Understanding Revenue Sharing & the Flow of Money in Retirement Plans
By Kelly Kurtz & John Higgins
As many plan fiduciaries can attest, retirement plan fees can be extremely complex and difficult to understand. This is due in large part to the lack of transparency surrounding plan fees and services, as well as the complicated and varying methods in which service providers are compensated.
Recognizing this problem, federal regulators have passed new rules requiring service providers to disclose their fees to plan fiduciaries. Although these rules will ultimately benefit retirement plans and participants, they place increased pressure on plan fiduciaries to interpret and evaluate the appropriateness of service provider compensation – a task many fiduciaries aren’t prepared to undertake. More than ever, it’s critical for plan fiduciaries to understand the various components of their retirement plans’ fees, particularly indirect fees and the concept of revenue sharing.
The following describes common ways that money flows through retirement plans. (Each provider may operate differently, so be sure to check with your provider for information specific to your plan.)
Service Provider Compensation
In general, plan fees cover expenses resulting from services provided in four primary areas:
- Advisory or brokerage services
These fees may be categorized as direct compensation, indirect compensation, or both.
Direct compensation: As its name implies, this type of compensation represents direct payments from the plan or plan sponsor to a provider for specific services rendered. It is typically paid as a flat dollar amount or deducted as a percentage of plan assets. Fees that fall into this category often cover plan-level expenses, such as recordkeeping, administration, or advisory services.
Indirect compensation: Commonly known as revenue sharing, indirect compensation refers to fees generally collected from plan investments that are passed through to other service providers. Investment costs, including revenue sharing payments, often represent the majority of a plan’s total fees.
The diagram below illustrates the expenses of a typical equity-based mutual fund that might be found in an employer-sponsored retirement plan.
The sum of all the fee components is known as the gross expense ratio. In this example, the fund has a gross expense ratio of 1.25%.
To help satisfy responsibilities under ERISA when it comes to measuring fees, plan fiduciaries must understand each component and be able to assess its reasonableness in relation to the services provided.
- Investment management: The investment manager charges these fees for managing the fund.
- Sub T/A: These fees are paid to a subcontracted third party for the accounting of participant shares.
- 12(b)-1: Found in more than half of all mutual funds, this fee represents (1) payment to a broker for the sale a fund and (2) fees paid for the ongoing servicing of the account or plan.
- Shareholder servicing fee: These fees are paid in addition to 12(b)-1s for services rendered to the plan (e.g., recordkeeping and administration).
Revenue Sharing for Commission-Based Plans
In the employer-sponsored retirement plan industry, all components of the gross expense ratio, with the exception of investment management fees, are generally classified as revenue sharing. The following diagram describes common revenue sharing arrangements for commission-based plans.
Revenue sharing components are highlighted in red in the chart below.
In this model, all revenue sharing is passed through the fund to the plan’s service providers. The investment manager receives the investment management fee as direct compensation.
Revenue Sharing for Fee-Based Plans
Some recordkeepers have the ability to credit back revenue sharing fees to the plan. Often, this is
done by creating an escrow account (known as an ERISA budget account) within the plan. This account collects all revenue sharing payments and then uses them to offset plan costs for services such as recordkeeping, administration, and advisory or consultant-related work. This model benefits plan fiduciaries by:
- Creating an environment ideal for assessing provider fees
- Reducing conflicts of interest among service providers
- Allowing for true independence when selecting service providers and investments
- Assisting in the fulfillment of fiduciary responsibilities
Above all, the transparency afforded by the fee-based model creates accountability on the part of service providers, which helps control plan costs. A diagram of this plan is shown below.
Working with an Advisor
When evaluating and managing retirement plan fees and services, fiduciaries need to determine if they can allocate enough time to properly assess and manage plan fees and have the necessary skills to properly evaluate the reasonableness of plan fees under ERISA standards.
Many plan sponsors partner with independent consultants to help navigate this topic. Hiring an independent advisor or consultant may a helpful solution to help meet fiduciary responsibilities in this changing environment.
John J. Higgins, CFP, AIF, CFS, is Managing Partner at Patterson Smith Associates, LLC and a Retirement Plan Consultant with Commonwealth with more than 20 years’ experience in the financial services industry.
Kelly A. Kurtz, CPC, QPFC, QPA, is Director of Retirement Services at Patterson Smith Associates, LLC. She spent much of her career designing and implementing 401(k) plans for employers as well as managing the overall process of plan operations and administration.
John and Kelly can be reached at 800-572-8859, firstname.lastname@example.org, or by visiting www.psabenefits.com.