Most companies recognize the benefit of offering a 401(k) plan to help retain and attract quality employees. And many of those companies also recognize the risks associated with such plans, and look to outside resources to help manage the plan. But selecting the right advisor and understanding their fee structures can sometimes be as complicated as deciphering the regulations put forth by the Department of Labor.

So, what questions should you be asking plan advisors?

How much would they charge to manage your plan? Are they fee-based, or do they collect 12b-1 commissions from the mutual funds in the plan? Is their fee entirely asset-based or is there a hard dollar component?

Knowing the answer to these questions is crucial to your role as a plan fiduciary. In fact, as part of the recently enacted fee disclosure regulations — 408(b)2 — plan fiduciaries have an obligation to determine if the fees they are paying to service providers are reasonable. It stands to reason that if you don’t know what those fees are, or how they are calculated, then you can’t really determine if they are reasonable.

In the early days of 401(k) plans, just about every plan available was commission based. A broker would sell a plan to a client, and then would collect the 12b-1 fees on the mutual funds inside the plan. This was known as a “trail commission.” The larger the plan grew, the larger the commission checks grew. If your company’s 401(k) plan grew rapidly from $2 million in assets to $4 million in assets thanks to a great stock market, would your broker deserve a 100% raise?

What if some of the funds in the plan pay different amounts of 12b-1 commissions? Would your broker be incentivized to steer employees into funds that pay the broker higher commissions? It is easy to see the potential for conflict in situations like this.

Such situations can be remedied by working with a fee-based advisor. Fee-based advisors generally charge a flat rate (asset based, hard dollar, or combination) across the entire plan, regardless of the mutual fund options available. This creates a conflict free environment and ensures that your employees can get unbiased advice. And, if you are looking for an advisor that provides 3(38) fiduciary protection, such services are not provided from a commission-based advisor.

And, finally, what is a reasonable rate for an advisor to charge? The DOL does not define “reasonable.” So, it becomes the responsibility of the plan sponsor to evaluate the entire scope of the services offered by the advisor, and to document the process that led to any conclusions.

Over the past decade, Target Date Funds (TDFs) have become the “go-to” investment for 401k retirement plans. Currently, there are over $500 billion in assets in TDFs, and more than 40% of 401(k) plan participants are invested in them. Often, they are sold as a “one-size-fits-all” solution, but are they right for you and your participants?

It’s easy to see the attraction to TDFs. Most participants left to their own devices are usually unskilled at creating their own investment portfolios. TDFs provide a simple solution to give them access to a diversified portfolio of funds. But since the market meltdown of 2008, they have received increased scrutiny from the Department of Labor (DOL), and plan sponsors alike.

In 2008, the most conservative TDF options lost between 3.5% and 41% of their value. How could a fund designed for someone retiring in a couple of years possibly lose 41%? That was the question everyone was asking. The answer was simple: A 2010 fund (the most conservative option in 2008) from one mutual company was very different from a 2010 fund from another mutual fund company. Equity allocations in these funds ranged from 20% to over 50%. There is no standardization when it comes to equity and fixed income allocations in these TDFs.

Target Date Funds generally fall into two categories—those that manage their asset allocation strategies in a “To Retirement” manner, and those that manage “Through Retirement.” Depending upon which strategy your TDF manager uses, the equity allocation at retirement can vary widely. In addition, each TDF manager has his own glide path. The glide path is how the fund manager changes the mix of stocks and bonds as the fund gets closer to retirement age. This can have a dramatic effect on the amount of risk a TDF takes on as your employees get older and closer to retirement.

One other drawback of target date funds is that most of them do not take risk into consideration. They assume that two people who are the same age should invest in the same portfolio. In our experience, risk tolerance is very diverse even among participants of the same age.

So, given the popularity of TDFs in 401(k) plans, and acknowledging that they will continue to attract millions of dollars in new assets, what is the best course of action for you as a plan fiduciary?

First, consider whether TDFs are right for you and your employees. There are other options available, and having customized, risk-based portfolios built for each individual may be the best choice.

