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401k Plan Sponsor Warning: DOL May Sacrifice Fee Purity for Fee Transparency

March 27
00:01 2012

The Department of Labor (DOL) has hinted it may allow certain normally prohibited transactions under its new fiduciary rule. Similar to current exemptions, self-dealing transaction fees such as 12b-1 fees and revenue sharing may be 359685_1020_sewage_warning_stock_xchng_royalty_free_300permitted as long as the service provider discloses those fees. While ostensibly legal, such an exemption does not necessarily remove – or even reduce – the fiduciary liability of the 401k plan sponsor. Indeed, a simple example explains how it might actually increase liability exposure. Here’s how.

We’ve earlier exposed the problems of revenue sharing (see “Exclusive Interview with Ron Rhoades: Revenue Sharing – Two Hats are Worse than One,”, January 31, 2012). Now we’ll explore the issues brought about by its cousin. Plan sponsors of 401k plans may have encountered a curious line item labeled “12b-1 fee” in the expense table of some of the underlying investment options’ fund prospectuses. What is a 12b-1 fee? And should 401k plan sponsors begrudge paying one?

For starters, a 12b-1 fee is a marketing charge. The fee, created in the early 80’s in order to put some loft under the wings of a mutual fund industry that was in rapid descent, authorizes fund companies to tack additional distribution fees onto the true cost of managing a fund. This charge typically ranges from .25-.75% and is built into a fund’s overall operating expense ratio.

The idea was these additional charges, borne by current fund owners, would be used to attract additional buyers, which would in turn drive down future costs for everyone. These intentions never came to fruition, however, and instead 12b-1 fees persist with none of the anticipated fee compression. In fact, some funds closed to new buyers still carry their original 12b-1 fees.

In the retirement plan industry, 12b-1 charges are used in several ways. One, they are used as an alternate form of compensation for individuals that advise (or more often than not, simply sell) plans. Here the code is fairly clear; as long as a fund does not charge over .75%/yr, a 12b-1 marketing fee is not a “commission” like the sales fees or loads so common in the mutual fund world. Used in this fashion, 12b-1 fees allow brokers/advisors to collect recurrent fees without having to overtly debit them.

Service providers often use 12b-1 fees as a form of fee crediting or “revenue sharing” for plans. In this context, the vendor collects 12b-1 fees to offset the recordkeeping and administrative costs of a plan. For example, a plan might offer American Funds Growth Fund of America as a fund choice. In doing so, the plan sponsor has the option of selecting from 6 different share classes (R1-R6), each of which carries a different 12b-1 fee. Fund sponsors that select R1 shares will incur a total operating expense of 1.43%, of which 100 basis points (or 1%) is a 12b-1 fee. Alternatively, sponsors that select the R6 share class secure the exact same underlying investments as the R1, but do so at a much more palatable cost of .33%.

So why would anyone select an R1 fund (or R2-R5, for that matter) over an R6? The short answer: to bury fees. Those that sell American Funds R1 shares can use the healthy 12b-1 fee as an offsetting credit towards plan-level expenses. Since fund fees are deducted daily, prior to fund pricing, participants never actually see the 12b-1 fees being debited. In this way, plan sponsors can offer participants a retirement plan that appears low or even “no cost.” Of course, invisible is not that same as free. But many sponsors prefer this more opaque billing methodology.

All of this commentary begs the following question: If you (and/or your participants) are not paying any more for your retirement plan, and the 12b-1 charge is being properly disclosed, should you care?

Enter the distinction between “fee purity” and “fee transparency.” Fee transparency becomes the law as of July 1, 2012 when the DOL’s new Fee Disclosure Rule. Transparency implies a fund company can freely charge whatever is legally permissible for its funds, including any 12b-1 fees, as long as these charges are disclosed. Similarly, as plan sponsors adhering to a fee transparency model can be indifferent to selecting the R1 shares versus the R6 shares (as in the example above), assuming 2 important things:

  1. The total cost of providing the plan is reasonable.
  2. The plan sponsor properly discloses the associated 12b-1 charges to its participants.

