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A watchful eye: closer scrutiny being paid to the management of 401(k), pension plans.

More than 40 million employees in the U.S. work force rely primarily on their 401(k) plan for retirement. But in today's investment environment, how safe are the investments within your company's plan--and who's responsible for monitoring them?

A recent survey by Financial Executives International and Duke University indicates that retirement funds may not be so safe as 47 percent of the CFOs surveyed indicated that the 401(k) plan at their company includes funds that have been tainted by the recent mutual fund scandal.

That does not mean all is lost. The good news is that across all companies surveyed, including those that have not been affected by tainted funds, half are considering changes in their plan investment options. This means more companies are considering the ramifications of fiduciary liability under the Employee Retirement Income Security Act.

Under ERISA, a fiduciary can be held personally responsible for shortages in the benefit plan's assets resulting from a breach of fiduciary duty, such as offering imprudent investment choices.

But how accountable is the sponsor company for the plan's performance? And what processes can be followed to ensure the best performance for the plan?

According to ERISA, plan sponsors must act "for the exclusive benefit of the participants" and follow the "prudent process rule." Not complying with these requirements can result in a huge liability for the employer.

There are four significant components of ERISA, which requires employers to follow certain rules in managing 401(k) plans. Employers are held to a high standard of care and diligence and must discharge their duties solely in the interest of participants and their beneficiaries.

Among other things, this means employers must:

1. Establish a prudent process for selecting investment alternatives and service providers;

2. Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided;

3. Monitor investment alternatives and service providers; and

4. Select investment alternatives that are prudent and adequately diversified.


Fiduciaries, defined as the person or persons having discretionary authority or exercising authority over the management of the plan or plan investments, must conduct a search for a plan provider or investments in a systematic and prudent manner with the ultimate selection made in the best interest of plan participants.

According to Bruce Ashton, a partner in the Los Angeles law firm of Reish, Luftman, Reicher & Cohen specializing in employee benefits, this means that the CEO who gives his 401(k) business to his golf buddy without conducting proper due diligence could be accused of violating the prudent process rule, resulting in fiduciary liability.

A conflict of interest in determining which investments to offer participants represents another violation subject to fiduciary liability.

"Typically, a broker receives higher commissions on the funds his firm wants to sell," says CPA Mark Murphy, a benefits compliance specialist at Lesley, Thomas, Schwarz & Postma in Newport Beach. "Therefore this advice may not be in the sole interest of the plan participants and beneficiaries, but in the sole interest of the broker and the investment firm."


In fact, since the SEC began a revenue-sharing probe in April 2003, it has found 14 brokerage firms that took cash from mutual fund investment advisers and 10 funds accepted payments in the form of brokerage commissions on fund trades.

"In return for these payments, 13 of the 15 firms appear to have favored the sale of the revenue-sharing funds by providing increased access and visibility in the broker-dealer's sales networks," the SEC said in a statement.

Implementing a prudent process should help uncover these conflicts and determine how commissions and fees are being distributed.


Plan fiduciaries must understand the fee structure of the plan and demand full disclosure of compensation received directly or indirectly by service providers.

For the most part, expenses are disclosed in the prospectus, but they are not always easy to understand. Without expert assistance, plan sponsors may not realize how much gross investment returns are being diminished by expenses.

If the mutual funds are offered through an insurance company group annuity contract, there is often an additional layer of asset-based fees, which can add an additional 1 percent or more to total fees.

Fiduciaries must closely examine plan fees on behalf of plan participants and make sure fees are not unreasonable relative to the value of services provided.

Plan sponsors may think that they are paying little or no fees for services provided, when in fact substantial fees are being paid to service providers.

Mutual fund companies use various names to share fees with other service providers, such as 12b-1s, shareholder service fees, sub-transfer agency fees, etc.

