Expect 401k Adviser Pay to Fall if Recent Lawsuits go Unchecked

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Two big lawsuits have been filed recently by St. Louis based law firm Schlichter, Bogard, & Denton. The first suit, against Anthem, alleges that even the Vanguard fund chosen was not cheap enough based on the buying power of the plan and the fact that a cheaper version of the fund did exist. The second suit alleges that Chevron should have selected a cheaper, better yielding stable value fund to replace the more expensive, lower yielding Vanguard money market.

It pains me to keep writing “cheap” like this. But it is at the heart of both suits. In the fund world, it is possible to get the exact same basket of investments for a lower fee. The funds can be identical identical except for the fee. The same underlying investments, the same service, just different fees.

Additionally, the Chevron suit explicitly alleges that the revenue sharing arrangement resulted in extra fees for the recordkeeper as the assets grew and did not have a corresponding increase in services. Connecting the dots: The increase in revenue was not reasonable based on the fact that no additional services were rendered to the plan. The consequence of this unreasonableness could be a fiduciary breach under ERISA.

So what does that have to do with adviser fees? Many advisers charge an asset-based fee. As the markets advance, so does the adviser’s paycheck. If this Chevron suit goes through, a dangerous precedent will have been set. Up to now, many advisers have sold asset-based compensation as “I share in the same gain as the participants; I win when they win.” If this suit goes through, the assumption will be that the adviser must provide additional services to match the increase in compensation instead of the paradigm of reward for good performance we have seen up to now.

On the other side of the potential precedent, it would seem that an adviser is resetting the acceptable floor every time the market drops. It doesn’t take much to continue the argument as such: The reduced revenue was acceptable for the adviser in 2007 and 2008; therefore, the adviser should have had a reduced commission rate in 2009-20013 as he demonstrated that he could provide the same services for less commissions during the market correction. So just like an inverted high water mark on an annuity, you could be slashing your own fees every time you sit quietly as the market goes through a correction. Just for argument’s sake, the same could be true as we look at the potential for large distributions as Boomers retire.

This creates an unfortunate paradox. When the market is tanking, that is when a 401k adviser is in highest demand by the participants. Plan sponsors routinely rely on the adviser to provide education to the participants during these times of market turmoil. Under this dangerous precedent, it could further hurt the adviser because he is working harder and for less money, essentially driving that floor lower.

There would appear to be two ways to avoid this. The first is to charge a flat fee for service or a per head charge. This structure eliminates the potential issues caused by an asset-based fee tied to the ebbs and flows of the market. However, this also requires registration as an RIA, which could mean new licensing in addition to repapering all of your clients.

The second way to combat this is to better educate clients about all of the work that goes into their plans. As I have said before, I believe that adviser compensation is artificially low in the micro-small market. These suits make it absolutely clear: Absent any other information, the cheapest (Argh!) option is the one that the responsible plan fiduciary should select. Helping a client to understand why and how his adviser gets paid seems smart. Additionally, it helps to illustrate an inherent difference between the adviser fee and the investment fee. In investments, you can have lower fees for the same product. If your client doesn’t understand what you do, he could easily assume that your fees are like the fund fees – same great service, new lower price!

If these suits go through as written, plan sponsors will be looking to make sure that their fees are the cheapest (Argh! There’s that word again!) regardless of the level of service being provided.

Disclosure: I’m not an attorney, or an accountant. So don’t take this as legal or tax advice.