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The “Free 401(k)” and the Prohibited Transaction

I’m continually amazed at the number of plan sponsors who do not know how much they are paying for their 401(k) plan, and, in some cases, to whom. Aside from that being a breach of fiduciary responsibility, IMHO, many plan sponsors and advisers today are unknowingly putting themselves and their plan at risk of a Prohibited Transaction through this behavior. Here’s how -

In these cases all plan expenses are typically paid out of revenue sharing arrangements such as 12b-1 fees.  All funds and share classes do not pay at the same rate, so within the same line-up there is likely a variety of 12b-1 payment schedules (the most extreme differences are typically found when comparing actively managed funds vs. index options that typically do not pay revenue sharing).

For many plans it is very common for the adviser to work one-on-one with participants and provide advice recommendations.  Let’s say that the adviser recommended an actively managed fund that pays revenue sharing, over an S&P 500 Index fund that does not.  While we all know there may be very valid reasons to do so, but ERISA is very clear that fiduciaries must act solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them.

By recommending a fund that pays revenue sharing over a fund that does not, that adviser (acting in a fiduciary capacity) has just influenced their own compensation, or their firms, thus creating a prohibited transaction.  Therefore, what started out as a qualified financial professional providing assistance to a plan participant, ended up in creating a prohibited transaction for the plan.

In my experience, most plan sponsors do not realize the risk they are putting themselves and their plan in by entering into such arrangements.   This is where you can help them understand the inner-workings of the plan services and fee arrangements to help them from inadvertently creating a prohibited transaction.

So what is an adviser to do?

For plan-level services, make sure you clearly document your fees and services in your plan sponsor agreements so they have a clear understanding of what fees are being charged and how they are being paid.  The fees and services being offered should be a separate conversation from the investment options in the plan.  Then, after a prudent process to select the funds in the plan, if there is revenue sharing available, this money can be used to help offset the plan’s expenses.

For participant-level advice, ERISA has outlined a number of arrangements by which a conflict-free or conflict-mitigated investment advice can be offered to participants such as through an Independent Third Party or the Pension Protection Act.  Many outsource this function to a third party to not only, but help prevent inadvertent conflicts of interest but also to provide a scalable solution.  Whichever way you go, make sure the services and fees are set up in such a way that all fiduciary services solely benefit the plan’s participants.


Scott Swezy
VP Smart401k