Your Insurance Company’s 401(k) Fees Are Too High!
The Cost of Cell Phones and 401(k) Services in 1985.
I purchased my first cell phone in 1985. It was a Motorola DynaTAC model and it was more or less permanently attached to the center console of my car. “The Brick” was not portable, provided only voice telephone service and cost over $9000 when it was introduced in 1984. Today, a smartphone fits in your pocket, provides an unlimited number of functions and (depending on the model) costs just a few hundred dollars.
If you were a small business or professional organization shopping for a 401(k) provider in 1985, you would have also had few, if any, choices outside of an expensive insurance company to provide recordkeeping, investment options and compliance services. Today it’s a different story for these smaller plans.
The availability of low cost 401(k) recordkeeping, administration and compliance services for smaller plans today is very much a reality. Despite this fact, a shockingly high percentage of these smaller plans are still managed by bundled insurance company providers and are among the most expensive 401(k) options for smaller businesses, including physicians, dentists and attorneys.
Why We Put Up With High Fees.
The question we should all be asking is why insurance company plans so expensive. And more importantly, why do plan sponsors continue to put up with these high costs?
My answer? Insurance plans are expensive because the insurance companies know they can get away with higher fees. And many of these plan sponsors either don’t know or don’t care. They should.
Despite all of the sophisticated and expensive marketing and enrollment materials they provide to plan participants, insurance companies are often the least transparent in regard to plan fees. In many cases, their fees are simply buried in annuity contracts with employers. And when employers decide to change providers, surrender charges can hold them hostage. This makes it nearly impossible for a plan sponsor to meet their fiduciary responsibility regarding reasonable fees.
Are My Plan’s Fees Reasonable?
Plan sponsors have a fiduciary responsibility to ensure that their 401(k) fees are reasonable. In practice, this requires that they calculate the “all-in” fees (service provider fees + investment fees) and compare these fees to 3 or more providers. This benchmarking process should be done on an annual basis.
Your fees don’t have to be the lowest available in order to be reasonable. But they must be justified based on the services received. At my firm, we work with 401(k) providers whose fees are transparent. In practice, lack of fee transparency is the most common red flag that your fees are too high.
What Do Variable Annuities Have to Do With High Plan Costs?
If your retirement plan’s provider is an insurance company, your plan’s investments are likely a variable annuity. Understanding the differences between a variable annuity and a mutual fund is key to unlocking the high fees typically associated with insurance providers.
Variable annuities are essentially mutual funds wrapped in a layer of insurance that renders the investment returns and income from the investment tax-deferred. This makes them an attractive alternative to certain individual investors who may be in higher tax brackets.
When used inside a 401(k) retirement plan, however, this is a distinction without a difference, since all investments returns inside of a 401(k) are already tax deferred. So, do variable annuities have other advantages when used in a 401(k) plan? Not really. But they present a number of disadvantages, including additional fees and onerous trading restrictions.
Wrap Fees, Surrender Charges and Commissions.
A retirement plan funded by variable annuities is structured so that participants do not directly own a mutual fund. Instead, they own “units” of an account that holds mutual funds owned by the insurance company. These units have a variety of wrap fees including investment management fees, surrender charges, mortality and expense risk and administration fees. Variable annuities also include a commission which is paid to the broker who sold them.
These fees can range from .25% up to 1.25% of assets, depending on the size of the plan. They are often estimated as a percentage of assets in 408b-2 fee disclosures, as opposed to stating the actual dollars that are being extracted from participants. Even more frequently, they are buried in dense and often confusing group annuity contracts with the employer. These hidden fees can be destructive to your long term financial health. A plan with total assets of $1 million invested in a group annuity with a 1.00% wrap fee would generate annual hidden compensation of $10,000 to insurance companies and plan advisors yet provide questionable participant benefits. And since these fees are variable based on assets, they are increasing over time.
Surrender Charges: Adding Insult to Injury.
One of the most devastating wrap fee consequences associated with plans funded with variable annuities are serious and onerous trading restrictions. Because annuity contracts are written with an expiration date, an employer who wishes to terminate the contract prior to expiration is subject to surrender charges often as high as 7%. While the industry defends these fees as an offset to the cost of setting up the plan, their true and obvious purpose is to hold plan sponsors hostage. They create a nightmare scenario for plan sponsors who wish to terminate their provider for poor performance or high administrative fees.
