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2007Annual-Revenue_Sharing_and_Expenses

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 Revenue Sharing and Expenses:
      What’s appropriate?
Moderator:
David Edwards, Dodge and Cox

Panelists:
Robert Liberto, Segal Advisors
Thomas Mueller, Sanitation Districts of LA County, CA
Kirstin Poirier-Whitley, Jones Day
The Range of DC Plan Fees and Expenses



               Robert Liberto
              Segal Advisors
               Table of Contents

Plan Administrative Fees

Investment Fees

Mutual Fund Share Classes

Revenue Sharing Arrangements Between Providers

Fee Credits To The Plan
            Plan Administrative Fees

 Communication/Education

 Discount Brokerage

 Investment Advisory Services

 Participant Loans

 Recordkeeping
                   Investment Fees

 Management & Operating (expense ratio) - Ongoing charges
  for managing the assets of the fund
 Sales Charges (loads or commissions) - Transaction cost for
  buying and selling shares
 Wraps - Charges for a variable annuity program, offered by
  insurance companies, that bundle together a suite of services
 Sub-Transfer Agency - Payments to recordkeepers from
  mutual fund companies related to account servicing
 Brokerage - Paid to a broker for purchasing or selling mutual
  funds
            Investment Fees (continued)

 Mortality Risk & Administrative Expenses (M&E) - Fees for
  providing an annuity product and life insurance
 Contingent Deferred Sales Charges (CDSC) - Sales charge
  or load that mutual fund investors pay when selling Class-B
  shares within a specified number of years of the date on
  which they were originally purchased
 Redemptions - charged when a participant liquidates
  assets prior to the expiration of the minimum holding period
 12b-1 - Fees paid to broker- dealers for fund distribution,
  marketing and service support
           Other Fee Structures/Credits
Mutual Fund Share Classes
 Retail (A,B,C) - Often used by brokers or advisors - these share
  classes carry front-end or back-end loads.
 Institutional (I,R,Y) - No load funds. Offered in most defined
  contribution plans.
Revenue Sharing Arrangements Between Providers
 Payments from Mutual Funds, Mutual Fund Management Companies,
  and other investment providers. Often used to reduce recordkeeping
  and administrative charges to the plans they serve.
Fee Credits to the Plan
 A portion of or all of the revenue sharing arrangements between
  providers can be credited back to the plan to reduce plan cost or pay
  for other professional services.
 Revenue Sharing and
Understanding Expenses

               Tom Mueller
    Sanitation Districts of Los Angeles
                  County
“If you are charged a $0
 administrative fee, it does not
 necessarily mean you are getting
 a competitive deal.”

           Michael Weddell, Watson Wyatt
           Pensions and Investments
         U.S. Senator
       Peter G. Fitzgerald
• “the mutual fund industry is the
  world’s largest skimming operation”

• characterizes industry as a $7 billion
  trough
          SEC Inquiry
       Conflicts of Interest
“…many companies that offer defined-
 contribution plans…are unaware of hidden
 compensation arrangements that influence
 which funds are included”
                           Gretchen Morgenson
                           New York Times
                           July 7, 2004
What is Revenue Sharing?
• Commissions paid by mutual fund companies
  that are shared
• Substantially reduce or eliminate participant
  fees and, in some cases, result in surplus
• Most retirement plans use retail shares
• Some mutual funds pay commissions but
  others do not (e.g., Vanguard)
• Insurance companies not regulated by SEC
“…research has found that 80% of
 401(k) style plan participants do
 not know how much they are
 paying in fees.”
       Government Accountability Office
       November 2006
“…less than 60% of plan
 sponsors claim to understand
 the revenue sharing
 agreements in place at their
 mutual fund companies.”

       Plan Sponsor Magazine
       June 2006
        12b-1 Fees
      (SEC regulated)
• Mutual Fund Co has no sales force
• Compensate brokers for selling fund
  shares
• Typically paid after the 13th month on
  monies that have remained in the fund
• 12b-1 fees may start immediately if forego
  dealer concessions
• If keep money in fund, why do
  commissions continue to be paid?
   Dealer Concessions
    (SEC regulated)
• Also known as Finders Fees       (little
  known)
• Load Funds - Load generally waived if
  over $1 million (AmFunds $500M)
• Paid on all new monies going into fund
• Typically 25BP
• Paid to broker-of-record as commission
  for selling shares - even if load is
  waived!
Sub-Transfer Agency Fees (Not
       SEC Regulated)
   • Mutual fund companies do not need to
     do record keeping (statements, phone
     calls, etc.)
   • Paid to the record keeper
      -Paid on % of assets, and/or
      -Per participant (e.g., AmFunds $3 to
      $12)
   • Institutional Shares - may offer rebates
     too
  Management Fee Sharing
   (Not SEC Regulated)

Stable Value Funds
 -economies of scale will
 typically dictate availability
  of rebates
GAO Recommendations:
-Disclose to participants fee information
on each fund in a plan.

