When constructing an investment menu for a defined contribution retirement plan, the focus is often on selecting the right investment managers and products. The goal is to choose options that best align with the retirement plan committee’s investment philosophy and are most suitable for the organization’s workforce. While these decisions are important, we believe it is equally important to select the right investment vehicles to fulfill that strategy. That is, the most appropriate mutual fund share class or collective investment trust (CIT) tier.
In this post, we review various investment vehicle types, discuss how vehicle choice can impact fees and performance, and outline key criteria to consider when analyzing the reasonableness of the fee structure for a given defined contribution plan.
Key Terminology
First, it is critical to establish key terminology for this discussion. While this list is not exhaustive, it covers many of the relevant terms used when evaluating investment menu share class decisions and overall fee structures.
The Current Landscape
The Employee Retirement Income Security Act of 1974 (ERISA) requires retirement plan fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficiaries. As such, the Department of Labor’s (DOL) fee guidance to plan sponsors has emphasized the responsibility of plan sponsors to monitor plan expenses, including assessing the reasonableness of total compensation paid to service providers, identifying potential conflicts of interest, and making the required disclosures to participants.
To help plan sponsors evaluate fee reasonableness, the DOL’s guidance on section 408(b)(2) of ERISA requires service providers like recordkeepers and advisors, to disclose total compensation received by the service provider, their affiliates, or subcontractors.
Despite this guidance and the benefit of required disclosures, some fee arrangements — such as those involving revenue sharing — can be difficult for plan sponsors to analyze, let alone participants. Not surprisingly, several organizations have found themselves in fee-related lawsuits over the last decade. In our practice, we see most plan sponsors moving away from revenue sharing and other opaque fee arrangements.
Aside from concerns about fee-related litigation, many plan sponsors value the clarity provided to plan participants when offering only zero-revenue share classes in their plan lineups. Participants can easily ascertain recordkeeper fees and be assured the mutual fund expense ratio is used only for the mutual fund provider’s expenses.
The Plan Sponsor Council of America’s (PSCA’s) 66th Annual Survey reported that only 35% of plans surveyed include revenue-sharing funds within their investment lineups, meaningfully lower than in prior years. In our role as plan advisor, we have helped many plan sponsors reduce plan fees and increase fee transparency by moving to zero-revenue share classes. We expect this trend to continue in the coming years.
Share Class Choice Impacts Fees and Investment Performance
From a fee perspective, the difference between revenue-sharing and zero-revenue share classes is illustrated in Figure 1. In the example, the revenue-sharing share class (R3) of a popular target date fund is compared with the zero-revenue share class (R6). The values are normalized from an approximately $30 million plan with roughly $20 million invested in the target-date funds. In this example, there is approximately $125,000 of revenue sharing generated by the R3 share class (as estimated by comparing the modeled investment fees of the R6 share class to the modeled investment fees of the R3 share class).
Figure 1. Share Class Difference Illustration
Notably, in this example, the difference in manager fees between the two share classes is typically used to compensate the recordkeeper and/or advisor — either in part or in whole. In the R3 share class scenario, it is likely the $125,000 difference between the R3 and R6 share classes (representing distribution fees) would be used to pay part or all the recordkeeper and/or advisor fees. Conversely, in the R6 share class scenario, the advisor and/or recordkeeper fees would need to be paid by the plan or by the plan sponsor directly. In both cases, a plan sponsor would need to determine what is a reasonable level of fees for an advisor and a recordkeeper based on plan size and participant count as well as services included.
In addition, in the case of revenue sharing, plan sponsors must ensure anything above the “reasonable” fee level is credited back to participants or used to pay other plan expenses. To make this fee reasonableness determination, a plan sponsor must calculate the amount of fees going to vendors and compare that figure to industry benchmarks for plans of similar size, receiving similar services, on an annual basis. This can place a significant burden on plan sponsors and, in our experience, is not often reliably completed.
Following this approach, many plan sponsors discover their fees are out of line with industry benchmarks and can achieve cost savings by moving to zero-revenue share class structures.
From an investment performance standpoint, fees have an impact on investment performance. The higher the fees, the less money available to compound and grow in each participant’s investment portfolio. In Figure 2, we illustrate the differences in performance between the R3 and R6 share classes of the same target-date fund as Table 1. As a reminder, they both hold the same investment portfolios: the only material difference is the expense ratio. Comparing the performance of a $10,000 investment over a 10-year period, an investor in the R6 share class would end with approximately $1,000 more than an investor in the R3 share class. Larger investments or longer periods of time would magnify this effect, resulting in even greater differences in outcomes.
Figure 2. Investment Performance Illustration
Estimate is hypothetical and assumes an initial investment of $10,000 is invested for 10 years in the R3 share class and the R6 share class of the same target date fund in the same vintage and utilizes historical 10-year annualized return as of 12/31/2023.
