W. Scott Simon
In this column last month, I wrote about the case of Tibble v. Edison International, the first 401(k) excessive investment fee case to go to trial that resulted in a judgment. I thought that it might be of interest to expand on that discussion of this case since it has generated so much commentary.
Revenue-Sharing Isn’t Necessarily Good for Plan Participants
Some of this commentary has centered on the notion that Edison, the plan sponsor, had the “Duty to Ask” about the availability of institutional, lower priced mutual fund investment options for the Edison 401(k) plan. I posed the question last month why Hewitt Financial Services, one of the largest and most prestigious investment consultants in the land and an investment advisor to Edison, would have ever let Edison continue to offer retail, higher priced mutual funds in a multi-billion dollar 401(k) plan? I suggested that before imposing any Duty to Ask on Edison, it might be more appropriate to first impose on Hewitt the “Duty to Tell” Edison that burdening plan participants (and their beneficiaries) with such higher costs was entirely unnecessary.
In earning its fees, what other “investment advice” could Hewitt offer Edison that would be of more importance to participants? Surely it couldn’t be noodling with the Edison staff over the (past) performance of the plan’s investment options. While the return on investment options is important, it’s also an entirely random variable over which no one has any control. It’s much more beneficial to plan participants for a plan sponsor (and its advisors) to work to manage the risk and reduce the costs of a retirement plan’s investment options–both of which enhance return and therefore leave more money in the pockets of plan participants.
Doing away with revenue-sharing in a retirement plan is one good way to reduce the cost of the plan’s investment options. For the sake of simplicity to illustrate a concept, suppose a plan has just one mutual fund investment option. It has an annual expense ratio of 1.25% (or 125 basis points), and included in that number is 0.50% (or 50 basis points) of revenue sharing. Now suppose that the same mutual fund was available–without revenue-sharing–with an annual expense ratio of 0.75% (75 basis points). The plan’s record-keeper is now out 50 basis points of revenue-sharing fees but since this is America it cannot work for free so it must be paid something.
One possible alternative is to directly bill the plan sponsor with an invoice for record-keeping services of 50 basis points. Another possible alternative is for the advisor to suggest to the sponsor that the record- keeping fee of 50 basis points be wrapped into the expense ratio of the fund and be fully disclosed to the plan participants. But if the advisor is truly worth its salt, it will advise the sponsor to shop the market for a record-keeper that will work for a fully disclosed fee that is tied directly to fully disclosed services performed. And the sponsor will probably find that it will be able to get a record-keeper to work for less– say, 25 basis points–than for more–50 basis points.
And that’s why revenue-sharing isn’t good for plan participants: when it’s present, the expense ratio of a plan’s fund investment option is often kept artificially high because there’s no breakout of the record- keeper’s costs plus its profit. But when a fund with no revenue-sharing replaces a revenue-sharing laden fund, something remarkable happens: the true cost of revenue-sharing for plan participants is isolated and exposed to the sunlight. When the cost of revenue-sharing–including the record-keeper’s “excessive” profit–is unlocked from a fund’s expense ratio, record-keeping costs are driven down. This is due primarily to the profit portion of the record-keeper’s costs going from “excessive” to “reasonable” which is a result of market competition. That result is much better than a plan sponsor and its advisor guessing about the true cost of record-keeping and other services. It’s also much better than having a court attempting to guess after the fact a plan sponsor’s motives concerning revenue-sharing.
Revenue-sharing, of course, is perfectly legal–even when it’s not disclosed. At present, plan service providers are under no requirement to disclose costs to plan sponsors even though, under section 404(a) of the Employee Retirement Income Security Act of 1974 (ERISA), sponsors have the fiduciary duty to know what those costs are in order to determine whether or not they’re “reasonable” in relation to the services for which they’re expended. (This is the great “disconnect” in the ERISA statutory scheme that I’ve written about in previous columns.) But even when 408(b)(2) is fully implemented, guess what: sponsor will still have the duty to determine whether or not costs are reasonable in relation to services. So the game remains the same.
