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 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:
- Investment-related expenses (“investment expenses”).
- Recordkeeping and administration expenses, which include communications, compliance, and other services related to the operation of a plan (“administrative expenses”).
- Investment consulting, brokerage, or advisory services (“advisory expenses”).
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 use 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 interest 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 amount the three categories.