401K REVENUE SHARING
A recent spate of litigation involving 401(k) plan fees has drawn the attention of employers, the media, and Congress. At issue in these cases is hundreds of millions of dollars
in potential liability, and also the very backbone of the retirement plan industry. Employers can expect more scrutiny of their plans from employees and, in some unfortunate
circumstances, from plaintiffs' attorneys.
Class action attorneys have identified their next target, and it isn't cigarette manufacturers, pharmaceuticals, or falling stock prices. Instead, they have in their sights
something that is much more pervasive in the business community, and potentially more explosive: the 401(k) industry and employers who participate in it. A series of
class action lawsuits filed in late 2006 and early 2007 challenges the way that employers pay for the 401(k) plans that they sponsor. At last count at least seventeen cases
were pending in federal courts from Maryland to California, each arguing that investment-related fees paid by plans to their service providers were so excessive as to
violate the Employee Retirement Income Security Act of 1974 ("ERISA").
Coming on the heels of the stock-drop cases that continue to plague employers that offer company stock funds in their plans, this new rash of litigation has the potential to
affect many more plans and plan sponsors. These lawsuits attack the basic fee structure used by most 401(k) plans. They have received significant media attention, leading
to increased scrutiny from legislators and plan participants. And although the courts have not yet considered the merits of the claims, they are already altering the way that plans
The Substance of the Claims
The current challenges come primarily from participants in employer-sponsored 401(k) plans. Long predicted by benefits prognosticators, this new wave of litigation is largely
driven by three factors: demographics; the growing prevalence of 401(k)-type arrangements as the primary source of retirement savings; and the stock market. As the vast majority of American workers face the prospect of retirement without the security of a traditional defined benefit retirement plan, the investment options made available to participants in 401(k) arrangements and the net investment return on those options will increasingly come under scrutiny. Ultimately, these lawsuits can be traced to the convergence of these three factors.
According to the complaints, administrative fees paid by the plans - and indirectly paid by plan participants - were excessive, improperly diluting the returns on participants' 401(k) investments. The lawsuits seek to recover what could amount to many millions of dollars from plan sponsors and executives who allowed the plans to pay the allegedly excessive fees, and in some cases from the plan service providers who received those fees. Although the employers and plans that have been sued so far are very large, including Kraft, International Paper, Caterpillar, and Boeing, the legal theories advanced by the plaintiffs would apply to almost every 401(k) plan and plan sponsor. With over $2.9 trillion in the 401(k) industry at stake and baby boomers on the cusp of retirement, it's clear that these issues are not going away soon.
Revenue Sharing Under Fire
The common theme among all of the cases that have been filed to date is an attack on a practice the plaintiffs characterize as "revenue sharing." That term can have different interpretations depending upon the kind of investments offered under a plan (e.g., annuity contracts, collective trusts, and mutual funds). In the context of mutual funds - perhaps the most common 401(k) investment vehicle - revenue sharing generally refers to a practice in which mutual fund companies carve off a portion of the management fees they receive from investors and then "share" that revenue with other service providers with whom the fund companies sub-contract. Revenue sharing is a practice that is common throughout the 401(k) industry.
One of the allegations in the class complaints is that plan fiduciaries did not understand the complicated fee structures that are common in the 401(k) industry. For a more detailed explanation of those structures, please refer to the discussion found at Understanding 401(k)Fees
The complaints characterize revenue sharing payments in two ways. First, the plaintiffs claim that these payments amount to "hidden" fees, largely because they are difficult to understand and rarely disclosed to participants. Second, the plaintiffs contend that revenue sharing payments are actually assets of the plans which are improperly used to benefit parties other than plan participants, in violation of ERISA's "exclusive benefit" and "prohibited transaction" rules. The complaints characterize these payments as "the big secret of the retirement industry."
The plaintiffs allege that the defendants in these cases breached their fiduciary duties under ERISA by failing to investigate whether the plan's service providers received revenue sharing payments. They contend that plan expenses could have been reduced - and participants' investment earnings could have been increased - if the defendants had uncovered these arrangements and used that information to negotiate for lower fees. They also suggest that defendants violated ERISA by failing to disclose the existence of revenue sharing payments to participants.
lthough the attack on revenue sharing is at the core of these suits, the plaintiffs challenge a number of other practices as well. A few of the complaints argue that some direct (or "hard dollar") payments from the plans to their service providers were not adequately disclosed to participants. For example, they say that this happens when plans participate in master trust arrangements (which are trusts that pool the assets of multiple plans), and payments are made to service providers from the master trust. The lawsuits suggest that fees paid directly from the master trust - rather than from a component plan - were not disclosed to plan participants, making it appear that plan expenses were very low or even nonexistent.
