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All 401(k) plans require three basic administration services – asset custody, participant recordkeeping and Third-Party Administration (TPA). A 401(k) provider can be paid “direct” or “indirect” fees from plan assets to deliver these services. Direct fees are deducted from participant accounts, while indirect fees are paid by plan investments. The most common form of indirect fee is revenue sharing. Below are five reasons why employers should pay direct fees for 401(k) administration services instead.
1. Revenue sharing is difficult to total
Employers have a fiduciary responsibility to pay only “reasonable” 401(k) fees from plan assets. Meeting this responsibility is important because excess fees reduce 401(k) investment returns unnecessarily and increase fiduciary liability. To meet this responsibility, employers must be able to total their 401(k) fees.
It’s usually easy to total direct fees due to their transparency. Their dollar amount must be explicitly disclosed in 408b-2 and 404a-5 fee disclosures, plan financials, and participant statements.
Revenue sharing is a different story. It can be estimated in 408b-2 fee disclosures, buried in 404a-5 fund expense ratios, and not appear at all in plan financials or participant statements. To total the revenue sharing paid by a 401(k) plan, use of a spreadsheet is usually required.
2. Revenue sharing can outstretch service level
401(k) providers are paid revenue sharing based on a percentage of assets. That’s a problem because 401(k) administration services generally scale with employee headcount, not assets. This disconnect can result in a 401(k) plan with lots of assets paying much higher provider fees than a comparable plan with fewer assets for the same administration services. That’s not right and a potential source of fiduciary liability for employers.
The only 401(k) administration service that should scale with plan assets is asset custody. As such, only custody fees should be based on a percentage of assets. Fees for other 401(k) administration services should be based on employee headcount. Direct fees can be structured to accommodate this bifurcation.
3. Revenue sharing limits investment options
One of the most important 401(k) fiduciary responsibilities is selecting “prudent” plan investments – basically, investments that meet their investment objective for reasonable fees. In my view, the most inherently prudent 401(k) investments available today are passively-managed index funds and ETFs that deliver market returns for low fees.
None of the most popular index funds or ETFs pay revenue sharing. That fact effectively makes these investments unavailable to employers that want to pay their 401(k) administration fees by revenue sharing.
4. Revenue sharing is often unfair
ERISA is generally silent about acceptable method(s) for allocating 401(k) fees amongst plan participants – it only says the method used must be “reasonable.” Reasonable usually means pro rata or per capita.
Unless all 401(k) plan investments pay the same rate of revenue sharing, participants will pay a different rate of administration fees. That means participants invested in funds that pay a high rate of revenue sharing will pay a disproportionate share of administration fees.
5. Revenue sharing is baked into fund expenses
In a recent study, we found 79% of our small business clients pay 100% of their 401(k) administration fees from a corporate bank account, not plan assets. This approach is popular because it can be a win-win for 401(k) participants and business owners. Participant savings will grow faster, while business owners can reduce their fiduciary liability, lower their taxes, increase their personal savings, and improve their plan’s attractiveness to employees.
Revenue sharing doesn’t give employers this option because it’s baked into fund operating expenses.
“Fee levelization” to the rescue? Not so much
Following a groundswell in excessive 401(k) fee litigation over the past decade, employers are demanding more transparent and fair provider fees to help them stay out of trouble. This trend has led to a decline in the use of revenue sharing.
However, many 401(k) providers aren’t ready to give up these lucrative payments just yet. They claim a recordkeeping process coined "fee levelization” makes revenue sharing just as transparent and fair as direct fees. The process involves two steps:
- Refunding the revenue sharing paid from participant accounts.
- Deducting direct fees from participant accounts using some uniform basis for paying them from a corporate bank account.
I disagree. At best, the complicated process puts lipstick on the revenue sharing pig, and at worst, makes 401(k) fees even less transparent.
Let’s make revenue sharing obsolete!
Bottom line – revenue sharing makes it more difficult than necessary for employers to meet their fee and investment-related fiduciary responsibilities. To lower fiduciary liability, I recommend employers pay direct fees to their 401(k) provider instead.
