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A Better Partnership


Aug 2013
August 08, 2013

Empty Heads Are No Excuse - 8 Questions Employers Must Be Able To Answer About Their 401(k) and 403(b) Plans

Nearly every 401(k) plan offers its participants some investment options that include revenue sharing. For many years, employers were not even aware that their participants' investments were generating these payments. Today, in the wake of new Department of Labor (DOL) disclosure and reporting rules and well-publicized cases attacking employers for inattention to revenue sharing, ignorance is no longer an excuse.

Recently the Employee Benefits Security Administration of the DOL (EBSA) addressed an important question: when do revenue sharing amounts become plan assets? The answer to this question is important for determining when the ERISA trust requirement applies, who is a fiduciary, whether prohibited transactions have occurred and what reporting and disclosure rules apply. EBSA generally concluded that whether or not revenue sharing amounts are plan assets depends on the facts and circumstances - they are not always plan assets. The Advisory Opinion, however, went further and detailed the responsibility of employers with respect to ERISA accounts and revenue sharing generally.

Following the Advisory Opinion, employers are on notice that they must be able to at least answer the following questions regarding their 401(k) and other defined contribution plans, such as 403(b) plans.

Do any of your investment funds generate revenue sharing?

Odds are, the answer is "yes." In this context, revenue sharing payments are amounts paid to a record keeper for hosting an investment fund on the record keeper's 401(k) platform. These payments include 12b-1 fees, shareholder service fees, and sub-transfer agency fees. These fees are generally built into the fund's expense ratio, which is the cost charged to investors for management of the fund.

Because the expense ratio is taken out of the fund's earnings, many employers believed for years that both the investment and the record keeping were "free." Neither the employers nor the participants understood that the investment management and record keeping was anything but free. It was coming right off the top of the earnings being credited to the participants' accounts. Generally speaking, the higher the revenue sharing being paid to the record keeper, the higher the expense ratio (cost) of the fund and the fewer dollars actually allocated to the participants' accounts. The DOL has observed that even a 1% difference in fees over 35 years at 7% return results in a 28% reduction in the participant's account balance at retirement.

Because of the damage to participants' retirement income, EBSA last year began to require that these payments be reported to employers for inclusion on the 5500 Schedule C and on the so-called "provider" or "408(b)(2)" disclosures. Every employer now receives these disclosures and must have a record of having reviewed and understood them. If you placed your disclosure in the circular file, it is time to retrieve it. If you did not receive these disclosures, it is your obligation to ask for it.

What agreement do you have with your record keeper on revenue sharing?

If you have no agreement with your record keeper on revenue sharing, it is likely that your record keeper is keeping the revenue sharing. You are responsible for understanding how much that revenue sharing is and the total compensation the record keeper is receiving from all sources for its services. If you have not determined that the total compensation received by the record keeper, including revenue sharing, is reasonable for the services provided, you are likely engaged in a prohibited transaction. You need to review your costs with your record keeper.

If you have an agreement on revenue sharing, you must be able to answer the following questions.
  • Do you have an ERISA account or budget?

    An ERISA account or budget is established when the revenue sharing amounts received by the record keeper exceed the costs of record keeping.. The excess is set aside and may be used in different ways. If you have an ERISA account, you negotiated the record keeping costs with the record keeper and should have a written contract setting out that agreement. You should also have a record of how the reasonableness of the record keeping cost was determined. Again, if there was no process for determining the reasonableness of the cost, you may be engaged in a prohibited transaction.

  • Is your ERISA account established within your plan trust or is it part of an omnibus account maintained by your record keeper?

    The Advisory Opinion says that the treatment of the ERISA account depends on the contract language. If the excess revenue sharing is deposited into the plan, the amounts are treated as plan assets as soon as deposited. If instead, the record keeper maintains the excess in an omnibus account outside the plan, the right of the plan to make a claim against that amount for plan expenses is a plan asset that must be protected, but the dollars are not plan assets. This is usually referred to as an "ERISA budget." If you have not yet negotiated access to excess revenue sharing, an ERISA budget outside the plan may be preferable, since any imperfect usage of those funds would only be a fiduciary breach and not a prohibited transaction. In either event, you are responsible for negotiating for the use of those assets on behalf of the plan.

  • What expenses can be paid from your ERISA budget?

    ERISA accounts or budgets can be used only to pay plan expenses, such as: preparation of summary plan descriptions and plan forms; record keeping and other plan administration; audits; trustee fees; fiduciary expenses, such as investment advice; and maintaining the plan's tax-qualified status, including preparation of required amendments and IRS submissions. Settlor expenses, which include investigating plan design options, preparing discretionary plan amendments and resolutions, and plan terminations, cannot be paid from these funds.

  • Who approves the expenses and makes the fiduciary determination that the expenses are reasonable?

    The plan document identifies the persons who have the authority to approve each expense. If anyone else is approving the expenses, the approval power should be delegated to that person in writing. You should also confirm that whoever is approving the expenses is making a determination that the expenses are reasonable for what the plan is receiving. Failure to follow a proper approval process would be a fiduciary breach and, if the amounts are paid from an in-plan ERISA account, may also be prohibited transaction.

  • If amounts remain unused in an ERISA account at the end of the year, is the excess allocated to participants?

    The IRS plan qualification rules require that all amounts in a defined contribution plan like a 401(k) be allocated among participants at least annually. An unallocated amount in an in-plan ERISA account cannot be carried over from year to year. Your plan should provide how the unused portion of the ERISA account should be allocated at year end. Options include allocating it per capita or pro rata among the participants. The decision of the method to use involves fiduciary considerations that should be discussed with legal counsel.

  • Do you track and confirm that your ERISA budget was used as agreed?

    You should review at least annually a list of the ERISA budget payments, including the amount of the budget for the year and whether: (1) it was used in accordance with the agreement, (2) whether a proper process was followed for approval of expenses, and (3) whether unused amounts were properly allocated to participants at year end. Written plan records should reflect that this review was undertaken.
Once you can answer all of these questions appropriately, you can be comfortable that you have satisfied your fiduciary responsibilities with respect to revenue sharing generated by your 401(k) plan.

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