401(k) Double Dipping: 3 Ways Your 401(k) Plan is Double Dipping on Fees
Just like it's not cool to double dip your chip at the company pot luck, it's also not very cool when you find out you're paying a lot more in fees for your 401(k) than you were originally lead to believe.
So, is your 401(k) service provider double-dipping? Here are a few ways that service providers could be double-dipping on their fees at your expense and what actions you should take so you can be a retirement plan hero for your employees!
1. Proprietary Funds
The most obvious "double-dip" occurs when companies with their own mutual funds also offer a 401(k) product. Not only are they going to charge a fee for managing the 401(k) plan, they're also going to be collecting the investment management fees that are built into the mutual funds themselves.
This in and of itself is not that unreasonable, since they are in fact two different products. One of them is a vessel, the other is the fuel - the 401(k) is the truck and the mutual fund is the gasoline.
However, conflicts of interest start to develop once the 401(k) provider starts restricting access to investment options for plan sponsors. This can happen in one of two ways: either by severely limiting alternative options (i.e. competing funds) or by requiring/mandating the use of their own funds in some sort of ratio. By offering a reduced or "preferred" price to plan sponsors for their restricted platform - which the plan sponsor may not even know is restricted - the true intent is often times overlooked.
Propriety target date funds pose a conflict of interest in this scenario as well - especially during a transition from one 401(k) provider to another. Even without knowing anything about the new participants other than their age, a 401(k) provider does in fact know that a large amount of the participants that automatically transition to their target date funds - this is called "mapping" in 401(k) speak - will never move out of those funds after the transition.
One of the more noteworthy lawsuits regarding proprietary funds and self-dealing (which is discussed later), is the lawsuit that Fidelity settled in 2014. With their own employees. It's worth a read!
What can you do?
Fortunately for you, there are a number of things you can do to avoid being double dipped with proprietary funds:
Work with a provider that allows for "Open Architecture." That's a little industry jargon for having access to the entire universe of investment options. It's not that you're going to want to have that many options actually in your plan…you just shouldn't be restricted to one company's options, especially while taking care of your fiduciary responsibilities.
Make sure that you're being offered the lowest share class possible. What's a share class? Well, a mutual fund will have two to maybe even five "versions" of the same exact mutual fund. The difference is primarily the cost.
Lets say a mutual fund has three share classes: A, B, and I (for Institutional). One of the three versions - the I Share - has every extra cost stripped out, while the other two versions - the A and B Share - have imbedded costs that are typically used to pay the commission to a broker for making a sale.
An alternative to a single-mutual fund company's Target Date Funds would be a custom made modeled portfolio based on the diversified plan options already in place. There are providers that will offer to create these models for you and your plan - some for an additional cost and others may not charge anything. If that's not an option, at minimum, compare the default Target Date Fund to other TDFs and document that comparison! The default option may still be the better option, but at least you have something to substantiate your reasoning behind why you chose that TDF over another, instead of telling a regulator, "This was the only option they gave me."
2) Ancillary Service Offerings or Non-Core Business
Small businesses need reliable, efficient payroll systems to keep track of employee pay, tax information, and time tracking. They also need access to cash for a variety of reasons, whether they're just starting out or have been in business for many years. Both types of service providers though - payroll companies & banks that offer 401(k) products - are the culprits of double-dip #2.
Leveraging Your Data
Over 5 million businesses with less than 20 employees rely on some sort of payroll service to keep track of employee wages, deductions, and personnel. Even though a 401(k) is a seemingly natural product offering for a payroll provider, it can be a nightmare for someone in a fiduciary capacity that has to make decisions that are both a) in the best interest of the employees and b) best interest for the business.
It's a little bit of a process, but here's the scenario and the steps taken to where payroll providers do a full-court press to "Double Dip" on their fees.
Step 1: An existing small business owner client of the payroll provider is contacted by their payroll relationship manager to go over the existing contract for a review.
Step 2: When the payroll Relationship Manager shows up to the client's office, he or she brings along a guest - their 401(k) salesperson.
Step 3: In a tag team fashion, the payroll RM and 401(k) salesperson hard sell "401(k)/payroll integration."
Step 4: Typically with pre-filled paperwork, a contract is pushed in-front of the client with a feigned sense of urgency to sign it very quickly.
Step 5: After the contract is signed, the small business owner is transitioned over to a variety of different people, departments, and varying levels of service
Step 6: Fed up with the broken promises of the 401(k) salesperson or even the payroll relationship manager, the small business owner attempts to fire payroll or 401(k)
Step 7: The Double Dip
So, if the 401(k) is cancelled, an uptick in the payroll pricing can occur. It can go on for months unnoticed and when addressed as to the reason why the increase in price, the payroll company says it was because the client was receiving a preferential price for having multiple lines of their product (sort of like home and auto insurance).
