Most plan sponsors work with advisers to select the investments for their 401(k) and 403(b) plans. Those advisors tend to fall into one of two categories, based on the form of compensation paid.
One form of compensation varies depending on the investments that are selected for the plan. This form of compensation is typically a commission paid by a provider of investments to a plan, such as a mutual fund or its management company (or an affiliate of the management company). It sometimes includes finder’s fees for new deposits into the plan (such as transferred amounts from a prior provider, new contributions and deferrals, rollovers to the plan, and so on), together with an ongoing 12b-1 fee—most often ¼ of 1% per year (sometimes referred to as 25 basis points). The arrangement is common in broker-sold investments. (A broker may also be known as a registered representative, financial adviser or financial consultant.) The compensation is usually split between the broker and his broker-dealer.
The other type of adviser is an investment adviser, sometimes called an IAR—or investment adviser representative, which is affiliated with an RIA, or registered investment adviser. The compensation for an IAR and RIA is typically a discreet fee paid for by the plan (or perhaps by the employer) as a fixed dollar amount or as a fixed percent of the plan assets. That is, the fee is not usually paid by the mutual funds (although some new classes of mutual fund shares have provisions for compensating investment advisers). The fee is typically split between the IAR and the RIA.
Because of ERISA’s fiduciary responsibility and prohibited transaction rules, a broker typically cannot serve as a fiduciary to a plan. Instead, the broker provides education and guidance—but not advice, about the investments to plan sponsors and fiduciaries.
On the other hand, investment advisers are almost always fiduciaries to a plan and typically agree in writing to serve in that capacity.
In both cases, ERISA imposes on plan fiduciaries have the responsibility to understand the direct and indirect compensation being paid.
Since the investment adviser is typically paid by a check from the plan or the plan sponsor, those fees are fairly easy to understand. (However, it is possible that an adviser may receive funds from other sources, such as investment managers or mutual funds and their affiliated companies.)
To ensure that the primary plan fiduciaries are aware of all of the direct and indirect compensation being received by the adviser, they should ask their adviser for a representation that their compensation is limited to the amounts paid directly by the plan or its sponsor or, alternatively, that all of the compensation is disclosed.
In order to determine the amount and sources of compensation for the broker and broker-dealer, the fiduciaries should also request information about amounts paid to both from all sources, direct or indirect. That enables the fiduciaries to evaluate the services being provided by the broker and his broker-dealer and to compare those services to their total cost.
I recently reviewed an investment advisory agreement for the adviser to a large 401(k) trust. In that agreement, the investment adviser (who referred to itself as a “Consultant”) made the following representations and disclosures, which I thought were helpful to the plan fiduciaries and supportive of their need to know and evaluate the true cost of the adviser.
Consultant agrees to undertake the following obligations and responsibilities with respect to the Funds for the Client:
Consultant agrees to serve the Funds as a fiduciary and to assume the standard of care imposed on a fiduciary under the Employee Retirement Income Retirement Act of 1974 (ERISA).
Consultant agrees not to accept or receive any commission or other soft dollar payment from any source with respect to the Funds.
Consultant warrants that it receives no compensation, soft dollar-based or otherwise, from any investment manager or mutual fund, and that it will continue to refrain from receiving such income during the course of this agreement.
Consultant agrees not to sell any services to managers, including but not by way of limitation, banks and investment advisory companies. The purpose of this limitation is to ensure the Client receives objective advice.
The DOL is currently working on three pieces of guidance that would require much greater transparency for fees and revenues of providers and advisers. The guidance will require disclosure of both direct and indirect compensation. (Examples of indirect compensation would include both finder’s fees and revenue sharing.) Both fee-based and commission-based advisers, as well as a providers, should anticipate that guidance and begin providing client plans with full and transparent disclosure of all fees, expenses and revenues, if they are not already doing so.
Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.