With lawsuits and enforcement actions mounting, and new rules in place, what DOL wants is not all that abstract or theoretical anymore

October 8, 2012 — 5:12 AM UTC by Guest Columnist Sheldon Geller

1 Comment

Being sued or assessed monetary sanctions is an effective but expensive way for 401(k) advisors to become familiar with the Labor Department’s way of viewing things.

There’s a better way: learning from the mistakes of other plan sponsors and financial advisors.

Perhaps nowhere is this more true than in the nettlesome area of fees — hidden ones, excessive ones and ones that fit the revenue-sharing mold. A plan fiduciary needs to identify, understand and evaluate fees and expenses relating to plan investments and services. Accordingly, monitoring fees and expenses in light of the services rendered for the plan is a continuing fiduciary responsibility, one that has prompted a recent wave of lawsuits, regulatory guidance and Department of Labor enforcement efforts.

Lawyers steeped in the Employee Retirement Income Security Act of 1974 can tell you what the rule is but they don’t do due diligence or know the difference between a reasonable and unreasonable fee. They’re more reactionary. Reasonableness is a function of the marketplace. So there has been a wave of cases alleging excess fees.

There is a knowledge gap between what lawsuit defendants are finding out and what plan sponsors and financial advisors with 401(k) plan fiduciary responsibility believe. There are some basic thoughts that an advisor can get a grip on that may avert lawsuits and make this a better industry.

Hidden fees

There are many types of hidden fees, commonly referred to in the aggregate as revenue sharing, which plan fiduciaries need to monitor for reasonableness. The increased public and regulatory interest in hidden fees has resulted in claims against service providers and plan sponsors, including individual fiduciaries responsible for plan management.

The questions of fact have included whether plan sponsors have acted prudently in selecting investment options and service providers. Claims have also included allegations that plan sponsors paid excessive fees directly or through indirect compensation known as revenue sharing, as well as permitting service providers to retain revenue-sharing payments instead of crediting these payments to the plans or to participant accounts.

Regulatory guidance

The Department of Labor issued final regulations under ERISA Section 404(a) mandating that sponsors of participant-directed plans provide fee and expense information to participants. Plan sponsors now need to provide participants with information related to fees and expenses for general administrative services, and fees and expenses chargeable to individual participant accounts. Participants are also entitled to investment-related information, including performance and benchmark data for the investment fund alternatives offered under a participant-directed plan.

The final regulations impose uniform disclosure requirements on all participant-directed plans. The preamble to the final regulations makes clear that the selection of investment alternatives is a fiduciary act for which there is fiduciary liability under ERISA. Plan fiduciaries have a duty to prudently select and monitor service providers and investment alternatives under a participant-directed plan.

The final regulations were preceded by the recently revised Schedule C, made a part of Form 5500, reporting requirements for plan sponsors, setting forth instructions for the enhanced reporting of a plan’s investment and service fees, including revenue sharing.

Revenue-sharing arrangements

Plaintiffs have alleged in excess-fee complaints that plan sponsors have not sufficiently scrutinized compensation and revenue- sharing arrangements, to the detriment of participants, thus violating ERISA.

Recent lawsuits have alleged that plan sponsor boards, officers and other in-house plan fiduciaries have breached their fiduciary duties by failing to investigate plan transactions, and have required fiduciaries to disclose based upon then existing law and related regulations.

Revenue sharing, sometimes referred to as “hidden compensation,” is a plan asset and refers to the portion of the expense ratio that is used to pay plan fees or credited to participant accounts. Plan sponsors may pay plan expenses with revenue, hard dollars, or a combination of both. The expense ratio, which is the fee charged by a mutual fund, decreases gains and increases losses of investments in participants’ accounts.

If a plan sponsor opts to apply revenue sharing as the method of paying plan fees, then it needs to determine if this method is in the best interest of plan participants. Greater revenue sharing may mean higher expense ratios and thus higher expenses for plan participants. Nevertheless, nothing in ERISA prohibits the use of revenue sharing to pay for services to a plan.

Further, once the fee amount is disclosed to plan participants, the failure to disclose the manner in which those fees were paid is not an ERISA violation, unless there was an intentionally misleading statement or a material omission. ERISA requires that plan participants be afforded the opportunity to obtain sufficient information to make informed investment decisions.

An uneducated plan sponsor may select what would appear to be free record keeping, without realizing that plan participants are paying the cost in the form of higher fund expenses. If a plan sponsor is unaware of the true cost of plan services, there is likelihood that the plan will pay excessive fees, adversely affecting plan participants and creating liability for the plan sponsor.

Recent ERISA fee litigation

There has been an increase in ERISA class action lawsuits alleging excessive fees charged to plan participant accounts in 401(k) plans. The basis for these lawsuits is that the plan fiduciary committed a breach of the duty of prudence in the selection of investment funds with excessive fees. Such a lawsuit was recently dismissed stating that the plan offered a range of investment alternatives with varying expenses and levels of risk.

Whereas, another lawsuit was reinstated for alleged imprudence with respect to a plan offering a far narrower range of investment alternatives that made it possible that the plan was imprudently managed by the plan sponsor. Recent court decisions have identified issues that 401(k) plan fiduciaries need to consider to ensure the prudent and most efficient management of a plan.

ERISA 404© provides plan fiduciaries with an affirmative defense to a claim of a fiduciary breach if the participates lose money on their investments. However, plan fiduciaries may be liable if they do not act prudently in the selection of the investment funds made available under a so-called 404© safe harbor, participant-directed 401(k) plan. The plan sponsor acting as a plan fiduciary must prudently select investments and determine whether such investments should continue to remain available as participant-directed investment options.

Claims of a breach of a fiduciary duty have been somewhat successful when a fiduciary selects mutual funds charging excessive fees. Plan fiduciaries were deemed to have violated their duty of prudence by selecting mutual funds whose fees were based on the retail share class rather than the institutional share class. The only difference between these two classes of funds was that the retail share class charges higher fees to plan participants. The fiduciaries needed to consider whether the institutional share class would have offered greater benefits to plan participants.

The Labor Department has taken the position that the 404© safe harbor does not protect fiduciaries to the extent that they act imprudently by selecting investment options with excessive fees. This position is based upon the premise that plan fiduciaries have a responsibility for the prudent selection and monitoring of investment options, which is outside the protection of the 404© safe harbor. The 404© safe harbor protects fiduciaries only from losses arising as a consequence of a participant’s independent exercise of control over plan assets in his or her account. The Labor Department also has argued that the duty to disclose fee information to plan participants arises both from ERISA’s statutory reporting and disclosure requirements and from its statutory duties of prudence and loyalty.

Best 401(k) plan fiduciary practices

The department’s enforcement efforts and recent case law have made clear that the focus is not on results achieved but rather on process. Accordingly, plan sponsor fiduciaries need to implement objective processes to identify fees, obtain fee disclosures, document service and fee reviews, and utilize independent third-party experts. Further, plan sponsors should conduct a fiduciary audit, in-house or with an independent expert, if a service provider fails to adequately disclose fees and expenses or if fees and expenses do not appear to be reasonable.

It is critical that plan fiduciaries have the requisite skills and knowledge to review and understand these issues. Plan fiduciaries are charged with the duty to monitor a plan’s fees, which has resulted in regulatory and litigation-driven scrutiny of plan fees. As a result, many plan sponsors are adopting best practices intended to satisfy this ERISA requirement.

Plan sponsors should consider the following best practices to monitor plan fees and expenses in an effort to comply with ERISA, recent case law and Labor Department initiatives:

Record-keeping fees. Plan sponsors must monitor fees and revenue sharing and demonstrate that plan sponsor decisions are in the best interest of the plan and for the exclusive benefit of plan participants. Plan sponsors should not permit service providers to retain revenue sharing that exceeds the value of plan services. It is not prudent to use an asset-based fee arrangement to pay for plan administration services if fees increase and no additional services are provided to the plan.

Fee offsets. Plan sponsors must negotiate mutual fund revenue-sharing offsets with service providers to reduce the cost of providing administrative services to plan participants. Plan sponsors must use their purchasing power — and, if it’s a large plan, their leverage — to negotiate and reduce plan fees payable with plan assets. Plan sponsors must uncover embedded fees, potential conflicts of interest and self-dealing and contract limitations in the service agreements of non-fiduciary service providers.

Selection of investments. Plan sponsors must document the process of evaluating alternative investment funds. Plan sponsors may not delete a well-performing fund or use an alternative share class to create more revenue sharing simply to offset fees. It is not prudent to replace funds to create additional revenue sharing if the change in fund selection provides no reasonable investment advantage to plan participants.

Investment policy statement. Plan sponsors must adhere to the guidelines, if any, set forth in the investment policy statements adopted by their board-appointed retirement plan committees with respect to fund replacements and the payment of plan fees with revenue sharing generated on the investment of plan assets in mutual funds.

Corporate services. Plan sponsors must avoid the payment of fees that exceed the market costs for plan services in order to subsidize corporate services for the plan sponsor, including payroll processing, welfare benefit plan and pension plan services.

Float income. Float, or the income and interest earned when contributions and disbursements are held temporarily during the transaction process, constitutes plan assets and, therefore, must be allocated only among 40 (k) plan participant accounts.

Fiduciary-monitoring criteria. Plan sponsors must review custody statements monthly, compare investment manager performance quarterly, evaluate service provider quality annually, and formally scrutinize service provider contract capabilities, service quality and fees every three years. Plan sponsors must follow processes and document fiduciary decisions relating to the use of plan assets to pay plan fees and expenses.