In the absence of revenue sharing, a plan that charges fees to participants would allocate the advisor and/or recordkeeper fees to participants’ accounts, which would appear as a separate line item on their statements and could lower account performance net of fees. Nevertheless, in our experience, moving to a zero-revenue share class fee structure often results in lower total fees for the recordkeeper and investment providers than when compensating the recordkeeper or advisor partially or fully with revenue sharing, which ultimately results in improved investment returns.
Analyzing Fee Arrangements
In our practice, we find three common revenue-sharing methods: revenue sharing, revenue offset, and revenue rebate. Below, we contrast these methods with zero-revenue share classes. When evaluating these structures, it is important to remember the elements common to all three revenue sharing methods: fulfilling fiduciary responsibilities under ERISA, following relevant DOL guidance, and the requirement to understand and calculate total fees paid for fee reasonableness.
- Revenue Sharing
When evaluating a revenue-sharing arrangement in which an advisor or recordkeeper is receiving indirect compensation from investment managers via 12b-1 and other fees, it is important to calculate total compensation paid to each service provider. This can be accomplished by reviewing 408(b)(2) disclosures from each service provider earning compensation from the plan. Once you have calculated what the advisor or recordkeeper is earning from the plan, it is important to benchmark the results against industry standards for similar services to plans of similar size. If the total compensation is higher than industry standards, we recommend shifting to a lower-cost share class (preferably a zero-revenue share class) or to negotiate “revenue caps” with your providers and collect any excess revenue and credit it back to participants.
2. Revenue Rebate
Revenue rebate refers primarily to the process whereby fees above a revenue cap are rebated to participants, or whereby all revenue sharing is rebated to participants. The cap and resulting rebate serve as a ceiling on plan fees and can help keep plan fees in line with industry benchmarks, relative to uncapped fees.
However, this process still creates the potential for lower investment performance as participants forgo potential investment earnings during the period between when the recordkeeper collects the revenue sharing and rebates it back to participants’ accounts. Because this period can be several months, the performance drag can be a meaningful detriment to participant results. When engaging in this type of fee arrangement, we recommend analyzing fees on at least an annual basis to ensure the revenue cap is working as designed and that participants are being rebated fees accurately and in a timely manner.
3. Revenue Offset
Revenue offset typically refers to a recordkeeper offering a discount to standard pricing if a plan sponsor includes mutual funds that are proprietary or affiliated with the recordkeeper in the investment menu. In this type of arrangement, despite recordkeepers offering a “coupon” or “discount” to use proprietary funds, plan sponsors are not exempt from fulfilling their fiduciary duty to make prudent investment decisions. This means plan sponsors still need to follow a rigorous due diligence process to determine if the specific investments are suitable for their workforce, including evaluating other available funds in the investment universe. While it is important to have reasonable recordkeeper fees, plan sponsors should not, in our view, allow a discount to supersede the requirement for a review that meets the fiduciary duty of applying ERISA’s prudent investment expert standard.
4. Zero Revenue
Zero-revenue share classes typically do not pay service fees, 12b-1 fees, sub-transfer agency fees, or other revenue to the plan’s service providers, such as the plan’s recordkeeper. The expense ratios of such share classes are generally lower than revenue-sharing share classes. Because fees are not combined, plan sponsors using zero-revenue share classes can more easily evaluate the reasonableness of each type of fee — investment, advisor and recordkeeper — against industry benchmarks for plans of similar size, receiving similar services. Additionally, administrative fees charged to participant accounts are separate from investment fees, providing more transparency.
Free Equity Among Participants
One additional consideration in evaluating fee arrangements is to consider fee equity for participants. Consider three scenarios that create fee inequity, or in other words, the risk that some participants pay more fees than others based on their investment elections, all else being equal:
- An investment menu in which different funds pay different levels of revenue sharing.
- An investment menu in which some funds are proprietary or affiliated funds, which provide a revenue offset to recordkeeping fees.
- An investment menu where some funds utilize revenue-sharing share classes and some use zero-revenue share classes.
In our view, inequitable fee arrangements disadvantage some participants relative to others. This can create unnecessary risk for plan sponsors, especially when alternatives are available.
Final Thoughts on Zero-Revenue Share Classes
In our view, it is difficult to justify the use of revenue-sharing funds in a plan lineup where equivalent zero-revenue options are available. We believe the benefits of zero-revenue share classes in an investment lineup, particularly fee transparency, are of substantial value to plan sponsors and participants. If your participant-directed retirement plan is currently offering revenue-sharing share classes, we suggest speaking with your advisor about the benefits of moving to a zero-revenue share class fee structure.
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