However, reading your reply has caused me to reread Dr. Rhoades’ original comment more closely, and I’ve now reached the conclusion he is simply attacking a straw man to further his argument in favor of a more broad fiduciary standard, something that has nothing to do with the prohibited transaction exemptions he incorrectly asserts are unnecessary.

His basic thesis in the first paragraph is that “revenue sharing” results in variable compensation to the advisor, which would lead to conflicted fiduciary advice. To put it in the vernacular–well, duh! That’s been the longstanding view of everyone. What’s more, such conflicted advice by a fiduciary is already prohibited and there is no exemption. Why is he discussing it all? He is doing so to incorrectly assert that broker dealers are violating this standard, when the reality is that they generally are not fiduciaries under the current rule. This rule, by the way, is the regulatory definition of the term “fiduciary” that has nothing to do with prohibited transactions and their exemptions! (Yes, the application of the prohibited transaction rules depends on fiduciary status, but the definition of fiduciary is entirely separate from the PT rules–modification of the PT rules has no effect on the definition.)

The Frost Bank Advisory Opinion (AO 97-15A) clearly lays out the issues relating to receipt of mutual fund service payments (or “revenue sharing”) and DOL clearly says that you cannot receive such payments from funds about which you provide fiduciary advice to a plan unless you offset the fees to remove any economic incentive that would influence your fiduciary advice. (This, by the way, is not an “exemption” from a prohibited transaction–offsetting prevents a PT from ever existing rather than excusing a PT that would otherwise occur).

The issue, then, is whether one is a fiduciary. And under current DOL regulations (not prohibited transaction exemptions, but regulations interpreting 3(21)) you are a fiduciary advisor if you regularly give individualized advice for a fee subject to a mutual understanding that the advice will form the primary basis for the plan’s decision-making.
Broker dealers typically are not fiduciaries under this definition. That seems to be what is really bothering Dr. Rhoades.

Thus, I’m back where I started. If you want to have a legitimate debate about the conduct of advisors, including when and how the fiduciary standard should apply, that’s a legitimate debate. But to couch this question in terms of exemptions from the prohibited transaction rules, or as a departure from the intended purity of those rules, is simply incorrect. If you want to fight about the regulatory definition of an ERISA fiduciary advisor (a current debate that is the subject of a DOL regulation likely to espouse Dr. Rhoades’ policy view that we anticipated seeing in May) then do so honestly.

Article: Leidy, though, analyzed the example in the press release and discovered revenue sharing accounted for 10 basis points. “In actuality the fee is 42bps,” he points out. “If a sponsor/advisor were to select Admiralty/Signal shares, additional ‘out-of-pocket recordkeeping fees’ would apply.”

Simply stated, what Mr. Leidy describes as “revenue sharing” is actually Vanguard’s system of attributing a portion of the expense ratio (currently 10 basis points) of the Investor share class of Vanguard funds in plans that we recordkeep to the recordkeeping and administrative services that we provide. These credits are used to offset the cost of those services and they are clearly disclosed. They do not represent an additional payment above the expense ratio of the Investor share class funds. In the example you have used, using the lowest-cost share classes would yield an all-in fee that is 33bps—not the 42bps cited in the article.

To explain how that works, here’s some additional background. Historically, Investor Shares of Vanguard funds have been the primary share class used by our full-service recordkeeping clients. This is because many of our plan sponsors had elected to have their plans pay for recordkeeping services through asset-based fee structures, and that’s still primarily the case today. However, because some plan sponsors wanted to move to fixed out-of-pocket fee structures, we now provide sponsors and their committees with increased flexibility in determining how their plans pay for services. We have simplified our eligibility criteria so that all plans have access to lower-cost share classes, which for our 401k service for small businesses are Signal Shares for Vanguard index funds and Admiral Shares for active funds. The share class that a sponsor chooses does not impact a plan’s all-in fee; it simply provides flexibility in how a plan pays for recordkeeping services.

