Background

Defined contribution plans having a cash or deferral feature, more commonly known as 401(k) plans (named after the section of the Internal Revenue Code that governs many of the terms of such plans), have increasingly become the chief - or only - retirement savings vehicle for millions of Americans1. An increasing number of employers have terminated or frozen their traditional pension plans, i.e., defined benefit pension plans, due to many factors, including what is sometimes viewed as increasingly onerous legislation and regulation. As a result, for many workers, the investment results over time with respect to their 401(k) plan balances could make the difference between a comfortable retirement and no retirement at all. Recently, an issue has been given considerable attention in the press, and litigation has arisen, concerning the effect of the various fees that are charged in connection with 401(k) plans - fees which can, over time, dramatically affect the investment returns of participants in such plans. Coming to the forefront of attention, and being an issue that could potentially affect the majority of 401(k) plans, this issue commands the attention of all employers who sponsor such plans.

The Problem

Typically, employers allow their employees to choose among an array of investment funds in which to invest their accounts, many of which are mutual funds or collectively managed funds. By transferring control of the investment of account balances to participants, this arrangement generally gives the employer certain protection from the threat of liability with respect to the fiduciary responsibility that otherwise would arise under the Employee Retirement Income Security Act of 1974 ("ERISA"), since participants make their own investment choices2. However, mutual funds and other investment vehicles are subject to various fees that typically are deducted from a participant's account balances, rendering such fees, absent full disclosure by the employer or the fund administrator, transparent to participants. Yet the effect of such fees over the course of an employee's career can be alarming. Consider this example appearing on the website of the Employee Benefits Security Administration ("EBSA"):

"Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investment in your account over the next 35 years average seven percent and fees and expenses reduce your average returns by one half 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 one and a half percent, however, your account balance will grow to only $163,000. The one percent difference in fees and expenses would reduce your account balance at retirement by 28 percent3."

Since the above example assumes that no more contributions will be made to the participant's 401(k) balance, it actually underestimates the effect of fees, since most participants contribute regularly to their accounts, and these fees typically are deducted on the basis of a percentage of a participant's account balance, which grows over time. Types of 401(k) Plan Fees

The types of fees associated with 401(k) plans include the following: Contract fees (i.e. management fees). These fees are expressed as basis points (i.e., interest), and are charged in exchange for the fund manager's efforts in managing the investment of monies in the fund.

Fund fees (also known as investment fees). Also expressed as basis points, these include so- called "12b-1" fees4 associated with marketing, internal administration, and sub-transfer agent fees. Generally, a participant's investments are spread over a variety of investment funds, and fees are charged for each fund. These fees typically are based on a percentage of that portion of the assets in an individual's account that are invested in the particular fund. The problem is that these fees are often glossed over in reports, which do not identify gross returns minus fees charged, but rather show only the net rate of return for the fund.

Employee fees. These fees are paid to the third-party administrator or broker for record-keeping and associated tasks. These fees typically are charged to the employer.

Statement fees. These fees, which cover services such as producing and mailing quarterly statements to participants and providing telephone and internet access to participants' accounts, generally are directly accessed against participants' accounts.

Trustee, audit and legal fees. These are fees charged by the plan's trustee, auditor and legal counsel in exchange for services rendered. Of the above fees, fund fees generally are the most significant with respect to their effect to participants' accounts5.

In addition to the above fees, so-called "soft dollar" arrangements are often transparent to participants and can indirectly effect their account balances. Generally stated, these arrangements involve commissions paid to brokers under SEC rule 28(e)6, and are used to purchase additional goods and services from a brokerage firm. Revenue sharing arrangements, in which third-party administrators and brokers are paid revenues from mutual funds representing a portion of the funds' section 12b-1 fees, also affect total returns, and are often obscured from plan participants.

Participants in smaller plans often pay larger fees than participants in larger plans, which can negotiate lower fees due to their significantly larger combined plan assets.

The Perceived Inadequacy of Current Law and the GAO's Proposed Changes

Under ERISA, which was enacted before the advent of 401(k) plans, information on fees that is required to be disclosed to participants is limited. The GAO observes that, although ERISA requires 401(k) plan sponsors to disclose the amount of participant accounts and the plan's overall financial status, there is no direct mandate to disclose plan fees. However, there is a "safe harbor" set forth in DOL regulations under ERISA Section 404(c) that protects plan sponsors that adequately describe "any transaction fees and expenses that affect a participant's account balance in connection with purchases or sales of interests in investment alternatives (e.g., commissions, sales loads, deferred sales charges, redemption or exchange fees)."

Most plans, according to the GAO, provide information on fees in piecemeal fashion, requiring participants to study various documents, and do not provide a simple way for participants to compare plan investment options and the fees associated with them. As a result, most plan participants, when choosing among investment funds, may not be aware that the choice of a particular fund over another could have a significant effect on total returns over the span of their employment7.The American Association for Retired Persons ("AARP") reported in 2004 that, based on a nationwide survey, more than 80 percent of 401(k) plan participants do not know how much they pay in fees8. Further, such fees often are excessive. Bloomberg.com reports a situation where plan participants were charged $250 per participant, when the same services could have been provided for between $60 to $80 per participant9.