However, the client had been paying the same amount for payroll prior to selecting their 401(k) option and it was never brought up in the sales process. Upset about price increase - which in many cases the client should have fired the payroll provider at the same time - the client is talked back into re-starting the 401(k) plan - possibly at no additional charge.
Clients that are maintaining a 401(k) and running a business are stuck in a very difficult place here, almost like a fiduciary purgatory, balancing their ability to manage the overhead expenses of their business (finding a cheaper payroll/401(k) provider) yet they could run into trouble with their 401(k) if a decision to choose a particular provider was based on "getting a better deal on their payroll" instead of a more deliberate process.
Jack of All Trades Master of None…Except Money.
Banks find ways to make money - even if you have none. In 2012, $32 billion - yes billion - was made by U.S. banks in overdraft fees alone. But how are they making sure to keep their ancillary business lines profitable? Well, similar to what payroll providers do - subsidize costs or at least imply that the costs are subsidized - to ensure clients continue to use their mainstay service: lending money.
"Wait, so the banks are lending 401(k) plans money?"
No, but they do lend money to clients that need capital funding for business operations.
And clients that borrow money are using the bank's proprietary 401(k) product or a white-labeled version - which is basically paying another 401(k) provider to use their product as though it were their own, typically paid for at a premium.
Clients that utilize the bank's 401(k) product and do their normal banking (beyond basic checking/savings accounts) have at times been handcuffed from leaving the 401(k) relationship, due in part to a preferential lending rate because of the 401(k) business itself.
Now, since I am not an attorney, I'm not speaking to the legality of this type of scenario. What I am trying to point out, is that it's at LEAST pretty darn shady and like the payroll providers, this is another outside influence that may not necessarily be in the best interest of the plan.
What can you do?
Make sure that the costs for your services are transparent, easy to understand, and accurately accounted for. What I mean by the last statement, is that you should be paying for the 401(k) service separately from the payroll service and the payroll service should not be subsidized with plan based fees.
Anything beyond that, if you feel pressured or uncomfortable, don't hesitate to take your business elsewhere. It's not worth the stress or the fiduciary risk.
There are exceptions to the rule. Since major payroll providers top the list when it comes to the number of 401(k) plans they control - as you can see from this 2016 survey, two of the top three volume producers are payroll companies - the law of large numbers suggests there may be a few good apples amongst the rest.
Building a relationship with a bank is tough; it takes time, effort and trust, so I definitely don't take this subject lightly. However, it may be a good idea to have more than just one banking relationship when it comes to how you secure funding, especially if you're using the 401(k) platform from the same bank.
If pricing of the 401(k) is discounted, make sure that it is in good faith and not contingent on how or what your company is able to borrow from the bank for your normal business operations.
3) Portfolio Management:
Investment Advice and Investment Education are two different things….technically. One is specific and personalized, the other is general, informative, and instructive. However, it's still a pretty confusing statement. One person's interpretation of education is different from the next person's.
A prohibited transaction is where a plan fiduciary - a trustee, plan sponsor, advisor…basically anyone with authority on the plan - is involved in a transaction that effectively takes advantage of their position or role for their own gain. Self-dealing is a prohibited transaction. In the case of 401(k) plans, providing advice to participants compared to educating participants, can have serious implications for both the advisor and the plan itself.
When advisors are providing guidance to the plan sponsor by helping them make investment selections, monitoring the investments, or recommending fund line-up changes, whether they acknowledge it or not, they are acting in a fiduciary capacity.
Most of the time they are also going to be helping the employees with the 401(k) as well - it makes sense and there's nothing inherently wrong when doing that, except that the advisor can't be "self-dealing."
A self-dealing fiduciary would trigger a prohibited transaction - this scenario is why there has been so much push back from the financial services industry. A prohibited transaction can disqualify an entire 401(k) plan, meaning the government would take away the tax benefits that are associated with the assets in that plan.
Many firms - too many firms actually - already try to do everything in their power to make sure their Registered Representatives do NOT become fiduciaries…basically so the prohibited transaction rule wont apply to them and they can effectively self deal!
Double Dipping on Model Portfolios
Model portfolios are fantastic - they can make the investment process more efficient for an advisor and more enjoyable for a participant. A modeled portfolio is a prepackaged group of funds created from the underlying fund lineup. Categorized based on risk level, there are usually anywhere from 5 to 10 different models, all with varying levels of equity and bond exposure.
This is probably the trickiest of the Double Dips to spot because a) it's another that has a couple layers to it and b) it can seem very benign. Sometimes the model portfolios within the 401(k) plan themselves have their own ADDITIONAL fee, on top of the plan advisory fee. Again, charging an advisory fee to the plan for the services outside of investment management…fine. The value is substantiated. Charging a fee for creating, selecting, and monitoring the model portfolios…also fine.