The fundamental, underlying problem with the notion of revenue-sharing is that it’s not broken out and tied directly to the cost of the various services being performed. Revenue-sharing evolved as a way for the retirement plan industry to share revenue among its constituent parts in order to build a solution for defined contribution plans. But it’s often an imprecise tool that’s not directly correlated to the true cost (or value) of providing services, leaving plan sponsors unable to line up costs with services so that they can fulfill their fiduciary duties. That very imprecision is what can breed abuses in the pricing of plan services by some plan service providers.
Even though revenue-sharing isn’t illegal and while it can be a (really) good gig for some plan service providers, that doesn’t necessarily mean that it’s good for plan participants (and their beneficiaries) who, as we all know, are the center of the ERISA universe. It would be far simpler to disclose to a plan sponsor a charge of, say, 20 basis points for record-keeping or a flat dollar charge per participant, which still includes a fair and reasonable profit for the service provider. That way, a sponsor and its advisor can know the true cost being charged, and can compare it in the open market and/or benchmark it appropriately. By the way, a clear segmentation of fees to help drive down record-keeping costs helps answer those who say that the only thing plan sponsors need to know about is the total amount of costs involved, not each cost. So breaking out costs can help drive down costs which benefits both sponsors and participants, while wrapping up everything in one big total number keeps ’em ignorant–and poorer.
There Were No 3(21) or 3(38) Fiduciaries in Tibble
Other commentary about Tibble has cited the case for the proposition that, while plan sponsors have the power under ERISA to delegate certain duties (and any associated liabilities) to others, they cannot completely abdicate them. That may be a proposition appropriate to other such cases but not to Tibble. In fact, the Tibble opinion cited no entity as an ERISA section 3(21) fiduciary. That’s why, for example, neither Hewett nor the Frank Russell Trust Company (Russell) (another investment advisor to the Tibble retirement plans) could have shared in, or accepted delegation of, any fiduciary duties: they weren’t fiduciaries. Either entity (or both of them) may, in fact, have been a 3(21) fiduciary but the opinion didn’t indicate that.
On the contrary, the Tibble opinion stated clearly that Edison’s internal investment staff made recommendations to Edison’s two internal investment committees which together were responsible for any final decisions concerning the selection, monitoring and replacement of the investment options offered in the Edison 401(k) plan. This would obviate the need for retaining an ERISA section 3(38) Investment Manager. (It’s important to note a small but important subtlety here. The inherent powers of any plan sponsor include those of selecting, monitoring and replacing a plan’s investment options. But such powers can be labeled only as “3(38)” powers when the sponsor (or some entity appointed by the sponsor) has actually delegated them to some outside third party bank, insurance company or an RIA that accepts such powers in writing as a self-acknowledged ERISA section 3(38) Investment Manager. In Tibble, then, Edison’s two internal investment committees had the powers to select, monitor and replace the plan’s investment options but these could not be referred to as “3(38)” powers because no outside third party entity was involved.)
Since there’s no evidence that any “discretion” was built into Edison’s investment process for Hewitt (or Russell) to, for example, assume control of the plan’s assets, it’s probable that Hewitt was acting only as a paid consultant to Edison which carries no fiduciary duties. Hewitt simply delivered quarterly reports to Edison, commented on them and talked to the Edison investment staff, among other duties non-fiduciary in nature.
But even if Hewitt was, in fact, an ERISA section 3(21) fiduciary, the most that it could do would be to offer only on-going advice with no power to share in any discretionary decision-making processes for which liability could attach. No doubt many plan sponsors value highly the advice offered to them by their 3(21) “co-fiduciary” advisor. But the difference between that feeling and the fact that a 3(21) “co- fiduciary” advisor offers no real legal fiduciary protection to its plan sponsor clients is significant. In any event, the Tibble opinion contained no reference to any 3(21) or 3(38) fiduciaries.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.