There’s a perfect storm brewing in the 401(k) space
Commentary: The 401(k) space is in the infancy of a complete overhaul. With employees fighting back and winning against high fees and a new fiduciary standard on the way, we’re on the cusp of some radical changes to the corporate retirement landscape.
This movement started about five years ago. A July 2010 study by Transamerica found that “while the majority of employers believe their employees have a clear understanding of fees associated with participating in the retirement plan, only 26% of workers are aware of any fees.” This highlighted a glaring disconnect between employers’ perceptions and workers’ actual understanding.
The Department of Labor introduced its fee disclosure rule in 2010 to clear up this disconnect. The rule, which went into effect in 2012, said that vendors expecting to receive at least $1,000 in compensation, directly or indirectly, must disclose their fees to employers. Employers must then disclose these fees to their employees.
An important aspect of the 401(k) fee disclosure rule was a little known provision stating plan sponsors are responsible to “determine reasonableness” of their plans’ fees. Such fees, the mandate states, must be “usual and customary”. This means that simply disclosing a 401(k) plan’s fees is not sufficient. Plan sponsors must take action to ensure that their 401(k) plans’ fees meet the DOL requirement. Since the DOL did not give a definition of “reasonableness”, the term “benchmarking” surfaced as a way to measure the cost effectiveness of 401(k) plans.
The rule was intended to promote consistency among retirement plan providers and help both employers and their workers make more informed decisions about their retirement plans, but it didn’t go far enough. In the following years the 401(k) space saw a large influx of lawsuits surrounding fees and suitability. One case in particular made it all the way to the Supreme Court.
The Tibble v. Edison International case was focused on a statute of limitations issue, but its ruling, which went in favor of Edison’s employees last May, could trigger a wave of lawsuits against companies over the way they set up and manage 401(k) retirement accounts and similar plans. Even before the Supreme Court’s ruling, the Ninth Circuit Court of Appeals had already determined that Edison International violated ERISA by introducing high-expense ratio retail-class mutual funds rather than lower-cost institutional-class funds. The damage done to the employees was further compounded by Edison’s participation in a revenue sharing model, which required participants to pay overcharges to compensate for the fees for vendors and middlemen, a portion of which was kicked back to Edison.
This ruling came right as the Obama administration began placing heightened scrutiny on retirement plans, the fees they charge and the potential for adviser conflicts. The DOL introduced its fiduciary standard rule in April, and all those involved in the 401(k) space are anxiously awaiting its final version. U.S. brokers and financial advisers would face new constraints under the plan, as it’s aimed at reducing conflicts of interest and hidden fees that cost Americans billions of dollars in retirement savings in 401(k) plans.
The new rule would hold brokers to the same standard of care as registered investment advisors. This proposed rule would not impact RIAs, as they are paid a percentage of assets under management rather than commissions, removing an otherwise glaring conflict. Rather, the rule will have a huge impact on thousands of brokerages, from large players such as Fidelity, Wells Fargo, Merrill Lynch, Morgan Stanley and Raymond James, to smaller, independent shops. Brokers will be held to a higher fiduciary standard, requiring them to put their clients’ financial interests ahead of their own.
These landmark rule changes and court cases are steadily altering how 401(k) plans are delivered. Many providers, like Fidelity, are already changing their platforms as a result. Other providers such as retirement plan giant Vanguard, whose platform never worked with brokers or permitted retail mutual funds or revenue sharing arrangements, are now focusing on the smaller plan market, bringing the benefits large plans have enjoyed to employees at smaller companies.
There is clearly a perfect storm brewing, and employers need to be put on notice. Their responsibility to be aware of these new laws and product changes will be overwhelming as the margin for error dramatically narrows.
Brian Menickella is a co-founder and managing partner of The Beacon Group of Companies, a broad-based financial services firm offering companies and individuals advice on insurance, investing and employee benefits.