By Dusty M. Burke 

A typical 401(k) plan offers an array of mutual funds as investment options under
the plan. Each plan participant directs the investment of his or her 401(k) account
by selecting from among the various investment options. The employer, who is
often the plan “fiduciary,” hires a “recordkeeper” who tracks the performance of the mutual funds and credits or debits each participant’s account with the earnings and/or losses based on the performance of the selected investment options. Periodically the participant goes online and checks his or her account balance and sees that his or her account has been credited or debited for what the participant assumes — naively — is an amount based wholly on the performance of the stocks and/or bonds that are the underlying investments in the particular investment fund.

In connection with the hiring of the recordkeeper, the employer/fiduciary and the recordkeeper enter into a recordkeeping contract, which sets forth the recordkeeper’s duties, the fees that the recordkeeper is charging for its services, and the intended relationship between the recordkeeper and the plan. The contract generally provides for annual administrative fees — either a flat services fee or a per participant fee, plus additional fees for nondiscrimination testing and other plan services. Often the recordkeeper completely waives all the administrative fees in the agreement. It looks like a bargain.

But what is really happening?

The Hidden Fees 
The recordkeeper of a 401(k) plan typically receives its compensation from three sources—only one of which is the administrative fee stated in the recordkeeping agreement. The recordkeeper also typically receives compensation under various “compensation sharing arrangements” between the plan’s mutual funds and the recordkeeper associated with the plan’s investments. And, the recordkeeper generally gets (and keeps) all the earnings generated when plan assets sit in a segregated account waiting for a pending distribution or for participants to cash their checks (float). The result is that the recordkeeper is actually receiving more — sometimes a lot more — in compensation in connection with its services for the 401(k) plan than just the administrative fees set forth in the recordkeeping agreement.

The employer/fiduciary of course is aware of the contract administrative fees. But it is often not aware of the compensation sharing fees or the float that the recordkeeper is receiving. After all, there is nothing in the contract that states that the recordkeeper must tell the employer/fiduciary that it is receiving additional fees from third parties as a result of its administration of the 401(k) plan. In fact, the recordkeeping agreement generally states expressly that the recordkeeper is not a “fiduciary” or an “investment adviser,” provisions intended to negate any disclosure requirement.
 
So, what’s the problem with these hidden fees?

These hidden fees, which are often significant, raise concerns that the recordkeeper might be receiving, and the plan might be paying, more than reasonable compensation for the recordkeeper’s services to the 401(k) plan. The participants may also be receiving a lower investment return than they are entitled to receive because the mutual fund is paying the additional compensation to the recordkeeper. It is also possible that these compensation sharing arrangements potentially result in the recordkeeper acting in its own best interests, and not acting in the best interests of the plan, resulting in the plan not receiving the best price for each trade or “best execution.” In addition, the participants might have, because of the fee sharing arrangements, more limited or less desirable investment options than the options they would otherwise have.

Proposed Legislation and Regulations
To date, there is no requirement under ERISA (the federal law that regulates 401(k) plans) for a non-fiduciary recordkeeper to disclose these hidden fees to the employer/fiduciary — even though, anomalously, the employer/fiduciary will have a requirement to disclose those fees (of which it may be totally unaware) to plan participants beginning in July 2010. But the hidden fee concerns have gotten the attention of Congress and the Department of Labor (DOL). Last year the DOL proposed regulations under ERISA mandating disclosure of these types of hidden fees. However, those DOL regulations were held up by the Obama administration, and it is unclear if or when they will be released. In addition, the 401(k) Fair Disclosure for Retirement Security Act of 2009 is currently pending in the House Committee on Education and Labor. That act requires more specific fee disclosure than even the proposed DOL regulations. So, it appears fairly certain that there will be a requirement under ERISA for the recordkeepers to disclose the hidden fees at some point, presumably in the very near future.

Meanwhile...

Hidden Fee Class Actions Under ERISA by Plan Participants Against Plan Fiduciaries 
Angry participants, spurred by the continuing economic slump and the recent publicity that has brought the practice of hidden fees to light, have begun to file class action lawsuits against employers, plan fiduciaries, plan recordkeepers, and plan investment providers demanding to know the scope of these fees, challenging the propriety of these fees, and attempting to recoup or disgorge the amounts under ERISA. Under ERISA, the fiduciary of a 401(k) plan has a fiduciary duty to make sure that fees paid to a 401(k) plan recordkeeper are not excessive. If a recordkeeper’s fees are excessive, the employer/fiduciary could be liable for breach of fiduciary duty or for engaging in a prohibited transaction under ERISA — either violation potentially resulting in significant penalties and damages. 

All employers who maintain 401(k) plans, all fiduciaries of those plans, and all recordkeepers that provide services to 401(k) plans, are vulnerable to this type of ERISA class action lawsuit. It is likely that these cases will explode when either the DOL regulations under ERISA are released and/or the 401(k) Fair Disclosure for Retirement Security Act is enacted.

Potential Securities Claims by Plan Fiduciaries Against the 401(k) Plan’s Recordkeeper
Historically, most employers/fiduciaries have been unaware of, or have not understood, the hidden fees paid by the mutual funds to their recordkeepers. So an employer/fiduciary could be blind to the fact that the plan is — and has been for years — paying excessive fees to the plan’s recordkeeper. Can the employer/fiduciary make a claim against the recordkeeper if the unsuspecting employer/fiduciary is held liable to the participants under ERISA on account of the hidden fees?

Plan fiduciaries have potential claims against the recordkeepers for violating the securities laws by failing to disclose to the plan fiduciaries compensation sharing arrangements between the recordkeeper and the mutual funds. Potentially, the recordkeeper is an “investment adviser” subject to the provisions of the Investment Advisers Act of 1940. If the recordkeeper is engaging in a regular business of providing investment advice, or making direct or indirect recommendations on securities, and receiving compensation for the service, the recordkeeper is potentially an investment adviser subject to the 1940 Act. As such, the recordkeeper would have a duty (and would have had that duty since the inception of the relationship with the plan) to disclose all information relating to its relationship with the plan, including whether the recordkeeper was being compensated from other sources in connection with its services to the plan. In addition, the anti-fraud provisions of the 1940 Act impose a duty on investment advisers to act as fiduciaries in dealing with their clients. If the recordkeeper is an investment adviser, the recordkeeper would have an obligation to hold the plan’s interest above its own and avoid all conflicts.

What Should Employers/Fiduciaries and Recordkeepers Be Doing? 
Disclose, disclose, disclose...

And get ready for the lawsuit.