Revenue Sharing Arrangements: Hidden Fees
Revenue sharing arrangements are another source of hidden fees for participants. These fees are far from transparent and are often buried within the expense ratios of plan investments. Often identified as 12b-1 and sub-TA fees, these fees are used to indirectly compensate recordkeepers, custodians, TPA’s and advisors for services provided to the plan. Because the true cost of most plan services scale based on the number of plan participants as opposed to the total plan assets, these fees become increasingly expensive as plan assets continue to grow. They are seldom justified.
“I Own A Mutual Fund in My 401(k), Right?”
Variable annuities are often identified in marketing materials and other plan communications by their underlying mutual fund. This can lead some participants to conclude that they are investing directly in a mutual fund when in fact they are investing in variable annuity units subject to additional fees. As a result, plan participants who wish to invest in low-cost mutual funds may not realize that while the underlying fund has low fees, the unit expenses could be considerably higher. That’s not my idea of transparency!
Good News! You’ve Got Options!
Fifteen or twenty years ago, the smallest 401(k) plans had few options outside of variable annuities and bundled insurance providers. Today, the 401(k) landscape has changed. Mutual fund minimums have been reduced and lower cost share classes are available on most competitive recordkeeping platforms. Regulatory reform in recent years has mandated fee disclosure to both plan sponsors and participants. As a result, there has been an acceleration in the number of insurance companies who have sold or exited their 401(k) recordkeeping business in the past 5 years.
What Must I Do Now?
Insurance companies get away with high fees for two reasons: The first reason is that their fees are often intentionally hidden. True, fee disclosure reform has increased transparency somewhat in recent years, but insurance company fee disclosure continues to be among the most confusing and least transparent.
I have found that many, if not most, plan sponsors need help when it comes to properly identifying and benchmarking their 401(k) plan fees. You should ask your advisor for help if he is not already providing you with that service.
You should also understand how your advisor, as well as other 401(k) providers are paid for their services. Revenue sharing arrangements and insurance company wrap fees are often expensive and involve conflicts of interest that should be avoided.
Apathy and indifference among plan sponsors when it concerns high fees, however, is both expensive and inexcusable. Putting up with high 401(k) fees charged by insurance providers when there are far less expensive options available to smaller plans increases your legal liability, reduces participant outcomes and is a serious breach of fiduciary responsibility. Both you and your employees deserve better.
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education to company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
On a chilly March day in 1911, over 100,000 people gathered on the dock in Belfast, Ireland to witness the launch of the Titanic, the largest and most luxurious cruise liner of its day. It was widely reported that the ship’s builders and owners claimed she was “unsinkable”, while the actual claim that was made was that she was “practically unsinkable”. Close enough, but nevertheless an unfortunate statement and one which would haunt both builder and owner for over a century.
The builder’s overconfidence in the Titanic serves as a nearly perfect analogy for many fiduciaries who consider themselves bulletproof from liability for participant losses under the provisions of ERISA 404(c). These hidden liabilities exist for a significant number of plans today, despite the fact that plan sponsors wrongly assume that they are “unsinkable” when it comes to losses incurred by poor investment decisions by participants.
What is ERISA 404(c)?
It is important to understand that the general rule for retirement plan fiduciaries is that they are liable for all aspects of selection and monitoring of plan investments, even if the investments they select are typically offered by a provider as part of a default plan investment menu. In short, that means that they are on the hook for participant claims for losses incurred in the plan. Section 404(c) is a safe harbor exception to that rule in that liability protection would apply to those fiduciaries whose plan complies with the law’s specific requirements in terms of investment selection and monitoring, administration and certain plan and investment disclosures.
The problem for plan sponsors is that while 404(c) is an exception to that general rule of full liability, it is a limited exception which is dependent on a fiduciary process which must be followed by the plan. A plan sponsor that is unaware or fails to diligently follow this process may not receive the full blanket of protection that 404(c) offers.
