12b-1 Fees/Revenue Sharing Add to 401k Plan Sponsor Fiduciary Liability Woes

March 24
01:18 2015

The SEC is going after 12b-1 fees. The DOL is questioning revenue sharing. Jerry Schlichter and other class action attorneys are winning cases against plan sponsors exposed to these “backdoor payments” as the White House has called 622792_88155825_dinosaur4_stock_xchng_royalty_free_300them. Could it be, after years of warnings, we are finally about to witness the fall of the house of 12b-1? Will revenue sharing go the way of the dinosaur? More importantly, will the fossils they leave behind be fraught with fiduciary liability that 401k plan sponsors will continue to pay for years from now?

To begin to piece together answers to these intriguing questions, polled financial professionals from across the country for their thoughts, ideas, and speculations.

To set the stage, we first explored the history of 12b-1 fees as they pertain specifically to 401k plans. “Plans primarily used mutual funds with 12b-1 fees as a way of compensating their service providers and/or financial professionals,” says Paula Friedman, Managing Director at encore401k in McLean, Virginia. “These fees are commonly paid by mutual funds as a way to pay providers for offering (or distributing) a product on their platform or for performing certain administrative services.”

The wide use of 12b-1 fee compensation models in the early years – at one time nearly every 401k plan contained 12b-1 plan mutual funds in their investment menu – could in part be attributed to aggressive marketing by certain sectors of the financial services community. Andrew J. DeGroat, Principal at WhartonHill Advisors in Fort Washington, Pennsylvania says, “A vast majority of the plans that were sold to plan sponsors were sold by brokers who could only accept commissions. They were not registered as an RIA. There brokers needed to get paid and commissions/12b-1 fees were the only option.”

So popular were 12b-1 fees and revenue sharing as a way to eliminate direct billing that even non-investment related services took advantage of them. “12b-1 fees were once necessary in the 1990’s to create a compensation incentive for recordkeeping vendors to offer non-proprietary mutual funds onto their recordkeeping platforms,” says Robert A. Massa, Director, Retirement, Ascende, Inc. in Houston, Texas.

But use morphed into abuse, to the point where it’s not unusual to hear cynical comments regarding 12b-1 fees from anyone, even financial professionals. Paul Ruedi, CEO of Ruedi Wealth Management, Inc. in Champaign, Illinois says 12b-1 fees “allowed the company owners to let their golfing buddies take advantage of the working folks, passing the costs (all or most) onto the backs of the workers.”

Still, some believe 12b-1 fees have gotten a bad rap. Robert Richter, based in Jacksonville, Florida, is vice president of SunGard’s Relius says, “There are a wide variety of mutual funds and one cannot simply state that a mutual fund is a bad investment solely because there are 12b-1 fees.”

There is a growing consensus that states, no matter their original attributes, 12b-1 fees should be relegated to the 401k history museum. “12b-1 fees are a big part of why we have open architecture mutual fund 401k platforms available to us today,” says Massa. “However, they have outlived their usefulness and the time has come to eliminate 12b-1 fees and revenue sharing and go with a system that is more transparent, regardless of plan size.”

It would seem more and more plan sponsors agree. According to data from the ICI, only about 10% of 401k plans continue to use 12b-1 fees. The same cannot be said of revenue sharing, as another survey suggests 87% of 401k plans contain funds exposed to revenue sharing. Perhaps this is because 12b-1 fees are stated openly and clearly on the mutual fund prospectus, making them an easy target. Ruedi implies when he says the drop in 401k plans using 12b-1 fee funds has occurred “because folks like me take the time to use the other companies own data against them and show plan sponsors they face the risk of lawsuits and just plain bad publicity if they continue to use them.”

More likely, though, has been the influence of fee disclosure rules like 408(b)(2). “The increased regulatory scrutiny around plan fees and service provider compensation has caused many plans to reduce or eliminate revenue sharing,” says Friedman. “More sponsors are aware of how investment costs negatively impact account performance and have been working to increase transparency while reducing these fees. These sponsors are also gravitating towards advisers that accept fiduciary responsibility and receive level compensation which has also impacted the use of 12b-1 fees.”

