For years, 401(k) plan service providers have utilized revenue sharing arrangements to "share" in the revenue earned from plan investments as a source of compensation. Until recently, the U.S. Department of Labor ("DOL") had not provided guidance as to whether the revenues received by service providers in conjunction with such arrangements are assets of the 401(k) plan whose investments resulted in the revenues. Recently, the DOL issued Advisory Opinion 2013-03A, which provides valuable guidance for plan sponsors on revenue sharing arrangements.
Revenue Sharing Arrangements Generally
Revenue sharing is a common practice in the retirement plan industry, whereby recordkeepers and other service providers receive payments from mutual funds and other investment funds for the services they provide to the funds. Examples of the payments service providers receive include transactional costs associated with the cost and distribution of investments (Securities and Exchange Commission Rule 12b-1 fees), shareholder servicing fees (such as recordkeeping or administrative fees) and management fees. Revenue sharing payments are charged directly or indirectly to investment fund, and reduce participants' benefits accordingly. The amount of revenue sharing payments provided to the service provider is directly proportional to the amount the service provider's plan clients invest in the funds. Thus, the more a plan invests, the more payments the service provider receives from the investment funds.
Revenue Sharing Payments as Plan Assets
The DOL has promulgated regulations that describe what constitute employee benefit plan assets.1 However, until recently, no DOL guidance has focused on whether revenue sharing payments constitute plan assets. If revenue sharing payments are plan assets, fiduciary obligations would be imposed on the parties involved in such transactions (including service providers, trustees, plan committees, and plan sponsors) under the Employee Retirement Income Security Act of 1974 ("ERISA") and the payments would have to be held in trust.
On July 3, 2013, the DOL issued an advisory opinion to Principal Life Insurance Company ("Principal"), a service provider that provides investment, recordkeeping and other administrative services to 401(k) plans and other participant-directed defined contribution plans. Principal receives revenue sharing payments from investment funds it makes available to plans and retains all such payments in its general asset accounts rather than establishing a special account for the payments. However, as is common practice in the industry, Principal keeps track of the revenue sharing payments attributable to the investments of each of its plan clients and will provide its clients with credits as a result of those payments (commonly referred to as "revenue sharing credits"). Principal will apply the revenue sharing credits to pay for certain plan expenses or will make payments directly into a plan account equal to the amount of the revenue sharing credits.
Principal posed the specific question of whether the revenue sharing payments constitute plan assets under ERISA. In its response, the DOL noted that the answer to that question depends on the facts and circumstances of the revenue sharing arrangement, citing previous DOL guidance, which provides that "ordinary notions of property rights" determine whether an amount is a plan asset under ERISA.2 Under traditional notions of property rights, if a plan has a "beneficial ownership interest" in any property, that property will be a plan asset. Accordingly, determining whether any amount is a plan asset requires a careful analysis of plan documents, service contracts and other instruments describing the revenue sharing arrangement, as well as the actions and representations of the parties involved.
In Advisory Opinion 2013-03A, the DOL pointed to several factors that could suggest that plan has a beneficial interest in revenue sharing payments, including:
- Whether the payments are held in 2 a trust on behalf of the plan;3
- Whether the documents governing the plan specifically provide that separately maintained payments belong to the plan;
- Whether intent has been expressed to grant the plan a beneficial interest in the payments; or
- Whether a representation has been made sufficient to lead participants and beneficiaries of the plan to believe that such payments are plan assets.
The fact that Principal kept track of revenue sharing payments for purposes of its own bookkeeping did not mean that such payments were plan assets prior to the time payments were made to the plan. However, the arrangements giving rise to revenue sharing credits with plan clients create in each such plan a contractual right to receive such credits and the right to have those credits applied to pay certain plan expenses or to receive direct payments to the plan. Those contractual rights are plan assets. Further, any revenue sharing payments that a plan actually receives also are plan assets.
Other ERISA Fiduciary Concerns with Revenue Sharing Arrangements
- Reasonable and Prudent Arrangements
Regardless of whether revenue sharing payments are plan assets, ERISA provides that service contracts and arrangements (and the compensation paid for such services) must be reasonable and the services must be necessary for the establishment and operation of the plan. Furthermore, ERISA's general standards of fiduciary conduct require plan fiduciaries to act prudently and solely in the interest of plan participants in determining whether to enter into or continue contractual relationships with service providers.
The DOL specifically noted that revenue sharing is a component of the service provider relationship that must be analyzed thoroughly. In particular, plan fiduciaries must obtain sufficient information regarding the revenue sharing arrangement so as to be informed as to whether the arrangement is reasonable. To this point, plan fiduciaries must use a prudent process to understand the methodology and formulas associated with revenue sharing in order to properly oversee and monitor the service provider's compensation attributable to such arrangements. Plan fiduciaries should also memorialize and keep a record of the process by which they determine the reasonableness of revenue sharing arrangements.
- Potential Self-Dealing and Conflicts of Interest
Lastly, the DOL noted the potential for self-dealing and conflicts of interest on the part of service providers who are also fiduciaries to the plan by virtue of providing investment advice for a fee. In providing investment advice, Principal could, in theory, influence the decision making process and cause the plan to invest in funds which pay Principal higher revenue sharing payments relative to comparable investments. Even if the revenue sharing arrangement was reasonable, this situation would result in a prohibited transaction simply as a result of the self-dealing and conflict of interest. Accordingly, the DOL suggests that fiduciaries should take into account the potential for self-dealing and other conflicts of interest when determining whether to enter into or continue a revenue sharing arrangement.
Defined contribution plan sponsors, plan committees and other individuals operating in a fiduciary capacity to such plans must consider a number of issues when entering into, negotiating, monitoring, and evaluating revenue sharing arrangements with service providers.