Revenue Sharing

[Guest texasactuary]

We have a client that uses revenue sharing to pay administrative fees for the plan. Due to reduced fees the revenue sharing exceeds the fees. How can the excess be handled? (1) returned to the plan as investment income and allocated to participants based on account balance? (2) returned to the plan and put in forfeitures? if so does it matter how forfeitures are handled?

[Jon Chambers]

How about select less expensive funds with lower revenue sharing, and eliminate the problem altogether? While I doubt you will be the test case, beware of the litigation of the future--excessive revenue sharing as a per se fiduciary breach, violating the basic fiduciary duty of cost control.

If you have to pick a corrective approach, I'd allocate like income, not like forfeitures, since the revenue sharing is generally based on asset levels, not income levels.

[Guest rmeigs]

How about select less expensive funds with lower revenue sharing, and eliminate the problem altogether? While I doubt you will be the test case, beware of the litigation of the future--excessive revenue sharing as a per se fiduciary breach, violating the basic fiduciary duty of cost control.

Right on target Jon, but as long as the plan fiduciaries are monitoring and actively recovering the excess revenue sharing for the benefit of the participants, they are a lot farther ahead than a majority of plans.

texasactuary: IMHO, the excess should be credited to the plan as income and not "put in forfeitures."

[Guest texasactuary]

Thanks for the help guys, I agree with you both. I was hoping for something more concrete but did not really think that there was a reg or other "bright line" ~ that would be more helpful when dealing with clients. I am sure that it will not be long and we will have more guidance.

[Guest wcmoore]

To add my two cents, since revenue-sharing (RS) is the participants' money (specifically those participants investing in funds generating RSing), it should be returned to the plan as income and re-allocated pro-rata only to those participants whose accounts are invested in RSing funds.

Otherwise, there would be an allocation of income to participants who had no direct connection to its original generation. Furthermore, I'm unaware of any defined plan event that permits excess RSing to be recharacterized as a forfeiture.

As an additional thought, please keep in mind that if only a few funds generate all RSing, then participants invested in those RSing funds in effect are paying all plan admin costs.

I agree with Jon to beware that the SEC, DOL, and even the NASD are both looking for greater accountability about how RSing is generated/determined, used/who the RS benefits, and especially how its accounted for.

[alanm]

My firm credits back 12b-1 and sub TA fees to participants. The practical aspect of this is that revenue payments from the funds often are subject to a waiting period, sometime as long as a year in the case of some Oppenheimer funds and typically three months for others. So when you receive the revenue, often the participant has sold the fund generating it and it is too difficult to track. We have a policy of allocating this revenue on a cash basis to participants who actually own the fund at the time of receipt, as a fair an equitable way of distributing earnings back to the plan in excess of plan costs.

[jquazza]

You have to use extreme caution there. If your firm is not allowed to keep the sub-TA or 12b-1 fees in excess of the plan fees and you credit the plan for that excess, you might very well be violating securities laws. The extra income to the plan could very well be construed as preferential dividend (the plan received more income on its investments than the rest of the shareholders) and that's a big no-no.

Contrary to the other posts, I would either credit the plan fees for future expenses or actually return the money to the investment provider (inasmuch as we hate doing that, they might actually need it these days.)

You may also want to amend your fee agreement so that you can keep these fees in the future.

[alanm]

There is an opinion from the NASD that says you can credit the fees to the participants and it is not a violation of NASD rule 2740. Look at letter to Jay Knight dated March 8th, 2001 signed by Philip Shaikun, Counsel for the NASD.

Look at DOL opinion 95-15A, the "Frost Letter" where this was approved.

If the 12b-1 fees and sub TA fees are in excess of plan administration costs and the excess is returned to the participants who generated the revenue by their investment choices, I fail to see how they got an unearned dividend because those fees ultimately reduce their returns in the first place. It would seem to me they were just getting their due. I will bet in the future that the regulators put out guidance saying this is the preferred way for fiduciaries to act because it removes bias from brokers anf others who select the platforms. As you know bias is not allowed under NASD rule 2830 and ERISA 406, all you have to do is read the Wall Dtreet Journal to see what is happening to "pay to Play" arrangements or view proposed rules 15-c2 and 15-c3 on the SEC website.

[FJR]

Don't forget it can also be used to help offset investment advisory fees as well. Most of the post assume there are only TPA admin. fees. Our plans never have a problem using all the Rev. share for both admin and investment advisory fees.

[Kirk Maldonado]

alanm:

You stated:

We have a policy of allocating this revenue on a cash basis to participants who actually own the fund at the time of receipt, as a fair an equitable way of distributing earnings back to the plan in excess of plan costs.