Some of the plans offered participants the ability to invest in mutual funds that charge a fee for active management, but that allegedly behave like passively managed index funds. The complaints assert that the returns participants earned on those funds were virtually identical to the returns they could have obtained from an index fund which has a much lower management fee. They argue that the management fees imposed by these alleged "shadow index funds" were therefore excessive, and that the plans' fiduciaries should not have accepted them.
In a few of the cases the plaintiffs take aim at practices associated with employer stock funds. These funds allow (and in some cases require) plan participants to invest in the stock of the plan sponsor. The participants contend that the employer stock funds charged improper management and administration fees, when there really was no "management" of the fund at all. They also argue that fiduciaries allowed excessive cash to be held in unitized employer stock funds, thus diluting returns.
End Run on Section 404(c)
Also common to all of the lawsuits is the plan participants' assertion that they were not fully informed about the expenses associated with their accounts. This, they say, vitiates the protection from liability that plan fiduciaries might otherwise have had under Section 404(c) of ERISA. The implication is that participants whose 401(k) accounts suffered investment losses could seek to recover those losses from the fiduciaries, in addition to the allegedly excessive fees.
Most plans that allow participants to choose how to invest their money do so in reliance on Section 404(c). That statutory provision protects plan sponsors and fiduciaries from liability for any losses participants may incur when making their own investment choices. However, this protection applies only if participants are given sufficient information with which to make investment decisions. According to the participants, by failing to provide adequate information about plan expenses, the fiduciaries did not comply with Section 404(c), and thus they remain responsible for any investment losses the participants may have suffered.
Assessing the Risk
The defendants in the currently pending suits are mounting a vigorous defense, filing a flurry of preliminary motions. Based upon the arguments they have raised to date and recent decisions by courts in the Fourth (LaRue v. DeWolff, Boberg & Assocs.) and Fifth (Langbecker v. EDS Corp.) United States Circuit Courts of Appeal, it appears that the plaintiffs will have an uphill battle. Nevertheless, these cases will be heavily fact-dependent, and are unlikely to be resolved in the early stages of litigation.
Of equal concern may be the possible legislative and regulatory responses to these lawsuits. Already the U.S. House Committee on Education and Labor has held hearings to address 401(k) fees. More hearings are set for later in the year. The Department of Labor also is considering several initiatives to regulate the relationships between plans and their service providers, and to increase the transparency of retirement plan fees. Thus, the changes that emanate from Washington could have a more significant impact on employer-sponsored 401(k) plans than the threat of litigation.
It is likely that more lawsuits will be filed in the coming months. Although the St. Louis-based Schlicter, Bogard & Denton law firm is primarily responsible for the current wave of litigation, there are indications that other plaintiffs' firms are poised to join the fray. Internet reports indicate that a large firm with a well-established ERISA practice is "investigating" the fee practices of insurance companies that provide retirement plan services. Moreover, the Schlicter firm has placed newspaper advertisements to solicit potential plaintiffs for lawsuits that target at least 15 additional plans.
More recently, plaintiffs have added plan service providers to the list of those they sue. In each of the last three cases filed by the Schlicter firm, Fidelity Management Trust Co. and Fidelity Management Research Co. have been named directly as defendants. In those cases, Fidelity's involvement with the investment funds offered under the plans was allegedly so pervasive as to make Fidelity an ERISA fiduciary with respect to the plans. In addition, plan sponsors themselves have sued insurance company providers directly - Nationwide, The Hartford, and Principal - in what purport to be national class actions on behalf of all plans and plan sponsors that have engaged those entities.
Cases are now pending in federal district courts in the Second, Sixth, Seventh, Eighth, and Ninth Circuits. As these matters proceed, it is likely that the courts will render substantive interpretations of ERISA that are not always consistent. Unless Congress intervenes, it will be up to the Supreme Court to explain the extent of the rights and obligations that employers - and employees - have with respect to 401(k) plans. Thus, for some time to come these lawsuits will shape the legal landscape in which retirement plans are administered.
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A Look At 401(k) Plan Fees
More and more employees are investing in their futures through 401(k) plans. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.
