Surrender Charges: The Problem and the Solution
Some 401(k) and 403(b) investment products have surrender charges—which are imposed when the plan sponsor ends the relationship with the investment provider. These charges are also known as termination fees, back-end charges, contingent deferred sales charges, and CDSCs.
We were recently hired by a plan sponsor to advise them on the demand by an insurance company that they pay a six-figure surrender charge.
The sponsor had become concerned about the expenses and performance of the investments in their plan. As a result, the sponsor obtained proposals from several providers and, based on the information received and reviewed, decided to switch providers. When the sponsor contacted its old provider to discuss the procedures for transferring the money, the provider pointed to contract provisions which allowed the imposition of substantial surrender charges.
Without going into detail, we are looking at these issues:
- ERISA prohibits a provider from imposing a penalty on a plan. While a provider may recoup reasonable start-up expenses, it may not impose unreasonable charges, penalties or conditions on a plan. To do so is a prohibited transaction.
- The unfettered power of an investment provider to amend the contract—and specifically to amend the provision regarding the surrender charge—is tantamount to discretionary authority under ERISA. Because of its ability to exercise discretionary authority over a plan asset (that is, the contract is a plan asset), the provider is a fiduciary. As a result, it must use its power in the best interests of participants and for the purpose of providing retirement benefits (among other things).
- The provider has unilaterally removed and replaced mutual funds as investment options within the plan (without complying with the conditions in the DOL’s Aetna Advisory Opinion). As a result, it is an ERISA fiduciary for purposes of selecting those investments. In that capacity, it must act for the best interests of the participants and it cannot, under ERISA section 406(b), use its authority to cause itself to be paid additional fees. For example, it cannot use its power to advantage itself through revenue sharing with mutual funds.
By and large, these are well-established legal principles. It is surprising that an investment provider would not have structured its contract to take these rules into account. Legal issues aside, though, this case illustrates the reaction of most employers to back-end charges. With the advantage of hindsight, the provider would have been well-advised to waive most or all of those charges.
© 2004
Reish Luftman Reicher & Cohen. All rights reserved. The ERISA Report for Plan Sponsors is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.
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