Proprietary Funds: The New Lightning Rod for 403(b) Plans?
In the world of 403(b), variable annuities have been a lightning rod for criticism by anyone paying attention. And, for good reason, with the caveat that there are some variable annuities offered by low-cost providers that shouldn’t be lumped in with the rest.
However, in the large 403(b) plan space, the criticism of variable annuities has all but evaporated, since, with some low-cost exceptions, variable annuities no longer exist. Most large plan sponsors began using mutual funds in the 2000s (some as early as the 1990s), and have never looked back.
With no high-cost variable annuities to critique, proprietary funds have appeared to take the place as the top target for criticism. Recent litigation, as well as a number of articles in the press, have been highly cynical of recordkeepers’ proprietary fund offerings (i.e., funds where the recordkeeping company also serves as the fund manager) and the plan sponsors who select such offerings.
However, unlike variable annuities, where the criticism was a slam dunk, the assessment of proprietary funds in 403(b) plans is more like a half-court heave - once you get past the obvious conflict of interest of a recordkeeper offering funds on the platform it also manages. Here’s why:
- Unlike 401(k) plans, where assets are held in a trust, a significant amount of 403(b) assets (including nearly all assets in 403(b) contracts that existed prior to 2000) are individual annuity contracts/custodial account agreements that are controlled by each individual participant, rather than the employer. Thus, for existing plan assets, if a plan sponsor wishes to move assets out of a fund, they must obtain consent from each and every participant who owns assets in the fund (an impossible task). Therefore, while future contributions may be directed to an alternative fund, existing assets will remain in the original fund, whether the plan sponsor likes it or not.
- Proprietary funds aren’t always bad. In fact, in the case of some low-cost providers, the proprietary fund may be the best available choice, keeping in mind that 403(b) plans are generally limited to variable annuities and mutual funds, eliminating alternative options such as ETFs.
- While some recordkeepers require the use of one or more proprietary funds, which is not ideal from a fiduciary perspective, in most large 403(b) plans, the use of these funds are completely optional. And, in some cases, a fee discount is offered if a proprietary fund is used. Though I am often suspicious of these discounts, they could be a great value for plan participants if the investment in question is the best available, which is sometimes the case.
- Some proprietary funds enjoy an almost cult-like following among participants, and I have witnessed situations where the removal has caused participant mutiny. Unfortunately, the fiduciary duty to act in the best interest of plan participants and beneficiaries does not always coincide with what participants THINK is in their best interest. Of course, I am not suggesting that a plan sponsor retain a fund that is a clunker, just because it is popular among employees, but employee disruption, and overcoming it, should be evaluated with any fund change, so that a plan can be put in place to address employee concerns.
Having said all of this, due to the litigation and bad press, any plan sponsor who selects/retains a proprietary fund (or funds) in their investment array is likely going to need to defend that decision at some point. The good news is that this should be fairly straightforward for plans with a written investment policy.
The question here is simple: per the fund selection/retention criteria of the plan’s investment policy, would the proprietary investment be selected/retained if the investment were not proprietary (e.g., if it were offered by a fund family unrelated to the recordkeeper)? If the answer to this question is “yes,” then the fiduciaries should be able to easily defend the inclusion in the investment array. If the answer is “no,” the fiduciaries should review their decision to include the proprietary fund.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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