Consider this statistic: during the three-year period from 2012 to 2015, there were ten litigation claims levied against plan sponsors. In the following three-year period ending 2017, that number jumped to 85![1] A large majority of these legal cases involved the design of the retirement plan’s investment menu as the key underpinning.

One potential issue: the plan sponsor’s use of their recordkeeper’s proprietary funds.

As a plan sponsor, you are responsible for every service provider hired for your retirement plan. This, of course, includes both the quality of the service provided, along with the price paid for it. However, it also pertains to the responsibility around mitigating all potential conflicts of interest.

A sponsor can choose a recordkeeper that has proprietary funds on its investment platform or it can choose one that does not. Proprietary funds play a prominent role on some of the largest recordkeepers’ platforms. It is not uncommon for these firms to either require or make it attractive for you to choose their funds. Why?

Because recordkeepers can often obtain greater profits from the use of their funds than from the recordkeeping itself.

Open-architecture platforms a solution?

In the early 1990s, many of the retirement plan platforms available to plan sponsors were through mutual fund companies. It was typical to have an investment menu comprised entirely of that company’s funds. The revenue generated from the funds allowed the mutual fund company to offer to sponsors what at times looked like a ‘free’ plan without any fee invoices.

Recordkeeping trading technology at that time was not built out to allow for a multi-fund family (i.e. ‘open-architecture’) approach. Insurance companies, using a group-annuity offering, were among the first to offer a multi-family platform. From there, several mutual fund platforms then pioneered a new wave of technology that brought open-architecture to another level.

Why do many recordkeepers still fail to provide open-architecture platforms?

Today open-architecture platforms are common, but the presence of providers continuing to utilize their own investment funds remains very much a part of the retirement world. These structures exist in large part as a means to obtain additional revenue.

Over the past decade, median recordkeeping fees have been cut in half.[2] As a result, recordkeepers have sought out other sources of revenue. One such means has been to tout their own investment funds. A typical arrangement involves the recordkeeper offering up a fee concession as a means to entice the plan sponsor to use its proprietary funds.

For a while, we saw a trend away from this structure—one toward open-architecture. This had given retirement plan sponsors more flexibility to design their investment lineups utilizing more of a ‘best-in-class’ approach. 

Now, however, the pendulum appears to be swinging back.

With renewed vigor, recordkeepers are enticing fee-focused sponsors with attractive offers tied to the use of their own target date fund suites, stable value option, or other strategies.

Looking specifically at the target date fund space, the use of non-proprietary fund options is prevalent throughout but to what degree seems to depend on the size of the plan. A study found that 64% of sponsors overseeing plans in excess of $1 billion are using non-recordkeeper options; however, for plans under $100 million, the number is only 32%.[3]

But is it wrong for plan sponsors to lower overall plan expenses by using a recordkeeper’s proprietary investments?

While plan sponsors should consider fund expenses when selecting investment options, they also must consider who benefits from specific cost savings – the plan sponsor or participants. Focus should be placed on a fund’s overall expenses. A recordkeeper may offer revenue sharing on a fund to offset the plan’s administrative expenses; however, if the fund’s overall expense ratio is relatively high, then that could harm participants in the long run.

To be clear, the practice of using your recordkeeper’s proprietary funds is not illegal, nor is it necessarily wrong. While ERISA requires plan sponsors to act solely in the best interest of plan participants, it does not specify the types of investments a sponsor must offer those participants and it does not require sponsors to automatically choose the lowest cost funds. The practice can however reduce the overall level of fee transparency for the plan. 

So, what are plan sponsors to do?

Paying close attention to the plan’s fee structure is certainly an important undertaking. However, it is just as important to think objectively and make decisions about what is in the best interests of the participants. Be careful not to compromise quality as a means to save a few basis points on recordkeeping.

An academic study discovered that “…poorly performing funds are less likely to be removed from and more likely to be added to a 401(k) menu if they are affiliated with the plan trustee.”[4] In fact, the study found that only 13.7% of the poorest performing proprietary funds were removed, compared to 25.5% of the poorest performing non-proprietary funds. So ask yourselves one very important question: do the funds in my investment lineup occupy their place based on their merit, or are they there solely as a means to reduce my recordkeeping fee?

Many of a recordkeeper’s funds may be competitive options. But the decisions around constructing a retirement plan menu should be based on the merit of the investment options and the interests of plan participants, not the recordkeeper’s profit margins.

In the end, this should always be the beacon that guides a plan sponsor. When gray areas present themselves, come back to that beacon and let that be your standard.