Fee Arrangements – Put a Process in Place
By Shawn P. Huxley, CPA, MSA and James Alexander, Samet & Company PC

Plan sponsor and participant disclosures have raised the awareness of plan fees. Are the fees being charged prudent and the amount reasonable in light of the service being provided?  Is the cost structure appropriate for the plan? There should be a process in place to evaluate these questions at least on an annual basis.

There are a variety of fee arrangements used to pay for the services used by defined contribution plans. One provider might be paid a single fee to cover all the administrative services or the fee for recordkeeping might be deducted from the investment return and paid directly to the record keeper in a revenue sharing arrangement.  

Fees generally fall into one of the following three categories:

Administrative - These expenses cover the day to day operations in administering the plan and include the expenses incurred in making sure the plan is operating properly.  Examples of administrative expenses include legal, audit, trustee services, and Form 5500 preparation.  It also includes recordkeeping services to maintain participants’ accounts and process participant transactions as well as fees for providing educational materials and plan sponsor and participant communications.

Investment - Typically this is the largest plan expense and is associated with managing the plan’s investments and other investment-related services.

Individual services - These fees are charged separately to the account of the participant taking advantage of a particular plan feature.  An example of this fee is the charge for processing a loan.

Direct vs. Indirect Compensation - Responsible plan fiduciaries must ensure that arrangements with their service providers are “reasonable” and that only “reasonable” compensation is paid for services.  Service providers receive either direct or indirect compensation from the plan.  Direct compensation is the compensation paid to service providers directly from the plan (and does not include payments made by the plan sponsor).  

The service provider must disclose all direct compensation, either in the aggregate or by service, which the service provider, affiliate, or a subcontractor reasonably expects to receive in connection with the covered services.
Indirect compensation is the compensation received by the service provider from any source other than the plan, the plan sponsor, a service provider, an affiliate, or a subcontractor.  

The service provider must disclose all indirect compensation that the service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with covered services.  The disclosure must include an identification of the services for which the indirect compensation will be received and identification of the payer of the indirect compensation. Compensation can be billed to the plan or deducted directly from the plan’s accounts or investments.

Who Pays the Fee?

The options for paying the fees for administering the plan are to charge them directly to the plan sponsor, participant accounts, or pay them from plan assets.  The plan fiduciary must consider whether it is an expenditure that may be paid from plan assets and, if so, whether the plan document allows or prohibits the payment of the expense from the plan.  If the document provides for the employer paying the expense, then plan assets cannot be used. 

In some cases, the plan sponsor’s bottom line necessitates shifting some of the costs to the plan or its participants.  In other cases, the plan sponsor may be concerned about passing the fee along to the participants and may pay it directly by the company or use forfeitures, if the plan allows.  A typical plan provision provides that expenses of the plan be paid from plan assets, unless paid by the employer (an advance) and that the employer may be reimbursed by plan assets for the advance.
It is important to note that although 88% of plans are permitted to pay direct expenses from plan assets, the type and dollar amount of expenses paid can vary widely between different plans.

Revenue Sharing Agreements

The term revenue sharing refers to a process of reimbursements made to service providers from mutual funds for sales and service fees charged (“12b-1 fees”).  These reimbursements are typically intended to cover the service provider’s fees for recordkeeping, custody, and individual level accounting at the fund and participant level.  Oftentimes, service providers offset these revenue sharing payments against other recordkeeping or advisory fees that are charged to the plan.

Allocations to Participants
The method for allocating expenses among participants in a defined contribution plan may be in the plan document.  If the plan document is silent, the plan sponsor must determine a reasonable method for allocating costs among participants.  The three most common methods are:

Per capita - Spreads fees equally among participants regardless of the asset size of the individual’s account.  This may be an equitable method of allocating fixed fees such as recordkeeping, legal, or auditing.

Pro rata - Allocates a portion of the expenses to each individual’s account based on the asset size of the account.  This method may be reasonable where the fees are based on account balance (e.g. investment management fees).

Per use - Charges participant directly for certain services that they use such as a fee for initiating a loan, a hardship distribution, withdrawal, brokerage account fee, or a qualified domestic relations order.

The plan sponsor must be cautious when determining which fees to charge terminated versus active employees. They must be careful that the terminated participants are not subsidizing the costs of administration for active employees or charged a higher fee for the same service.

Both participants and employers may be unaware of how or even if certain fees and expenses are being paid because they are deducted from the investment earnings.  With the requisite fee disclosures, plan providers are required to tell the plan sponsor how much they are being paid.  Participants are also supposed to receive statements that include the plan investments, their performance, the fees each investment incurs, and the fees taken out of their account.

It is crucial that plan sponsors understand the nature of the fees their plan is paying. When fees are unreasonable, the plan risks being subjected to litigation.  Potential ways to prevent litigation include:

• Having a fee statement that describes the activities and procedures designed to promote oversight and fee management.  It should include the delegation of responsibilities regarding fees and expenses, identification and documentation of the fees charged to plan assets or paid by the plan sponsor and the procedures for approving expenses and fees to be charged to plans assets.

• Documenting efforts through committee minutes or other official records. This documentation is important to help ensure that fees are reasonable in light of the services provided.

• Having procedures for fulfilling required annual reporting and disclosures, including government filings and participant disclosures.

