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Revenue Sharing on Trial

The answer to the complexity, inefficiency, and unnecessarily expensive practice of revenue-sharing so well exposed in Tussey v. ABB is to simply do away with revenue-sharing, writes W. Scott Simon of Prudent Investor Advisors.

W. Scott Simon, 05/03/2012

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award. 

I could just kiss Nanette Laughrey--chastely, of course, on the hand.

Laughrey is the federal judge for the Central Division of the Western District of Missouri who handed down her 81-page opinion in Tussey, et al. v. ABB, Inc., et al. on March 31. That opinion (rendered after a lengthy, four-week "bench" trial before a judge, not a jury) illustrates very clearly, among other things, the complex, inefficient, and unnecessarily expensive Rube Goldberg-like contraption that is revenue-sharing. This contraption in turn befuddles otherwise presumably intelligent employees at plan sponsors who are in charge of running 401(k) plans. The consequences of their ill-informed decision-making contribute directly to a less secure and comfortable retirement lifestyle for plan participants (and their beneficiaries).

About Revenue-Sharing
Every mutual fund bears an annual expense ratio, which is the "cost" that a mutual fund provider such as Fidelity charges an investor for the privilege of choosing to invest in any of that provider's proprietary funds.

In the context of a 401(k) plan, mutual funds are placed on a trading platform maintained by a record-keeper such as Fidelity Trust. That record-keeper as well as other service providers to a 401(k) plan must be paid for the services they provide, such as maintaining a system that participants can access to make changes to their contributions and investment options in a 401(k) plan.

"Revenue-sharing" is a way for these service providers to be paid for rendering such services. In Tussey, for example, Fidelity Trust negotiated revenue-sharing agreements with the different mutual fund companies that maintained funds on Fidelity Trust's platform. Those agreements allow the companies to "carve out" a certain portion (i.e., revenue-sharing) of a fund's annual expense ratio and pay it to Fidelity Trust in exchange for Fidelity Trust's services as the plan trustee and record-keeper.

The expense ratio of a mutual fund that pays revenue-sharing must be inflated to accommodate the extra fee paid to a service provider such as Fidelity Trust. The expense ratio of any fund is paid by a plan participant invested in that fund, so when they invest (unknowingly) in funds that pay revenue-sharing, that inflated fee going to pay a record-keeper and trustee will be paid (unknowingly) by plan participants. In Tussey, for example, plan participants unknowingly paid Fidelity Trust for record-keeping and trustee services whenever they invested in funds that paid revenue-sharing.

In many cases, then, it is plan participants that pay the administrative costs of a 401(k) plan (through an inflated expense ratio), not the plan sponsor. That's why some sponsors think that their 401(k) plans are "free" since plan participants also pay the part of an expense ratio related to investment costs. In such cases, the plan is free to the sponsor, but not to the participants.

The basic problem with revenue-sharing is that it is an inefficient and opaque way to compensate service providers. Its needless complexity leaves many plan sponsors unable to line up costs with the value of services so that they can prudently fulfill their fiduciary duty to determine the reasonableness of costs. In this way, revenue-sharing is like any other third-party payer system. In cases such as Tussey, revenue-sharing costs incurred by plan participants went unnoticed by the plan sponsor and therefore remained unknown, harming plan participants while generating an "unreasonable" profit for Fidelity. (The Tussey Court determined that Fidelity's profit was "unreasonable" to the extent that the revenue-sharing fees it received exceeded the value of the services provided by Fidelity.)

An even more fundamental problem with revenue-sharing is that it places plan sponsors in an untenable position. It essentially makes them hostage to a record-keeper that has already negotiated with various fund companies the amounts of revenue-sharing that will be paid by the mutual funds that the record-keeper "recommends" that a plan sponsor include on a plan's menu of investment options for investing by plan participants. As such, plan sponsors find themselves (usually unknowingly) playing second fiddle to the terms in contracts that have already been entered into by third parties: a record-keeper and the fund companies. The real underlying reason why revenue-sharing exists, of course, is so a plan's record-keeper can control as much as possible its own revenue stream regardless of any negative ERISA implications that may arise in cases such as in Tussey.

There's nothing illegal about revenue-sharing, even when it's not disclosed. When section 408(b)(2) of the Employee Retirement Income Security Act of 1974 (ERISA) is implemented on July 1, plan sponsors will be able to see the amount of revenue-sharing for every fund on a plan's platform that pays it. But the number disclosed will be only a gross revenue-sharing number, not a number that's broken out and tied directly to the cost of each of the services being performed. So even then, plan sponsors will still have the duty to determine whether revenue-sharing payments are "reasonable" (pursuant to ERISA section 404(a)(1)(B)) in relation to the value of the services for which they're expended.

