumstances, and it is up to the sponsor to understand the charges and avoid improper ones.