The near extinction of 12b-1 fees in the retirement plan arena has required an evolution in business models. DeGroat says, “As the independent BD and RIA advisor community has grown, the use of funds with 12b-1 fees has gotten smaller. In addition, if the adviser acts as a 3(21) plan co-fiduciary then level compensation is an extremely important issue. It is very difficult if not impossible to create a true best in class investment menu on an open architecture platform and have level fees if the compensation is 12b-1 driven. RIA fees are the most effective option.”

So, why, despite the movement of the industry, increased regulatory oversight, as well as those previously mentioned high profile court rulings, do some plan sponsors continue to use funds with 12b-1 fees? Larry Solomon, President of Alliance Benefit Group Consultants in Salt Lake City, Utah says, “Plan sponsors who are not educated in best practices still remain in situations that are expensive and not well monitored. As plan sponsors become more aware of the impact of 12b-1 fees on the returns of the account, they will look to more favorable accommodations with fee-based advisors.”

For all the emphasis on employee education, perhaps overlooked is the need for plan sponsor education. “For most plans,” says Friedman, “I find the underlying reason relates to a lack of sponsor education. There are no transactions shown on account statements that show the 12b-1 payments and without the assistance of a prudent expert (typically an investment professional), a sponsor may not realize these fees exist, let alone what impact they have on the overall plan expenses. As plan sponsors become more educated and engaged in the process, we are seeing the overall plan costs (specifically investment costs) decrease as a result of removing revenue sharing payments. For smaller plans, the 12b-1 fees may be less expensive than a provider’s minimum fees since they are calculated as a percentage of assets. The lower the level of plan assets, the lower these payments become. While these fees may be lower at first, plans need to think ahead and evaluate whether a flat fee structure makes more sense as the plan assets grow.”

Clearly, 401k plan sponsor is not a high priority, especially for smaller companies where those responsible for the plan must also focus on urgent business matters that consume most of their working day. Adam D. Koos, President/Portfolio Manager at Libertas Wealth Management Group, Inc. in Columbus, Ohio says, “401k plans that continue to use funds with 12b-1’s are either doing so out of the recommendation of the advisor tied to the plan; or if there is no advisor servicing the plan, the plan sponsor is still unaware of the additional cost for whatever reason. HR Directors, CEO’s, and CFO’s are busy people, and especially with all the mess surrounding healthcare these days, I think retirement plans have a tendency to be overlooked – or at least, they’re not a priority, especially since the market has been climbing for 6 years now.”

Ignorance, however, is no excuse for the law. Eventually, past decisions will come home to roost. Ruedi says, “It is becoming increasingly clear that plan sponsors who ignore high costs or unreasonable costs could face personal financial liability. And you folks on the investment committee… your wallets are at risk too!”

It is the very nature of 12b-1 fees and revenue sharing that places 401k plan sponsors are risk. “When fees never have a chance of reducing as a plan grows in size,” says Solomon, “the plan sponsor accepts full responsibility by not acting in the best interest of the plan participants and their beneficiaries as ERISA mandates.”

There exists a cold hard reality for all 401k plan sponsors, one they are loathe to disregard. “Plan sponsors are required to carry out their fiduciary responsibilities solely in the interest of the plan participants,” says Friedman. “This includes ensuring that the services provided to the plan are necessary and that the cost of those services is reasonable. When a plan’s investment lineup includes revenue sharing payments, the sponsor is responsible for tracking the amount of these fees and which service provider receives them as compensation. Since 12b-1 fees vary based on the balance in the fund, the amount of the compensation paid could change significantly. This leaves the sponsor open to additional liability since they need to document the reasonableness of the payments on an ongoing basis. Additionally, the participants that invest in those funds that pay 12b-1 fees are most likely subsidizing the costs for the entire plan. This causes an unequal allocation of fees and could also pose potential liability concerns for a sponsor.”

