The Fiduciary Duty to Keep the Fox Out of The Hen House - Part 1


We come across many plans that have serious conflicts of interest which are often the result of undisclosed affiliations or compensation arrangements.  In many cases, the conflicts are fairly easy to identify, for instance, when uneven compensation in the form of 12b-1 fees is received by a non-fiduciary advisor, broker or consultant to the plan (in other words, a financial salesperson.)

However, we often come across plan sponsors who rely directly on the investment recommendations of non-fiduciary plan providers (usually mutual fund companies who have a 401(k) platform or product) without the services of a true fiduciary advisor.  All too often, these plan sponsors fail to see how biased these providers are in terms of recommending/designing a fund lineup for a plan and struggle to grasp their responsibility to identify and eliminate these conflicts.

Stepping back for a moment to provide context, most large mutual fund companies recognized many years ago that developing a 401(k) "product" was a great distribution mechanism for driving assets into their proprietary funds.  Over the past 10 years or so the idea of "open architecture" has taken hold and most of these fund companies have realized that a completely proprietary platform inhibits their ability to compete and led them to enter into "selling agreements" with other mutual fund companies to provide the appearance of more choice.

Now think about the financial implications of these arrangements for a moment.  Fund Company A wants money invested in their proprietary funds.  However, to compete more effectively, they enter into an agreement with Fund Company B to allow plan participants to redirect assets away from Fund Company A, meaning a loss of revenue.  Hence, the creation of "revenue sharing" arrangements, whereby, Fund Company B pays Fund Company A a portion of their compensation for the opportunity to gain access to Fund Company A's retirement plan participants (i.e. "paying for shelf space").  Although Fund Company A makes less revenue in this arrangement than they would if money flowed solely into their proprietary funds, at least something is better than nothing.  

Thus, we have conflict of interest #1 - Fund Company A would prefer more money be invested in their own funds than in Fund Company B's because they make more money.  As a result, Fund Company A may impose a certain number of proprietary funds be utilized in these cases in order to protect their margins or influence the inclusion of their own funds.

It also stands to reason that Fund Company A will not enter into any type of selling agreement with another fund provider who is unwilling to share revenue.  In addition, Fund Company A will reduce or limit access to most passive or index funds because these low-cost options, rarely pay any type of revenue sharing.

Thus, we have conflict of interest #2 - Fund Company A will only provide access to non-proprietary funds that "pay-to-play" which usually means actively managed funds.

So now that we have a contextual backdrop, let's discuss how the vast majority of mutual fund 401(k) providers "advise" plan sponsors who desire investment recommendations.

Assume the plan sponsor has a $20 million plan with 400 participants and is evaluating Fund Company A (among others) for providing 401(k) services.  Fund Company A determines internally that their "required revenue" to recordkeep/administer this plan is approximately $70,000 or the equivalent of $175 per participant.  As a point of reference, Fund Company A never discloses this revenue target to the plan sponsor who, in turn, doesn't even know to ask for this number.  Fund Company A knows that telling the plan sponsor to write a check for $70,000 would make them "appear" much more expensive than their competitors and likely result in a lost opportunity.  Therefore, Fund Company A proposes a $20,000 "billable" or "hard dollar" fee for recordkeeping and administration services.  The plan sponsor believes this to be the true cost for operating the plan and agrees this is a reasonable expense.  However, internally Fund Company A's finance group tells the administration and sales teams that the plan needs to generate an additional $50,000 in revenue to be profitable.  

During the sales process the plan sponsor asks whether Fund Company A has investment consulting resources and capabilities to aid in selecting the fund lineup.  "Why of course," says the sales team, "we have a team of over 100 investment professionals who can help you."  The plan sponsor asks Fund Company A's investment team to recommend a proposed lineup.  The investment team then works in conjunction with the sales and finance teams to generate a proposed fund line-up made up of multiple fund families for the appearance of "open architecture." As a value-add, the sales team even gives the plan sponsor a "boilerplate" investment policy statement (IPS) to put in their file (if they keep one) because it's a fiduciary "best practice."

The fund lineup includes 1-2 index funds for appearance sake as well.  All the funds (both proprietary and non-proprietary) pay revenue sharing of .25% to the administration group, with the exception of the index funds which contribute no revenue sharing.  The plan sponsor agrees to this fund lineup and in the conversion process, the plan assets are all mapped into the funds that pay revenue sharing and, although participants are free to move their money into the index options, most do not.  Therefore, the $20 million flows into funds that pay .25% or the equivalent of the $50,000 per year which meets the revenue requirement.  Even better, since this revenue sharing is asset-based, over time the administration group has a nice little growing stream of revenue without having to ask for it, even though their services are participant-driven functions and the amount of assets should have no bearing. When the plan grows to $30 million, the administration group now receives $75,000 per year in asset-based revenue, which, when combined with the $20,000 billable fee means that the same recordkeeping and administrative functions cost the equivalent of $237.50 per participant (roughly a 35% increase.)

And now everybody's happy and although the plan sponsor has no clue this is actually how the process worked they feel pretty good about themselves and their efforts, can "set it and forget" and move on to more important things since the 401(k) plan is not a key business driver anyway.  To a certain degree it's hard to blame the plan sponsor for not knowing how the system works although the courts and the Department of Labor don't generally accept the "I didn't know" defense.  This perfectly illustrates why American workers need meaningful, accurate and easy-to-understand fee disclosure from the retirement plan industry (despite the strong efforts of many service providers who fight against it.)

And there you have the "unbiased" perspective of Fund Company A and clearly an excellent way to develop an investment policy for the plan, right?  Stay tuned for Part 2 where I contrast this approach with a more sound fiduciary process the plan sponsor should have followed, rather than allowing the proverbial "fox into the hen house."

Click here to read Part 2.