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How much does your company pay each year for the administration of your 401(k) plan? If your company is like most, the answer isn't readily available. Why not? The confusion can be traced to a process called revenue sharing. Every company is responsible for administering 401(k) plans in the most fiscally prudent manner possible. And HR professionals need to communicate with employee participants and have answers to their questions about 401(k) fees. This article explains why the "Zero Rev" approach may be a potential solution to increasingly high 401(k) fees and how this approach can also simplify the entire fee process.

What is Revenue Sharing?

A quick query to your accounting department is likely to confirm that few, if any, payments were made to your record-keeping vendor (the company that provides quarterly statements, participant and plan sponsor Web sites and day-to-day administration for a 401(k) plan) in prior years. The lack of a payment, however, does not mean the administrative services are free. The 401(k) industry is like any other: no one does anything for free.

The lack of a sizeable payment instead indicates that the record keeper is making all the money it requires – and potentially more – from agreements with the funds within the menu. This process of behind-the-scenes passing of revenue from the investments to the record keeper is known as revenue sharing.

The practice of revenue sharing has received increased attention over the past few years, culminating in lawsuits against some of the nation's largest employers (Kraft, John Deere, and Caterpillar, among others). Some suits have fizzled while at least one, Caterpillar, was settled.

The crux of these suits is that plans with hundreds of millions or more in assets should offer investment menus at a cost that reflects their buying power (retail share classes of funds should not appear where lower cost institutional classes are readily available). Higher investment costs yield higher amounts of revenue sharing, and plaintiffs argue that larger plans should become less expensive as they grow. Plan sponsors (employers), they say, should monitor the amount of revenue being paid, and participants should reap the benefits of the larger asset base through lower investment expenses.

One particular fund might be offered in five different share classes with five different expense ratios. The main difference between the share classes is the amount of revenue sharing paid with the most expensive versions paying the highest amount of revenue sharing. Those behind the lawsuits seek to compel employers to utilize the lowest cost share class where it is available. Many employers may not even be aware of the existence of the cheaper share classes and the amount of revenue a fund pays is often a deciding factor in whether or not a recordkeeping vendor offers it as a choice.

Take, for example, an S&P 500 Index fund. This fund offers low cost, broad-based exposure to the U.S. stock market by investing in the 500 companies that make up the index. The controversy arises when participants in a 401(k) plan are given an S&P 500 fund that has annual expenses of 0.30 percent or more while that same kind of fund can be purchased by individual investors for as little as 0.10 percent. The differential between 0.10 percent and the higher fees is the amount attributable to revenue sharing. Plaintiffs argue that a plan with tens or hundreds of millions of dollars in assets should not feature funds that cost 300 percent or more than what can readily be had by someone with $3,000 to invest.

Beyond the basic issues regarding the reasonableness of a fund's expense ratio, there are myriad other ways that revenue sharing can play havoc with the distribution of fees. Consider the items in Table 1.

Table 1: Different Investment Categories Pay Differing Amounts of Revenue

Fair and reasonable are terms being debated in the courts, but HR professionals, working in conjunction with finance, should make their own assessments regarding the company's plan and its investments. Specifically, determine the company's comfort in an environment where those investing in brokerage accounts or company stock pay nothing in the way of revenue sharing while many other participants using the core options within the plan pay the administrative fees through investing in the core mutual fund lineup. Should revenue sharing be disclosed (and would anyone understand it)? Should the company pick up some or all of these fees as a deductible employer expense?

A Potential Solution

It is nearly impossible to create a situation where every menu option, including company stock and brokerage accounts, pays the same amount of revenue. Moreover, continued use of revenue sharing to pay the administrative costs means that the fees will continue to rise as the assets within the plan grow.

The best way, perhaps the only way, to produce a level playing field and answer the "how much" question is to avoid revenue sharing altogether and change your pricing arrangement to a flat, per-head fee, known as the "Zero Rev" approach. Under Zero Rev, fees are linked to the number of participants in the plan (more participants equals more fees for the record keeper; the reverse is also true). The growth of the assets is not a factor, and the ability to drive down participant investment expenses receives a huge boost as the lowest cost version of each fund is the standard.

The Pros and Cons of the Zero Rev Approach

Although the Zero Rev approach seems straightforward, there are a number of obstacles to this approach. Table 2 shows a high-level view.

Table 2: Obstacles to Zero Rev

If a company is able to convert the asset-based fees to a per-head fee, it will have to tackle the employee communication issue head on (unless it intends to absorb the per participant fees as an employer paid expense). Most participants likely have no idea what they pay in investment expenses or how much of that amount is paid back to the record keeper. Many of these same participants will also likely have questions about the $15 per quarter fee now appearing on their statements with the conversion to a Zero Rev menu. The benefits of the lower investment cost – particularly for those with larger balances – are undeniable. But helping participants recognize those benefits may be a challenge.

Questions to Ask

Two basic questions can be asked, in writing, of the current record keeper to help identify the existing cost structure:

• How much did the record keeper receive in the prior two calendar years in the way of soft dollar revenue sharing payments? The response should be in writing and should break out the amounts by fund.
• Is the record keeper willing to amend the existing agreement to state that future fees will be based on a per participant basis with revenue sharing amounts either eliminated from the plan or credited back against the per participant fees?

Conclusion

HR professionals should work with their internal finance department and the company's record keeper to determine if the Zero Rev approach is truly the best approach. Future actions of the regulatory bodies or U.S. Congress may require the disclosure and level playing field provided via a Zero Rev menu. But even without a regulatory requirement, every employer still should have an understanding of how much it costs to administer its 401(k) plan.

This article was originally published in the WorldatWork April 2010 edition of Workspan.  Published with perfmission of the WorldatWork 2010.

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Marshall J. Cobb, CRSP, is president and founder of Cobb Retirement Solutions, LLC., an independent, fee-only firm offering qualified plan analysis and oversight exclusively to corporations and organizations. Cobb's first-hand knowledge as a veteran representative of retirement plan vendors beginning in 1990 gives him a unique perspective as he advises his clients. Cobb runs his office -- based in Houston, Texas -- with employees and clients across the country.