Caveat Adviser: Choose Fund Share Classes With Care

Choosing the right share class needs careful consideration as the Department of Labor (DOL) is paying more attention to investment menu options.

Several larger plans are being sued over costs of investment options. In Tibble v. Edison, cited as a Several larger plans are being sued over costs of investment options. In Tibble v. 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 “9th 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.

Expert sources in the industry weighed in on the subject with a number of observations and some suggestions to help retirement plan sponsors make the right choices for their plans. First, have a fee policy statement that addresses share classes. Next, discuss share class options with the adviser. Do not forget to document the decision process. Would a zero-revenue share class make a difference? Voya Financial (formerly ING U.S.) offers this class, but says fees are comparable. 

Philip J. Koehler, chief executive of ERISA Fiduciary Administrators

Slowly, the curtain has been pulled back on this practice—it’s a key issue. You’d think highly sophisticated managers and advisers would be more aware, but, nevertheless, high-priced, revenue-share classes wind up on investment lineups.

The fiduciaries in Tibble v. Edison decided to include revenue-sharing funds disconnected from any inquiry. 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.

Koehler,  cont.

The 9th Circuit says if you’re going to include these revenue-sharing or retail class shares, and you don’t make some fundamental inquiry as to the availability of lower-cost, non-revenue shares or institutional share classes, that is per se imprudent, and a breach of fiduciary duty.

They didn’t have 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. (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. Or it can limit the extent to which it will accept revenue sharing, such as reimbursement for specific expenses. 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.

Ary Rosenbaum, principal of the Rosenbaum Law Firm

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

A plan could be offering the wrong share class when the very same fund has a less expensive share class. 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. A broker who sees a client only every six months may not be providing enough fiduciary support.

The most important thing is to have the conversation with the investment adviser about what share classes are in each fund, and whether each fund has an appropriate share class for the size of the plan. 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. More expensive funds drag down the rates of return.

The nature of the business plays a part. 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. The financial adviser doesn’t want to negatively impact a relationship that’s a referral source.

James F. Sampson, managing principal, Cornerstone Retirement Advisors

This is something we deal with fairly regularly. The general discussion starts 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. This is how we generally identify if there is a particular aspect to the plan that has a disconnect between the services and fees provided.

The size of the plan is also important. 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. Not necessarily a bad thing, especially if the contract is priced appropriately.

Once plans get bigger and get more into the world of open architecture, then the share class becomes a higher point of scrutiny. However, I don’t think it’s just a matter of “is there a cheaper share class?”, because there other factors are involved. 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.

There needs to be 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…..It gets messy fast. (Just my opinion, I think this is 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).

This whole discussion goes away if all of the fund companies create a zero-revenue share class, allow its use with no minimums, and then plans layer in the necessary fees for recordkeeping/ administrative/custodial/advisory services, or just pay those fees themselves. Some recordkeepers are starting to build platforms that look like this, and it’s a much cleaner approach.

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. And, historically, there are many different ways to generate fees to offset TPA [third-party administrator] expenses, or adviser expenses for a plan. Two years ago we looked at ways to introduce more flexibility to a plan, such as building a product that included funds that didn’t generate any revenue sharing.

R6 share classes were starting to come out at least 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. None are built into cost of R6. So they fit the definition of a no-revenue share fund.

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. We have an explicit daily asset charge that generates the revenues to offer our services. From the feedback we received, it simplifies the story for them.

We look at the balances associated with a plan across all the funds on a daily basis. 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. 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. The fees are comparable at the end of the day.

Bill Elmslie, head of national intermediary distribution and service at Voya Financial’s Retirement Solutions

How does the client want to pay for the services that the providers, vendors and TPA bring to the table? The adviser may gravitate to something that may seem simpler. 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.