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How Many Small Business Owners Accidentally Trap Themselves with This Treacherous 401k Fiduciary Conflict?

How Many Small Business Owners Accidentally Trap Themselves with This Treacherous 401k Fiduciary Conflict?
August 13
00:03 2019

In many small businesses with 401k plans, the company’s owner owns the bulk of the plan’s assets (sometimes far exceeded a majority of plan assets). The owner is not only the largest holder of plan assets, but also the plan sponsor and therefore a fiduciary to the plan. This yields a dangerous combination. It can ensnare the unsuspecting plan sponsor.

It’s so tempting. It’s so logical. And successful business owners, by virtue of their very success, are most susceptible to this trap. What is this too often overlooked conflict-of-interest and how can small company plan sponsors avoid it?

The circumstances creating this situation can be quite common. The owner is also the plan sponsor of the company’s 401k plan. Since the firm is small, the retirement plan is also small. This means, on average, the plan is paying higher fees compared to larger 401k plans. These fees aren’t “high” in the sense that the service provider is charging too much. Rather, it’s a reflection of the lack of economies of scale faced by all small retirement plans.

The owner’s retirement account represents a majority of the plan’s assets. As a result, the owner’s account absorbs a majority of the plan’s expenses, all at the same high rate as the rest of the plan participants.

It’s not unusual for the business owner to be older, an age at which penalty-free in-service distributions can be made.

This is where the trouble can start. Typically, you might expect a business owner to have both retirement savings and after-tax savings. It’s therefore easy to imagine a situation where the business owner has two investment advisers – one for the company retirement plan and one for the personal after-tax savings. Of course, remember, this is a small business. So, it shouldn’t surprise you if, while the total sum of the owner’s retirement and after-tax savings might represent a substantial sum. Separately, however, neither account by itself is enough to qualify for a fee break.

Suppose, then, the owner’s personal adviser, one not affiliated with the retirement plan’s adviser, offers a significant fee break to the owner if the owner transferred the retirement account to this adviser. The owner takes a look at the expenses the retirement plan pays and the share of those expenses allocated to the owner’s retirement account. The math says it’s in the owner’s best interest to take the funds out of the retirement plan and consolidate with the personal adviser.

But is that transaction in the best interests of the remaining plan participants? All the fixed fees associated with the plan must now be absorbed by them, potentially raising their fees quite dramatically.

Remember, the owner is a fiduciary to the firm’s retirement plan. As such, the owner has a fiduciary obligation to the plan participants. Does the contemplated transfer of the owner’s retirement assets, for the sole reason to cut the fees paid by the owner, represent a fiduciary breach?

“It is very common, especially in small employer plans, for the plan fiduciary to also have a large account balance in a plan,” says David N. Levine, principal at the Groom Law Group in Washington, DC. “When wearing the fiduciary ‘hat’ the fiduciary needs to act for the interests of the plan as a whole, not their own individual interest. Where people have gotten into trouble in the past is picking advisers that benefit them outside of the plan – and caution is warranted there.”

This caution is not an idle musing. “I don’t recall the case, but there is at least one case in which the ruling was that a fiduciary’s obligation was to act in the best interest of all of the participants, not of any particular participant,” says Los Angeles-based Fred Reish, partner at Drinker Biddle and Reath and Chair of the Financial Services ERISA Team. “That suggests that if a fiduciary acted to benefit one participant to the detriment of the other participants, it could be a fiduciary breach.”

Whether an actual breach occurs depends on the specific facts and circumstances of each case. Clearly, though, the optics of such a move are, in the very least, “challenging.” “Owners of a company typically have the most assets in the plan,” says Ary Rosenbaum of The Rosenbaum Law Firm P.C. in Garden City, New York. “They should be cautious in what they do with their account to make sure nothing they do looks bad on paper and could be construed as a breach of fiduciary duty.”

Indeed, “paper” might be the operative word here. The plan document can be constructed to remove some of the potential liability. “Where an individual has a large account,” says Levine, “and the plan design allows any participant to move funds out of a plan or to choose to use a plan feature (such as a self-directed brokerage option), the fact that their movement of funds could impact plan pricing doesn’t automatically raise a fiduciary issues. Of course, if a third party – whether another employee in the company, a committee, or an outsourced provider – has responsibility for plan actions, it can also avoid this discussion as well.”





In other words, absent mitigating language in the plan document, the owner can choose to remove all appearance of a conflict of interest simply by ceding the relevant responsibilities to an experienced provider. “An owner could certainly appoint an independent fiduciary to make the decisions in terms of transferring assets,” says Rosenbaum.

Still, the plan design alone does not offer complete safe harbor from the potential breach. “The fiduciary breach could be a decision that is not in the best interest (‘prudent’) of the plan or participants as a whole,” says Reish. But, if the plan is amended to provide for brokerage accounts and each participant is informed of that right, then arguably any participant could select a brokerage account and then there would not be a breach for that reason. But, if the owner-fiduciary’s account does not share in the allocation of the recordkeeping expenses, then there could be a breach for using an allocation method that was not prudent. There could also be a prohibited transaction for using plan assets (of the other participants) to pay the owner-fiduciary’s part of the recordkeeping costs.”

There are other ways around this problem. Extending the line of thinking from above, Reish offers this example: “Assume that the increased cost for the other participants would be that the recordkeeping costs would be allocated to the remaining participants, and the owner-fiduciary would no longer pay a proportionate share of those costs. That raises another fiduciary issue of the decision on how to allocate recordkeeping costs. The question is whether a prudent fiduciary would allocate all of those costs to some participants but allow others to be in the plan without costs. The problem could be solved by having the plan sponsor pay the recordkeeping costs. In that case, the investments for the rank-and-file participants could be very low cost. Between eliminating the payment of recordkeeping costs and providing low-cost, non-revenue sharing investments for the participants, I think the situation becomes very manageable.”

Finally, where does this potential conflict-of-interest leave the fiduciary adviser? Recall that most service providers have a fiduciary obligation to the plan. The good news, however, is that this fiduciary obligation is often narrowly defined to the specific scope of services offer by the provider. In many cases, this does not include a general obligation to all aspects of the plan.

“I think there is an open question of whether a fiduciary investment adviser would be a fiduciary for this purpose,” says Reish. “But he or she would be a co-fiduciary and, upon becoming aware of a fiduciary breach, would have a legal obligation to protect the participants, for example, to report the breach to the DOL. Obviously, no one wants to get to that point in a relationship. So, the better approach would be to tell the owner about the adviser’s concerns and recommend that the owner-fiduciary consult with an ERISA attorney.”

It may not immediately strike small business owners that they may not have complete control or access to their own retirement assets that sit within the company plan they sponsor. Before making any moves with those assets from which they stand to personally benefit, it remains prudent to vet that action with appropriate counsel.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

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.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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