401k Whitepaper
- 1. Is Your Company’s Retirement Plan a Litigation Time Bomb? At this point almost everyone is aware of the multitude of 401(k) lawsuits filed by employees against their employers for excessive fees and other fiduciary breaches under ERISA. This has all lead to a very turbulent and stressful time for the fiduciaries of retirement plans. This has also brought into question what the future holds for these plans and the investment options within them. Many plan sponsors are trying to determine if their current retirement plan is putting them in jeopardy and what they should focus on when considering other options. http://bit.ly/2dPBInW With the Department of Labor's Fiduciary rule squarely at the center of change, plan advisers are now closely reviewing their investment line-ups, fee structures and overall transparency within the plans they serve. The 401(k) litigation in recent years was led by law firms representing employees of companies that have breached their fiduciary responsibility under the ERISA regulations. DOL’s ERISA regulations have been reinforced by a Supreme Court ruling deciding 9-0 in favor of fiduciaries taking responsibility for fees and management practices. Failure to follow these regulations have led to settlements between $3.8 million and $140 million. On average, these settlements have resulted in companies paying out $49.96 million in settlements to avoid reaching legal judgement (not including paying for plaintiff litigation fees, restructuring of 401k administration, and other non-monetary provisions of settlement). Most of these lawsuits have involved very large companies with very deep pockets, however that trend may be changing. Most recently in the news, two smaller plans ranging between $9 and $25 million are currently facing litigation. This could be the canary in the coal mine signaling a period of widespread lawsuits may be imminent. If lawyers find that employers will not risk going to court and settlements can be done with very little time and expense, almost every plan will be vulnerable to scrutiny and potentially legal action. In August, ERISA class action lawsuits were filed against universities alleging that they had not met their fiduciary responsibilities to employees enrolled in 403(b) plans. Until now, governmental plans, school plans and non-electing church plans have been exempt from ERISA regulations. In recent guidance, however, the DOL has indicated that 403(b)s could only be exempt from ERISA and other retirement regulations if there were no employer contributions, if the employer had little-to-no involvement in the plan, and if participation was voluntary for employees. The three lawsuits filed in August allege that plan sponsors and their fiduciaries ensured that fees were reasonable, failed to seek out less expensive administrative services for
- 2. the 403(b) plan by not seeking competitive bids, breached their duty of loyalty by hiring a third- party provider with some relationship to the sponsor or plan fiduciaries, failed to ensure that only prudent investment options were offered, failed to monitor investment options to remove those that regularly underperformed and charged excessive expenses as compared to similar options available in the marketplace. Duke, Vanderbilt, Penn and Johns Hopkins joined a growing list of universities targeted by class actions that now includes Yale, MIT, NYU, Cornell, Columbia, Northwestern and the University of Southern California. All of the class actions were filed by St. Louis-based Schlichter, Bogard and Denton, the firm responsible for bringing Tibble vs. Edison International before the U.S. Supreme Court, a case that ruled that 401(k) fiduciaries are responsible for regularly removing “imprudent” investments from their plans. DOL penalties for ERISA violations have also increased in 2016 and will be automatically adjusted for inflation moving forward. The fact that DOL is revising these fees should be a signal to all fiduciaries that the potential for audits in the future are likely increasing. This paper will not be going over all the changes made to these penalties but this should be a major consideration along with the lawsuit settlements. A couple of the changes made to these penalties include a penalty of $2,063 per day for failure or refusal to file a Form 5500. Additionally, there was an increase in the penalty for refusing to furnish statements of benefits to former and current participants or dereliction in duty to maintain records from $11 per employee to $28 per employee. It is critical that plan sponsors and fiduciaries understand what they need to focus on to avoid being named in one of these lawsuits. According to Fidelity’s plan sponsor survey, 38% of plan sponsors are concerned about their fiduciary duties up from 24% last year. Additionally, 23% of plan sponsors are actively looking to change advisors up from a low of 10% in 2013. Fiduciary responsibility is one of the cornerstones of running a good 401(k) plan. This means the selection of the correct individual to be your fiduciary is incredibly important as well as having a complete understanding of what the position entails. Knowing what the fiduciary’s responsibilities consist of is critical for your company to avoid unnecessary litigation. A fiduciary is chosen based upon functions performed for the plan and not based on the title. Naming someone as fiduciary but having that person’s responsibilities be different from overseeing the plan is a grave first step. Fiduciaries can take many different forms such as a board trustee or an investment adviser. The key component to being a fiduciary is using discretion in control over the plan and acting in the plan participants’ best interest. Some of the responsibilities that fiduciaries are liable for include: 1. Acting onlyin the interestof the plan participants and beneficiaries withthe sole purpose of providing benefits to them; 2. Carrying out duties prudently; 3. Following plan documents unless they are in conflictwithERISA guidelines; 4. Diversifying plan investments; 5. Paying reasonable expenses for plan investments and services; 6. Avoid conflicts of interestwith the plan. Prudence, in this context, focuses on the process for which decisions are made about the plan. This entails that all decisions are documented as well as the reason for making that decision. In
- 3. the event that a fiduciary is not knowledgeable in one of the many key areas of being a fiduciary; the fiduciary will want to hire or request consultation of someone with professional knowledge in that area. Similarly, when a fiduciary is considering to hire a service provider, the fiduciary should ask for identical information from the potential service providers to be able to make a valid comparison. The fiduciary should also be aware of the plan document as well as review and update it regularly to insure that it is always reflecting the current state of the plan. http://bit.ly/2e7Otxl The reality of the situation facing plan participants is that they must determine how much they should be adding to an account. This determination implies that plan participants bear most, if not all, of the risks inherent in the plan. Most companies are aware (or even betting on the fact that) their employees do not have the proper financial literacy to understand how their funds are managed (by fund managers, fiduciaries, or plan providers). This provides both mutual funds and plan sponsors with an advantage over their plan participants but that advantage can, and does, end up creating a problem for plan sponsors in the form of class action lawsuits by employees and attorneys who are well versed in 401(k) law. With the fiduciary responsibility comes the reality that the fiduciary and plan sponsor are liable for the plan. There are ways to reduce the liability however as you will see it cannot be completely eliminated. Fiduciaries may hire service providers to handle the liability while setting up an agreement that they be held legally responsible for those decisions. Similarly, the fiduciary must ensure that the service provider is maintaining the investments prudently and within their purview. Many companies are laboring under the delusion that is pushed by third party fiduciary vendors that, by entering into business with those vendors, they are free from the responsibility of the plan. You may hear the phrase 3(21) or 3(38) being tossed around when the discussion of fiduciary responsibility comes up. These numbers simply refer to the definition of the different types of fiduciaries under the ERISA regulations. A 3(21) is a general fiduciary, defined as: Anyone who makes decisions aboutmanaging the plan or its investments, such as selecting the investmentchoices for participants or hiring persons who provide services to the plan; Anyone who makes decisions aboutadministering the plan,such as determining eligibilityof participants,providing benefits statements and ruling on benefits claims,or Anyone who is paid to provide investmentadvice to a plan.
- 4. A 3(21) may include the plan sponsor, trustee, plan administrator and investment fiduciary. The investment fiduciary is a paid service provider that gives investment recommendations but does not necessarily have discretionary authority to make the actual investment decisions. Instead, the investment fiduciary typically provides suggestions to the plan sponsor, who is free to accept or reject those recommendations and who must then execute the investment decisions for the plan. The plan sponsor and the investment fiduciary, therefore, share fiduciary responsibility. A 3(38) on the other hand, is a special type of fiduciary called an investment manager, who has been specifically appointed to have full discretionary authority and control to make the actual investment decisions. The 3(38) investment manager has full fiduciary responsibility for its investment decisions, subject to the terms of the plan documents and its investment policy statement. The plan sponsor and all other plan fiduciaries are relieved of all fiduciary responsibility for the investment decisions made by the investment manager. The plan sponsor does have a continuing responsibility to monitor whether the investment manager is actually performing the services but need not second guess its investment decisions. In the face of ever-increasing litigation and heightened regulatory scrutiny, many plan sponsors want this extra layer of protection, especially if they are not comfortable making the plan’s investment decisions themselves. Neither the 3(21) nor the 3(38) totally eliminate the responsibility of the fiduciary or the plan sponsor. This is important to understand because many third parties promise to eliminate fiduciary responsibilities by utilizing a 3(21) or 3(38) option. It is not always evident that the fiduciary or plan sponsor are still responsible for ensuring that the best interest of the participants are being met. The most obvious necessity for this oversight becomes apparent with the fact that most 3(21) or 3(38) are services provided by the plan provider. Neglecting to monitor the fees being paid to the retirement plan that is also providing the fiduciary oversight could be catastrophic. Fiduciaries can also open themselves and the company up to litigation if there is more than just a business relationship with the plan sponsor. This relationship can come in many different forms, whether it be a friend, relative, or some other personal connection to the fiduciary or another individual in the company that may have influence in the decision. This is a clear breach of ERISA code 404(a)(1)(A) and can be cause for fines, legal recourse, or other non-monetary business changes. These types of arrangements can lead to the acceptance of poor performance or excessive fees in a plan, resulting in plan participants having just cause to file a lawsuit for negligence even if the plan sponsor was following ERISA rules otherwise. A key resource for the fiduciary in determining what fees that the participants and company are paying for the retirement plan is the 408(b)(2) disclosure. These annual disclosures that are provided by covered service providers include a breakdown of the fees paid to the service providers as well as any specific investment fees paid by plan participants. The illusive piece of dealing with the 408(b)(2) disclosure is that it is not reported in a specific federal form. Therefore plan sponsors must be familiar with what should be disclosed to ensure they are receiving all the pertinent information. Along those lines, a plan sponsor should monitor for the possibility of the service provider charging a fee that violates the plan sponsor’s fiduciary duty as well as charging a fee that is not disclosed on the 408(b)(2).
- 5. http://bit.ly/2e7Otxl Many plan sponsors correctly assume that the primary burden of providing these required disclosures falls on the service provider. However what they may not realize is that the 408(b)(2) rules and the related fiduciary requirements under ERISA also impose numerous duties on the plan sponsor. Specific duties are triggered in the event the required disclosures are defective or are not delivered on time, effectively forcing the plan sponsor to monitor and police the disclosure efforts of the plan’s various providers. Furthermore, plan sponsors in their role as the “responsible plan fiduciaries” for purposes of these rules also have an overarching duty to review these disclosures and to evaluate the reasonableness of the providers’ total compensation. Meeting these obligations is contingent on the quality of information delivered by the plan provider. This means that plan sponsors should look through the information to determine if they need to contact the plan provider about possibly breaching ERISA regulations. The easiest way to determine this is to see if the disclosures have the following required elements: 1. Services:A description of service provider’s services 2. Status as a fiduciary:The disclosures in question must include thatthe provider is registered investmentadviser or a plan fiduciary(or in some cases both), if appropriate 3. Directand indirectcompensation: The disclosure should include compensation and identityof payer. 3a. Subcontractor compensation:The disclosure should include anycompensation paid to third parties that is seton a transaction basis.This also includes compensation thatis againstthe covered plan’s investmentand reflected in the netassetvalue of the investment. 4. Fee upon termination of services:The disclosure should include anyfees that were payable upon termination or in cases of refund 5. Method of payment: This is the mostimportantpart as itis where many,many plan sponsors gethit with legal issues.This where the plan sponsors have a fiduciaryduty to ensure that all fees on the plan are reasonable and are described in enoughdetail to be able determine if fees are paid correctly.If this is notmet, the fiduciaryand plan sponsor has a responsibilityto ask service provider for the necessary information. Since the 408(b)(2) disclosure primarily revolves around the fees associated with retirement plans, this seems like the perfect time to look into these expenses in more detail. 401(k) plan fees and expenses generally fall into three categories: Plan administration fees. The day-to-day operation of a 401(k) plan involves expenses for basic administrative services – such as plan recordkeeping, accounting, legal, trustee services, and any other plan features that are available to all plan participants (i.e. online access and transactions). These costs may be covered by investment fees that are deducted directly from investment returns. Otherwise, if administrative costs are separately charged, they will be borne either by
- 6. your employer or charged directly against the assets of the plan. When paid directly by the plan, administrative fees are either allocated among participant’s individual accounts in proportion to each account balance or passed through as a flat fee against each participant’s account. Investment fees. By far the largest component of 401(k) plan fees and expenses is associated with managing plan investments. Fees for investment management and other investment-related services generally are assessed as a percentage of assets invested. You should pay attention to these fees. You pay for them in the form of an indirect charge against your account because they are deducted directly from your investment returns. Your net total return is your return after these fees have been deducted. Individual service fees. In addition to overall administrative expenses, there may be individual service fees associated with optional features offered under a 401(k) plan. Individual service fees are charged separately to the accounts of participants who choose to take advantage of a particular plan feature. For example, individual service fees may be charged to a participant for taking a loan from the plan or for executing participant investment directions. In addition to the fees charged for administration of the plan itself, there are a couple of basic types of fees that may be charged in connection with investment options in a 401(k) plan. Generally, investment-related fees,usually charged as a percentage of assets invested, are paid by the participant. These fees, which can be referred to by different terms, include: Sales charges (also known as loads or commissions). These are transaction costs for buying and selling of shares. They may be computed in different ways, depending upon the particular investment product. Management fees (also known as investment advisory fees or account maintenance fees). These are ongoing charges for managing the assets of the investment fund. They are generally stated as a percentage of the amount of assets invested in the fund. Sometimes management fees may be used to cover administrative expenses. You should know that the level of management fees can vary widely, depending on the investment manager and the nature of the investment product. Investment products that require significant management, research and monitoring services generally will have higher fees. Mutual funds are the most common investments found in 401(k) plans and these funds cover a vast variety of investment choices. The largest concern for the fiduciary of the plan is the performance of the investments as well as the related expenses for each mutual fund. There are mainly two categories that mutual funds fall into, these are referred to as “actively managed” and “passively managed.” Actively managed funds have an investment adviser who continually researches, monitors, and actively trades the holdings of the fund to seek a higher return than the market and these generally have higher fees. While actively managed funds seek to provide higher returns than the market, neither active management nor higher fees necessarily guarantee higher returns. Passively managed funds seek to obtain the investment results of an established market index, such as the Standard and Poor’s 500, by duplicating the holdings included in the index. Thus, passively managed funds require little research or trading activity and generally have lower management fees. There is a newer investment option available in 401(K) plans called ETFs (Exchange-Traded Funds). Mutual funds have existed since The Great Depression while ETFs are a relatively new investment and are approximately 20 years old. ETFs are investments in securities that offer an already diversified stock portfolio and are traded on the open market in a manner that is similar to stocks or bonds. ETFs are usually fairly inexpensive due to fewer fees than other investments
- 7. while providing a high level of clarity that isn’t found in other investment instruments. Like mutual funds, ETFs offer a variety of options that can, and do, vary from plan to plan. The safety of an ETF or mutual fund primarily depends upon the type of investments included within the fund. The vast majority of ETFs are indexed funds and invested in a security that is tied to a given index like the NASDAQ. Indexed ETFs also don’t have fund managers associated with them which is the primary reason for the lower fees inherent in indexed ETFs. Safety in mutual funds is mostly determined by the management of the fund and the use of derivatives within the fund. Management’s performance and fees is key with actively managed funds and the net outcome must be compared closely against the benchmarks. Derivatives are often traded in mutual funds but it is not always clear how much risk (if any) they may pose. http://bit.ly/1QJOqEu Over 60% of Americans believe they pay no 401(k) fees which couldn’t be further from the truth. Most plan providers make the majority of their profits by taking a cut of the fees charged by the mutual funds offered in their 401(k) plans. Although these fees may sound like small percentages, they have a huge impact on the participants plan value over time. DOL has stated that hidden fees and backdoor payments in retirement plans are costing Americans over $17 billion annually. So this concept of “pay to play” results in many funds with hefty fees when alternate options may not be made available by the plan providers. This is likely a large contributing factor as to why low-cost index funds tend to be a rarity in 401(k) plans. Fiduciaries and plan sponsors should pay particular attention to these areas: 1. Focus on plans that have access to the lowest-cost index funds - Index funds consistently outperform most actively managed mutual funds over the long term. These passive investments have minimal expenses and as such should offer very low fees to plan participants. If you’re not sure of how expensive the index funds are in comparison to the market or other plans, see #2 because you really need to start benchmarking. 2. Benchmark your plan – DOL requires that a periodic benchmark be completed as part of the plan sponsor’s fiduciary duty, however it is also critical to protect the business from any litigation by plan participants. The fiduciary’s personal involvement with the due diligence is critical in this process because simply using comparisons provided by the broker will not suffice. You must ensure that the broker is not serving their own best interest and look outside the products and investments that he/she makes available. 3. Ensure arm’s length transactions - Many employers were sold their plans by brokers who may also be personal friends. Breaking up is hard to do, but a personal relationship is not a defensible position with the Department of Labor. 4. Remove conflicts of interest - If you are using a plan where the provider is being paid by the mutual funds in the plan, they have an inherent bias to sell you their own name-brand
- 8. proprietary funds or to select more expensive funds. If your current plan provider is offered by an insurance company, payroll company, or mutual fund company, you should ask your plan provider if they are “revenue sharing” with the mutual funds they offer. 5. Use a third-party fiduciary 3(38) - These 3(38) fiduciaries will take over nearly all of the responsibilities and much of the liability of the plan sponsor. However there are still certain aspects that the plan sponsor must be diligent about to ensure the plan is operated in the best interests of the plan participants. For example, the 3(38) fiduciary is typically a service available through the plan provider, and as such these fiduciaries may not be quick to question the fees charged by the plan provider employing them. While you are busy running your business and offering a 401(k) as a benefit for your employees, lawyers are reaching out to employees with opportunistic letters that highlight how they have been harmed as a result of employers breaching their fiduciary obligation. Although the larger employers have already experienced the flood of lawsuits and paid millions to settle these suits, the focus is now turning to the smaller plans where excessive fees are most prevalent. These lawsuits should be the guiding light for plan sponsors to complete a rigorous evaluation of their existing plan, as well as actively assessing other plan providers in the marketplace.
- 9. Citations Boyte-White, Claire."Make Sure You Avoid Adding These Mutual Funds to Your 401(k)." Investopedia.2016. Accessed September 29,2016. http://www.investopedia.com/articles/investing/012516/make-sure-you-avoid- adding-these-mutual-funds-your-401k.asp. "DOL Increases Penalties for ERISA ComplianceViolations."FYI, July 18, 2016,1-3. "ERISA COMPLIANCE AN OVERVIEW OF DOL 408(b)(2) DISCLOSURE ..." Accessed September 29, 2016. http://www.davis-harman.com/pub.aspx?ID=VFdwak5BPT0=. "Hedge Funds in Your 401(k): Do They Fit?" Wall Street Journal. http://www.wsj.com/articles/hedge-funds-in-your- 401-k-do-they-fit-1408146408. Marc L. Ross,CFP, CPA®, CLU®. "Mutual Funds Vs. ETFs: A Comparison."Investopedia.2012.Accessed September 29, 2016.http://www.investopedia.com/financial-edge/0112/mutual-funds-vs.-etfs-a-comparison.aspx. Meeting Your Fiduciary Responsibilities.Washington,D.C.: U.S. Dept. of Labor, Employee Benefits Security Administration,2010. Rosenbaum, Ary, P.C., and Dr, Gregory W. Kasten, CEO. "3(38) Fiduciary Versus 3(21) Fiduciary:WhatAre the Real Duties and Risks?"Www.Fi360.com. http://www.fi360.com/main/pdf/KastenRosenbaum_2012_slides.pdf. Siedle, Edward A.H. "Secrets of the 401k Industry:How Employers and Mutual Fund Advisers Prospered as Workers' Dreams of Retirement Security Evaporated." Benchmarket Alert. http://www.benchmarkalert.com/Secrets of the 401k Industry.pdf. Staff, By Investopedia."Mutual Funds: Different Types Of Funds | Investopedia." Investopedia.2016. Accessed September 29, 2016. http://www.investopedia.com/university/mutualfunds/mutualfunds1.asp. Wohlner, Roger. "Are ETFs a Good Fitfor 401(k) Plans?"Investopedia.2015.Accessed September 29, 2016. http://www.investopedia.com/articles/financial-advisors/101315/are-etfs-good-fit-401k-plans.asp. A Look At 401k Plan Fees. PDF. DOL, August 2013. https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource- center/publications/401kFeesEmployee.pdf @orthopracticeus."IsYour401(k) Plana TickingTime Bombof Personal andProfessionalLiability? - Columns,CurrentIssue - OrthodonticPractice US."OrthodonticPractice US.2016. AccessedOctober19, 2016. http://www.orthopracticeus.com/columns/401k-plan-ticking-time-bomb-personal-professional- liability. Legg-MasonAssetManagement.Putting408(b)(2) Disclosure RulesintoPractice:A Guide forPlan Sponsors. http://www.wagnerlawgroup.com/documents/Putting408b2DisclosureRulesIntoPracticeAGuideforPlanS ponsors.pdf ChristopherRobbins.Lawsuits,DOLRule Blurthe Line Between403(b) and401(k). AccessedOctober19, 2016. http://www.fa-mag.com/news/lawsuits--dol-rule-blur-the-line-between-403-b--and-401-k- 29465.html. Iacurci,Greg. "FiduciaryConcernClients'No.1 ReasonforHiring401(k) Advisers:Study."Fiduciary ConcernClients'No.1 ReasonforHiring401(k) Advisers:Study.AccessedOctober19,2016. http://www.investmentnews.com/article/20160817/FREE/160819952/fiduciary-concern-clients-no-1- reason-for-hiring-401-k-advisers-study.