Running a 401(k), or other defined contribution plan, isn’t free. Furthermore, the costs can be distributed unequally.
In a previous blog post, we discussed fee equality between 401(k) plan participants. As a short recap, the employees investing in the company retirement plan can select cheap investments or expensive investments, which often pay for the management of the plan. In practical terms, this means that the investors using expensive investments (with high revenue sharing ratios) are subsidizing the plan management costs of the investors that selected cheap, passive funds.
There are other examples of fee inequality, some involving self-directed brokerage. Let us explain self-directed brokerage. Most employee sponsored retirement plans offer their employees a lineup of investments that are supposed to be fairly comprehensive, but the employee must select their investment from the given menu of options. There are a few employee retirement plans that offer self-directed brokerage access, which means that investors can choose from the vetted menu of retirement options, but they may also set up a trading account to buy nearly any investment – stocks, mutual funds, ETFs, etc. – even if they aren’t part of the plan line-up.
One common mistake for plan sponsors is when the cost of administering the self-directed account is borne by those participants using the plan-selected investment lineup; the employee using self-directed brokerage gets what you could call a free lunch. This is a clear mistake, and easily resolved.
There are, however, more subtle problems that arise when plans allow self-directed brokerage. For example, several employees may use their self-directed brokerage account to buy a specific type of investment – a Master Limited Partnership (MLP). An MLP throws off a special type of income – UBTI, Unrelated Business Taxable Income – which does not follow the general rules about what is allowed in a 401(k) or other ERISA sanctified retirement plan. Specifically, Unrelated Business Taxable Income generates additional taxes and liabilities, which have to be paid immediately. So, who pays the taxes? You might think that the employee who is using the MLP should be subject for paying these additional taxes, but ordinary plan operations are designed to have the employer pay for extraneous expenses. This causes disparity since the trust funds or corporate funds which are supposed to support the entirety of the retirement plan are being used to benefit a small number of employees. More confusing, if corporate funds are used to pay off the taxes, does this count as an additional contribution to benefit the highest compensated individuals?
How can employers resolve these sorts of questions? First, they must read the fine print of their plan document for direction on how to fairly allocate fees and what latitude exists around self directed brokerage. Are there any guidelines on how expenses are treated? Secondly, the employer should conduct additional discrimination testing to assure that their practices are falling in line with ERISA guidelines. Are there any guardrails or limitations which prevent employees from buying investments with taxable interest?
Understanding and resolving these sort of issues should distinguish between an investment-only focused firm and a wider-scope fiduciary firm.