Over the last few years there have been plenty of articles addressing the importance of periodic plan expense benchmarking, and full disclosure of all plan-related costs.
With all of this discussion about the amount of fees being charged, plan sponsors seem to be overlooking another important issue; making sure participants understand not only what fees the plan is being charged as a whole, but how those fees are being allocated to individual plan participants?
If a plan participant came to their human resources department and asked, “How much am I paying in plan-related fees?” it might be a difficult question to answer. Most plan sponsors and HR professionals would direct the participant to the recordkeeper’s website.
A participant might be able to look up the mutual fund expenses within their account, and with some effort, might be able to determine how much the recordkeeper charges to the plan. However, it is unlikely they will be able to calculate the total fees they are paying as an individual participant in the plan.
Before discussing how to simplify plan costs so they can be easily explained to employees in one succinct sentence, let’s spend a minute talking about “revenue sharing.”
Revenue sharing is simply a mutual fund sharing a portion of the revenue received from expenses charged to investors in the funds. Revenue sharing can be used to pay all or some of a plan’s recordkeeping fees.
What could be wrong with that? Well, revenue sharing can make it very difficult to determine how much an individual participant is paying and can result in an unfair allocation of costs to plan participants. Here’s how:
Nearly all mutual funds have multiple share classes. These share classes pay varying amounts of revenue sharing (including zero) and have different returns and expenses.
For the most part, there is a direct relationship between revenue sharing, investment returns, and fund expenses. For example, if we were to compare two share classes of a mutual fund (same exact fund holdings, but a different expense ratio); one which pays no revenue sharing, and one that pays .25%, we’d find the share class that does not pay revenue sharing has a .25% better investment return, and expenses would be .25% lower.
In other words, in order to pay the revenue sharing, the fund needs to increase its expenses by roughly the same amount as the revenue sharing, thereby reducing the fund’s returns.
Now here’s where things get a bit challenging.
Most plans have a menu of mutual funds from different mutual fund companies, and each fund may provide a different amount of revenue sharing. The S&P 500 Index fund might not pay any revenue sharing, but the actively managed large-cap growth fund might pay .30% in revenue sharing.
If all recordkeeping fees are covered by revenue sharing, the participant entirely invested in the index fund will pay no record keeping fees.
Meanwhile, the participant entirely invested in the large-cap growth fund will pay .30% of their account balance in fees each year.
In essence, the participants invested in the revenue sharing funds are subsidizing the costs of participants invested in funds that do not pay revenue sharing. If this were a clear, fully informed decision by the two participants, it would be one thing. In all likelihood, the two participants are unaware of this cost allocation method.
Now let’s walk through a cost-related decision-making process plan sponsors should follow.
- Make sure the fees are reasonable and competitive. To be fair, the services provided by the recordkeeper, as well as their fees, should be brought into consideration. This is a critical exercise that should be performed periodically to minimize the plan sponsor’s fiduciary exposure.
- Determine how fees should be charged by the providers. Should they be calculated as a percentage of plan assets, per capita or a flat annual fee?
- Determine who should pay plan fees. Should the fees be paid by the plan participants, the company, or a combination of both?
For fees to be paid by participants, determine how participants should pay those fees. There are four primary methods of allocating fees to participants.
To help illustrate these four methods, let’s assume you have a $10 million plan with 500 participants, and the recordkeeper is charging .05% of plan assets ($50,000 per year).
No. 1: Revenue sharing
Use the revenue sharing generated by the mutual funds to pay recordkeeping fees. This will often result in an unfair allocation of fees to participants and make it very difficult for an individual participant to determine exactly how much they are being charged. Under this scenario, your answer to a participant asking about their annual recordkeeping fee will be “That depends on the mutual funds you’re using.”
No. 2: Charge participants a fee per capita
This can be accomplished even if you elected to be charged a fee as a percentage of assets by the recordkeeper. Simply take the total plan assets, multiply that by the percentage fee charged by the recordkeeper, and divide that amount by the number of participants with a balance in the plan. You now have the per capita participant fee.
This per capita fee will adjust each year as the assets and number of participants change, but it will be easy to tell a participant exactly how much they are being charged each year. Under this approach, any Revenue sharing paid by the mutual funds should be first allocated back to the mutual fund that paid the Revenue sharing.
Then the per capita fee can be charged to all participants. Now, your answer to a participant asking about their annual recordkeeping fee will be “$100 annually” ($50,000 divided by 500 participants).
No. 3: Charge participants a fee as a percentage of assets
This approach can be used even if you elected to be charged a flat or per capita fee by the recordkeeper. Just take the total annual flat or per capita fee, divide that amount by total plan assets, and you have the percentage amount to charge participants.
As in scenario No. 2, any Revenue sharing paid by the mutual funds should be first allocated back to the mutual funds that paid the revenue. Then you can charge participants an equal percentage. Now, your answer to a participant asking about their annual recordkeeping fee will be “.05% of your account balance annually” (assuming the annual flat fee is $50,000).
No. 4: ‘Hybrid’ allocation
This approach is a combination of Nos. 2 and 3. Some committees may feel scenario No. 2 is unfair because the per capita fee has a bigger impact on the participants with a very small account balance vs. a participant with a large balance. Conversely, some will feel the percentage of assets fee is unfair to the participants with the larger balances.
The hybrid approach can be utilized to address both concerns. For example, you might feel $40 per head is fair. $40 times 500 participants is $20,000, leaving another $30,000 owed to the recordkeeper. That $30,000 is then charged to participants as a percentage of assets. Now, your answer to a participant asking about their annual recordkeeping fee will be “$40 per year, plus .03% of your account balance”.
It is critical to periodically benchmark overall plan-related costs and services. Equally as important is developing an equitable approach to allocating those costs to plan participants.
Dallas Otter is Executive Vice President and a Plan Advisor with Washington-based Heffernan Financial Services.
Dallas Otter is the Senior Vice President of Heffernan Retirement Services’ Seattle office. He has over 35 years of experience in the retirement plan consulting industry, and provides fiduciary governance guidance to investment committees, employee education, cost benchmarking, and service provider search services.
