Revenue Sharing - What's the right way to apply it in a 401(k) Plan?

In order to understand the question of how to apply Revenue Sharing in a 401(k) plan, it begs explanation as to what Revenue Sharing really is, what form it takes and how it's commonly applied.  In short, revenue sharing typically takes the form of basis points (bps) built into the underlying expense ratio of certain mutual funds, collective investment funds or annuity sub-accounts (referred to herein as "funds").  Not every fund has revenue sharing, but many do.  

Ex.) The Vanguard S&P 500 Index Admiral Share Class (VFIAX) costs 0.05%.  There isn't any revenue sharing in this fund.  Whereas, the Dodge & Cox Income fund (DODIX) costs 0.43%, but contains 0.08% (8 bps) of revenue sharing, making the underlying net expenses, 0.35%. 

Both of these funds are considered very good or excellent by most methods of evaluation, yet one has excess revenue built into it and one does not.  So what is this revenue?  Why is it there? What should a plan trustee do with it since it is a plan asset?

Revenue sharing came about as an industry concern as technology advanced in the late 1990's.  It comes in various forms or names.  Some of these names are Sub Transfer Agency (Sub-TA) fees, shareholder servicing fees, finder's fees or even 12(b)-1 fees which are typically used to pay brokerage commissions.  

If one were to look back at what the 401(k) product landscape looked like in the mid and late 1990's, it would be observed that there were two dominant types of products.  The first, is the Group Variable Annuity, where the investments were sub-advised funds, and the second was a mutual fund product offered by a mutual fund company containing only their mutual funds.  These "proprietary products" were often recordkept by that insurance company or that mutual fund company's transfer agency.  Transfer agencies are required by the investment industry and act as the record keeper for such things as share-lot accounting, tax basis, customer information and the like.  Transfer agencies are not revenue generating centers, rather they are a cost center to the investment houses.  They are financed by a ledger transaction on the fund company balance sheet called a 'Transfer Agency Fee' or a TA Fee.

During this period of time, technological systems and customer demand necessitated the creation of 'Multiple Fund Family' products, a predecessor to true open architecture.  These products still exist today.  Typically, this type of product would be distributed by a group of fund families partnered together.  Ex.) 8 fund families, 400 funds. Arguably, this is better than one fund family's 40 fund product on its own.  Often these products would only include those funds typically distributed by brokers for a commission (so no Vanguard, no DFA, etc.), and it is here that we find the birth of Revenue Sharing as we see it today.

Technology gave rise to "independent" record keeper service providers.  These record keepers were independent of the fund families, and often had superior technology and the ability to link together investment trading for multiple fund houses.  They took over the fund companies role as transfer agent for the 401(k) clients.  This freed up the aforementioned TA Fee for these types of accounts.  It didn't take the fund companies long to realize that this TA Fee could become an incentive to the record keepers for priority shelf space, similar to having a sugary cereal at eye level for a seven year old to see.  This incentive became the SUB-Transfer Agency fee (Sub-TA).  This was/is a legal practice, but it did have some systemic abuses.  In the following 5-15 years it was mainly a hidden secret of the retirement industry.  It was really in the mid-late 2000's when it gained notoriety, and then with the advent of the fee disclosure rules, primarily 408(b)-2 it became more widely known.

All that said, revenue sharing can be a good or bad thing.  It has its place in the fiduciary decision tree on the mechanics of paying for necessary services.  The question now shifts away from discovery of the existence of revenue sharing in the funds in a plan to how to properly allocate this revenue sharing.  

The Department of Labor (DOL) has been somewhat vague on this.  The 'Frost Letter', DOL Advisory Opinion 97-15A is the best guidance the industry has and essentially says that if a provider is a plan fiduciary, that it cannot retain revenue sharing received from funds and that it must credit it back to the plan.  This avoids any potential Conflict of Interest in the form of Self Dealing.  Okay, fair enough.  We, the fiduciary, pick a fund, it has revenue sharing, we collect it and give it back to the plan.  That makes sense.  Hey DOL, so how do we give it back?  In other words, what is the appropriate method?  The DOL is silent on this issue.  

Last year, in DOL Advisory Opinion 2013-03A, the DOL had a chance to illuminate the industry on what is the appropriate allocation method and, specifically, it opted not to; saying "this letter also does not address any fiduciary issues that may arise from the allocation of revenue sharing among plan expenses or individual participant accounts . . .”   Leading ERISA Attorney, Fred Reish reminds us that the method of allocation is a fiduciary decision and must be prudently considered by the responsible plan fiduciary (http://fredreish.com/advisory-opinion-2013-03a/).

