Please note that “Mercer’s best practices” were developed based on general principles and without reference to any specific plan sponsor or employer. The circumstances of any given plan sponsor will be unique, and, as with any fiduciary decision, these sponsor-specific circumstances should be taken into account in determining whether and/or how to implement these practices. Accordingly, individually considered plan sponsors’ decisions on these topics may not align with these practices. Mercer’s principles include:

• Disaggregate recordkeeping and investment management expenses
• Appropriate fee allocation: Within practical bounds, fees should be reasonable in relation to the work performed (e.g., charging recordkeeping fees based on assets under management may overcharge those with higher balances)
• Fee transparency for plan sponsors: All fee arrangements and other revenue sources should be identified and fully disclosed
• Clarity for participants: Participant disclosure is critical; participants should be able to understand the fees they are paying

The above principles typically lend themselves to a recommendation to eliminate revenue sharing. These principles are discussed more fully in the Mercer publication “Defined Contribution Plan Fee Practices.”

There may be exceptions where it is not feasible or appropriate to entirely eliminate revenue sharing:

• For example, where an investment strategy is not available without revenue share, we think it is a best practice that plan sponsors credit revenue sharing to those participants invested in the fund options that generate revenue sharing.
• There can be situations where lower “net of revenue sharing” costs could be achieved for participants by offering a share class that includes revenue sharing, and crediting those dollars back to the participants invested in that specific fund. However, this situation raises a number of other complications, including transparency, participant communication, and the fairness of the crediting approach.

This paper addresses the complications resulting from focusing on the lowest net of revenue sharing expense ratio and how a Plan Sponsor may wish to navigate some of these challenges.

The use of revenue sharing as a vehicle for paying recordkeeping fees, at least among larger plans, has largely become obsolete. However, many plan sponsors who do not need revenue share may still choose to use a higher-cost revenue sharing mutual fund share class and credit back the revenue share in an effort to offer participants the “lowest net cost”, i.e. net of revenue sharing option.

Consider the examples below, which are based on actual cases but with the names removed, keeping in mind that the “Published Expense Ratio” is the fee that appears on all fact sheets and mandatory participant fee notices:

• Fund A’s published expense ratio for the “Institutional” share class is 88 bps including 10 bps of revenue sharing. If the 10 bps of revenue sharing is credited back to the participants that invest in that fund, this results in a lower net cost of 78 bps after the revenue sharing is credited. If the revenue share wasn’t credited back to participants, and was retained by the recordkeeper, that would not impact the published expense ratio for the mutual fund, it would still be 88 bps. However, the plan could offer the higher-cost “Investor” share class (113 bps) with 40 bps of revenue sharing, and if that revenue share was credited back to those participants investing in the fund, the “net cost” would actually be 5 bps less expensive (73 bps vs. 78 bps) after credit.
• Fund B has a zero-revenue sharing “R6” share class with a published expense ratio of 71 bps. The plan could offer the “A” share class with a published expense ratio of 118 bps but with 50 bps of revenue sharing. Assuming revenue sharing is credited, that would result in a lower net cost to participants of 68 bps vs. 71 bps.

The calculation of the net cost, i.e. the “net of revenue sharing expense ratio”, assumes that the revenue share is credited back to the individual participant in proportion and at the same time as the net expense ratio is levied. In reality, this does not always happen, and plan sponsors should consider this issue as they decide which approach to use. Timing is often delayed, and the method of allocating back revenue sharing varies across recordkeepers, and in some instances, credits may not solely be allocated to those that generated the revenue.

This situation creates an interesting question for plan sponsors. Is it better to seek the lowest net investment cost, or is it more prudent to offer the share class with the lowest published expense ratio (remember, participants only see the published expense ratio on fund fact sheets, recordkeeper websites, etc.)? Furthermore, does the practice of seeking the lowest net cost for participants pose additional fiduciary risks for the plan sponsor?

Plan sponsors and participants have greater awareness of the impact of fees than ever before. This is driven by broader availability of online data, research, tools and enhanced regulatory disclosures. Easy access to plan and fund data enables plan sponsors and participants to quickly compare investment fees charged by their DC plan to a spouse’s plan, an IRA provider or a competing employer’s plan. The upside of this greater transparency has been increased marketplace competition and potentially lower fees. Sponsors are now under greater scrutiny and must consider the implications when selecting investment vehicles and mutual fund share classes.

From the participant’s standpoint, annual fee disclosures, fund fact sheets and third-party data sources (e.g. Morningstar, Form 5500, manager websites) in the public domain reference and benchmark the published expense ratio. There is no standard way to capture revenue sharing since the amount and way it is used varies from plan to plan and from recordkeeper to recordkeeper. Absent any plan-specific education on the treatment of revenue share, participants could rightfully conclude investment fees are higher than they should be, since they are not aware of the revenue share credit.

Furthermore, the method in which revenue sharing is credited back to participants is not required to be disclosed and often takes the form of a credit on their statement. Even if the plan sponsor does carefully explain the treatment of revenue share in plan communication, there are concerns as to whether participants actually read and digest this information, as most communications do not get the attention they deserve from participants.

The use of more expensive retail share classes (where the intention is to credit back revenue sharing) can also impact plan sponsor benchmarking. When comparing investment fees to peers defined by size, industry or asset class, we believe revenue share should be “netted off” in the analysis. If revenue share is not considered, it will make the plan, and its options, appear more expensive and less competitive than they would be on a net basis.