If you are among those who direct your investments, you will need to consider the investment objectives, the risk and return characteristics, and the performance over time of each investment option offered by your plan in order to make sound investment decisions. Fees and expenses are one of the factors that will affect your investment returns and will impact your retirement income.
The information contained in this booklet answers some common questions about the fees and expenses that may be paid by your 401(k) plan. It highlights the most common fees and encourages you, as a 401(k) plan participant, to:
- Make informed investment decisions
- Consider fees as one of several factors in your decision making
- Compare all services received with the total cost
- Realize that cheaper is not necessarily better
Keep in mind, however, that this booklet is a simplified explanation of 401(k) fees. It is not a legal interpretation of the nation's major pension protection law, the Employee Retirement Income Security Act (ERISA), or other laws, nor is this information intended to be investment advice.
Why Consider Fees?
In a 401(k) plan, your account balance will determine the amount of retirement income you will receive from the plan. While contributions to your account and the earnings on your investments will increase your retirement income, fees and expenses paid by your plan may substantially reduce the growth in your account. The following example demonstrates how fees and expenses can impact your account.
Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.
In recent years, there has been a dramatic increase in the number of investment options typically offered under 401(k) plans as well as the level and types of services provided to participants. These changes give today's employees who direct their 401(k) investments greater opportunity than ever before to affect their retirement savings. As a participant you may welcome the variety of investment alternatives and the additional services, but you may not be aware of their cost. As shown above, the cumulative effect of the fees and expenses on your retirement savings can be substantial.
You should be aware that your employer also has a specific obligation to consider the fees and expenses paid by your plan. ERISA requires employers to follow certain rules in managing 401(k) plans. Employers are held to a high standard of care and diligence and must discharge their duties solely in the interest of the plan participants and their beneficiaries. Among other things, this means that employers must:
What are 401(k) Plan Fees and Who Pays for Them?
- Establish a prudent process for selecting investment alternatives and service providers
- Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided
- Select investment alternatives that are prudent and adequately diversified
- Monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices
If you want to know how fees affect your retirement savings, you will need to know about the different types of fees and expenses and the different ways in which they are charged.
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 record keeping, accounting, legal and trustee services -- that are necessary for administering the plan as a whole. Today a 401(k) plan also may offer a host of additional services, such as telephone voice response systems, access to a customer service representative, educational seminars, retirement planning software, investment advice, electronic access to plan information, daily valuation and on-line transactions.
In some instances, the costs of administrative services will 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 your employer or charged directly against the assets of the plan. When paid directly by the plan, administrative fees are either allocated among individual accounts in proportion to each account balance (i.e., participants with larger account balances pay more of the allocated expenses) or passed through as a flat fee against each participant's account. Either way, generally the more services provided, the higher the fees.
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. For this reason, these fees, which are not specifically identified on statements of investments, may not be immediately apparent.
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 individuals 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.
401(k) plan investments and services may be provided through a variety of arrangements:
Employers may directly provide, or separately negotiate for, some or all of the various services and investment alternatives offered under their 401(k) plans (sometimes referred to as an unbundled arrangement). The expenses of each provider (i.e., investment manager, trustee, recordkeeper, communications firm) are charged separately.
In many plans, some or all of the various services and investment alternatives may be offered by one provider for a fee paid to that provider (sometimes referred to as a bundled arrangement). The provider will then pay out of that fee any other service providers that it may have contracted to provide the services.
Some plans may use an arrangement that combines a single provider for certain services, such as administrative services, with a number of providers for investment options.
Fees need to be evaluated, keeping in mind the cost of all covered services.
What Fees are Associated with My Investment Choices in a 401(k) Plan?
Apart from fees charged for administration of the plan itself, there are three basic types of fees that may be charged in connection with investment alternatives in a 401(k) plan. These fees, which can be referred to by different terms, include:
- Sales charges (also known as loads or commissions). These are basically transaction costs for the 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.
- Other fees. This category covers services, such as record keeping, furnishing statements, toll-free telephone numbers and investment advice, involved in the day-to-day management of investment products. They may be stated either as a flat fee or as a percentage of the amount of assets invested in the fund.
In addition, there are some fees that are unique to specific types of investments. Following are brief descriptions of some of the more common investments offered under 401(k) plans and explanations of some of the different terminology or unique fees associated with them.