“The blanket of protection offered under 404(c) is a sliding scale of protection- the more a plan sponsor follows a prudent fiduciary process, the more liability protection they can get”, states prominent ERISA attorney, Ary Rosenbaum. (1)
Understanding this sliding scale of protection is critical if plan sponsors wish to avoid the hidden liabilities inherent with their fiduciary duties. As with with the Titanic, there is a fine line between “unsinkable” and “practically unsinkable”!
To take advantage of the protections offered under Section 404(c), a plan must comply with the requirements detailed in three areas
1. Investment Selection 2. Plan Design 3. Disclosure of Sufficient Information
1. Rosenbaum, Ary, The Potential Liability of Participant Directed 401(k) Plans, 2017
Investment Selection is a Fiduciary Process
In order to qualify for the safe harbor protections of 404(c), a plan must offer a broad range of investment options. ERISA has defined this to mean at least three investment alternatives are offered to participants, with further qualification that each option be adequately diversified, offer distinct and different risk/return characteristics from the others and offer further diversification when combined with the other options. In reality, this requirement is easily met today by most defined contribution plans.
However, in practice, many plan sponsors are either unaware of or seriously neglect their investment selection fiduciary responsibilities in that they do not adhere to an initial or ongoing internal process. The courts have ruled that if a fiduciary does not have the education, experience or skill to determine the needed information on their own, then ERISA requires that they retain experts who can provide such information to the plan and its participants. (2)Most need a qualified financial advisor to guide them through the details of these important investment decisions and the resulting impact on plan participants.
Investment selection and monitoring is an ongoing process for plan sponsors as opposed to simply authorizing an initial plan lineup and is a critical practice to establish 404(c) protections.
“Investment selection is about a process. The idea that a plan sponsor can ‘set it and forget it’ is an absolute mistake, one that could cause major liability headaches” comments ERISA attorney, Ary Rosenbaum. (3)
Good investment processes and ultimately, good investment decisions, are not random. One of the core beliefs that I share with other successful retirement plan advisors and consultants is that decisions should always be guided by a blueprint. Specifically, that blueprint is an investment policy statement (IPS) that serves as a tool to show why investments were selected and by what criteria they are either retained or replaced. Importantly, the IPS is a living document and must be followed. Every investment decision for your plan should align with the IPS and be documented. Having an IPS and not following it is more detrimental from a liability standpoint than not having one at all. Although having an IPS is not specifically required under ERISA, I believe it to be an essential document to safeguard 404(c) compliance.
2. Donovan v. Bierwirte, 680 F. 2nd 263, 272-73, (2d Circuit 1982)
3. Rosenbaum, Ary, Potential Liability of Participant…Plans, 2015
Investment Fees Are Important!
One of the most litigated areas regarding investment selection under 404(c) concerns evaluating participant expenses and investment fees when making investment decisions for the plan. Although recent disclosure regulations have made this somewhat more transparent, plan sponsors must be diligent in asking these four questions when it comes to evaluating fees:
1. Are the investment fees reasonable? 2. Was a revenue sharing arrangement a major reason for fund selection? 3. Are most or all of the investment options offered to plan participants the proprietary funds of a plan provider? 4. Are improper share classes being utilized when less expensive share classes were available?
The above reasons for high fees, while all too common, raise a number of red flags for plan sponsors and should be avoided. The solution is for these sponsors to elect “open-architecture” investment platforms for their plan investments and hire an advisor to assist them with prudent investment selection, fee evaluation and the on-going monitoring of their investment lineup. These fees should be monitored and evaluated not less than annually, and the results documented. At SRP, we guide you through all aspects of investment selection, fee evaluation and performance monitoring and the documentation required for all investment decisions made on behalf of the trust.
Plan Design and Administrative Requirements
ERISA 404(c) specifies that compliant plans must give participants the right to control and direct the investment of their account. This control includes the ability of participants to transfer in and out of core options not less than quarterly, communicating a clear process for giving investment instructions and assigning fiduciary responsibility for ensuring participant investment instructions are carried out. In addition, fiduciaries must maintain confidentiality of information relating to the purchase, holding and sale of employer securities if offered by the plan.
