As Nevin Adams on NAPA.net wrote about a few weeks ago in his article “Excessive Fee Suit Comes From a New Direction,” an excessive fee lawsuit was filed in Colorado on behalf of a participant whose company 401(k) plan’s recordkeeper and investment platform was Vanguard Group Inc. Yes, you read that correctly, Vanguard. For those of you who know a bit about investing, Vanguard is almost synonymous with low cost. So how is it that they found themselves the defendants in a fee lawsuit? It all comes down to share class.
Share class questions
In the 401(k) world of investing there are often one or two letters or numbers that follow the name of the investments that are meant to distinguish the internal expenses of the investment. They include (but are not limited to) all of the following: A, I, K, Y, R1, R2, R3, R4, R5, R6, Z, Adm, Instl, and Srv. Confused? Of course you are because it is confusing and pretty much meaningless to the average investor. A, for instance, typically indicates that the investment will pay the investment adviser a commission of 0.25%; whereas, R6 usually has no commissions built into the investment. To add to the confusion, there are also internal investment expenses that compensate the recordkeepers for maintaining participant records. In the case of the Vanguard complaint, the plaintiff claims he was overcharged because there were lower cost share class options available for the same investment. This is very common; where the same investment has multiple share classes all with different internal expenses and therefore different total expense ratios.
Why does it matter?
The simplest reason for why it matters is that every dollar you and your plan participants pay in fees and/or expenses is one less dollar that goes to retirement savings. Why regulators and attorneys care is much more complex. It has been common practice for plan advisors and plan providers to use the internal investment fees to completely pay for or to subsidize the cost of providing advice or administrative services to the plan; creating what the industry sold as a “free plan” or one where there was not a billable expense to the plan sponsor because all fees were covered by the investment revenue sharing. This is not necessarily wrong or a bad practice and in some cases it can be shown that it actually creates a lower overall cost to the plan to use investments that carry a higher expense ratio, but completely pay for plan expenses. However, this approach carries with it the potential for confusion and complaints for a couple of reasons. First, as plan assets grow the cost to operate the plan will also increase as much if not more right along with it. As noted in the Vanguard complaint, the plaintiff’s attorney claims that between 2012 and 2015 plan assets increased by 40.5%, but the direct compensation paid to Vanguard more than doubled. Second, the fact of the matter is that if your plan is using a share class that has internal fees, there is a chance there are lower cost investment options out there and the trend in the market today is to use those lower cost options. In many cases, the same investment will have multiple share classes and your plan may be able to keep the same investments and just change the share class.
What to do from here?
Document, document, document! Again, it is not necessarily wrong to use the investments with the built-in fees, but your plan needs to be able to show why those investments were selected and how they were monitored. Additionally, challenge your plan providers to investigate whether it would be more cost efficient to use a non-revenue sharing investment and bill for their fees. The common misconception with billable fees is that it is going to be a cost to the company, but in reality the billable fees can be paid in much the same way as revenue sharing was done, through participant accounts. Also, when you have a better understanding of what everyone is being paid, there may be a better opportunity to negotiate fees.
If you would like to discuss how share classes may affect your plan, please give me a call at 205-970-9088 or email me at email@example.com.