401(k) Fees Lawsuits: No Longer a Hypothetical Issue

Documentation is essential for plan sponsors when faced with a lawsuit

With the signing of the Pension Protection Act on August 17, the retirement plan landscape improved in many ways for 401(k) plan sponsors and participants. However, on September 12, the first of a series of lawsuits was filed that has changed the landscape yet again. This lawsuit was directed toward Northrop Grumman Corporation, The Northrop Grumman Corporation Savings Plan Administrative Committee and Investment Committee, numerous corporate officers, and the Board of Directors. The charges revolve around participant fees.

Fiduciary Duties
Plan sponsors hear the term “fiduciary duties” at every turn, as well they should. It is difficult to overstate the impact of plan sponsor decisions on participants. Consider that plan sponsors control:

• The investment options from which participants choose.
• The guidance or advice participants have access to through the plan.
• The fees participants pay on the journey to retirement.

During the past five years, the focus of these fiduciary requirements has centered on investment monitoring. It is easy to understand why. We have had significant asset class cycles over the last seven years. Large capitalization companies went from being the Wall Street darlings to the Wall Street outcasts while small capitalization companies enjoyed the opposite trip. The investment selection process is undeniably important, but there is more to the story. 

As plan sponsors have no control of the investment markets, the focus is now shifting to an area that is more certain and calculable regarding the impact on plan participants — fees. Plan sponsors are once again at a disadvantage. This is partly due to the complicated nature of 401(k) fees and partly due to provider’s lack of presenting these fees in an easy to understand format.

How Fees Can Affect Plan Sponsors
Northrop Grumman is one of the first companies to face an actual lawsuit over 401(k) fees. The following outlines a number of the allegations from the Northrop Grumman lawsuit and how they relate to plan sponsors:

1. Fees and expenses were charged to the plan that were not solely for the benefit of participants and beneficiaries of the plan.
   The first tenant of fiduciary responsibility is to make all decisions in the best interest of participants and beneficiaries. If plan fees are used to purchase services that are not solely for the participants benefit, the plan sponsor has entered into a prohibited transaction. The second tenant should be to document the first. Plan sponsor should consider an annual review of total fees paid by the plan, who received those fees, and what services were performed. Many plan providers are willing to provide this if asked. 
2. Plan sponsor entered into agreements with third parties which caused or allowed the plan to pay fees and expenses that were not reasonable or incurred solely for the benefit of participants and beneficiaries.
   This charge alleges a prohibited transaction but also brings into question the reasonableness of fees and expenses. Plan sponsors should periodically review the third party fees paid by the plan and compare alternative options. Unfortunately, plan sponsors may find it difficult to identify alternatives and create consistent comparisons. 
3. Plan sponsor failed to monitor the fees and expenses.
   In the following quote from an Employee Benefits Security Administration (EBSA) booklet for plan participants titled “A look at 401(k) plan fees,” the EBSA clearly identifies the responsibilities of a plan fiduciary. 
   
   “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:
   
   •   Establish a prudent process for selecting investment alternatives and service providers. 
   •   Ensure that fees paid to service providers and other expenses 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.” 
   
   The first bullet states that a process must be used. One of the most important perspectives a plan sponsor can have is to think in terms of a process.
4. Plan sponsor failed to understand the various methods plan providers use to collect payments.
   To ensure that fees are reasonable, a plan sponsor must understand the fees. This may be one of the most difficult tasks for plan sponsors but a requirement nonetheless. Providers receive revenue in myriad ways. Those related to investments include: 
   
   •   12b-1 fees
   •   sub-TA fees
   •   per head fees in specific mutual funds 
   
   One method of adjusting provider revenue is by changing share classes. For example, the R5 share class of a particular fund pays the recordkeeper 0.10 percent as a sub-TA rebate. The R3 share class of the same fund pays the recordkeeper 0.10 percent sub-TA rebate and a 0.50 percent 12b-1 fee. The investment portfolio is identical, but the fee wrapper or expense ratio is significantly different. That increased expense ratio directly affects participant returns.
5. Plan sponsor failed to establish, implement and follow procedures to determine if fees are reasonable and solely for the benefit of participants and beneficiaries.
   Plan sponsors are not required by ERISA to select the lowest-cost provider. However, they are required to establish a prudent process for decision making and for ongoing monitoring. The challenge for plan sponsors is the prudence threshold. Plan sponsors are compared to “prudent experts” not a “prudent layperson.” Plan sponsors should consider adopting a plan fee disclosure policy. This policy should outline the prudent process that will be followed in analyzing and monitoring fees. 
   