Most of these requirements are easily satisfied today with online access offered by most 401(k) plans. However, recent court decisions have taken the position which suggests that if participants are not provided with material investment information necessary to protect their interests, then those participants cannot be said to have exercised control over their account. (4)
4. Regions Morgan Keegan ERISA Litigation, (W.D. Tenn. 2010); Sprint Corp, (D. Kansas 2004)
Disclosure of Sufficient Information
Far too many plan sponsors do not fully understand that ERISA 404(c) will protect them from losses sustained by participants only up to the degree that they take part in a process of prudent investment selection and providing participants sufficient information to make informed investment decisions. The courts have repeatedly held this to be true in assigning liability for participant investment choices. “A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard…. The failure to make an independent investigation and evaluation of a potential plan investment is a breach of fiduciary duty.” (5)
This principal presents some interesting scenarios. For example, if a participant were to invest all of his/her assets into an emerging markets fund offered by the plan and lose 50% in a market downturn, the participant cannot successfully claim a fiduciary breach related to his concentrated selection of the fund unless he/she can claim that the plan did not properly follow 404(c). However, the participant could claim a fiduciary breach regarding the plan offering this fund on its menu in the first place if the selection or monitoring of the fund was imprudent, suggests a recent white paper authored by Michael Webb of Cammack Retirement Group. “Thus, the protection from fiduciary liability offered under 404(c) is quite limited.”(6)
Likewise, the DOL has taken a clear position that Section 404(c) does not shield plan sponsors from liability for claims of imprudent selection of plan investment options. In a 2008 case, Kanawi vs Bechtel Corp, they emphasized that a fiduciary has a continuing duty to monitor the prudence of investments in the plan, regardless of the scope of a participant’s control.
5. Fink v. National Savings & Trust, 772 F. 2d 951, 957 (D.C. Circuit 1985)
6. Webb, Michael, AIF,CEBS, The Top Five Things You Need to Know About ERISA 404(c), November 2014
7. Kanawi v. Bechtel Corp., 590 F. Supp. 2d p1213, 1232, 2008
What Constitutes Sufficient Information?
The standards of what constitutes “sufficient information” is documented in Section 404(c) as information which must be disclosed to participants prior to making an investment decision:
• A description of each available investment option including its objective, risk/return characteristics, and portfolio holdings • The procedures for giving investment instructions. • A description of charges incurred for the purchase or sale of any investment option (e.g. sales loads, deferred sales charges, redemption or exchange fees). • Information on voting rights if passed through to participants. • A description of the information that is available upon request and the fiduciary responsible for providing the information.
The following information must also be made available to participants upon request:
• A description of each option’s annual operating expenses • Prospectuses, financial statements or other materials relating to an investment option. • Each portfolio’s holdings, their value or percentage of the portfolio, and for any fixed-rate insurance or bank contract, the issuer, contract term and rate of return. • The value of shares or units for each investment option as well as past and current performance determined net of expenses. • The value of shares or units held in the participants account. • The value of shares or units for each investment option as well as past and current performance determined net of expenses.
In addition, there is a disclosure requirement for additional information on the plan’s default investment, or QDIA, 35 days prior to possible investment and not less than 30 days prior each plan year. That means if your QDIA remains the same year to year, the details need to be disclosed to all participants and beneficiaries every year.
Finally, plan sponsors must provide notification annually that the plan intends to comply with regulations set forth in 404(c) and that plan fiduciaries are not liable for any losses resulting from participant investment instructions. This statement is usually provided in the Summary Plan Description that is given to all eligible participants and beneficiaries on an annual basis.
From my perspective as an advisor, the disclosure of the risk/return characteristics of each investment choice and how it compares to other investments offered by the plan is a common area that most plans fall short. Enrollment materials featuring smiling couples on cruise ships should feature this information instead. Ours do just that!
Am I Required to Provide Investment Education?
While ERISA does not explicitly require a plan to offer educational content or programs to participants, previously mentioned decisions by at least two courts have suggested that if participants are not provided with the material information necessary to protect their interests, then participants cannot be said to have exercised control over their 401(k) account as required by ERISA for 404(c) status. (8)
This might imply that a participant’s lack of education and therefore understanding of the investment’s underlying risk/return objectives could be a fiduciary breach of the safe harbor provisions of 404(c) and subject the plan sponsor to liability for investment losses sustained by an uninformed participant.
Many plan sponsors have leaned away from providing investment education due to the fear that such “education” might be construed as “advice”. In response, the DOL published an Interpretive Bulletin in 1996 defining activities that could be considered investment education. (9) A plan that provides plan information, general financial and investment fundamentals, asset allocation information and interactive investment materials would be permitted to provide this to participants as education as opposed to investment advice.
“If the DOL gives a blueprint on what investment education is, and encourages plan sponsors to offer it, you need to provide it to plan participants to get 404(c) liability protection!” (10)
8. Regions Morgan Keegan ERISA Litigation, (W.D. Tenn. 2010); Sprint Corp (D. Kansas 2004
9. Department of Labor, Interpretive Bulletin 96-1, Participant Investment Education, June 11, 1996
10. Rosenbaum, Ary, Why 401(k) Plan Sponsors Should Make Sure Education and Advice is Offered to Their Participants, 2011
Why Participants Experience Investment Losses
Occasionally I have young participants from other plans tell me that they have taken investment losses in their 401(k) accounts and I am always shocked. The truth is, they really had no clue to begin with about the investments that they owned in their account. When financial markets experience the normal (but unpredictable) declines, they often sell their investments (typically at or near market lows) and replace them with other investments that they do not understand. And so, the cycle repeats itself a few years later with the same results. It should never happen!
It is indisputable that educating participants on what to reasonably expect from the investment options available to them through their 401(k) plan has a huge impact on their ultimate success. To that point, Dalbar’s annual studies prove conclusively that individual investor’s historically poor investment results are far more the result of poor investor psychology and behavior than the choice of investments. (11)Providing basic investor education and guidance goes a long way toward not only how participants value your plan, but toward reducing the future liability for any participant losses for those who choose to ignore the information.
My point here is that, while not legally required, plan sponsors have at least an ethical responsibility to provide basic educational information in regard to basic investment fundamentals to participants. This argument is even more persuasive given the Security and Exchange Commission’s recent study which concluded that most Americans are functionally illiterate with regard to investing. (12)
A 401(k) plan is a quality benefit for your talented employees to save and invest for retirement through a tax deferred account. The opportunity for participants to get education and advice on managing these funds will not only add employee recognition and value to this benefit, but also include an important step in satisfying the fiduciary process set out in Section 404(c).
11. Dalbar, Quantitative Analysis of Investor Behavior, 1994-2019
12. SEC, Study Regarding Financial Literacy Among Investors, 2012
The Key to 404(c) Protection: Document Everything!
One of the keys to ensuring you are covered by the full protection of ERISA from liabilities stemming from participant investment losses is to make sure you document everything. I mean E-V-E-R-Y-T-H-I-N-G!!! This means having and maintaining your IPS, keeping minutes and notes for every investment decision made by the plan, and keeping records of all disclosures, educational and otherwise, to plan participants. As part of best practices, you should document the content given to participants at all enrollment and educational meetings and keep an attendance sheet.
At SRP, we supply our plan sponsor clients with a 404(c) Checklist to make it easy for them to determine that they have properly executed and documented their fiduciary process. We will be happy to send you a complimentary copy!
404(c) Compliance is an Inexpensive Insurance Policy
The causes of the infamous Titanic tragedy are still being debated over 100 years later. But clearly the builder’s description that she was “unsinkable” went down off the coast of Newfoundland long ago.
The point of this article is that you are neither bulletproof as a plan sponsor nor are you responsible for investment results. You are, however, primarily responsible for diligently executing a fiduciary process. If that is performed correctly, and you document the process, then Section 404(c) is a shield that protects you from liability for investment losses sustained by participants.
Famous ERISA attorney, Fred Reish, summarizes the 404(c) safe harbor perfectly”
“Basically, 404(c) is a relatively inexpensive insurance policy. Plan sponsors and fiduciaries should make every effort to obtain its protections.” (13)
13. Fred Reish, The New Take on 404(c), May 2009
Brian C. Rall
President – Strategic Retirement Partners, LLC
brian@strategicretirementllc.com
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.
It is highly probable that your company’s 401(k) plan will be subjected to audits conducted by the DOL and the Internal Revenue Service at some point in the future. If you are not 100% certain what documents you will need, download this free copy of our “Fiduciary Audit File Checklist” and be sure!
