This article examines the importance of understanding and managing revenue sharing, fee equalization, and net expense ratios in retirement plans to minimize litigation risks. With an increasing number of lawsuits filed against plan fiduciaries for excessive fees, it is crucial for fiduciaries to regularly benchmark their fees, employ fee equalization, and select investment options with the lowest net expense ratios. Furthermore, the article suggests best practices for auditors to include information about fee equalization and share class selection in their audit reports to provide context for Schedule C of Form 5500, potentially reducing litigation risks.
Every investment option has some cost to it, and this cost is known as the fund’s expense ratio. For example, if one invested $100 in a mutual fund with an expense ratio of 1.00%, the mutual fund company would receive $1.00 in revenue as compensation for their services. In some cases, this revenue does not fully stay with the mutual fund company; instead, a portion of it may be shared with a third party, generally an investment advisor, recordkeeper, etc.
Fee equalization occurs when, instead of revenue sharing going to a third party, it gets returned to the participant that generated it. Continuing the prior example, if an individual invested the $100, which generated $1.00 for the mutual fund company, the mutual fund company would keep the $0.75, and the $0.25 in revenue sharing would be returned to the participant’s account. This illustrates an important point when evaluating investment options; in the example we’ve been using here, the mutual fund has a Gross Expense Ratio of 1.00%, but, when fee equalization is enabled, that same fund would have a Net Expense Ratio of 0.75%.
Net Expense Ratio
Net Expense Ratio, while on the surface appearing fairly straightforward, can, on occasion, be a little confusing for plans. For example, assume your plan is using fee equalization, and we continue with the same fund that has a Gross Expense Ratio of 1.00% and a Net Expense Ratio of 0.75%. Let’s call this fund “Neil Fund Class 1.” Now, let’s say, instead of your plan using “Neil Fund Class 1,” it had the option of using “Neil Fund Class 2,” which is invested the exact same way as “Neil Fund Class 1” but has a Gross Expense Ratio of 0.80% and no revenue sharing for you to worry about. Which fund would you select for your plan? All things being equal, you should select “Neil Fund Class 1,” because even though this fund has a higher gross expense ratio (1.00% vs. 0.80%), it has a lower Net Expense Ratio (0.75% vs. 0.80%), and that is what really matters. Mutual funds have different Share Classes like this (i.e., Class 1, Class 2, etc.), so it’s essential to understand these funds’ different expense ratio dynamics and seek out the mutual fund with the lowest Net Expense Ratio that your plan qualifies to use (assuming, of course, that you have determined the mutual fund to be a prudent investment option for your plan; that would be step 1, share class evaluation would essentially be step 2).
Understanding terms like Gross Expense Ratio, Revenue Sharing, Fee Equalization, Net Expense Ratio, and Share Class (and how they apply to your plan) is critically important in today’s litigative landscape. As a result of well-established case precedent, a record number of court cases are being filed against plan fiduciaries claiming that the fees in their plans are excessive. These fiduciaries (who oftentimes do not even realize they are fiduciaries of their company’s retirement plan) are personally liable in their role, which makes this risk an extremely significant one to be aware of, understand, and manage. The solution seems fairly obvious: regularly benchmark your fees, use fee equalization, and seek out the investment option with the lowest net expense ratio. However, even then, you still may not have gone far enough to protect yourself.
Form 5500 and Schedule C
Retirement plans, such as a 401(k) plan, need to file a Form 5500 at year-end with the Department of Labor and Internal Revenue Service. Form 5500 discloses certain information about a plan, such as the number of participants in the plan, assets, etc. There are two types of Form 5500: a short form for small plans and a long-form for larger plans. Larger plans using the long form will include what is known as “Schedule C.” Schedule C, in short, discloses information about compensation arrangements in the plan. Revenue sharing, for example, could be a compensation arrangement, and therefore, when it is present in a plan, the amount of revenue sharing flowing through the plan needs to be disclosed on Schedule C.
Here lies the problem: the revenue sharing will show up on Schedule C regardless of whether you use fee equalization or not; there is no place to specify that your plan is using fee equalization. This means that, to plaintiffs’ attorneys searching for excessive fee plans, you may be using fee equalization, but your plan may present as being very expensive based on the revenue sharing disclosed on Schedule C.
The Crux of the Issue and Fighting Back
You don’t want to deal with this in court. It can be extremely expensive to deal with, and the frequency with which these cases are being filed is one reason why the cost of fiduciary insurance is going up. So, fee equalization is a big deal, and it should be considered in the course of making decisions about which fund to use to access the lowest net expense ratio.
It may seem like an easy issue to resolve with a motion to dismiss is granted once the “truth” about your plan using fee equalization comes to light, but unfortunately, that may be a difficult “fact” to establish. There are instances where courts have not accepted the fact that a plan is using fee equalization at the early stages of considering a motion to dismiss.
Best Practices: Audit Reports
To address this issue, the latest best practice we’re encouraging for our clients is to have their auditors include a paragraph in their audit report indicating that fee equalization is occurring in the plan. Furthermore, if possible, the auditors could include an explanation about share class selection being factored in light of this; that would be a best-case scenario. By taking these measures, it helps to establish the fact in advance so that when the 5500 is submitted to the judge, the accompanying audit report clarifies the handling of revenue sharing and logic behind share class selection, which provides a better context around the compensation disclosed in Schedule C. While this does not guarantee that the judge will consider the fact established, it certainly increases the likelihood that they do, which in turn, should increase the likelihood of a motion to dismiss being granted (assuming that the case is being brought on the grounds of fees where the use of fee equalization would clearly be grounds for dismissal). In fact, the note may even prevent the plaintiff’s attorneys from ever even choosing to proceed with a plan in the first place.
As a plan fiduciary, it is essential to understand and manage revenue sharing, fee equalization, and net expense ratios in retirement plans to minimize litigation risks. Regularly benchmarking fees, employing fee equalization, and selecting investment options with the lowest net expense ratios are vital steps to ensure your plan participants are receiving the best value and that you are fulfilling your fiduciary responsibilities.
To provide further context and help mitigate potential litigation, ask your auditor to include information about fee equalization and share class selection in their audit report. This can help clarify the compensation arrangements disclosed on Schedule C of Form 5500 and establish the fact that your plan is using fee equalization, potentially reducing litigation risks.
Meet the Author
Lead Retirement Plan Consultant
Neil Plein, CPFA™, AIF®
Aldrich Wealth LP
Neil is a Certified Plan Fiduciary Advisor (CPFATM) and Accredited Investment Fiduciary (AIF®) who acts as the quarterback of a retirement plan. He guides employers through the overall plan management with the knowledge to do a deep dive into any aspect of plan operation. Neil connects the dots between internal staff and external service providers…
- Corporate retirement plans
- Recordkeeper selection
- Strategic planning and consultation
- One-to-one consulting participant meetings
- Certified Plan Fiduciary Advisor (CPFATM)
- Accredited Investment Fiduciary (AIF®)