Retirement Plans in the Crosshairs – 401(k) Fee Litigation

A series of ERISA-based class action lawsuits has been filed, challenging service provider and investment-related fees charged to 401(k) plans. The defendants in the cases are plan sponsors, their boards,  plan committees, and individual executives who serve on those committees.

The lawsuits allege that the defendants breached their fiduciary duties of loyalty and care under the Employee Retirement Income Security Act (ERISA) by subjecting the plan participants to excessive fees and expenses, which reduced the participants’ account balances, and by failing to inform plan participants of the fees. It is alleged that the excessive fees were incurred because the plan fiduciaries failed to, among other things, identify all the direct and indirect fees paid to service providers, evaluate the fees against services received, and monitor the amount of the fees.

The defendant plan sponsors in these lawsuits are very large employers; however, the legal theories in the cases could apply to most 401(k) plans. The lawsuits are hitting closer to home than most PEOs would like. Litigation firms representing plaintiffs are currently soliciting claims from participants via postings on their Web sites, including participants in a retirement plan arrangement maintained by a large PEO.

The allegations in the lawsuits are very broad and may not consider all the factors that affect plan expenses. The plan fiduciaries being sued may have acted in accordance with ERISA’s fiduciary requirements and the plan participants may have been well served. Filing a complaint is not the same as surviving a defense in a lawsuit or surviving an appeal. Even so, this wave of 401(k) fee litigation is significant and should serve as a wake-up call to PEOs regarding the importance of ERISA fiduciary best practices.

The lawsuits may be seen as a predictable outgrowth of the increased public and regulatory interest in 401(k) plan fees and expenses over the past decade. The U.S. Department of Labor (DOL) has long been concerned with the effect of fees that are deducted from a participant’s account balance. A DOL publication for participants provides as follows: “Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investment in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by .5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your
account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses will reduce your account balance at retirement by 28 percent.”

Even at the time of this writing, Congress is holding hearings on 401(k) fees and expenses.

This article will review relevant ERISA fiduciary responsibilities, common fee structures used by 401(k) plans, including PEO-sponsored multiple employer plans (MEPs), and provide recommendations for PEOs to protect themselves from alleged breaches of fiduciary duty.

401(k) Fee Structures

Some view the lawsuits as an attack on the asset-based fee structures employed by many 401(k) plans, such as the revenue sharing arrangements between plans, mutual funds, insurance companies, and plan service providers. Lawsuits have also been filed against investment vendors (i.e., insurance and mutual funds companies) challenging their 401(k) fee structures.

“Revenue sharing” is a broad term used to describe indirect payments (i.e., not paid directly by the plan) to plan service providers by third parties such as mutual funds and insurance companies. In many cases, revenue sharing payments made to service providers are derived from expenses embedded in the plan’s investment options. Other types of “revenue sharing” include finder’s fees paid to brokers and other service providers by some mutual fund companies for the placement of
money in their investments. Finder’s fees can be an attractive revenue sharing vehicle for service providers because the fund family, not the plan, pays them. Unfortunately, plans sometimes unknowingly permit finder’s fees to be retained by a broker or other service provider who has failed to disclose the fee. Plan fiduciaries should be aware of any finder’s fees and should take the position that such fees belong to the plan.

The vast majority of plan sponsors do not know the actual cost of running their 401(k) plans. However, a fiduciary is obligated to understand and analyze plan fees and expenses. Understanding total plan expenses is not sufficient; the fiduciary must also understand the fees paid to service providers and evaluate the services provided to the plan. The fees and expenses include direct payments and the hidden, or indirect “revenue sharing” payments, such as finder’s fees, fees paid from mutual fund expense ratios (e.g., 12b-1 fees and sub-transfer agency fees), and float income. A fiduciary who fails to understand 401(k) fees and expenses, as well as the actual compensation received by the parties servicing the plan, is open to allegations of a breach of fiduciary duty.

Many plan sponsors, including PEO sponsors of MEPs, have shifted most, if not all, plan costs to their 401(k) plans. In the case of PEO MEPs, cost shifting to a plan is generally accomplished by all or a combination of the following fee arrangements:

Asset charge

This is an asset-based fee paid from participants’ accounts to compensate the third party administrator (TPA), record keeper, broker, consultant, etc. The fee is usually expressed in basis points, with each basis point representing a fraction of a percent. For example, an 80 basis point asset charge would be expressed as .80 percent. One hundred basis points would be a 1 percent annual charge on participants’ accounts. In some PEO MEPs, the asset charge varies by adopting employer, depending upon the amount of plan assets attributable to the adopting employer. In other cases, the asset charge does not vary by adopter and is based upon total plan assets. In some PEO MEPs, there is no asset charge. When this occurs, the fees for servicing the plan are generally derived from the fund expenses (described below.)