Some Common Investments and Related Fees
Most investments offered under 401(k) plans today pool the money of a large number of individual investors. Pooling money makes it possible for individual participants to diversify investments, to benefit from economies of scale and to lower their transaction costs. These funds may invest in stocks, bonds, real estate and other investments. Larger plans, by virtue of their size, are more likely to pool investments on their own -- for example, by using a separate account held with a financial institution. Smaller plans generally invest in commingled pooled investment vehicles offered by financial institutions, such as banks, insurance companies or mutual funds. Generally, investment-related fees, usually charged as a percentage of assets invested, are paid by the participant.
Mutual Funds - Mutual funds pool and invest the money of many people. Each investor owns shares in the mutual fund that represent a part of the mutual fund's holdings. The portfolio of securities held by a mutual fund is managed by a professional investment adviser following a specific investment policy. In addition to investment management and administration fees, you may find these fees:
- Some mutual funds assess sales charges (see above for a discussion of sales charges). These charges may be paid when you invest in a fund (known as a front-end load) or when you sell shares (known as a back-end load, deferred sales charge or redemption fee). A front-end load is deducted up front and, therefore, reduces the amount of your initial investment. A back-end load is determined by how long you keep your investment. There are various types of back-end loads, including some which decrease and eventually disappear over time. A back-end load is paid when the shares are sold (i.e., if you decide to sell a fund share when a back-end load is in effect, you will be charged the load).
- Mutual funds also may charge what are known as Rule 12b-1 fees, which are ongoing fees paid out of fund assets. Rule 12b-1 fees may be used to pay commissions to brokers and other salespersons, to pay for advertising and other costs of promoting the fund to investors and to pay various service providers to a 401(k) plan pursuant to a bundled services arrangement. They are usually between 0.25 percent and 1.00 percent of assets annually.
- Some mutual funds may be advertised as "no load" funds. This can mean that there is no front- or back-end load. However, there may be a small 12b-1 fee.
Collective Investment Funds - A collective investment fund is a trust fund managed by a bank or trust company that pools investments of 401(k) plans and other similar investors. Each investor has a proportionate interest in the trust fund assets. For example, if a collective investment fund holds $10 million in assets and your investment in the fund is $10,000, you have a 0.1 percent interest in the fund. Like mutual funds, collective investment funds may have different investment objectives. There are no front- or back-end fees associated with a collective investment fund, but there are investment management and administrative fees.
Variable Annuities - Insurance companies frequently offer a range of investment alternatives for 401(k) plans through a group variable annuity contract between an insurance company and an employer on behalf of a plan. The variable annuity contract "wraps" around investment alternatives, often a number of mutual funds. Participants select from among the investment alternatives offered, and the returns to their individual accounts vary with their choice of investments. Variable annuities also include one or more insurance elements, which are not present in other investment alternatives. Generally, these elements include an annuity feature, interest and expense guarantees and any death benefit provided during the term of the contract. In addition to investment management fees and administration fees, you may find these fees:
- Insurance-related charges are associated with investment alternatives that include an insurance component. They include items such as sales expenses, mortality risk charges and the cost of issuing and administering contracts.
- Surrender and transfer charges are fees an insurance company may charge when an employer terminates a contract (in other words, withdraws the plan's investment) before the term of the contract expires or if you withdraw an amount from the contract. This fee may be imposed if these events occur before the expiration of a stated period and commonly decrease and disappear over time. It is similar to an early withdrawal penalty on a bank certificate of deposit or to a back-end load or redemption fee charged by some mutual funds.
Pooled Guaranteed Investment Contract (GIC) Funds - A common fixed income investment option, a pooled GIC fund generally includes a number of contracts issued by an insurance company or bank paying an interest rate that blends the fixed interest rates of each of the GICs included in the pool. There are investment management and administrative fees associated with the pooled GIC fund.
While the investments described above are common, 401(k) plans also may offer other investments which are not described here (such as employer securities).
Where Can I Get Information about the Fees and Expenses Charged to My 401(k) Plan Account?
If you have questions about the fees and expenses charged to your 401(k) plan, contact your plan administrator, who should be able to assist you with the following documents:
- If your plan permits you to direct the investment of assets in your account, the plan administrator should provide you with copies of documents describing investment management and other fees associated with each of the investment alternatives available to you (i.e., a prospectus). The plan administrator should also provide a description of any transaction fees and expenses that will be charged against your account balance in connection with the investments you direct.
- Your account statement will show the total assets in your account, how they are invested and any increases (or decreases) in your investments during the period covered by the statement. It may also show administrative expenses charged to your account. Account statements will be provided once a year upon request, unless your plan document provides otherwise.
