The 401(k) industry calls it revenue sharing. The mutual fund industry calls it 12b-1 fees, subtransfer agency fees, shareholder servicing fees, and profit-sharing payments. The Department of Labor (DOL) calls it indirect payments. Plaintiffs' attorneys call it "hidden and excessive" fees.
By now, everyone in the 401(k) community must have some understanding that almost all plan providers and many advisers receive indirect payments from the investments in 401(k) plans.
The DOL has taken the position that fiduciaries have a duty to know and evaluate indirect payments. In performing that evaluation, fiduciaries need to consider whether the total amounts received, directly and indirectly, by their service providers are reasonable. Further, fiduciaries must evaluate whether the payments cause potential conflicts of interest and, if so, whether the plan and participants are protected from those conflicts.
The failure to evaluate those issues is a fiduciary breach. With that "big picture" introduction, let's look at two types of revenue sharing, and the potential conflicts of interest.
Subtransfer agency fees/shareholder servicing fees
These fees are paid by mutual funds to 401(k) providers who perform the recordkeeping function for 401(k) plans. They are charged against the mutual funds and thereby reduce the participants’ investment returns and, ultimately, their benefits.
Purpose: The payments are intended to support transfer agent and shareholder servicing activities by the recordkeeper. That ordinarily would include keeping track of share ownership at the plan and participant account level, conveying information about the mutual fund to the plan and participants, and so on.
Since mutual funds are required to provide those services, in most cases, the funds would have borne those costs (or perhaps similar, but lower, costs) in any event. However, these payments can vary from mutual fund to mutual fund and from share class to share class; as a result, fiduciaries need to be attentive to the amounts being paid.
Potential conflicts and reasonable compensation: There may be several potential conflicts, but let’s focus on one—the possible reluctance of the recordkeeper to disclose its revenues from those sources, and what it otherwise would charge for its services.
For example, if a recordkeeper is receiving $50,000 in revenue sharing, and if a reasonable charge for its services is $50,000—the same amount—there is no conflict. However, if the plan grows with time and the revenue sharing grows to $85,000, but a reasonable charge only increases to $60,000, the fees have become excessive. At that point, the responsible fiduciaries have three jobs: to know about the amount of the revenue sharing, to know the reasonable cost of the recordkeeper’s services, and to reclaim the difference for the plan and the participants.
Purpose: These fees are paid by mutual funds to broker/dealers, and a part of those fees is passed on to financial advisers for their services to 401(k) plans. Under the securities laws, the technical purpose is for the sale or “distribution” of mutual funds. From the perspective of the 401(k) community, the payments are for assistance in the selection and monitoring of the mutual funds, enrollment meetings, investment education for participants, and so on.
Potential conflicts: The potential conflict should be obvious; that is, the broker/dealer and financial adviser may recommend mutual funds that pay higher compensation (or 12b-1 fees). In other words, they may place the benefit to themselves ahead of the best interests of the plan and the participants.
Determining the reasonableness of fees and compensation is difficult, even under the best of circumstances. In many cases, fiduciaries are not receiving complete information about costs and compensation. However, there is relief on the horizon. Much of the needed information will be required to be disclosed by guidance recently proposed by the DOL.