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Important Reminder!!!

Revenue Sharing and Expenses: What’s appropriate?

Moderator: David Edwards, Dodge and Cox

Panelists:Robert Liberto, Segal AdvisorsThomas Mueller, Sanitation Districts of LA County, CAKirstin Poirier-Whitley, Jones Day

The Range of DC Plan Fees and Expenses

Robert Liberto

Segal Advisors

Table of Contents

Plan Administrative Fees

Investment Fees

Mutual Fund Share Classes

Revenue Sharing Arrangements Between Providers

Fee Credits To The Plan

Plan Administrative Fees

Communication/Education

Discount Brokerage

Investment Advisory Services

Participant Loans

Recordkeeping

Investment Fees

Management & Operating (expense ratio) - Ongoing charges for managing the assets of the fund

Sales Charges (loads or commissions) - Transaction cost for buying and selling shares

Wraps - Charges for a variable annuity program, offered by insurance companies, that bundle together a suite of services

Sub-Transfer Agency - Payments to recordkeepers from mutual fund companies related to account servicing

Brokerage - Paid to a broker for purchasing or selling mutual funds

Investment Fees (continued)

Mortality Risk & Administrative Expenses (M&E) - Fees for providing an annuity product and life insurance

Contingent Deferred Sales Charges (CDSC) - Sales charge or load that mutual fund investors pay when selling Class-B shares within a specified number of years of the date on which they were originally purchased

Redemptions - charged when a participant liquidates assets prior to the expiration of the minimum holding period

12b-1 - Fees paid to broker- dealers for fund distribution, marketing and service support

Other Fee Structures/Credits

Mutual Fund Share Classes Retail (A,B,C) - Often used by brokers or advisors - these share

classes carry front-end or back-end loads. Institutional (I,R,Y) - No load funds. Offered in most defined

contribution plans.Revenue Sharing Arrangements Between Providers Payments from Mutual Funds, Mutual Fund Management Companies,

and other investment providers. Often used to reduce recordkeeping and administrative charges to the plans they serve.

Fee Credits to the Plan A portion of or all of the revenue sharing arrangements between

providers can be credited back to the plan to reduce plan cost or pay for other professional services.

Revenue Sharing and Understanding Expenses

Tom Mueller

Sanitation Districts of Los Angeles County

“If you are charged a $0 administrative fee, it does not necessarily mean you are getting a competitive deal.”

Michael Weddell, Watson Wyatt Pensions and Investments

U.S. Senator Peter G. Fitzgerald

• “the mutual fund industry is the world’s largest skimming operation”

• characterizes industry as a $7 billion trough

SEC InquiryConflicts of Interest

“…many companies that offer defined-contribution plans…are unaware of hidden compensation arrangements that influence which funds are included” Gretchen Morgenson New York Times July 7, 2004

• Commissions paid by mutual fund companies that are shared

• Substantially reduce or eliminate participant fees and, in some cases, result in surplus

• Most retirement plans use retail shares• Some mutual funds pay commissions but

others do not (e.g., Vanguard)• Insurance companies not regulated by SEC

What is Revenue Sharing?

“…research has found that 80% of 401(k) style plan participants do not know how much they are paying in fees.”

Government Accountability Office

November 2006

“…less than 60% of plan sponsors claim to understand the revenue sharing agreements in place at their mutual fund companies.”

Plan Sponsor Magazine June 2006

12b-1 Fees(SEC regulated)

• Mutual Fund Co has no sales force• Compensate brokers for selling fund

shares• Typically paid after the 13th month on monies that have remained in the fund• 12b-1 fees may start immediately if forego

dealer concessions• If keep money in fund, why do

commissions continue to be paid?

Dealer Concessions(SEC regulated)

• Also known as Finders Fees (little known)• Load Funds - Load generally waived if

over $1 million (AmFunds $500M)• Paid on all new monies going into fund• Typically 25BP• Paid to broker-of-record as commission

for selling shares - even if load is waived!

• Mutual fund companies do not need to do record keeping (statements, phone calls, etc.)

• Paid to the record keeper -Paid on % of assets, and/or -Per participant (e.g., AmFunds $3 to $12)

• Institutional Shares - may offer rebates too

Sub-Transfer Agency Fees (Not SEC Regulated)

Stable Value Funds -economies of scale will typically dictate availability

of rebates

Management Fee Sharing(Not SEC Regulated)

GAO Recommendations: -Disclose to participants fee information on each fund in a plan.

