Keeping an Eye On Plan Fees and Costs
As we approach the first wave of retiring baby boomers, participants in 401(k) plans are keeping a closer eye on how their plan investments perform. They are learning that no matter how well the underlying investments perform, fees and costs associated with their investments are key components in determining overall return. Accordingly, unless the company officers that select the plan investment options are mindful of the fees and costs, it's increasingly likely that they will face lawsuits by dissatisfied participants whose retirement benefits have been eroded by arguably excessive fees and costs.
One of the fundamental responsibilities of ERISA fiduciaries is "defraying reasonable expenses of administering the plan." A plan's most significant expenses are typically investment-related costs. Those costs include investment management fees, distribution or sales costs (e.g., 12b-1 fees), and administrative costs, which are most often expressed as a percentage of the total amount of plan assets.
Different types of investments carry with them different types of fees and expenses. Mutual funds investments, for instance, typically involve so-called 12b-1 fees. Variable annuities offered by insurance companies, meanwhile, usually impose fees such as mortality and risk expense charges and asset-based fees, and sometimes have surrender charges. (Surrender charges may--but do not necessarily--disappear once the annuity contract has been in force for a certain specified period of time.)
Fees and costs associated with a retirement plan's investments are inevitable. However, ERISA considers any compensation paid to any service provider--including an investment provider, manager or advisor--to be a prohibited transaction unless the compensation is reasonable. Plan fiduciaries who allow the plan to pay more than reasonable compensation may be held personally liable for the difference between what the plan actually pays, and the amount that constitutes reasonable compensation.
By way of illustration, assume that the average amount of plan assets over a three year period is $10,000,000, and that investment related expenses in each year amount to 1.75 percent. The investment-related expenses in each year would be $175,000, for a three year total of $525,000. If a court concluded that a reasonable investment related expense would have been only 1% (for a three year total of $300,000), a plan fiduciary could conceivably be held personally liable for the difference of $225,000, plus earnings on the foregone difference, as well as the attorneys' fees charged by the participant's attorney! (Note: Any plan participant that sued for a breach of fiduciary duty would be required by law to sue on behalf of the plan as a whole, and not just the proportionate share of damages sustained by the individual participant.)
ERISA doesn't impose liability on plan fiduciaries on the basis of "Monday morning quarterbacking." That is, to avoid liability, a fiduciary doesn't need to be perfect; rather, fiduciaries must engage in a prudent process. This includes an obligation to prudently examine the plan's investments, and the fees and costs that are associated with those investments.
Here are some tips on how to engage in that prudent process, and how to document that process to protect yourself from liability:
- When setting up a plan, consider proposals from multiple investment providers. Consider hiring a consultant to help you identify "hidden" fees and costs. (Also, engage in a reasonable process of locating and hiring any investment advisors or consultants that you use. Make sure that the compensation paid to investment advisors is not out of line with industry standards.) Ask questions, preferably in writing, about the fees and other expenses associated with the provider's products. Insist upon getting answers to those questions in writing. When you reach a decision regarding the most appropriate investment vehicle(s), prepare a written memorandum outlining how you reached your decision. If the investment options you select include higher fees than alternatives that were considered, explain (with the help of your advisor) why the higher priced options are justified.
- Establish a firm schedule for reviewing your plan's investments, including the costs and fees charged, and meet with your consultant to review the investments according to that schedule.
- Establish benchmarks regarding the investments that you select. The benchmarks should factor in the fees and costs associated with your plan's investment options relative to fees and costs in investments within a comparable class. If you decide to maintain a fund with above-average expenses as an investment option, explain in writing why you made the decision. Preferably, your decision is on the basis of professional advice, but at the least it should be well-reasoned.
- Finally, consider purchasing fiduciary liability insurance. Most director and officer (D&O) insurance policies will not cover claims against company executives arising out of their roles as ERISA plan fiduciaries.
In a presentation to the CEO Summit of the Chief Executive Leadership Institute on May 28, 2004, Secretary of Labor Elaine Chao said "[t]he time has come to move the focus of pension plan governance out of the human resources department and beyond compliance with tax laws. The executive level suite needs to focus on pension plan governance itself, especially the responsibility and liability of pension plan fiduciaries." The statement is a harbinger of things to come. Plan participants and the Department of Labor will increasingly have their eyes on how well corporate executives fulfill their duties as plan fiduciaries. The good news is that following good business practice--and obtaining insurance commensurate with the risk they face in today's environment--can help protect fiduciaries from risk.
© 2005
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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