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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.

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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