-Provide a summary of fees that are paid out of plan assets or by participants

Government Accountability Office

November 2006

“I recommend that plan sponsors test the waters at least every three to four years”

Fred Reish Reish, Luftman, Reicher & Cohen

May 2007

Broker-of-Record

• 12b-1 fees and dealer concessions paid to broker-of-record

• Need agreement with each mutual fund • Determines share class & revenue sharing• Broker-of-record may or may not be willing

to share any of these commissions

1997 NASD Letter• Basis for broker/dealer commission

rebates• NASD rules preclude members from

sharing commissions to unregistered broker/dealers

• Plans that purchase mutual fund shares at net asset value are excluded

• Proceeds are used to defray various expenses incurred by the Plan

Excess Revenues to Participants?

• Requested ruling from NASD

• NASD directed Districts to the SEC

• SEC issued “no-action” letter

LACSD-Assets: $140 Million-Fund of Funds: 22 Mutual Funds-All institutional class but 4 funds-Collect commission expense on all 4

retail share funds-Collect sub-t fees on American Funds’

institutional shares

LACSD

-Average Expense ratio = 65BP

-Range of 9BP (Vanguard 500) to 114BP (First American Eagle A

share)-Stable Value Fund

• LACSD has $0 administrative fee structure with low operating fund expenses

• Institutional shares offer a lower expense ratio

• Proprietary funds sometimes offer low expense ratios; beware of fees

• LACSD actually has a surplus balance; rebated to participants

Effect on Participant Fees

Variable Annuities

“Variable annuities make very, very little sense”

Scott Dauenhauer, presidentMeridian Wealth Management

• The “guarantee” is the rate of return• Diversity is lacking if only one GIC• Expenses are often hidden• Backed solely by one insurance company• Insurance company’s general assets• If bankrupt, GIC assets on same level as general creditors (lawsuit?)• Appropriate• Must monitor ratings!• Stable Value Fund difference

GIC’s

“Providers who offer “free” service are typically compensated through fees that are imbedded in their products, rebates from other plan providers and/or the expectation of future revenues”

Standard Retirement ServicesMarch 2007

“I’m afraid the revenue sharing [concept] would just confuse people.”

Third Party AdministratorLos Angeles TimesOctober 2006

President, Profit Sharing/401(k) Council of AmericaLos Angeles TimesSeptember 2006

“Added disclosure could scare them away from 401 (k)s...”

NAGDCA website

“Plan sponsors have the responsibility to monitor not only the fees of their plan but also the compensation of their vendors to make sure that they are reasonable.”

“There is no such thing as a free lunch”

“…but at least

you can find

out the price

before you get the check”

-Zenith Capital, Investment Advisor

What You Don’t Know Can Hurt You:

The Plan Expense Legal Landscape

Kristin Poirier-Whitley

Jones Day

Why be concerned about fee arrangements? – Private Sector v. Governmental Plans

• Most of the regulatory guidance and lawsuits relate to fiduciary obligations under ERISA.

• ERISA is derived from common law of trusts; private and governmental plan fiduciaries have analogous duties.

• Regulatory guidance and outcome of various lawsuits will impact industry standards.

Why be concerned about fee arrangements? - Fiduciary obligations

• Plan must be managed and invested prudently.• Assets must be held for exclusive purpose of

providing benefits and defraying reasonable expenses.

• Plan must be administered solely in interest of plan participants – prohibition on self-dealing.

• Participants must be kept sufficiently informed.

Why be concerned about fee arrangements? – Practical impact on participants – example from DOL website

• Assume that you are an employee with 35 years until retirement and a current plan balance of $25,000. If returns on investments in your account over the next 35 years average 7% and fees and expenses reduce your average returns by .5%, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5%, however, your account balance will grow to only $163,000. The one percent difference in fees and expenses would reduce your account balance at retirement by 28%.

Why is this a hot topic now?Actions by regulatory agencies

• In 1997, the DOL held a public hearing on whether participants were adequately informed about 401(k) fees and expenses. A report followed entitled “Study of 401(k) Plan Fees and Expenses,” which decried a lack of information about these costs.

• The 2005 SEC investigation of 24 pension consultants focused on the method of payment for services. The SEC Staff then issued a “Report Concerning Examination of Select Pension Consultants,” which identified fee disclosures by pension consultants as an issue of regulatory concern.

• In May 2005, the DOL issued a fact sheet entitled “Selecting And Monitoring Pension Consultants – Tips For Plan Fiduciaries,” which offers advice about how to monitor the fees charged and how to identify a service provider’s conflicts of interest.

Why is this a hot topic now?Actions by regulatory agencies (cont.)• Elliott Spitzer, as the New York Attorney General, led investigations

of expense reimbursements and commissions paid to insurance brokers in connection with the sales of variable annuities to retirement plans.

• Proposed changes to Form 5500. The DOL issued proposed rules in September 2006 that would require plan administrators to disclose indirect fees, including revenue-sharing fees, on the Form 5500.

• In October 2006, the Attorney Generals of New York and New Hampshire persuaded ING to set a new industry standard for 403(b) retirement plan disclosures. As part of the agreement, the service provider will provide a simple cover-page summary of all costs for each plan it offers.

Why is this a hot topic now?Actions by regulatory agencies (cont.)

• GAO Report. In November 2006, the Government Accountability Office issued a report entitled “Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” calling for legislative and regulatory changes to provide greater disclosure of fee information.

• Request for Information. On April 25, 2007, the DOL issued a Request for Information seeking input from plan sponsors, participants, and the 401(k) industry with respect to additional disclosure requirements.

The rise of plan expense lawsuits – Who is being sued?

• Service Providers– Haddock v. Nationwide Financial Services

• Trustees sued Nationwide in connection with the revenue sharing it received from funds that it offered as investment options to the plans.

• Court denied defendant’s motion for summary judgment.

• Trier of fact could find that:– Nationwide was a fiduciary with respect to ability to

substitute mutual funds on the investment menu.

The rise of plan expense lawsuits – Who is being sued? (cont.)

• Haddock (cont.)• Trier of fact could find that:

– Revenue sharing dollars were assets of the plan.

• Those amounts were received as a result of Nationwide’s fiduciary status and at expense of plan participants.

– Even if the revenue sharing payments were not plan assets, Nationwide engaged in prohibited transactions – i.e. self-dealing.

The rise of plan expense lawsuits – Who is being sued? (cont.)

• Sisters of Haddock – Governmental 457 plan sponsors suing the providers of annuity wrap products – e.g. ING and Nationwide Financial Services – under common law theories similar to the ERISA theories relied on in Haddock.

• Cousins of Haddock - 403(b) participants suing service providers and unions for ERISA violations under theories similar to those in Haddock plus claims that unions received kickbacks for endorsements.

The rise of plan expense lawsuits –Who is being sued? (cont.)• Other Cousins of Haddock – Plaintiffs’ bar now suing

employers in their capacity as plan sponsors and administrators as well as investment and administrative committees for large 401(k) plans, rather than just the service providers.

• The list of current defendants include: Lockheed Martin, International Paper, Exelon, Caterpillar, United Technologies, Northrup Grumman, General Dynamics, The Boeing Company, Bechtel, Deere & Company, Unisys Corporation, ABB, Inc., Kraft Foods Global, Cigna and General Motors.

• Although large plans tend to have better procedures in place, they are being sued first because more money is at stake.

• A second generation of lawsuits (Deere, Unisys and ABB) add as defendants third-party service providers, such as Fidelity Management and Trust Company.

What are plaintiffs’ theories? - Suits against service providers

• Service provider is a fiduciary.• Revenue sharing payments are plan assets.• Breach of duty of loyalty – i.e. self-dealing – by arranging

for and keeping revenue sharing payments for itself.

What are plaintiffs’ theories? (cont.) - Suits against sponsors and administrators

• Failed to prudently investigate, monitor and control plan expenses, including revenue sharing arrangements.

• Fees are excessive and not incurred solely for benefit of participants.– Revenue sharing = hidden compensation– Retail vs. institutional shares (similar issues with

different classes of retail shares)– Leverage to negotiate lower fees– Active management fees for funds that mimic index

funds– Asset based fees for services that do not expand as

assets expand

What are plaintiffs’ theories? (cont.)- Suits against sponsors and administrators

• Failed to accurately disclose the total amount of fees and expenses paid.

