Surviving a DOL Audit in a Post Fee Disclosure World

by | May 7, 2015 | Institutional Services


The Department of Labor (DOL) is moving into enforcement mode following a whole host of court rulings aimed at plan sponsors and plan providers regarding excess fees imbedded in 401(k) plans. This is a significant shift that all 401(k) plan sponsors need to anticipate. DOL auditors have added several very pointed questions to the list of items they request during “routine” audits they conduct. It is clear from reviewing these questions that they expect plan sponsors to demonstrate specific attention to these developments and have put in processes and procedures to ensure compliance.

Over the last several years a number of very high profile “excess fee” cases have wound their way through the courts, most, but not all, involving large 401(k) plan sponsors and brand name plan providers. Initially, the results have been mixed. In a few cases we saw the exoneration of the defendants, while others resulted in millions of dollars in awards to restore lost benefits due to excess fees. Now, with the DOL’s issuance of final regulations on fee disclosures that provide for very specific enforcement mechanisms, be warned, the DOL seem ready to act.

With that as background here are specific steps plan sponsors should take to survive a DOL plan audit in a post fee disclosure world.

Formalize a Plan Expense Policy

If it is not clear by now, running a 401(k) plan is not “free.” However, over the years the way plan sponsors have chosen to finance the services necessary to maintain a robust 401(k) plan has evolved, often by default. Historically, it was not unusual for the plan sponsor to directly pick up a large portion of the plan’s administrative expenses and have the plan pay for investment related expenses. Today, with the advent of revenue sharing payments made by investment products (see Understanding Revenue Sharing Arrangements below), direct payment of fees by plan sponsors has all but disappeared. This leaves the plan on the hook for covering the entire expense. A well thought out Plan Expense Policy formalizes this evolution and clearly states the plan sponsor’s intentions as to how and who will finance the plan’s operations. As long as the plan documents provide for it, it is perfectly legal to have the plan pay its own way (see Benchmarking Fees below), however, without a clear policy in place the plan sponsor could unwittingly be seen as self-dealing when negotiating fees with a plan service provider. This was the case with one of the aforementioned court cases, where direct payments were substituted with revenue sharing to the benefit of the plan sponsor. In short, plan sponsors need to step back and reassess this issue in a thoughtful, well documented way, such as through a detailed Plan Expense Policy.

Understanding Revenue Sharing Arrangements

A quick look at a menu of mutual funds offered by a typical 401(k) plan reveals an alphabet soup of different share class designations, from Class A to Class R to Class I, Y, and K shares. Often the same underlying fund will offer several different share classes from which to choose. This is often discussed in the context of retail vs. institutional share classes, though in truth, that distinction is no longer meaningful. The evolution of 401(k) plan expense financing, as discussed above, created this seemingly byzantine array of share classes to accommodate plans of various sizes and service needs. Unfortunately, it is up to the plan sponsor to understand and sort this out for their particular plan.

The fundamental difference between a fund’s various share classes is the amount of revenue sharing payments (12b-1 fees, shareholder service fees, sub transfer agency fees etc.) the fund will pay a third party service provider to perform marketing, administrative and transfer agency services on behalf of the fund out of its stated expense ratio. For example a fund with three available share classes may be structured like this:

Expense Ratio        Revenue Sharing Payments

ABC Fund Class A                 1.00                        0.50

ABC Fund Class R                  0.75                        0.25

ABC Fund Class I                   0.50                        0.00

So why would a plan choose a Class A Share over a Class I share when it is obvious that at the Class I share is less expensive? First, assuming that any chosen share class expense ratio is in line with the plan’s investment guidelines on monitoring fund expenses, the simple answer may be that the revenue required by the plan’s service providers is only supported by the use of the more expensive share class. Provided the Plan’s Expense Policy states that the plan will pay all its related expenses, the higher fee structure is justified. In reality, the analysis is made more complex. First, you must determine what the service provider’s revenue requirement is. Next, if the plan offers funds with different share class structures that all pay varying amounts in revenue sharing you must take that into account in meeting the service provider’s revenue needs. Further complications arise if there are investment minimums imposed by funds to access lower cost shares or if the recordkeeping platform used by the plan has other limitations.

Only with proper understanding and documentation of the service provider’s revenue requirements, the recordkeeping platform capabilities, and the available share class structures available to the plan, will plan sponsors be in a position to understand the options. Absent that, the courts and the DOL’s examination questions have seemed to create the default position that only the cheapest share class will do and it will be up to the plan sponsor to defend its decision to do anything different. Therefore it is imperative that plan sponsors can produce detailed documentation on why its plan owns the share classes it does.

Benchmarking Fees

Notwithstanding the discussions above, this is the most important step to take and document. It is exceedingly clear that the DOL expects plan sponsors to regularly monitor all the fees deducted, either directly or indirectly, from plan accounts and make a positive determination that the services the plan is paying for are necessary and the fees paid for such services are reasonable. In fact, under the final 408(b)(2) regulations issued in 2012, failure to do so results in a “prohibitive transaction” that would require that any paid fee deemed non-compliant would have to be restored to the plan, along with potential excise taxes. And because the regulations allow plan service providers to avoid such penalties by providing plan sponsors with mandated disclosures, it falls directly on the plan sponsor to show complete compliance. In fact it even imposes on the plan sponsor the burden of reporting non-compliant service providers in order to avoid culpability. In short, there is no way out of this. While there are a wide range of ways to comply, including a formal Request for Proposals, less formal Request for Information, more general plan benchmarking resources such as the 401(K) Averages Book or a detailed analysis provided by a qualified independent source, it is imperative that you decide on the appropriate approach and develop an ongoing policy for review as the plan’s size and needs change.

Manage Plan Expense Reimbursement Accounts Properly

One of the more recent developments in retirement plan pricing is the emergence of Plan Expense Reimbursement Accounts (PERA). Like mutual fund share classes, there are several names for these types of accounts and they are operated and structured in many different ways. Once only found in large 401(k) service arrangements, the use of these accounts has become more commonplace in all size plans.   A PERA is usually established as a result of a fee negotiation between the plan sponsor and the plan service provider. As described above, a plan service provider receiving revenue sharing payments may agree through negotiation to rebate all or a portion of those payments to the plan. This is commonly done after a plan benchmarking exercise determines that the amount of revenue received by the service provider exceeds a reasonable amount. In order to bring the arrangement into alignment, the excess is deposited into the PERA. Once the PERA is funded, the plan sponsor is responsible for directing the proper use of those assets, not unlike how plan sponsors administer the plan’s forfeiture account. However, unlike plan forfeiture account administration guidelines, current plan documents rarely make any mention of the existence of PERA-type accounts. This is where a properly drafted and implemented PERA Policy becomes essential.

The elements of such a policy will detail how the money deposited to the PERA will be used. For example it may say deposited monies will be used to defray other qualified expenses, such as annual audit fees, investment advisory fees, etc., or be reallocated back to participants. It will also define qualified expenses and specify the frequency and method of participant reallocation.

Summary – Proper Documentation is Essential

Proper documentation is the key to surviving a DOL audit in a post fee disclosure world. Plan sponsors need to demonstrate that they engaged in thoughtful and through review of their plan’s service provider arrangement(s) and have made a positive determination that the services provided are both necessary and reasonably priced based on the needs of the plan and it participants. Sponsors should also make clear that they understand and properly manage the plan expenses within the context of today’s complex plan pricing models, multiple share class options, and PERA accounts.

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