Basic Organization

As we have discussed, in the typical 401(k) plan, participants choose investments from a fund menu, and they are generally (and with some common exceptions) allowed to change investments daily. To set up a 401(k) plan, someone must construct and “populate” that fund menu with investment options.

The other critical features of 401(k) plans—and the other main generators of fees—are recordkeeping and trust services. The daily valuation of 401(k) plans requires significant recordkeeping infrastructure. Typically, the plan retains—and pays for, generally out of participants’ accounts—a participant recordkeeper (to value and keep track of participant accounts) and a custodian/trustee (to value and keep track of trust assets).

Fiduciary Selection and Monitoring of Plan Service Providers

In the typical 401(k) plan, plan fiduciaries, e.g., a plan investment committee of company officials appointed by the sponsor’s board of directors, “construct” a plan fund menu. This menu construction process generally involves two steps: (1) the committee makes decisions about what sorts of investment options will be offered to participants;29 and (2) it then selects the providers—mutual funds, collective trusts, separate accounts, fund managers—that will provide/manage those funds.

A plan fiduciary (in some cases, the same one that constructs the fund menu, in others a different “administrative committee”) must also select a recordkeeper and a trustee, negotiate the terms of their arrangement with the plan and monitor their performance.

In these respects, these committees are generally acting as fiduciaries, and committee members are held to an ERISA prudence standard.

None of the foregoing is, strictly, a function of regulation—rather it is a function of the way 401(k) plans developed and spread. The mutual fund industry led a process that produced the “typical” 401(k) plan that we now have, with daily recordkeeping and participant control of basic investment decisions, choosing their investments from a fund menu “curated” by plan fiduciaries.

These decisions of plan fiduciaries—selecting plan investment managers/funds and recordkeepers and trustees—have been the primary target of regulatory efforts and litigation over the last 10 years. And in those regulations and that litigation, the primary issue has been fees.

So let’s consider the “flow of fees” under different 401(k) fee structures.

The Structure of 401(k) Plan Fee Arrangements

In the simplest fee arrangement, a service provider provides services directly to the plan and is paid an explicit fee. For non-investment service providers, this sort of arrangement is relatively transparent. Certainly where, e.g., for recordkeeping, the plan writes a check to the service provider, it’s clear what the plan is paying.

Assets-Under-Management Investment Fees

Things get a little more obscure when we consider the assets-under-management fee that investment managers are typically paid and that mutual funds charge. Before DOL’s adoption of its 2010 provider-to-sponsor fee disclosure regulation (discussed in the following chapter), there was no requirement that, e.g., a mutual fund disclose anything other than what was in its prospectus: generally, its “expense ratio”—the percentage/basis points assets-under-management fee that was deducted from mutual fund assets.30

There was no requirement to account (literally) for how much fees that expense ratio, for any period (e.g., month or year), generated from plan investments. Thus, sponsor fiduciaries and participants could find out that, e.g., a particular mutual fund had an expense ratio of 50 basis points (and thus, oversimplifying a little, the fund management fee was 0.5% of fund assets), but could not easily determine how much the mutual fund organization was actually paid out of assets invested in the fund by the plan.

Recordkeeping and Trustee Fees—Mutual Fund Bundled Services

Recordkeeping and trustee fees may be (and not infrequently are) paid for on a per capita basis, e.g., $100 per participant per year. But one of the innovations that the mutual fund industry brought to 401(k) plan administration was “bundled services” arrangements: some mutual fund organizations would provide all services—investment management, recordkeeping and custody—for a single fee, often providing recordkeeping and custody services for “free,” recovering its cost for those services (and its profit) out of the assets-under-management expense ratio on its funds in the fund menu.

Under DOL regulations providers have since 2010 had to provide “a reasonable and good faith estimate of the cost to the covered plan of such [‘free'] recordkeeping services.”

Paying Unaffiliated Recordkeepers out of Mutual Fund Fees—Revenue Sharing

As the industry evolved, and in response to sponsor demands for the ability to include funds other than those of the mutual fund bundled services provider in the fund menu, or to use a recordkeeper that is not affiliated with the mutual funds being used in the plan fund menu, the industry developed revenue sharing arrangements.

Major independent recordkeepers also developed bundled services arrangements, partnering with a specified “slate” of mutual fund organizations and funding recordkeeping services out of revenue sharing paid by those mutual funds.

These arrangements significantly complicated how 401(k) plan service providers got paid.

Under these sorts of revenue sharing arrangements, assets-under-management fees that are generated as part of a fund menu mutual fund’s expense ratio are paid to an unaffiliated recordkeeper/trustee as compensation for non-investment management services.

The same profit-and-loss rationale applies in both of the cases we are considering—whether the recordkeeper is affiliated with the mutual fund organization or not. The economies of scale, reduced marketing costs, etc. of (some) 401(k) plans justified giving back some of the mutual fund’s expense ratio/assets-under-management fee. If the recordkeeper was affiliated with the mutual fund organization, then recordkeeping could be marketed as “free,” and the cost of the service was covered internally, within the mutual fund organization.

If the recordkeeper was not affiliated with the mutual fund organization, then an explicit revenue sharing fee was paid by the mutual fund organization out of its expense ratio to that outside recordkeeper.

Figure 20.1 illustrates the three sorts of recordkeeper compensation arrangements we have been discussing: (1) an explicit fee arrangement; (2) a revenue sharing arrangement; and (3) a bundled services “free” recordkeeping arrangement.

Problems with Revenue Sharing

There are, however, at least three features of revenue sharing arrangements that presented special problems.

First, revenue sharing is paid as an explicit fee to the outside service provider. Therefore, it is possible to (1) quantify that fee and (2) attack it as unreasonable. It’s nearly impossible to do that with respect to the “free” recordkeeping provided directly by a mutual fund organization.

Second, a critical feature of most revenue sharing arrangements was that the recordkeeper was paid an assets-under-management (rather than a per-participant) fee. This could result in, for instance, recordkeeping fees going up as the market went up: that is, an increase in asset values would result in an increase in recordkeeping fees. Even though the number of participants in the plan had not changed. That feature of revenue sharing practice was criticized by some.

And, third, revenue sharing arrangements introduced a further level of obscurity, complicating the sponsor-fiduciary’s job, making the process of evaluating the reasonableness of fees more complicated.

As a result, and as we discuss in Chapter 22, revenue sharing arrangements have been the target of considerable litigation.

Current Practice

Buying and pricing strategies in this space have continued to evolve. Many recordkeepers now offer to re-credit to the plan revenue sharing above agreed-upon levels. Because revenue sharing is not typically credited in the same amount/percentage from each fund in a plan fund menu (indeed, some funds, e.g., guaranteed investment contracts and company stock funds, typically pay no revenue sharing), there are some complicated issues about how these re-credits should be allocated under the plan.

A change in mutual fund regulation under the Investment Company Act of 1940 now allows the crediting of preferential dividends, which gives mutual funds the ability to effectively reduce the (ultimate) net cost of fund investments by 401(k) plans. As a result, mutual funds are developing different sorts of pricing models that may allow them to negotiate different (net) prices for different customers.

In this newer environment, revenue sharing may, however, remain viable as a marketing/pricing/business model, where providers believe that they can provide a better product at a better price through integrating services and establishing strategic relationships. That is, mutual fund and recordkeeping providers may be able to partner to create vertically integrated services that are more efficient and cheaper for plan participants than buying each service (fund management and recordkeeping) separately.