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Case Highlights the Perils of Revenue Sharing

The Tibble v. Edison International case brings some interesting issues to light.

W. Scott Simon, 01/06/2011

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

Much commentary has been generated about Tibble v. Edison International, the first 401(k) excessive investment fee case to go to trial that resulted in a judgment. A federal district court judge in California awarded damages of $370,732 to Glenn Tibble, et al. against Edison, et al. in August 2010. This being America, naturally both Tibble and Edison have appealed the judge's ruling to the U.S. Ninth Circuit Court of Appeals.

I thought it might be of interest to go into some detail in describing the plan governance involved in running a large retirement plan such as the Edison 401(k) plan. That would include the various fiduciary entities comprising Edison's decision-making structure and how they rely on internal staff and outside advisors.

Background
Glenn Tibble is a participant in the Edison 401(k) Savings Plan and lead plaintiff in a class action lawsuit against defendants Edison International, which is the parent company of Southern California Edison Company, the sponsor of the plan; the Southern California Edison Company Benefits Committee; the Edison International Trust Investment Committee; the TIC Chairman's Subcommittee; and certain named fiduciaries of the plan (the defendants).

Administration. The Benefits Committee is the ERISA section 3(16) Plan Administrator of the plan. Members of the Benefits Committee are appointed by the SCE CEO and report to the SCE board of directors. The benefits administration staff is responsible for implementing administrative changes to the plan, overseeing the budget for plan administration costs and monitoring the on-going performance of the plan's record-keeper, Hewitt Associates. Hewitt Associates is responsible for preparing reports concerning the plan that are sent to plan participants and regulators, and maintaining a system that participants can access to make changes to their contributions and investment elections in the plan.

Investments. The SCE and the Edison Board of Directors delegates the authority to select and monitor the plan's investment options to the TIC. (If the TIC were an entity outside of Edison--a bank, insurance company or RIA--then it would be an ERISA section 3(38) Investment Manager with this delegation). The TIC can delegate certain investment responsibilities to the Sub-TIC, which focuses on the selection of specific investment options. The TIC and the Sub-TIC (the investment committees) are fiduciaries of the plan.

The investment committees have the discretionary authority to select, maintain and replace the plan's investment options. SCE's investments staff provides information and recommendations to the investment committees regarding which plan investment options to retain or replace, and is responsible for monitoring and evaluating them. The investments staff does not have any authority over the administration of the plan, the selection of the plan's third-party service providers, or the selection of the plan's investment options (during the relevant time period of Tibble, the Edison plan's menu of investment options had approximately 40 mutual funds available for selection by plan participants).

The investments staff attends the quarterly meetings of the investment committees and gives presentations regarding the plan's overall performance. The investments staff presents information regarding the performance of specific investment options and recommends changes in the plan's menu such as adding or deleting investment options. The investment committees, which have discretion to accept or reject the recommendations of the investments staff, usually accept such recommendations.

Hewitt Financial Services, an affiliate of the plan's record-keeper Hewitt Associates, is the advisor to the plan. The investments staff relies on HFS to provide it with investment advice. For example, HFS provides the investments staff with written monthly, quarterly, and annual reports regarding the performance and fees of the plan's investment options to help monitor them. These reports include short- and long-term performance, annualized performance, risk, and performance of peer groups and benchmarks. The investments staff confers with HFS representatives to review the reports on a quarterly basis, has an annual meeting with HFS to undergo a more in-depth analysis, and confers with HFS on an as-needed basis to discuss specific investment options.

The investments staff also confers with the Frank Russell Trust Company regarding fund performance. The investments staff conducts its own independent analysis regarding the performance of the plan's investment options. This research includes using data from Morningstar, Financial Engines and other sources to track the options' performance. When a new option needs to be added to the plan, the investments staff requests that HFS identify a small number of investment funds that would meet the plan's needs. Additionally, the investments staff conducts independent research to choose a new option to recommend to the investment committees. After the recommendations are made to the Investment Committees during the quarterly meetings, the investment committees may ask questions about the recommendations.

The Duty to Tell Rather Than the Duty to Ask
The judge in the case held that Edison breached its duty of prudence under ERISA section 404(a)(1)(B) by choosing to invest in the higher-cost retail share classes of the three mutual funds in question rather than the lower-cost institutional share classes of the funds. (The judge made clear that he was not holding that institutional-class funds are preferable to retail class funds per se.) No one at Edison (or its outside advisors) appears to have inquired if less-expensive institutional funds were available to replace the mirror-image (except for costs), more-expensive retail funds offered on the plan's menu. One commentator has characterized this as the affirmative "Duty to Ask."

My first reaction after reading the Tibble 80-plus page opinion was to wonder why a large 401(k) plan (with assets of $3.172 billion as of Dec. 31, 2005) would offer plan participants retail priced mutual funds when Hewitt Financial Services was involved as the investment advisor to the plan--with backup from Frank Russell, another well-known, large, and prestigious consultant to sponsors of 401(k) plans. How could that have happened? My issue here is not with Hewitt (or Russell) per se; in fact, it would apply to any advisor in their place.

