As a retirement plan sponsor, you’re probably familiar with “revenue sharing.” If you’re unfamiliar with this jargon or the concept is a bit hazy, don’t feel ashamed—you’re not alone. Let’s take a closer look at factors influencing fiduciaries to consider zero revenue-sharing options over revenue sharing.

SPOILER ALERT! Litigation and the Department of Labor’s focus on fee disclosure transparency have led to increased sponsor demand for fee simplicity.

Transparency and simplicity are the primary reasons why fiduciaries find using zero-revenue funds advantageous. However, to fully benefit from them, it’s important to understand how revenue sharing works. So, as promised, let’s break it down.

What is revenue sharing?

Revenue sharing entails attaching additional fees to a mutual fund’s investment management fee (expense ratio) to pay for non-investment management services. In a retirement plan, the added fees represent "revenue" typically used to cover plan recordkeeping, administration, and advisory costs or "shared" with plan service providers. The revenue component of the expense ratio does not go to the company managing the fund.

Is revenue sharing allowed?

Yes. Revenue sharing is permitted under ERISA as long as plan fiduciaries follow the established standards and guidelines designed to prevent misusing plan assets and notify plan participants how the revenue is spent. Plan fiduciaries also have an obligation to understand and monitor revenue sharing to ensure that the fees paid to plan service providers are reasonable.

So, what’s the issue?

Because the non-investment management service costs are paid by revenue attached to the investments and not billed directly, it's more difficult for plan sponsors and participants to discern the costs associated with services and determine their reasonableness.

An ample number of lawsuits have been filed by employees suggesting that fiduciaries of plans with sufficient assets have a duty to use their bargaining power to negotiate lower plan costs and obtain funds with lower expense ratios. Therefore, it's prudent for plan fiduciaries to document all efforts to reduce fees, including using less expensive investments. Documentation can be critical where differences in fund share classes are attributable to revenue sharing, as all cost reductions can directly benefit the plan. Monitoring and documenting fee negotiations and revenue-related share class selection increases fiduciaries' responsibility.

An even larger issue is that revenue-sharing rates can vary widely among investment options in the same plan and generate unequal revenue levels. Thus, plan participants inevitably contribute unequally to covering plan costs. For example, if Participant A selects an investment that shares less revenue than an investment selected by Participant B, participant B bears a greater share of the plan costs. From experience, this kind of imbalance often raises concerns among fiduciaries, who are typically very mindful of avoiding any perception that some participants are unfairly subsidizing others.

Is there anything else I should know?

Another issue worth noting is that because fees cut directly into performance, revenue sharing (using funds with higher expense ratios) also makes it more difficult for fiduciaries to measure investment manager performance accurately.

For example, fiduciaries typically gauge investment competitiveness based on fund performance relative to benchmarks and peers. Consider the following example, which illustrates two share classes of the same underlying strategy, where the expense ratio of the A share class (0.78%) includes 0.40% of the revenue share. In contrast, the expense ratio of the R6 share class (0.38%) does not share revenue. If the plan's IPS states investments should outperform their benchmark and 50% of peers in the category over specific time frames, the revenue sharing fund (Class A) would be considered failing despite achieving the same objective.

This is a common challenge for quantitative scorecards, which are widely employed by fiduciaries to evaluate funds. It requires them to repeatedly perform additional diligence to determine that the scoring deficiency is related specifically to revenue sharing and document that the fund would otherwise meet the IPS criteria and remain a suitable investment.

Another thing to note is that even if a plan sponsor grasps this, unless a participant reads and understands the plan fee disclosure, they may be unaware of how fees are being paid and question the relative performance and relatively high expense ratios on the seemingly underwhelming investments available to the plan.

So, what can fiduciaries do to avoid these issues?

One option to ensure the equitable allocation of plan costs and reduce the risk of a participant claiming unfairness is fee-levelization. Today, many recordkeepers can credit revenue sharing directly back to the specific participant using an investment option rather than the plan to be used for plan fees.

Depending upon the recordkeepers' capabilities, fee leveling can give the plan sponsor flexibility on how fees are paid. They may continue to use revenue-sharing and credit revenue back to participants who incurred excess costs while debiting the accounts of participants who incurred less than their fair share. Otherwise, they may elect to credit all revenue back to participants and directly charge fees to every participant, typically a percentage of assets.

In certain instances, fee-leveling may also create an opportunity to provide participants with investment expense savings by selecting investment share classes with the lowest "net cost." To illustrate how this could work, examine an example of five share classes of the same mutual fund, each with a different expense ratio and revenue sharing level.

Assuming the revenue sharing portion can be reimbursed to participants, plan sponsors may use the A share class with the lowest "net" investment manager fee (0.54%) despite having the highest gross expense ratio. Since the funds are managed identically, this may be illogical, yet it is how many fund expense structures look in the marketplace.

Lowest investment expense sounds good. What’s the catch?

While this potential cost savings is attractive, there are some drawbacks. The lower "net" investment expense benefit is not transparent to participants. Unless they've delved into the plan fee disclosure to understand how revenue sharing and fee leveling work, the high total gross expense ratio stands out. Moreover, the share class underperformance may be unsettling when they look at fund performance results.

For example, below is a sample illustration of the performance that participants would find for the same set of funds. Lower revenue share classes will always exhibit better results.

So, although a participant pays a marginally lower investment manager expense, the benefit is unclear. It's also virtually impossible for participants to calculate the investment results, including periodic revenue credits that appear as line-item transactions on their account statement, to compare and determine whether or not they achieved a better outcome than if they were invested in a zero-revenue share class of the same fund.

Returning to fiduciary responsibilities, it's prudent to document when higher expense ratio share classes are selected, even when a plan is fee-levelized.

Fee-Levelization makes sense, but is there a simpler option?

The inequity associated with revenue sharing makes fee-levelization a critically important feature for plan sponsors to consider. However, as you can see, it does not solve the issue of transparency, and the administrative aspects are complex.

While zero revenue funds may not guarantee the lowest investment management expense, they can be competitive and provide superior fee transparency for sponsors and participants. With zero revenue funds, participants can easily distinguish the investment management fee of each investment (the expense ratio) and determine how much they are being charged for recordkeeping and/or other plan services, which appear as a distinct line item on their statements. Meanwhile, because plan service providers do not receive any revenue from zero revenue share funds, it is also simpler for plan sponsors to evaluate the reasonableness of the administrative fees charged.

In addition to the advantages of fee equitability, transparency, and simplicity, zero revenue funds can also make it easier for fiduciaries to evaluate and monitor fund performance and other investment-related metrics, which are reviewed regularly. Because fund performance fluctuates with markets and as different investment styles move in and out of favor, determining the extent to which revenue sharing is time-consuming and can be difficult. Zero revenue funds eliminate the additional burden.

To learn more about retirement plan fees, reach out to our team for more information.

Interested in learning more about retirement plan fees? Check out this article: How Advisors are Approaching Retirement Plan Fees.

Investment advice offered through OneDigital Investment Advisors LLC. These materials are provided for informational and educational purposes only and do not constitute a recommendation to buy, sell, or hold any security, nor do they constitute legal, accounting, investment, or tax advice. These statements do not constitute an offer or solicitation in any jurisdiction.