The Frugal Fiduciary Small Business 401(k) Blog
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Last week, the Supreme Court of the United States (SCOTUS) issued their highly-anticipated Hughes v. Northwestern University decision. In a unanimous opinion, the court reaffirmed – as articulated in Tibble v. Edison International – that 401(k) fiduciaries have an obligation under ERISA to continuously “monitor” their plan’s investment menu and to remove any imprudent investments timely. A lower court - the 7th U.S. Circuit Court of Appeals - had dismissed case in 2020, suggesting that 401(k) fiduciaries could shield themselves from claims of imprudent investment selection by offering a diverse investment menu. SCOTUS returned the case to the 7th Circuit for reconsideration.
401(k) providers can charge “direct” and/or “indirect” fees for delivering plan administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and professional investment advice. The difference between the fees is how they are paid. Direct fees can be paid by the plan sponsor or deducted from participant accounts, while indirect fees increase the cost of plan investments – reducing their returns. If you’re a business owner, I strongly recommend you avoid indirect fees for two reasons – 1) they lack the transparency of direct fees – which makes excessive 401(k) fees harder to avoid and 2) they could limit your access to top 401(k) investments - which often pay no indirect fees.
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Believe it or not, ERISA imposes few fiduciary responsibilities on business owners when selecting investments for their 401(k) plan. They boil down to picking – and maintaining - enough “prudent” investments to allow plan participants to diversify their account “so as to minimize the risk of large losses.” Prudent 401(k) investments are simply funds that meet their investment objective for reasonable fees.
Inappropriate investment selection is one of the top three reasons why 401(k) fiduciaries are sued today. In my experience, employers can easily avoid these lawsuits by having a clear understanding of their investment-related 401(k) fiduciary responsibilities. These responsibilities are surprisingly basic. They boil down to selecting enough “prudent” investments to permit any plan participant to sufficiently diversify their account – to minimize their risk of unrecoverable losses. A prudent investment is simply one that meets its investment objective for reasonable fees. I’ve never seen a leading index fund from providers such as Vanguard, Fidelity, or Schwab fail to fit this bill. For that reason, I consider these funds to be indisputably prudent 401(k) investments.
To meet retirement goals as affordably as possible, 401(k) participants must do three basic things – save early and often, invest appropriately, and keep account fees to a minimum. Investing appropriately involves constructing - and maintaining – a 401(k) investment portfolio that balances growth potential with the risk of losses.Striking this balance is important. Otherwise, a 401(k) participant could miss out on gains by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when near retirement.
All 401(k) plans require three basic administration services – asset custody, participant recordkeeping and Third-Party Administration (TPA). A 401(k) provider can be paid “direct” or “indirect” fees from plan assets to deliver these services. Direct fees are deducted from participant accounts, while indirect fees are paid by plan investments. The most common form of indirect fee is revenue sharing. Below are five reasons why employers should pay direct fees for 401(k) administration services instead.