The argument some in the industry make is this. Since only some funds have revenue sharing, while others do not, and revenue sharing is experienced as a cost by those who invest in those funds, but not experienced by participants who don't invest in those funds, shouldn't the revenue sharing be rebated back ONLY to those participants who experienced it as a cost?  Sounds right.  That's how other rebates work in other industries.....however, common industry practice is for revenue sharing to offset provider costs. If these costs are not offset, they would've been passed to ALL of the participants prorata.  Some providers don't give the plan trustees the option.  Some do.  Some providers provide a gross invoice that is then offset by revenue sharing and then give the client the choice to write a check on the net invoice or pass it to the participants.  

Some providers have shifted to the "participant-level" revenue sharing rebate process.  This then begs the question of when?  When is it applied, daily, monthly quarterly, annually?  What if the amount expected to receive differs materially from what is actually received?  How does one collect and then apply the difference?  Are their earnings adjustments required, if so who pays for those?  Could plan discrimination issues arise, benefits, rights and features issues?  All these are valid questions.  The issue of application of revenue sharing has now become a differentiating issue for providers, i.e. a product feature issue that can be sold or sold against.

After reading Fred's blog post linked above, he mentions forewarned is forearmed.  Rather than this becoming a potential fight one needs to be armed for, how about this instead?  As a challenge to the DOL, PLEASE COME UP WITH A 'SAFE HARBOR' METHOD ON HOW TO APPROPRIATELY ALLOCATE REVENUE SHARING WHEN IT EXISTS WITHIN A 401(K) PLAN!!!!  This would sure solve a lot of unnecessary problems or potential future problems.



     

Just who's Revenue Sharing is this Anyway? Good question Fred.....

This is a straight re-post from Napa-Net.  Original author, Fred Reish, link to follow.

http://www.napa-net.org/news/managing-a-practice/regulatory-compliance/whose-revenue-sharing-is-it-anyway/?id=6661&tkn=940127217506af86e247cd&mqsc=E3570246&utm_source=WhatCountsEmail&utm_medium=NAPA_List+Napa-Net%20Daily&utm_campaign=NAPA%20Net%20Daily

Is revenue sharing a plan asset? This issue and others were addressed in a July 3 DOL opinion letter (Advisory Opinion 2013-03A) addressed to the Groom Law Group concerning a plan administered by Principal.

In the situation addressed in the letter, Principal receives payments in the form of 12b-1 fees and other revenue sharing to offset expenses and deposit excess monies in a general account. Unless there is a specific agreement to the contrary, Principal is not required to hold each plan’s excess revenue sharing in a separate account. The DOL said that the revenue sharing received by Principal is a plan asset, but not before it is received.

Since Principal is using the revenue sharing to pay for the cost of the plan, some of which is paid to itself and from funds it manages, it is incumbent upon the plan fiduciary to ensure that the services and costs are necessary and reasonable. In particular, the letter stated:

It is the view of the Department that the responsible plan fiduciaries must obtain sufficient information regarding all fees and other compensation that Principal receives with respect to the plan’s investments to make an informed decision as to whether Principal’s compensation for services is no more than reasonable. … Prudence requires that a plan fiduciary, prior to entering into such an arrangement, will understand the formula, methodology and assumptions used by Principal in arriving at the amounts to be returned to the plan or used to pay plan service providers following disclosure by Principal of all relevant information pertaining to the proposed arrangement.

While this question is not addressed, if revenue sharing is considered a plan asset just like the investments themselves, doesn’t the revenue sharing really belong to the participants? If so, it raises the question of why one participant should have to pay more than another with the same account balance to offset the cost of administration of the plan just because the funds they invest in have higher revenue sharing. Would that pass the “reasonable” test?

Good questions.....ultimately the bigger question that I have is whether any of these standard industry practices would meet a true interpretation of the Exclusive Purpose rule......perhaps that's a matter of opinion, but my sense is that the participants are the last things on the mind of the big insurance companies and big mutual fund houses......

Coming Soon.....Participant Fee Disclosure!!!! Get your helmets on....

What exactly is it that get’s Retirement Plan Professionals, advisors and service providers alike, so worried about when it comes to Fee Disclosure? That’s a bit rhetorical, as I suspect the answer is mostly obvious for those who read this blog. In the last year or two, the anxiety level regarding fee disclosure has been quite apparent. As a clarifying point for those who are unaware, there are TWO sets of fee disclosure rules. The implementation date of one of these, commonly referred to as the 408(b)(2) fee disclosure rules, has been postponed to 01/01/12 (at the time of this writing), and perhaps will be again. The other set of rules are the new rules under ERISA §404(a)(5), commonly referred to as ‘Participant Disclosure’. These rules are going to be effective for the 4th Qtr. of 2011, right around the corner. Surprisingly and confusing to me, even though these are the more difficult set of rules, these seem to be the one’s that fewer practitioners are worried about.