As long as the fees/services are line-itemed, charging for both services is still acceptable. However, there can be a large gap in transparency, especially if employers are paying 100% of the plan advisory fee - which would not show up on a participant statement - while the participants are paying for the investment management fee for the models.
It's a tactic some firms have used to artificially reduce fees on the surface, knowing that they can expect XX number of participants to select the models. If they increase the fee within the models, it will offset the reduction they gave to the plan sponsor itself. But the issue is when the participants are directed to the model portfolios by the advisory firm providing "education." Even though the advisory firm calls it education, the models were created specifically for individuals with a particular risk tolerance and that's where the self-dealing comes in, unbeknownst to plan sponsors and participants.
Coming full circle though, this is where Advice and Education is so important - since there is an additional fee being charged favors the advisor or advisory firm, the advisor can NOT direct people to use the model portfolios in this case. This is self-dealing; in some cases, the advisors themselves don't realize what they are doing, let alone the plan participants. Especially if an inexperienced member of the advisory firm may not know the full details of the plan or potential issues pertaining to the modeled portfolios. Even if the advisor was providing "general education," the education could be considered advice by the participants and cause some issues.
Double Dip In Action - An Example
Let's take a look at an example where a self-dealing scenario might take place. We have two firms competing to become the 401(k) plan advisor for a company that has $5,000,000 of assets in the plan.
The current firm or advisor is Company A; Company B is the competitor who got the attention of the CFO based on a lower price. Both companies offer similar services, including investment management. Their investment management styles are even similar. However, Company B separates the investment management fee out from the plan advisory fee.
Both companies are paid according to the Assets Under Management (AUM) charged directly to the client's business account but since Company B charges the investment management fee separate, that is directed towards participants.
Company A charges 50 basis points (or bps, pronounced BIPS) which comes out to $25,000. This includes everything from investment management, creating model portfolios, and education meetings for employees.
Company B charges 25 bps or $12,500. This includes all the services to the plan, expect investment management of the model portfolios. For the portfolios they create, they charge a 1.00% fee to any participant utilizing a portfolio.
After a number of discussions, the CFO's choice to reduce the businesses expense for the 401(k) by 50% is approved by the board and Company B wins the bid.
Company A appreciated the opportunity they gave them over the years, no feelings were not hurt, and no bridges were burned. Company A takes the defeat graciously and does not advertise their distain for Company B as they respected their practice.
Once Company B is introduced, they begin to talk about how great their portfolios are and how easy it is for participants to use them, since all they have to do is check a box to sign up. Before you know it, by the end of the year, Company B has 75% of the assets in their models because of the "education" campaign they used to promote the model portfolios directly to participants.
Here's what the Double Dip looks like in action -->
A. Old Advisor Fee Collected by Company A: $25,000 = ($5,000,000*.005)
B. New Advisor Fee Collected by Company B: $50,000 = $12,500 + $37,500 or ($5,000,000*.0025) + ($3,750,000*.01)
C. Participants go from paying zero dollars for their model portfolios and the business reduced their own costs by 50% at the same time
D. Company B promotes, advertises, and encourages participants to use the model portfolios
The facts A-C alone don't make this a bad or wrong choice - in-fact it still can be a win-win situation for clients and participants as long as there is an understanding of ALL the rules that are in place to protect participants of the plan.
What it comes down to, is the final piece: Company B was a fiduciary to the entire plan, not JUST the investments. Company B's intent was to use the 401(k) plan for their own self dealing by offering a "sweetheart" deal for the business, knowing they (Company B) would have virtually unfettered access to drive participants into the model portfolios.
As odd as it sounds, if Company B was hired only to provide the investment management and the portfolios, then they actually could promote the use of their models in the 401(k) plan. The business would still have had a fiduciary obligation to monitor Company B in this case but it can be much more manageable than doing the investment due diligence on their own.
What should you do?
First, check to see if you even have modeled portfolios. If that is the case, make sure any fees or expense information is accurate and current.
Have an evaluation process in place to compare advisory firms that use model portfolios. Now, that doesn't mean pick the firm that looks like it has the best returns - remember that's looking in the rear view mirror and we want to be looking out the windshield to where we are going. Instead, ask questions about their own process or philosophy.
All year long and through the fall, the Fiduciary Rule had been talked about extensively. It was going to have a positive impact on plans in general, but more so it may have been able to help with the issues discussed here. Now that "The Donald" is going to be taking over the White House soon, the Fiduciary Rule in it's current state may not even come to fruition.
Either way, if you're working with a firm or a provider that claims they are a fiduciary - and will also confirm that in writing - that's going to put you in a much better position than anything to make sure you're not paying twice for the same service to your 401(k) provider!
So do you think you've been double dipped? How transparent are the fees being charged to your plan - for you or your participants?