The issue of 401(k) fees and expenses has been simmering on the back burner of the business world for some time. Now it's threatening to come to a full boil thanks to a barrage of lawsuits filed against several large companies. The lawsuits charge, among other things, that the companies in question, as plan sponsors, allowed unreasonable fees to be charged to 401(k) plan participants, failed to monitor the fees and expenses paid by the plan, and neglected to educate themselves about vendors' fee structures and other fee-related issues.
Although the lawsuits will take years to play out, the economic stakes are potentially enormous. Matthew D. Hutcheson, an independent fiduciary based in Portland, Ore., estimates that total fees and expenses for a typical 401(k) plan range between 300 basis points and 900 basis points annually and that 401(k) plan participants typically are paying at least 200 basis points more than they have to in fees and expenses. If that's the case -- and if the courts determine that plan sponsors could have done more to rein in those expenses and that individual participants' account balances were adversely affected -- the final costs in these lawsuits may be quite significant. And that could lead to a flood of similar legal actions. "I personally believe that these lawsuits have teeth and that they could lead to some positive change in the industry," says Hutcheson. "Positive change means no more games."
At minimum, the lawsuits will bring the issue of 401(k) plan fees and expenses to the forefront and drive plan sponsors to be more aware of what they are paying for and why, if only to be able to answer inevitable questions from plan participants. "These lawsuits are driven by demographics," says Gregory Ash, partner and chair of the ERISA litigation group with law firm Spencer Fane Britt & Browne in Kansas City, Kan. "The baby boomers are getting ready for retirement without a traditional defined-benefit pension plan, so their retirement income will come primarily from their 401(k) plan. In many cases, the amounts in those accounts are less than individuals expected, and they are looking for ways to make up for that gap. Litigation is one of the ways of doing so."
Ash notes that this first group of fee-related lawsuits is just the beginning, and many more companies are targets for other lawsuits. Because the lawsuits are aimed at very large plans, the judgments may be substantial. However, he notes that "the plaintiffs have to establish that the plan fiduciaries were asleep at the switch" with regard to plan fees and expenses.
The current rash of lawsuits comes as no surprise to some observers. "People have been confused about the fee issue for years," says Rania Sedhom, senior manager in BDO Seidman LLP's New York City offices. "And plan fiduciaries have been complacent about fees because they focused more on making sure the plan's investments were delivering an appropriate return on investment."
Even if the lawsuits go nowhere, the fee question will not disappear entirely. "The lawsuits are just one part of the equation," says Fred Reish, managing director at Reish Luftman Reicher & Cohen, a law firm in Los Angeles. "The U.S. Department of Labor is also taking steps to require more disclosure of 401(k) plan fees and expenses, including disclosure on each plan's [Internal Revenue Service] Form 5500 filing."
So what are 401(k) plan sponsors to do? For one thing, they need to take stock of the fees and expenses their plan is paying and conduct some benchmarking or market analysis to make sure those costs are reasonable. Many consultants maintain this type of information. Alternatively, a company can benchmark by shopping the plan among vendors and using the resulting information to see whether its current vendor is competitive.
The trouble is, getting to the bottom of the fee question is not easy. Martha Priddy Patterson, a director with Deloitte Consulting's human capital practice in Washington, D.C., notes that some plan sponsors have been working on the fee issue for the last four or five years in order to be clear about what they're paying and where hidden fees might be lurking. "It's not as easy to do that as one might think," she says.
Indeed, many experts suggest that a great many 401(k) plan sponsors would be unable to clearly answer one simple question: What are the total fees paid by their plan for what services? For plan fiduciaries, answering "I don't know" is essentially an admission that they are not fulfilling their obligations to the plan and its participants.
That's why concern about 401(k) plan fees and expenses has been growing for some time. Nearly half of the 200 finance executives who responded to a Hewitt Associates survey conducted in 2005 said that reducing the 401(k) investment management fees paid by their employees would be a priority in the years to come.
The investment fees charged by mutual fund companies, which make up 70 percent to 80 percent of all fees for most 401(k) plans, should be a particular target for plan sponsors. For example, a business with plan assets that have grown significantly from year to year may have the critical mass of assets necessary to use institutional mutual funds in its plan rather than retail funds, which tend to have much higher investment fees. If plan fiduciaries neglect to shop the market periodically to see if such a change is viable, they could be leaving themselves and the plan sponsor vulnerable to a lawsuit. "The common thread is that plan sponsors can do more to reduce fees and negotiate with providers as the asset base gets larger," says Reish.