Fund expenses

The fund expenses, also expressed as basis points, are asset-based fees embedded within the mutual fund options offered under the plan. These fees include so-called “12b-1” fees and sub-transfer agency fees. A fund’s expenses or fees are referred to as the fund’s “expense ratio.” It stands to reason that expense ratios will vary for different mutual funds (e.g., an actively managed fund will be costlier to operate than an index fund). However, mutual funds frequently offer multiple share classes of the same fund with different expense ratios. A mutual fund may offer a “retail” class of shares that has an expense ratio of 125 basis points (i.e., 1.25 percent in annual fees), with 40 basis points paid to the fund’s investment manager and 85 basis points paid as “revenue sharing” to the plan’s broker, TPA, record keeper, and/or other service providers. The exact same mutual fund may offer an “institutional” class of shares with 40 basis
points paid to the investment manager, with no revenue sharing paid to service providers.

Per participant fees

This fixed fee is generally deducted from each participant’s account balance through the year and is used to pay administrative costs. This fee generally ranges from $20 to $45 per year per participant. Some PEO MEP sponsors and adopting
worksite employers mistakenly view a PEO MEP as “free” when all plan costs are paid to service providers indirectly as a percentage of fund returns rather than as a direct separate charge to the plan sponsor or participants. In any case, with plan costs borne by participants, some might assert that plan fiduciaries should be even more vigilant with regard to understanding plan fees and determining whether such fees are “reasonable.”

What is a Reasonable Fee?

Plan fiduciaries have a duty to pay only “reasonable” fees and there is no defined standard for what constitutes a “reasonable” fee. It should be stated that the least expensive alternative might not be what is best for a retirement plan. The DOL has stated that service quality is a factor that should be taken into account in determining whether plan fees are reasonable.

Single-employer plan fees can usually be benchmarked against plans with similar characteristics to determine if the fees are reasonable. However, determining the appropriate benchmark for PEO MEPs is more difficult. For starters, there are only a small number of service providers in the PEO MEP marketplace. Further, should a PEO MEP be benchmarked only against other PEO MEPs, or should a PEO MEP also be benchmarked against similarly sized single-employer plans? While the latter comparison may not seem fair given the complexity of a PEO MEP, a plaintiff in a lawsuit might assert that this comparison is appropriate.

Another possible benchmark might compare MEP costs incurred by each adopting worksite employer to the 401(k) costs an adopter might obtain in the open marketplace. This comparison would vary depending upon several factors, such as the work-site employer’s size, plan assets, etc.

What Can PEO MEP Sponsors Do to Protect Themselves?

PEO MEP sponsors should consider the following steps, which represent prudent fiduciary “best practices,” to protect themselves from potential lawsuits:

  • Avoid transactions with vendors who refuse to disclose the amount and sources of all fees and compensation received in connection with the plan.
  • Determine annually how much the PEO, the MEP, and the participants are paying in fees and expenses. Service providers should provide annually in writing a complete breakdown in exact dollar terms of the fees and expenses (including any “hidden” fees, such as finder’s fees and float income) that are being charged.
  • For each investment option, obtain information on fees and any revenue sharing arrangements. Determine the availability of other mutual funds or share classes within a mutual fund with lower revenue sharing arrangements (i.e., lower expense ratios) prior to selecting an investment option.
  • Review fee arrangements and investment alternatives regularly. According to the DOL, a fee arrangement that is best for a new plan with a smaller asset pool may not be the best arrangement for the same plan a few years later when asset values have grown, either through increased participation, merger with other plans, or market upturn. A fiduciary should be able to identify an opportunity to negotiate a better fee structure.
  • Be aware that with asset-based fees, fees can grow as the size of the asset pool grows, regardless of whether any additional services are provided; as a result, asset-based fees should be closely monitored.
  • Consider hiring an independent (i.e., not tied to or receiving fees from the investment vendor, TPA, etc.) consulting firm to analyze and compare the amount of fees and expenses paid by the plan and its participants to other plans having similar attributes.
  • Provide participants with clear information regarding total plan fees. The lawsuits allege that participants must be provided detailed information regarding revenue sharing; however, this is an open issue. The DOL may require detailed disclosure in the future.
  • Document the process that plan fiduciaries followed to analyze/monitor fees and ensure that the fees are reasonable.
  • Identify all fiduciaries, allocate fiduciary authority to the appropriate persons, and establish a committee to oversee the plan.
  • Implement, follow, and periodically review the plan’s investment policy statement.

Conclusion

With the increased scrutiny of 401(k) fees by lawmakers, regulators, the press, and plan participants, along with the new wave of 401(k) fee litigation, PEO plan sponsors should pay serious attention to fiduciary best practices. This would include a detailed understanding of all plan fees and expenses and thorough documentation of the process used to monitor fees and expenses. Plan sponsors who engage in this “prudent process” are far less likely to be deemed in breach of their fiduciary duties under ERISA.

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REPRODUCED WITH PERMISSION OF THE NATIONAL ASSOCIATION OF PROFESSIONAL EMPLOYER ORGANIZATIONS
PEO INSIDER | MAY 2007

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