-Provide a summary of fees that are paid
out of plan assets or by participants

       Government Accountability Office
       November 2006
“I recommend that plan sponsors
 test the waters at least every three
 to four years”

            Fred Reish
            Reish, Luftman, Reicher & Cohen
            May 2007
        Broker-of-Record
• 12b-1 fees and dealer concessions paid to
  broker-of-record
• Need agreement with each mutual fund
• Determines share class & revenue sharing
• Broker-of-record may or may not be willing
  to share any of these commissions
       1997 NASD Letter
• Basis for broker/dealer commission
  rebates
• NASD rules preclude members from
  sharing commissions to unregistered
  broker/dealers
• Plans that purchase mutual fund shares
  at net asset value are excluded
• Proceeds are used to defray various
  expenses incurred by the Plan
      Excess Revenues to
         Participants?
• Requested ruling from NASD

• NASD directed Districts to the SEC
• SEC issued “no-action” letter
             LACSD
-Assets: $140 Million
-Fund of Funds: 22 Mutual Funds
-All institutional class but 4 funds
-Collect commission expense on all 4
  retail share funds
-Collect sub-t fees on American Funds’
  institutional shares
           LACSD
-Average Expense ratio = 65BP
-Range of 9BP (Vanguard 500)
to 114BP (First American Eagle A
  share)
-Stable Value Fund
Effect on Participant Fees
 • LACSD has $0 administrative fee
   structure with low operating fund
   expenses
 • Institutional shares offer a lower
   expense ratio
 • Proprietary funds sometimes offer low
   expense ratios; beware of fees
 • LACSD actually has a surplus balance;
   rebated to participants
Variable Annuities

 “Variable annuities make
       very, very little sense”

        Scott Dauenhauer, president
        Meridian Wealth Management
             GIC’s
• The “guarantee” is the rate of return
• Diversity is lacking if only one GIC
• Expenses are often hidden
• Backed solely by one insurance company
• Insurance company’s general assets
• If bankrupt, GIC assets on same level as
general creditors (lawsuit?)
• Appropriate
• Must monitor ratings!
• Stable Value Fund difference
“Providers who offer “free” service
are typically compensated through
fees that are imbedded in their
products, rebates from other plan
providers and/or the expectation of
future revenues”

              Standard Retirement Services
              March 2007
“I’m afraid the revenue
sharing [concept] would just
confuse people.”

         Third Party Administrator
         Los Angeles Times
         October 2006
“Added disclosure could scare
them away from 401 (k)s...”


           President, Profit Sharing/401(k)
           Council of America
           Los Angeles Times
           September 2006
“Plan sponsors have the
responsibility to monitor not only
the fees of their plan but also the
compensation of their vendors to
make sure that they are
reasonable.”

                 NAGDCA website
“There is no such thing as a free lunch”


   “…but at least
   you can find
   out the price
   before you get the check”

         -Zenith Capital, Investment Advisor
What You Don’t Know Can Hurt You:
The Plan Expense Legal Landscape

          Kristin Poirier-Whitley
               Jones Day
Why be concerned about fee arrangements?
– Private Sector v. Governmental Plans

   • Most of the regulatory guidance and lawsuits
     relate to fiduciary obligations under ERISA.
   • ERISA is derived from common law of trusts;
     private and governmental plan fiduciaries have
     analogous duties.
   • Regulatory guidance and outcome of various
     lawsuits will impact industry standards.
Why be concerned about fee arrangements?
- Fiduciary obligations

