Reconsidering Revenue Sharing
Revenue sharing, the part (or “share”) of an investment manager’s expense that can be used to pay retirement plan costs, remains a common practice among defined contribution (DC) plan sponsors.1 This article looks at the reasons why revenue sharing arrangements should be reconsidered in light of increased legal scrutiny of the reasonableness of fees and the spirit of transparency motivating recently required disclosures to plan sponsors and participants.
1 50% of plans according to The Economics of Providing 401(k) Plans, Vol. 23, No. 4, June 2017
Revenue sharing and plan fees
DC plans require recordkeeping, administration, advice, audit and other services. Fees for these services can be paid by the plan sponsor, participants, or both. Historically, plan participants have borne plan expenses either directly (e.g., through quarterly account deductions), or indirectly (e.g., through “wrap” fees deducted from performance); or from investment management fees (through revenue sharing).
Whether deducted from plan performance or manager performance (an expense), plan fees reduce overall returns. As a fiduciary, the plan sponsor must ensure that plan service provider and manager expenses are reasonable relative to services provided.
Revenue sharing fees are typically embedded in the overall fee charged by a mutual fund, thus reducing fund returns. These fees are collected by the firms that administer and recordkeep defined contribution plans. The fees are typically labeled “sub-transfer agency fees”, “shareholder servicing fees” or may be referred to by a recordkeeper a “service fee offset” and can vary significantly from one fund to another. These mutual fund expenses cover services not needed in a DC recordkeeping arrangement, making them available for other uses such as recordkeeping, plan administration and other service costs.
Whatever its source or designation, these “extra” fees can be used to pay plan expenses. Alternatively, the portion of investment expenses available for revenue sharing could be returned to the plan participants since their investment performance was reduced to generate this expense. Or in other words, revenue sharing is refundable. When applied such that each participant pays the same amount for recordkeeping services, regardless of which funds they are invested in, is sometimes called “fee leveling.”
Annual fee notice: an example
Since 2012, DC plan sponsors are required to receive an annual Fee Notice, called a 408(b)(2) disclosure after the relevant section of the Employee Retirement Income Security Act (ERISA) governing provider compensation. This section lists the various types of direct and indirect payment received by a plan’s record keeper, managers, and other service providers. The purpose of a Fee Notice is to enable the plan sponsor to evaluate the reasonableness of fees compared to services provided. Included in the Fee Notice is typically a list of plan investment managers and their associated expenses. The following is a hypothetical example of what is contained in a Fee Notice.
|Manager||Strategy||Market Value||Operating Expense||12b-1/Sub TA/Shareholder Service Fees|
|Mega Investment Company||US Stocks||$10,000,000||.75%||.25%|
In this example, Mega Investment Company (Mega) receives 0.75% for fund management expenses, of which 0.25% is considered revenue sharing and is available to the plan to pay plan expenses, such as recordkeeping, or to fund an ERISA budget account for future plan expenses. The 0.25% may also be refunded to plan participants.
For our hypothetical example we assume that the 0.25% is not refunded to participants. That means that participants invested in this fund pay 0.25% of $10,000,000 or $25,000 towards overall plan expenses.
Revenue sharing: concerns
The above example raises at least a few questions.
First, participants invested in Mega are paying $25,000 in recordkeeping or other plan fees and may be “subsidizing” other participants who are paying less (or nothing at all). Is this the plan sponsor’s intention? Is it fair?
Popular passively-managed funds, such as the Vanguard 500 Trust, do not share revenue. A plan relying on revenue sharing to pay expenses and offering a fund such as the Vanguard 500 permits Vanguard 500 investors to “freeload,” enjoying reduced recordkeeping or other plan costs at the expense of participants who may, unwittingly bear the cost of recordkeeping services.
Second, participants invested in Mega see only net performance (gross performance less the 0.75% management fee). Part of their performance goes to Mega and part goes to the plan’s record keeper or other service providers. Is this disclosed to investors? Surprisingly, such disclosure is not required.
Third and finally, revenue sharing operates in the shadows. It is easily forgotten about, causing some plan sponsors to neglect assessing reasonableness of fees relative to services provided, and potentially misleading participants about the true cost of plan recordkeeping and administration.
ERISA has been interpreted to require regular, ongoing monitoring of fees relative to services provided. Revenue sharing makes this duty harder to fulfill.
Mind the net
There are, oddly, cases where a fund with a higher gross expense ratio that includes revenue sharing is less expensive on a net basis than a fund with a lower expense ratio on that does not. So long as the revenue sharing is returned directly to plan participants, then participants would be better off in the fund with the higher gross, but lower net, expense. In the example below two different share classes, one with revenue sharing and one without, are compared.
|Manager||Strategy||Share Class||Operating Expense||12b-1/Sub TA/Shareholder Service Fees|
|Mega Investment Company||US Stocks||R||.75%||.25%|
|Mega Investment Company||US Stocks||Z||.60%||NA|
In this case, the “R” share class carries a net-of-revenue-sharing fee of 0.50% (0.75% less 0.25%), whereas the Z (“zero revenue”) share class carries a net (and gross) fee of 0.60%.
Clearly, using the “R” share class and refunding revenue sharing to plan participants results in a lower net fee.
All else equal, a plan sponsor should attempt to minimize net fees, and should review available share classes and expenses regularly.
Breaking the link
There is no real reason to tie investment fees to other plan expenses. These fees are simply unrelated and the practice may create the perception of “hidden costs” and produce unnecessary fiduciary risk.
Moreover, revenue sharing seems increasingly like a relic of an era characterized by less-intense fee disclosures, and increasingly hard to defend under the scrutiny of publicly-available DC plan benchmarking websites, let alone the recent explosion in “excessive fee” litigation. The tone of recent laws, regulations, and judgments clearly favors separation in the assessment of, and transparency in the reporting of, costs.
Revenue sharing has been challenged and courts have consistently upheld the practice. So while there is nothing legally wrong with revenue sharing, it should be used cautiously and deliberately. Where revenue sharing is used it should be monitored closely.
Bio: Click Here
Marc Fandetti is a Director and Senior Investment Consultant in P-Solve’s Boston office.
Marc consults to defined contribution, defined benefit, and retiree health plans.
Prior to joining P-Solve, Marc was a Principal and Consultant at Meketa Investment Group, an Institutional Consultant at Graystone Consulting, and Managing Advisor at CitiStreet Advisors, a State Street and CitiGroup Company.
Marc graduated from Providence College with a degree in Economics and is a CFA charterholder and CFP designee.
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