by Fred Reish
When a company sponsors a retirement plan, it takes on fiduciary responsibility under a federal law known as ERISA, the Employee Retirement Income Security Act. Typically, a company appoints either an officer or a plan committee to make the decisions about the plan’s investments and operation. That officer and those committee members are also fiduciaries. (For ease of reading, this article will use the term “plan committee” as the plan fiduciary.)
Under ERISA, fiduciaries, such as plan committee members, are subject to high standards of care. The most important standard is the prudent man rule, which requires that plan committees use prudent processes to make knowledgeable and informed decisions. Unfortunately, from time-to-time committees are sued for allegedly violating the prudent man rule. For participant directed plans, such as 401(k) and 403(b) plans, those lawsuits typically include a claim that the committee members selected investments for the plan that were overly expensive. As that suggests, the prudent man rule requires that fiduciaries select investments that are reasonably priced.
Surprisingly, in many cases the claim is not that another mutual fund would have been less expensive. Instead, it is that the committee selected a more expensive share class of a mutual fund, when a less expensive version, or share class, of the same mutual fund was available. For example, the expense ratio of a retail share class of a mutual fund might be 1% (or 100 basis points) per year. But the institutional share class expense ratio for the same mutual fund might be .80% (or 80 basis points) per year. If the institutional share class was available to the plan and was the prudent choice, the selection of the retail share class of the mutual fund would be a fiduciary breach because the added expense reduces the return to the participants by the difference in the expenses year after year.
In one of the leading ERISA cases, the judge said that there was a duty to ask about whether lower cost share classes are available to a 401(k) plan. However, if plan committee members don’t know what a share class is, how will they know to ask about lower cost share classes. In that 401(k) lawsuit, the committee members had not asked, and if they had, they would have had access to lower cost investments. The case was settled for a substantial amount of money.
The decision in that case, and the “duty to ask,” raise a number of questions for plan sponsors and their committees. For example, do the members the committee know what a “share class” is; do they know whether their plan is using the lowest cost share classes of the mutual funds in the plan; if the plan isn’t using the lowest share class, have they made an informed and prudent decision about the share classes they selected?
If the answer to those questions is “no,” the committee members have a significant risk of being liable for a fiduciary breach. That is because ERISA’s prudent man rule requires that plan committees give “appropriate consideration to those facts and circumstances that, given the scope of such fiduciary's investment duties, the fiduciary knows or should know are relevant to the particular investment…” In addition ERISA requires that plan committees act “…with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use…”
In other words, fiduciaries, such as plan committee members, are accountable for knowing what a person who is familiar with mutual funds and their expenses would know. It’s not enough for committee members to do their best; instead, they need to do what a person who is knowledgeable about investments would do. Because of that standard, fiduciaries are sometimes sued because of what they didn’t know and didn’t do, rather than being sued because they knowingly made a bad decision.
Fortunately, ERISA does not require that committee members be experts on investments. It does require, though, that where committees lack the required knowledge, they hire knowledgeable advisers.
The need for a competent adviser is even greater than the discussions in this article would suggest. For example, in some cases it could make sense to select a more expensive share class. That could happen when the share class that appears to be more expensive doesn’t really cost more. Is that confusing? Read on.
Some mutual funds pay “revenue sharing” to service providers for retirement plans. (The primary provider for 401(k) plans is a “recordkeeper.” Recordkeepers hold plan investments, provide the plan website, facilitate the transactions, and so on.) “Revenue sharing” refers to payments made by mutual funds or their service providers.
If a plan committee is aware of those payments—which it should be—and takes them into account in evaluating the compensation for the recordkeeper, the payments will reduce the recordkeeping fees, and that will benefit the plan and the participants. Going back to my earlier example, if the retail share class of a mutual fund has an annual expense of 1% (or 100 basis points) and the institutional share class charges .80% (or 80 basis points), the retail share class appears to be .20% more expensive. But what if the retail share class paid .25% to the recordkeeper each year, thereby reducing the plan’s expenses for recordkeeping? Then the true, or “net”, cost of the retail share class would be .75%, making it cheaper than the institutional share class.
Plan committees are responsible for knowing and understanding the concept of net costs and the availability of the different share classes and their actual costs. What if the committee members don’t know and understand how that works? Once again, under ERISA’s fiduciary rules they can hire the expertise by engaging a knowledgeable adviser to help them gather and evaluate the information.
Concluding Thoughts
At first blush, the selection of mutual funds for a participant-directed retirement plan, such as a 401(k) plan, may seem straightforward. As this article explains, it is not. Unfortunately, the lack of knowledge about share class issues and revenue sharing has resulted in lawsuits against plan committee members. The share class issue may be the top claim in fiduciary litigation. It is not to be taken lightly.
While committee members may not have the knowledge to navigate these fiduciary waters without help, there is a solution. A knowledgeable retirement plan adviser can help guide committees through the decisions that need to be made, the information that should be considered in making those decisions, and the process for making an informed and prudent decision about plan investments.
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.