Actions and Reactions

Retirement plan providers are under pressure to reduce fees--and are likely to respond by shifting more focus to non-plan products.

Under Newton’s Third Law, for every action, there is an equal and opposite reaction.

Fee compression for retirement plan providers, such as plan recordkeepers and investment providers, is well documented. See, for example,
NEPC: Corporate Defined Contribution Plans Report Flat Fees (noting that fees have stabilized after dropping from 57 basis points in 2006 to 41 basis points in 2017) and Adjusting to the Squeeze of Fee Compression (citing a variety of causes for this compression).

Significantly, this wave of fee compression affects a number of different revenue streams and stems from a variety of different causes:

•      Direct recordkeeping fees are down, with this decrease likely attributable to fiduciary litigation and expanded requirements regarding fee disclosure.
•      Asset management fees are decreasing, with this decrease likely attributable to the growth of passively managed/index funds. See Index funds to surpass active fund assets in U.S. by 2024: Moody’s
•      The ability to leverage recordkeeping relationships to promote proprietary funds is also under pressure; “bundled” plans (where plans use the same provider for recordkeeping and investment funds) is on the decline. See Callan Institute, 2019 Defined Contribution Trends.
•      Insurance companies continue to feel pressure from low interest rates. See Investment News, Insurers pivot amid declining interest rates.

Moreover, these trends are not likely to abate; index funds are here to stay and plan fiduciaries are not likely to decide that they can relax their scrutiny of plan costs. And so, these providers will continue to ramp up their quest for alternative revenue streams.

A New Term for a Long-Standing Problem

As noted, plan fiduciaries are not going to relax their scrutiny of plan costs, so plan providers will look to replace compressed revenue from sources just beyond the scrutiny of (most) plan fiduciaries–through the sale of non-plan products to individuals participating in employer-sponsored plans. Revenue from financial products sold outside of plans that seek to “capture” nontaxable distributions is significantly higher than fees available for in-plan products. See, for example, ICI RESEARCH PERSPECTIVE, The Economics of Providing 401(k) Plans: Services, Fees, and Expenses, 2018, noting that (on an asset weighted basis) fees for retail mutual finds are over 30 percent greater than fees in 401k) plans. And, for more complex products such as annuities, revenue from financial products sold outside of plans can be multiples of the revenue derived from servicing the same assets in-plan.

As fee compression continues to drive down providers’ direct revenue from the in-plan products and services (that are subject to fiduciary scrutiny), providers are likely to ratchet up their cross-selling efforts and increase their focus on transferring assets to more profitable revenue sources outside of a plan–so that the providers can reclaim more “compressed” revenue from these sources and preserve overall (service provider) profitability. And, when plan fiduciaries pose intrusive questions about the cost of products and services provided in-plan, these providers can present very low costs for in-plan products and services, knowing that the higher revenue occurs outside of the plan.

And so, our new term for the day is “revenue rinsing”–providers increasing efforts to transfer assets to more profitable revenue sources outside of a plan and, in effect, keeping the service providers’ revenue “clean” of the pesky questions posed by plan fiduciaries.

Cross-selling (and revenue rinsing) is not new to the DC markets and the need for fiduciaries to pay attention to cross-selling is also not new. As we have noted in the past, providers’ failure to disclose cross-selling efforts and the indirect revenue derived from non-plan products and services impairs fiduciaries’ ability to assess the reasonableness of providers’ compensation, undermines plan health, and erodes participant retirement savings. And, as we have also noted in the past, these cross-selling efforts represent a direct conflict of interest: providers are retained by fiduciaries to administer the employer-sponsored retirement plans and they are not retained to cross-sell non-plan products and services in order to “harvest” retirement savings that accumulate in employer-sponsored plans.

What is new is the increasing–and enduring– importance of cross-selling and the size of the problem created by cross-selling and the undisclosed indirect revenue derived by plan providers. In other words, fee compression leads to (indirect and undisclosed) compensation expansion. What a provider may lose in direct revenue they stand to make up (and more) in indirect revenue.

The Next (Fiduciary) Frontier

As plan providers use revenue rinsing to ameliorate the impact of fee compression, fiduciaries will also need to up their game. And, we are already starting to see some of that. Most notably, recent settlements reached in some high-profile fiduciary litigation have sought to eliminate cross-selling on nonplan products by recordkeepers. See, for example, the settlement agreement in Tracey v MIT (prohibiting plan recordkeeper from “communications to Plan participants (in their capacities as such) concerning non-Plan products and services”.

However, there is too much at stake (financially) for providers to give up on revenue rinsing. Rather, we expect further industry moves to drive revenue rinsing further out of sight. And so, fiduciaries will need to stay vigilant–by doing things like monitoring provider “education” for participants and reviewing distribution patterns for non-taxable distributions– to identify emerging provider practices that will reveal the existence of revenue rinsing. After all, ERISA requires that a prudent fiduciary act with “care, skill, prudence, and diligence under the circumstances then prevailing.” With fee compression, new circumstances are prevailing on plan providers–and on fiduciaries.