- Your 401(k) plan's summary plan description (SPD) will tell you what the plan provides and how it operates. It may tell you if administrative expenses are paid by your plan, rather than by your employer, and how those expenses are allocated among plan participants. A copy of the SPD is furnished to participants when they join a plan and every 5 years if there are material modifications or every 10 years if there is no modification.
- The plan's annual report (Form 5500 series) contains information regarding the plan's assets, liabilities, income and expenses and shows the aggregate administrative fees and other expenses paid by the plan. However, it will not show expenses deducted from investment results or fees and expenses paid by your individual account. Fees paid by your employer also will not be shown. You may examine the annual report for free or request a copy from the plan administrator (for which there may be a charge). In general, the summary annual report, which summarizes the annual report information, is distributed each year.
In addition, you may want to consult the business section of major daily newspapers, business and financial publications, rating services, the business librarian at the public library or the Internet (see the list of helpful Websites listed at the back of this booklet). These sources will provide information and help you compare the performance and expenses of your investment options with other investments outside of your 401(k) plan.
If, after doing your own analysis, you have questions regarding the rates of return or fees of your plan's investment options, ask your plan administrator for an explanation.
What Other Factors Might Impact the Fees and Expenses of My 401(k) Plan?
- Funds that are "actively managed" (i.e., funds with an investment adviser who continually researches, monitors and actively trades the holdings of the fund to seek a higher return than the market) generally have higher fees. The higher fees are associated with the more active management provided and sales charges from the higher level of trading activity. While actively managed funds seek to provide higher returns than the market, neither active management nor higher fees necessarily guarantee higher returns.
- Funds that are "passively managed" generally have lower management fees. 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.
- If the services and investment alternatives under your plan are offered through a bundled program, then some or all of the costs of plan services may not be separately charged to the plan or to your employer. For example, these costs possibly may be subsidized by the asset-based fees charged on investments. Compare the services received in light of the total fees paid.
- Plans with more total assets may be able to lower fees by using special funds or classes of stock in funds, which generally are sold to larger group investors. "Retail" or "brand name" funds, which are also marketed to individual and small group investors, tend to be listed in the newspaper daily and typically charge higher fees. Let your employer know your preference.
- Optional features, such as participant loan programs and insurance benefits offered under variable annuity contracts, involve additional costs. Consider whether they have value to you. If not, let your employer know.
- Pension plans, such as 401(k) plans, are group plans. Therefore, your employer may not be able to accommodate each employee's preferences for investment alternatives or additional services.
Is There a Checklist I Can Use to Review My 401(k) Plan's Fees?
There is an array of investment options and services offered under today's 401(k) plans. While there is no easy way to calculate the fees and expenses paid by your 401(k) plan due to the number of variables involved, you can begin by asking yourself questions and, if you cannot find the answers, by asking your plan administrator. Answers to the following 10 questions will help in gathering information about the fees and expenses paid by your plan.
401(k) Fees Checklist
- What investment options are offered under your company's 401(k) plan?
- Do you have all available documentation about the investment choices under your plan and the fees charged to your plan?
- What types of investment education are available under your plan?
- What arrangement is used to provide services under your plan (i.e., are any or all of the services or investment alternatives provided by a single provider)?
- Do you and other participants use most or all of the optional services offered under your 401(k) plan, such as participant loan programs and insurance coverages?
- If administrative services are paid separately from investment management fees, are they paid for by the plan, your employer or are they shared?
- Are the investment options tracking an established market index or is there a higher level of investment management services being provided?
- Do any of the investment options under your plan include sales charges (such as loads or commissions)?
- Do any of the investment options under your plan include any fees related to specific investments, such as 12b-1 fees, insurance charges or surrender fees, and what do they cover?
- Does your plan offer any special funds or special classes of stock (generally sold to larger group investors)?
This booklet is only the beginning of your educational process. You should ask questions and educate yourself about investments. Monitoring your current investment selections and reviewing the investment alternatives offered under your plan are part of a process that you, as an informed participant, will need to undertake continually.
Keep in mind that the law requires the fees charged to a 401(k) plan be "reasonable" rather than setting a specific level of fees that are permissible. Therefore, the reasonableness of fees must be determined in each case.
For additional information regarding the level of fees typically charged to 401(k) plans and 401(k) plan fees and expenses generally, see the Employee Benefits Security Administration's