Revenue sharing declines among DC plan sponsors

Although some defined contribution sponsors swear by revenue sharing, surveys show that more of them are likely to swear at it.

The percentage of DC plans using revenue sharing — or a combination of revenue sharing and other forms of plan payments — has been declining over the years. The strategy has been a casualty of trends in lower fees, more transparency, government regulation, litigation risk and fiduciary liability insurance requirements.

"We recommend eliminating revenue sharing," said Gregg Levinson, the Philadelphia-based senior director for retirement at Willis Towers Watson PLC. "It's a huge red flag and it's uncontrollable," he said. "There's no relation between revenue sharing and the cost of the plan. It just pays the vendor with no relation to the cost."

Revenue sharing is basically indirect payments between one service provider, such as an investment manager, and another service provider, such as a record keeper, rather than the sponsor making direct payment for plan services. The investment manager collects certain fees from plan assets in a specific mutual fund, which is used as a credit to pay the record keeper's fees.

"There has been a slow and steady trend" to removing or reducing revenue sharing among clients, said Vin Smith, the Wellesley, Mass.-based partner and senior defined contribution consultant for Fiducient Advisors.

Plan executives' efforts to cut fees, offer greater transparency on fees and provide greater fee-paying consistency among participants within each DC plan are primary reasons for client actions, Mr. Smith said.

Annual surveys by the Plan Sponsor Council of America illustrate revenue sharing's declining role.

Between 2014 and 2019, the percentage of plans using revenue sharing in investment pricing declined to 15.2% from 21.2%, according to the latest available data.

During this period, the percentage of plans using a combination of revenue sharing and institutional pricing fell to 25.3% from 35.5%.

Meanwhile, the percentage of plans relying solely on institutional pricing rose to 59.5% from 43.4%. The number of respondents varies each year. There were 602 profit-sharing and 401(k) plans in the most recent survey.

Among DC plans, revenue sharing is basically a function of mutual funds with share prices that cost more than those of institutionally priced shares. As more plans offer institutionally priced mutual fund shares and other investment options like collective investment trusts, separate accounts and exchange-traded funds, revenue sharing investments get pushed aside.

"As asset managers lower the investment minimums of collective investment trusts to take advantage of lower-fee trends, we'll see plans move away from revenue sharing," Mr. Smith said.

If sponsors are hesitant about these other investments, outside forces may force their hand because revenue sharing has become catnip for plaintiffs' lawyers and a flashing red light for providers of fiduciary liability insurance.

"You can tip your hat to the plaintiff's bar" for encouraging sponsors to reconsider, revise or remove revenue sharing, said Michael J. Francis, president of Francis Investment Counsel LLC , Brookfield, Wis.

Revenue sharing plays a frequent role in ERISA lawsuits that often attack plans for failing to use or investigate institutionally priced mutual fund shares or other options that can be cheaper.

Revenue sharing is "highly endangered in qualified (DC) plans," said Mr. Francis, adding that ERISA plans account for only a small percentage of the revenue-sharing universe. The big markets are private wealth management, endowments, foundations and corporations, he said. As for DC plans, "there's no reason to keep it."

Litigation risk is tied to an increasingly tough market for fiduciary liability insurance as sponsors are faced with paying more, receiving less and answering far more detailed questions than they once did. Revenue sharing ranks high among plaintiffs' allegations in ERISA fee cases. "There are more questionnaires" from insurers to sponsors, said Mr. Smith of Fiducient Advisors. "Most questions are about fees."

If DC plans use revenue sharing, consultants say they should negotiate a per- capita record-keeping fee for participants rather than a fee based on plan assets.

If sponsors go with the plan-assets approach, they should negotiate a cap with their record keeper. Otherwise, a big gain in plan assets over time will cause a corresponding increase in fees. "This puts the onus on the sponsor to manage it," said Mr. Levinson of Willis Towers Watson.

And sponsors are getting the message, according to surveys conducted by Willis Towers Watson every three years.

