Why Fees Matter for 401(k) Plan Fiduciaries, But Not Defined Benefit Pension Plans
It's okay with the Department of Labor (DOL) if plan sponsors spend money foolishly on the administration and management of defined benefit pension plans. However, DOL balks at similar behavior for defined contribution plans. To understand the difference, let's look at who bears the risks in providing for plan participants' retirement.
Defined Benefit: Plan Sponsor Bears Risks
Plan sponsors more or less guarantee a predetermined benefit to participants in traditional pension plans. This is why they're called defined benefit (DB) plans. Whether plan sponsors spend wisely or foolishly on their plans, the sponsors are still on the hook for paying the agreed-upon pensions to their retirees.
For example, let's say a plan sponsor invests in a global index fund with an expense ratio of 2% instead of 1%. The additional 1% in expenses has no direct impact on plan participants' retirement income because participants' benefits are set independently of investment returns. Also, the extra 1% in expenses comes out of the plan sponsor's pockets, not the plan participants'. Pensions' investment portfolio assets belong to corporations, not employees. This contrasts with the situation for defined contribution plans.
Defined Contribution: Plan Sponsors "Off the Hook" for Benefit Level
Plan sponsors make no promises about the level of benefits that participants in defined contribution plans will receive. In fact, the only thing participants know for sure is what is contributed into their defined contribution (DC) plan. The plan sponsor isn't even required to contribute to participants' retirement. Moreover, in contrast to the DB situation, the assets in the DC plans don't belong to the corporation. They are held in trust for the benefit of the participants and their beneficiaries.
Here's why plan expenses matter in 401(k) plans: The level of portfolio returns will affect the participants' retirement income. Expenses—along with contributions and investment performance—are an important factor in long-term returns. Plan participants bear all of the risk if their portfolios don't return enough to provide the retirement income they anticipated.
Higher expenses mean lower returns. This is why DOL sets high standards for DC plan sponsors' expenses, yet pays little attention to expenses of their DB peers.
Duty of Loyalty AKA Exclusive Benefit Rule
Fiduciary duty aims to protect plan participants from the negative impact of high expenses paid out of their assets. It requires plan sponsors to act "…solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them." This is the Duty of Loyalty, also known as the Exclusive Benefit Rule. These tie in with the fiduciary duty to pay only plan expenses that are reasonable relative to services provided. The plan sponsor must document that services and expenses are reasonable.