Mailbag; What about Hedge Fund companies using their own hedge funds in their own 401(k) Plan?

Occasionally, we will receive a reader question that requires a little digging into.  When we get one like this, we feel like we should put it up for all to see.

Question from Steve: We have a client who is the CFO of a Hedge Fund company.  100% of their employer match is being automatically put into their own hedge fund.  We believe that this presents a real fiduciary risk for our client, but I was hoping you could site a lawsuit or DOL guidance?

Our Response:  Steve, there are several situations that I think apply to this directly, and specifically with regard to hedge funds.  The first issue is a recent case, Sulyma vs. Intel; reference article here Former Employee Sues Intel Over Hedge Fund.  This lawsuit is ongoing and only alleges imprudent investing in hedge funds meaning that it does not allege a conflict of interest which would be a violation of duty of loyalty to the participants (ERISA §404(a)).  I believe your group would have both the imprudent investing problem as well as a conflict of interest; a possible Self-Dealing violation of ERISA §406(b). So they would be potentially violating two sections of ERISA §404(a) and have a non-exempt Prohibited Transaction under §406(b)(2).

ERISA § 404(a)(1) to act solely in the interest of the participants and beneficiaries of the plans they serve and “(A) for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan” and (B) to discharge their duties “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

In the Intel lawsuit it almost implies that a plan can never invest outside of the current norm (Modern Portfolio Theory, “normal” asset classes, etc.).  So the question is: “How does innovation occur in the prudent world of ERISA plans?”  This is something the industry will have to address at some point.

I also wanted to dig into whether or not there would/could be a Prohibited Transaction Exemption (PTE) for this.  For example, there are PTEs for mutual fund companies selecting their own funds for their employees 401(k) Plan.  Actually American Express tried to cite this PTE when they were sued a few years ago by their employees and when ruled they didn't meet the PTE, Amex settled the case for $15m.  Not to be too technical here but I don't think many of the PT exemptions (listed below) are going to be available to this group.  As mentioned, there is, in fact, a DOL opinion that deals with mutual funds, but, because the hedge fund is specifically not a registered investment company under the Investment Company Act of 1940, I believe they have much less room to act.

The potential conflicts of interest that could arise are numerous.  Here’s just a few.  Are they receiving any fees? Are the plan assets giving them some kind of economy of scale? Are the plan assets used as seed money for a new fund?  Here is full piece on the matter published by Groom Law Group, but the excerpt I clipped out below is what’s applicable.  See the yellow highlighted area.

http://www.groom.com/media/publication/145_erisa_for_security.pdf

Investing Plan Assets in Proprietary Mutual Funds. To the extent that a plan fiduciary also serves as investment adviser to a registered, open-end investment company, the fiduciary’s investment of plan assets in the mutual fund may involve one or more fiduciary conflicts. PTE 77-4 (for client plans) and PTE 77-3 (for the fiduciary’s own, in-house, plans) provide relief for such investments provided that certain conditions are satisfied, including disclosure and consent, and taking steps to avoid double fees. Similar relief is granted under PTE 79-13 for in-house plans of closed-end investment companies (but not for client plans, which effectively prevents most registered hedge fund managers from relying on these exemptions). PTE 84-24 also exempts, among other things, a plan’s investment in a mutual fund where the fund’s adviser or principal underwriter is also a directed trustee, prototype plan sponsor, or other service provider with respect to a plan (but not a discretionary investment manager or trustee, nor the plan sponsor), where an

affiliate of the fund’s adviser or principal underwriter will receive a sales commission with respect to the transaction. For this purpose, sales commissions generally include 12b-1 distribution fees. The PTE does not explicitly authorize the receipt of fund-level advisory and other fees (in contrast to PTEs 77-3 and 77-4), though it appears to do so implicitly. (Note that PTE 84-24 is not limited to the marketing of proprietary funds, though it is often used for that purpose.)

Steve, thank you for the excellent question and the chance to flex our research muscles.

- Jason Grantz

 

Revenue Sharing - What's the right way to apply it in a 401(k) Plan?

In order to understand the question of how to apply Revenue Sharing in a 401(k) plan, it begs explanation as to what Revenue Sharing really is, what form it takes and how it's commonly applied.  In short, revenue sharing typically takes the form of basis points (bps) built into the underlying expense ratio of certain mutual funds, collective investment funds or annuity sub-accounts (referred to herein as "funds").  Not every fund has revenue sharing, but many do.  

Ex.) The Vanguard S&P 500 Index Admiral Share Class (VFIAX) costs 0.05%.  There isn't any revenue sharing in this fund.  Whereas, the Dodge & Cox Income fund (DODIX) costs 0.43%, but contains 0.08% (8 bps) of revenue sharing, making the underlying net expenses, 0.35%. 