If you decide that you want to invest in TDFs, you have to figure out which suite of TDFs is right for you and your employee base. Some questions to answer beforehand include:

• What is the investment sophistication level of your employees?
• Is your plan generous with matching and profit sharing contributions?
• What is the average age and salary of your employees?
• Does your Investment Policy Statement include criteria for selection and monitoring of TDFs?
• Did you merely accept the TDFs that your record keeper offered you?
• Answering these questions will help you better evaluate which target date funds are appropriate. If you do not perform a due diligence process of evaluating the different TDF suites available, some serious consequences can arise.

While Target Date Funds are often marketed as one-size-fits-all or as a set-it-and-forget-it solution for participants, they also require more oversight from you as a plan fiduciary. In the end, a custom model designed around your specific needs and managed by a 3(38) fiduciary can yield better results with less liability.

The Department of Labor’s 408(b)2 fee disclosure regulations went into effect July 1, 2012. As a requirement under these regulations, plan sponsors were supposed to receive notices from all covered service providers (CSPs) detailing services provided, fees charged and any potential conflicts of interest. These regulations apply to ERISA defined contribution and defined benefit plans.

A CSP is a provider that expects to receive at least $1000 in direct or indirect compensation for services provided to the plan. One of the purposes of this regulation was to help plan sponsors assess whether the fees they were paying for certain services were reasonable. You can find more detail on the regulation on the DOL website (www.dol.gov).

Unfortunately, there was no standardization of the format for these 408(b)2 disclosure notices resulting in extremely confusing information for even well-informed plan sponsors. As a result, the DOL has recently proposed a follow up guide to be issued with disclosures that would summarize or help explain the disclosures from service providers. That proposal has not been finalized as of April 2014, but RPS will continue to monitor its progress and keep our clients informed of any notable news.

In addition to making sure notices are received from ALL covered service providers, there is an inherent obligation on the plan sponsor to actually do something with these notices. In the event of a DOL audit, you will likely be asked what you did with the notices you received. So, just filing them away is not a good strategy. How do you determine if, indeed, the fees you are paying for services are reasonable? Did you address any potential conflicts of interest? What was the process you employed to determine this? Is it documented? A good advisor will help walk you through this process.

The failure to provide these disclosure notices can result in the arrangement becoming a prohibited transaction for the advisor or service provider. If you as the plan sponsor did not receive a disclosure from a CSP, this, too, can result in a prohibited transaction unless you take action to contact the service provider(s) and request the missing disclosures. Then you will have to evaluate whether they meet the requirements of the regulations. If a service provider does not comply within 90 days, you must inform the DOL and terminate that relationship.

The 408(b)2 fee disclosure regulations were certainly established to bring clarity to the issue of 401k plan fees. However, many plan sponsors we have talked to still don’t understand the amount or structure of the fees involved with their plan. That’s when having a 3(38) fiduciary on your side to ensure transparency can really provide a benefit to you and your employees.

Within any discussion about fiduciary protection, it’s important to first identify and understand the different fiduciary roles present in a retirement plan. Under the Employee Retirement Income and Security Act of 1974 (ERISA), fiduciaries are either named in the plan document, or identified due to the functions or activities they perform with regards to the 401k plan. There are three types of fiduciaries: 3(16), 3(21) and 3(38).

Typically, the plan sponsor is the named fiduciary in the plan document. That person is normally identified as the plan administrator and has general responsibility for oversight and administration of the plan. These functions generally fall under the 3(16) fiduciary’s authority. Other fiduciaries would include anyone who exercises control or discretion over plan assets, plan management or plan administration. However, It’s the control or discretion over plan assets and the roles of 3(21) and 3(38) fiduciaries that are the focus of this article.

Generally speaking, a 3(21) investment fiduciary provides some general process control and oversight over the screening, selection, and ongoing monitoring of investments in the plan. However, even when your advisor or service provider is a 3(21), the plan sponsor still has the final say (and responsibility) in choosing the investments. In contrast, a 3(38) investment fiduciary has discretion over the fund lineup, and ultimately takes responsibility for those choices. A plan sponsor usually is not liable for the 3(38) fiduciary’s acts or omissions, but they are responsible for selecting and monitoring the 3(38).

Most plan sponsors do not have expertise in exercising discretion or control of investments. However, absent an advisor who fills that role for them, the fiduciary responsibility for selecting and monitoring investments falls solely on the plan sponsor. Many plan sponsors I have met are either unaware of this potential liability, or believe that their record keeper/TPA (third-party administrator) is assuming that role for them. In some cases, the record keeper can act as an investment fiduciary. If so, it should be specified in the contract with that provider.

