There is a fiduciary responsibility under ERISA to evaluate arrangements with service providers and to determine if they are reasonable. That includes the fees being paid to advisers, the revenues received by recordkeepers and third-party administrators, and the investment expenses. That responsibility was explained by the Investment Company Institute (ICI) in testimony before the Department of Labor (DOL) Advisory Council in 2007, testimony that went on to describe several options that plan sponsors have for reducing the cost and fees—if they have become too high. The ICI said:
If the growth of plan assets supports a revision of the arrangement, the plan fiduciary and service provider have a number of options. One is to lower total plan costs by replacing existing plan investments with lower-cost options or share classes. Another is to provide the plan and participants with additional services that were not originally affordable. A third option for plan fiduciaries might be to negotiate with the recordkeeper to share some of the recordkeeper's revenue with the plan. Finally, the plan fiduciary can put the service contract out for bid to determine whether other service providers might offer comparable services at a lower cost.
The focus of this column is the third option—"sharing" some of the recordkeeper’s revenue with the plan.
As a plan grows, the cost of investing and administering the plan should not grow as quickly. As a result, the earnings of the recordkeeper (or, for that matter, the investment manager) may, in time, exceed a reasonable amount. At that point, fiduciaries have an obligation to reclaim that “excess” money for the benefit of the plan and its participants, but how do you know if costs are unreasonably high?
The theoretical answer is that the service provider is, as a general matter, entitled to recover its costs and a reasonable profit. Any amounts above that are, generally speaking, unreasonable compensation. However, if a service provider operates efficiently, it may reasonably be entitled to a higher profit margin. So, a practical analysis is based on the competitive marketplace. That analysis can be implemented by “benchmarking” your providers, by comparing their charges with those of competitive providers. If you benchmark a provider and the costs are within the range of what other quality providers are charging, then you are almost assured that the costs are reasonable. That doesn’t mean that you can’t find a lower-cost provider that affords even greater benefits to your participants, but it does mean that you have fulfilled your legal responsibility to incur no more than reasonable costs and to pay no more than reasonable compensation.
I also should point out that there are two forms of “revenue” that should be considered, particularly when evaluating your recordkeeper. The first is compensation received from mutual funds—regardless of whether the mutual funds are affiliated with the recordkeeper—as well as any amounts received directly from the plan. The second involves credits or discounts, and usually occurs when the plan uses mutual funds that are managed by an affiliate of the recordkeeper. At this point, recordkeepers are not required by ERISA to give plan sponsors information about the revenue-sharing that they receive from third-party or affiliated mutual funds. However, as a practical matter, most do. Recordkeepers also are not required to inform plan sponsors about the discounts or credits that they are receiving from affiliated investments—and most don’t. A bill has been introduced by Senators Harkin (D-Iowa) and Kohl (D-Wisconsin) that would change that. If that legislation becomes law, or if a DOL regulation is issued with similar provisions, plan sponsors will be entitled to know all of the money that is subsidizing the cost of recordkeeping. At that point, they will be in a much better position to negotiate for a sharing of that revenue, regardless of whether it is received by the recordkeeper as credits or cash.
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.