• Any failure to disclose revenue-sharing fees prevents a section 404(c) defense because participants did not have sufficient information to make informed investment decisions.

• ERISA 404(c) relieves plan fiduciaries from liability for participant-directed investments provided certain requirements are satisfied

• Some governmental plans may be subject to similar state laws.

• Even without similar state laws, a similar defense may be argued based on causation.

How are "excess" service fees measured?

• All “revenue sharing” fees?• All “asset based” fees for administrative and

recordkeeping services?• Only amounts that are in excess of market rates?• Only amounts that were not determined to be reasonable

by the plan’s fiduciaries?• Procedural prudence vs. substantive prudence

• Amount disclosed vs. the amount charged?• All fees subject to conflict of interest?

What are the defenses?

• Procedural prudence by plan fiduciaries.• Fiduciary standard of care does not require lowest cost

service; all facts and circumstances were considered.• Plan purchased services in accordance with terms available in

the marketplace; fees were objectively reasonable.• No causal connection between “excess” fees and market-

based losses in participant accounts.• No causal connection between lack of disclosure and

participant investment decisions – detailed knowledge of fee allocations (v. total fee) would not affect investment decisions.

• Disclosures are adequate and any losses were attributable to exercise of participant control (ERISA 404(c) – type defense).

Examples of defenses at work

• Loomis v. Exelon Corp.: Court struck claim for market-based investment losses because no alleged causal connection between such losses and "excess fees."

• Hecker v. Deere & Co.: Motion to Dismiss Granted. – Disclosures which did not include details on revenue

sharing were consistent with express disclosure rules under ERISA and regulations.

• Acknowledged that required disclosures may changed in the future, but not currently required.

• Disclosure regarding revenue sharing would not have enhanced investment decisions.

Examples of defenses at work (cont.)

Hecker v. Deere (cont.) • ERISA 404(c) safe harbor protected defendants with

regard to excess fee allegations.– Participants had available not only 20 funds

selected by defendants, but 2500 other retail funds available through an open window.

– Untenable to suggest all 2500 publicly available investments had unreasonable expense ratios.

– Thus, participants were in a position to exercise control over expenses.

What fee arrangements are receiving the closest scrutiny?

• Anything that can be labeled “revenue sharing.”• Retail shares held in a plan where institutional shares

would have lowered fees (similar issues may arise with different classes of retail mutual funds).

• Active management fees for funds that largely mirror an index fund.

• Payments to the plan sponsor or an affiliate.• Master trusts; allocation of expenses among plans with

multiple layers of expenses.• Payments by a service provider to its affiliates.

Lessons from these cases?

• Fiduciaries should take steps:– To be adequately informed about fees and expenses

when selecting investments and service providers (including understanding the different fees associated with different share classes).

– To ensure that total compensation paid to service providers (taking into account any revenue sharing arrangements) is reasonable and appropriate.

– To adequately disclose fees and expenses to plan participants.

What steps should you take?

• Review and understand the fees charged.- Different types of fees- Whether there is revenue sharing- Differences in expenses between different share

classes and between retail and institutional funds- Require information from service providers

regarding conflicts of interest; consider using DOL’s “Selecting and Monitoring Pension Consultants – Tips for Plan Fiduciaries.”

- Consider using DOL model Fee Disclosure Form

What steps should you take? (cont’d)

• Use competitive bidding to assist with evaluation of reasonableness.

• Negotiate for lower fees, rebates to the plan and more transparent fee structure.

• Use input from independent and experienced consultants.

• Use benchmarking.• Monitor market trends.• Periodically review the performance of plan’s

investment funds and their expenses.• Document your decision-making process.

What steps should you take? (cont’d)

• Review and revise as necessary fee disclosures to plan participants.

• Use legal counsel to review fee structures, participant disclosures and procedures for selecting and monitoring service providers.

• Where plans invest in pooled vehicles or share service providers, carefully allocate expenses among plans.

What may a plan do with fees that are rebated/returned to the plan?

• Allocate to accounts of affected plan participants.• Use to pay administrative expenses of the plan.• For separate investment accounts, apply to increase NAV.• Check to be sure plan documents are not inconsistent with

approach.

Q&A