The Trouble with ERISA Plan Fees

Posted on 01/15/2010

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The business of pension plan servicing, being a mere graft of the already complex financial services industry, has naturally adapted to multi-faceted fee-sharing arrangements (aka: revenue sharing).  Troubles arise, however, where these arrangements are not disclosed to participants, beneficiaries, – and plan sponsors, because the Employee Retirement Income Security Act of 1974, as amended, generally prohibits self-serving transactions among plan service providers.   

The impact that fees and expenses can have on an investment’s final balance can be significant.  For example, the United States Department of Labor (“DOL”) serves up the simple illustration of a 401(k) account balance of $25,000 averaging 7 percent over 35 years and growing to $227,000 (where fees and expenses charged on the investment reduce average returns by 0.5 percent).  On the other hand, where fees and expenses total 1.5 percent, the same account balance would grow to only $163,000 over the same 35 year period.  Thus, a fee that might otherwise seem miniscule, 1 percent, leads to a dramatic 28 percent reduction.[i] 

It follows that litigation surrounding allegations of excessive or undisclosed fees and revenue-sharing is becoming more prevalent, and calls into question the grey area of what degree of diligence ERISA requires of plan fiduciaries pursuant to their duties of prudence and loyalty.    In Hecker v. Deere & Co., , 556 F.3d 575 (7th Cir. 2009), sponsor Deere entered into an agreement with plan trustee Fidelity Management Trust Co. and agreed to limit its selection of investment options to funds offered by another Fidelity entity, Fidelity Management and Research.  Participants alleged fiduciary breach because Deere and the Fidelity companies provided investment options with excessive fees and violated ERISA by failing to disclose the fact that Fidelity Research and Fidelity Trust also shared revenues.  The appeals court ruled that ERISA does not require the disclosure of revenue-sharing, nor does it require that a fiduciary “scour the market” for the lowest possible fees.[ii]

In Braden v. Wal-Mart Stores Inc., No. 08-3798, 48 EBC 1097 (8th Cir. Nov. 25, 2009), the Eighth Circuit addressed some of the same issues raised in the Deere case, but reached a different conclusion.  Plaintiff Wal-Mart employee alleged that the plan’s fiduciaries failed to prudently evaluate the investment options and ultimately offered unreasonably expensive mutual funds which impacted final account balances.  Plaintiffs also claimed fiduciaries breached their duties by failing to apprise participants of the impact fund fees would have on savings.  The Eighth Circuit vacated the lower court’s dismissal and sent it back for trial, ruling that nondisclosure of fees and revenue-sharing prevents adequately informed investment decisions.[iii]

 

Notwithstanding the grey areas of the law, fiduciaries are responsible for evaluating the costs charged to a plan and must consider the impact that the various forms of compensation arrangements can have on their plan’s assets.[iv]  Plan services such as investment management, trust management, and recordkeeping may be made available through multiple providers.  The cost of each service may be charged separately, but are often charged by a central provider for a single aggregated fee (referred to as a “bundled arrangement”).  The provider offering a bundled arrangement may then pay various other service providers with whom it contracts.[v]  Such costs can therefore be hidden from the view of plan participants, and even plan sponsors, wherever they are not required to be disclosed.[vi]  Arrangements allowing for the payment of compensation between service providers come in many forms and can be charged as necessary expenses to the plan.[vii]  This type of arrangement is known as “revenue sharing,” and many service providers, consultants and advisers receive compensation in this manner.[viii] 

  Services impacting plan costs are generally investment-related or administrative in nature.[ix]  Administrative service fees represent the cost of the day-to-day operation of a plan, such as recordkeeping, accounting, and custodial services.  Certain types of plans, such as 401(k) plans, often include various additional services, such as customer service access, investment education and advice, on-line transactions, and plan information access.  Administrative fees charged to 401(k) plan accounts can also be proportionately allocated among individual accounts so that participants are either charged a flat, per capita amount, or a pro rata amount where those with larger account balances pay more.[x]

