Background

Financial institutions that sell mutual funds to the public often maintain 401(k) and other retirement plans for their own employees. In these plans, many financial institutions make their own mutual funds available to employees as investment choices, and collect the mutual fund fee from those funds. 

But can a financial institution collect fees from its own mutual funds held in its employees’ retirement plan without violating its fiduciary duties or subjecting itself to hefty taxes on a prohibited transaction? This subject has been addressed in a number of recent court cases, as retirement plan fees continue to be the subject of much scrutiny.

What the Law Says

It is generally a violation of law for a retirement plan fiduciary to deal with plan assets, either directly or indirectly, for its own interest. A fiduciary can be taxed on a self-dealing prohibited transaction in an amount equal to 15% of the amount involved for each year in the taxable period. If the prohibited transaction is not corrected, IRS can impose a 100% tax on the amount involved. However, there are a number of exemptions to this rule.

In addition, a fiduciary’s self-dealing with retirement plan assets can result in an employee lawsuit that could require the fiduciary to pay back what it took from the plan if a breach of duty is proved.

Tax Exemptions for Fiduciary Self-Dealing

PTE 77-3

Because the law recognizes that there are technical violations of the self-dealing rule that cause no actual harm, a series of exemptions have been developed. For example, Prohibited Transaction Exemption 77-3 permits the payment of the mutual fund’s customary investment advisory fee to an insider if:

• The fee to the plan is not more than to other shareholders in the market;
• The fee is properly disclosed under the terms of the investment advisory agreement and underwriting contract;
• The plan does not pay a redemption fee in connection with the sale of the fund shares unless (a) that fee is paid only to the investment company, and (b) the existence of such redemption fee is disclosed in the investment company prospectus; and
• The plan does not pay a sales commission in acquiring or selling the fund.

PTE 84-14

There is a different exemption from the tax on self-dealing by qualified professional asset managers (“QPAM”) (or their affiliates) that sponsor retirement plans for their own employees. This second exemption generally applies to a QPAM that:

• Has discretionary authority or control over plan assets involved in the transaction;
• Adopts a written policy designed to assure compliance with the exemption;
• Engages an independent auditor to conduct a fiduciary audit on an annual basis and provide a written report to the plan regarding its compliance with the policies and procedures adopted by the QPAM and the objective requirements of the exemption; and
• Certain other conditions must also be met. For example the QPAM offers its services on a comparable basis to the general public.

A QPAM generally includes an independent fiduciary which is registered under the Investment Advisers Act of 1940 and has a total of assets under management in excess of $85 Million as of the last day of its most recent fiscal year, and shareholders’ or partners’ equity is in excess of $1 Million.

Fees and Fiduciary Duty: The Litigation Landscape

While meeting the requirements of a prohibited transaction exemption avoids the penalty tax otherwise due, it is not necessarily protective against a lawsuit asserting breach of fiduciary duty. In the past three years, more than two dozen financial companies, including JPMorgan Chase Bank, Charles Schwab Corp., and Morgan Stanley, have been targeted by proposed class actions challenging the in-house investment products in their employees’ 401(k) plans. Many judges have ruled against the financial company defendants, refusing to dismiss cases against BB&T Corp., Insperity, Deutsche Bank, and Edward Jones.  

Meeting Fiduciary Duties

Meeting a prohibited transaction exemption is not necessarily protective in a lawsuit where employees allege that the employer breached its fiduciary duty to employees by selecting and maintaining high-cost funds in the 401(k) plan, to collect fund fees at the employees’ expense.

However, the risk of such a challenge can be reduced by a fiduciary’s adopting policies and procedures that allow it to meet its fiduciary obligations to the plan. Steps that fiduciaries can take include:

• Having the plan administrative committee review the investment performance of the plan funds against the applicable benchmarks at least annually.
• Replacing plan funds with better performing funds, if applicable.
• Monitor fund costs to make sure that fees are reasonable and the plan is not over-paying for the services it is receiving. For example, if the plan qualifies for a lower-cost, institutional class of shares, those shares should be in the plan.
• Providing proper disclosures to Plan participants, as required by law.
• Comparing plan fund fees to services rendered and fees charged by similar funds. 
• Keeping minutes of plan fiduciary meetings to help demonstrate these various issues were considered and monitored.

Because of the intense scrutiny courts and the government have accorded retirement plan fees, all plan sponsors should review this issue in the context of their overall fiduciary duties. Financial institutions sponsoring retirement plans for their own employees should be particularly vigilant if they collect fees from those plans.