In plain English, “revenue sharing” is the practice of padding a mutual fund’s
expense ratio with general plan administration, marketing and other non-investment related fees, leaving these expenses to be absorbed by participants
who choose to invest in that fund.
A mutual fund’s expense ratio is stated as a percentage of assets under investment and is netted from the fund’s performance, or Net Asset Value (“NAV”). Therefore, the investor does not directly see the impact of higher expense ratios on the fund’s performance. In the “retail” investor market place, where mutual funds offer shares to individual investors, there are arguably sound economic principles that validate the mutual fund industry’s revenue sharing practices. Most mutual funds, however, recognize that these principles are not applicable in the “institutional” market place, where funds sell large blocks of shares on a regular basis. Here, the funds offer alternative “institutional” share classes with significantly lower expense ratios. A line of cases has developed that makes it clear that plan fiduciaries responsible for monitoring the reasonableness of vendor fees or the selection of investment fund options must exercise greater care in their oversight of revenue sharing arrangements.
In 2013 the Ninth Circuit affirmed in part, a district court’s decision that a 401(k) plan fiduciary’s failure to investigate the availability of ”institutional” class shares, when deciding to include “retail” class shares in the plan’s menu of investment fund options, was a fiduciary breach (conduct below the standard set forth in ERISA’s so-called “prudent expert” rule) giving rise to significant fiduciary losses sustained by the plan. Tibble v. Edison International ___ F.3d. ___ (2013 WL 1174167) reh den (9th Cir. 2013). In Tibble, the “institutional” share classes the fiduciaries could have selected had expense ratios in the range of 24-40 basis points cheaper than the “retail” share classes included in the plan’s menu and there was no evidence of what the court called “salient differences in the investment quality or management” between the two classes of shares. In 2012, a federal district court in Missouri held that, while revenue sharing is not on its face imprudent, fiduciaries cannot prudently evaluate the reasonableness of revenue sharing arrangements without a baseline that allows them to compare the total fees a vendor receives from all sources, making fee benchmarking a minimum standard of fiduciary inquiry. The court held that selecting fund options by merely comparing their gross expense ratios does not meet this fiduciary standard. Tussey v. ABB, Inc., No. 06-4305, 2012 BL 84927, 52 EBC 2826 (W.D. Mo. Mar.31, 2012)
As it has evolved in the 401(k) plan market, revenue sharing is used by mutual funds (and by insurance companies offering pooled separate account arrangements) to finance special fee payments to vendors performing record-keeping and other administrative services for the plan and encompasses a wide spectrum of applications. These vendors may or may not be affiliates of the mutual fund or insurance company. Vendors receiving revenue sharing payments may or may not use them to offset fees that the plan sponsor would otherwise pay pursuant to its administrative services agreement and, perhaps, even the plan document. When this occurs, the higher “retail” share expense ratios shift the expense of general plan administration (and other revenue sharing payments) from the plan sponsor to the participants invested in these mutual funds. This added expense materially reduces the participants’ return compared to the potential return that they could have achieved had they made the same investment in the “institutional” share class.
Where a plan’s menu of investment fund options includes both retail and institutional share classes, participants bear a disproportionately greater share of the plan’s general administrative expenses to the extent they select retail share classes. This haphazard distribution of the plan’s general administrative expenses among the participants, is another potentially undesirable outcome of revenue sharing.
Some funds pay so-called “12b-1 fees” (named after SEC Rule 12b-1 that regulates their payment). Generally, 12b-1 fees are paid by the mutual fund to a record-keeper or third party administrator for including the fund in the menu of investment fund options. These fees may also include fees paid by the mutual fund when it subcontracts the participant accounting to banks or trust companies, aka “transfer agents,” to execute, clear and settle trades and maintain shareholder relationship records per participant account. The funds also pay fees to other service providers to defray the cost of maintaining an open architecture, daily valued trading platform. Another fee that funds commonly classify as a 12b-1 fee is the payment of commission overrides to brokers for their performance of nominal services to the plan, as an extra inducement to sell that particular fund to the plan or to help the broker recoup its expenses in marketing the fund. In one of the more problematic forms of 12b-1 fees, funds have paid bonuses to vendors (i.e. compensation over and above the fee to which they’re entitled for performing regular administrative services) to induce them to help maintain the fund in the plan’s menu of investment options.
The U.S. Department of Labor (“DOL”) has issued a few advisory opinions on the subject of revenue sharing. Since 1997 the DOL has taken the position that plan fiduciaries are obligated to apprise themselves fully of the amount and source of all vendor compensation from wherever it is derived, including revenue sharing payments. DOL Advisory Opinion 1997-16A. In 2012, the Congress finally gave plan fiduciaries a valuable tool to monitor vendor fees in the form of the new ERISA Sec. 408(b)(2) fee disclosure requirements. ERISA Fiduciary Administrators LLC (“EFA”) utilizes the data gathered in these disclosures to monitor the reasonableness of vendor compensation and determine the amount, source and purpose of all revenue sharing payments. In its most recent pronouncement, the DOL warned that the failure to do so could result in a prohibited transaction and a fiduciary breach if it finds that based on these data the fees are excessive. DOL Advisory Opinion 2013-03A.
Revenue sharing may unintentionally creep into a plan’s fee arrangement without explicit consideration or authorization by the responsible plan fiduciaries. This typically occurs when the fiduciaries introduce “retail” share classes into the plan’s menu of investment fund options without documenting their consideration of “institutional” share classes. Institutional share classes have significantly smaller expense ratios than their retail counterparts, because the expense ratio of an institutional share class is intended to recoup only the effective cost of the mutual fund’s operation.
Retail share classes are the subject of separate revenue sharing agreements between a vendor and a mutual fund company, about which the plan sponsor may know nothing. These agreements commonly include a nondisclosure provision, which prohibits the vendor from disclosing the substance of the agreement. There is, of course, considerable tension between this nondisclosure provision in the revenue sharing agreement, the vendor’s ERISA Sec. 408(b)(2) fee disclosures and the responsibility of the responsible fiduciaries to monitor the reasonableness of the vendor’s fees in accordance with the official guidance from the DOL mentioned above.
While it can be argued that there is nothing wrong per se with the practice of revenue sharing and that it is a practical and simple way to pay some or all of the costs of plan management, it nonetheless obscures a key area of plan expenses and forces the plan to pass along administrative and other costs to participant accounts in a haphazard manner.
The key driver of the selection of retail class shares for inclusion in the plan’s menu of investment fund options should be the plan sponsor’s position on whether, and to what extent, the participants should pay the general expenses of administering the plan. For employers who believe that the general expenses of administering the plan are essentially business expenses that should be absorbed by the corporation, revenue sharing is simply inappropriate. In some cases, the plan, the summary plan description and/or the plan’s investment policy statement may have language that is inconsistent with, if not directly contrary to, revenue sharing. On the other hand, limited revenue sharing features might be appropriate where the plan sponsor believes that the general expenses of administering the plan should be shared between the corporation and the plan participants, as long as this does not conflict with the plan’s governing instruments, and the additional burdens these arrangements impose on the fiduciaries are fully understood. EFA will help the plan sponsor re-evaluate the pros and cons of revenue sharing.