Hosting an industry conference? Ask us about including it in this ticker?
What do you think of our site upgrade?

SEC’s 12(b)-1 Proposal: Does It Actually Increase 401k Fiduciary Liability?

August 18
22:43 2010

Has the new SEC 12b-1 proposal doomed ERISA plan sponsors of 401k plans of less than $10 million? This possibility isn’t as unbelievable as it first appears. Even the SEC questions the continued viability of the mutual fund distribution model 519008_84368395_chess_mate_transparent_stock_xchng_royalty_free_300designed specifically for these plans. Furthermore, does the SEC proposal – and the fiduciary standard it implies – expose some 401k plan sponsors to increased fiduciary liability? Or, will the fiduciaries embrace an obviously simple solution?

Fiduciary News talked to a spokesman for one of the largest industry groups in the financial services sector. On the condition of anonymity, he shared a shocking point in the SEC 12b-1 proposal that, given its potential impact, has, to date, failed to receive the media coverage one might expect.

To be fair, the issue pertains only to 401k plans – and small 401k plans at that. The Investment Company Institute (“ICI”) estimates 36 percent of all long-term mutual fund assets were held in retirement plans as of the end of 2009 (2010 Investment Company Fact Book, ICI, 2010). () However, only 20% of all 401k plans still use mutual funds that assess 12b-1 fees of 25 basis points or more. So, we’re talking about a little more than 7% of total mutual fund assets. That’s why this matter doesn’t get much media play.

On the other hand, if you’re a 401k fiduciary or plan sponsor, this small “oh, by the way” problem could greatly affect your business, your livelihood and even your lifestyle. SEC Chairman Mary L. Schapiro says “Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.” What she doesn’t say, but the SEC proposal states, is using mutual funds as investment options “may not be a viable option for retirement plans” under 10 million.

Which funds does this warning pertain to and which 401k plans are vulnerable? The SEC specifically cites mutual funds using R shares as those most at risk. According to Forbes, “The R is supposed to mean retirement and is geared toward investments parked in 401k and small corporate-retirement plans, those with less than $10 million of assets.” (“R Shares, Competitive–But For Whom?Forbes, August 13, 2003).   R shares are often used by these smaller 401k plans to pay service providers.

This explains the big concern in the retirement space, but the revenue sharing concern is a real issue for all funds. Our anonymous source tells Fiduciary News the potential impact on revenue sharing may result in a broker, under a 22(d) exemption, cutting prices to attract clients and then expecting the mutual fund to make up the difference. This could be problematic to smaller funds. In addition, adjusting for per account costs will disproportionately impact smaller funds. This could make them less likely to enter the 401k market.

“Using a 12b-1 fee as direct compensation to the advisor in the ERISA world just doesn’t make sense anymore,” says Jim Sampson, Managing Principal of Cornerstone Retirement Advisors, LLC.  Will brokers move to other investments to make up for loss of 12b-1? For example, sub-transfer agents are exempt and broker may opt to become transfer agents. The bigger issue is for smaller retirement plans relying on 1% 12b-1 fees, but this is primarily a concern within the broker distribution model, and may accelerate a transition to fee-based (investment adviser) distribution models. This would appear to be the obvious and easy solution. Harold Evensky of Evensky & Katz, a Miami RIA believes the “restriction or elimination of 12b-1 fees should in no way prevent providers from servicing the same client base and being compensated at the same level. Instead of earning a 1% 12b-1 fee, the advisor can simply charge a 1% advisory fee.”

Under the current SEC proposal, the migration from the 12b-1 distribution model to the fee-based model may become the predominant strategy for this simple reason: Even if some distribution system incorporating the new 12b-2 model emerges, 401k plans will have to change their recordkeeping systems to account for individual lots. This accounting method – which may represent a costly change – is currently not done for retirement plans.

The SEC is quite blunt regarding this increased cost. Here’s the language from their proposal:

…our proposal may require intermediaries such as retirement plan administrators or other omnibus account record keepers to begin tracking share lots and managing share conversions. This change may require these intermediaries to invest in new systems or enhance their current record-keeping and back office systems. If a retirement plan offers fund classes that deduct an ongoing sales charge, the proposal would require such shares purchased by plan participants to eventually be converted to a class that does not deduct an ongoing sales charge. This conversion requirement would create costs for retirement plan record-keepers because we understand that currently, most record-keepers do not maintain individual participant share histories. Record-keepers for plans that offer shares classes with an ongoing sales charge would need to begin tracking the date of purchase of each share lot for each participant, and tie that share history to the appropriate conversion date. In addition, plans currently usually only have a single class of shares for each fund offered within the plan. If our proposal is adopted, however, if the single class that is offered within the plan deducts an ongoing sales charge, a second class of shares for each fund (i.e. a target class for converted shares) would have to be added to the record-keeper’s systems, effectively adding more complexity and costs to their operations.

Jan Sackley, CFE, Fiduciary Risk and Regulatory Compliance Consultant at Fiduciary Foresight, LLC, feels “It would be much simpler if a transfer of shares out of a qualified retirement plan triggered an automatic conversion to the most favorable class available to the receiving account. Why force recordkeepers to create a new infrastructure to accommodate something that may be infrequent?”

Still, the proposal may force smaller plans unwilling to convert to a fee-based structure to reconsider the very existence of their plan. “Transparency has its consequences,” says Ray Rhoades, a private wealth manager from Ocala, Florida. “Once very small 401(k) plan sponsors understand how much their service providers get paid,” he continues, “they may opt to terminate their plans, and revert back to SIMPLE IRA plans (for less than 100 employees), or even to automatic payroll deductions into self-directed traditional or Roth IRA accounts. Indeed, given all the costs to maintain small plans under ERISA (TPA/record-keeping costs including tax filing, custodial fees, and other costs), one must ask why SIMPLE IRA plans and/or auto deduction to individual IRA accounts are not utilized more often, thereby avoiding costs resulting from ERISA’s requirements.”

As the SEC tackles the contentious 12b-1 fee issue, it remains cognizant the problems may differ for taxable investors compared to non-taxable investors. Indeed, as the stronger argument to retain 12b-1 resides on the taxable side not on the retirement plan side, the SEC freely discloses it expects other regulators, especially the Department of Labor, to hold far greater sway on the use of 12b-1 in retirement plans. But the 401k fiduciary cannot escape the fact the SEC may have let the cat out of the bag in so aggressively targeting R shares. Perhaps ERISA Accredited Investment Fiduciary Mark Levin best reflects the consensus. He says, “all fees should be disclosed and the clients will see the value or move on. Fully transparent programs will benefit all.”

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Scott
    Scott August 19, 13:28

    I think its a good thing for plan sponsors and coincides with a move to full fee disclosure. Disclosing fees will enable plan sponsors to evaluate, many for the first time, whether the fees they/the plan are paying are reasonable w/ regards to the services provided. While I think it may cause some advisers/provides to leave the market, others will stay/enter and adjust their models to work within the new framework.

    CEO, Smart401k

Only registered users can comment. Login is sponsored by…

Order Your 401k Fiduciary Solutions book today!

Vote in our Poll


The materials at this web site are maintained for the sole purpose of providing general information about fiduciary law, tax accounting and investments and do not under any circumstances constitute legal, accounting or investment advice. You should not act or refrain from acting based on these materials without first obtaining the advice of an appropriate professional. Please carefully read the terms and conditions for using this site. This website contains links to third-party websites. We are not responsible for, and make no representations or endorsements with respect to, third-party websites, or with respect to any information, products or services that may be provided by or through such websites.