Fees and expenses related to investment management are typically charged on the basis of a percentage of the plan’s assets before investment returns are stated or realized.[xi]  Investment related fees and expenses come in two basic forms: management fees, and sales charges.[xii]  Management fees are usually charged as a percentage of the amount of assets invested in a particular fund[xiii], and funds that promise greater returns may charge higher management fees to cover the investment’s ongoing and active research, trading activity, and monitoring.[xiv]  Sales charges represent another cost form and are often logged as transaction costs and commissions; these may be further broken down and described as finder’s fees, front-end sales charges, contingent deferred sales charges, subtransfer agency fees, and 12b-1 fees.[xv]  Finder’s fees are usually limited to financial intermediaries, such as an investment advisor or broker, who processes the initial transaction for a plan.[xvi]  Finder’s fees can be as high as 1 percent of the amount invested and are sometimes paid by the investment fund when new money is invested by a plan.[xvii] 

Front-end fees (also known as front-end loads) are charges applied to the purchase amount and so reduce initial investment.[xviii]  Front-end fee amounts typically are paid to the brokers that sell the investment.[xix]  Contingent deferred sales charges (aka: back-end loads) are best understood as an exit fee that may be reduced, or altogether waived, depending on how long the investment is held.[xx]  Subtransfer agency fees are designed to spread costs among investment funds and service providers for everyday operational expenses such as recordkeeping as well as the provision of fund prospectuses and other “pass-through” materials.[xxi]  Subtransfer agency fees vary from fund to fund and are often undisclosed to the plan sponsor.[xxii] 

12b-1 fees are those fees paid by investment funds to cover commission costs for sales persons, advertising, and fund promotion[xxiii]; 12b-1 fees are typically paid to brokers of funds.  12b-1 fees may also be paid to service providers for their part in a bundled plan arrangement.[xxiv]  12b-1 fees get their name from the securities law rule that allows the fee to be charged for the selection, distribution, and participant education.[xxv]  Subtransfer agency and 12b-1 fees are the ones sparking the most concern these days because they go largely unnoticed and, therefore, undisclosed to plan sponsors and the plan’s participants.[xxvi] 

ERISA requires that fiduciaries act with the exclusive purpose of providing benefits to participants and their beneficiaries and to defray reasonable expenses of administering the plan.[xxvii] 

The fiduciary must also prudently select and monitor the plan’s service providers.[xxviii]  Such prudent selection and monitoring requires obtaining sufficient information to ensure that decisions made about the services to be provided are fully informed.[xxix]  The reasonableness of the fees and expenses to be charged to the plan must be weighed by the fiduciary in light of such information.[xxx]  In Liss v. Smith, 991 F.Supp. 278, 300 (S.D.N.Y. 1998), the court opined that “[a]t the very least, [fiduciaries] have an obligation to (i) determine the needs of a fund’s participants, (ii) review the services provided and fees charged by a number of different providers and (iii) select the provider whose service level, quality and fees best matches the fund’s needs and financial situation.”[xxxi]  An investment course of action will comply with the fiduciary’s expected level of competence and prudence if he gives appropriate consideration to those facts and circumstances he knows or should know are relevant to the particular decision, including the role the investment decision or course of action plays in that portion of the plan’s investment portfolio.[xxxii] 

The DOL has proposed three regulations whose ultimate design is to provide fiduciaries, plan participants, and others, with information the Department believes necessary for informed decisionmaking regarding investment choices.  Amendment of the current DOL regulation § 2550.408b-2 is aimed at effectively revealing any previously undisclosed compensation and potential conflicts of interest that might exist among plan service providers.[xxxiii]  Further, DOL regulation § 2550.404a-5 will essentially require that fiduciaries prove 408b-2 compliance by providing the disclosed information to the plan’s participants.[xxxiv]  And finally, Schedule C, the part of the Form 5500 Annual Report plan sponsors use to disclose fees paid by plans for services, now requires disclosure of both direct and indirect compensation received by providers even loosely associated with a plan’s transactions.[xxxv]  It is reasoned that only upon the provision of such information can a plan fiduciary make the kind of informed decisions necessary to fulfill his or her fiduciary duties (i.e.: to review the services provided and fees charged, as well as to select that provider whose service level, quality and fees are the best match).[xxxvi]  A full discussion of these regulations, however, is beyond the scope of this article.