• Comparing fees charged to similar investments to ascertain reasonableness.

Current Fee Climate

Plan sponsors are tasked with the great responsibility of always acting in the best interest of the employees who invest their money in the plan.  This responsibility encompasses a broad range of topics and oftentimes plan sponsors fall short of fulfilling this responsibility.  In recent years, the industry has seen numerous cases that highlight the shortcomings in specific areas.

In a Higherlawreport.com article from August 2016, it was reported that class action lawsuits were being filed against three large universities.  New York University, Yale, and Massachusetts Institute of Technology were alleged to have breached their fiduciary responsibilities by allowing their employees to be charged unreasonable fees on their retirement accounts. 

This news followed other class action lawsuits against other large entities such as Lockheed Martin, Boeing, and Novant Health.  The Lockheed Martin case was reportedly settled for a staggering $62 million.  In July 2018, the case against NYU was settled with the court ruling that the plan’s retirement committee had satisfied its fiduciary duties in respect of the plan’s fees and investment selections. 

The court cited the committee’s documentation of its process for deciding which vendors to use, which investments to offer or continue to offer, and the reasonableness of fees charged to the plan as a major reason for arriving at its ruling.
However, it is not just large employers that are at risk for litigation.  In a July 2016 article, Investmentnews.com reported that Cetera Advisor Networks was named as a co-defendant in a lawsuit relating to the $25 million Checksmart 401(k) plan.  This suit accused plan fiduciaries of allowing “grossly excessive fees to be charged for investments that delivered extremely underwhelming performance over a six year period.” 

Additionally, the suit alleged that the plan offered an unusually disproportionate number of actively managed funds, which are typically more expensive than passive indexed funds.  This case was ultimately dismissed in 2018 as a result of a statute of limitations that applied because Checksmart had provided the required fee disclosures to the plaintiff within the previous three year window.  Had this not been done, the result could have been very different.

Even investment firms are subject to strict scrutiny, as Neuberger Berman was named as the lead plaintiff in a 2016 lawsuit that accused the firm of costing its employees $130 million by putting one of their own actively managed funds with high fees and low performance into the plan.  In this particular case, the identified fund was said to have charged fees of “at least $20 million…over the past five years” while a similar fund “would have charged just under $500,000 over that time period.  This particular case is still ongoing, despite U.S. District Judge Laura Taylor Swain deciding in October 2018 that many of the defendants named were not actually fiduciaries. 

The outcome for the investment committee as the sole remaining defendant has not yet been determined.   Similar lawsuits have been brought against financial service companies such as American Century Investments, Allianz, New York Life Investment Management, Putnam, Deutsch Bank, M&T Bank and BBT Bank.

As the attention paid to plan fees continues to grow, the complexity of the lawsuits brought continues to expand.  In a June 2017 article by Investment News, it was alleged that Nationwide provided a fee structure to the Andrus Wagstaff, PC 401(k) Profit Sharing Plan that was not in the Plan’s best interest.  In this case fees for recordkeeping services were charged at 1% of plan assets.  This resulted in annual recordkeeping fees of approximately $500 per participant in 2015, which according to a survey conducted by New England Pension Consultants, should have ranged from $35 - $64 per participant. 

In late 2018, Andrus Wagstaff was added as a defendant in the case, based on the accusation that as the employer, they were also culpable due to their selection of Nationwide as a service provider.  A similar lawsuit was brought against VOYA Financial, Inc., as detailed in a September 2017 Bloomberg article.  This case alleges that participants in the Cornerstone Pediatric profit sharing plan were charged, on average, $1,819 per participant in 2015 for recordkeeping services. 

As recently as August 2018, a federal judge ruled that there was sufficient merit to move forward with a case against T. Rowe Price, in which the company is accused of breaching its fiduciary duties by offering only T. Rowe Price funds as investment options in the plan.  

These cases illustrate the danger of basing certain fees on a percentage of plan assets, because in the case of recordkeeping fees, plan assets may increase dramatically from one year to the next due to participant contributions and investment return, while the level of service remained consistent in both years.

These cases underline some of the pitfalls that employers can fall into when administering a defined contribution plan.  In order to safeguard against these types of lawsuits and ensure the fulfillment of their fiduciary duty to their employees, employers should adhere to the following best practices:

• Review and understand recordkeeping fees

• Review and understand investment fees

• Maintain records of investment committee minutes documenting fund selection and vendor services

• Update and maintain record of vendor contracts

• Form an investment committee and perform the following:

• Develop a formal committee charter

• Meet at least quarterly and review investment options annually

• Keep minutes for each meeting to document why decisions were made

• Create and adhere to an investment policy statement

It is becoming increasingly clear that employers are held to a high standard when it comes to administering their retirement plans.  As always, the issues that put the most pressure on employers continue to change and evolve, with investment selection and fee monitoring being two of the most current.  Employers should be aware of these issues, identify how they might impact their plan, and document a proactive plan to mitigate them.

Shawn P. Huxley, CPA, MSA is a Director at Chestnut Hill, MA CPA firm, Samet & Company PC and can be reached at shawnh@samet-cpa.com or 617-731-1222. James Alexander is a Supervisor at Samet & Company PC and can be reached at 617.731.1222 or jamesa@samet-cpa.com