Plan Sponsors Don't Have to Engage in Revenue-Sharing
Revenue-sharing is seen by many plan sponsors and their advisors as something that's a permanent part of the retirement plan marketplace. In writing this month's column, I ran across an email that I wrote four years ago to my partners at Prudent Investor Advisors commenting on an article that I had just read. The article boasted that, after a fee study and analysis of a revenue-recapture program [involving revenue-sharing], a certain $1.6 billion retirement plan was able to realize a savings of $558,000. My comment: "That's significant? Nobody put 2+2 together to remind the plan's fiduciaries that it's a Fidelity bundled plan! No one bothered to tell the fiduciaries that YOU DON'T HAVE TO HAVE A PLAN THAT INCLUDES ANY REVENUE-SHARING IN THE FIRST PLACE! IT DOESN'T HAVE TO BE THAT WAY AT ALL! UNBELIEVABLE IGNORANCE!" (Emphasis in the original.)

The answer to the complexity, inefficiency, and unnecessarily expensive practice of revenue-sharing so well exposed in Tussey is to simply do away with revenue-sharing. As one prominent ERISA attorney noted in concluding his analysis of Tussey: "I would have [a] real question, going forward as a plan sponsor, as to whether it makes any sense at all to continue with revenue sharing. Better to just pay a fixed cost than to risk extensive liability for engaging in revenue sharing." Whoever said that attorneys cannot come to eminently sensible conclusions?

The Players in Tussey
Defendant ABB, Inc. ABB manufactures power and automation equipment. It sponsors a number of retirement plans to attract and retain employees that totaled $1.4 billion in assets in 2000. Two of these plans, the subject of the Tussey lawsuit, are the Personal Retirement Investment and Savings Management Plan and the Personal Retirement Investment and Savings Management Plan for Represented Employees (collectively, PRISM Plans), both 401(k) plans.

Plaintiff Ronald Tussey and others sued ABB, three ABB entities that were responsible in part for running the PRISM Plans, as well as an ABB employee on behalf of a class of present and former ABB employees who participated in the PRISM Plans for damages and injunctive relief. Tussey also sued Fidelity Management Trust Company (Fidelity Trust), the plans' record-keeper (which provided record-keeping services and other administrative services) and the "directed" trustee of the trust (which provided trustee and custodial services such as safe-keeping the assets of the plans), pursuant to direction by ABB. Tussey sued another Fidelity affiliate as well: Fidelity Management & Research Company (Fidelity Research), the investment advisor to the Fidelity mutual funds offered by the PRISM Plans.

The Background of the Tussey PRISM Plans
Fidelity Trust presented ABB with a recommended menu of investment options, which ABB accepted and then directed Fidelity Trust to make available to participants in the PRISM Plans on the Fidelity Trust trading platform. This kind of recommendation is non-discretionary advice. According to Fidelity (and other providers like it), the (legal) buck always stops with a plan sponsor. That is, a sponsor ultimately is solely legally responsible and liable for the selection, monitoring, and replacement of a 401(k) plan's investment options. That's why Fidelity (and other providers like it) is seldom even named as a defendant in lawsuits alleging excessive fees in a plan's investment options, or if it is named, it is not found liable.

In Tussey, participants directed Fidelity Trust to take their contributions and invest them as directed in designated mutual funds from the menu of investment options on the platform maintained by Fidelity Trust for the PRISM Plans. These options included Fidelity "proprietary" mutual funds provided by Fidelity Investments (yet a third Fidelity entity that, unlike Fidelity Trust and Fidelity Research, was not a defendant in Tussey) as well as "non-proprietary" (to Fidelity) funds provided by other fund companies.

Fidelity Trust became the record-keeper for the PRISM Plans beginning in 1995. At first, Fidelity Trust presented ABB with an invoice whose total was derived by multiplying a hard-dollar, per-participant fee by the number of plan participants. ABB paid for Fidelity Trust's record-keeping and trustee services in the 1990s. But eventually the costs for those services were paid by participants in the PRISM Plans who invested in funds that paid revenue-sharing.

Not all mutual funds on the platform maintained by Fidelity Trust for the PRISM Plans paid revenue-sharing. Any participant that invested in such funds paid no revenue-sharing. That means some participants paid more in revenue-sharing while others paid less, with some paying nothing. In addition, different funds paid different levels of revenue-sharing. So some participants in the PRISM Plans were subsidizing the costs of record-keeping and trustee services for other participants not invested in funds that paid revenue-sharing. That's not a level playing field, which leads to some participants getting free rides at the expense of others.

ABB Did Not Know How Much Revenue-Sharing Was Paid to Fidelity Trust
A significant problem for ABB in Tussey is that it had no idea how much revenue-sharing the fund companies were carving out of the funds' expense ratios and then paying to Fidelity Trust. Nor was any revenue-sharing being paid to Fidelity Trust explicitly reported in the fund's prospectus or disclosed as such to plan participants investing in any fund paying revenue-sharing.

