Troutman Sanders LLP: The Next Frontier in Fiduciary Oversight Litigation?

By Jonathan A. Kenter and Gail H. Cutler

In the latest of a series of high-profile class action suits against large 401(k) plans, ABB, Inc., a North Carolina power generation products manufacturer, and its 401(k) plan committees, were held jointly and severally liable, for a record $37 million in damages to the company's 401(k) plans on account of their payment of excessive record keeping and investment management fees [enhanced version available to lexis.com subscribers]. Although the size of the award has left many a plan fiduciary breathless, the lesson to be learned from this case is not all that complicated - monitor record keeping and investment management fees, negotiate for cheaper share classes and rebates where possible and ensure that fund selection/deselection complies with the plan's investment policy statement.

A significant issue raised but not resolved in the ABB case - a matter that may very well be the next frontier in fiduciary oversight litigation - is, whether the record keeping costs of a 401(k) plan may be borne exclusively by those participants whose investment funds enjoy revenue sharing (also known as 12b-1 fees) while participants whose accounts are invested in investment funds with no revenue sharing pay little or nothing.

As the record keeper for the ABB plans, Fidelity Management Trust Company was primarily compensated with "revenue sharing" from investment options available in the ABB plans' investment lineups. Investment companies sometimes pay a percentage of their revenue (usually 10 - 50 bps) directly to plan record keepers to maintain participant level records, or to an expense recapture account that the plan administrator uses to pay various expenses. Revenue sharing amounts differ by share class or collective trust agreement. The actively managed mutual funds in the ABB plans' investment lineups paid higher levels of revenue sharing than the passively managed index funds which paid little or no revenue sharing. Effectively, participants who invested their accounts exclusively in the passive or index funds paid little or nothing for recordkeeping while participants who invested their accounts in the plans' actively managed mutual funds bore the lion's share of the record keeping cost. Although this is a common practice among 401(k) plans it is vulnerable to attack. Here's why.

The use of revenue sharing to offset recordkeeping fees is not per se imprudent. Rather, plan fiduciaries who choose to utilize revenue sharing to pay for recordkeeping services, must confirm that revenue sharing is permitted under the plan documents and conduct a deliberative process for determining why such a choice is in the Plan's and participants' best interest. The court in ABB observed,

ABB fails to explain how it is prudent to require participants who chose managed funds, those that produce revenue sharing, to pay for the recordkeeping expenses of the participants who chose more conservative investments that did not produce revenue sharing.

From a fiduciary standpoint, allocating record keeping fees only to those who invest in actively managed funds would seem arbitrary, although this practice is common in the industry. Absent finding a justification for such a practice, plan fiduciaries should consider a variety of options in the allocation of record keeping expenses to participants, a few of which are listed below:

  1. Pro-rata allocation - under this approach, participants in all investment funds would share ratably in the cost of the record keeping fee. Any revenue sharing received could be credited back to the funds or participants as part of a periodic expense balancing true-up.
  2. Per capita allocation - under this approach, all participants would be charged a uniform record keeping fee. As above, any revenue sharing received would be periodically allocated ratably to all investment funds or participants.
  3. Combined pro-rata and per capita allocation - under this approach, all participants would be charged a record keeping fee comprised of uniform and variable components (e.g., $10 plus 20 bps per year, not to exceed an aggregate fee of say $90 per year).
  4. Hard wire the allocation method in the plan document - under this approach, removing the allocation of record keeping fees from the realm of fiduciary conduct, the plan sponsor, acting as settlor, would amend its plan document to provide that record keeping fees would be borne exclusively by those participants whose investment funds enjoy revenue sharing.

The Department of Labor ("DOL") in Field Assistance Bulletin FAB 2003-03 has offered that while in most cases a pro rata method of allocation on the basis of the assets in an account is equitable, a per capita method may also be reasonable for allocating certain fixed costs such as record keeping fees. Moreover, the DOL's new Participant-Level Fee Disclosure Rules which become effective as of August 1, 2012 require a quarterly statement that some of the plan's administrative expenses for the preceding quarter were paid from the total annual operating expenses of one or more of the plan's designated investment alternatives (e.g., through revenue sharing).

Planning Pointer: In this era of increased transparency, if your 401(k) plan's record keeping fees are borne disproportionately by those participants whose investment funds enjoy revenue sharing your plan committee should conduct a thorough review of how plan costs are allocated to participants, consider the options listed above (and any others that may be relevant), engage in a deliberative process, reach and implement its decision and maintain a robust paper trail. The same holds true when changes are made to a plan's investment line-up. Attorneys in the Troutman Sanders Employee Benefits and Executive Compensation Practice Group are available to assist 401(k) plan committees through this process which can only pay dividends down the road.

© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.

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