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Callan

Investments
Institute

August 2013

Research

Beyond Revenue Sharing


Exploring DC Fee Payments

Revenue sharing is a standard way to pay defined contribution (DC) participants plan administration
fees. However, many plan sponsors are rethinking this method due to regulatory changes, lawsuits,
and fairness to participants, among other reasons.
Alternative payment methods, such as a dollar charge or a flat basis point fee, can make plan
administration fees more transparent.
Callan recommends progressing through three steps to arrive at an appropriate fee payment policy:
one, determine the fee payment source; two, evaluate and select the fee payment method; and three,
identify the payment approach.
In this white paper, we explore trends in fee payments, alternatives to revenue sharing, and implications
for plan sponsors and participants.

Introduction
Is revenue sharing in DC plans going the way of the buggy whip? Several trends may be making such fee
payment approaches less palatable, including:
Recently implemented Department of Labor (DOL) fee disclosure requirements, which shed a much
brighter light on revenue sharing arrangements for both DC plan sponsors and participants
Fee lawsuits, such as Tussey vs. ABB, Inc., that target revenue sharing arrangements, among other fees
Growing concerns about the fairness of fee payments when revenue sharing is employed
Greater flexibility by recordkeepers to accommodate alternatives to revenue sharing
Increased availability ofand comfort withinstitutional structures such as collective trusts and
separate accounts, which often do not offer revenue sharing
In light of these trends, we consider the current state of revenue sharing, examine typical challenges, and
suggest three steps to take when identifying or revising a fee payment policy.

Knowledge. Experience. Integrity.

Current Environment
Revenue sharing is a standard way to pay DC participants plan administration fees. Revenue sharing is
the practice of rebating a portion of an investment funds expense ratio to the recordkeeper in order to
offset administrative expenses, either through 12b-1 fees, sub-transfer agency fees, or internal allocations.1 According to Callans 2013 DC Trends Survey, plan participants are at least partly responsible for
the payment of administration expenses in 83% of large DC plans, and revenue sharing is employed by
two-thirds of those plans.
ERISA does not preclude the use of revenue sharing. Indeed, the DOLs Field Assistance Bulletin (FAB)
2003-3 (see http://www.dol.gov/ebsa/regs/fab2003-3.html) notes that ERISA contains no provisions specifically addressing how plan expenses can be allocated among plan participants and beneficiaries. However, the same FAB points out that a fiduciary must be prudent in selecting the method of fee payment,
weighing the competing interests of various classes of the plans participants and the effects of different
allocation methods on those interests. The FAB states that a fiduciarys decision must satisfy the solely
in the interest of participants standard. However, it asserts that a method of allocating expenses would
not fail to be solely in the interest of participants merely because it disfavors one class of participants,
provided that the plan sponsor selected this method on a rational basis. In short, provided plan sponsors
engage in a prudent process that is solely in the interest of participants, there is considerable latitude when
it comes to acceptable DC fee payment approacheswhich may include revenue sharing.

The Challenges of Revenue Sharing


So why are plan sponsors reconsidering the use of revenue sharing? Exhibit 1 illustrates one compelling
reason: fee equality. According to Callans 2013 DC Trends Survey, just 2% of plans with revenue sharing
have all of the funds in the lineup pay revenue sharing. Most commonly, 51% to 75% of funds in the DC
plan offer revenue sharing. However, for nearly half of plans, funds that offer revenue sharing payments
are in the minority. Simply put, some participants may pay much more of the plans administration expenses than others, depending on their investment choices. Certain participants might not pay administration
expenses at all.
Exhibit 1
Frequency of Revenue
Sharing Across DC
Fund Lineups

What percentage of the funds in the plan offer revenue sharing or some
kind of administrative allocation back from the investment fund?
0%

0.0%

<10%

13.6%

10% to 25%

13.6%
15.9%

26% to 50%

25.0%

51% to 75%

22.7%

76% to 99%
100%

2.3%
6.8%

Uncertain
0%

5%

10%

15%

20%

25%

30%

Source: Callans 2013 DC Trends Survey

1 An internal allocation is a payment that is made by a recordkeepers proprietary fund within a DC plan to the administration division
of the plans recordkeeper in order to offset administration expenses.

