Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries. What is revenue sharing?

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1 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries The spotlight on plan fees has gotten a lot brighter. Final regulations recently issued by the Department of Labor and renewed scrutiny of 12b- 1 fees by the SEC will undoubtedly change the way retirement plan providers do business in the coming year. These rules will apply to all plans that are subject to ERISA. Plan sponsors will know how much they re paying for the administration of their plans and participants will have access to this information under pending legislation. Until now, the question How much are we paying for the administration of our plan? was not an easy one to answer. Why? The confusion can be traced to the practice of revenue sharing What is revenue sharing? Many plan sponsors may find that they are not making hard- dollar or fixed payments to their recordkeeping vendor for their services (e.g. quarterly statements, websites, and day- to- day administration). This does not mean that those administrative services are free. There is no such thing as a no cost retirement solution. The recordkeeper is making most of the money it requires possibly more than it requires from agreements with the funds in the plan (including guaranteed and stable value accounts). For example, when a plan uses mutual funds, the overall expenses of each fund is expressed as an expense ratio. This can range from 0.20% for a low cost index fund to 2.0% for an actively managed fund. A portion of that fee pays for the function of investment management (generally ranging from 0.25% to 1.0%), a portion is allocated to operating expenses (generally ranging from 0.05% to 0.40%), and the rest consists of revenue sharing payments. These payments are used to pay for recordkeeping and administrative services like account statements, Form 5500 preparation, call centers, and websites. Stable value accounts have similar fee structures to mutual funds in that they have specified expense ratios with a portion of the fees used to cover investment management expenses, while the remaining fees cover administrative operating expenses and any potential revenue sharing that has been built into the product. Essentially, plan participants pay the total expense ratio as stated by the fund. That total expense payment is then divided into either (1) investment management fees (and related operating costs) which are retained by the fund company, or (2) any revenue sharing payments to the recordkeeper. Qualified and experienced consultants can help you uncover these costs and determine the reasonableness of each

2 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries Not all funds necessarily make revenue sharing payments. And, the funds that make revenue sharing payments do not all pay the same amount. Proprietary funds (funds created and managed by the recordkeeping vendor) generally tend to pay the most amount of revenue sharing. Actively managed funds typically pay more revenue sharing than index funds. Revenue sharing payments in mutual funds (or stable value funds) usually consist of: 12b- 1 fees charged by some funds to cover marketing and distribution expenses of the product. These fees are generally paid to the plan s recordkeeper, but can also be used to compensate a broker for education or to pay a TPA for other administrative services. This fee generally ranges between 0.25% and 0.75% of invested assets. Shareholder servicing fees similar to 12b- 1 fees, but are typically used by no load mutual fund products. Only service providers such as recordkeepers and TPAs can receive these fees, which can be used to compensate them for recordkeeping, administration, and education services. No- load fund products can pay up to 0.25% as a shareholder servicing fee without being required to call it a 12b- 1 fee. Sub- Transfer Agency fees (Sub- TA fees) usually a payment to a TPA or recordkeeper who holds an omnibus account at the mutual fund company, eliminating the need for the mutual fund company to maintain individual participant accounts. Instead, participant accounts are maintained by the TPA or recordkeeper. Because this reduces the cost for the mutual fund company, they pay the TPA or recordkeeper a fee for this service. Typically, this fee ranges from 0.10% to 0.35% of invested assets. 12b- 1 Fees or Commissions % Revenue Sharing Investment Management Fees/ Overhead Expenses % Sub- TA or Shareholder Service Fees % Total Mutual Fund Fee = 1.45% - 2 -

3 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries In contrast to mutual funds and stable value funds, general account products offered through insurance companies do not have a stated expense ratio. Instead, the assets are invested in higher yielding instruments than what is guaranteed to the contract holders. The resultant spread is kept by the insurance company. This may be used to cover investment management expenses, insurance fees, administrative costs, and revenue sharing. Because the fees are not typically explicit, it is difficult to determine the actual cost to a retirement plan. In some cases, the spread cost may exceed 2.0%. These descriptions are intended to cover most common practices. When in doubt, remember that you re paying for plan administration somehow. Starting 2011, because of pending DOL regulations, service providers will be required to tell you how much. What are your fiduciary duties with regard to revenue- sharing arrangements? Plan fiduciaries have the obligation to ensure that all plan expenses are reasonable in light of the services provided, including indirect compensation and revenue sharing as described above. This can be difficult because of the convoluted way by which many vendors get paid. Fortunately for plan sponsors, the trend towards disclosure and transparency is under way and accelerating. However, once plan fiduciaries regularly receive additional accurate information on fees, expenses and revenue sharing, the expectations for prudence regarding fees will be heightened. Fiduciaries will be expected to evaluate the information they receive and to make informed decisions. The majority of employers seek the help of an advisor to decipher plan costs and determine whether those costs are reasonable. Even in a no- cost solution, fiduciaries should ensure that: The contract or arrangement with their vendor is reasonable; The services are necessary for the establishment or operation of the plan; and No more than reasonable compensation is paid for the services If these conditions are not satisfied, it can be argued that a prohibited transaction under ERISA has occurred, for which the fiduciaries may have personal accountability. Further, if revenue sharing exceeds the reasonable charge of doing business, it is a reasonable interpretation of the law that fiduciaries must act to restore this money to the plan. There are a variety of ways that this can accomplished. Another alternative would be to change to a share class of mutual funds with lower revenue share

