Art by Joseph Ciardiello
Retirement plan committees continue to be sued over the cost of 401(k) investments. Participants allege that they pay unreasonably high expenses, which reduces the returns and, ultimately, savers’ retirement nest eggs.
A reasonable expense for a plan to pay is not the same as a reasonable expense for an individual investor. Plans have much larger asset pools, so they can buy less expensive shares such as institutional share classes of the same mutual funds.
The Department of Labor (DOL) takes the position that wasting a plan’s money is a breach of a committee’s fiduciary duties. Its reasoning is that, if a plan can afford less expensive share classes, but instead uses more costly shares, the committee has “wasted” the participants’ money to the extent of the difference in cost. As a result, committees need to use their plan’s purchasing power to select lower-cost share classes. A recent Supreme Court decision (Fifth Third Bancorp v. Dudenhoeffer) confirms that committee members can be liable for causing their plan to pay excessive investment fees when a costly share class is used but a lower-cost share class is available to the plan.
Does this mean institutional class shares should automatically be used? The answer is not that simple. While institutional class shares have low annual costs—referring to expense ratios—they typically don’t pay revenue sharing. Revenue sharing from mutual funds is often used to pay recordkeeping and other expenses plans would otherwise pay directly. Committees may take into account both expense ratios and revenue sharing.
How Should Share Classes Be Evaluated?
Below, we describe an approach that committees might use to deal with this issue.
Generally speaking, costs are only one consideration when selecting investments. But, within a single mutual fund, the only difference between share classes is cost. Committees should consider which available share class is the least expensive to participants in terms of net cost. While other approaches may also be prudent, this net cost analysis offers committees a transparent and reasonable way to satisfy their duties. For our purposes, a share class is available to a plan if the plan satisfies the eligibility requirements to invest in that share class. For example, a particular share class may require a minimum investment amount. In some cases, though, that condition may be waived by the fund. Make sure to ask.
As a part of the process, committees should make sure any revenue sharing is used solely for the benefit of the participants. For example, after revenue sharing is used to pay reasonable plan expenses, any remaining excess should be refunded to participant accounts. That is, all revenue sharing should provide a real- dollar economic benefit to participants by offsetting plan charges they would otherwise pay and, if there is revenue sharing left over, through crediting to their accounts. By way of this process, the true net cost of a share class can be determined simply as expense ratio minus revenue sharing.
To illustrate, if one share class has an expense ratio of .70% per year and pays .30% in revenue sharing, its net cost to participants is .40%. This is because the revenue sharing either offsets expenses the plan would pay directly or is refunded to the participants, or both. Additionally, for example, the .40% “net cost” might be .10% lower than an institutional share class of the same mutual fund with an expense ratio of .50% but that pays no revenue sharing. The second fund appears to be cheaper—i.e., .50% vs. .70%—but participants would be worse off, by .10% annually, if it were selected.
Some institutional class shares may be money-wasting from this perspective. So, institutional share classes of funds could be the best choice in some cases but not in others. In the Supreme Court decision noted earlier, the fiduciaries did not perform this type of analysis. According to the court, the committee did not offer a “credible” explanation for using the retail class funds. In other words, the fiduciaries were not liable just because they used retail class funds but, rather, because they didn’t act prudently in selecting share classes based on their net cost.
A plan may be eligible for a large number of share classes that mutual funds offer, but, by using the above analysis, the plan can identify the lowest available net-cost class, whether two, three or 10 share classes are available. Committees should follow this process when selecting funds and revisit prior share class decisions where a lower net cost might be achieved. This will improve results for participants and help protect committees.
Fred Reish is a partner at Drinker Biddle & Reath LLP's employee benefits and executive compensation practice group and chair of the financial services ERISA team. Bruce Ashton, a partner of the firm, and Joshua Waldbeser, an associate, contributed to this article.