12b-1 Fees/Revenue Sharing Come Under Increased Scrutiny

by Mark Hebner and IFA Contributors - Wednesday, 25 March, 2015

In the wake of a recent Presidential announcement, mutual fund 12b-1 fees/revenue sharing known as “backdoor payments” as the White House calls them, are under investigation by the Securities and Exchange Commissions (SEC) and the Department of Labor (DOL).

“Plans have primarily used mutual funds with 12b-1 fees as a way of compensating their service providers and/or financial professionals,” says Paula Friedman, a Managing Director at encore401k, in this article. She further elaborates, “These fees are commonly paid by mutual funds as a way to pay providers for offering their funds on the providers’ platform.” In the investment world, this type of setup is commonly referred to as “pay to play.”

In the early years of defined contribution retirement plans, the 12b-1 fee compensation model was widely used, and at one time nearly every 401k plan contained 12b-1 mutual funds in their investment lineup, according to the author of the article, Christopher Carosa. He attributes this to the aggressive marketing by certain sectors of the financial services community, as a vast majority of plans were sold by brokers who could only accept commissions. He notes that since they were not registered investment advisers who could charge a percentage of assets, commissions and 12b-1 fees were the only option for them to be paid.

With the realization that plan costs were unjustifiably high and a rash of lawsuits led by attorneys like Jerome Schlichter, we saw increased regulatory scrutiny around plan fees and service provider compensation. This was the basis for fee disclosure rules enacted in 2012 by the DOL which has led to more sponsors and participants becoming aware of how investment costs negatively impact investment performance. This prompted some plans to reduce or in some cases eliminate revenue sharing.

About two years ago, PBS Frontline aired a documentary called The Retirement Gamble which we wrote about here.  A recent follow-up article to the documentary features an interview with Mr. Schlichter where he decries the practice of record keeping costs being paid as a percentage of assets rather than number of plan participants. Another practice called out by Schlichter is having plan participants pay for other plans (such as executive pension plans) provided to the plan sponsor by the fund company (Schlichter won a $13.4 million judgment against ABB for allowing Fidelity to overcharge 401(k) plan participants in order to subsidize their executive retirement plan. Schlichter identifies several similar potential conflicts of interest that may result from having a bank or insurance company provide a company’s 401(k) plan.

There is no doubt that Schlichter’s lawsuits have played a large role in the call for the fiduciary standard to be applied to brokers that service retirement plans. This call was recently echoed by the chairwoman of the SEC, Mary Jo White, who in an address to the Securities Industry and Financial Markets Association said, “The SEC should implement a uniform fiduciary duty for broker-dealers and investment advisers where the standard is to act in the best interest of the investor. I believe the SEC has an obligation to establish a uniform standard for the industry.” Please note that she did not limit herself to advice provided to retirement investors.  We at Index Fund Advisors will be watching this situation with great interest.  In case you have not seen it yet, we provide the full video of The Retirement Gamble below.