A fog has
long shrouded the inner workings of 401(k) plans. This lack of transparency has
prompted action by the Securities and Exchange Commission, the Department of
Labor and Congress-who are working on new rules that will ultimately dictate
how the fees in these plans will be applied and disclosed.
Among
the items that have sparked the interest of regulators are 12b-1 fees, the
status of fiduciaries and brokers, plan sponsor fee disclosure and participant
fee disclosure. Ultimately, these regulators and legislators will converge on
the source of the fog: revenue sharing. And their work could dramatically alter
revenue-sharing practices. Advisors who work with qualified retirement plans
had best be up to speed on the nuances because it will affect both their
revenue and their liability.
Understanding Fees
Consider
an investor, Sam, who makes a single purchase of $10,000 of "Bond Fund
Class A" within an IRA or brokerage account via a fund company. Sam's
purchase includes a sales charge of 4% that is netted from the $10,000. He also
pays a 1% annual operating expense of the fund netted from the gross returns.
Where
does the money generated by this fee go? Who is Sam paying?
Figure
1 shows how this 1% annual operating expense is allocated when Sam makes the
purchase in an IRA or brokerage account. While other expenses, such as the cost
of purchasing the underlying investments, are netted from the returns, let's
limit this inspection to the base annual operating expense.
Three
components make up the 1% fee. Note that only 0.35% of the fee goes to the
individuals who manage the fund.
"Other
operating expenses," a somewhat vague category that can include any number
of things, accounts for 0.40% of the fee. Generally speaking, this category
refers to the administrative functions required to keep the fund operating.
A
key element of the "other" category is "Fund Company ABC,"
the firm that runs Bond Fund A and is responsible for keeping tabs on Sam as an
individual investor. When Sam has a question about his account, it's someone
from Fund Company ABC that takes his call. When he moves and wants to have his
statement sent to his new address, it's once again Fund Company ABC's
responsibility. The company may be split into several affiliated companies to
perform these services but, ultimately, it's still Fund Company ABC.
The
remaining 0.25% is the "12b-1 servicing fee." The merits of this
commission have been debated for years, and 12b-1 fees in excess of 0.25% might
disappear if the SEC follows the path it has laid out.
These
three components add up to the 1% fee netted from the gross returns of Bond
Fund Class A. It's a bit of an oversimplification-but essentially accurate-to
say that if the fund makes a gross return of 10% this year, Sam and the other
shareholders will receive 9%.
While the
fee breakdown is fairly straightforward, things get a bit murkier when the fund
is purchased within a 401(k) plan.
Enter the Recordkeeper
Let's
assume Sam participates in his employer's qualified 401(k) plan managed by a
record keeper. Sam sees no line item on his quarterly statement from the record
keeper about fees and is delighted by the fact that Bond Fund Class A (the same
fund he uses in his IRA) is also one of the options available under the 401(k)
plan. He pays no upfront fees or commissions when he purchases that same fund
in his 401(k) account as he does when he makes purchases of Bond Fund Class A
in his IRA account. Since it's the same share class, the operating expense is
exactly the same: 1%.
But
what Sam-and many others-may not realize is that the allocation of that 1% is
very different under the 401(k) plan. Figure 2 depicts the change.
While
the total is still 1%, it now appears that all of the 12b-1 servicing fees and
some of the "other operating expenses" are being paid to the record
keeper.
Who
is this record keeper? It's the firm that provides the quarterly statements for
the 401(k) plan. It also runs the Web site and call center for the plan so Sam
can review his investments and make changes to his account.
Why
is nearly half of the overall expense ratio now paid to this record keeper?
There are two reasons.
Firm
ABC, which offers Bond Fund Class A, doesn't have to keep track of Sam as an
individual if he buys Bond Fund Class A within the 401(k) plan. Instead, the
record keeper now has to keep track of Sam's account and produce his
statements. Because of this, Firm ABC has volunteered to "share" some
of the revenue it receives with the record keeper.
The
other, more subtle, reason for this transfer in revenue-including the
significant transfer of all of the 12b-1 fees generated by Sam's investment-is
that the record keeper only works with funds that share the revenue. If Firm
ABC refused to share this revenue, the record keeper might not make it
available as an option. In short, it's pay to play.
Why
should the record keeper care? After all, it could always bill Sam's employer
for the work it's providing.
Perhaps,
but that's not the way the 401(k) industry functions. Record keeping companies
have typically marketed their products assuming that some or all of their fees
would be paid by revenue sharing from the funds within their client's plans.
Companies sponsoring plans have become accustomed to the concept that there are
few billable costs for the plan. Sam, as a participant, and his employer, as
the sponsor, may have never paid a direct fee related to the 401(k) plan.
Many
have argued that this arrangement is meaningless to participants since the same
1% is assessed either way. But those people seem to be losing ground to the
critics, who say that the menu of available funds within a 401(k) plan are too
influenced by whether the fund shares revenue with the pay-to-play record
keeper. If the broker or advisor servicing the plan expects to receive the
12b-1 fees as compensation, this can further eliminate options that might
otherwise be available. It might also mean even more expensive share classes (R
shares) are used to pay all of the various parties.
Figure
3 again examines our hypothetical investment in Bond Fund Class A, this time
including a look at the sister funds-Class Admin, Class Inst. and Class R-with
differences in their overall pricing structure. R shares, a relatively recent
class, are funds often offered at much higher expense ratios to generate
greater revenue.
The
"Institutional" class is virtually identical to the Class A version
except that it has less than half the overall cost and there is a significant
difference in the revenue sharing. While Class A generates 0.45% (nearly half
the operating expenses) in revenue for the record keeper, Class Inst. generates
only 0.10%.
This
is a dramatic disparity in revenue by percentage, one that is amplified many
times over when 401(k) plans with millions in assets shift to different share
classes. A $10 million investment in Bond Fund Class A generates $45,000 in
revenue sharing while the same investment in Class Inst. generates only $10,000
in revenue.
A
federal judge recently ruled that energy company Edison International violated
its "duty of prudence" by using retail funds when the company could
have used available institutional versions instead. There is not, as of yet, a
litmus test to determine what amount of fees is appropriate. We will have to
wait and see what the SEC, the DOL and Congress come up with as the final
answer to this question.
In
the meantime, it may be wise for advisors to examine their current practices in
anticipation of coming changes.
Here
are some guidelines that may be useful for advisors and their clients:
- Be straightforward about the universe of funds
available through the record keeper. Don't promise to screen the entire
universe of funds if, in reality, the record keeper/revenue requirement limits
it to a few hundred.
- Calculate the annual revenue sharing and
commissions (if applicable) being produced by the plan and share these results
with the plan sponsor.
- Benchmark the all-in fees of the record keeper
to see if they are within a reasonable range of the competition's.
- Avoid offering the most expensive share classes
of the investments to generate excess revenue.
Given the ramifications of
pending regulatory activity on advisors' revenue and liability, those
professionals servicing qualified plan clients should know exactly where their
practice stands on revenue sharing. Given the added costs and potential for
lower returns with funds that share revenue, it's even more important.