Both of these funds are considered very good or excellent by most methods of evaluation, yet one has excess revenue built into it and one does not.  So what is this revenue?  Why is it there? What should a plan trustee do with it since it is a plan asset?

Revenue sharing came about as an industry concern as technology advanced in the late 1990's.  It comes in various forms or names.  Some of these names are Sub Transfer Agency (Sub-TA) fees, shareholder servicing fees, finder's fees or even 12(b)-1 fees which are typically used to pay brokerage commissions.  

If one were to look back at what the 401(k) product landscape looked like in the mid and late 1990's, it would be observed that there were two dominant types of products.  The first, is the Group Variable Annuity, where the investments were sub-advised funds, and the second was a mutual fund product offered by a mutual fund company containing only their mutual funds.  These "proprietary products" were often recordkept by that insurance company or that mutual fund company's transfer agency.  Transfer agencies are required by the investment industry and act as the record keeper for such things as share-lot accounting, tax basis, customer information and the like.  Transfer agencies are not revenue generating centers, rather they are a cost center to the investment houses.  They are financed by a ledger transaction on the fund company balance sheet called a 'Transfer Agency Fee' or a TA Fee.

During this period of time, technological systems and customer demand necessitated the creation of 'Multiple Fund Family' products, a predecessor to true open architecture.  These products still exist today.  Typically, this type of product would be distributed by a group of fund families partnered together.  Ex.) 8 fund families, 400 funds. Arguably, this is better than one fund family's 40 fund product on its own.  Often these products would only include those funds typically distributed by brokers for a commission (so no Vanguard, no DFA, etc.), and it is here that we find the birth of Revenue Sharing as we see it today.

Technology gave rise to "independent" record keeper service providers.  These record keepers were independent of the fund families, and often had superior technology and the ability to link together investment trading for multiple fund houses.  They took over the fund companies role as transfer agent for the 401(k) clients.  This freed up the aforementioned TA Fee for these types of accounts.  It didn't take the fund companies long to realize that this TA Fee could become an incentive to the record keepers for priority shelf space, similar to having a sugary cereal at eye level for a seven year old to see.  This incentive became the SUB-Transfer Agency fee (Sub-TA).  This was/is a legal practice, but it did have some systemic abuses.  In the following 5-15 years it was mainly a hidden secret of the retirement industry.  It was really in the mid-late 2000's when it gained notoriety, and then with the advent of the fee disclosure rules, primarily 408(b)-2 it became more widely known.

All that said, revenue sharing can be a good or bad thing.  It has its place in the fiduciary decision tree on the mechanics of paying for necessary services.  The question now shifts away from discovery of the existence of revenue sharing in the funds in a plan to how to properly allocate this revenue sharing.  

The Department of Labor (DOL) has been somewhat vague on this.  The 'Frost Letter', DOL Advisory Opinion 97-15A is the best guidance the industry has and essentially says that if a provider is a plan fiduciary, that it cannot retain revenue sharing received from funds and that it must credit it back to the plan.  This avoids any potential Conflict of Interest in the form of Self Dealing.  Okay, fair enough.  We, the fiduciary, pick a fund, it has revenue sharing, we collect it and give it back to the plan.  That makes sense.  Hey DOL, so how do we give it back?  In other words, what is the appropriate method?  The DOL is silent on this issue.  

Last year, in DOL Advisory Opinion 2013-03A, the DOL had a chance to illuminate the industry on what is the appropriate allocation method and, specifically, it opted not to; saying "this letter also does not address any fiduciary issues that may arise from the allocation of revenue sharing among plan expenses or individual participant accounts . . .”   Leading ERISA Attorney, Fred Reish reminds us that the method of allocation is a fiduciary decision and must be prudently considered by the responsible plan fiduciary (http://fredreish.com/advisory-opinion-2013-03a/).

The argument some in the industry make is this. Since only some funds have revenue sharing, while others do not, and revenue sharing is experienced as a cost by those who invest in those funds, but not experienced by participants who don't invest in those funds, shouldn't the revenue sharing be rebated back ONLY to those participants who experienced it as a cost?  Sounds right.  That's how other rebates work in other industries.....however, common industry practice is for revenue sharing to offset provider costs. If these costs are not offset, they would've been passed to ALL of the participants prorata.  Some providers don't give the plan trustees the option.  Some do.  Some providers provide a gross invoice that is then offset by revenue sharing and then give the client the choice to write a check on the net invoice or pass it to the participants.  

Some providers have shifted to the "participant-level" revenue sharing rebate process.  This then begs the question of when?  When is it applied, daily, monthly quarterly, annually?  What if the amount expected to receive differs materially from what is actually received?  How does one collect and then apply the difference?  Are their earnings adjustments required, if so who pays for those?  Could plan discrimination issues arise, benefits, rights and features issues?  All these are valid questions.  The issue of application of revenue sharing has now become a differentiating issue for providers, i.e. a product feature issue that can be sold or sold against.