In contrast, fee purity suggests a sponsor should pay for services rendered separately from a fund’s other operating expenses. This discipline has several meaningful advantages.

First, fee purity encompasses fee transparency. As such, adopting a fee purity doctrine requires all charges associated with the plan be discrete line items overtly charged to participant accounts (or directly to the sponsor, depending upon their generosity); hence, all fees levied under a fee purity model will also be completely transparent.

In addition, fee purity allows sponsors to pay for plan expenses directly, thus making many of them tax deductible to the company. Expenses otherwise packaged as part of an investment’s internal operating expense cannot be deducted for tax purposes. Often, the participants with the largest balances, (i.e., those paying the lion’s share of the plan’s fee), are  owners and/or senior managers, i.e. those individuals who would benefit the most from having expenses charged “above-the-line.” Plan sponsors who deduct the cost of providing their plan achieve a lower after-tax retirement plan cost for themselves and their employees.

Perhaps most importantly from a fiduciary perspective, using 12b-1 charges to pay for plan services breeds fee cross-subsidization. For example, consider a plan with $100,000 in assets and only 2 participants. This admittedly over-simplified plan also only offers 2 investment alternatives:  Vanguard’s S&P 500 Fund, Signal Class (VLCSX) and the aforementioned American Funds Growth Fund of America R1 (RGAAX). In addition, let’s assume that each participant has an equal balance in the plan ($50,000) and that one is entirely invested in the VLCSX while the other is entirely invested in RGAAX.

Under these circumstances, it is possible this plan has no overt charges. Instead, these essential plan-level services are being 100% paid for by the 12b-1 fees of the funds. Given that only one of the funds (RGAAX) has a 12b-1 fee, one of the participants in the above example is paying all of the plan’s expense.

Although this is a rudimentary example, fee cross-subsidization in 401k plans is rampant. And while not necessarily an explicit fiduciary breach, using 12b-1 fees to pay for plan services can directly pit the interests of various participants against one another.

Said another way, if the participant who owns RGAAX suddenly switched all of his or her assets into the Vanguard fund, the recordkeeper/administrator would be forced to charge the plan directly. These direct, top line charges would then be split evenly among the two participants; thus, achieving a much more equitable sharing of plan costs.

Lastly, the notion of a fee-for-service model is muddled when using 12b-1 fees. For example, many plan sponsors would benefit from switching their recordkeeping fee structure away from an asset-based charged to a per capita model. Why? Recordkeeping is a function of headcount, not size of the total plan assets.

Unfortunately, including your recordkeeping fees in the cost of your underlying mutual funds ensures that you will always pay for “per participant” services based on asset size. If a plan’s assets double over the next 5 years, but headcount only increases by 25%, should your plan’s recordkeeping expenses double as well?

As a recent ICI study shows, nearly 90% of all 401k plans may be subject to 12b-1 or revenue sharing fees. Based on the above, all 401k plans should abandon the use of these fees. Plan sponsors adopting a fee purity model can attain the advantages listed above and eliminate the potential fiduciary challenges that arise from fee cross-subsidization.

About Author

Jonathan Leidy, CFP®

Jonathan Leidy, CFP®


  1. Joe Gordon
    Joe Gordon August 30, 08:50

    Not weel written by a CFP with little experience, making generalizations about all 401(k) plans…but when someone just learning about disclosure starts to opine about “all record keepers charge asset based fees,” he is out of his league.
    When you only talk about fees, it is becasue you know little else.
    Playing the Morn* style police is also another amateurish assessment of how things work….
    One valid point on revenue sharing…there has been no movement until the last 12 months to attempt to get record keepers to credit revenue sharing directly back to the participants generating by virtue of their selections…it is a programming issue, yet to be considered becasue the same folks have been scurrying to get the 404(a)(5) participant fee disclosure programming right!

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