Effects of Expense Subsidies

Jeb Graham CEBS, CIMA® of CapTrust Financial Advisors has written an excellent article at 401khelpcenter.com on plan fees. The article can be read at:

http://www.401khelpcenter.com/401k/graham_stable_value.html

Preliminarily, he focuses on stable value fund economics. Stable value fund is such a loose term that different stable value funds may be invested in different asset types and may have different expense structures. Expenses may not even be fixed in amount or by a formula.

The more essential point made by Mr. Graham is that fees that are not disclosed, but are instead applied to reduce the expenses of plan administration through, e.g., sub-TA fees, are inevitably allocated unfairly.

For example, suppose two employees invest the same amounts in different funds, and one has an expense total of $100 while the other has an expense total of $200. Because the extra expense of $100 reduces the second participant's income, the plan and that participant are bearing that cost, which may or may not be reasonable. If the extra $100 is, instead, paid to the plan’s TPA, then (a) the extra is clearly not needed by the investment provider to operate the investment, (b) the use of the extra money to reduce plan administration is needed to restore fairness to the plan, and (c) the second participant, by selecting the more expensive investment, is subsidizing the operations of the plan.

If the plan’s sponsor would otherwise pay the extra $100, because the sponsor pays the plan administration fees, then there is an indirect benefit to the sponsor of $100. This may constitute a prohibited transaction under §4975 of ERISA §406, although since the effect is to pay for plan administration, and plans are allowed to defray administration expenses, it should not be a prohibited transaction, or at least not a violation of the exclusive benefit rule.

If the plan receives a subsidy from the investment provider and uses it to reduce total plan administration expenses paid by the plan, then the plan as a whole is treated fairly but there is, in effect, a subsidy of the first participant who invested in the lower-expense investment by the second participant who bore higher expenses that now reduce everyone else’s costs.

To eliminate the subsidy from one set of participants to another, the plan would have to apply the subsidy it receives to reduce the expenses only of those participants who invested in the higher-expense investment.

But look at the result of doing so. If the participant bears the higher expense through reduced investment yield, then gets it back through an expense reduction, the whole exercise is pointless. That is, the investment provide‚’s setting up of the arrangement only makes sense if it is not returned to the participant who bears the expense.

The only reason to jump through the hoops needed to create the arrangement is to use the money to influence the behavior of the plan or its advisers in the fund selection process. (To encourage use of the investment by participants, the best approach would be to eliminate the extra fee and have a higher product yield.) If the subsidy is created to encourage sales outside of employee benefit plans, and a full rebate is made, the arrangement may be defensible, although the plan needs to know about the subsidy to decide if it should be specially allocated. Otherwise, defending such an arrangement cannot be much fun.