The handling of funds that flow into and out of Section 401(k) plans and the question of who profits from the float income generated while the money is held by a service provider before its investment or before it is it cashed by participants is an issue that, until recently, has received little consideration. But the practice has gained the attention of regulators and attorneys and could create legal problems for employers and their plan fiduciaries if not carefully considered, said Joshua J. Waldbeser, an attorney with the law firm Drinker Biddle & Reath.
Historically, firms that provide recordkeeping services to 401(k) plans have kept this float income as part of their compensation, Waldbeser said.
Last March, however, a federal district court ruled such a practice illegal and ordered a 401(k) plan's recordkeeper to repay plan participants $1.7 million in float income it had retained over a six-year period (Tussey v. ABB Inc., W.D. Mo., No. 2:06-CV-04305-NKL, 3/31/12).
The court found that under the Employee Retirement Income Security Act, “any service provider with the power to determine how plan assets (including float) are used cannot unilaterally exercise its fiduciary authority over those assets to pay itself additional compensation without triggering a prohibited transaction for fiduciary self-dealing,” Waldbeser said.
In short, a service provider cannot legally retain income generated from the float, unless specifically permitted to do so by contract and unless doing so is justified as a reasonable compensation for services rendered, said the law firm Schiff Hardin in a case analysis.
In addition to the $1.7 million that the recordkeeper was required to repay in Tussey v. ABB, the court also ordered the employer, its 401(k) recordkeeper, the plan administrator, and the investment manager to pay $35.2 million to participants for failure to monitor recordkeeping related to other revenue-sharing payments.
For example, the employer never calculated its annual expenditure on recordkeeping and administrative fees, the court said.
The plan's revenue-sharing payments to providers were plan assets. Under the plan's investment policy statement, the employer had a legal obligation to manage those investments in a way that would reduce any related recordkeeping and administrative costs, the court said.
The company and the recordkeeper breached fiduciary duties by failing to negotiate rebates from the investment manager and from the other service providers, Schiff Hardin said.
The employer-plan sponsor had an investment policy statement, but plan fiduciaries failed to follow it, said Charles D. Epstein, president of the 401(k) Coach Program consulting firm.
The regulations governing defined contribution retirement plans encourage but do not specifically require plans to have an investment policy statement, Epstein said.
The fact that the employer had not monitored its recordkeeping costs was bad enough, but the plan exacerbated the situation by failing to follow its investment policy statement and by forgetting to adjust “the document when its internal practices differed from the written specifications,” said Earle Allen, vice president of the benefits consulting firm Cammack LaRhette.
Furthermore, although the court said it did not consider the recordkeeping fees to be extremely unreasonable, they could have been less if the plan's sponsor had made the effort to track and benchmark them, which represented another failure of its fiduciary duty, Allen said.
To avoid a similar situation, plan fiduciaries should negotiate with service providers about the status of float income and any other fees and revenue-sharing arrangements.
Fiduciaries also should provide “full and fair disclosure regarding the use of the float,” Waldbeser said.
The questions Waldbeser suggests fiduciaries ask service providers regarding current arrangements and prior to signing new contracts include:
• How will any float income be earned and who retains it?
• What standards are used to determine the length of the float income on contributions that are pending investment?
• What is the deadline for investing a contribution?
• When does the float period begin and end?
• Does the float period include mailing time and other relevant time periods that might affect checks pending distribution?
• What interest rate will be used during the float and how is it calculated?
Plan fiduciaries should review their contracts with regard to float income to ensure the contracts comply with requirements and provide protection against related prohibited transactions, Waldbeser said.
Service providers, meanwhile, must be able to account for all the compensation that is anticipated from float income in their disclosures to the plan, Waldbeser said.
Providers with unexplained income could be found guilty of engaging in a prohibited transaction and forced by the Labor Department to return any related compensation, as well as face civil penalties and excise taxes, he said.
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