The Growing Crackdown on 401(k) Share Class Selection
As an ERISA attorney who has defended plan sponsors against Department of Labor (DOL) investigations, I’ve seen firsthand how improper mutual fund share class selection in 401(k) plans has become one of the most common—and costly—compliance failures. The DOL has collected over $1.8 billion in restitution since 2015 through its share class initiative, with average fines ranging from $25,000 to millions depending on plan size.
Table of Contents
What Constitutes a Share Class Violation?
The DOL considers it a prohibited transaction when:
- Higher-cost retail shares are used when identical institutional shares are available
- Revenue-sharing payments create conflicts of interest
- Sub-transfer agency fees aren’t properly credited to the plan
Most Commonly Misused Share Classes
| Retail Share Class | Institutional Equivalent | Fee Difference |
|---|---|---|
| American Funds R3 | R6 | 0.35% vs 0.29% |
| Fidelity Advisor A | Fidelity Institutional | 0.75% vs 0.45% |
| T. Rowe Price R | I | 0.65% vs 0.50% |
How the DOL Calculates Fines
The standard remediation formula requires:
- Restitution of all excess fees paid over 6 years (ERISA’s statute of limitations)
- Lost earnings calculated using IRS underpayment rates
- Civil penalties up to 20% of recovered amount
Example Calculation for $10M Plan:
- Excess Fees Formula:
\text{Excess Fees} = (\text{Retail ER} - \text{Institutional ER}) \times \text{Plan Assets} - Example Calculation:
= (0.75% - 0.45%) \times $10,000,000 = $30,000/\text{year} - Restitution Calculation:
\text{6-Year Restitution} = \$30{,}000 \times 6 = \$180{,}000 - Lost Earnings:
\text{Lost Earnings} = \$180{,}000 \times 15\% = \$27{,}000 - Civil Penalty:
\text{Civil Penalty} = \$207{,}000 \times 20\% = \$41{,}400 - Total Fine:
\text{Total Fine} = \$207{,}000 + \$41{,}400 = \$248{,}400
Recent Enforcement Cases
Case Study 1: Mid-Sized Manufacturer (2023)
- Assets: $50 million
- Violation: Used American Funds R4 shares when R6 available
- Restitution: $425,000
- Penalty: $85,000
Case Study 2: Hospital System (2022)
- Assets: $300 million
- Violation: Failed to negotiate institutional share conversion
- Settlement: $2.1 million
How Plan Sponsors Can Protect Themselves
1. Document Share Class Selection Process
- Maintain records showing institutional shares were considered
- Document why retail shares were used if applicable (e.g., minimums not met)
2. Implement Regular Fee Benchmarks
- Compare all fund expenses against:
- Morningstar category averages
- DOL’s 408(b)(2) fee disclosure rules
3. Conduct Independent Audits
Hire a 3rd party to:
- Inventory all share classes in plan
- Identify available lower-cost alternatives
- Calculate potential excess fees
Sample Audit Checklist:
- Are institutional shares available for >90% of funds?
- Is revenue sharing properly disclosed?
- Do any funds have 12b-1 fees >0.25%?
Corrective Actions Under DOL’s VFCP
The Voluntary Fiduciary Correction Program allows self-reporting with reduced penalties if:
- Restitution is made to participant accounts
- Plan documents are amended within 120 days
- Procedures are implemented to prevent recurrence
Typical VFCP Timeline:
- Identify violation
- Calculate damages
- File with DOL within 30 days
- Implement corrections within 90 days
The Role of Recordkeepers
Many recent cases involve recordkeepers failing to:
- Disclose all available share classes
- Pass back revenue sharing
- Update to lower-cost shares when thresholds met
Red Flags for Plan Sponsors:
- Recordkeeper refuses to provide share class comparisons
- “Revenue neutral” explanations for share class choices
- Lack of annual fee benchmarking reports
Participant Lawsuit Risks
Beyond DOL actions, improper share classes expose plans to:
- ERISA §502(a)(2) breach of fiduciary duty claims
- Class action lawsuits (average settlement: $12M)
- 20% excise taxes on prohibited transactions
Best Practices Going Forward
- Annual Share Class Review: Require recordkeeper to certify all funds use lowest-cost available shares
- Participant Disclosure: Clearly explain share class selection in SPDs
- Fiduciary Training: Educate committee on ERISA §404(c) requirements
- Fee Policy Statement: Include share class selection criteria
Key Questions for Your 401(k) Provider
- “When did you last conduct a share class audit?”
- “What percentage of our funds currently use institutional shares?”
- “How do you monitor when share class conversions become available?”
- “Can you provide a written certification that all funds use the lowest-cost share class available?”
The DOL has made clear that share class compliance remains a top enforcement priority. Plan sponsors who proactively review their fund lineup and document their decision-making process significantly reduce their exposure to costly fines and litigation. Would you like me to review your current 401(k) investment lineup for potential share class issues? I can provide a confidential preliminary assessment.
