These are just a few of the recent headlines on litigation involving defined contribution plans and the fiduciary responsibility of plan sponsors to ensure that their participants are paying appropriate fees.
A recent Supreme Court decision in Hughes v. Northwestern University, an 8-0 decision, reinforced that providing some prudent investments in a retirement plan does not negate the need for fiduciaries to ensure that all investments in a plan are prudent. Under ERISA, fiduciaries who manage defined contribution retirement plans have a continuing duty of prudence that requires them to monitor investment options and remove imprudent ones. In practice, the definition of what is most prudent is focused on fees, as litigation for using an excessively high-cost investment is more likely to succeed than litigation for a fund having poor performance. Plan fiduciaries should take action to ensure and document that their retirement plan investments are prudent and especially that their participants are provided with the lowest cost option.
Plaintiffs’ attorneys seeking to file lawsuits scour publicly available filings of IRS Form 5500 to look for plans that hold mutual funds that may not be the lowest cost available. It is common for a mutual fund with the exact same investment portfolio to have four or more different share classes, each with a different fee. If a large plan utilizes mutual funds that do not have the lowest costs, then it becomes a target for potential litigation. Failure to actively monitor this issue can lead to a very expensive lawsuit.
Historically, investment and recordkeeper fees were not always transparent to plan sponsors or participants. Most plan recordkeeping expenses were paid via fees from the investment products in the plan fund lineup. Recordkeeping costs could vary widely between participants depending on which funds they happened to invest in and from year to year depending on investment market performance. Today there is more scrutiny over fees, and it is legally mandated that administrators provide fee disclosures to the plan sponsor and participants (formally known as a 408(b)(2) disclosure).
As a result of the confusing nature of fee arrangements and increased disclosure requirements, many plan sponsors have taken the prudent step to reduce fees and improve transparency for their participants by paying for recordkeeping using a flat dollar or percent per participant methodology, e.g. $65 per participant per year.
In conjunction with standardizing administrative fees, many plan sponsors also moved all investments to “institutional” or equivalent share classes. These share classes generally pay zero, or very low, revenue sharing to the recordkeeper and have the lowest visible, or “headline” fees for a given investment product. With moving to “institutional” share classes they are nevertheless still a potential target for future litigation because they may still not be delivering the lowest available costs to their participants.
Plan fiduciaries must be aware that delivering the lowest cost investments to their participants is not as simple as ensuring that all investment options are in “institutional” class mutual funds. Determining the true lowest cost option for participants also depends on revenue sharing arrangements between the recordkeeper and fund companies. Revenue sharing arrangements are generally not publicly available and plan sponsors have to request the information directly from the plan’s recordkeeper. Below is an example of how this works and why it is important for fiduciaries.
The Awesome Corporation 401(k) plan offers the World’s Best Fund (WBF) as an investment option. The WBF has multiple share classes with different “headline” fees (expense ratios), and the fiduciaries have to choose which one is the most appropriate for their plan. The plan is large enough that they can obtain the Institutional share class. The available WBF share classes are:
|Fund Name||Fund Ticker||Expense Ratio|
|World’s Best Fund Institutional||WBFI||0.45%|
|World’s Best Fund “A”||WBFA||0.60%|
|World’s Best Fund Retail||WBFR||0.85%|
Many plan fiduciaries would look at the above options and decide to use the Institutional share class. However, the table above is missing critical information. Specifically, how much revenue is paid from the mutual fund company to the recordkeeper? That question can only be answered by speaking with the plan’s recordkeeper.
For the Awesome Corporation 401(k), which uses AdminCo as the plan recordkeeper, the table below also applies:
|Fund Name||Fund Ticker||Headline Expense Ratio||Revenue Sharing||Net Expense Ratio|
|World’s Best Fund Institutional||WBFI||0.45%||0.0%||0.45%|
|World’s Best Fund “A”||WBFA||0.60%||0.10%||0.50%|
|World’s Best Fund Retail||WBFR||0.85%||0.45%||0.40%|
With this additional information, the decision to use the “institutional” share class may not be so clear-cut. It is possible for almost all recordkeepers to credit participants directly with any revenue sharing generated from their investments. If fiduciaries take this step, then in many cases the lowest cost investment options can be ones with relatively high “headline” fees. In the example above, the “retail” share class has the lowest fee when considering revenue sharing amounts that are credited back to participants. We believe it is imprudent to not credit revenue sharing back to participants and to not consider the lowest net share class.
Another trend in the 401(k) plan market is the emergence of pooled employer 401(k) plans. In these arrangements, a company joins a larger 401(k) plan as a participating employer and effectively “pools” its assets with other participating employers to create economies of scale with administration, recordkeeping, and investment fees. From our experience, the potential fee savings for participants can be meaningful. While plaintiff attorneys have not caught on to this trend quite yet, it’s only a matter of time before they do and all companies that currently sponsor a 401(k) plan will not be immune. For this reason, it is again a prudent exercise for fiduciaries to analyze their current arrangement against what is available in the market and have documented reasons for their decisions.
While all the same arguments apply related to investment fees, defined contribution plans that delegate the investment decision to an ERISA 3 (38) investment manager mitigate this risk. This is true for either a standalone 401(k) plan or a pooled employer plan.
Fiduciaries that do not take steps to evaluate their fee arrangements may find themselves the subject of a scary headline and a lawsuit that may be difficult to defend.