by Fred Reish
Companies that sponsor retirement plans are fiduciaries for those plans. ERISA—the Employee Retirement Income Security Act—says that when a plan sponsor makes decisions about the investments and operation of a retirement plan, such as a 401(k) or 403(b) plan, the plan sponsor is a fiduciary for those decisions. In many cases, the responsibility for the decisions is given to a plan committee; in those cases, the members of the committee are also fiduciaries. (Since it is common for plan sponsors to appoint committees for this purpose, this article refers to those committees as the plan fiduciaries.)
The Legal Requirements for Selecting Plan Providers
Under ERISA plan committees have a duty to act prudently and with a duty of loyalty to the participants in the plan. The law’s prudent man rule says that committee members must act “solely in the interest of the participants and beneficiaries and—
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;…”
In other words, when plans hire service providers, the fiduciaries—the committee members--must determine that the compensation of the service providers is no more than a reasonable amount. However, the law does not dictate what is reasonable. Instead, it says that reasonableness is established by a transparent and competitive market for those services. As a result, plan committees need to know what providers are actually charging for services they provide to similarly situated plans.
The Fiduciary Process for Selecting Service Providers
In order to choose a service provider for a retirement plan, a fiduciary must engage in a prudent process to evaluate its services and fees. Typically, the key service provider for a 401(k) or 403(b) plan is the plan’s recordkeeper. (A recordkeeper provides services such as being the platform for the plan’s investments, the provider of the plan’s website, the creator of the participant communication materials, and often the provider of the plan document.) As a result, while these rules apply to all of a plan’s service providers, this article refers to the plan’s “recordkeeper.”
To decide whether a recordkeeper’s compensation is reasonable, a plan committee must know what competitive providers charges for the types of services the plan is receiving. Usually there is a range of charge. That is known as the “range of reasonableness”. Unfortunately, that information is not publicly available. However, retirement plan advisers have access to benchmarking services that can provide that data. As a result, plan sponsors and their committees should consider engaging an adviser who specializes in working with retirement plans.
Another way to obtain competitive data is through a request of proposal, or RFP, process. However, that can be time-consuming and an expensive use of a company’s administrative personnel--and may require the engagement of a consultant to help with the RFP request and the evaluation of the responses. As a result, most plans use benchmarking services to obtain competitive prices for plans of their type and size.
The next step is to calculate the total compensation of the plan’s recordkeeper. At first blush that seems simple…just look at the charges to the plan for those services. However, in most cases it is more complicated than that. The complexity is that recordkeepers often receive “indirect” compensation (which is also called “revenue sharing”). The revenue sharing is paid from the plan’s investments (e.g., mutual funds) and their affiliates. The payments are intended to help the recordkeeper defray the cost of accounting for the fund shares and distributing the fund materials. However, from a legal perspective, the revenue sharing is compensation for the recordkeeper’s services to the plan. (Those payments are considered to be indirect because they go from the investments to the recordkeeper without going through the plan. As a result, the payments will not be obvious to plan committee members.)
Since revenue sharing is treated as compensation to the recordkeeper, it must be included in the calculation of the total compensation—direct and indirect—that the recordkeeper is receiving.
Once the total compensation is calculated, it should be compared to the information about the “range of reasonableness” for the pricing of similar services to similar plans. If the recordkeeper’s total compensation falls within the range of reasonable fees, the committee’s legal work is done. The pricing is reasonable. Keep in mind, though, that committees must regularly monitor the fees of their service providers to make sure that they continue to be reasonable. While there isn’t a legal time limit, some courts have suggested that it should be done at least every three years. Some plan committees take a more conservative approach of benchmarking every year.
But what it the direct and indirect compensation is more expensive than the range of reasonableness? That’s a problem. The committee needs to make adjustments to make sure that the compensation of the recordkeeper is reduced so that is reasonable. There are two ways that are commonly used to do that. The first is that the committee members could decide to use share classes of their plan’s mutual funds that do not pay revenue sharing (or pay less revenue sharing) to the plan’s recordkeeper. (See How to Reduce Fiduciary Risk: Selection of Mutual Fund Share Classes)
The second is to negotiate with the recordkeeper for a reduction in its compensation. Since, in many cases, substantially all of the recordkeeper’s compensation is from revenue sharing, a reduction in that compensation will mean that money must be restored to the plan or put in an account for the benefit of the plan.
Under the first option, when money is restored to a plan, that money typically gets allocated to the accounts of the participants.
While that can be done, a more common arrangement is for the money to be placed in an account for the benefit of the plan. For example, the recordkeeper might create a credit account that the plan committee can use to pay bills for other plan expenses, for example, for the plan’s adviser or the plan’s accountant. Since those expenses would otherwise be paid from the plan’s assets, the money is being used for the benefit of the participants.
These accounts are fairly common and can be a good approach for negotiating fees with a plan’s recordkeeper. These accounts are referred to as “ERISA Budget Accounts” and “Plan Expense Recapture Accounts” (or PERA).
Concluding Thoughts
The first step is avoiding fiduciary liability is know what the rules are. One of the most important rules is that plan sponsors and their committees must know how much their plan service providers are making and whether it is reasonable.
Unfortunately, the compensation of service providers, and particularly of recordkeepers, is not always transparent. As a result, plan committees need to investigate the different forms of compensation—direct and indirect—that the plans” service providers are receiving. That involves difficult issues, such as knowing about share classes and revenue sharing. As a result, committees should consider working a knowledgeable adviser to help with that task.
Once the different forms of compensation have been identified and calculated, plan sponsors and their committees need to have reliable market data about the pricing of similar services. The most common source of that data is through benchmarking services. An experienced plan adviser can help obtain that information.
The last step is to compare the market data to the actual compensation of the recordkeeper. If the total compensation falls in the range of reasonableness, the fiduciary job is done. However, if the compensation is excessive, the committee must engage with the recordkeeper to reduce the compensation to a reasonable amount. That is most commonly done through changing to lower cost, non-revenue sharing investments or through negotiating for an ERISA Budget Account.
These are complex issues that require knowledge of the retirement and investment industries and their practices. It is hard to do this job without the help of a retirement plan adviser.
This content was authored by Fred Reish. Fred Reish is a partner with the law firm of Faegre Drinker who specializes in retirement law, focusing on fiduciary and best interest standards of care, prohibited transactions, conflicts of interest, and retirement plans.
The views expressed in this article are those of Fred Reish, and not necessarily of Faegre Drinker or HUB International. The article is for general information only and is not intended to provide investment, tax or legal advice, or recommendations for any particular situation. Please consult with a financial, tax or legal advisor on your circumstances.
HUB International’s retirement plan fiduciary advisors provide ongoing guidance on your plan’s setup and management to ensure it meets regulatory compliance guidelines and the interests of your employees. Contact HUB to request an assessment of your organization’s retirement plan.