If you have a 401(k) plan, there’s a pretty good chance that someone has their hands in your proverbial cookie jar and you may not even know it. It could be your advisor, broker, TPA, or even your recordkeeper/plan provider. We see it every day with plan sponsors who think they are being charged little to no fees. The conversation usually goes something like this:

 

[Sponsor] – “We don’t pay our advisor/broker/recordkeeper/etc.”
[US] – “So, they do it for free?”
[Sponsor] – “Uh, no; I think they get paid another way.”

 

Ding, ding, ding; right answer. Nobody provides services on your 401(k) plan for free. They are getting paid. And if you don’t know or understand how they are getting paid, then they likely have their hand in the cookie jar of 401k Indirect Compensation. And they may be pulling out some pretty big cookies. So what is indirect compensation and why is it a problem?

Cookie-Jar

 

DIRECT VS INDIRECT COMPENSATION

There are two main ways that service providers can be paid in a 401(k) plan – directly, or indirectly. Direct compensation is when a provider is paid directly by the plan sponsor or the plan participants. These fees can come as fixed yearly fee, per participant fee, or asset based fee. Direct compensation is usually clearly disclosed and shows up in an invoice, quarterly statement, 5500 filing, or fee disclosure.

 

Indirect compensation is different. Rather than paying a service provider directly, that provider is usually getting paid indirectly from another provider in your plan. The most common example would be an advisor who is getting paid from the mutual fund companies based on the funds in your lineup. These fees are usually difficult to find and understand – even with the new regulations around fee disclosure. That’s a problem. And it’s just the tip of the iceberg when it comes to problems with indirect compensation.

 

 

THE PROBLEMS WITH INDIRECT COMPENSATION

1) Major Conflict of Interest: Indirect compensation can present a major conflict of interest. In many cases, the service providers getting paid indirectly from the mutual funds (advisors, recordkeepers, etc.) are also playing a major role in helping you select the funds in your lineup. You’ll have to excuse yet another metaphor, but that’s like the fox watching the hen house. The provider is incentivized to recommend more expensive mutual funds that pay them a higher % or commission (known as 12b-1 fees) rather than recommending funds in the employees’ best interest. These expensive mutual funds are usually actively managed and carry expense ratios between .80% and 1.8% in addition to a host of other fees. These fees have a drastic effect on your employees’ retirement. This brings us to our next problem.

 

2) Employees are Footing the Bill: Employees are the ones paying for the majority of indirect compensation out of their retirement accounts. These investment costs decrease investment returns for employees and the long-term impact is astounding. A 1% difference in fees will decrease an employee’s nest egg by 20-30% over a 20 year period. Let that sink in. Advisors and fund providers will try to tell you that the returns of the funds make up for the cost. But that’s rarely true and easy to disprove. Net of fees, those expensive mutual funds almost always underperform inexpensive index funds over time. But that’s a discussion for another article.

 

3) Companies are Bearing the Risk: As a plan sponsor, you are usually acting as the 3(38) investment manager or at least sharing that role. Consequently, you have a fiduciary duty to provide a fund lineup that is solely in the best interest of your employees – not a service provider being paid from the funds. So if an employee sues, or the IRS or DOL come knocking, you’ll be the one responsible. And you, the plan sponsor, gets stuck dealing with the lawsuit and fines.

 

In summary: service providers help recommend funds, from which they are getting paid, that eat away at your employee’s retirement savings, and you take on all of the risk. That doesn’t sound so great. And it’s happening in the majority of 401(k) plans we see. So how can you fix it?

 

HOW TO FIX IT

STEP 1: Find out how your service providers are being paid
Make a list of all of your service providers. That list can include your recordkeeper, TPA, advisor, broker, consultant, trustee, custodian, etc. Then, dig around to find out how they are being paid. Start by looking in your contracts, plan documents, 5500 filings, and fee disclosures. Sometimes those documents can get pretty nebulous. If you need help, give us a call. We’ll help you do it for free.

 

STEP 2: Change how they are paid
If you still want to stay with your provider after finding out how much they have been making through indirect compensation, you can simply change the way they are paid. Tell them you want to pay them directly as a fixed fee or % of plan assets depending on what you feel is the value of the services they provide.

 

STEP 3: Change service providers
If you decide that you don’t want to use that service provider after learning about their fees and conflict of interest, go find a provider that doesn’t allow indirect compensation on their plans. We know a few – wink, wink.

 


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Matt is the CEO of BenefitGuard. His professional passion is helping employees retire with more money in the bank. BenefitGuard does this by helping companies eliminate 401(k) fees, risk, and work unlike anyone else in the industry. Additional roles Matt enjoys: surfer, soccer coach, husband, and father of 5.

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