Finance executives and other plan fiduciaries can help their organization avoid liability for breach of responsibility to participants by taking action.
• Insist that vendors disclose all fees and expenses. 401(k) fee structures are complicated, and nailing down exactly who is paying what to whom can be difficult. "There are a slew of fees out there, and they cover activities and services that the plan may not need," says Sedhom. Plan sponsors must be confident that they're getting what they're paying for. For example, if the plan is paying investment fees for actively managed investments, they must ensure that those investments are indeed actively managed.
The first step in this process is to pressure the 401(k) plan's current vendors to provide full disclosure of fees and expenses if they are not currently doing so. Plan sponsors can also find some of this information in their service contracts with the vendors. The key is to understand exactly how much is being charged for what services; who is paying those fees; and where the money is going, particularly any money that is being paid out of participants' assets. Plan sponsors should push investment providers to disclose any revenue-sharing agreements and should factor in not only annual investment management fees, but also 12(b)-1 fees, which are disclosed in the mutual fund prospectus.
• Compare plan providers. The 401(k) marketplace is dynamic and highly competitive. If a company has not shopped around recently, it should do so. It might be able to obtain a more favorable deal with another vendor or develop the market intelligence it needs to negotiate a better deal with its current vendor. For example, up-to-date market information might indicate that similarly sized plans pay per-participant fees for plan recordkeeping services rather than paying fees as a percentage of plan assets. Or the plan might be large enough to qualify for less expensive institutional mutual funds instead of retail funds.
Several types of fees and expenses are involved in running a 401(k) plan. To get to the bottom of what a vendor is making from a plan, it's essential to ask the right questions. If no one in the organization has enough expertise and knowledge of all of the different ways money can change hands in a 401(k) plan -- for example, through revenue sharing, split transfer fees and 12(b)-1 fees -- the company should find someone who does. (See Types of 401(k) Investment Fees below.) Consultants can help with this process. Companies that want to go this route should look for a consultancy that has experience with plans of a similar size to their own.
Types of 401(k) Investment FeesSoft dollar fees. These represent the portion of the commission from stock trades that a brokerage firm gives back to investment managers or consultants to pay for research or other costs associated with the investment process. Sub-transfer agent fees. These fees are incurred as a flat dollar amount per participant or as a percentage of plan assets when a plan's own transfer agent (usually a bank, trust company or mutual fund) subcontracts the accounting of participant shares to a third party, such as a third-party administrator or other recordkeeper. 12(b)-1 fees. These come in two varieties: sales commissions paid to a registered representative for selling mutual funds and servicing fees paid for servicing an account after the sale. Variable-annuity wrap fees. Some 401(k) plans allow participants to invest in variable annuities. These vehicles have wrap fees that consolidate a number of other fees, including investment management fees for the mutual fund investments within the variable annuity, surrender charges and administrative fees. |
While it is a plan sponsor's fiduciary duty to ensure that 401(k) plan fees and expenses are reasonable, this process is not necessarily about obtaining the absolutely lowest fees. Instead, it's about making sure that participants' money is being spent in the most profitable and productive way. After all, there's no sense in choosing a provider that can offer only low-performing investments simply because it offers the lowest fees.
• Document the decision-making process. The Employee Retirement Income Security Act (ERISA) does not expect perfect actions and decision-making from plan fiduciaries. Plan fiduciaries must simply show that they used and documented a prudent process for making their decisions. No matter what a company does to ensure that its 401(k) plan fees and expenses are reasonable, it should document the process it uses to do so.
• Conduct the review process regularly. Over time, the 401(k) plan marketplace inevitably changes, and individual 401(k) plans grow. Larger plans with hefty assets not only have more negotiating leverage with providers but may also require different fee structures than smaller plans do. For example, smaller plans might find it advantageous to pay fees as a percentage of assets, but that approach could result in excessive fees once the plan has grown beyond a certain size. Once a company has identified its plan fees and expenses the first time, it should make it a practice to do so at regular intervals to make sure that fees continue to be reasonable. "You want to make sure that fees don't spiral out of control," says Diana Jordan, vice president with Sikich LLP in Aurora, Ill. "Companies are starting to wake up to the need to monitor this."
Once plan sponsors have educated themselves about the fees and expenses their plan is paying, they need to keep the information ready and available in case participants start asking questions about those outlays. "Plan sponsors may be asked for this information by participants, and 'I don't know' is the wrong answer," says Ash.