The 408(b)(2) rules are getting a lot more industry attention, perhaps this is due to how much the industry has historically done to disguise fees, that it is going to be incredibly difficult to accurately show clients how to follow the money trail. Perhaps it is because this is the rule that makes Broker/Dealers and Insurance Company’s a little squirmy due to that little requirement where the service providers have to declare if their acting as a fiduciary or not. Whatever the reason is, the practical reality is that some difficult discussions (and maybe decisions) will happen between service providers and clients. But this is a difficult business, and I believe that ultimately most of the good practitioners will get through it with most of their client relationships intact.

However, participant disclosure……that’s a whole other scenario, and it’s happening first!!!! This article, by David McCann from CFO Magazine does a good job of thousand footing the situation.
http://www.cfo.com/article.cfm/14570384/c_14570395

I, and most practitioners I know believe that the majority of participants have no idea what the retirement plan costs are and many think that they are getting a free benefit, that they pay nothing for their 401(k). This is a systemic issue. Most 401(k) mouse traps in the market, historically, have been designed to disguise fees from the participants. The group annuities (and Collective Funds) unitize the investments and thus are embedding fees into the unit prices. Many mutual fund platforms are often registered rep distributed, and their compensation is in the expense ratio, but also built into share prices, not to mention implicit revenue sharing arrangements. Even environments where the fees are deducted as line item expenses from participant accounts will often not be explicitly disclosed. For the participant to discover these charges, they will have to search for these deductions online in the form of a customized transaction report.

As a result, the new participant disclosure rules will 100% create a HUGE amount of phone calls, complaints to everyone and anyone associated with creating and managing their plan. Frankly, I think, it will cause a large quantity of plans, big and small, to search out new providers. For proactive practitioners, this is absolutely an opportunity. Advisors who aren’t in front of this are going to have to back pedal as the business owners and CFOs start getting questioned by staff. As Mr. McCann says in his article……..consider yourself warned!

Impact of the elimination of 12b-1s on retirement plans

The SEC recently published new rules governing 12b-1s and sales charges in general. These are proposed rules and will be in their comment period until November 2010. Final rules are unlikely to be effective sooner than two years from now due to the substantial cost and effort of transition. These are big changes for the brokerage industry, much less so for retirement plans.

Basics of the New Rule:

• 12b-1s Are Dead
These are replaced with 12b-2s and 6c-10s. The 12b-1s are being phased out and replaced with a combination of a 25bp “marketing and service fee” (the “12b-2 fee,” though SEC wants everyone to stop describing it using a Rule number) and an “ongoing sales charge”.

• Lower Lifetime Cap
The maximum ongoing sales charge will be capped at a level lower than what is currently possible under FINRA rules, representing a slight pay cut for brokers under certain circumstances. The change is mainly procedural except in that it eliminates C shares and alters the profile of B shares slightly.

• The “X-Share”
Creates a new “Account Level Sales Charge” option that allows ANY share class to be sold at NAV with no fund level sales charges, and a sales charge is instead assessed at the account level in the same way a fee is assessed. No limits on the amount of such account level charges—just like in the fee-based world.

• 5 Year Grandfathering of 12b-1s
Grandfathers existing share classes for five years after the implementation date, which is realistically about two years out from August 11, 2010.

• Some Forms of Revenue Sharing will Continue
Forms of revenue sharing other than 12b-1s continue to be acceptable, so shareholder servicing fees and sub-transfer agency fees are not affected. The new rules are concerned solely with sales charges. A fund can have a 25bp marketing and service fee, a 25bp shareholder servicing fee, and a 10bp sub-t/a fee, presumably all at once, without being affected by the new rules. But, remember that brokers can’t get paid by shareholder servicing and sub-t/a fees.

Impact on Retirement Plans:

• The Need to Track Share Lots…At Considerable Expense.
A side effect of the new rules is that, in order to keep track of the maximum permissible “ongoing sales charge,” recordkeepers will have to begin tracking share lots, which virtually no one in the industry does today. Building the systems to do this will be expensive and annoying, and will in reality have minimal impact given the relatively small percentage of funds affected. ASPPA Executive Director Brian Graff is considering a push for a retirement plan safe harbor that would allow a flat annual charge (e.g., 50bp) in addition to the 25bp marketing and service fee, and that charge could be perpetual so no share lot accounting would be required. Absent such a change or something with similar effect, recordkeepers will have a job ahead of them, the costs of which will presumably find their way to participants.

