However, many small and mid-sized plans pay for their recordkeeping costs through revenue sharing. For our purposes, “revenue sharing” is defined as payments from mutual funds and their affiliates. That could include payments to the recordkeeper or an affiliate such as 12b-1 fees from a mutual fund, sub-transfer agency fees from the transfer agent for the fund, and revenue sharing from the investment manager for the fund.

In some cases, though, paying a recordkeeper through revenue sharing can produce results that may be seen as unfair (and perhaps even as imprudent). For example, assume that a 401(k) plan has three mutual funds: one with a 50 basis point 12b-1 fee, another with a 25 basis point 12b-1 fee, and a third with no 12b-1 fee. Since 12b-1 fees are charged directly against the investments in the fund (as a higher expense), this means that the participants who invest in the funds that pay those fees are paying for the cost of the recordkeeper.

Continuing with our hypothetical, also assume that the plan covers three participants: A secretary, a bookkeeper, and the owner of the plan sponsor. Then assume that the two lower-paid participants invest in the fund that has a 50 basis point 12b-1 fee and the owner invests in the fund with no 12b-1 fee. If the 12b-1 fees cover the full cost of the recordkeeping, the two rank-and-file participants are paying the entire cost of the recordkeeper and the owner is paying none of the cost. While this is an extreme example, it illustrates an allocation method that is neither pro rata nor per capita and that may be imprudent.

As another example, assume a medical corporation’s 401(k) plan, where all of the doctors are using brokerage accounts that don’t pay revenue sharing to the recordkeeper and all of the rank-and-file participants are invested in mutual funds that do pay revenue sharing to the recordkeeper. In that case, while the doctors may benefit significantly from the plan, they participate without cost for the recordkeeper. While they may pay investment fees, such as commissions on transactions or transaction fees on mutual funds, they’re not paying for the tax benefits of the plan, the plan documents, the reporting and disclosures, and so on. All of those costs are being paid by revenue sharing generated from the investments of the rank-and-file employees.

Are those arrangements fair? That is in the eye of the beholder. Are those allocations of costs prudent? People may disagree; there isn’t any specific IRS or DOL guidance and there haven’t been any reported cases. But I think most people would agree that imposing the burden of the plan’s cost on the rank-and-file participants to the benefit of the highly compensated feels risky.

To compound that matter, there are other potential issues. Under both ERISA and the Internal Revenue Code (the “Code”), it could be a prohibited for a plan fiduciary to use plan assets for his or her personal benefit. If, in the first example, the owner of the company is the primary plan fiduciary, it’s possible that the use of the revenue sharing to free the owner from the cost of the plan could be a prohibited transaction. 

Another issue is that the allocation of the cost of plan services could be a “benefit” or “feature” of the plan (as in “benefit, right or feature”). If it is, and that is not clear, the Code says that, as a qualification matter, plan features cannot discriminate in favor of the highly compensated. In that case, it is possible that the two examples in this article are discriminatory and could potentially disqualify the plan.

So, what can be done? 

The concept of “levelizing” or “equalizing” revenue is the starting point to developing an equitable solution.

There is a concept of “equalization” or “levelizing” costs in which all participants pay a fair share of the costs for recordkeeping. That “fair” share could be a percent of account balances or it could be a dollar amount. In other words, it could be pro rata or per capita.

The key is that all participants would pay a reasonable fee for the benefit of plan participation and the recordkeeper’s services.

Here is one way to accomplish that result: The first step is to restore all revenue sharing payments to the affected participants’ accounts. In that case, the 50 basis point 12b-1 fee in the first example would be restored to the accounts of the secretary and the bookkeeper. Then the recordkeeping fees would be allocated to the three participants, either pro rata or per capita. (As a practical matter, the pro rata method is the most common.)  If we assume that the recordkeeping cost is $1,000 and the owner has 80% of the assets and the two rank-and-file participants have 10% each, the owner’s account would be charged $800 and the other two participant’s accounts would each be charged $100. That is quite a change from the owner paying nothing and the other participants paying the full $1,000. Further, since the two rank-and-file participants had the 12b-1 fees on their accounts restored to their accounts, the net cost to them would be significantly less and maybe even a net gain. (Don’t get too involved in trying to reconcile the revenue sharing amounts and the recordkeeping fees in this hypothetical. This is an example written by a lawyer; the numbers won’t add up.)

Concluding Thoughts

While the law on these issues is not explicit, there are principles that suggest that allocations that disproportionately shift plan costs to rank-and-file participants could be problematic under ERISA and the Code. As a result, the safe course of action is to avoid the risk of a fiduciary breach or plan disqualification. This is particularly significant since, in most cases, the intent of the plan sponsor and fiduciaries is not to accomplish the disproportionate result. Instead, it is likely that the result in inadvertent. Financial professionals to plan sponsors should consider educating them on these issues and the possible solutions. The concept of “levelizing” or “equalizing” revenue is the starting point to developing an equitable solution. Fortunately, most recordkeepers have systems to accommodate the restoration of revenue sharing to the accounts of affected participants and then to allocate the recordkeeping costs to participant accounts on either a pro rata or per capita basis.