We have already seen methods of addressing these concerns implemented in the marketplace. One model that has emerged, says Koos, “has been the fee-only, open architecture RIA model where the record keeper is NOT a fund company. This way, the plan can be built with any investment under the sun that has a symbol and is traded on an exchange (other than an individual stock, that is). These platforms allow the plan sponsor to get the help of an advisory firm that can actually give personalized advice to the employees and some choose to act as 3(28) or 3(21) fiduciaries, thus reducing the fiduciary liability of the plan sponsor. They can use ETF’s as part of the plan – or any institutional class mutual fund, for that matter. The goal is to keep the fees as low as possible while giving full flexibility to the plan sponsor. With these models, the plan sponsor is also reducing fiduciary liability through reduction in fees, but they further reduce what they’re ‘on the hook for’ through the open architecture platform and having advisory firms that act as investment or plan fiduciaries on their behalf.”

With fee disclosure now more than two years old and in anticipation of the DOL’s new conflict-of-interest rule, plan sponsors are quickly moving away from the old 12b-1/revenue sharing model. “There has been a trend towards a more transparent, conflict-free form of compensation for plan providers and advisors,” says Friedman. “Many advisers now charge fees as either a percentage of assets under management (i.e. annual fee of 0.80% of assets) or a flat dollar amount. Adviser fees typically decrease as an overall percentage of assets as the plan grows. Many service providers (i.e. recordkeepers /Third Party Administrators) have begun to price services by using a base fee plus a flat dollar amount per participant. This allows them to charge for the amount of work associated with a plan which generally increases as the number of eligible employees increases. These vendors will usually offset any fees with the revenue sharing received (if any). I believe that these compensation structures allow a sponsor to easily identify the plan expenses without ‘having to look behind the curtain.’ The adviser fees are clearly disclosed on participant statements along with any other vendor fees. In addition, the investment professional that charges a level fee is most likely taking on some level of fiduciary responsibility which further protects the sponsor.”

Don’t expect the meteor to hit these dinosaurs yet. Koos says, “12b-1’s aren’t necessary, but they aren’t going anywhere anytime soon. As long as there are brokerage firms and other FINRA regulated advisory firms (independent or captive) offering 401k plans as a service to their business clients, there will be 12b-1’s that come along with those relationships.”

Richter reminds us of an earlier attempt to address the problem of 12b-1 fees: “Years ago,” he says, “the SEC had proposed to limit 12b-1 fees, not eliminate them (the proposal was to rename them 12b-2 fees). 12b-1 fees are generally marketing expenses and when the mutual fund industry was in its infancy, marketing was essential. The industry has matured and the concern is whether these marketing fees are now excessive and/or are being used to pay non-marketing expenses. Marketing of funds is still needed so it’s hard to envision 12b-1 fees being totally eliminated. Again, it goes to whether the fees are excessive and it also raises the question as to what falls within a marketing umbrella. Both of these are very subjective issues so it’s difficult to see the total elimination of 12b-1 fees.”

While we see no push to remove 12b-1 fees from the retail market, the clock may be ticking its final ticks for 12b-1 fees in the retirement arena. “As long as commissioned brokers continue to provide investment services to individual investors, 12b-1 fees will be needed outside the 401(k) world so that brokers can service this market,” says Massa. “I’m not sure the SEC will act without a court of law ruling that the use of revenue sharing payments and 12b-1 fees violate the fiduciary standard. I think it is more likely that the regulatory standard will first come down from the Department of Labor and that 12b-1 fees and revenue sharing will be eliminated from use by the vendors themselves without the need for direct SEC action.”

We’ve already seen new business models evolve from the old 12b-1 business model, and this is likely to continue. Friedman says, “I do not believe that 12b-1 fees are necessary and that a more transparent model can take the place of the ‘hidden fees’ and conflicts-of-interest that they cause. A sponsor that is not an investment professional should be able to determine how much they pay in expenses without having to review pages of disclosures and legal documents. That said; I do not see changes happening any time soon, given the regulatory obstacles the SEC needs to overcome.”