If more expensive retail share classes are utilized to achieve the lowest net cost for participants, then the plan sponsor should also take care to assess the impact on investment performance. Industry-standard investment performance reporting does not assess the impact of crediting revenue sharing to participant accounts. Therefore, retail share classes with higher expense ratios will typically underperform institutional share classes with lower expense ratios on a net-of-fee basis. If an investment option’s retail share class underperforms its stated benchmark and peer universe median return, while the institutional share class outperforms due to lower fees, this may cause additional fiduciary risk to the plan sponsor, which should be assessed.

Finally, there is a growing desire by plan sponsors to retain retirees in the plan as an alternative to having those participants roll assets out to an IRA that likely has higher fee, retail-oriented products. Asset retention may lead to greater economies of scale and potentially lower fees for all plan participants. However, offering higher cost share classes with revenue share may make the plan look less competitive and potentially lead to greater retiree distributions as a result.

The approach of crediting revenue sharing back to participants does create complications with fee transparency and clarity of communication with participants. There is no doubt that removing revenue sharing and focusing on published expense ratios is easier from a transparency and communication perspective.

The mechanics of charging a higher expense ratio and then crediting back a portion of those fees has logistical challenges that fall into the three general categories described below:

Our/Mercer’s preferred approach is to credit the revenue share paid directly back to the fund and/or individual investor so only those investors in the fund receive the credit.

The above is summarized in the table below:

If revenue sharing is being credited back to participants, a key issue is assessing the reasonableness of the allocation methodology. A net cost approach implicitly assumes that revenue share credits are perfectly allocated. In reality, the crediting methods have varying degrees of simplification and hence the implicit assumption will often not be true. That said, within the last five years, Mercer has observed that an increasing number of recordkeepers now have the ability to offer dollar-weighted crediting of fund revenue share, making the lowest net cost approach to share class selection a much more viable option than in years past.

The Department of Labor (DOL) has not issued any formal guidance on the proper treatment of revenue sharing, or more specifically, if plans should strive for the lowest net expense ratio or net cost. However, the DOL has taken the position that plan fiduciaries have a duty to know and evaluate indirect payments to plan vendors, including fund revenue sharing. Fiduciaries should consider whether the total amounts received, directly and indirectly, by their plan vendors are reasonable. Indirect compensation, including the disposition of fund revenue share, must be disclosed to participants. Moreover, fiduciaries should evaluate whether these payments cause potential conflicts of interest and, if so, whether the plan and participants are protected from those conflicts.

There is now also a fairly robust body of case law that offers guidance to plan sponsors given that revenue sharing has been the subject of numerous lawsuits over the past decade. In general, these lawsuits have focused on plan sponsors’ alleged failure to disclose that participant monies were being invested in high-cost mutual fund share classes to pay for plan expenses when lower cost share classes and/or investment vehicles were available.

Fiduciary breach litigation can be the result of law firms reviewing regulatory filings looking for red flags or participants seeking legal representation if a complaint is not adequately addressed by plan management. As noted earlier, the practice of using higher-cost funds with revenue share to decrease net costs may increase the visibility of the plan in the marketplace, since Form 5500 and related publicly available plan documentation are unlikely to adequately define the practice and hence will simply disclose high published expense ratios. As such, it becomes especially important for fiduciaries to document the rationale and benefits of using this approach, if adopted. This includes documenting the potential cost savings to participants relative to zero revenue share funds and disclosing that revenue share is credited back to participant accounts. Plan fiduciaries should consult ERISA counsel as appropriate on fee related legal or regulatory matters.

Using funds where revenue sharing will be credited back to participants to obtain the lowest net cost will generally, in publicly available documents, disclose higher relative published expense ratios. This can attract the attention of the plaintiffs’ bar since the plans’ investment options will possibly appear more expensive compared to non-revenue sharing classes or peer funds.

Reinforcing general principles of ERISA’s fiduciary standard of prudence, court cases have shown that the strongest defense for a fiduciary is to have an established and deliberate decision-making process that considers all relevant material facts, documenting the rationale for fiduciary decisions.

Given the discussion above, we can see that many plan sponsors would prefer an approach that treats all participants equitably and avoids the pitfalls addressed previously, and hence would gravitate to a method that focuses on the lowest published expense ratio. However, this is complicated if the net cost method suggests a lower cost could be achieved. In these cases, if a lower net cost approach is available, the potential impact of this alternative should be considered, but along with the practical challenges of crediting revenue share.

As set out at the beginning, Mercer believes in eliminating revenue sharing to the extent possible.

However, we know there will be circumstances where a plan sponsor may find it appropriate to retain revenue sharing. In such cases, it is important that the plan sponsor consider issues of fee allocation, fee transparency and clarity for participants. Focusing on net cost (i.e., net of revenue sharing expense ratios) and relying on revenue share credits does add more complexity that the plan sponsor should consider.

Regardless of which approach a plan sponsor uses, Mercer is a proponent of disaggregating recordkeeping and investment management fees, including revenue share, identifying all sources of revenue earned, and maintaining the highest possible level of transparency to the plan sponsor and participants.

Sponsors are encouraged to evaluate and document all practices that are periodically reviewed within the context of evolving industry practice and recordkeeper capabilities. Additionally, the plan should review all participant communications to ensure the approach utilized is explained in simple terms that are easily understood by all participants, including those with a limited spectrum of financial knowledge. This will promote greater transparency and participant trust.

Important notices