After reading Fred's blog post linked above, he mentions forewarned is forearmed.  Rather than this becoming a potential fight one needs to be armed for, how about this instead?  As a challenge to the DOL, PLEASE COME UP WITH A 'SAFE HARBOR' METHOD ON HOW TO APPROPRIATELY ALLOCATE REVENUE SHARING WHEN IT EXISTS WITHIN A 401(K) PLAN!!!!  This would sure solve a lot of unnecessary problems or potential future problems.



     

Excessive Fee Case: Mass Mutual is on the Defense.

This is a great case, thanks to FRA Plan Tools for the link below describing the circumstances of the suit.

http://blog.fraplantools.com/new-excessive-fee-case-filed-by-massmutual-employees/

The complaint from the plaintiffs allege a variety of improper or missing fiduciary process' costing the plan and its participants millions of dollars over the years.

I echo the conclusions drawn by FRA re posted below. 

So what does this mean for plans that use MassMutual as a provider or advisors who recommend MassMutual services and products? It means that you should use this as an opportunity to review your plan’s relationship with MassMutual. This is only a complaint and no one can predict with any certainty how it will turn out. But that being said, if any of the specific allegations found in the complaint could apply to your plan, you have now been put on notice to investigate. This can include asking for more information, re-reviewing your 408(b)(2) disclosures and agreements, or benchmarking your plan’s fees. These tasks should obviously focus on analyzing any investments in your plan and ensuring that any fees paid are reasonable and necessary.

MEP's - EBSA Speaks and More Opinions Coming

Well folks, for those of you who know me, you've probably come to understand that I'm a cautious (re: Prudent) person by nature. I'm suspicious of new spins on old concepts and of slick sales pitches which are used to imply one thing, but deliver something less. In that context, I've written, at times sarcastically, about Multiple Employer Plans (MEPs). My underlying message has always been, Proceed with Caution. The idea is that if sounds too good to be true, it usually is and it doesn't hurt to question the idea at its source.

Recently, I personally attended the annual 401(k) Sales Summit put on by the American Society of Pension Profesionals & Actuaries (ASPPA). At the opening of Day 2 of the conference, I attended a session which was a one on one interview of Michael Davis of the Department of Labor by Brian Graff of ASPPA. There were several topics discussed, upcoming fee disclosure rules, the proposed expanded definition of a fiduciary, and yes, MEPs. Mr. Davis, was one of the better DOL speakers I've heard present and I felt he was very clear in that he felt that the current rules governing Qualified Retirement Plans (the ERISA) do not support the concept of an "Open MEP", meaning MEPs for employers that are unrelated and subjected to a collective bargaining agreement. He mentioned this three separate times, so it was very clear. This took place on March 19, 2012.

Interestingly, this news was met with shock/surprise (perhaps anger?) by many of the members of the audience, whom are other pension practitioners like myself. It SHOULDN'T have come to a surprise to anyone as these remarks are consistent with what has been coming out of EBSA for the last year or so, and even again just two weeks prior on March 7, 2012 at Phyllis Borzi's (Assistant Secretary of Labor) testimony to the Special Committee on Aging of the U.S. Senate. Press Release Here --> http://www.dol.gov/ebsa/newsroom/ty030712.html.

In this testimony, Ms. Borzi specifically stated that the idea of "Open MEPs" is not an established concept under ERISA and went on to express concerns about aggressive marketing and promotion of Open MEPs stating that:

1. Adopting Employers are fully releived of fiduciary obligations for administering and monitoring investments and of administrative reporting duties.


2. That by pooling plans together can reduce administrative burdens and costs.

They have stated that two separate Opinions will be forthcoming dealing with the concept of the Open MEP. We are on record (see blog posts from July 2011 and again in August 2011) stating that we believe that any person/entity that may excercise discretion or control over plan assets (whether specifically named in the plan document or not) is a fiduciary as defined under ERISA Section 3(21) and that includes employers who adopt into an MEP. If the rules change, we may also change our opinion. Until then, the message remains, BE CAUTIOUS. Investigate these structures thoroughly including gaining a strong understanding of the relationship between those providing services to the plan (and charging fees) and those in a fiduciary position. We believe that many of the ones we've looked at appear to be in violation of the ERISA Prohibited Transaction rules.

An Oldie but a Goodie - Criminal Rule, listen up Bank Lenders!

