The 3 Main Functions 401(k) Providers Fulfill
Operating a 401(k) plan has three main components: The Adviser, The Record Keeper/Administrator, and The Custodian. While it is common for the large household-name providers to handle all three functions, it may not be in your company's or the employees’ best interest to have one company handling all three.
Plans where three separate companies handle each function often have lower overall fees. When all three functions are handled by the same company there is an incentive to compensate advisers based on the overall profitability of the plan, including from ‘hidden’ revenue sources.
When the functions are handled by three separate companies, the adviser can hold each company accountable for keeping fees down and protecting the client, assuming there are no back-end revenue-sharing agreements between the companies and the adviser. As an example: with the 401(k) plans I provide, my compensation comes 100% from the employer or the employees within the plan, so there is no incentive for me to increase the other company’s profits. Instead, independent advisors like myself have an incentive to switch custodians or administrators if their fees get too high or if they see concerns with how they do business.
The Adviser is the person your company will directly interact with. An adviser might be set up as a Registered Investment Adviser, a stock broker, an insurance agent, or a combination of the three.
The adviser will recommend the structure of the plan, how the fees are charged, and the investments you should have in your plan. These recommendation will be true advice if the advisor is a Registered Investment Advisor and will legally be only a sales pitch (not advice) if the advisor works for a broker dealer, insurance company, or fund company.
To know if you have a good adviser, ask the following questions. You can (and should) check out the adviser at BrokerCheck.org to verify their answers to the questions below and review their disciplinary record, if they have one.
Key Questions to Ask the Adviser
Are you a Registered Investment Adviser, a broker, and/or an insurance agent?
Currently, only Registered Investment Advisers are held to the Fiduciary Standard of being legally required to do what is in your company’s and your employees’ best interests. Brokers and insurance agents are salespeople of the company they represent and have a legal duty to their employer - with no fiduciary duty to you.
While most advisers will say they will do what is in your best interest, unless they are a Registered Investment Adviser, you have limited legal recourse if they don’t. You can read more about the Fiduciary Standard in the third section below.
What are your licenses?
There are a lot of licenses an adviser might have. Registered Investment Advisers hold the Series 65 license. An adviser holding only this license is paid by the client for the advice they give and doesn’t sell products on commission.
All other licenses in the financial services industry are commissioned sales licenses and allow an adviser to earn commissions for the financial products they sell. (With sales pitches often disguised as advice).
Do you take on the legal liability for the investment plan as an ERISA 3(38) fiduciary?
Advisers who are fiduciaries can take on some or most of the fiduciary liability for the investments offered in the plan. You can read more about this below, but the upside is an adviser who takes on the fiduciary liability significantly reduces the liability to your company.
Who do you use as the record keeper/administrator and custodian of the plan?
You will want to make sure the record keeper/administrator and the custodian are major companies with significant experience in their respective fields. This is especially true for the custodian as this company will actually hold your plan’s money.
The custodian should be a large, well-recognized financial institution with a long history of protecting investors’ funds. If you’ve never heard of the custodian, it is a red flag. My firm uses TD Ameritrade or Charles Schwab as the custodian which holds plan money; while Bernie Madoff used Westport National Bank, a Connecticut bank with one office and just nine affiliated branches.
How do you choose investments that go in the plan?
This is definitely the question with the most subjective ‘right’ answer. Investment strategies vary significantly by adviser, and there is no single correct strategy.
You want to see they have a structured process for choosing investments, emphasize low-fee fund options, avoid using mostly or solely one company’s funds, and have a strategy to minimize your company’s liability for offering limited investment choices. It is important to realize that simply offering a lot of fund choices does not, by itself, meet ERISA legal requirements.
The Record keeper/Administrator
The Record Keeper and Administrator of your plan will be responsible for documenting transactions, filing government reporting forms, keeping records, and providing legally-required disclosures and other information to employees and plan participants at the appropriate time.
Most are not household names, but you will want to look for a company that is low-cost and has significant experience doing specifically this function. The administrator/record keeper presents the biggest liability risk for your company if legally-required disclosures and timelines are not met. (Aside from extraordinarily high fees and outright fraud.)
Key Questions to Ask about the Record Keeper/ADMINISTRATOR
Do you have ERISA and Tax attorneys on staff?
This function of a 401(k) plan is heavily steeped in both tax law and the Employee Retirement Income Security Act (ERISA). Having attorneys who specialize in these two areas of the law, and any changes that occur due to court cases, is extremely important. Without skilled attorneys, the record keeper/administrator may not be effective in providing the proper guidance and service to your plan.
How do you ensure disclosure and timeline requirements are met?
It would be extremely scary if the record keeper/administrator did not have a detailed and controlled process for ensuring your plan complies with the law in a timely manner. While you will likely get the same, good answer from every provider, it is still wise to ask.
How is the record keeper/administrator fee calculated?
Most record keepers/administrators charge a fee as a percentage of assets. While this is advantageous when the plan has little money within it, the fee can quickly become astronomical as the plan grows. The fee should, at the very least, offer breakpoints with a reduction in the percentage as the plan assets increase.
Ideally, look for a fee mostly made up of a small flat-fee per employee and for the plan as a whole. This flat-fee structure will become relatively cheaper as the retirement plan grows in size.
What is your process for watching over the actions of the adviser and the custodian?
One of the major advantages of having three companies do the three main functions of a 401(k) plan is they help hold each other accountable. The record keeper/administrator is in the unique position to monitor what is going on at the advisor and the custodian levels.
While it is not their responsibility to catch all fraud (your company is always responsible for doing your own monitoring) a good record keeper/administrator can be an important ally in helping you protect your plan’s assets and reduce your company’s liability.
Will you take on the fiduciary liability for plan administration as an ERISA 3(16) fiduciary?
Your company can further reduce it’s liability by delegating the fiduciary administrative functions to an administrator who takes on paperwork, disclosure, and filing responsibilities as a 3(16) fiduciary. Again, you can read more about this below, but the upside is the a significant reduction in the liability to your company.
The Custodian of your plan will be the company which actually holds plan assets and accepts the plan money. This will be the company who receives the money from your company for the plan and will distribute the money back to plan participants.
Here, bigger is truly better, and you will want one of the large, well respected, custodian financial institutions as the company that holds the money. Examples of custodians with long histories of protecting investor assets (in alphabetical order) include Charles Schwab, Fidelity, TD Ameritrade, and Vanguard. While there are many other good custodians beyond this limited list, you want to make sure the custodian isn’t an unknown company.
Key Questions to Ask about the Custodian
Do they have SIPC and additional insurance for plan moneys?
The SIPC is the government insurance program that protects investor money from losses due to fraud, similar to how the FDIC protects depositors money with banks. Unlike the FDIC, however, investors can always lose money in their investments and the SIPC insurance will not cover the investment losses. Many custodians will purchase additional private insurance to increase the protection for investors to amounts much higher than what the SIPC covers.
How can plan participants access their accounts and information related to their accounts?
Custodians should send statements directly to plan participants on at least a quarterly basis. While advisers and record keeper/administrators may also send statements, the employee should always have direct access to a statement from the custodian. This allows employees to verify accuracy and reduces the chance of fraud.
Online access to accounts and access through mobile apps can also be helpful in keeping employees informed and engaged.
What is their process for watching over the actions of the adviser and the record keeper/administrator?
The custodian should actively be looking for fraud, embezzlement, and other criminal activities. Custodians should have extensive written policies and procedures for protecting your plan money.