DOL Rule May Encourage 401(k) Zero Revenue Sharing Trends

Many employers provide their employees with benefits in addition to income, such as retirement plans. These retirement plans usually involve employees and employers investing into a fund that will, hopefully, increase over time so that when employees retire, they will have a secure amount of income to cash out. The plans are typically managed through a third-party fiduciary that handles the investments. Of course, there are service costs to administer and manage retirement funds, which are paid for by the employee, employer, or a combination of both. In financial terms, employees are referred to as the participants and employers are referred to as the plan sponsors.

The new fiduciary rule of the Department of Labor ("DOL") addresses conflicts of interest between fiduciary advisers and their clients. Under this rule, advisers who receive compensation through 12b-1 fees, commissions, or any other means will be subject to greater compliance requirements and litigation risks through the rule's Best Interest Contract Exemption ("BICE") provision. Specifically the provision states, "certain types of fees and compensation common in the retail market, such as brokerage or insurance commissions, 12b-1 fees, and revenue sharing payments, may fall within ERISA prohibitions when received by fiduciaries as a result of transactions involving advice to the plan." 29 C.F.R. Part 2550 . To evade potential risk and liability, experts believe advisers will stop using revenue sharing plans that bundle all service costs and take money up-front, and switch-over to zero revenue sharing plans that deliberately outline the compensation that they receive.

The Difference Between Revenue Sharing and Zero Revenue Sharing

In the history of 401(k) plans, participants typically pay for fiduciary services through revenue sharing, which is a practice in which the administrative, marketing, and non-investment related fees are automatically deducted from a portion of the participant's return of investment. Moreover, under this type of plan, the plan providers and plan sponsors (as opposed to the participants themselves) agree on the percentage of the investment's return (or basis points) that will be used to pay the fees. If the revenue derived from the basis points does not cover the fees, the providers can bill the participants to cover the rest. On the contrary, if the revenue derived from the basis points exceeds the costs, the providers can refund the amount to the participants, although the participants have no way of knowing whether they are entitled to such refund. Since many plans do not have a clear method in place on how to handle situations where there is either a deficiency or a surplus after deducting the service fees, a potential conflict of interest arises under revenue sharing plans; while there is a direct benefit of compensation to plan providers, there is no benefit to the participants, and, in some cases, costly consequences.

However, more recently, zero revenue sharing plans have become increasingly popular, which is a plan where non-investment related fees are directly billed in separate line items. In other words, the expenses of the plan and fees paid to the plan providers are clearly delineated so that investors know exactly what fees they are paying. The zero revenue sharing plan essentially eliminates the potential conflict of interest that exists under the revenue sharing plan.

Zero Revenue Sharing on the Rise

As mentioned, zero revenue sharing plans have been on the rise, while revenue sharing plans have been on the decline. According to the consulting firm, Callan Associates, the proportion of defined-contribution plans that used revenue sharing to pay at least a portion of plan administrative expenses fell from 67% in 2012 to 52% in 2015. Meanwhile, assets held in the various "R" share classes that were in share classes that strip out the 12b-1 fee - a characteristic typical in a zero revenue sharing plan - increased from 56% in 2012 to 72% in 2015.

This recent trend is perceived to be caused by the DOL's 2012 fee-disclosure regulation, along with ongoing lawsuits that target excessive 401(k) fees. Experts believe that the BICE will accelerate this trend.

Although there are other ways to achieve level compensation without adopting a lineup of zero revenue sharing funds, such a practice would be more complicated. For example, it would require advisers to determine the amount of revenue necessary to pay for plan services and then match funds for the plan with the required revenue sharing expense. Additionally, zero revenue sharing funds often can achieve a lower net cost.

While plan providers furnish the scope of the plan's options, plan sponsors must approve the options. Sponsors have been cautious to switch-over to zero revenue sharing plans for fear that their employees would become upset when all the service fees become transparent. Although such fear should not preclude any fiduciary responsibilities, it is important that both plan sponsors and participants are well-informed of the difference between revenue sharing and zero revenue sharing and how the latter may be more beneficial and equitable for the participants.

The legal team at SFMS has significant experience litigating securities matters. If you have any questions regarding this subject or this posting, please contact Nick Lussier ( [email protected]) or Chiharu Sekino ( [email protected]). We can also be reached toll-free at (866) 540-5505.

Shepherd, Finkelman, Miller & Shah, LLP is a law firm with offices in California, Connecticut, Florida, New Jersey, New York and Pennsylvania. SFMS is an active member of Integrated Advisory Group (www.iaginternational.org), which provides us with the ability to provide our clients with access to excellent legal and accounting resources throughout the globe. For more information about our firm, please visit us at www.sfmslaw.com.

Written by Casey Yamasaki

SOURCES

29 C.F.R. Part 2550 2016

Lacurci, Greg. "DOL fiduciary rule will nudge 401(k) advisers to zero-revenue-share fund lineups." InvestmentNews. Last modified on June 28, 2016.

United States Department of Labor. "Understanding Retirement Plan Fees and Expenses." Employee Benefits Security Administration. https://www.dol.gov/ebsa/publications/undrstndgrtrmnt.html