The Employee Retirement Income Security Act (ERISA) allows plan sponsors to maintain spending accounts funded by revenue generated by mutual fund holdings to help pay for the costs of running a 401(k) Plan. While these spending accounts—also known as revenue-sharing accounts, budget accounts, ERISA buckets or plan expense reimbursement accounts—can be helpful in defraying plan expenses, it’s important that plan sponsors understand the details of revenue-sharing agreements and the fiduciary responsibilities they entail.
This can be a challenge, especially for smaller plans. Not only do many plan sponsors not fully understand the mechanics of how spending accounts work, it’s not uncommon for administrators to not even realize that the funds they offer have revenue-sharing agreements. This can cause sponsors to neglect their fiduciary duty to track and provide transparency for funds in spending accounts and how that revenue is used—opening the plan up to lawsuits by plan participants.
To help clear up this confusion, we answer some of the most common questions that plan sponsors have about ERISA spending accounts.
What Is an ERISA Spending Account?
To understand ERISA spending accounts, it’s important to know how the revenue is generated. Some investment options—usually mutual funds—offer rebates or paybacks for using their investment funds. The payback is built into the expense ratio for the fund and is returned to the recordkeeper. In turn, the recordkeeper takes its fee for hosting the mutual fund and then the remainder goes into a revenue-sharing account that is directed by the plan sponsor to either pay for plan expenses or be allocated as earnings to participants with 401(k) accounts
Often, plan sponsors are not aware that they have a revenue-sharing account, or they think that the recordkeeping is free. This is mostly because recordkeeping fees are taken out of the fund’s earnings (or the expense ratio).
What Can the Account Pay For?
Typically, funds in the ERISA spending account are allocated as earnings to the participant with a 401(k) Plan balance or are used to pay other 401(k) Plan operational expenses, including:
- Audit fees;
- Third Party Administration services including annual discrimination testing;
- Transactional expenses, such as calculating hardship, QDRO and loan expenses; and
- Legal and other annual professional fees.
The account can’t pay settlor fees, amendment to plan fees or costs associated with adding voluntary features to the plan. In addition, ERISA spending account balances can’t be carried over to the next plan year.
What Happens to Excess Revenue?
If there is excess revenue in the account after these expenses are paid, plan sponsors typically return it to participants. The plan document should outline how excess revenue is distributed to participants. Some plans distribute it to all participants while other plans distribute it only to participants who invest in funds with revenue-sharing agreements.
Should My Plan Have an ERISA Spending Account?
When selecting any investment option to be included in a plan, sponsors need to ensure that the fees for the investment funds are reasonable. This is a fiduciary decision that plan sponsors make for all funds, regardless of whether they offer spending accounts. In some cases, including a fund with higher expenses and revenue-sharing may be completely justified by the fund’s expected returns or other factors.
Today, only 27 percent of plans have ERISA spending accounts, according to the Plan Sponsor Council of America’s 60th Annual Survey of Profit Sharing and 401(k) Plans. In addition to the rising popularity of exchange-traded funds (ETFs), index funds and other lower-cost investment vehicles that typically don’t offer revenue sharing, another reason that plan sponsors are moving away from this approach are the rules related to transparency and documentation when selecting funds.
Plan sponsors using spending accounts should clearly document the reasons for choosing funds that offer revenue sharing. Several lawsuits have come before federal courts where participants have charged that investments that provide revenue sharing were not in their best interest.
Insight: Know Your Responsibilities for Spending Accounts
Navigating the complexities of asset managers, funds and share types to decide which investment options to include in a company’s retirement plan can be a daunting process. Spending accounts and the widespread confusion about how they work only adds to the challenge.
Even though spending accounts are declining in popularity, they shouldn’t be an afterthought for plans’ investment committees. That is why it’s important for plans to work with investment advisors who have experience working with these types of arrangements. At a minimum, plan sponsors need to understand the mechanics of any revenue-sharing agreement they enter into and be able to justify why the fund’s fees are reasonable. Sponsors also need to understand their responsibilities for tracking and distributing excess revenue.
It’s important to revisit fee arrangements when adding a new investment or changing service providers. Plan sponsors are required to be aware of fees being paid—even costs paid directly by participants. There are no “free” services, so plan sponsors with ERISA spending accounts need to frequently determine whether this strategy provides value to the plan and its participants.
While this can be a complicated topic, your representative can help you better understand how ERISA spending accounts may impact your 401(k) plan.
Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP.