Caveat Sponsor: Choose Share Classes Wisely

Several larger plans are being sued over costs of investment options. In Tibble vs. Edison, cited as a watershed moment, the plan sponsor was found to have breached fiduciary responsibility because it did not offer institutionally priced shares of a fund that were, in fact, available. (See “9^th Circuit Affirms Ruling in Retail Fund Dispute.”)

The Employee Retirement Income Security Act (ERISA) says fees must be reasonable, and investigations into share class choice go to the heart of the reasonableness of fees.

The curtain is gradually being pulled back on this practice, according to Philip J. Koehler, chief executive of ERISA Fiduciary Administrators. “It’s a key issue,” Koehler says. “You’d think highly sophisticated managers and advisers would be more aware, but nevertheless, high-priced, revenue-share classes wind up on investment lineups.”

“Share class is really emerging as an important issue over the last couple of years, so it’s not surprising the DOL is getting more interested,” agrees Ary Rosenbaum, principal of the Rosenbaum Law Firm.

The fiduciaries in Tibble vs. Edison decided to include revenue-sharing funds disconnected from any inquiry, Koehler says. “In fact, these retail class fund shares were shares of the same fund that had institutional shares, and there was no record to show they ever bothered to make inquiries about other share classes.”

According to Koehler, the 9^th Circuit says that including revenue-sharing or retail class shares without first making some fundamental inquiry as to the availability of lower cost, non-revenue shares or institutional share classes is per se imprudent, and a breach of fiduciary duty.

“This is a hot topic for ERISA attorneys and financial advisers, and [choosing a sub-optimal share class] happens more than you’d think,” Rosenbaum. At a recent sales meeting, Rosenbaum notes the savings that a new financial adviser said he would bring was a huge amount: 30 basis points to 40 basis points, based on a $25 million plan.

The problem arises when a plan offers the wrong share class from a fund that offers a less-expensive share class, Rosenbaum says. “Advisers in larger plans are usually aware, but in the smaller plans it depends on the sophistication of the adviser and how often he monitors a client,” he says. “A broker who sees a client only every six months may not be providing enough fiduciary support.”

Assessing Reasonableness

This is something we deal with fairly regularly, says James F. Sampson, managing principal, Cornerstone Retirement Advisors, noting that the general discussion opens with the question of what fees are involved, and whether they are reasonable. “Then it’s important to identify how the fees are divided and disbursed, and what services those fees are paying for,” he says. “This is how we generally identify if there is a particular aspect to the plan with a disconnect between the services and fees provided.”

The size of the plan is also a factor, Sampson says, adding that for smaller plans, there may not be multiple share classes available. “The recordkeeper may have negotiated a certain share class to their platform to cover appropriate expenses, and the sponsor doesn’t get to choose the share class like they might in an open architecture environment,” he says. “It’s not necessarily a bad thing, especially if the contract is priced appropriately.”

Share class becomes a higher point of scrutiny for bigger plans and the open-architecture environment, according to Sampson.

“Inappropriate share classes generally happen when plan size grows, and no one has been checking to see if there is a better, more appropriate share class for the plan,” Rosenbaum says. “More expensive funds drag down the rates of return.”

However, Sampson says, he doesn’t think the sole question should be, “Is there a cheaper share class?” “Other factors are involved,” he says. “Who is paying for the services? If the sponsor is paying for recordkeeping, administration and advisory services, then, by all means, you want the lowest share class. But if the participants are bearing that expense, then the lowest is probably not an option.”

Rosenbaum feels the nature of the business plays a part in share class decisions. “The adviser recommends the third-party administrator (TPA), and the last thing the TPA wants to do is become an issue between the plan sponsor and the plan adviser,” he says. “The financial adviser doesn’t want to negatively impact a relationship that’s a referral source.”

Perhaps most important is to have the conversation with the investment adviser about the share classes in each fund, and whether each offers an appropriate share class for the size of the plan, Rosenbaum says. Inappropriate share classes generally happen when plan size grows, and no one has been checking to see if there is a better, more appropriate share class for the plan.

The Importance of an IPS

Koehler says a glaring omission in the Tibble case was the lack of an investment policy statement (IPS) that informed them how to look at that decision. “One thing the plan sponsor needs to avoid liability is a fee policy statement or fee policy that lays out who pays for something, which can be part of the IPS,” he says. (See “Do You Recommend a Fee Policy Statement?“)  

A well-drafted IPS has a provision or many provisions that state that a company’s policy is to avoid revenue-sharing classes in the plan, Koehler says. “Or it can limit the extent to which it will accept revenue-sharing, such as reimbursement for specific expenses,” he says. “Fund classes with the lowest expense ratios just pay for the fund itself, and fees increase incrementally, with as many as 16 different share classes. Each uptick in the expense ratio is intended to absorb additional expenses.”

Sampson recommends a consideration of what revenue-sharing dollars are being used to pay for those expenses. “Then you get into the discussion of this fund pays X, that fund pays Y, and who is paying for what,” he says. “It gets messy fast.”As an aside, he feels this could be the next big lawsuit wave: having some employees paying for costs of services and others not because some pay revenue sharing and some don’t.

One solution, according to Sampson, makes the whole discussion disappear. “All of the fund companies create a zero-revenue share class, allow its use with no minimums, and then the plans layer in the necessary fees for recordkeeping/ administrative/custodial/advisory services, or just pay those fees themselves,” Sampson says. “Some recordkeepers are starting to build platforms that look like this, and it’s a much cleaner approach.”

“Historically, there’s many different ways to generate fees to offset TPA [third-party administrator] expenses, or adviser expenses for a plan,” says Ralph Ferraro, head of product management in the small and mid-corporate markets segment in Voya Financial’s Retirement Solutions. “It’s obviously extremely important for the plan sponsor client and the participants to fully understand the fees associated with administering their retirement plan.”

Zero-Revenue Funds

Two years ago, Ferraro says, the firm began building a product that included funds that didn’t generate any revenue sharing, as a way to introduce flexibility.

Ferraro explains that R6 share classes were starting to come out in the small and midsize end of the market. “This share class of funds is designed specifically by investment managers without additional fees beyond investment management fees, no 12(b)1 or transfer agent fees,” he says. “None are built into cost of R6. So they fit the definition of a no-revenue share fund.”

But the funds are not exactly free of fees. “When we say choice and flexibility, we offer products that still generate revenue share and the costs overall from revenue generating are comparable from our perspective,” Ferraro says. An explicit daily asset charge generates the revenues to offer Voya’s services. “From the feedback we received, it simplifies the story.”

The asset charge is calculated daily, Ferraro explains. “We look at the balances associated with a plan across all the funds on a daily basis,” he says. “One fee is applied against those assets on a daily basis to produce the revenue that offsets the services provided to that plan. The fund has an investment management fee, and we provide in our disclosure what the asset charge is.”

Funds that generate revenue share may not have an asset charge—the revenue generated produces that comparable revenue to offset services provided, according to Ferraro. “If it costs $100 to administer the plan, and compensate advisers and the TPA for their services, you could have funds in a plan that generate revenue shares to accumulate $100. With a no-revenue share menu, you would have an asset charge,” he says. “The fees are comparable at the end of the day.”

How does the client want to pay for the services that the providers, vendors and TPA bring to the table? asks Bill Elmslie, head of national intermediary distribution and service at Voya Financial’s Retirement Solutions. “The adviser may gravitate to something that may seem simpler,” he says. The zero-revenue menu is primarily, but not exclusively, composed of R6 shares—there’s some collective investment trust (CIT).

“We’re providing the fee disclosure material to our plan sponsors, to participants, who may gravitate to a simpler story,” Elmslie explains.