• Retirement Share Classes are Dead
R shares (or N shares, or whatever the fund families call them—think American Funds R3) are dead for new plans. They’ll probably be replaced by “X shares” (i.e., any share class that invokes the account level sales charge exemption) or fee-based accounts. The general trend toward fee-based work would seem to have been given a boost by the new rules.

• B and C shares are Dead
They never really belonged in retirement plans anyway.

• Share Class Conversions Will Chew Up Time for the Recordkeeping Industry.
Regardless of whether SEC creates a safe harbor for retirement plans, there will be a rush to do share conversions to share classes that allow brokers to continue getting paid for what they do beyond the grandfathering period. That’s a lot of work, sort of like the work the industry had to do when Rule 22c-2 was created (the SEC Rule concerning redemption fees and trading restrictions to limit market timing and other abuses). Work is cost, and distracts us from our mission, so it will have an impact, but it’s one-time.

• Impact Localized to Small Plans.
Naturally, the impact will be almost exclusively in the small and micro plan markets since those are the only places to find 12b1 fees above 25bp currently. But it’s important to remember that 80% of all plans have fewer than 100 eligible participants; so this change affects most plans.

Impact on Unified Trust Clients and Advisors

Our interpretation is that there will little to no impact to our business model. Our average revenue share from all sources tends to be way below 25bp, and we only trade a handful of funds (e.g., old American Funds R3 shares we’ve not yet converted to R5 for operational reasons) with 12b-1s greater than 25bp. Payments to advisors have nothing to do with the 12b-1s since we follow the Frost model with 100% fee recapture. Bottom line, the new rules are not a big deal for Unified Trust, its clients, and the advisors who serve them.

What to Do If You’re an Advisor

Accelerate your movement to a more fee-style model. Use this opportunity to approach all of your plans that have fund family products and evaluate if any changes make sense. Such as a move to Unified Trust.

Credit to Pete Swisher, Senior Institutional Consultant at Unified Trust Company, N.A. for above content.

Law Suits - Coming Down Market

We invariably have discussions surrounding Discretionary Trustee Services, Fiduciary Services, Fiduciary Responsibility and Liability that lead to the following inevitable question. What is the real risk of all of this stuff? The question is clearly pointed at challenging whether or not the risks are real risks or simply overzealous rule following. This is especially important as the spate of law suits that are publicized in this area are always with very large plans (Deere, Ford, etc.) and their providers, again mostly very large companies. That contrasts to Unified Trust’s typical market, where we partner with Advisors, which we would define at the Under $100m space. We believe that the risk question misses the point. Liability relief is important and useful to a Plan Sponsor who has concerns in this area, however, the point is that the rules under ERISA are written the way they are because they create a path to follow that mandates ‘Best Practices’. If followed absolutely, they should generally lead plans to be more successful at providing adequate benefits to the participants in a fair way than when they aren’t followed. Obviously, we are a true proponent of ‘best in process, best in outcomes’ based approach to Retirement Plan Management. This applies to both Defined Contribution and Defined Benefit Plans.

That said, it should come as no surprise to anyone reading this that the quantity of law suits in the Retirement Plan industry has increased dramatically since the end of 2007. No one worries when the market is going up if their robust returns are slightly lower due to excessive fees, but in a down market even the slightest hint of excessive fees can bring participants and Plan Sponsor’s blood to boil. We have always stated that it would only be a matter of time before we were hearing about fee-driven law suits in the small plan space and that engaging in ‘Best Practices’ is a good way to avoid risk regardless of market cycles or client size.

In the latest edition of Investment News (July 20, 2009), there is an article that discusses a plan of approximately $2m in assets that is suing its Investment Advisor, Custodian and Recordkeeper. To read the full article, click here.

Interesting to us is that the suit is regarding fee disclosure, revenue sharing and hidden fees. We have written on this subject before in published papers and prior emails. I can forward them to anyone interested. The bottom line is that a fee-based environment (as opposed to commission based) where all fees are known, accounted for and disclosed is the only environment appropriate for Retirement Plan Sponsors. That’s appropriate whether using the Suitability Standard or the Fiduciary Standard.

The following are articles by Unified Trust that discuss fee disclosure, what’s broken and how it works and how it should work.

Ethics of 401(k) Revenue Sharing and Disclosure — Full Article
Revenue Sharing For Qualified Plans — Full Article