   Another step that plan sponsors should consider is an annual fiduciary education meeting for all members of the 401(k) committee. This education should include a discussion of prohibited transaction rules and examples.
6. Plan sponsor breached its fiduciary duties by failing to disclose that hidden and excessive fees were and are being assessed against assets of the plan and by failing to stop such hidden excessive fees.
   This is a no-win situation here. How do you disclose a hidden fee? The real issue is plan sponsor knowledge. If a plan sponsor does not have adequate knowledge, they are required to seek outside assistance. In this case, knowledge would include the varying methods plan providers receive fees. The DOL has this to say, “Unless they possess the necessary expertise to evaluate such factors, fiduciaries would need to obtain the advice of a qualified, independent expert.” [DOL Reg. A7 2509.95-1(c)(6)] 
7. Plan sponsor failed to monitor the performance of appointed fiduciaries and failed to ensure that they were fulfilling their duties.
   The short definition of fiduciary is any person with discretionary authority over plan assets, plan administration or anyone who is paid a fee for investment advice. That definition thus includes persons responsible for the appointment of other individuals to monitor the plan. This is how officers and directors can be attached to a fiduciary claim. Individuals responsible for appointing the 401(k) committee should think carefully of how they will monitor that committee and will probably want to consult their ERISA attorney or independent advisor regarding committee oversight.
8. Plan sponsor failed to properly inform or disclose to participants the fees and expenses of the plan.
   Plan sponsors are required to disclose fees and expenses to participants. In the past, plan sponsors have in large part relied upon prospectuses to accomplish this. Many times prospectuses contain multiple share classes and sometimes even multiple funds in the same prospectus booklet. 
   
   To address this issue, plan sponsors should consider using a 404(c) policy statement. 404(c) is the ERISA section that extends a protection to the plan sponsor for participant investment decisions. One of the requirements of 404(c) is to provide a disclosure of fees that are deducted from participant accounts. A 404(c) policy statement should contain a fee disclosure form that identifies each investment alternative, the expense ratio of that alternative and any contract asset charges assessed against the assets of the participants.

What Should Plan Sponsors Do to Best Protect Themselves?
At this point, the eight bullet points above are all allegations. If Northrop Grumman does not receive a Summary Judgment for Dismissal, these charges will have to be defended. The defense of charges costs money, which, in some cases, leads to a settlement when no wrong was actually committed. With that in mind, documentation is your first best defense. By clearly demonstrating that fees were addressed, understood, and that a prudent process was used in the decision making process, plan sponsors will find themselves in a much better position. The following are best practices that can help establish that prudent process. 

Annually, prepare a fee disclosure worksheet to be provided to participants. Request full disclosure of all revenue sharing arrangements and any asset based fees that reduce participant returns. This process will either confirm fees are in-line or alert the committee of potential issues. 

On a three- to five-year basis, conduct a full fee benchmarking analysis. Plan sponsors may also want to conduct a fee benchmarking any time plan demographics change dramatically, for instance, after a merger or acquisition.

• Ask your current provider to re-bid the plan as if you are a new client.
• Seek bids from ten other providers that service plans of similar demographics.
• Compare current fee structure to the average of the respondents by examining the following:
  • Calculate the investment expense to the participants by multiplying the expense ratio of the fund by the assets in that fund. Then add up the total for each fund.
  • Administrative fees paid by the company
  • Total fees (total investment expense plus total administrative fees). 
    
    Keep in mind that plan providers can move fees from the company to the participant and vice versa. In bidding situations, plan providers typically seek to provide a plan with zero administrative costs to the company. This can be accomplished by adjusting fees inside of stable value funds and co-mingled trusts. It may also be done by changing the share class of the funds offered. In either case, the changes typically increase the investment expense to the participant.
• Request the provider provide “all-in pricing” on a per/head basis, with all provider revenue received applied to the fee. In this arrangement excess revenue becomes the plan’s to use to pay for ERISA-approved expenses or to rebate back into participant accounts. Providers are typically hesitant to agree to this type of arrangement because it limits the upside of their revenue. Try to negotiate a three- to-five year term on the per/head fee.

The Challenges Plan Sponsors Face
As the trend continues and 401(k) plans become viewed as one of the primary sources of retirement income for employees, plan sponsors’ actions (or lack thereof) will be reviewed with increased scrutiny. With every decision, a plan sponsor should ask, “is this in the best interest of participants?”, “What process was used to come to this decision?”, and, “Can we document that fact?” Until the industry institutes needed disclosure rules, plan sponsors must either improve their education concerning fees or seek outside counsel. If a plan sponsor is not confident with its level of education, knowledge, and experience in managing the process surrounding a 401(k) plan, it would be wise to seek the guidance of an independent advisor.

There Is Light at the End of the Tunnel
In July, 2006, the Department of Labor (DOL) proposed changes to the Form 5500 annual report that would create more fee disclosure. Any person receiving more than $5,000 in compensation from the plan would be identified. This compensation would include both direct and indirect revenue. More importantly, any fiduciary or service provider receiving greater than $1,000 in indirect compensation would be identified. This second group would likely include brokers, administrators, providers, custodians, trustees, and recordkeepers. 

A number of industry groups have voiced concerns over the ability to collect the data, and the added administrative burdens the requirements would create. Other groups argue that the revenue service providers “share” with one-another should not be required to be disclosed — only fees that are directly paid by the plan should beA0subject to required disclosure. 

If the proposed changes to Form 5500 are adopted, they will certainly make it easier for plan sponsors to identify who is being paid from the plan. Keep in mind that these disclosures will not eliminate the requirement under ERISA that plan sponsors establish a prudent process to determine if fees and expenses are reasonable. 

Plan sponsors should remember to first consider what is in the best interest of the participants, establish a prudent process, and document, document, document. 

Note: lawsuit charges obtained from 401(k)helpcenter.com