The regulations and rules governing employer-sponsored retirement plans are typically complex and can be difficult to decipher. This is certainly the case when it comes to determining reasonable compensation for a plan advisor.
The fees that may be charged by an advisor are governed by ERISA, and executed by the Department of Labor (DOL), ERISA’s enforcement arm. With the recent revocation of the DOL’s conflict of interest final rule on fiduciary investment advice—AKA the Rule—this might seem confusing, as the Rule provided some guidance regarding reasonable compensation. Absent the Rule, where should a plan sponsor look for guidance to determine what is and what is not reasonable compensation?
The DOL and the Rule aside, reasonable compensation is a qualification imposed by ERISA for employer-sponsored retirement plans; it is statutory, meaning it carries a penalty prescribed by statute for any violation. The qualification applies to all entities providing services to employer-sponsored retirement plans and IRAs, regardless of fiduciary status. And, given its statutory nature, it can only be repealed by congress—not the DOL, the SEC, or any state rule; any repeal is unlikely.
Unfortunately, ERISA does not provide specific figures or formulae for what constitutes reasonable compensation. According to Michael Davis, former DOL deputy assistant secretary, “The Department doesn’t typically prescribe numerical targets.” As a result, a plan advisor must dig a little deeper to determine whether the fees being charged are reasonable. This is made that much more difficult as, according to Mr. Davis, “There’s no hard-and-fast rule. What’s reasonable for one engagement might be completely unreasonable for another.”
So how can a plan sponsor determine what constitutes reasonable compensation for a plan advisor? ERISA and the Internal Revenue Code (IRC) use the term “compensation” to cover all payments, monetary and non-monetary, that are compensatory. This applies to anything “partially or entirely, directly or indirectly, attributable to an investment or insurance recommendation.” Although the reasonableness requirement is imposed by law, the standard itself is an industry or market standard. According to the DOL, several factors inform whether compensation is reasonable, including but not limited to the market pricing of service(s) provided and the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is the final determinant of whether compensation is reasonable; the essential consideration is whether the charges are reasonable in relation to what the investor receives.
While this guidance may be instructive, it fails to provide specific direction for determining what constitutes reasonable compensation. To help determine market standards for advisor compensation, the DOL suggests firms seek impartial reviews of their fee structures, or “benchmarking.” Bear in mind, however, that benchmarking a fee structure may not provide complete protection against a claim of excessive fees. Firms should recognize that “reasonable” and “customary” do not necessarily mean the same thing. For instance, in limited circumstances, the markets may not provide competitive pricing.
In the absence of a precise definition of reasonable compensation, documentation of the steps taken to determine the reasonableness of fees is critical. Procedural due diligence is especially important in evaluating the performance of investment options offered under a 401(k) or 403(b) plan where participants can direct the investment of their personal accounts. Direct and indirect fees and other charges affect the value of participants’ accounts, and the documentation of procedural diligence can provide an effective defense in the event of litigation claiming the plan fiduciary has violated its duty to monitor fees and expenses. Plan fiduciaries should have a process in place to periodically monitor the performance of a 401(k) or 403(b) plan’s investment options. They should also document that the plan continues to provide a broad range of investment options that conform to the plan’s investment policy and do not charge excessive fees.
In summary, there are many factors that go into determining costs and what is reasonable. Reasonable means that fees and costs are commensurate with the investments and services provided. Not every plan will have the same costs for investments or advice because it depends on the specifics of the plan and the level of services rendered. The best advice may be to stay on top of fee structures. Plan sponsors may wish to consider “re-benchmarking” their advisor compensation structures at reasonable intervals—what is reasonable this year might not be reasonable next year.