ERISA requires, both in its fiduciary rules and its prohibited transaction
restrictions, that fiduciaries pay no more than reasonable expenses from plan
assets. That rule seems simple enough, but I am concerned that it is being
misinterpreted in some cases and ignored in others.
Where it is ignored, the fiduciaries are often paying too much for the plan's
investments and services. Where it is misinterpreted, fiduciaries may be
tempted to pay too little.
The fiduciaries of all plans, large and small, should have certain basic
information about expenses, regardless of whether the payments are direct
or indirect. (Direct payments are made from plan assets with the knowledge
and approval of the fiduciaries. Indirect payments are usually made from the
plan's investments, or the investment managers, to the plan's service
providers—for example, to the recordkeeper and adviser. The fiduciaries may
not be aware of these payments—but they should be.)
The data on expenses should be divided into three categories:
The first category, investment expenses, covers the costs for the
investments. For example, the expense ratio of the mutual fund, including the
management fee of the advisory firm. However, that data needs to be
modified because of the unique characteristics of 401(k) plans.
The amount of revenue from the investments paid (or "shared," ergo revenue
sharing) to either of the other two categories (administrative and advisory
services) should be subtracted from the investment costs. That would
include, for example, fees or commissions that are paid to the broker,
consultant, or adviser.
It also includes any subsidy paid for recordkeeping and administration. The
resulting “net” number is the true cost of the investments.
The second, administrative expenses, includes any charges specifically for
recordkeeping, administration, compliance, communications, and other
operational services, as well as any revenue-sharing or other payments
received from the investments. Those payments include subtransfer agency
fees and shareholder servicing fees.
The third category, advisory services, covers any amounts paid directly by
the plan to consultants, advisers, or brokers, as well as any indirect
payments. That includes, for example, finder's fees, 12b-1 fees, bonuses,
and so on.
Equipped with this information, plan sponsors and fiduciaries are in a position
to evaluate the services they are receiving in each of the three categories,
with the costs properly allocated for purposes of that comparison.
In my estimation, it is difficult, if not almost impossible, for fiduciaries to
properly assess the value of the investments and services without this type of
allocation of expenses.
For example, if a plan uses index funds, collective trusts, or institutional class
shares of mutual funds, which paid little, if any, revenue-sharing, the plan or
the employer would be required to pay additional amounts for advice,
recordkeeping, administration, and compliance. However, if a plan uses retail
class shares, which are more expensive, many, if not all, of those services
would be paid for by the revenue-sharing from the higher-cost investments.
Further, unless the fiduciaries understand and properly allocate these costs
and revenues, they may not be aware of conflicts of interests that could
possibly harm their participants. For example, if an adviser is paid more for
recommending certain mutual funds, the fiduciaries should consider that
conflict in evaluating the advice.
Similarly, if the recordkeeper has an affiliated mutual fund management
company, is there an incentive to charge less for the recordkeeping if related
mutual funds are used? Again, the fiduciaries need to understand and
consider the potentially conflicted financial interests of the provider.
In order to perform their job properly, fiduciaries should require that their
providers, regardless of whether or not bundled, provide this information and
properly allocate revenues and expenses among the three categories.