12b-1 Fees: How To Avoid Hidden 401(k) Fees
What are 12b-1 fees? How do they crimp 401(k) savings? How do you know if your 401(k) advisor is engaging in revenue sharing?
Mutual fund expense ratios. There, we’ve said it. Just reading that phrase makes the eyelids droop. But those mutual fund expenses are usually the greatest cost of running your company’s 401(k). And because fund expenses are an indirect cost—that is to say you don’t sit down every quarter to write a check to pay them—they can be hard to track.
You know what is harder to track? What a fund’s expense ratio actually covers. For example, the bulk of the expense ratio typically reflects the investment manager’s fee. Often this is a nice round figure like 0.50% or 1.0%. But there is often more to the total fund expense ratio than the management fee. It can include revenue sharing fees which are also paid directly from the assets invested.
What is revenue sharing?
Revenue sharing refers to payments made by a mutual fund to certain service providers. Instead of someone writing a check to pay a service provider, a transfer agent, for example, payment is made by diverting a portion of assets to that provider. Among the most well-known type of revenue sharing fees is the 12b-1 fee.
What is a 12b-1 fee?
The first thing to notice about 12b-1 fees is that the name itself is hardly self-explanatory. To put it into English, a 12b-1 fee is a payment to the broker or advisor who sold you the investment.
The justification for 12b-1 fees—a form of revenue sharing—has been around for decades. The name comes from a 1980 SEC rule that allowed fund companies to be compensated for acting as their own distributors. The purpose of the provision was to encourage the formation and success of mutual fund companies in the wake of the 1970s bear market.
As the industry evolved, the 12b-1 fee became a form of compensation to brokers and advisors for offering the mutual fund to their clients. Today, the 12b-1 fee is commonly used to “pay for access” to one of the large mutual fund platforms. But because the 12b-1 fee is siphoned from fund assets, it is the mutual fund shareholders, not the fund company, paying for the platform access.
In the 401(k) world, a 12b-1 fee often flows to the plan’s investment advisor. The idea is that these assets are taken from the mutual fund shareholders to compensate the retirement advisor for services performed.
Problems with the 12b-1 fee
When it comes to your company’s 401(k), the most obvious problem with 12b-1 fees is that they increase the expense ratio. These fees can range quite a bit, with a maximum allowable by law of 1%, and Motley Fool research article says “funds had an average net expense ratio of 1.19%, an average 12b-1 fee of 0.13%.” And higher expenses cut into fund performance. If a 12b-1 fee could somehow turbocharge fund performance, then perhaps it would make sense to own these more expensive funds. But an examination of returns from funds with and without 12b-1 fees over a 15-year period revealed a clear (and unsurprising) advantage for funds with no 12b-1 expenses.
While paying an additional 0.25% in fund expenses may seem insignificant, such an amount can take a big bite out of returns over several years. Check out our blog post, The 401(k) Expense Ratio, to see how a little bit of fund expense goes a long way toward shrinking retirement assets.
Explanation of how 12b-1 fees and other fund fees can impact retirement savings
|Plan 1||Plan 2||Plan 3|
|Gross Annual Return||7%||7%||7%|
|Fund Expenses (including 12b-1 fees)||0.58%||0.80%||1.30%|
|Return Net of Fees||6.42%||6.20%||5.70%|
|Assets in Year 40||$1,831,422||$1,728,534||$1,441,189|
|Difference from Plan 1||–||-$102,888||-$390,233|
While the 12b-1 fee was originally promoted as a way for fund companies to improve economies of scale and ultimately bring down expenses for fund investors, that has not generally not been the case. What is starting to bring down fund expenses is competitive pressure from low cost passive investments.
Another issue working against 12b-1 fees is how they can seem to be “hidden”. Paying an advisor from the assets of a mutual fund chosen by a plan participant is opaque and unnecessarily complex given the thousands of investment options available today with no 12b-1 add on. How could the average 401(k) participant easily understand which of their retirement fund options were making 12b-1 payments and which ones were not?
Does revenue sharing lower costs?
Some argue that revenue sharing can actually lower the total cost of a 401(k) plan. After all, if it’s cheaper to indirectly pay for the 401(k) costs through mutual fund fees than writing a check, what’s all the fuss?
While some smaller plans may actually benefit from such an arrangement, there are a couple of problems with revenue sharing even aside from the opacity.
First, these types of fees are asset based fees. As assets grow, these fees can increase dramatically. Eventually the money redirected to service providers in this manner can be far greater than what the services would cost under a negotiated fee arrangement.
Some plans have tried to address this pitfall with a revenue neutral fee structure. Here, revenue sharing expenses are rebated to the plan sponsor who then writes a check to the service provider. If the rebate is greater than the actual cost of the services, those dollars are retained for future plan expenses, and perhaps eventually returned to the participants.
While perhaps fair, that arrangement contrasts sharply with regulatory and market trends moving toward simplicity and transparency regarding 401(k) fees.
A less obvious drawback to indirect fees is that the burden is not equally shared among employees. 401(k) participants invested in funds carrying revenue sharing fees are subsidizing those who have not invested in these higher cost funds. Fund line-ups often include a variety of funds with varying fee structures.
Finally, can your 401(k) advisor truly offer unbiased advice to your employees if they receive different asset based compensation depending on which investment an employee chooses? For example, if you plan has a low-cost, passive index fund and an actively managed fund that pays the advisor a fee, which investment do you think the advisor will recommend to your employees? Even if you advisor is a “good guy” they are still conflicted – everyone likes getting paid! By design, ForUsAll is a level-fee fiduciary, which means we get paid the same amount, regardless of which investment options your participants choose. This removes any conflict of interest that we might have when recommending investment selections to your employees, and helps us remain a true fiduciary to you and your employees.
A direct, transparent payment may be the better approach. After all, the Department of Labor’s position is that fiduciaries have a duty to evaluate indirect payments and consider whether the total amounts received, directly and indirectly, by their service providers are reasonable. So if nothing else, revenue sharing adds complexity to your 401(k) plan. It certainly increases the complexity of big, complicated tasks like preparing the Form 5500 or preparing for the annual audit.
Is your advisor engaged in revenue sharing?
Large 401(k)s are less likely to participate in revenue sharing, primarily because they have the clout to include only institutional fund classes in their plans. These lower expense funds have no wiggle room to charge extra fees to support revenue sharing arrangements. In addition, larger plans are more likely to negotiate favorable contracts directly with their service providers, so revenue sharing would be pointless.
But revenue sharing in general remains common. Each mutual fund’s prospectus provides a breakdown of expenses, including 12b-1 fees. But you can get a handle on your plan’s expenses without wading through documents published by each fund in your plan. Retirement plan service providers are required to share information about your plan’s fees. And you, the employer, are required to disclose fees to your plan’s participants. A close examination of this information will reveal how much, if any, indirect payments are covering your plan’s expenses.
But it takes time to properly evaluate the reasonableness of plan fees under ERISA standards. And rounding up fee disclosures while unearthing how vendor payments are being made is more time spent not running your business. Our 401(k) Resources page has a link to a fee checklist that you can use to help understand your plan’s costs.
At ForUsAll we believe that efficiency and transparency are the best policies. If there are simpler ways to pay each vendor and clearly disclose that payment, then why use the less transparent methods of 12b-1 payments and revenue sharing?
If you are looking for a more direct approach to running your 401(k), talk with us to see if an online 401(k) by ForUsAll makes sense for your small business. You can also download the fee evaluation worksheet below to help assess your plan’s costs (and of course identify opaque 12b-1 fees!)