Today, plan sponsors and fiduciaries of retirement plans have knowledge of all the fees being charged to their 401(k) or 403(b) plans by various services provides. The new disclosure requirement under ERISA Section 408(b)(2) requires all service providers to disclose their fees. This is very important information to have for plan fiduciaries to decide on service providers and designated investment alternatives. However, a simple comparison of fees charged by different record keepers is not a good enough reason to make a hiring or investment decision. This article will show an example of how the same fee charged by two different recordkeepers may create different returns for similar mutual funds and why it is important to rebate all revenue sharing back to plan participants who paid those fees. Both fiduciaries to retirement plans and the U.S. Department of Labor should understand that the fee disclosure alone is not enough information to make a hiring decision and further study and possible regulation may be required in regards to recordkeepers.
Many fund companies have imbedded revenue sharing fees in their net asset charge; such fees are 12b-1, Share Holder Service Fees, Sub TA, and others. These fees can range from 0.05% to 1% or even higher and are used to pay financial intermediaries for their services. However, in some cases, financial intermediaries rebate all revenue sharing back to the plan and have a separate asset charge for services provided. Rebating all revenue sharing available back to the plan participants is a proper way of avoiding a potential conflict of interest; such as, recommending only high revenue sharing funds. Also, if the revenue sharing is credited back properly, the separate financial charges for recordkeeping, TPA, and advisory services will be more transparent, easier to understand, and fairly distributed among all participants in the retirement plan instead of unevenly skewed towards participants invested in high revenue sharing mutual funds.
Rebating all available revenue sharing fees to plan participants is a right direction towards being fair but it does not guarantee fairness. In the following example, both recordkeepers avoid a conflict of interest by rebating the revenue sharing available and charging a separate 0.50% of plan assets for their services. However, having identical fee schedule can still create different returns using the same mutual funds. The difference between these two recordkeepers is in the way they rebate the revenue sharing paid by mutual fund companies. First, we will examine the recordkeeper A that uses the average method to rebate revenue sharing fees. Average method credits revenue sharing fees equally among all participants despite the fact who paid those fees. Then, we will compare the recordkeeper A to the recordkeeper B that implements the direct method of rebating the revenue sharing fees. Direct method credits revenue sharing fees directly to those participants who actually paid those fees. In real life, the cost of using the direct method to rebate revenue sharing is likely to be higher than the cost of using the average method, but to see a clear difference from using these two systems, we assume that both recordkeepers charge the same fee of 0.50% despite a likely higher cost of using the direct method. Also, we assume that both recordkeepers have access to the identical mutual funds’ lineup.
In the first example, the recordkeeper A provides service to the 401(k) plan with two participants named Jay and Bob and uses the average method to rebate available revenue sharing (see Table 1). Both participants have $100,000 account balance. Jay is 35 years old employee who invests all his money in a passively managed Large Cap Blend mutual fund, Vanguard 500 Index Signal. This fund charges the total net fee of 0.05% with no revenue sharing available. The second participant is Bob; he is 65 years old and near retirement. Bob invests all of his account balance in a more conservative Intermediate-Term Bond Fund, JP Morgan Core Bond R2. This fund has a net expense ratio of 1.01% with imbedded 0.50% of potential revenue sharing available in the form of a 12b-1 fee. For more complete picture of fees, let’s assume that there are two additional service providers to this 401(k) plan that charge a fiduciary services fee of 0.70% and a recordkeeping fee of 0.50%. The time horizon is one year.
Using the average method of rebating the revenue sharing will decrease the total cost to investor Jay at the expense of investor Bob. The entire revenue sharing paid by Bob will be split equally among all participants in the 401(k) plan. In this example, both Jay and Bob will receive 0.25% credit of revenue sharing. The total cost for Jay will be 1%, and the total cost for Bob will 1.96% (see Table 1).
There is a better and fairer way to credit back the available revenue sharing fees; lets call it the direct method. In the second example, we have a recordkeeper B that services the same 401(k) plan with the same two participants: Jay and Bob (see Table 2). The only difference is in the way the revenue sharing fees are being rebated. Record keeper B is using the direct method of crediting back the revenue sharing to a participant who actually paid it. In this example, Jay will receive zero revenue sharing and Bob will receive the entire 0.50% back. As a result, the total cost for Jay will be 1.25%, and the total cost for Bob will be 1.71%.
Direct method of crediting back available revenue sharing costs, is a way of treating all participants fairly. In the example above, by using a direct method of rebate, investor Bob was able to lower his cost by 0.50% instead of only 0.25% when the average method was used. In contract, by using the average method of rebate, Bob would have subsidized the plan cost for other employees who do not pay any or pay lower revenue sharing fees; such as participant Jay.
In this article, we looked at two potential unfair uses of revenue sharing fees. First, high revenue sharing fees may create a conflict of interest when brokers’ compensation is based on the revenue sharing fees. Such brokers are likely to recommend more expensive mutual funds with high revenue sharing fees. Second, when the average method is used, participants invested in mutual funds with high revenue sharing fees pay the greater portion of plan cost. The preferred solution to these two problems should come from the U.S. Department of Labor. In order to distribute the total plan cost evenly among all participants based on their account balances, fees paid to financial intermediaries should come from plan assets and not from the revenue sharing. Brokers should not be incentivized with high revenue sharing fees to recommend mutual funds. Instead all available revenue sharing should be rebated back to the plan and a separate asset charge can be used to pay for advisory services. Revenue sharing fees; such as 12b1, are typically paid annually based on the average daily net assets of each mutual fund subject to 12b1 fees. When the mutual fund company sends the payment to the recordkeeper, additional information should include the time frame for which this payment is attributable to. The recordkeeper can then calculate the average daily net assets of mutual funds for each participant in the plan during the time horizon for which the revenue sharing fees were paid. New software update can help recordkeepers to automate this process. The benefit of using the direct method should outweigh its cost.
The new regulation requires all service provides to disclose their fees, but it does not require recordkeepers to rebate all revenue sharing using the direct method. This article shows a simple example of why a direct method of rebating the revenue sharing fees is fair to all participants. As was mentioned earlier, the cost of directly rebating available revenue sharing is likely to be higher than the cost of using the average method. Thus, recordkeeper B is likely to charge a higher fee than recordkeeper A. There is an additional cost that plan participants may have to pay if they want to be treated fairly. Both fiduciaries to retirement plans and the U.S. Department of Labor should analyze the data beyond a fee analysis to determine at what price point the direct method to rebate available revenue sharing is better than the average method. If the extra fee is justified, the direct method should be the preferred way of rebating available revenue sharing fees.
Another possible solution to divide the plan cost fairly among participants is by offering investment alternatives with zero revenue sharing available. The fees paid to the mutual fund company will be used to cover the investment management cost only. In this case, participates will see a separate asset charge for recordkeeping, advisory, and administrative services. Having multiple fee lines may intimidate participants at first, but this type of plan will provide favorable environment for participants to make investment decisions. The participant in this plan will have more control over the cost and will have more transparent information available. Many mutual fund companies have already started offering investment alternatives with zero revenue sharing available. At some point in the future, all mutual funds may have a share class with zero revenue sharing available. Until that time, the way the revenue sharing is being rebated and the way financial intermediaries are being compensated should be revised.
ECNFIN.com is not associated with nor does it necessarily represent the opinion or advice of Culver Investment Company LLC. Past performance doesn’t guarantee future results.