If a plan uses Investor Shares, it receives credits toward recordkeeping costs. Conversely, plans using the lower expense ratios of Signal and Admiral share classes don’t receive a credit toward the cost of recordkeeping and so an out-of-pocket hard-dollar charge—either paid by the participant or by the sponsor—is necessary to cover the cost of recordkeeping and other services. As a result, plans can choose to pay for plan services among the following structures:
1) Through asset-based fees.
2) Through direct participant- or sponsor-paid fees.
3) Through a combination of asset-based and direct fees.

Again, regardless of the structure the client chooses, the all-in-fee of your example would be 33 bps, not 42 bps. The primary difference is based on how those fees are paid.

Article: The larger question is Vanguard’s casual acceptance of revenue sharing to give the impression of lower fees… AND… By lauding a “low-cost” product where that “low-cost” is predicated on revenue sharing, Vanguard risks exposing 401k plan sponsors to increased fiduciary liability.

Once more, Vanguard’s recordkeeping credits are not revenue sharing. They are used to offset the cost of the administrative services that we provide when sponsors choose to use Vanguard Investor share class funds. Furthermore, the use of recordkeeping credits does not materially impact a plan’s all-in fee—it simply provides clearly disclosed flexibility to sponsors. The credit cannot be used by sponsors to pay third parties or financial advisors. It may only be used to reduce the annual out-of-pocket plan fee and participant fee. In instances that Vanguard receives revenue sharing from non-Vanguard fund companies, it is applied toward the cost of recordkeeping the plan. Vanguard always discloses these amounts to plan sponsors.

As you may know, historically there has not been a requirement to disclose revenue sharing payments—and won’t be until Department of Labor regulations become effective later this year—so some plan sponsors may still be unaware that their explicit recordkeeping fee is being highly subsidized by payments from third parties. In contrast, even in the absence of a regulatory disclosure requirement, Vanguard has long proactively and routinely disclosed plan fees in a comprehensive manner. This includes our all-in fee disclosure, which we began using in the late 1990s.

To reiterate, plans will have approximately the same all-in fees whether the plan uses the lowest-cost shares available or our already low-cost Investor Shares, with any slight variation depending on the funds offered in the plan line-up.

Because of Vanguard’s transparent approach on how revenue sharing is applied, plan sponsors are fully aware of all fees and how the cost impacts their participants, which helps them fulfill their fiduciary obligations of determining the reasonableness of plan fees.

Linda Wolohan
Vanguard

Nice piece! Thanks!

Pendant appears to be referring to fees that are similar to those charged by trustees. This is generally a statutory fee promulgated at the state level for individual trustees. This is certainly a long tradition of service providers receiving compensation for providing their services to trusts (and, by extension, retirement plans). The only possible exception might be the prohibition against charging a fee to your own plan. Disclosure: I’m neither a trust attorney nor have I stayed at a Holiday Inn Express, so don’t take my word on this.

The types of conflicted transactions Dr. Rhoades addressed aren’t the base fees, but fees augmented by making a self-interested transaction (i.e., getting paid a commission for the purchase of a security). This may or may not result in the same purchase that would result in a truly disinterested transaction. It is this different outcome that gives rise to the conflict of interest fiduciaries ideally would avoid.

I assume Dr. Rhoades actually meant the he opposed the administrative, rather than statutory, exemptions to the prohibited transaction rules. Even there, though, one does not have to look very hard to find an endless parade of perfectly necessary administrative exemptions. My guess would be that if Dr. Rhoades offers any employee benefit plans to his employees, he probably utilizes quite a few administrative exemptions or DOL policy interpretations that undercut the purity of the prohibited transaction rules “as written.”

Regardless of one’s views on the proper legal constraints on conduct by a financial advisor to an ERISA plan (a legitmate debate), surely we can all agree that the prohibited transaction rules without any exemptions (administrative or stautory) would simply not work?

Ron Rhoades as usual is brilliantly incisive.

Wouldn’t it be great if Ron actually ran a regulator, he would save millions if not billions in overhead, bring uncommon clarity and would greatly simplify the unnecessarily complex business.

Instead we have very little depth of understanding in Washington that is vastly overpaid, very easily swayed that have forgotten their principle mission is to protect the best interest of the investing public rather than the best interests of the industry.

SCW