How Mutual Fund Revenue Sharing Hurts Retirement Savers

What You Need to Know

The use of mutual fund revenue sharing is very common in the world of 401(k) plans.
Critics of the practice say it results in higher fees and possible conflicts of interest.
A new NBER paper finds strong evidence to suggest revenue sharing increases costs and lowers net-of-fee performance.

The practice of revenue sharing in retirement plans is equal parts complicated and controversial, and a new working paper published by the National Bureau of Economic Research is bound to add fuel to the fire.

According to the paper, 401(k) plans that utilize mutual fund revenue sharing as a method of paying for recordkeeping fees and other administrative services are more expensive on average, and the higher expense ratios are not offset by lower direct fees or by superior performance.

The NBER paper was penned by Veronika Pool of Vanderbilt University; Clemens Sialm of the University of Texas at Austin’s McCombs School of Business; and Irina Stefanescu, principal economist of the Federal Reserve Board.

In sum, the authors find revenue-sharing plans are more expensive and fail to deliver superior net-of-fee performance. Furthermore, the authors show the amount of rebates tends to increase with the market power of the recordkeeper — suggesting that third-party funds may purposefully utilize revenue-sharing arrangements to gain access to retirement assets.

A Source of Fierce Debate

As Pool, Sialm and Stefanescu write, retirement plans are among the most important distribution channels for mutual funds, accounting for approximately two-thirds of the entire $7.7 trillion invested in 401(k) plans in 2021.

As the analysis explains, the same companies that provide mutual fund families are often hired by employers sponsoring 401(k) plans as “recordkeepers,” and they are tasked with helping to establish and administer the set of investment options offered to participants.

The authors posit that 401(k) plans typically adopt an “open architecture” investment approach, whereby the menu includes third-party investment options along with options affiliated with the recordkeeper. Within such arrangements, recordkeepers typically collect compensation through a mix of direct and indirect payments. Often, indirect payments occur in the form of rebates made by third-party mutual funds to the recordkeeper.

Such rebates arise, for example, when third-party fund expense ratios include a charge for administrative services, though these services are outsourced to the plan recordkeeper. According to the authors, if direct and indirect payments do not offset each other, recordkeepers may collect more revenue in the presence of indirect compensation and participants may pay higher fees in their retirement plans.

Additionally, if recordkeepers are better off when they receive compensation indirectly, the paper suggests, they may influence 401(k) sponsors to include (and subsequently keep) funds on the menu that pay a higher rebate.

Staying Power of Revenue-Sharing Funds

To investigate the incentives arising from indirect compensation and their effects on retirement savers, the authors use data on mutual-fund level revenue sharing. Specifically, the trio “hand collected” menu options for the 1,000 largest 401(k) plans in the U.S. for the 2009 to 2013 sample period, based on annual plan-level Form 5500 disclosures filed by plan sponsors.

In studying plan sponsors’ menu change decisions, such as deletions and additions, the authors find funds that use revenue sharing are significantly less likely to be deleted by plan sponsors. In particular, the average deletion rate is around 20% for revenue-sharing funds and 28% for non-revenue-sharing funds.

The authors ran similar tests for fund additions, finding that funds that tend to revenue share on other menus and tend to pay higher rebates are significantly more likely to be added to revenue-sharing plans. Importantly, the authors explain, there appears to be no significant relation between a fund’s tendency to revenue share and its performance outcomes.

“Overall, our results suggest that revenue sharing affects the investment choices offered to plan participants,” the analysis concludes. “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. Consequently, participants face higher all-in fees in revenue sharing plans.”

Do Higher Fees Mean Higher Returns?

As the authors note, a natural follow-up question to this primary analysis is whether higher fees are offset by higher returns for retirement savers. The authors say their data shows this is clearly not the case. In fact, the future performance of revenue-sharing funds is weaker than that of non-sharing funds.

The bulk of the under-performance is driven by higher fees, according to the authors, though revenue-sharing funds still display lower performance even after accounting for fees.

“These results are consistent with the well-documented negative correlation between mutual fund fees and performance,” the authors conclude.

In the final analyses of the paper, the authors use “network centrality measures” to study the market power of recordkeepers, finding similar results. That is, recordkeepers that are more central in the network of families that service 401(k) plans receive higher rebates without reliably delivering superior performance.