To address this situation, the GAO has proposed amending ERISA to require employers sponsoring participant-directed plans (a/k/a 404(c) plans) to disclose fee information on each investment option in a way that facilitates comparison among funds, and to disclose any compensation they receive from service providers. The GAO also recommends that the DOL require employers to report a summary of all fees that are paid out of plan assets or by participants. In response, the DOL has stated that it will give careful consideration to the GAO's recommendations.

Recent Litigation

A series of lawsuits recently were filed against at least ten large companies and their third-party administrators, charging that the plan fiduciaries breached their duties under ERISA by subjecting plan participants to excess fess and expenses, consequently reducing the value of their investments. The lawsuits claim that the defendants cannot hide behind ERISA Section 404(c), because they did not fully disclose the full amounts and nature of the fees. The lawsuits also allege that the "hidden" fees and revenue sharing arrangements amount to prohibited transactions between the plans and the service providers under ERISA Section 406, having violated the requirement that plan assets be used solely for the benefit of participants and beneficiaries. The outcome of these lawsuits could have dramatic implications for employers generally, because the facts in these cases are very similar to those with respect to many other employer-sponsored 401(k) plans.

The United States District Court for the District of Connecticut recently denied a motion for summary judgment filed by the defendant, a 401(k) plan service provider, in Haddock, et al. v. Nationwide Financial Services Inc., et al.10 The plaintiffs, 401(k) plan trustees, had sued Nationwide Financial Services and Nationwide Life Insurance Company (collectively, "Nationwide"), seeking financial damages and equitable relief, claiming that Nationwide's contractual arrangements with mutual funds or their affiliates and its retention of revenue sharing payments constituted breaches of Nationwide's fiduciary duties under ERISA. The plaintiffs also claimed that Nationwide's contracts with the mutual funds and revenue sharing arrangements constitute prohibited transactions. Opening the door to a trial on the merits, the court held that a rational fact finder, viewing the evidence in a light most favorable to the plaintiffs, could conclude that (i) Nationwide was an ERISA fiduciary; (ii) triable issues were raised concerning whether the challenged payments constituted plan assets (which could result in a finding of breach of ERISA fiduciary responsibility) and (iii) Nationwide's service contracts constitute prohibited transactions.

Recently, Eliot Spitzer, Attorney General of the state of New York, filed a complaint in the Supreme Court of New York against the Hartford Financial Services Group, Inc. and Hartford Life, Inc. (collectively, the "Hartford"), alleging that the Hartford fraudulently and secretly compensated selected brokers in return for the brokers steering clients into the purchase of the Hartford single premium group annuities. Mr. Spitzer alleges that the Hartford devised sham "expense reimbursements" and "consulting agreements" purporting to reimburse the brokers for expenses, or as reimbursement for services they provided the Hartford. Mr. Spitzer also alleges that these arrangements breached the brokers' common law fiduciary duties to its client11.

What Employers Can Do to Protect Themselves

Many employers are justifiably concerned that the current litigation might represent the "tip of the iceberg." As news of the recent lawsuits becomes well known, similar actions are likely to follow. Employers, therefore, need to carefully assess their situation with respect to the various fees that are charged in connection with their 401(k) plans. In this regard, the following are steps that can be taken in an effort to protect employers from potential lawsuits:

  • First and foremost, make a concerted effort to learn how much your company, plan and participants are actually paying in fees and expenses. Ask each of your service providers and fund managers for a complete breakdown, in exact dollar terms, of the fees and expenses (including any "hidden" fees) that are being charged. Insist that each provider and fund adequately discloses the details behind the figures in an understandable fashion.
  • Consider hiring a consulting firm to investigate and compare the amount of fees and expenses the plan and its participants are paying in comparison with plans having similar attributes and demographics. Review on a regular basis the plan's funds' fee structures against investment alternatives. Use this information to negotiate lower fees from the plan's service providers and funds, if warranted.
  • Make sure that all fees - including any "soft dollar" or revenue sharing arrangements - are fully disclosed to participants. Being that the DOL is considering the GAO's proposal that would require participants to be given a summary of all fees paid out of plan assets, it makes sense to begin doing so now.
  • Similarly, fees relating to particular plan investment funds (including company stock funds) should be disclosed in a way that facilitates comparison among the funds. A spreadsheet or chart format may be helpful in this regard.
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  • Fully document the fiduciary's review and negotiation with respect to all plan service and similar agreements.
  • Require that the plan's investment adviser regularly monitor each investment fund's fee structure against published surveys.
  • Ensure that all plan fiduciaries are properly identified in the appropriate documents, and that fiduciary authority is allocated to the appropriate persons. This could limit the number of named defendants, should a lawsuit ensue.
  • Ensure that the plan's investment policy statement is being followed with respect to all applicable decisions and actions.

Conclusion

Given the sudden outpour of publicity regarding the issue of 401(k) plan fees, along with the threat of possible litigation, employers should quickly act to defend themselves by following the suggestions above. Above all, the importance of full disclosure of all fees to plan participants cannot be overemphasized, along with comparing the plan's fees to comparable fees charged to similar sized plans. Full documentation of this process is essential.