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Indirect Compensation: Understanding how it Affects Employees in Qualified Retirement Plans

Friday, December 15, 2017
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Authored by Samuel Martin, Cerity Partners

What is Indirect Compensation

Indirect Compensation also referred to as “revenue sharing”, is a commission payment made by mutual fund companies to the service providers of qualified retirement plans. These types of payments initially began as a way for mutual fund companies to incentivize broker-dealers to sell a specific mutual fund to their clients, and were maintained in the qualified retirement plan under the guise of “being a simpler method of paying service providers”. These commission payments are built into the expense ratio of the mutual funds and are often misunderstood by the employees and plan committee in a corporate sponsored retirement plan who purchase the mutual funds.

Types of Indirect Compensation

There are two primary types of indirect compensation that can be built into a mutual fund:

12b‐1 Fees – This refers to rule 12b‐1 under the Investment Company Act of 1940. These fees are built into the expense ratio of a mutual fund as an operating expense and are, by law, to be used for the sale or distribution of a mutual fund. These fees are most commonly paid directly to the advisor of a qualified retirement plan for recommending the fund be utilized within a qualified retirement plan.

Sub‐transfer agency fees/shareholder servicing fees – These fees can be applied by a mutual fund in two ways. The first is the same manner in which 12b‐1 fees are, which is built into the expense ratio of the mutual fund. The second way would be a flat dollar fee per employee account fee assessed by the mutual fund. These fees are most commonly paid to administrative service providers (recordkeeper, third‐party administrator, and custodian).

How Indirect Compensation Works

 ABC Company sponsors a 401(k) plan for its employees. The company sponsored plan offers the following three investments:

Fund Name Expense Ratio Underlying 12b‐1 Fee Underlying Sub‐TA Fee
Large Cap Index Fund I 0.20% 0.0% 0.0%
Mid Cap Growth Fund A 1.00% 0.40% 0.10%
Emerging Markets Fund R3 1.25% 0.50% 0.15%

 

All employees of ABC Company receive the same services through the 401(k) plan. Employee 1 decides to invest his full account of $10,000 into Fund A. The Large Cap Index Fund is an institutional fund that has no underlying revenue sharing. Due to this, Employee 1 is not paying any administrative expense to maintain their account in the 401(k) plan. In contrast, Employee 2 decides to invest their $10,000 into Fund C. The Emerging Markets Fund is a retail share class that has revenue sharing built into the expense. Employee 2 is indirectly paying $65 per year in administrative costs to maintain their account in the 401(k) and receiving the exact same services as Employee 1.

These fees, being paid by the mutual fund companies to the services providers do not show up on any invoice or line item deduction for either the employees or the plan sponsor, which often leads employees and sponsors to believe they’re receiving low‐cost or sometimes even free services.

The Problems with Indirect Compensation

There are two core problems with indirect compensation arrangements:

Inequitable Distribution of Plan Fees – As exampled above, employees participating in a company-sponsored retirement plan could be paying drastically different fees for the exact same services.

Conflicts of Interest and Self‐Dealing – The service providers of the above‐exampled plan understand that they will be paid more by Fund C than by Fund A. Due to this, they may find ways to direct money into Fund C simply for their own benefit without regard for what’s in the best interest for the employees.

Why this should matter to Plan Sponsors

In a single word: Liability. These same service providers, who are structuring plans to include indirect compensation, are the same ones refusing any type of liability of those same plans. This leaves the sponsoring company and, specifically, anyone named to oversee the plan with the responsibility to fully understand and monitor these underlying offerings between mutual fund companies and the services providers of their retirement plan. Additionally, anyone named to oversee the qualified plan bears personal liability to ensure the fees being paid between mutual fund companies and services providers are in line with the ERISA standard of reasonableness.

How to Resolve Issues with Indirect Compensation

There are several ways in which to avoid indirect compensation arrangements. The first step, regardless of the method, is to notify the service providers that you wish to end the indirect compensation arrangement. Once the service provider is notified there are a few methods in which to proceed:

  1. The least efficient, but perhaps simplest method is to create an ERISA Fee Recapture Account. In this method, the indirect compensation paid by the mutual funds is placed into an account controlled by the plan sponsor rather than being paid to the service providers. The service providers prepare an invoice for their services, which the plan sponsor can use the ERISA Fee Recapture Account funds to pay for. The advantage of this method is that it is usually the easiest to implement, however, a major drawback is the preservation of the inequitable distribution of fees based on the investments selected by employees.
  2. The second method, which is similar to the first, is called a “level fee arrangement” or “fee equalization”. In this method, the indirect compensation paid by the mutual funds is rebated back to every employee. From the previous example, Employee 1 would be credited $30 and Employee 2 would be credited $65. The service providers prepare an invoice which can be paid by the sponsor or equitably distributed amongst the participating employees. This arrangement completely eliminates all of the issues of indirect compensation. However, this type of arrangement can be complicated to establish or may not even be available from the service provider.
  3. The third method would be to introduce investments into the plan that to not provide for any indirect compensation. Most mutual fund companies will provide different options for the same mutual fund, referred to as “share classes”, which can control the amount of indirect compensation paid by the fund. Some research by the investment advisor for the plan and the processing of a fund change can eliminate all revenue sharing from the investments being offered. The advantage of this method is it ensures the lowest cost option for a given mutual fund is being offered through the plan. One difficulty is the available investment options can vary from service provider to service provider.

 

HPM Partners: Philip Steele, AIF Partner, psteele@hpmpartners.com 
11601 Wilshire Blvd., Suite 2240 
Los Angeles, CA 90025

HPM Partners Retirement Plan Services practice is led by Philip Steele, a retirement industry veteran who is widely considered a pioneer in the concept of financial wellness within corporate plans. Philip heads up a deeply experienced team of plan design specialists who prove to be valuable in evaluating your current plan’s design and the resulting benefits or drawbacks associated with the design. In addition to the current regulatory focus on the plan design, fee structure and many other possible conflicts, this evaluation provides for a great opportunity to make the retirement plan more bullet‐proof for the plan fiduciaries, while greatly enhancing the tangible benefits for the plan participants.

Disclosures:

Cerity Partners LLC (“HPM”) is an SEC registered investment adviser with offices in New York, Illinois, Ohio, Michigan and California. This publication contains general information only, and neither HPM nor its affiliates or subsidiaries is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect your company’s retirement plan or its participants, you should consult a qualified professional adviser. HPM and its affiliates and subsidiaries shall not be responsible for any loss whatsoever sustained by any person who relies on this publication. There is no guarantee that the views and opinions expressed in this publication will be effective in your particular circumstances. The information presented is subject to change without notice. All information is deemed reliable but is not guaranteed. For information pertaining to the registration status of HPM, please contact us or refer to the Investment Adviser Public Disclosure website(www.adviserinfo.sec.gov).

Material posted on this website is for informational purposes only and does not constitute a legal opinion or medical advice. Contact your legal representative or medical professional for information specific to your legal or medical needs.

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