[i] See U.S. Department of Labor, Employee Benefits Security Administration, A Look at 401(k) Plan Fees, available at http://www.dol.gov/ebsa/pdf/401kFeesEmployee.pdf. 

[ii] Hecker v. Deere & Co., 556 F.3d 575, 586 (7th Cir. 2009).

[iii] Braden v. Wal-Mart Stores Inc., No. 08-3798, 48 EBC 1097 (8th Cir. Nov. 25, 2009).

[iv] ERISA § 404(a)(1)(A).

[v] See generally Advisory Council on Employee Welfare and Pension Benefit Plans, Report of the Working Group on Fee And Related Disclosures To Participants (November 10, 2004) available at http://www.dol.gov/ebsa/publications/AC_111704_report.html.

[vi] Id.

[vii] Id.

[viii] Id.

[ix] See U.S. Department of Labor, Employee Benefits Security Administration, Understanding Retirement Plan Fees and Expenses (May 2004) at 3, available at http://www.dol.gov/ebsa/publications/undrstndgrtrmnt.html.

[x] Id.

[xi] Id.

[xii] Id at 5.

[xiii] Id.

[xiv] Id at 9.

[xv] Id at 6-7.

[xvi] See Matthew D. Hutcheson, Uncovering and Understanding Hidden Fees in Qualified Retirement Plans (Feb. 1, 2007) available at http://www.401khelpcenter.com/pdf/mdh_understanding_fees_v2.pdf; see also U.S. Securities and Exchange Commission, Mutual Fund Fees and Expenses, (Modified: Aug. 8, 2007) available at http://www.sec.gov/answers/mffees.htm. 

[xvii] Id.

[xviii] U.S. Department of Labor, Understanding Retirement Plan Fees and Expenses, at 7.

[xix] Id.

[xx] U.S. Securities and Exchange Commission, Mutual Fund Fees and Expenses.

[xxi] See Hutcheson, Uncovering and Understanding Hidden Fees.

[xxii] Id.

[xxiii] U.S. Securities and Exchange Commission, Mutual Fund Fees and Expenses.

[xxiv] U.S. Department of Labor, Understanding Retirement Plan Fees and Expenses, at 7.

[xxv] U.S. Securities and Exchange Commission, Mutual Fund Fees and Expenses.

[xxvi] See Hutcheson, Uncovering and Understanding Hidden Fees, at 11.

[xxvii] ERISA § 404(a)(1)(A).

[xxviii] ERISA § 404(a)(1)(B).

[xxix] 29 C.F.R. § 2550.404a-1. 

[xxx] Id.

[xxxi] Liss v. Smith, 991 F.Supp. 278, 300.

[xxxii] 29 C.F.R. § 2550.404a-1. 

[xxxiii] See Reasonable Contract or Arrangement Under Section 408(b)(2) – Fee Disclosure; Proposed Rule, 72 Fed. Reg. 70,988 (December 13, 2007).

[xxxiv] Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Proposed Rule, 73 Fed. Reg. 43,014 (July 23, 2008).

[xxxv] See Notice of Adoption of Revisions to Annual Return/Report Forms, 72 Fed. Reg. 64731 (Nov. 16, 2007); also see Annual Reporting and Disclosure; Revision of Annual Information Return/Reports; Final Rule and Notice, 72 Fed. Reg. 64710 (Nov. 16, 2007) (adoption of final regulations).

[xxxvi] Liss, 991 F.Supp. 278, 300.

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