Even when most or all funds in the plan pay revenue sharing, it is probably not at equal levels. Revenue
sharing arrangements are often negotiated between the recordkeeper and the investment manager and can
vary widely.
Exhibit 2 shows three funds with revenue sharing. Their expense ratios range from 80 to 87 basis points,
while revenue sharing varies from as low as 15 basis points up to 40 basis points. Complicating matters,
Fund A has the highest expense ratio, but Fund B has the greatest portion of revenue sharing. If the plan
offered all three funds, a participant with $100,000 in assets and all of his/her money in Fund B would pay
$400 per year in administrative expenses. That same participant would pay only $150 in administrative expenses if he/she chose Fund C instead, despite the fact that Fund B has a lower overall expense ratio. Such
discrepancies in payments are becoming more and more transparent thanks to the DOLs new fee disclosure
regulations, and plan sponsors are weighing their comfort level with these arrangements.
Exhibit 2
Revenue Sharing:
Three Examples

Fund A

Fund B

Fund C

Expense Ratio

0.87%

0.80%

0.81%

Revenue Share

0.25%

0.40%

0.15%

Lawsuits are also giving plan sponsors pause. In 2012, plaintiffs in a DC fee lawsuit against ABB, Inc.2 were
awarded $35 million in a judgment that mentioned revenue sharing more than 100 times. Specifically, the
judgment found that ABB favored funds that offered revenue sharing because this method of fee payment
was more opaque to plan participants and therefore made the plan look more appealing.
The Court ultimately found that ABBs choice to use revenue sharing to pay for recordkeeping expenses
is not uncommon among plan sponsors, [but] ABB failed to assess the prudence of its choice. Moreover,
it found that ABBs choice of target date funds that offered revenue sharing over ones that did not was selfserving and motivated by a desire for ABB to decrease the fees it paid and to maintain the appearance
that employees were not paying for the administration of the plan. It concluded: While revenue sharing is
accepted industry wide as a method of paying for plan recordkeeping services, the prudence of choosing
that option must be evaluated according to the circumstances of each plan. Lawsuits such as this beg the
question: What are prudent circumstances for employing revenue sharing?

Changing the Revenue Sharing Equation


Following the implementation of the DOLs fee disclosure requirements, recordkeepers now offer greater
flexibility in terms of their ability and willingness to support open architecture, and their receptiveness to alternative fee payment structures. Plan sponsors that were constrained to manage their plans under an assetbased fee structure that was fully funded by revenue sharing in the past may now be experiencing greater
freedom. They can explore fee payment approaches that are predicated on fixed-dollar administration costs,
including revenue sharing rebates and explicit fee payments.
2 An online search will yield numerous articles related to this lawsuit. To view legal documents, see http://abberisaaction.com/
ImportantDocuments.aspx.

Knowledge. Experience. Integrity.

When administration fees are based on and fully funded by revenue sharing, the structure and administration are quite simple: Whatever revenue sharing is generated goes to offset plan fees. The complexities lie
in managing fee payment levels when they are tied to assets and to fund investments. After all, asset-based
revenue sharing will fluctuate as asset values change, participants change their asset allocations, and/or
the fund lineup evolves. Fee payments from revenue sharing that were reasonable when assets were $100
million may be very high at $200 million. Further, plan sponsors find that as they replace high-revenue sharing funds with lower-revenue sharing funds, their recordkeepers may object on the grounds that revenue
sharing becomes insufficient to cover plan expenses. Managing the fund lineup is challenging when revenue
sharing is part of the equation. In essence, revenue sharing becomes the tail that wags the dog.
In contrast, a fixed fee approach breaks the link between revenue sharing and the level of fees paid. In a
fixed fee approach, the plan sponsor and recordkeeper agree on the overall cost of administration. Because
actual payments are determined up front, they are far more straightforward, controllable, and transparent,
and there is full flexibility in the fund structure. However, administration can be more challenging. Revenue
sharing may still be used to pay plan fees, but the amount of payment is now disentangled from the method
of payment. If too much revenue sharing is generated relative to the amount required, excess revenue sharing must be used to pay for additional services or rebated back to the plan. Conversely, if revenue sharing is
insufficient to pay the agreed-upon fees, either the plan sponsor or participants must make up the difference
through an explicit fee payment.
Take the example of a fixed fee arrangement where plan costs are assessed to be $100,000 annually. If the
funds in the lineup generate $150,000 annually in revenue sharing, the plan sponsor must decide how to
handle the excess revenue sharing so that the plan is not paying more than it needs to for administration. As
Exhibit 3 shows, the plan may decide to use half the excess revenue sharing ($25,000) to pay for additional
services and then rebate the rest of the money to participant accounts.
Exhibit 3
Example of Fixed Fee
Arrangement