Courts continue to emphasize the importance of implementing and adhering to a deliberative process and focusing on the merits of employer decisions affecting plan participants. Plan sponsors may have to explain, if not defend, their actions in retaining service providers if they do not conduct a full request-for-proposal process to formally test the retirement plan marketplace every three years.

However, neither ERISA’s prudence requirement nor the exclusive-benefit rule support a rule of law requiring plan fiduciaries to conduct a competitive bidding process to support a fee and avoid litigation.

Service providers have an information advantage over plan sponsors. Nevertheless, in the context of 401(k)s and other participant-directed plans, ERISA’s fiduciary requirements apply to the initial and continued selection of the investment options for a plan’s fund lineup and the plan’s service providers.

Reasonableness of plan fees

Plan sponsor fiduciaries may use plan assets to pay plan fees provided, however, that the services for which fees are being paid are necessary for plan operation, are provided under a reasonable arrangement and no more than reasonable compensation is paid by the plan. Effective July 16, 2011, no arrangement will be considered reasonable unless the service provider discloses fees as required by the final regulations under Section 404©.

The Labor Department has set forth guidelines for plan fiduciaries to determine whether fees are reasonable in order to satisfy ERISA’s fiduciary requirements as follows: (1) the plan fiduciary needs to make certain that direct and indirect (revenue sharing) compensation paid to service providers is reasonable, (2) the plan fiduciary needs to obtain sufficient information regarding fees and other compensation received by the provider, and (3) the plan fiduciary needs to engage in an objective process to obtain the necessary information to assess provider qualifications, service quality and the reasonableness of fees taking into account the services provided to the plan.

Plan fiduciaries are prohibited from engaging in a transaction if the fiduciary has an interest in the transaction that may affect the fiduciary’s best judgment.

Investment policy statements

The process of selection and monitoring of a fund lineup in participant-directed plans, including 401(k)s, is commonly set forth in a plan’s investment policy statement. It is not prudent to maintain an investment policy statement without adhering to its guidelines in relation to fund replacements and the payment of plan fees with revenue sharing.

Accordingly, plan sponsors should update their investment policy statements annually with respect to the payment of fees with plan assets, the selection of funds and service providers, and the attributes applied to the investment selection and monitoring process. There are counsel representing plan sponsors, however, that advise against the maintenance of an investment policy statement for fear that the plan sponsor will fail to apply the guidelines set forth therein, thereby creating liability for the plan sponsor.

Plan fiduciary legal landscape

Recent legal decisions underscore the importance of adopting prudent operational-compliance procedures and best-practice governance standards. These cases are premised, in part, on claims against plan fiduciaries that act upon the advice of conflicted non-fiduciary service providers. Relying on the advice of a non-fiduciary is not evidence of procedural or substantive prudence and offers plan sponsors no exculpatory relief.

The Labor Department has announced a plan expense audit Initiative imposing personal liability on corporate executives for failing to monitor the reasonableness of plan fees and expenses. Aggressive enforcement efforts have enabled the collection of tens of millions of dollars of fines resulting from the payment of improper plan expenses and failing to prudently monitor service providers.

The high cost of maintaining a retirement plan has been overshadowed by the fact that most plan participants were enjoying high investment rates of return. The markets were so strong that few considered the extent to which they were paying fees or paying excessive fees. Plan participants were focused on double-digit returns and exotic investments.

Flat or declining markets, together with industry developments, have resulted in a renewed interest in direct fees, indirect compensation and services. As the challenging economic environment prompts more lawsuits over retirement plan losses, boards of directors, retirement plan committees and other plan fiduciaries responsible for proper plan operation should consider the retention of advisors and attorneys with subject matter expertise to manage conflicts of interest, avoid prohibited transactions and effect compliance with ERISA’s fiduciary-responsibility requirements.

An annual audit process provides monitoring and documentation procedures necessary to ensure best-practices standards of fiduciary governance. The very presence of documentation ensures the quality of fiduciary decisions and reduces litigation risk.

Sheldon M. Geller is a managing member of Stone Hill Fiduciary Management LLC in Great Neck, NY

Share your thoughts and opinions with the author or other readers.


Fred Nobel said:

November 4, 2012 — 3:40 AM UTC

What next, an article by Ivan Boesky about the evils of insider trading? The allegations regarding Sheldon Geller (google Sheldon Geller) have never been fully addressed by Mr. Geller, especially how his father in law had an auditing practice, auditing Geller & Wind retirement plan clients (the father in law was Wind) while Sheldon was listed as that auditing firm’s 401(k) plan trustee, as well as the successor CPA firm, where Sheldon again was the 401(k) plan trustee. Mr. Geller’s reputation in the 401(k) plan industry is abhorrent and it is a shame that RIABiz would try to help rehabilitate the image of a man who was well known to pocket revenue sharing and no disclose it to the clients. It’s people like Mr. Geller that required the DOL to implement fee disclosure.

Submit your comments: