With Plan Participants Increasingly Litigious, Are You “Reasonable?”

Posted on June 20, 2011. Filed under: Uncategorized |

The following is a terrific article for plan sponsors and their consultants to read and heed.  We have inserted some questions we think sponsors and their consultants should consider and welcome any commentary or insight of your own to add to this timely discussion.

Nowhere to Hide on Hidden 401(k) Fees

With plan participants increasingly litigious, plan sponsors must take care that investment and administration expenses are “reasonable.”
Jeff Mamorsky, CFO.com | US
June 20, 2011

Under ERISA, CFOs and other retirement-plan fiduciaries are required to understand the fees and expenses charged and the services provided to the plan. While ERISA does not specify a permissible level of fees, the Section 404(a) fiduciary rules require that fees charged to a plan be “reasonable.”  (For participant advice, we’ve come across many HR managers that clearly don’t know if they have this service or not, what the fee is, and where the fee is deducted.  Many believe the service is free!  Yet they are unaware that it is actually included in the investment advisory fee, thus “hidden” from their awareness and understanding.  Surely this isn’t about to become a problem for them…)

Not only is there potential fiduciary liability for failure to examine this issue, but also the ERISA Section 404(c) safe harbor (which insulates a plan sponsor from ERISA fiduciary liability) may be negated by a failure to identify and disclose all plan fees and expenses to participants.  (Are you at risk of negating your safe harbor status?)

In addition, arrangements with service providers may be considered prohibited transactions under Section 406 if the exemption provided in Section 408(b)(2) is not satisfied, subjecting the plan fiduciaries and the service providers to tax penalties. To satisfy the requirements of this exemption, an arrangement between a plan and a service provider will not be a prohibited transaction if: 1) the contract or arrangement is “reasonable,” 2) the services provided are necessary for operating the plan, and 3) the service provider’s compensation is “reasonable” for such services. Currently, the standard for evaluating what fees are reasonable is unclear, making it difficult for plan sponsors to determine whether a service provider arrangement will constitute a prohibited transaction.

A Ploy Named Sue
This has led to a flurry of “hidden fee” litigation, reflecting plan participants’ dissatisfaction with inadequate fee-disclosure requirements and the need for protection from excessive fees. Plan participants have filed multiple lawsuits against plan sponsors, claiming that the decision to pay excessive investment and administrative fees was imprudent and a breach of the fiduciary duty of care.  (Why not move away from “hidden fee” arrangements and enlist flat fee providers who fully disclose their services to not only protect you, but do the right thing for your employee participants.  By using the right provider you may be able to document a higher value service for a lower flat fee…thus removing the “wind in the sails” of participants claiming excessive and imprudent fees etc.  If your vendors won’t do this, shouldn’t you find one that models their practice around how you choose to do business rather than requiring you to conform to them, the vendor?)

As a result, employer plan sponsors have hired investment consultants to advise them on the reasonableness and identification of plan investment and administrative fees and expenses. In fact, there is a tendency to rely on such independent advice from outside experts.

However, in the first “excessive and unreasonable fees” decision to go to trial, a U.S. District Court in California held that while securing independent advice from an investment consultant is “some evidence” of a thorough investigation, it is not a complete defense to a charge of imprudence. At the least, said the court, plan fiduciaries must “make certain that reliance on the expert’s advice is reasonably justified.” According to the ruling, this is accomplished with evidence demonstrating the thoroughness and scope of the consultant’s review. In effect, an employer plan sponsor cannot “hide behind” a consultant but must be able to produce evidence of a robust and thorough investigation through procedural and substantive prudent process standards, a forensic fee audit, and benchmarking [Tibble v. Edison Int’l, C.D. Cal., No. CV 07-5359 SVW (AGRx), 7/8/10]. (Be sure to realize that you will still want to have your documentation that you have a thorough competitive bid for each service in your plan as opposed to just relying on your plan c0nsultant, as the onus of proof is still on you to prove you did this thorough due diligence.)

In a comprehensive 82-page decision, which is must reading for employers concerned about hidden fee liability, the district court found that the fiduciaries of Southern California Edison’s (SCE) 401(k) plan breached their duty of prudence under ERISA when they selected more costly retail class mutual funds for the plan instead of attempting to secure institutional class mutual funds.  (How much longer until we see the analogy of “retail” vs. “institutional” funds play out in litigation over other vendors services like participant advice for robustness of services delivered for how comparable a cost?)

The fiduciaries found liable were not only the employer plan sponsor but also members of the plan investment and benefits committees, the vice president of human resources, and the manager of the sponsor’s Human Resources Service Center. (Hence, nowhere to hide.)

In concluding that the fiduciaries breached their duty of prudence, the court emphasized that there was no evidence that the fiduciaries investigated the difference between the retail-class funds and the institutional-class funds. Had the fiduciaries weighed the relative merits of the two fund types, said the court, “they would have realized that the institutional share classes offered the exact same investment at a lower cost to the Plan participants.”

Plaintiffs representing the plan participants in this class-action suit argued that, when deciding to invest in the retail share classes rather than the cheaper institutional share classes, the defendant fiduciaries were improperly motivated by a desire to capture more revenue sharing for Southern California Edison (SCE), even though doing so increased the fees charged to plan participants. Plaintiffs argued that defendants put the interests of SCE in offsetting the plan’s record-keeping costs through revenue sharing above the interests of the plan participants in paying lower fees. To support that claim, plaintiffs relied primarily on a series of e-mails, generally between members of SCE’s investments staff and human resources department.

To determine whether the decision to invest in retail share classes constituted a breach of the duty of prudence, the court examined whether the fiduciaries engaged in a thorough investigation of the merits of the investment at the time the funds were added to the plan. The finding was that “there is no evidence that defendants even considered or evaluated the different share classes when the funds were added to the Plan.”

The court further emphasized that the presentation materials the SCE investment staff, prepared for Plan Investment Committee meeting at which the Investments Staff recommended adding these funds to the plan, “contained no information about theinstitutional share classes.” According to the court, “The Investment Staff simply recommended adding the retail share classes of these funds without any consideration of whether the institutional share classes offered greater benefits to the plan participants. Thus, the plan fiduciaries responsible for selecting the mutual funds (the Investment Committees) were not informed about the institutional share classes.” (Just because there is an investment committee doesn’t mean they understand these nuances and are doing the best thing.  For example we came across one that actually told us it was BECAUSE of the Pension Protection Act of 2006 that they couldn’t hire an independent, objective participant advisory fiduciary to provide advice to their participants!  Clearly it was this very thing that came about to help sponsors feel more comfortable in reaching out to independent professional advisory solutions to help their employees who are clamoring for such services.)

Specifically, the court said, the defendants did not present evidence of: the recommendations the investment consultant made to the investment committee; the scope of the consultant’s review; whether the consultant considered both the retail and the institutional share classes; whether the consultant provided information to the investment committee about the different share classes; what questions were asked regarding the recommendations; and what steps the investment committee took to evaluate the consultant’s recommendations. Thus, while reliance on a consultant’s recommendations may be justified in some circumstances, in this instance the court could not conclude that such reliance was prudent or reasonable.

What Fiduciaries Can Do
It is imperative that employer plan fiduciaries establish best-practice governance standards relating to the identification and disclosure of “hidden” fees so they can demonstrate the robustness of their analysis and conclude that 1) the compensation paid directly or indirectly to investment and administrative service practices is no more than “reasonable,” and 2) actions of the service providers are monitored to assure that any fee offset to which the plan is entitled is correctly calculated and applied.

“Reasonableness of fees” is not easily ascertained. Service providers normally disclose fees otherwise required to be disclosed, such as 12b-1 fees, but not indirect fees they receive from mutual-fund vendors, which are typically prevented from disclosure by agreements that service providers claim are confidential or proprietary. Accordingly, it may be difficult to conduct a forensic investigation and the “adversarial” negotiation necessary to identify embedded and undisclosed fees. (Do you believe that if it was you under this same scrutiny for your plan or your client’s plan that you can document that a vendor’s fee is “reasonable” compared to the vendor’s peer group universe?  If you have any doubt, don’t you think you should secure this documentation as soon as is practical?)

That is the purview of an independent ERISA attorney. In-house and plan counsel, as well as accounting or consulting firms, may not be able to offer confidentiality as a result of the “fiduciary exception” to attorney-client privilege. Making all efforts to establish and preserve confidentiality is critical in the event of litigation for excessive fees that may come to light as the result of a forensic plan-expense review.

Jeff Mamorsky is co-chair of the global benefits practice at law firm Greenberg Traurig.

© CFO Publishing Corporation 2009. All rights reserved.

We hope you enjoyed this article.  We also hope that our comments may initiate a meaningful discussion on these timely topics.

Thank you for stopping by!


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