The judge in Tibble goes on at some length to register his wonder that no one in authority asked if there were any cheaper institutional fund alternatives. Even Edison's own expert witness testified that plan fiduciaries could have obtained institutional share classes with lower fees given the large asset size of the Edison 401(k) plan. The judge also noted that one of Edison's defenses--"hey, we relied on Hewitt for advice"--wouldn't fly. Although reliance on experts is often necessary to evidence a thorough investigation of, say, the costs of different share classes, that reliance must be reasonable, according to the judge. The real-life problem, of course, is that many plan sponsors have little understanding of share classes or much else concerning retirement plans, which is why--to circle back--they rely so heavily on their advisors!

But before charging a plan sponsor with the Duty to Ask--as Tibble shows we must--shouldn't we first expect of an advisor that it exercise the "Duty to Tell" the plan sponsor that there are cheaper investment options available? After all, the Edison Investments Staff relied on Hewitt to provide it with "investment advice" and when a new investment option needed to be added to the plan menu, the staff requested that Hewitt "identify a small number of investment funds" that would meet the plan's requirements. Surely these responsibilities would encompass the requirement to inform Edison's discretionary fiduciaries and their staffs of the availability of cheaper institutional share classes. (According to Morningstar Principia, as of Sept. 30, 2010, the annual expense ratios of the three mutual funds at issue in Tibble ranged from 57 to 157 basis points, 120 to 150 basis points, and 130 to 161 basis points; it's likely that these costs--while quite high, especially for a large plan like Edison's--were even higher during the relevant time period of Tibble.)

The opinion doesn't reveal whether Hewitt was an ERISA section "limited scope" 3(21) fiduciary to the plan. It most likely was providing ongoing advice and acting only as a paid consultant, which implies no fiduciary duties owed to Edison. On the other hand, if Hewitt was a 3(21), and even though its advice may (or may not) have been of value to the Edison plan fiduciaries and their internal staffs, Tibble reveals that a 3(21) limited scope cofiduciary--given its lack of discretion--offers no fiduciary protection to plan sponsors (neither Hewitt nor Russell were even named as defendants by plaintiffs).

Revenue Sharing
So just why were most of the funds in the Edison 401(k) plan priced at retail? A good part of the answer has to do with revenue sharing. "Revenue sharing" refers to the practice by which mutual funds collect fees from mutual fund assets held by participants in their 401(k) accounts and then distribute them to service providers such as a record-keeper like Hewitt Associates, which is an affiliate of Hewitt Financial Services, the plan's advisor. Each type of fee is collected out of the mutual fund assets and is included as a part of a mutual fund's annual expense ratio.

In Tibble, some of the plan's mutual funds offered revenue sharing, which was used to pay for part of the record-keeping costs charged by Hewitt Associates. Hewitt Associates then billed SCE for its services after having deducted the amount received from the mutual funds from revenue sharing. In short, revenue sharing offset some of the fees that SCE would otherwise have to pay to Hewitt Associates. Given this setup, it's easy to see that the defendants might have been motivated to select only mutual funds for the plan that offered revenue sharing, since that would have reduced the fees they would have been required to pay Hewitt Associates.

The judge didn't buy that, noting that the selection of investment options for the plan showed a general trend toward reduced revenue sharing. That is, in 33 out of 39 instances, changes (additions or replacements) to the mutual funds in the plan showed either a decrease or no net change in the revenue sharing received by the plan. But an alternative analysis would show that in 21 out of 39 instances the changes to the mutual funds in the plan showed either an increase or no net change in the revenue sharing received by the plan. In addition, there's no way to tell how much revenue sharing--in actual dollars--changed hands. So, for example, the six instances of mutual fund replacements that increased revenue sharing may (or may not) have dwarfed the 18 instances of mutual fund replacements that decreased (or resulted in no) revenue sharing. The problem is that there's no way to tell one way or the other from the record.

What is clear, however, is that revenue-sharing is seen by many plan sponsors as a way of life; it's something that just seems to be part of the retirement plan landscape. That's wrong, of course: revenue-sharing is simply a legacy of the cost structure that needs to be in place to support a very inefficient system of gathering assets and distributing benefits in retirement plans. For many 401(k) plans laboring under the current revenue-sharing system, there's nothing institutional about it: no institutional provider and no institutional client. For a first-hand look at the Kafkaesque world of revenue sharing, read the excellent white paper issued by Reish and Reicher, a prominent employee benefits law firm, titled "Allocating Fees Among Participant-Directed Plan Participants." The fact that it takes 24 pages (including 60 footnotes)--to fully expose the Rube Goldberg-like revenue-sharing model with its various and sundry contortions, back-flips, dry holes, and rats' nests--shows how crazy and wholly unnecessary the circus of revenue-sharing really is.

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W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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