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Rekenthaler Report

With 401(k) Plans, What You Don't Know Can Hurt You

The silent damage caused by revenue-sharing agreements.

Rebates--or Kickbacks?
Among the many reasons that Wall Street evokes little public sympathy--in a 2019 poll, even 60% of Republicans supported increased regulation of financial companies--is its habit of camouflaging how it gets paid. All too often, the Street's apparently free services come with strings firmly attached. (Consider, for example, Robinhood's no-cost stock trades.)

Such can be the case with 401(k) plans. Broadly speaking, 401(k) plans incur three types of expenses:

1) Corporate--The cost of researching, establishing, and overseeing the plan.

2) Administrative--The cost of maintaining participant records.

3) Investment--The cost of managing the participants' investments.

The first and third items are straightforward. The company foots the corporate bill, while participants pay the investment costs (usually, but not necessarily, in the form of mutual fund expenses). However, responsibility for the administrative fee varies. Sometimes the company absorbs those costs, sometimes the recordkeeper directly charges participants, and sometimes those fees are covered by payments from the plan's investments.

Should the latter occur, with a fund that is not operated by the recordkeeper itself, the transaction is referred to as a "revenue share." In exchange for the privilege of becoming a plan option, the fund rebates--or, for those in a less generous mood--kicks back some of the expenses that it collects to the recordkeeper. The administrative cost is thus defrayed, but in a fashion that is all-but-invisible to the participant.

Higher Costs
That is the "what you don't know" part from this section's headline. Now comes the discussion of how this practice can hurt. Two academics and a Federal Reserve economist, Veronika Krepely Pool, Clemens Sialm, and Irina Stefanescu, have posted a paper, "Mutual Fund Revenue Sharing in 401(k) Plans." The trio found that, on average, revenue sharing increases the total expenses paid by plan participants, with no apparent benefit.

The authors combed through the Department of Labor filings--documents that also can be requested by 401(k) investors, but which of course rarely are--for the 1,000 largest 401(k) plans from 2009 through 2013. (The wheels of academia turn slowly, as does the progress of DOL filings.) Through this effort, they were able to compare plans that used revenue-sharing schemes against those that did not.

First, some basic statistics. The average participant expense for all plans, including those that permitted revenue sharing and those that did not, was 0.62% of assets per year. Of those 62 basis points, 56 consisted of investment expenses, while 6 basis points came from administrative costs. Slightly more than half of all plans engaged in some form of revenue sharing. When they did, the average amount that was rebated from the fund to the recordkeeper was 0.18% annually.

The immediate question is, after the adjustments are made, are the all-in costs for plans with revenue sharing different than those that forbid the practice? The answer is yes. The costs are higher. Plans with revenue sharing have steeper average fund expense ratios, which is to be expected, since their funds send the recordkeeper some of their receipts. This extra expenditure theoretically could be counterbalanced by reduced administrative fees. In practice, though, it is not.

The authors summarize, "Overall, our findings suggest that plan participants pay more in revenue-sharing plans and, consequently, recordkeepers receive more revenues in these plans. While expense ratios of revenue-sharing funds are higher than those of similar non-revenue-sharing funds, plan administrative expenses are not lower in these plans."

Lower Returns
Naturally, if the pricier funds delivered superior performance, all would be forgiven. However, several decades of mutual fund experience has amply demonstrated that paying higher fund expenses doesn't lead to better results. On the contrary, doing so reduces expected returns, because each dollar that exits the fund in the form of expenses is a dollar that shareholders no longer possess. Fund investors most certainly do not get what they pay for.

To no surprise, the funds in the authors' 401(k) database behaved similarly. They conclude, "The future performance of revenue-sharing funds is significantly weaker than that of non-sharing funds.” Most of that deficit owes to their higher costs, but the "revenue-sharing funds [also] display lower performance even after accounting for fees." Having worse results even after expenses are considered is unusual. If it wasn't for bad luck, it seems, revenue-sharing funds wouldn't have no luck at all.

Practical Implications
This system exists due to happenstance. Because 401(k) investors dislike paying explicit fees, recordkeepers compete aggressively on price, often to the point where the business will lose them money if the revenues are not supplemented. So, they seek remittances from fund companies, most of which will happily pay for the chance to raise additional assets. The intent, by and large, is innocent. A favor for a favor.

Unfortunately, as demonstrated by this paper, the outcome is not so innocent. In essence, 401(k) investors who use plans that have revenue-sharing agreements subsidize investors who do not. That is illogical. Why should one firm's employees have a weaker retirement plan because that organization's benefits department failed to understand the implications of revenue-sharing arrangements? Surely it would be better to require recordkeepers to bid for exactly what they will receive. No undercover payments, no surprises.

Regrettably, such a proposal carries a side effect. Today, recordkeepers that do not also offer funds use revenue sharing as a tool for remaining competitive. Without that ability, they would likely be chased out of the industry, unable to compete with fund companies that underbid for recordkeeping contracts, so that they can acquire a 401(k) plan, into which they will place their funds.

It therefore seems to me that, as appealing as it first appears, banning revenue sharing is impractical. The sounder approach, I think, is to educate plan sponsors, as with the authors' paper. Better-informed buyers make better decisions.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.