Admin Fees
Required:
$100,000

$100,000 to
Recordkeeper
Revenue Sharing
Generated:
$150,000

$50,000 to Expense
Reimbursement
Account

Source: Callan

$25,000 for
Additional
Services
$25,000
Back to
Participants

To handle excess revenue sharing, a plan sponsor can establish an ERISA expense reimbursement
account. Excess revenue sharing is funneled into this account, and the money can be used to pay for
additional plan expenses such as communication, legal, auditing, and consulting fees. It can also be
directed back to plan participant accounts at the discretion of the plan sponsor.
The administrative complexity of expense reimbursement accounts is that there is very little regulatory
guidance on the appropriate operational approach. These accounts may or may not be viewed as an asset of the plan, and they may or may not expire at the end of the plan or calendar year. Often, all expense

reimbursement account balances that go unused within the plan or calendar year are allocated back to
plan participant accounts (e.g., quarterly). However, not every recordkeeper administers expense reimbursement accounts as plan assets, and not every recordkeeper allows for rebating back to participants.
In essence, the exact approach and the operational process available depend on the recordkeeper.

Alternatives to Revenue Sharing: The Path to Full Fee Transparency


Because of administrative complexities such as those outlined above, some plan sponsors are simply
moving their DC plans away from revenue sharing altogether. This could involve shifting to a fund lineup
that includes the institutional share classes of mutual funds, collective trusts, and even separate accounts.
In this model, participants pay fees through explicit, out-of-pocket approaches, such as a dollar charge
(e.g., $50 per participant) or a basis point fee (e.g., 10 basis points across all investments). According to
Callans 2013 DC Trends Survey, 16% of plans with participant fee payments adopt the former approach
as the sole method of paying administrative expenses, while 13% use the latter. (The remainder largely
use revenue sharing.)
Going back to FAB 2003-3, choosing whether a dollar or basis point fee is most appropriate depends on
what is solely in the interest of participants. It can disfavor one class of participants, provided that a
rational basis exists for the selected method. For example, if administration costs $100,000 per year and
there are 2,000 participants in the plan with a combined $100 million in assets, participants could pay an
annual fee of $50 per person or they could pay 10 basis points annually to cover plan expenses under a
fixed fee arrangement. Which approach is reasonable, appropriate, and fair? One could argue that the $50
per head charge is fair and reasonable because, generally speaking, recordkeeping services are the same
regardless of balance size. Whether a participant has a small balance or a large balance, he/she will use
about the same amount of services.
Exhibit 4 shows how a flat dollar charge translates into basis points for two participants: Participant A has a
$500 balance and Participant B has $200,000. In percentage terms, at 10% the level $50 fee appears to be
punitively high for administering Participant As account. That same $50 amounts to a tiny percentage for
Participant Bs account administration. Some plan sponsors have addressed this small-balance dilemma by
initially waiving plan fees to give participants time to grow their balances in order to reasonably support the
dollar fee. However, this can be challenging for recordkeepers to administer, and may require the plan sponsor to assume the responsibility for any resulting fee shortfalls.