This is an oldie but a goodie. The story goes like this, Plan Sponsor of a 401(k) Plan receives a call from their Bank. Specifically, it is from their lender. The Loan Officer, subtley or maybe not so subtley, tells the client that their credit is at risk if they don't put more assets with the bank. Subsequently, a broker (bank registered rep) is introduced and a few short months later the 401(k) Plan is moved to the bank or a different spin where the credit isn't at risk, instead the client is told that their rate will be reduced in exchange for the plan.

For those of us practicing in the ERISA Qualified Plan arena, this story or one like it is very familiar. We all competed against this type of scenario and we all know that it isn't legal. I've often cited that this is a Prohited Transaction (PT) and violates several different ones. Well, thanks to a linked in post that led me to this blog post from the Business of Benefits (nice one Mr. Toth) we can all now specifically cite the US Criminal code when this scenario presents itself. http://www.businessofbenefits.com/2010/06/articles/complex-prohibited-transaction/erisa-plans-ultimateand-criminalprohibited-transaction-rule-of-18-usc-1954/

To summarize the post, this behavior violates ERISA's Prohibited Transaction rules, but it also violates the US Criminal Code, specifically, 18 USC §1954. It specifically is an Anti-Kickback rule and is broad in nature although it does specify ERISA plans that

Whoever being—
(1) an administrator, officer, trustee, custodian, counsel, agent, or employee of any employee welfare benefit plan or employee pension benefit plan; or
(2) an officer, counsel, agent, or employee of an employer or an employer any of whose employees are covered by such plan; or
(3) an officer, counsel, agent, or employee of an employee organization any of whose members are covered by such plan; or
(4) a person who, or an officer, counsel, agent, or employee of an organization which provides benefit plan services to such plan

receives or agrees to receive or solicits any fee, kickback, commission, gift, loan, money, or thing of value because of or with intent to be influenced with respect to, any of the actions, decisions, or other duties relating to any question or matter concerning such plan or any person who directly or indirectly gives or offers, or promises to give or offer, any fee, kickback, commission, gift, loan, money, or thing of value prohibited by this section, shall be fined under this title or imprisoned not more than three years, or both.

Many scenarios could fall under this, but specifically, the act of Tying a company loan to the 401(k) Plan would fall under this. So, sometimes we need to look past ERISA to the Criminal Code itself to find something specific. I wonder if the banks have contemplated that this, technically, should be disclosed as compensation under 408(b)-2.......

Thanks Linked-In and thanks Mr. Toth for the good intelligence.

MEPs, Mediocre Employer Protection....Just Kidding, continued

As a follow-up to an earlier post from July 6th regarding Multiple Employer Plans, this author recently discovered (thanks Alan) an article that discusses the matter in much greater detail, linked here


http//www3.cfo.com/article/2011/8/retirement-plans_trouble-ahead-for-multiple-employer-retirement-plans

This article, published on cfo.com, titled 'Trouble Ahead for Multiple-Employer Retirement Plans?" is very thorough in its description of MEPs, concerns of the DOL and what the perceived and actual benefits to employers are for participating in them.

This author beleives that meaningful gains can be had in both the area of fiduciary relief and in economies of scale, but that it requires properly vetted and structured MEP programs. Given the amount of recent attention given to these programs, and a trend towards "open" MEPs, or MEPs of unrelated employers, the DOL was promted to make its voice heard on the matter.

Based on the DOLs comments, and our own interpretations of the statutes, we still believe that MEP programs can work well, but from a prudence perspective, we believe they are better structured as "closed" MEPs, meaning that the employer is CLEARLY related. An example of this can be a corporate entity and a group of franchises of the corporate entity.

Final thoughts (for now):

When, as a Plan Sponsor, evaluating whether to adopt a MEP or, as an advisor, whether to advise a client on the merits of a MEP program, I think a detailed evaluation of the structure should be documented and stored in employer minutes, thus, aiding in satisfying the fiduciary requirement of prudent selection. Even though the decision to join a MEP is typically stated as a settlor function, meaning business decision, the control of assets that typically follows puts that decison maker into fiduciary status.

In the previously linked article, the author raises the concern of a TPA sponsoring a MEP program which would be then offered out to its clients. This is a perfect example of an issue that would be discovered if the MEP program is vetted structurally. Under this scenario, the TPA, as an employer would be the primary adopter (or MEP Sponsor) and therefore clearly a fiduciary to the plan. Any financial benefit that TPA would then receive from the MEP, for example fees they charge to administer it for any/all future adopting employers, could then be (and likely would be) interpreted as self dealing. This is a clear violation of the Prohibited Transaction rules of ERISA, but one that the TPA likely isn't even aware they are violating. This is just an example, but their are many other equally risky scenarios that can play out. Caution is advised before proceeding into these types of arrangements without an expert level of understanding. In other words, if there was every a place to consult rather than sell to a client, this is it.