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New research indicates that mutual funds that offer revenue-sharing compensation to the recordkeepers of 401(k) plans are more likely to be added to the investment menu of those plans and are less likely to be deleted. Meanwhile, participants in the plans are more likely to pay higher fees without the benefit of higher performance.
Effects on menu design
The research, which was published in January, analyzes the practice in 401(k) plans of revenue sharing, which is a common form of indirect compensation for intermediaries in the mutual fund industry. Through revenue sharing, indirect payments or rebates are made to the recordkeepers of 401(k) plans by third-party mutual funds. Recordkeepers, which are the primary intermediary in retirement plans, help establish and administer the set of investment options offered to 401(k) plan participants, according to the paper. According to the paper, revenue sharing affects the menu design of the retirement plans.
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Authors of the paper are Veronika K. Pool of Vanderbilt University, Clemens Sialm of the University of Texas and the National Bureau of Economic Research and Irina Stefanescu of the board of governors of the Federal Reserve System. The research is based on menu options for the 1,000 largest 401(k) plans in the U.S. for the period of 2009 to 2013. In 54% of the plans, recordkeepers "receive a rebate in the form of a revenue-sharing arrangement from at least one fund on the menu," according to the study.
"High revenue-sharing funds are favored by plans," the paper states. "They are more likely to be added as an investment option and are also more likely to be retained. We also document that participants in revenue-sharing plans face significantly higher fees. Our results are consistent with the notion that these less transparent indirect payments allow recordkeepers to extract additional rents from plan participants."
Higher participant fees
Most recordkeepers collect both direct compensation in the form of administrative fees and indirect compensation in the form of revenue-sharing agreements, which are reported as a proportion of fund assets, according to the paper.
Because indirect compensation is less transparent than direct compensation, the paper's authors say intermediaries may be able to overcharge some of their customers, in part by failing to reduce direct fees sufficiently to offset the cost of the indirect fees. That leaves recordkeepers to collect more revenue and participants to pay higher fees. Rebates to the recordkeeper, meanwhile, increase depending on their market power, "suggesting that third-party funds may revenue share to gain access to retirement assets," according to the paper.
The authors found that revenue-sharing plans' higher expense ratios are not offset by lower direct fees.
"Our results indicate that rebates are associated with higher expense ratios in the retirement setting while direct fees are not significantly different across revenue sharing and non-sharing plans," the paper's authors wrote. "Consequently, participants face higher all-in fees in revenue-sharing plans."
In addition, those higher fees are not accompanied by superior performance.
"The future performance of revenue-sharing funds is weaker than that of non-sharing funds," the paper said. "The bulk of the under-performance is driven by higher fees, though revenue sharing funds display lower performance even after accounting for fees."
The higher the rebate, the less likely to be deleted
Revenue-sharing arrangements carry the potential to motivate recordkeepers' decision-making when it comes to a plan's menu design.
"If recordkeepers are better off when they receive compensation indirectly, they may influence 401(k) sponsors to include and subsequently keep funds on the menu that pay a higher rebate, even when these funds are dominated by peer options," according to the paper. "Therefore, revenue sharing may also impose costs on participants through its effect on the menu design."
In fact, supporting that concern, the study found that funds that revenue share are notably less likely to be deleted from plans – the average deletion rate for revenue-sharing funds is 20% and 28% for non-revenue-sharing funds. In addition, the higher the rebate, the less likely a fund is to be deleted. Unsurprisingly, funds with an above-median propensity to revenue share are more likely to be added to plans – having an average addition rate of 0.16% vs. 0.10% for plans with a below-median propensity to revenue share.
"Overall, our results suggest that revenue sharing affects the investment choices offered to plan participants," the study's authors wrote.
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