In a simple and easy to understand article, law firm K& L Gates explains revenue sharing in defined contribution (DC) plans like 401ks, their pitfalls and how plan sponsors can manage their duty to prudently monitor fees.
Though revenue sharing has a bad reputation and is the cause of many lawsuits with the SEC investigating these arrangements (and the DOL paying more attention), there is nothing inherently wrong or illegal with revenue sharing if properly understood and monitored within a prudent documented process.
Revenue sharing are extra expenses wrapped around fund expense ratios paid by plan participants when selecting investments. They come in the form of 12b1 fees, originally created to pay fund marketing expenses and now commonly used to pay advisor commissions or compensation, and sub transfer agency fees (Sub TA fees) designed to pay administrative expenses and commonly used to pay a plan’s record keeper or TPA.
The problem is that most participant don’t realize that within the expense ratio are fees to pay third parties and maybe one in ten plan sponsors understand revenue sharing all of which was supposed to be solved by the DOL’s regs in 2012 (408b2 to plan sponsors and 404a5 to participants) requiring fee disclosure documents by parties receiving direct or indirect (rev sharing) compensation. Except most people don’t read the disclosure which are often unnecessarily hard to understand and lengthy.
The solutions? Eliminate revenue sharing by only using fund share classes that do not carry extra expenses. Third parties like advisors and record keepers must be paid either by plan sponsors writing a check or deducting whatever is needed from participant accounts with simple disclosure about how these expenses are disbursed. Alternatively, plan sponsors can create a recapture account where all revenue sharing is paid and then disbursed fairly based on reasonable payments to vendors of the plan. Finally, plan can pay providers and advisors a flat fee, rather than a percentage of assets using no revenue sharing funds or recapturing all revenue sharing.
Whatever the decision about revenue sharing, ignore it at your peril making sure that you have a documented prudent process that determines what is reasonable compensation to third parties based on the services provided and what comparable plan sponsors are paying. The key is making sure you understand who gets paid what under revenue sharing – not as simple as it sounds within 401k and 403b plans.