Exhibit 4
Example of Flat Dollar
Fee Arrangement

Participant A: $500

Participant B: $200,000

{ Dollar Fee: $50 }


Fee Paid = 10%

Fee Paid = 0.025%

Source: Callan

Knowledge. Experience. Integrity.

Exhibit 5 uses the same two participant examples but with fees assessed on a percentage basis. It
shows how higher-balance participants could potentially shoulder a very large fee burden. If Participant A
with the $500 balance is charged 10 basis points for administration, he/she pays just $0.50 annually for
plan administrationessentially getting a free ride. In contrast, Participant B with the $200,000 balance
winds up paying $200 in annual fees for similar services.
Exhibit 5

Participant A: $500

Example of Basis Point


Fee Arrangement

Participant B: $200,000

{ Percentage Fee: 10 bps }


Fee Paid = $0.50

Fee Paid = $200

Source: Callan

An ideal solution may be to split the difference and structure the fee so that it is paid partially as a percentage of balances and partially as a flat dollar amount. However, many recordkeepers would require manual
processing or custom programming to facilitate this approach, which could introduce additional costs or
processing errors.

Selecting the Right Fee Payment Approach


Callan recommends the steps outlined in Exhibit 6 to arrive at an appropriate fee payment policy:
1. Determine the source of fee paymentthe plan sponsor, participant, or a combination of both.
2. Evaluate and select the method of fee paymentfixed fee or asset-based fee.
3. Establish the payment approachpercentage fee, dollar fee, 12b-1, revenue sharing, and/or an
internal allocation.

Exhibit 6
Fee Payment
Policy Options

Source of
Fee Payment

Method of
Payment

Plan Sponsor
(flat fee)

Fixed Fee

Payment
Approach
Percentage
Source: Callan

Plan Sponsor +
Participant

Plan Participant

Asset Based

Fixed Fee +
Asset Based

12b-1

Revenue
Sharing

Internal
Allocation

Dollar

12b-1

Revenue
Sharing

Internal
Allocation

More plan sponsors are documenting their DC fee payment policiesand the decision-making process that
led to themin a formal policy statement. According to Callans 2013 DC Trends Survey, more than 40% of
plan sponsors had a written fee payment policy in 2012. The fee payment policy is often part of the investment policy statement (23%), but it may also be a separate document (18%). As with any written DC policy,
the key to making such a document effective is to write it in a way that is actionable, to adhere to the policy,
and to periodically review and revise the policy as needed.

Conclusion
Given the various regulatory, legal, and industry trends of the past few years, it is increasingly important for
plan sponsors to understand, benchmark, and assess both the level of DC plan fees paid and how they are
paid. Fortunately, greater transparency and broader availability of flexible fee payment approaches provide
many DC plans with more latitude than ever before. At the same time, the bar is set higher in terms of serving
the best interests of participants when it comes to plan fee payments. A formal evaluation and documentation
process can help plan sponsors ensure that they are on a prudent and defensible fee payment path.

Knowledge. Experience. Integrity.

Author Lori Lucas, CFA


Lori Lucas, CFA, is Callans Defined Contribution Practice Leader. She sets the direction
of Callans DC business, provides DC support to consultants and clients, and develops
research and insights into DC trends for the benefit of clients and the industry. Lori is a
member of Callans Management Committee and is a shareholder of the firm.
If you have any questions or comments, please email institute@callan.com.
About Callan
Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have
empowered institutional clients with creative, customized investment solutions that are uniquely backed
by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises
on more than $1.8 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a client-focused consulting model to serve public and private
pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms,
investment managers, and financial intermediaries. For more information, please visit www.callan.com.
About the Callan Investments Institute
The Callan Investments Institute, established in 1980, is a source of continuing education for those in
the institutional investment community. The Institute conducts conferences and workshops and provides
published research, surveys, and newsletters. The Institute strives to present the most timely and relevant
research and education available so our clients and our associates stay abreast of important trends in the
investments industry.
2013 Callan Associates Inc.
Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be
reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this
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