For many years, critics of the current 401(k) fee system have claimed that high fees were hidden and not clearly disclosed by vendors. Plaintiffs in class action litigation have seized on this murky area and have been challenging plan fees paid by participants. In fact, studies have shown that a surprising number of plan sponsors and participants are under the misconception that they pay no fees for participating in 401(k) plans, but even those sponsors who desire to better understand the costs of running a 401(k) plan found it difficult since the applicable fees are paid to multiple service providers on a varied basis. Because often sunlight is the best disinfectant, the U.S. Department of Labor (DOL) responded to these concerns by issuing regulations requiring mandatory disclosure of direct and indirect fees by vendors to the fiduciaries who hire them and by plan administrators to plan participants. Rather than regulating the type or level of fees, the DOL is requiring greater fee transparency and fiduciary accountability. Fiduciaries who ignore their responsibilities to evaluate the disclosed fees will do so at their peril. In addition to being at higher risk of being sued by participants, they will find that the accountants who do required plan audits and DOL auditors will focus on compliance and fees in the future.
THE FIRST STEP: DID THE PLAN RECEIVE CORRECT DISCLOSURES FROM PROVIDERS?
Third party fiduciaries and vendors to U.S. pension and profit sharing plans were required to provide mandatory fee disclosure to the plan fiduciaries responsible for hiring them by July 1, 2012. No doubt, this has been a very big deal for the U.S. retirement plan and investment industry. The first step for plan sponsors is for fiduciaries to confirm that they received the required 408(b)(2) disclosures and to review them carefully. Retaining a service provider that has not provided the disclosure is a prohibited transaction under the Employee Retirement Income Security Act (ERISA), in the DOL’s view, and could expose fiduciaries to personal liability. Fiduciaries who have not received the mandatory disclosures or who have received incomplete disclosures must promptly request the missing disclosures and report any continued noncompliance to the DOL no later than 90 days thereafter. The DOL has also stated that noncomplying service providers must be terminated as soon as possible consistent with the fiduciary duty of prudence.
The disclosures provided by vendors will vary in their format and clarity, as the DOL did not specify any standard disclosure template. In many cases, it will be necessary to ask further questions or ask for additional information in order to understand the vendor’s fees, which is a prerequisite for evaluation. Some fees are direct, while others are “indirect.” It is especially important that the fiduciaries understand any so-called “revenue sharing” arrangements that are being used to pay plan fees. If disclosure was incomplete or unclear and clarification is not forthcoming, the safe course for plan fiduciaries is to treat this situation as noncompliance and to report it to the Department of Labor.
THE NEXT STEP: NEW PARTICIPANT DISCLOSURES
Plan administrators of most 401(k) and other participant-directed defined contribution plans must now inform the individual participants how much their plan participation costs. Plan vendors will provide drafts of required investment and fee disclosures to these plan administrators with instructions to distribute them by August 30, 2012. Plan sponsors might be inclined to distribute the drafts that were provided by their service vendors without review; however, unless the vendor is also the plan administrator (which is not typical), plan committees and/or responsible employees of the plan sponsor need to review these disclosures carefully to make sure that they accurately reflect the sponsor’s plan provisions and contain all of the legally-required information. It can be risky to simply distribute these without appropriate review, as the plan sponsor has primary responsibility for compliance, unless another plan administrator has been specifically designated under the plan.
Information now required to be disclosed to all eligible employees and all participants and beneficiaries with the right to direct plan investments includes:
- any charges or penalties resulting from switching from one fund to another
- how the plan handles proxy voting
- historical performance information for investments without a fixed return, measured against an independent or widely-used benchmark
- a glossary of commonly used investment terms
- information about whether plan expenses are paid through revenue sharing
- fund expenses as a dollar amount, not just a percentage, based on a hypothetical $1000 investment
- basic information (fees, transaction costs) associated with any brokerage windows available to participants
Each plan will also be required to give participants quarterly statements that itemize the specific fees deducted from their accounts.
POTENTIAL ISSUES WITH VENDORS
Although the U.S. Department of Labor in Field Assistance Bulletin 2012-02 provided some leeway for administrators and service providers who began in good faith preparing the disclosures before recent guidance was issued, this does not give administrators a “pass” to distribute the participant disclosures without review. Among the issues that have been spotted so far and that may need to be worked out with the vendors include:
- charts that use fund benchmarks that are different from those in the plan’s investment policy statement
- charts that use benchmarks that are not independent of the fund family or those not in widespread use
- the disclosure misdescribes the plan provisions (this is more common than one may think - - large vendors are producing these form disclosures for thousands of clients at the same time)
- the need for a cover letter that contains additional or customized plan information not part of the vendor’s standard template
PREPARING FOR THE PARTICIPANT RESPONSE
After plan participants see the new disclosures, they may have many new questions about how much their retirement saving plan costs. Plan sponsors should consider training their benefits managers to answer questions from participants about fees. Some participants may not have realized that they were paying any plan fees, and others may be seeing for the first time in their investment comparison charts the actual dollar value of fees on a $1000 investment. Sophisticated participants could potentially ask questions about index funds, share classes, fund expense ratios, loads and fee arrangements such as revenue sharing. Others may simply question why the plan costs so much.
FOLLOW UP BY HIRING FIDUCIARIES
Plan fiduciaries should also make sure that they are not diverted by this new round of disclosures from doing their required due diligence regarding the vendor disclosures they received. That job is just beginning. It is their responsibility not just to disclose the fees to participants, but to determine that the fees being paid are reasonable in relation to the services provided.
We suggest that pension plan committees and plan sponsors take the following steps:
- Add as an item to the pension committee agenda, “review and discuss fee disclosures received from plan service providers.” Document this review in detail in meeting minutes.
- Evaluate the reasonableness of fees paid. This should be done in the context of evaluating the level of performance and services received.
- Consider whether a better deal is available by obtaining an independent fee benchmark report, which will compare fees for similar plans, or undertaking an RFP for plan services to check that fees are appropriate for the service level the plan receives.
- Negotiate with vendors.
IMPLICATIONS FOR U.S. FIDUCIARIES
The new regulations are a significant development and one that plan fiduciaries should welcome. However, a hiring fiduciary’s obligations do not stop with understanding the fees being paid, but also require evaluation of the services being received. Fiduciaries need to remember that ERISA holds them to a “prudent expert” standard. If fiduciaries lack the expertise needed to make these determinations, they would be well-advised to seek qualified professional assistance.
IMPLICATIONS FOR CANADIAN EMPLOYERS
Canadian employers with U.S. operations will have to comply with U.S. fee disclosure regulations with respect to their U.S. plans. Employers with operations in both countries are aware that fee disclosure was in the spotlight in Canada before the U.S. regulations were finalized. In 2004, the Canadian Association of Pension Supervisory Authorities (CAPSA) published guidelines for capital accumulation plans which include the recommendation that RRSP members be provided with a description and the amount of all recordkeeping and investment management fees, expenses and transaction costs being paid by the members. However, CAPSA’s guidelines are intended to be “best practices” and do not have the force of law. Since reforms initiated in the U.S. are sometimes the model for changes in Canada, it is possible that proposals might be introduced in Canada in the future to make fee disclosure mandatory.