   • Plan must be managed and invested prudently.
   • Assets must be held for exclusive purpose of
     providing benefits and defraying reasonable
     expenses.
   • Plan must be administered solely in interest of
     plan participants – prohibition on self-dealing.
   • Participants must be kept sufficiently informed.
Why be concerned about fee arrangements? –
Practical impact on participants – example
from DOL website
    • Assume that you are an employee with 35 years until
    retirement and a current plan balance of $25,000. If
    returns on investments in your account over the next
    35 years average 7% and fees and expenses reduce
    your average returns by .5%, your account balance will
    grow to $227,000 at retirement, even if there are no
    further contributions to your account. If fees and
    expenses are 1.5%, however, your account balance
    will grow to only $163,000. The one percent difference
    in fees and expenses would reduce your account
    balance at retirement by 28%.
Why is this a hot topic now?
Actions by regulatory agencies
 • In 1997, the DOL held a public hearing on whether participants
   were adequately informed about 401(k) fees and expenses. A
   report followed entitled “Study of 401(k) Plan Fees and
   Expenses,” which decried a lack of information about these
   costs.
 • The 2005 SEC investigation of 24 pension consultants focused
   on the method of payment for services. The SEC Staff then
   issued a “Report Concerning Examination of Select Pension
   Consultants,” which identified fee disclosures by pension
   consultants as an issue of regulatory concern.
 • In May 2005, the DOL issued a fact sheet entitled “Selecting
   And Monitoring Pension Consultants – Tips For Plan
   Fiduciaries,” which offers advice about how to monitor the fees
   charged and how to identify a service provider’s conflicts of
   interest.
Why is this a hot topic now?
Actions by regulatory agencies (cont.)
• Elliott Spitzer, as the New York Attorney General, led investigations
  of expense reimbursements and commissions paid to insurance
  brokers in connection with the sales of variable annuities to
  retirement plans.
• Proposed changes to Form 5500. The DOL issued proposed rules in
  September 2006 that would require plan administrators to disclose
  indirect fees, including revenue-sharing fees, on the Form 5500.
• In October 2006, the Attorney Generals of New York and New
  Hampshire persuaded ING to set a new industry standard for 403(b)
  retirement plan disclosures. As part of the agreement, the service
  provider will provide a simple cover-page summary of all costs for
  each plan it offers.
Why is this a hot topic now?
Actions by regulatory agencies (cont.)
• GAO Report. In November 2006, the Government
  Accountability Office issued a report entitled “Changes
  Needed to Provide 401(k) Plan Participants and the
  Department of Labor Better Information on Fees,” calling
  for legislative and regulatory changes to provide greater
  disclosure of fee information.
• Request for Information. On April 25, 2007, the DOL
  issued a Request for Information seeking input from plan
  sponsors, participants, and the 401(k) industry with
  respect to additional disclosure requirements.
The rise of plan expense lawsuits –
Who is being sued?
• Service Providers
   – Haddock v. Nationwide Financial Services
      • Trustees sued Nationwide in connection with the
        revenue sharing it received from funds that it
        offered as investment options to the plans.
      • Court denied defendant’s motion for summary
        judgment.
      • Trier of fact could find that:
          – Nationwide was a fiduciary with respect to
            ability to substitute mutual funds on the
            investment menu.
The rise of plan expense lawsuits –
Who is being sued? (cont.)
• Haddock (cont.)
     • Trier of fact could find that:
         – Revenue sharing dollars were assets of the
           plan.
             • Those amounts were received as a result
                of Nationwide’s fiduciary status and at
                expense of plan participants.
         – Even if the revenue sharing payments were
           not plan assets, Nationwide engaged in
           prohibited transactions – i.e. self-dealing.
The rise of plan expense lawsuits –
Who is being sued? (cont.)
   • Sisters of Haddock – Governmental 457 plan
     sponsors suing the providers of annuity wrap
     products – e.g. ING and Nationwide Financial
     Services – under common law theories similar
     to the ERISA theories relied on in Haddock.
   • Cousins of Haddock - 403(b) participants
     suing service providers and unions for ERISA
     violations under theories similar to those in
     Haddock plus claims that unions received
     kickbacks for endorsements.
The rise of plan expense lawsuits –
Who is being sued? (cont.)
• Other Cousins of Haddock – Plaintiffs’ bar now suing
  employers in their capacity as plan sponsors and
  administrators as well as investment and administrative
  committees for large 401(k) plans, rather than just the service
  providers.
• The list of current defendants include: Lockheed Martin,
  International Paper, Exelon, Caterpillar, United Technologies,
  Northrup Grumman, General Dynamics, The Boeing Company,
  Bechtel, Deere & Company, Unisys Corporation, ABB, Inc.,
  Kraft Foods Global, Cigna and General Motors.
• Although large plans tend to have better procedures in place,
  they are being sued first because more money is at stake.
• A second generation of lawsuits (Deere, Unisys and ABB) add
  as defendants third-party service providers, such as Fidelity
  Management and Trust Company.
What are plaintiffs’ theories?
- Suits against service providers

• Service provider is a fiduciary.
• Revenue sharing payments are plan assets.
• Breach of duty of loyalty – i.e. self-dealing – by arranging
  for and keeping revenue sharing payments for itself.
What are plaintiffs’ theories? (cont.)
- Suits against sponsors and administrators
 • Failed to prudently investigate, monitor and control plan
   expenses, including revenue sharing arrangements.
 • Fees are excessive and not incurred solely for benefit of
   participants.
    – Revenue sharing = hidden compensation
    – Retail vs. institutional shares (similar issues with
      different classes of retail shares)
    – Leverage to negotiate lower fees
    – Active management fees for funds that mimic index
      funds
    – Asset based fees for services that do not expand as
      assets expand
What are plaintiffs’ theories? (cont.)
- Suits against sponsors and administrators
 • Failed to accurately disclose the total amount of fees and
   expenses paid.
 • Any failure to disclose revenue-sharing fees prevents a
   section 404(c) defense because participants did not have
   sufficient information to make informed investment
   decisions.
        • ERISA 404(c) relieves plan fiduciaries from liability
           for participant-directed investments provided
           certain requirements are satisfied
        • Some governmental plans may be subject to
           similar state laws.
        • Even without similar state laws, a similar defense
           may be argued based on causation.
How are "excess" service fees measured?

