Is ERISA Section 408(b)(2) the New 401(k) Fiduciary’s Achilles’ Heel

On July 1st, the disclosure requirements of ERISA 408(b)(2) go into effect with regard to plan providers and plan sponsors.  Disclosure requirements between plan sponsors and plan participants are scheduled to go into effect at the end of August.

Plan sponsors are already complaining that 408(b)(2)’s lack of a uniform system of disclosure is resulting in disclosures that are often hard to find and often cryptic, far from 408(b)(2)’s goal.  Such evasive tactics will only make the plan sponsor’s disclosure duties more difficult.

Plan sponsors should also note the special requirements for dealing with plan providers who fail to provide the required disclosure under 408(b)(2).  In such circumstances, the plan sponsor has a duty to request the required disclosure from the plan provider.  If the plan provider fails to make the required disclosure within 90 days, the plan sponsor is required to dismiss the plan provider and retain the services of a new plan provider.

408(b)(2) imposes greater responsibilities on plan fiduciaries to properly evaluate the fees being charged under the plan.  Failure to properly evaluate such fees can result in liability for both the plan and the plan’s fiduciaries. 

This responsibility and potential liability poses special questions with regard to actively managed mutual funds. Despite overwhelming evidence that actively managed mutual funds generally underperform passively managed index funds, most investment options offered by 401(k) plans are actively managed mutual funds. 

What many plan fiduciaries fail to understand is that a properly conducted cost-benefit analysis of such actively managed mutual funds may result in a breach of fiduciary claim, regardless of whether or not the inclusion of such fund resulted in a financial loss to the plan participants.  During a recent fiduciary audit, I analyzed the plan’s twenty mutual fund investment options using the Active Management Value Ratio (AMVR), a proprietary formula that I use to determine the cost effectiveness of an actively managed mutual fund.  My analysis indicated that three of the funds were prudent in terms of cost effectiveness and performance, five of the funds provided marginal benefits from active management, and twelve of the funds provided no benefit at all from active management.

In analyzing the active management component of a fund’s overall fee, I found situations such as 74 percent of a fund’s overall fee producing over 100 percent of the fund’s return, 88 percent of the fee fund’s overall fee producing 22 percent of the fund’s return, and numerous examples where the active component of a fund’s overall fee was producing a negative return.

When I presented the results of my analysis to the plan sponsor’s investment committee, I got the “OMG” response I often get.  The “OMG” response is usually followed with the “why didn’t someone explain this to us” question.  The usual answer is that the plan provider either employed the old 3(21) fiduciary trick, confusing the plan sponsor as to the plan provider’s fiduciary duties, or ignored conflict of interest issues, since alerting the plan sponsor to these active management cost-benefit conflict of interest issues would probably have resulted in the plan provider not getting the account.

With 408(b)(2), plan sponsors must be alert to such issues and perform a full and proper analysis of the cost issues inherent in their plan.  One of a fiduciary’s duties under ERISA is to avoid any unnecessary expenses and costs.  With the new disclosures required under ERISA Section 408(b)(2), plan sponsors and plan fiduciaries have a greater responsibility to properly review and evaluate a mutual fund’s fees.  Simply looking at a  funds stated expense fee does not provide the analysis required under ERISA to protect the plan and its participants, especially with regard to the generally higher fees charged by actively managed funds. 

If actively managed mutual funds are chosen as investment options offered within a retirement plan, the plan fiduciaries should evaluate the potential costs of the funds’ active management upon a participant’s return. The failure to recognize the potential impact of such costs and properly evaluate same should not be overlooked. Plan fiduciaries should heed the courts’ warnings that a fiduciary’s failure to personally perform a proper investigation and analysis of a plan’s investment options constitutes a breach of one’s fiduciary duty.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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