Three conflicts of interest 401(k) sponsors must avoid

In 2011, Dr. Ron A. Rhoades, an Assistant Professor and Program Chair for the Financial Planning Program at Alfred State College, Alfred, New York, was awarded the Tamar Frankel Fiduciary of the Year Award, for “changing the nature of the fiduciary debate in Washington.”

That same year he was also named one of the Top 25 Most Influential Persons in the advisory profession by Investment Advisor magazine. He’s a published author and sought after by regulators to provide his wisdom in the area of fiduciary compliance. 

So when Ron speaks, people listen.

Dr. Rhoades recently granted FiduciaryNews.com an exclusive interview, where he discussed three common conflicts-of-interest. He also offered four guidelines every 401(k) plan sponsors should require of their investment adviser. 

But it’s the conflicts of interest that were most revealing. Dr. Rhoades bluntly suggests 401(k) plan sponsors, while they can currently get away with using 12b-1 fees and revenue sharing to offset certain ERISA expenses, shouldn’t wait for the DOL to act against these arrangements.

The safest policy 401(k) plan sponsors can adopt right now is to avoid the three biggest investment conflicts of interest: 12b-1 fees, revenue sharing, and the little-known but perhaps most deadly issue, directed brokerage.

Each creates a self-dealing conflict of interest normally considered a prohibited transaction under the fiduciary standard. Over the years, however, the DOL has carved out exemptions which allow what for centuries was forbidden under trust law (which has been the basis for defining fiduciary duties).

Dr. Rhoades calls this conflict of interest “wearing two hats” one as an adviser recommending the purchase of the fund and one as the broker personally profiting from the purchase of the fund. 

Many plan sponsors like these arrangements because they “lower” fees to the plan. In effect, however, they merely rearrange the deck chairs by offering a convenient hiding place for fees.

It is expected the DOL’s new Fee Disclosure Guidelines will make it harder to bury these fees in the fine print of product offerings. Those guidelines, however, will only reveal the fees, not ban or eliminate them. That decision remains with the plan sponsor.

Even within the currently legal framework of the DOL, these payback arrangements can be problematic to 401(k) plan sponsors for two reasons. First, as Dr. Rhoades points out in the interview, these fees are not necessarily consistently applied across all investment options. This leads to some participants subsidize plan costs to a greater degree than other plan participants. 

The other reason is just coming to light now. A 2010 study suggested “broker-sold” funds – the kind that offer revenue sharing and 12b-1 fees – lag in performance to “direct-sold” fund (i.e., those without revenue sharing and 12b-1 fees) by an average of 1 percent per year. A new study is about to be published that offers a similar conclusion. 

It’s clear 401(k) plan sponsors have a fiduciary duty to protect the interests of the beneficiaries of the plan – the plan participants. It’s equally clear revenue sharing, 12b-1 and directed brokerage arrangements can harm investors.

Although there are ways to justify these payback arrangements, Dr. Rhoades offers the simplest, most effective, advice when he says 401(k) plan sponsors would do themselves a service by avoiding these types of funds altogether.

The adage one can serve two masters is as old as the Bible, if not older. Still, it leads one to wonder. Why do some 401(k) plan sponsors place themselves in peril by ignoring this centuries-old maxim? Worse, why do regulators continue to look the other way and allow this practice to continue?

About the Author
Chris Carosa

Chris Carosa

Christopher Carosa, CTFA, is chief contributing editor for FiduciaryNews.com, a leading provider of essential news and information, blunt commentary and practical examples for ERISA/401(k) fiduciaries, individual trustees and professional fiduciaries. With three decades of experience in the investment industry, Carosa has helped create or found a number of financial products and firms including mutual funds, common trust funds, registered investment advisers as well as a billion-dollar trust company. He is also the author of the new book, "401(k) Fiduciary Solutions." Follow Fiduciary News on Twitter and LinkedIn.

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