The Double Edged Sword of 401(k) Revenue Sharing Fees

Payola, is the illegal practice of payment by record companies for the broadcast of recordings on music radio, in which the song is presented as being part of the normal day’s broadcast.

A kickback is a return of a part of a sum received often because of confidential agreement or coercion.

In the 401(k) industry, revenue sharing is a compensation practice in which money is paid to plan providers out of 401(k) investments by the managers of these investments. Revenue sharing may also include 12b1 fees and sub t/a fees. Many fund companies pay revenue sharing fees in a variety of amounts and many mutual fund companies don’t pay them. Many third party administration (TPA) firms and plan advisors herald the use of revenue sharing producing funds because these payments are supposed to be used to offset administrative expenses, which are usually borne by the plan participants.

Prior to the implementation of the fee disclosure regulations in July 2011, it is still possible that TPAs and plan advisors may not inform plan sponsors in the amount of the revenue sharing amounts received and what they are used for. I used to work for a TPA that actually pocketed the revenue sharing fees without disclosure and then invented a fee to justify the pocketing of those fees.

So if you look at the definition of payola and kickback, are revenue sharing payments that much different? Revenue sharing payments are an incentive for TPAs and plan advisors to steer 401(k) money to the funds that pay them because they are used to offset administrative expenses. Since some fund families pay them and some don’t and some pay more than others, how is it not a kickback or like payola? The only reason I find is that the Department of Labor and Congress hasn’t found the practice to be illegal.

Friends that I have the industry say that I’m too hard on the revenue sharing practice and that I should keep in mind that this practice saves participants money because they typically are the ones who pay for the administration of their 401(k) plans. Without revenue sharing, my friends state that plan participants would lose more of their account balance to fees.

The problem with that argument is that there is a hidden cost with the selection of revenue sharing producing funds which negates their savings. The hidden cost is the actual selection of these revenue sharing producing funds. Since these funds pay revenue sharing to plan providers, they certainly have to be recouped in some fashion. Revenue sharing payments are not “manna from heaven”, they are probably reflected in the fund’s management expense ratio. Low cost mutual funds, index mutual funds, and exchange traded funds (ETFs) typically don’t pay revenue sharing because of the low fee and transparency of these investments. Add in the fact that more than 70% of mutual funds fail to meet the benchmarks that index funds and ETFs almost meet, and then you see where I’m going. Revenue sharing payments may actually induce TPAs, plan advisors, and plan sponsors to pick funds that are more expensive and underperforming to funds that don’t pay them. That would negate the benefits of these payments. So the hidden cost may be the lost opportunity to invest in a low fee fund that may produce a greater return that would more than compensate for the extra plan fees (since these funds pay no revenue sharing fees).

Here is another hidden cost, increased liability. A TPA I know states their fee and then states that their fee is lowered by the selection of “select” funds, as selected by the plan custodian. The selection of mutual funds for a participant directed ERISA §404(c) should be done in conjunction with the plan’s investment policy statement (IPS). Does an investment policy statement state that whether a mutual fund pays revenue sharing is a part of the criteria for its selection? I don’t recall seeing revenue sharing mentioned in an IPS. Is my legal theory that farfetched? Maybe, but probably would survive a motion for summary judgment.

My friends in the industry will state that my views will be made obsolete by the fee disclosure regulations because plan sponsors and eventually plan participants will know all the fees behind the administration of their plan and all revenue sharing payments received. I disagree, because I believe that plan participants and sponsors will only be concerned with the bottom line as to the net expense of plan administration. While they will know the revenue sharing payments, they will fail to understand the lost opportunities by using revenue sharing paying funds.

While I am not proposing that plan sponsors and advisors avoid revenue sharing paying funds, I want them to understand that many fund companies don’t pay these fees and using these funds may actually cost them more to use in the long run than if they stuck with an index fund or ETF.

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6 Responses to The Double Edged Sword of 401(k) Revenue Sharing Fees

  1. Pingback: Tweets that mention The Double Edged Sword of 401(k) Revenue Sharing Fees | The Rosenbaum Law Firm P.C. Blog -- Topsy.com

  2. bill thompson says:

    . . . and in this world you have Morningstar who both consults/gets paid for plan level and participant level investment advice.

  3. Karen Roberts says:

    You make some very valid points, as I have seen this in action myself. However, there are those of us in the industry who prefer an open architecture custodial platform from which we can choose the ‘best’ funds available. As an independent, fee for service fiduciary to our clients, it really does not matter how much revenue sharing the fund pays. We often put together index only options for clients who want to keep overall plan costs down. Should funds be recommended that provide revenue sharing, we use 100% of it to reduce plan costs.
    Plan sponsors should be asking their advisors how they are actually getting paid, and pay close attention to the fee disclosures (including the fine print) that are now required, as well as their 5500s. There are many advisors such as ourselves that conduct business in this manner, and plan sponsors would be well served to hire one of us.

    • admin says:

      I agree. With fee disclosures, advisors like you will have an easier time in getting business. Those that will suffer were those firms that were playing games with revenue sharing and inventing fees. Just glad the future is just around the corner.

  4. Silvia says:

    As a plan sponsor, I feel there is a valid case for revenue sharing utilized to offset plan expenses. We operate in a fully transparent fee/revenue sharing environment, accounting for all fund generated revenue sharing, offsetting this revenue sharing with our negotiated fees and then either crediting or debiting participant accounts each quarter. Revenue sharing is paid by fund managers mainly to offset the costs of the service provider for recordkeeping, issuing quarterly statements, etc. These costs of operating a mutual fund are embedded in the fees……..the fund manager isn’t incurring these costs because the tpa or service provider is performing these transactions, hence, the fund manager will pass along this revenue sharing to cover the costs of this fund administration (since they do not have this administrative burden). If revenue sharing is eliminated, the fund manager will be the winner……..NOT the plan participant. I’m not saying there may not be a better way to pay for these expenses (as I’m sure the industry will change with the fee disclosure regs), I just caution those who protest against revenue sharing since the plan participant would end up with the bill.

  5. Skip Schweiss says:

    Agree with comments above. And appreciate Ari starting the discussion. In a fully-disclosed/transparent world, the plan sponsor-acting as a fiduciary to the plan for the benefit of its employee/participants-should decide how to best procure and pay for services to the plan. One thing plan sponsors need to fully understand–and market participants need to acknowledge–is that using higher expense funds that “revenue share” back to the plan to offset plan expenses is akin to the plan shifting costs to participants. Again, as long as everyone in the supply chain is fully informed, rational choices can be made.

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