Are you saying that you pay those amounts to the participant in his or her individual capacity outside of the plan? Please clarify this point.

[alanm]

the 12b-1 fees are paid to a plan clearing account maitained by the broker of record. then they are allocated to participants by the record keeper based on ownership of the funds at the time, then the money is sent back to the fund companies where the plan omnibus accounts are maintained. The participants see the credits on their statements quarterly and the money never leaves the plan because the broker clearing account is designated as a plan account.

[FJR]

alanm, I'm curious how the broker gets paid in that example?

[Kirk Maldonado]

alanm:

Thanks for explaining how that works.

[Jon Chambers]

FJR, don't worry about the broker (or at least not about the brokerage firm). There are numerous ways that brokerages get paid in addition to the 12(b)1 fee, ranging from (soon to be illegal) directed brokerage, payments for shelf space, volume overrides, marketing support payments, etc. My guess is that in alanm's case, there is not a traditional broker involved (i.e., an individual responsible for selling funds to the plan), but that alanm's firm or an affiliate is serving as the "broker of record" for purposes of receiving 12(b)1 fees. The rationale for the 12(b)1 fees is to reduce plan administration charges, hence the fee offset and reallocation of excess amounts back to plan participants.

I do have a couple of remaining questions, and would be interested in alanm's thoughts.

First, are there any concerns by your firm or your client about the type of disclosure being provided to participants? If you distribute the fund prospectus to participants, fund expenses are overstated, since some of the 12(b)1 will be returned to participants. And due to the timing issues you note in an earlier post, the fund's effective expense ratio isn't simply the stated ratio minus the reallocation rate--it's more complicated than that, as the reallocation lags the deduction by 3 to 12 months, and as participants may have transferred between funds, taken loans or distributions etc, changing the composition of fund balances between the time of the deduction and the time of reallocation. I've seen vendors suggest this approach, but I've always struggled with the mechanics of disclosure.

Second, have you considered simply using lower cost share classes? Virtually all funds that pay 12(b)1 fees also offer an institutional share class, and it's often possible to qualify for the institutional share class at the omnibus level. I generally believe that plans are better served by seeking to minimize embedded investment expenses, and charging hard dollar fees against plan assets where necessary or appropriate, rather than maximizing revenue share, and reallocating excess revenue share back to participants. However, I acknowledge that the latter approach is more prevalent than the former, particularly in the small plan market.

Thanks for your helpful comments. I look forward to your thoughts on my questions.

[Guest Gordy]

I just received an unsolicited check from a Trust company. It's for "TPA revenue sharing" that someone signed me up for. It's transmitted from a person whose title is "Commissions Coordinator".

I'm certainly not up on SEC/Investment Advisor law, but, don't you have to be licensed in your state to receive commissions? I got 10 bps, just like a broker. I realize that they call it revenue sharing, accounting offset fees and lots of other creative things, but, a rose by another name.......

I'm confused on this. Clarifications would be appreciated. The check is going back regardless.

[alanm]

Here is the disclosure we make on the web: planRight.com, the SPD and enrollment material:

"Revenue paid by mutual funds as reimbursement of the expense ratios they charge will be credited back to participants on a cash basis. These revenues include 12b-1 and sub TA payments that are paid to the broker of record, usually with a three month lag, but may be up to a 13 month lag . As broker of record, SIC will receive the monies and credit participants who own the funds on the date the credit is processed by SIC, usually within 30 days of receipt of the credit. No accrual of this revenue will occur to participants who traded out of the funds in the interim."

The Broker or advisor gets paid by having a service contract with the plan and does not receive compensation through the back door. The contract basis point fee is also fully disclosed and represents a service fee for conducting enrollment meetings, reveiwing the platform of funds yearly and making recommendations, and giving individual investment advice to participants that request it. Ultimately, the plan sponsor must buy the brokers services in a negotiated contract, arm-length. Many brokers don't like disclosing what they are getting, but they realize the law is changing and they had better do it. By using no load funds, often they get more than the 12b-1 fees because the expense ratios are reduced by 100 basis points if VAnguard funds are plentiful.

We have a lot of Vanguard funds and no load funds on the platforms because the broker no longer cares about 12b-1 fees and we try to get the plan sponsors to select these, but there are always some funds they select that pay these fees and we credit them back. Obviously, only long term investors who stay put in the funds will receive the full benefit of the crediting: but this is what we are supposed to be telling the participants and it goes along with the SEC's concern about market timing. We also display the "net expense" ratio after the crediting.