Maybe regulation will be made moot by two other factors – technology and the free market. Todd Zempel of Gordon Asset Management, LLC located in Durham, North Carolina says, “Even though I personally believe that revenue sharing is an antiquated practice, I don’t feel that there is a need for the SEC to regulate it away. Between advancements in technology (allowing for the reallocation of revenue sharing back to participants), increasingly more productive fee disclosure, and stronger fiduciary oversight, I’m confident that the free market will ferret out the best ideas over time.”

Whatever the final outcome, 401k plan sponsors using mutual funds that contain 12b-1 fees and revenue sharing expose themselves to a greater fiduciary liability. And with any increase in liability comes a need to work harder to mitigate it.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? –  How to Increase the Odds You Will Retire in Comfort is available from your favorite bookstore.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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  1. Tyler
    Tyler April 06, 01:20

    Chris. As usual it is an interesting article. Generally speaking, I am a fan of reducing conflicts of interest as well as fees.

    But just to play devils advocate, what if a fund with 12b-1 fees consistently outperforms a fund without them? Is it then a conflict of interest to include that fund? As you have said in previous articles, performance relative to the underlying benchmark is more important than fees.

    And what about in the small plan market with 401k platforms such as Group Annuities or Group Funding Arrangements? The advisor receives the same comp no matter which fund they choose, 12b-1 or no 12b-1. Many “canned” 3(21) lineups that these products use include funds both with and without them. Of course like with all things in life, some of these 3(21) lineups are better than others. Are products like this creating a conflict of interest for advisors who are picking the fund lineup? Are these products going the way of the dinosaurs due to 12b-1 fees?
    The recordkeeper will make money and take a fee from each account with or without 12b-1 fees (as they have a right to do). At least with these products, if it is not a 12b-1 it will just be a hard cost… perhaps more transparent… but just different means to the same end.

    On to a deeper issue, if being a fiduciary is about acting in the best interest of beneficiaries. And the advisor is choosing funds based solely on a combo of performance & risk relative to the benchmark (which you have said in the past is more important than fees… & I agree). At that point why would the “type” of fee matter?

    Also, you use the term “flat fee”. Do you mean strictly just a flat dollar amount? Or does that also include a set % of AUM. (obviously each would be on a tiered scale)
    Is your stance against 12b-1 fees strictly just when they go directly to the advisor? Or do you include the recordkeeper in that stance too?

    Sorry for such a long comment. Thanks in advance for your thoughts.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author April 06, 16:10


    Thanks for your comments – and no need to apologize about the length.

    You bring up the entire sticky-wicket of the conflict-of-interest conundrum: What if the conflict-of-interest” produces a result in the best interest of the beneficiary? In the example you cite, this would be an after-the-fact occurrence, so I don’t know how an ex post facto “ends justify the means” argument would stand up. In general, though, “prohibited transactions” (of which a conflict-of-interest may fall under) deal with the act of the transaction and remains agnostic with regard to the outcome of that transaction.

    However, following the same line of reasoning you’ve brought up, what if the “conflict-of-interest” knowingly produces a “best interest” outcome for the beneficiary? That’s a great legal question of which I am ill-equipped to answer. I will, say, though, if such a transaction was in the best interest of the beneficiary and I was the fiduciary, I would seriously consider resigning from my fiduciary position so as to remove any conflict-of-interest. But that’s just me speaking, not the law.

  3. Jonathan Broadbent
    Jonathan Broadbent April 11, 11:53

    In depth and insightful, thanks for posting, Chris. A few follow-on thoughts…

    It’s important to take into consideration the environment under which 12b-1 and revenue sharing evolved. I’m not advocating for either; however, we should be clear about how we got to where we are and then develop clear strategies as to how it would be best to proceed.

    Workplace retirement plans have thrived on such hidden fees for a great number of years, as well as the inverse. Hidden fees not only existed, they greased the proverbial skids for the growth of workplace retirement plans such as 401(k). I doubt we would have nearly the prevalence of 401(k) plans today if these fees had not existed in the past. They allowed, among other even more ominous things, for plan sponsors and participants to imagine that their plan was free. If they’d known better, or had born more of the cost directly, many current sponsors might not have started workplace retirement plans to begin with. This is especially true where smaller employers are concerned.

    This is not meant to excuse the prevalence of providers who have manipulated this marketplace for personal gains or out of corporate greed, or the steps that some have taken in order to continue the ruse of “free” plans. It’s merely meant to address some of the psychology that exists around how plans are paid for.

    Unfortunately, even “post fee transparency”, we still see instances of employers somewhat willingly sticking their head in the sand, ignoring the back office revenue sharing deals that take place. 12b-1 Fees, Finder’s Fees, Overrides, Sub-TA, and other types of fees damage the growth prospects and future retirement readiness of our Great American Workers. Yes, I include Finder’s Fees and Overrides in this malicious equation.

    As a growing number of us push to make something of great importance and potential benefit even better, we should recognize that such changes should not be knee-jerk and will not happen over night. A complete elimination of revenue sharing, I argue, would be tremendously beneficial from a fee structure and disclosure perspective, buy would likely have the inadvertent side-effect of suppressing new plans from starting up and might also reduce participation when participants become more aware of the fees that they pay (without a commensurate appreciation for services that are provided).

    It’s a complex issue, worthy of strategic and concerted effort in the direction of low and fully disclosed fees – of the type that are not easily hidden. This should come with greater accountability on the part of service providers and related education of plan sponsors relative to roles and responsibilities.

    As far as 12b-1 fees, I suggest that they be eliminated tomorrow. These little hidden beasts have been paying for the silence of sales agents for years, encouraging them not to become retirement plan professionals. Furthermore, I suggest that pursuing our course toward an across the board fiduciary standard, at least for workplace retirement plans, would drive out conflicted sales agents and put only retirement professionals in charge. Those that don’t have conflicts of interest will do their job to reduce all other types of fees… or risk losing their job, working exclusively for the benefit of plan participants.

    These new, elite class of competent plan professionals would then be well suited to continue our progress toward eliminating revenue sharing altogether.

  4. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author April 11, 16:04

    Jonathan: Well said. You might appreciate the recent series on fee disclosure – in particular as it pertains to your point about having the unintended effect of discouraging savings.

  5. Tim Wood
    Tim Wood January 19, 15:12


    As usual, a great article on 12b-1 fees.

    I think one of the principal reasons these conflicts of interest continue, in addition to those expressed so well by those you interviewed in your article is the fallacy that someone else is paying.

    In your article, even Paula Friedman expresses this erroneous point of view, “These fees are commonly paid by mutual funds as a way to pay providers for offering (or distributing) a product on their platform or for performing certain administrative services.”

    Her statement is factually incorrect. The fees are paid by the employee in a 401k plan that is investing in the fund that charges and collects the 12b-1 fee from the saver.

    From some perspectives, if some big business has to pay the fees, it is better for them. I have seen some fee disclosure documents that have cleverly made the argument that the 12b-1 fees are some sort of benefit for the participant that defrays their cost of participation.

    The 12b-1 charging mutual fund is not paying anything, they are collecting those fees from an often unwitting investor. I know my point may appear picayune but my experience with thousands of 401k participants informs me that the vast majority of people think that being charged as much as 50 basis points as a 12-1 fee is better for them than an openly stated RIA fee of 30 basis points.

    Unfortunately, points of view as expressed by those that supposedly know better continues the status quo which is not in any investor’s best interest.

    Tim Wood, Principal

    Foster & Wood 5 Centerpointe Drive Suite 400 Lake Oswego, OR 97035

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