Many 401k plans are sold to employers through brokers who either cannot or will not serve in a fiduciary capacity. In these instances, plan sponsors routinely assume that the broker is a fiduciary, when in reality, they are simply a service provider. The result is that the responsibility for selecting and monitoring investments in the plan falls back on the plan sponsor.

That is why you should make sure your service providers or brokers/advisors identify their roles to you in writing. This will help you determine if you are receiving proper fiduciary protection, and will also help you determine if your advisor is acting in a 3(21) or 3(38) fiduciary capacity. And since plan sponsors can be held personally liable for fiduciary breeches in the retirement plan, this is not something you want left to chance or guesswork.

I recently attended a session at an industry conference on the topic of lowering costs in 401(k) plans. This intrigued me, as I have a vested interest in making the plans that I advise as cost effective as possible. With all of the opportunities to add value to retirement plans by focusing on ideas like fee transparency and share class analysis, I was surprised to find this session solely focused on the use of an index strategy as a way to cut cost. The pitch to the broker community was that this is a good way to make your imbedded fee look more reasonable.

As the presenter honestly admitted, the main reason these index funds are being pitched to plans are the low cost feature, not the net value. In fact, net investment return as a benefit to the investor was never mentioned in the hour-long session. The focus of the argument was how to win business with a “low-cost plan”.

Since that session, I have read many articles and pitch sheets on using low-cost index strategies in 401(k) plans to lower overall participant costs. While it is true that cutting management fees for equity mutual funds from an average of 1.00% to 0.25% will lower the cost burden for participants, what happens to the performance net of these fees? A goal of a fiduciary is to provide plan participants with the best opportunity to invest wisely and successfully. Often, index funds do not accomplish this goal.

Most mutual funds present historical return data net of fees. This helps make the decision easier when selecting a strategy. If you are presented with large-cap domestic stock fund that out-performed it’s best fit index consistently over time, net of fees, how could you exclude it from your lineup? If the index fund out-performed most actively managed funds in its category, net of fees, you would be compelled to make it available to participants. What you need is the skill to examine the active and passive alternatives for each investment category.

Morningstar, the leading mutual fund reporting agency, shows 75% of actively managed domestic large cap stock funds are currently under-performing the large-cap index for the 5-year annual return. On the other hand, 70% of actively managed domestic small-cap stock mutual funds are out-performing their best fit index. The results of this study do not necessarily mean you should index large cap and choose active funds for small cap. Within each investment style there are different strategies and levels of risk. Understanding how to determine net of cost value by including risk and return metrics is critical in the practice of building an effective 401(k) plan lineup.

Another consideration is the investment knowledge level of your employee base. One benefit of many actively managed funds is they have a skilled manager that can evaluate ever-changing economic, geo-political and market environments and use this knowledge to the benefit of the investor. The passive strategy simply invests in the entire market without regard to any of the data mentioned above. Do your participants have the knowledge themselves or the expert support to adjust their investment allocation amongst market cap and investment style?

Controlling plan costs should be a top priority for you, as a plan fiduciary, and there could be opportunities to reduce costs of plan investments without sacrificing the benefits of an active strategy. Many funds offer lower cost share class, depending on plan size and other considerations. Your investment choices could also include fees that are used to offset service provider costs or pay your broker, called 12b-1 fees. You should work with your service provider and advisor to evaluate these fees to determine if they are truly necessary.

I believe this trend to make a sweeping change in 401(k) lineups to include only index funds for cost reduction is misguided. Index funds may have a place in your plan lineup, and the fact that they cost less is attractive, but it is only the start of the analysis. If your goal is to provide your plan participants with investment choices that will give them the best chance to retire on time and financially secure, you must consider returns net of fees, risk compared to the index, and the ability of the manager to make sound investment decisions in changing environments.

– Are auto features right for your 401(k) plan?

– Are your company’s retirement plan fees shared equally?

– How do I recognize, and avoid, key risks associated with my company’s 401(k) plan?

– Are target date funds the answer for 401(k) success?

– How can you improve your employees’ chances for a financially secure retirement?