I write to bury revenue sharing, not to bash it.
Revenue sharing is the practice of adding additional non-investment related fees to the expense ratio of a mutual fund. These additional fees are then paid out to various service providers – usually unrelated to the fund company managing the fund.
Why is this controversial? Mutual fund returns are reported net of fees, so the money collected from investors and paid out to other parties is not explicitly reported to investors, it simply reduces the net investment return of the fund. Because investors don’t see the fees being deducted, the true cost of the fees charged is often overlooked when calculating the total cost of plan services.
Revenue sharing is limited to small business retirement plans
Larger 401k plans don’t have revenue sharing. Large employer plans have access to managed accounts and/or institutional share classes. These investments have lower expense ratios and no revenue sharing arrangements. Larger employers negotiate for the best fees for all plan services, and then determine how those fees should be allocated to plan participants or borne by the plan sponsor. Revenue sharing shifts all additional fees, by definition, to the plan participants, thus limiting flexibility. Revenue sharing, therefore, is limited to smaller retirement plans and the “retail” class shares of mutual funds.
Reports indicate revenue sharing has been declining over the last few years – both in terms of the percentage of plans including it and as a portion of the expense ratio. Fee disclosure requirements have likely played at least some small part in this trend. However, I would argue that market forces have been more influential in reducing the incidence of revenue sharing. I predict these market forces will bring the practice to an end – and soon.
Key takeaway: Plans grow out of revenue sharing, not into it.
As plan assets increase, plans tend to review fees, and to move away from the retail class of shares – and revenue sharing. Cause and effect? Yes.
Here are the market forces driving plans away from revenue sharing:
Revenue sharing is no longer “invisible.” With the rise in popularity of low-cost investments – particularly index funds and ETFs, more scrutiny is being placed on the total expense ratio of plan investments. The fee baseline is now about 0.15% (or less) for index funds. Funds with a typical management fee and revenue sharing now stand out more than just a few years ago when the baseline fee was higher. And the demand for index funds is increasing. As more small employers opt for low-cost investments, the more pressure that will be placed on fund companies to be competitive on fees. Look for fund companies to dump the “ballast” of revenue sharing in order to better compete on price as market competition continues to drive fees down.
Revenue sharing is not equitable. Unless all investments in a plan are subject to the same revenue sharing percentage, fees are being applied inequitably to plan participants. We see examples of this issue every day in plans mixing funds that have and do not have revenue sharing. Investors choosing revenue sharing funds pay a disproportionate portion of plan expenses – often without their knowledge. The DOL warns that sponsors are obligated to monitor the overall reasonableness and proportionality of fees – including those paid through revenue sharing arrangements. Sponsors evaluating fees are more and more rejecting all revenue sharing arrangements – they are just too time consuming and difficult to administer equitably. Small plans will continue to move away from revenue sharing as they continue to strive to meet fiduciary standards.
Revenue sharing is not efficient. Revenue sharing adds complexity to 401k plan administration – and drag. Form 5500 filings, plan audits, participant communications and plan fiduciary documentation are all made more difficult – and expensive – because of revenue sharing. And the benefits of revenue sharing? Fees are deducted from plan assets before investment returns – little value in our internet-driven culture of transparency. As sponsors become more educated on plan expenses and fiduciary responsibilities, they continue to opt out of complex fee arrangements in favor of fully-disclosed, transparent fee arrangements. This trend is not going away.
Revenue sharing is winding down. Small businesses will be the winners when it is gone.