“Excessive” 401k Fees Often in the Eye of the Fund Holder
When the DOL published the final version of its new “Conflict-of-Interest” (a.k.a. “Fiduciary”) Rule, it specifically allows for certain fees normally considered “conflict-of-interest” (e.g., commissions, 12b-1 fees, and revenue sharing) fees, but only under certain conditions. In particular, those conditions require “…the Adviser and Financial Institution must give prudent advice that is in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation.” (Federal Register/Vol. 81. No 68/Friday, April 8, 2016/Rules and Regulations page 20947)
The DOL feels so strongly about these condition as they pertain to their stated exemptions, that it reiterates the above again towards the end of the 100 page Rule when it says, “These exemptions require, among other things, that investment advice fiduciaries adhere to certain Impartial Conduct Standards, which are fundamental obligations of fair dealing and fiduciary conduct, and include obligations to act in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation.” (Federal Register/Vol. 81. No 68/Friday, April 8, 2016/Rules and Regulations page 20991)
While the DOL fails to define “reasonable,” it does offer a hint at what it expects. The published Rule says, “This final rule and exemptions aim to ensure that advice is in consumers’ best interest, thereby rooting out excessive fees and substandard performance otherwise attributable to advisers’ conflicts, producing gains for retirement investors.” (Federal Register/Vol. 81. No 68/Friday, April 8, 2016/Rules and Regulations page 20951)
So we are left with this loose definition: A fee is “unreasonable” (and therefore must be avoided) when it is “excessive” and “attributable to advisers’ conflicts.” At least that’s what the Rule states. On the other hand, there are many interpretations to the term “excessive” and the DOL has so muddied the waters when it comes to understanding what a conflict-of-interest is that some have said simply getting compensation represents a “conflict-of-interest.” We’ll save this latter confusion for another day and, instead, focus on “excessive.”
One quick and dirty way to define “excessive” is to compare it to the range of fees typically charged. Travis Smith, President and CCO at Tactical Investing, LLC in Spokane, Washington, says, “The line between reasonable and excessive fees is still blurry, but it becomes more transparent as you focus on averages. Generally, regulators want to see fees are within an average range for the industry. Obviously, with the new Rule, we expect that range to move toward lower fees.”
Still others rely on the DOL’s discussion on fees when the 2012 401k Mutual Fund Fee Disclosure Rule was unveiled. The issue wasn’t the size of the fee in of itself, but what services came with that fee. “Adviser fees are only ‘excessive’ when the value added does not justify those fees,” says Alexander Parker, Chairman and Chief Executive Officer of Midtown Manhattan-based The Buxton Helmsley Group. “If an adviser is not able to consistently add enough value to justify the fees being charged, they are ‘excessive.’ In more definitive terms, if they are not able to consistently outperform the market, then they have no business charging more than an average amount of fees. If they are able to add more value than the market returns on average, then it is hard for regulators to say that those extra fees are not justified.”
As we saw in 2012, the initial temptation is to measure fees simply on a “low” or “high” scale. When comparing similar services, this is a sufficient form of measurement. “The expectation is that advisers who are required to act as fiduciaries will recommend lower-fee investments to their clients,” says Cynthia Meyer of Financial Finesse in Gladstone, New Jersey. “The DOL has estimated that this will save investors up to $40 billion in fees over the next 10 years. The practical implication of the fiduciary standard is that when choosing between two otherwise very similar investments, a fiduciary would choose the one with the lower costs. This is very helpful as the structure of much of the financial services industry is full of inherent conflicts-of-interest that don’t always favor consumers.”
Although most of the attention has been on investment products (since those are the primary source of conflicts-of-interest), it’s important to remember the Conflict-of-Interest Rule pertains to all services and products, not just investments. Still, even within the realm of investment products, simple comparisons occur only in limited circumstances. One of those circumstances includes comparing index funds with each other (as opposed to comparing index funds with actively managed funds). Cynthia Meyer of Financial Finesse in Gladstone, New Jersey, says, “A mutual fund with fees and expenses at or below the average for similar funds would not be considered excessive. A highly similar fund in the same category in the upper quintile of expenses might be considered, ‘excessive.’ An investor should ask themselves if the same investment could be provided with the same quality for a lower cost (e.g., a no load S&P 500 index fund vs. a load S&P 500 index fund).”
A common rule of thumb states that commissions are most likely to present an “excessive” fee. Kort R. McCulley, President of McCulley Financial Group in Westchester, Illinois, says, “A fee charged in the absence of value. Many times this is taking the form of a large commission when very little (if any) service was rendered. Excessive fees are derived from a great disparity in charges and service delivered.”
But a case can be made, even with “large” commission, that neither the size of the commission nor the commission payment model represents an “excessive” fee. Ilene Davis at Financial Independence Services in Cocoa, Florida, says, “The fact is that using a fee-based account usually costs the client 1% of assets on top of investment expenses, whereas a mutual fund may charge less than 1% total once sales fees (i.e., commissions) are paid. For example, America funds C shares have a 1% annual load, while A shares have a 5.75% commission at max level. Over 10 years, the cost of ownership on most of their funds is less on sale-charged A shares than no-sales charge C shares.”
Practitioners, plan sponsors, and ERISA attorneys are left to wonder, absent any objective definition of ‘excessive’ and ‘reasonable,’ does the Conflict-of-Interest Rule have any real meaning, or is it merely another potentially lucrative cash-flow stream for class action attorneys courtesy of your friendly neighborhood government regulator? “I think this question really hits the nail on the head because so much of this new Rule is so subjective,” says Scott R. Carty of DC Capital Management in Livonia, Michigan. “The difficult part of this Rule is that ‘excessive’ or ‘reasonable’ are based on people’s thoughts and feelings, not on actual facts. What is reasonable to me may not be reasonable to you, and vice versa. Even if an adviser is able to justify to the client what a ‘reasonable’ fee is, it really is going to depend on the auditor whether they feel that a fee is reasonable based on the services provided.”
Unfortunately, we may have to wait for case law to determine what is ‘reasonable’ and what is ‘excessive.’ Garlewicz says, “Many of these rulings are vague and open to interpretation, until someone is in the hot seat.”
You can be sure, no one – whether they be a plan sponsor or a plan service provider – wants to be the case that solidifies the new definitions. Davis says the new DOL Rule “just opens it up for frivolous lawsuits and advisers who can afford to retire, like doctors with Obamacare, will retire and leave many clients stuck with robots or advisers who need the income.”
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort is available from your favorite bookstore.