The DOL’s proposed regulation on selecting investments, including alternative assets, 2026-06178.pdf, identifies six factors that need to be considered in the process of selecting any investments for participant-directed plans, such as 401(k) plans and private sector 403(b) plans. The six factors are: Performance, Fees, Liquidity, Valuation, Performance Benchmark, and Complexity. The proposal describes each of those factors and provides 20 examples of their application.
In my post Alternative Assets (9) I discussed the second factor, Fees. My last article, Alternative Assets (10), examined the first Fees example in the proposal. This article looks at the second DOL example of the application of the Fees factor.
The example is:
(2) Example. Fees; Share classes—
(i) Facts. A plan sponsor decides to establish a participant-directed defined contribution plan. The plan document specifies that the director of human resources is the named fiduciary of the plan and responsible for the establishment of the plan investment menu and selection and monitoring of designated investment alternatives. The named fiduciary does not enlist the services of an investment advice fiduciary within the meaning of section 3(21)(A)(ii) of ERISA, an investment manager within the meaning of section 3(38) of ERISA, or any other type of professional consultant. The named fiduciary purchases a subscription to an independent analysis ratings firm to research investment options before making a selection. The service rates funds overall but does not attach ratings to different share classes of the same fund. After a few years, the named fiduciary decides to replace one of the plan’s designated investment alternatives with a new fund, and to move participant investments from the old designated investment alternative to the new fund pursuant to ERISA section 404(c)(4). The new fund selected by the named fiduciary has high ratings from the service to which the named fiduciary subscribes and is a registered investment company within the meaning of the Investment Company Act of 1940. The named fiduciary makes a substantial investment in class R2 shares of the fund. The named fiduciary does not consider any differences in share classes offered by this fund. The fund offers multiple share classes, including multiple R share classes. Class R2 shares have substantially higher fees than class R6 shares. Based on the amount of the investment, the named fiduciary could have purchased class R6 shares without any negotiation or additional expenditure of plan assets or resources. Except for fee structures, both share classes are identical in terms of shareholder rights and obligations.
(ii) Analysis. A fiduciary must consider a reasonable number of similar alternatives and determine that the fees and expenses of the designated investment alternative are appropriate, taking into account the designated investment alternative’s risk-adjusted expected returns and any other value the designated investment alternative brings to furthering the purposes of the plan. The named fiduciary failed to give any consideration to the differences in fees between the various share classes of the fund, even though the size of the investment met the fund’s criteria for the lower fee share classes without any negotiation or additional expenditure of plan assets or resources. Class R6 shares have a superior value proposition to class R2 shares because both share classes are identical in all respects except that class R6 shares have lower fees.
(iii) Conclusion. The facts in this example do not establish that the named fiduciary satisfied section 404(a)(1)(B) of ERISA and paragraph (h) of this section when selecting the designated investment alternative. The selection process appears to be flawed because the named fiduciary failed to consider the difference in fee structures among the various share classes. A prudent selection process would ordinarily uncover the existence of more economical share class options for the plan. (The bolding in this article is mine…just to emphasize the points that I consider the most important.)
Comment: I have discussed some of the considerations in prior articles, e.g., risk-adjusted and reasonable number, and will not repeat those discussions here. Beyond that, this example illustrates the point that private sector plan sponsors and advisors already understand and, by and large, are satisfying. That is that the expenses of the share classes of a fund that are readily available to a plan of a particular size must be considered and, all other things being equal, the lower cost share class should be selected. However, there are exceptions. For example, if one share class is more expensive (let’s say by 15 basis points) than another share class of the same fund, but the more expensive share class has revenue sharing of 25 basis points—which is used to offset recordkeeping fees—the ostensibly more expensive share class is actually less expensive on a net basis to the plan. In that case, it would make sense for the fiduciaries to select the share class with the higher expense ratio, but with a lower net cost to the plan.
In this example, the DOL makes the point that it doesn’t take any additional effort or cost to use the less expensive share class of the fund. While that creates a cleaner example, I think a more complete analysis would be that the effort or cost would need to be compared to the benefit to that plan. For example, a one basis point difference is one thing, but a 10 basis point savings is quite another.
The preamble to the proposal discussed this example as:
Paragraph (h)(2) of the proposed regulation provides an example that does not demonstrate that the plan fiduciary satisfied section 404(a)(1)(B) of ERISA and paragraph (h) of the proposed regulation. In this example, which involves a highly rated registered investment company with multiple share classes, the plan fiduciary fails to consider the differences in fee structures among the various share classes of the fund and ultimately selects a more expensive share class that is identical in all respects to another available share class with lower fees. Nor did the fiduciary in this example enlist the assistance of professional advisor, manager, or consultant before making the selection. The example concludes the lower-cost share class appears to have a superior value proposition, and a prudent selection process ordinarily would have reflected that.
Comment: This explanation makes a point that the plan fiduciary did not seek the advice of a knowledgeable advisor. I have two thoughts on that. First the use of an adviser who is experienced in working with comparable plans is evidence of a prudent process. (In the full proposal, the DOL refers to “qualified” investment advisors and professionals more than 10 times. In my view, “qualified” means knowledgeable and experienced with plans of that size and type.) Second, I don’t recall seeing any examples where the DOL said that the plan fiduciaries used an advisor and then found the plan fiduciary to have acted imprudently. In other words, the DOL sees qualified advisers as an important element of a prudent process. (However, I don’t want to misrepresent the views of the DOL. The DOL is not saying that plans are required to have advisors. Even with that, though, later in this series we will look at the Complexity factor. It seems to me that, based on the Complexity factor alone, any reasonable fiduciary would want to work with a qualified advisor.)
Concluding Thoughts
This is an important example. Fiduciaries should always consider whether there are share classes that are available to the plan that are less expensive, based either on their stated expense ratio or on the net expense ratio (if the revenue sharing is paid into the plan and used for plan expenses or allocated to participants).
While experienced advisors are and have been aware of this standard, it is good for the DOL to highlight this issue. As a result, plan fiduciaries and their advisors, and the lawyers who work with them, should review their investment policy statements to ensure that the evaluation of share classes is a regular—probably annual–part of the fiduciary evaluation for the selection and monitoring of a plan’s investments.
