Affordable Care Act (ACA) regulations might be grabbing all the attention—but did you know 401(k) plan sponsors are facing increased risk?

Over the past several years, employers have necessarily focused on Affordable Care Act requirements. Considerations relating to cost, complexity and communication have led many organizations to change their plans significantly and devote less time and attention to running their businesses. Due to the political nature of ACA, media coverage has highlighted the ACA’s numerous rules, harkening back to when Congress was debating the program and President Obama signed it into law.

But this intense focus on the ACA has obscured another significant threat to organizations that sponsor another important employee benefit: 401(k) plans. Recent developments have resulted from governmental agency regulation and as well as participant litigation. The urgency for independent insurance agents to understand the new climate is twofold: 1) as sponsors of their own 401(k) plans, agents must understand the requirement for having a process to evaluate their 401(k) plans on a consistent basis; and 2) if agents write D&O coverage for their commercial clients, they must educate them about the importance of taking an active oversight approach for their 401(k) plans.

What’s the Problem?

In this regulatory landscape, if you ask most independent agency owners that sponsor a 401(k) plan whether they are carrying out their fiduciary duties, they would probably answer “yes”: They have a bank, brokerage firm or insurance company that provides a “list” of investment options including stock-based investments (large cap, small cap, international), bonds (corporate, government) or hybrid options (target-date funds) and a stable value account, also known as a “guaranteed account,” paying a stated rate of interest. Typically, agency principals may meet with their investment broker or advisor once or twice a year to review the list of offerings, and since the employees pick from among the options, agency owners believe they are satisfying their responsibilities.

Because the Employee Retirement Income Security Act (ERISA) deems 401(k) plans “qualified” retirement plans, sponsors must understand their respective responsibilities. For each plan sponsor, one or more people are deemed “fiduciaries” and as such have a fiduciary duty to the plan participants. Note that individual retirement accounts (IRAs), simplified employee pension (SEP) plans and SIMPLE IRAs do not qualify and are generally not subject to ERISA.

According to the Department of Labor (DOL) website, “Fiduciaries are generally those individuals or entities who manage an employee benefit plan and its assets. Employers often hire outside professionals, sometimes called third-party service providers, or use an internal administrative committee or Congress and eventually signed into law by President Obama.”

Importantly, the DOL adds, “Even if an employer hires third-party service providers or uses internal administrative committees to manage the plan, it still has fiduciary responsibilities,” and goes on to list the following examples of plan fiduciaries:

• The trustee
• The investment advisers
• All individuals exercising discretion in the administration of the plan
• Those who select committee officials

The problem? The actual responsibility is much broader and deeper than what most plan sponsors realize. Many are unaware that their organization is not paying the actual cost of administering the plan. Most employers focus on their out-of-pocket costs for paying for administration, but since many 401(k) plans are “bundled,” recordkeeping, investment firm and advisor compensation is hard to discern—and may typically involve cross-subsidies. This occurs when the recordkeeper earns payment from sub-transfer agent payments (also known as “sub-TAs”) and 12(b)(1) fees from the mutual fund companies. As a result, the actual invoice to the employer for recordkeeping and related plan services does not represent the total revenue paid to the recordkeeper, but instead what the employer pays. The plan pays the subsidies—which means the plan participants pay the subsidies.

In the Real World

Consider the following example: Assume an independent insurance agency with 15 employees has a 401(k) plan with $2 million in assets in various mutual funds. A third-party administrator bills the agency $2,000 annually. The employer believes that’s a good deal. But in reality, the administrator also receives 25 basis points of compensation from the mutual fund company equivalent to $5,000—bringing their total revenue to $7,000.

The mutual fund company may also pay compensation to the investment advisor or broker of another 25 basis points. If the investment advisor provides worthwhile service to the plan sponsor and employees, assisting with fund selection and monitoring as well as educating employees about saving for retirement and the investments, nothing is patently wrong with their remuneration.

The problem for plan sponsors in a bundled arrangement is that they are required to maintain a process for reviewing the costs of their plans—particularly with regard to any costs relating to 401(k) plans and, ultimately, the plan participants. This process begins with an investment policy statement that serves as a criteria basis for investment selection, evaluation and monitoring of the plan arrangement and cost, as well as investment performance.

Most plan sponsors only focus on the latter, not the other pieces. And that’s a mistake, considering the various share classes and the opportunity to lower the relative cost of services as the plan assets grow. This is where much of the 401(k) plan litigation has focused.

Don’t be surprised if 401(k) plan-related litigation picks up in frequency—and understand that the cost of a settlement, in addition to defending a suit, can be staggering for the plan sponsor. Plan participants have started to become more aware of their related plan expenses since the enactment of ERISA regulation 408(b)(2), which requires annual disclosures to each plan participant in dollar and percentage amounts so they can gauge the impact on their 401(k) account balance.

Bundling Woes

One of the key issues for plan sponsors is how bundled arrangements can impact the objectivity of the plan investments they offer or recommend. The amount of potential subsidies varies by share class, and arrangements and can greatly influence the menu of investment options that are available. As plan assets increase, lower-cost mutual fund or collective fund share classes may be available for plan sponsors to use to replace higher-expense choices.

One trend that has developed in response is the use of registered investment advisors (RIAs) that charge fees on a sliding scale: The fee percentage decreases as the assets increase. Then, the RIA selects among institutional funds that pay no remuneration to the recordkeeper or investment advisor (or is offset against the RIA fee). This approach provides transparency and makes it easier to digest total paid fees by removing fund subsidies. 

In light of the DOL’s increased emphasis on fiduciary responsibilities, plan sponsors, insurance agents and D&O clients should keep a close eye on the evolving landscape of litigation and regulation, looking below the waterline to see the whole story.

Dave Evans is a certified financial planner and an IA contributor.