In most 401(k) plans, a majority of the fees are made clear in the plan and fund service agreements. However, plan sponsors and advisors may be blindsided when these fees are shared or bundled, leaving the best interest of the retiree behind. It is crucial for plan sponsors to understand the ins and outs of the different plans, so they can offer their clients the best option.
Revenue sharing is the practice of paying third-party marketing agents and plan administrators a commission for offering mutual funds to their investors. In theory, revenue sharing could benefit plan sponsors as the commissions and removal of the need to pay a broker to provide plan services would lower their overall plan costs. In reality, revenue sharing agreements are risky for plan sponsors because they are often not in the best interest of the participants.
Revenue sharing commissions are paid directly from plan assets under management and can total well over one billion each year. This could erode the overall size of the plan, thus preventing it from qualifying for lower-cost institutional funds. For small funds, this can be particularly detrimental as they lack the size to negotiate for lower fees.
In recent years, two primary complaints have arisen against revenue sharing in 401(k) plans. First, plan sponsors are receiving or allowing third parties to receive excessive revenue sharing fees at the expense of the participants. Second, plan sponsors are engaging in revenue sharing practices to their benefit alone. These complaints have resulted in several class-action lawsuits, most notably a $415 million settlement by ING.
When revenue sharing or other practices are not in the best interest of participants, the DOL, who governs plan compliance, holds plan sponsors fully responsible. The question to keep in mind if you are considering a fund with a revenue sharing agreement is: Will the revenue be used for the exclusive benefit of the plan participants, or do you, as the sponsor, stand to benefit? (For related reading, see: Top Tips for Advising 401(k) Plan Sponsors.)
Bundled 401(k) Plans
401(k) plans used to require separate vendors to accommodate the recordkeeping, compliance and custodial services necessitated by the plan. When people began to complain that such plans were difficult to manage, bundled plans arose as the solution. With bundled plans, a single vendor is responsible for all of the plan’s recordkeeping and investment service needs. This gave plan sponsors a single point of contact and allowed them to face only one fee for all service costs. Bundled plans should have been simpler, as they eliminated the need to pay multiple vendors. Also, bundled plans were supposed to be cheaper since the fee was now based on plan assets and paid by plan participants. Instead, they became a way for vendors to disguise hidden costs by bundling them into their single fee. It is difficult for plan sponsors and participants to decipher exactly what services are being included in the bundled fee and if that fee is reasonable according to ERISA’s standards. (For related reading, see: 401(k) Plan Costs: How Advisors Can Help Keep Them Down.)
Many advisors charge asset-based fees, so fees are charged as a percentage of plan assets. This can be beneficial because the interests of the investor and advisor are aligned. From the perspective of an advisor, the better a portfolio performs, the higher the commission payout will be for the advisor. Ultimately, it is in the best interest of both parties to yield the best results.
Percentage-based fees can be risky for high expense ratio mutual funds. Plan sponsors may continue to buy higher-cost funds instead of more economical institutional funds. This can block plan participants from the benefit of economies of scale by preventing them access to lower-cost share classes. In such cases, this fee structure is no longer in the best interest of the participants.
Full Disclosure Is Paramount
It is the responsibility of plan sponsors and advisors to understand their plan’s fee structure. As the plan sponsor or advisor, you should know what fees are being levied and for what services. If you are using revenue sharing, the law requires that it be disclosed to participants. You need to be able to account for all revenue earned by the plan and how this revenue is distributed among providers and marketing agents so this information can be accurately conveyed to your participants. Bundled plans should be adopted with caution and percentage-based fees used with great care. Review your plan on a regular basis to ensure that all fees and practices are still the best available option for your participants.
(For more from this author, see: Are Hidden Fees Eroding Your Participants' Return?)