Fidelity Trust received "external" revenue-sharing from both Fidelity and non-Fidelity funds, and internal revenue-sharing from Fidelity funds. This was all going on (with the exception of just one fund) without the knowledge of ABB. Defendant John W. Cutler Jr., the director of a PRISM Plans committee since 1999, didn't know that revenue-sharing was being paid to Fidelity Trust for each of the retail-priced mutual funds that constituted Fidelity's proprietary Freedom Funds. Nor did he know that Fidelity charged an additional fee on top of those revenue-sharing fees for its services in deciding how additional funds coming into the Freedom Funds would be allocated. Cutler remained unaware of this fee for nearly five years and became aware of it only when another plan sponsor told him about it.

ABB also had no knowledge of the "internal" revenue-sharing received by Fidelity Trust such as in the case of Fidelity's Magellan Fund: whenever participants in the PRISM Plans invested in the Fidelity Magellan Fund (one of the mutual funds on the Fidelity Trust platform), a set number of basis points was carved out and transferred internally from Fidelity Research, which managed the Magellan Fund, to Fidelity Trust.

The Consequences of a 'Know-Nothing' ABB
ABB was a "Know-Nothing" concerning the amount of revenue-sharing fees that the participants in the PRISM Plans were paying to Fidelity, but Fidelity knew exactly the amount of those fees.

Fidelity Trust had no fiduciary duty to ABB, the PRISM Plans, or participants in the plans to utter a peep about the amount of revenue-sharing payments it received. When revenue-sharing was paid to compensate Fidelity Trust, its fee grew as the assets in the funds that provided revenue-sharing grew in value due to increased contributions and favorable markets--even though Fidelity Trust provided no additional services to the PRISM Plans.

On the flip side, when the assets in the funds that provided revenue-sharing declined, the amount of revenue-sharing paid to Fidelity for its services also declined. In times when the assets in the funds that paid revenue-sharing declined below a certain threshold, thereby threatening the amount of revenue-sharing required by Fidelity, Fidelity Trust would let out lots of peeps. At such times, Fidelity Trust demanded (as allowed by its contract with ABB) to be compensated by ABB with hard dollars to make up any shortfalls in its revenue-sharing payments.

So in Tussey, when markets went up in value, Fidelity received increased revenue-sharing payments, but when markets went down in value Fidelity received decreased revenue-sharing payments, but any shortfalls were made up by ABB in hard dollar payments to Fidelity. So heads, Fidelity wins; tails, ABB plan participants (and ABB) lose!

The Court's Findings and Assessment of Damages
The Court found that the ABB defendants breached certain fiduciary duties they owed to the PRISM Plans, including (1) failing to monitor the record-keeping costs earned by Fidelity Trust, (2) failing to negotiate rebates for the PRISM Plans from either Fidelity or other investment companies on the Fidelity Trust platform, (3) selecting more expensive share classes for funds on the Fidelity Trust platform when less expensive share classes were available, (4) improperly removing the Vanguard Wellington Fund (which paid 15 basis points in revenue-sharing) and replacing it with certain Fidelity Freedom Funds (which paid 35 basis points in revenue-sharing) and (5) paying Fidelity Trust an amount that exceeded market costs for services to the PRISM Plans in order to subsidize the corporate services provided to ABB by Fidelity Trust, such as ABB's payroll and record-keeping services for ABB's health and welfare plan and its defined benefit plan.

The Court also found that Fidelity Trust failed to distribute float income solely for the interest of the PRISM Plans and Fidelity Research transferred float income to the plans' investment options instead of to the plans themselves.

The Court determined that the PRISM Plans suffered total monetary damages of $36.9 million at the hands of the defendants: $13.4 million against ABB for its failure to monitor record-keeping costs and negotiate rebates, and $21.8 million for improper mapping of the Vanguard Wellington Fund to certain Fidelity Freedom Funds. The Court assessed monetary damages of $1.7 million against Fidelity for its breaches concerning float income.

The Court also provided injunctive (i.e., non-monetary) relief to the plan, including (1) requiring ABB to initiate a competitive bidding process (including a request for proposal) to select a new record-keeper within the 18-month period beginning on March 31, 2012 (with Fidelity being allowed to respond to the RFP), (2) requiring ABB to monitor the plans' record-keeping costs in accordance with ABB's duties of prudence (pursuant to ERISA section 404(a)(1)(B)) and loyalty (pursuant to ERISA section 404(a)(1)(A)), as well as its duty to follow all plan documents but only to the extent that they don't conflict with ERISA (pursuant to ERISA section 404(a)(1)(D)).

In my next column, I will analyze other issues raised by Tussey.

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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