4 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries To help identify your existing cost structure, you can start by asking two basic questions 1) How much did the recordkeeper receive in the prior two calendar years in the way of revenue sharing payments? 2) How much did any other parties (e.g. broker, advisor, TPA) receive in compensation? The response should be in writing and should breakdown the exact amounts by fund. Experienced consultants can also assist with the evaluation of plan expenses, provide benchmarking data, and assist with vendor negotiations to restore any excess revenue sharing to the plan. It is not the objective of plan sponsors to run the cheapest plan, but to maintain a plan that has demonstrated that plan fees are reasonable. While reasonable is a term debated in courts, fiduciaries should make their own assessments regarding their plan: Educate yourself on the various fees assessed to the plan Ensure that you are receiving adequate information from all service providers, including brokers and advisors Benchmark current plan fees at least every three years Not the perfect solution As you might expect, as plan assets continue to grow (largely a result of contributions and not necessarily market activity), so does the compensation paid to service providers through the revenue sharing arrangement. Also, economies of scale driven by vendor consolidation over the last few year and new technologies have increased the profit margins of many recordkeepers/administrators. While recordkeepers who have historically offered only proprietary funds are now opening up their offering to include best- in- class non- proprietary funds, plan assets tend to stay in those proprietary funds (absent an aggressive communications campaign). Furthermore, there are many questions that still remain regarding the appropriateness of the revenue sharing pricing mechanism, and its impact at the plan and participant level. It is nearly impossible to create a situation where every fund on a plan s investment menu pays the same amount of revenue sharing. Even if overall fees are disclosed, analyzed and determined to be reasonable, this creates a situation of inequity among participants. Plan participants invested in funds that pays a high amount of revenue sharing to the recordkeeper are paying a greater and disproportionate share of the plan s recordkeeping cost than participants who are invested in funds that pay little or no revenue sharing

5 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries What alternatives are available to the traditional revenue- sharing arrangements? Potential solutions to the traditional revenue sharing model include: Zero Revenue Start with funds that do not pay revenue sharing, and change the service provider s pricing arrangement to a flat, per- head fee. Pros of zero revenue approach: Produces a level playing field Avoids the potential confusion of revenue sharing altogether Growth of assets is not a factor Drives down participant investment expenses Cons of zero revenue approach : Recordkeeper may prefer a situation where increasing assets equals increasing fees Certain funds may not be available in a share class that does not include revenue sharing, thereby limited fund choices Communicating the benefits of the never- before- seen annual fee may be a challenge Gross- to- Net Pricing Revenue sharing that exceeds the cost of servicing the plan is deposited into an ERISA Budget account. Plan expenses (e.g. advisory fees, plan audit fees) may be paid from his account or allocated back to participant accounts. Gross- to- Net Pricing has been used since Pros of gross- to- net approach: Increases overall transparency of plan fees It was initially contemplated in a DOL Advisory Opinion to Frost Bank, which Helps ensure that services received are required a dollar- for- dollar offset of revenue commensurate with fees sharing against the provider s fee schedule Achieves more value for participants to eliminate any conflicts of interest. Cons of gross- to- net approach: Participants in funds that pay little or no revenue sharing typically pay a significantly lower share of recordkeeping fees than other participants in funds that do pay revenue sharing Reliance on revenue sharing payments to generate revenue may be a fiduciary concern, especially when mixed with funds that don t offer revenue sharing

6 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries Fee Normalization A fee is charged to each fund to levelize ( normalize ) the plan revenue across all funds so that all participants pay the same percentage of plan costs regardless of their investment allocation. Pros of fee normalization approach: Eliminates fairness issue of gross- to- net pricing. Allows use of any combination of funds or share classes, including institutional funds. No use of outside trusts Cons of fee normalization approach: Some recordkeepers may not be prepared to administer this type of accounting process Communicating the benefits of the never- before- seen fees may be a challenge Conclusion In the past, few plan sponsors carefully examined the fees associated with the plan investments. Good investment performance through most of the 1980 s and 1990 s obscured the costs that were mostly borne by plan participants. And a Catch- 22 existed. Even if plan sponsors asked the questions, there were no regulations requiring service providers to disclose fee information. Employers need to navigate the frequently changing retirement plan landscape. They need to understand how their service providers are compensated and how those service providers bring value to the plan and its participants. Even in a no cost arrangement, executives charged with fiduciary oversight of an organization s retirement savings plan need to understand plan fee arrangements; including how much is being paid, to whom and for what. Notwithstanding new IRS and DOL regulations, the fee disclosure saga will likely continue. The current Administration has made fee disclosure one of its priorities. Pending legislation will likely trump current rules. HR professionals should work with the internal finance departments and their plan recordkeepers to determine what approach to plan fees is best for them. Independent fee- based consultants can help by offering unbiased expertise that cannot be maintained in- house and advice that is not affected by profit and loss requirements of service providers

7 Retirement Plan Fees: Focus on Revenue Sharing and What it Means to Defined Contribution Plan Fiduciaries About Strategic Retirement Group, Inc. Strategic Retirement Group, Inc, (SRG) is a retirement plan investment consulting firm specializing in custom- designed services. Launched in 2006 by 20- year veteran David Hinderstein, SRG has built a reputation for best practices, high levels of service, and impactful communications that exceed client expectations and lead to award- winning results for our clients. Since its founding, SRG has developed a client base of over 30 retirement plans with $1.5 billion in total assets (as of September 30, 2010). We focus on educating fiduciaries, HR/Finance staff, and employees so that they can make the best decisions about their retirement program. 3 Barker Avenue, 5th Floor White Plains, NY (914) David S. Hinderstein, AIF dhinderstein@n- r- p.com Daniel R. Casella, CFP dcasella@n- r- p.com Securities offered through LPL Financial, Member FINRA/SIPC Investment Advice offered through Independent Financial Partners, a Registered Investment Advisor and separate entity from LPL Financial. Representatives of LPL Financial, Inc., Independent Financial Partners, and Strategic Retirement Group, Inc. are not tax or legal advisors. Consult with your tax or legal advisor before making plan decisions