Uncovering all plan expenses and offsetting revenue sharing agreements can be best accomplished through an open architecture 401(k) plan structure, according to Edward Heintzberger, president of The Heintzberger Company, plan administration consultants in Portland, Ore.

"Open architecture in a defined contribution allows investment offerings to be separated from the administrative apparatus and related fees. It allows fiduciaries to evaluate investments, administrative expenses and revenue-sharing arrangements on their own separate merits," says Heintzberger. "Armed with knowledge, the fiduciaries can then decide on the extent to which revenue-sharing arrangements should be used on behalf of participants and control how revenue sharing is spent."

According to Kathy Branconier, managing director of Retirement Plans at M Advisory Group in Torrance, some "80 percent of all mutual funds offer a revenue-sharing arrangement."

Revenue sharing is the soft dollar arrangements between mutual fund companies and brokerage firms or insurance companies, and is used to entice brokers to offer a certain fund or fund family. Revenue sharing is typically paid as commission to brokers in bundled or prepackaged 401(k) investment platforms, but can be used as an expense reimbursement to reduce overall plan expenses.

In lieu of commissions, an unbiased investment adviser who charges a flat fee can redirect revenue sharing to the plan trust through an open architecture platform. These expense reimbursements can offset the plan's legal, administrative and investment advisory fees.

Revenue-sharing credits vary by fund company, but average about 25 basis points, which equates to $12,500 per year on a $5 million plan. An open architecture platform, which uses revenue sharing to offset plan fees, has the potential of substantially reducing the annual cost of the plan.

An added benefit to open architecture is that the plan sponsor can choose investments from various mutual funds and offer plan participants the top performing investments in each asset class.


This sounds great in theory, but who will choose and monitor the investments? This requires a substantial time commitment, which many plan sponsors do not have.

Plan sponsors, although they must understand the investment process and choices, would like to leave the actual investment selection to the experts. Insurance companies make it easy for the plan sponsor by offering a prepackaged portfolio of mutual funds, known as a bundled approach.

However, 401(k) investments may achieve better performance using a different approach.

Even though choosing the bundled approach may seem easier for the plan sponsor, it may not constitute acting in the best interest of the participants.

What's the solution? Hire an unbiased professional investment adviser with a strict due diligence process for selecting retirement plan investments and is well-versed in the open architecture process.

Investment advisers can help you choose the top performing funds in each asset class and monitor those funds. Be careful not to confuse an investment adviser with a broker representing a bundled, prepackaged investment platform. According to Branconier, there is a difference between these two.

"A broker is typically commission motivated, and makes more money by selling bundled, prepackaged 401(k) investment platforms," says Branconier. "An investment adviser charges a negotiated flat fee and develops strict guidelines and investment selection criteria. The investment adviser's job is to use a prudent investment selection process to choose the top performing funds for the plan, not the best funds for his pocket. The focus of the investment adviser is client advocacy and due diligence ... to place the plan and participants in the best possible position for success."

A good investment adviser screens from an unlimited universe of mutual funds and develops a diversified portfolio using best of asset class funds for the client company's 401(k) plan.


Many participants and sponsors think their 401(k) offers funds in all the asset classes so they believe they are diversified. Perhaps yes, but are the funds being offered the best investments? Is there one insurance company or mutual fund family that offers top performing funds in each asset class?

It's unlikely. So, although offering participants funds in all classes from one provider may constitute adequate diversification, it may not be considered a prudent investment strategy.

Open architecture provides a better way. Through an unlimited universe of funds to select from, an investment adviser can recommend the top performing funds in each asset class, which can significantly boost plan performance.

Focusing on the above four areas should result in a reduction in fiduciary liability, reduced plan costs, enhanced plan performance--and peace of mind.

J. Daniel Vogelzang is president of Torrance-based M Advisory Group (, an executive benefit and financial advisory firm. You can reach him at
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Author:Vogelzang, J. Daniel
Publication:California CPA
Geographic Code:1USA
Date:Jan 1, 2005
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