In a survey of 464 DC sponsors last year, the firm reported that 67% charged participants a per-capita fee to cover ongoing record-keeping expenses, 23% used an asset-based approach and 10% used a combination of the two.

The firm's 2017 survey said 53% of respondents used the per-capita strategy, and the 2014 survey reported that 37% took the per-capita approach.

Although these surveys didn't specifically ask about revenue sharing, sponsors' changing attitudes about per-capita fees reflect their approach about retaining revenue sharing, Mr. Levinson said.

Sponsors that offer revenue sharing must make sure any excess beyond the fees negotiated with record keepers be rebated to the plan for additional services, he said. "You have to have a policy in place," he said. "Any excess should go back to the plan."

These sponsors establish so-called ERISA accounts to capture the excess fees to be returned to the plans. "It's a safety net," Mr. Levinson said. "It's the right thing to do. But why do revenue sharing in the first place? Why take on the added risk or dedicated staff to do this?"

Sponsors that offer revenue sharing also can rebate money directly to participants — a practice that has become more common, according to PSCA surveys.

In 2019, the latest data available, 51.4% of sponsors said they credited back money periodically to participants' accounts. In 2015, the first time PSCA asked the question, 37.1% said they periodically credited money back to participants.

Rebates to participants can create some instances in which revenue sharing can be cheaper for a specific mutual fund vs. the same mutual fund without it thanks to a negotiated rebate.

"We say avoid the gymnastics of a rebate" and avoid revenue sharing, said Mr. Francis of Francis Investment Counsel.

Participant rebates can be complicated because different record keepers have different capabilities, said Jana Steele, a Chicago-based senior vice president and defined contribution consultant for Callan LLC. Some record keepers "don't do a good job" of rebating to participants.

Annual DC sponsor surveys by Callan show that 12% of respondents paid for plan administration solely through revenue sharing last year vs. 11.7% in 2019 and 13.8% in 2018 and 14.2% in 2017. That's a big difference from the 36.2% in 2012. The number of respondents varies each year; 104 sponsors participated in the most recent survey.

"We tend to see clients edging away from revenue sharing," Ms. Steele said.

Sponsors' views on revenue sharing also have been affected by Department of Labor fee transparency rules enacted in 2012 covering communications between sponsors and participants and between providers and sponsors, Ms. Steele said. Although not aimed specifically at revenue sharing, the rules heightened sponsors' and providers' attention to making fee information more clear, she said.

Revenue sharing still thrives in smaller 401(k) plans that lack the asset size and resources to negotiate more comprehensive deals with record keepers and investment managers.

It is also common in 403(b) plans that have a long history of offering annuity-based investments and/or participants who negotiate individual contracts with providers.

The "insurance heritage" and the "legacy structures" of 403(b) plans limit sponsors' negotiating ability, said Fiducient Advisors' Mr. Smith, who defines a small 401(k) plan as one with assets of $50 million or less.

Other consultants pointed out that some asset managers' products contain revenue-sharing requirements with no opportunity for an alternative.

Small-plan sponsors "may not realize if they are paying revenue sharing or not," said Michelle Richter, principal and founder of Fiduciary Insurance Services LLC, New York, and executive director of the Institutional Retirement Income Council. She also defined a small plan has having $50 million or less in assets.

Decrying its "opacity," she said the revenue-sharing structure can make it difficult for sponsors to compare competing investment options.

The institutional pricing of mutual funds "is much more favorable than retail shares if they (sponsors) have a qualified adviser or internal experts," she said.

She pointed to a May 2021 research report that showed the impact of revenue sharing on participants and sponsors.

"Participants in revenue-sharing plans face significantly higher fees," said the report by researchers at Vanderbilt University, the University of Texas at Austin and the Board of Governors of the Federal Reserve System. The study looked at the 1,000 largest DC plans from 2009 to 2013.

"Overall, revenue-sharing plans are more expensive, as higher expense ratios are not offset by lower direct fees or by superior performance," said the study, published by SSRN, formerly known as the Social Science Research Network. "These less transparent indirect payments allow record keepers to extract additional rents from plan participants," the report said.