• All “revenue sharing” fees?
• All “asset based” fees for administrative and
  recordkeeping services?
• Only amounts that are in excess of market rates?
• Only amounts that were not determined to be reasonable
  by the plan’s fiduciaries?
        • Procedural prudence vs. substantive prudence
• Amount disclosed vs. the amount charged?
• All fees subject to conflict of interest?
What are the defenses?
• Procedural prudence by plan fiduciaries.
• Fiduciary standard of care does not require lowest cost
  service; all facts and circumstances were considered.
• Plan purchased services in accordance with terms available in
  the marketplace; fees were objectively reasonable.
• No causal connection between “excess” fees and market-
  based losses in participant accounts.
• No causal connection between lack of disclosure and
  participant investment decisions – detailed knowledge of fee
  allocations (v. total fee) would not affect investment decisions.
• Disclosures are adequate and any losses were attributable to
  exercise of participant control (ERISA 404(c) – type defense).
Examples of defenses at work

• Loomis v. Exelon Corp.: Court struck claim for
  market-based investment losses because no alleged
  causal connection between such losses and "excess
  fees."

• Hecker v. Deere & Co.: Motion to Dismiss Granted.
   – Disclosures which did not include details on revenue
     sharing were consistent with express disclosure rules
     under ERISA and regulations.
      • Acknowledged that required disclosures may
        changed in the future, but not currently required.
      • Disclosure regarding revenue sharing would not
        have enhanced investment decisions.
Examples of defenses at work (cont.)

Hecker v. Deere (cont.)
  • ERISA 404(c) safe harbor protected defendants with
    regard to excess fee allegations.
         – Participants had available not only 20 funds
           selected by defendants, but 2500 other retail
           funds available through an open window.
         – Untenable to suggest all 2500 publicly available
           investments had unreasonable expense ratios.
         – Thus, participants were in a position to exercise
           control over expenses.
What fee arrangements are receiving the
closest scrutiny?
• Anything that can be labeled “revenue sharing.”
• Retail shares held in a plan where institutional shares
  would have lowered fees (similar issues may arise with
  different classes of retail mutual funds).
• Active management fees for funds that largely mirror an
  index fund.
• Payments to the plan sponsor or an affiliate.
• Master trusts; allocation of expenses among plans with
  multiple layers of expenses.
• Payments by a service provider to its affiliates.
Lessons from these cases?

• Fiduciaries should take steps:
   – To be adequately informed about fees and expenses
     when selecting investments and service providers
     (including understanding the different fees associated
     with different share classes).
   – To ensure that total compensation paid to service
     providers (taking into account any revenue sharing
     arrangements) is reasonable and appropriate.
   – To adequately disclose fees and expenses to plan
     participants.
What steps should you take?
 • Review and understand the fees charged.
    - Different types of fees
    - Whether there is revenue sharing
    - Differences in expenses between different share
      classes and between retail and institutional funds
    - Require information from service providers
      regarding conflicts of interest; consider using
      DOL’s “Selecting and Monitoring Pension
      Consultants – Tips for Plan Fiduciaries.”
    - Consider using DOL model Fee Disclosure Form
What steps should you take? (cont’d)
  • Use competitive bidding to assist with evaluation of
    reasonableness.
  • Negotiate for lower fees, rebates to the plan and more
    transparent fee structure.
  • Use input from independent and experienced
    consultants.
  • Use benchmarking.
  • Monitor market trends.
  • Periodically review the performance of plan’s
    investment funds and their expenses.
  • Document your decision-making process.
What steps should you take? (cont’d)

  • Review and revise as necessary fee disclosures to
    plan participants.
  • Use legal counsel to review fee structures, participant
    disclosures and procedures for selecting and
    monitoring service providers.
  • Where plans invest in pooled vehicles or share
    service providers, carefully allocate expenses among
    plans.
What may a plan do with fees that are
rebated/returned to the plan?

•   Allocate to accounts of affected plan participants.
•   Use to pay administrative expenses of the plan.
•   For separate investment accounts, apply to increase NAV.
•   Check to be sure plan documents are not inconsistent with
    approach.
Q&A

				
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