The past few years have brought a shift toward fee-based retirement plan business, fueled in part by the Department of Labor’s Conflict of Interest Rule. As a result, some advisors have decided to accept some fiduciary responsibility and charge a fee to manage qualified plans—with the goal of remaining competitive in the retirement plan space.
But if you're like many advisors, you may feel hesitant to make this change, preferring to service your plans in a commission model. After all, there is a certain appeal to having all plan-related costs rolled into the expense ratio of the plan. So, how can you determine if a switch to fee-based retirement plan business could work for you? To aid you in the decision-making process, here we will take a closer look at how this model differs from a commission-based one, plus some of the benefits of doing fee-based retirement plan business.
Fee-Based Retirement Plan Business: 12b-1 Fees
So, what exactly does fee-based retirement plan business look like? To help paint the picture, I think it would be useful to start with the ways in which most major recordkeepers accommodate fee-based retirement business. Here, we’ll focus on their treatment of 12b-1 fees (i.e., commissions), which are the marketing and distribution expenses on a mutual fund that are paid by investors.
ERISA bucket. In a commission model, your clients may pay 12b-1 fees directly to your broker/dealer. In a fee-based model, however, recordkeepers can aggregate these fees in an “ERISA bucket.” You may hear this bucket referred to as an expense budget account (EBA), a plan expense reimbursement account (PERA), and an ERISA spending account.
The plan administrator uses that pool to pay for plan-related expenses, including advisor compensation. As the ERISA bucket does not require any change to the existing fund lineup, there would be minimal disruption to your clients.
Crediting back. In a process known as "crediting back," some recordkeepers will credit back the 12b-1s to the participants who generated them and can then charge plan participants a level advisory fee, which typically occurs quarterly on a pro rata basis. Alternatively, the plan sponsor may choose to pay the advisor fee out of pocket, rather than it being charged to participants. In any case, crediting back does not require a fund change.
Clean shares. Clean shares refer to a share class that does not have any 12b-1s. They are typically R5 or R6 share classes. Here, there is no commission getting kicked out, so there is no need to credit anything back. Once again, the recordkeeper can charge plan participants on a pro rata basis, or the plan sponsor can pay out of pocket.
It’s important to note that these are how 12b-1 fees are handled in general. Be sure to speak with your recordkeeping partners to determine what options they have available to accommodate a fee-based business.
Benefits of a Fee-Based Model
Now that you understand how a fee-based model differs in its treatment of fees, let’s move on to the benefits—for you and your clients.
Flexibility to control your profitability. Let’s say that one of your retail clients owns a business that is starting to take off, and your client now has an interest in establishing a 401(k) for the first time. Anyone who has set up a start-up plan or taken over a small plan knows that asset-based compensation can be very nominal—although the amount of work and time you spend with the client certainly is not! It often takes some time before that compensation is meaningful, and you have no flexibility in terms of when you receive a commission, as 12b-1s are fixed. Sure, in this situation you help the client because you value the overall relationship. But it doesn’t mean you should be losing money on servicing the plan.
Fee-based retirement plan business gives you the flexibility to control the profitability of each plan you manage. As such, you can help ensure that you are not losing money when servicing smaller plans. Like an attorney or a CPA, you have the ability to establish a flat fee or an hourly fee arrangement—and charge the client a fee that is on par with your time and level of service delivery.
Competitive pricing. For larger plans, you might consider a flat fee for more competitive positioning. Advisors who charge an asset-based fee get increased compensation as plan assets continue to grow. At a certain point, however, the level of service will typically plateau. The amount of work and time spent servicing a $20 million plan versus a $50 million plan is pretty insignificant. So, can you really justify earning more compensation for the $50 million plan? Here, you might consider segmenting your retirement plans by size or participant counts and setting a flat fee for that segment.
Deductible business expense. As previously mentioned, plan fees do not need to be paid out of plan assets. By structuring the plan using the appropriate fee-based arrangement, plan sponsors have the option to pay for plan expenses out of pocket. As the financial advisor, you would invoice the plan sponsor directly, and the plan sponsor would then pay for your advisory services from the corporate/business assets. When paying for service providers out of pocket, rather than from plan assets, that expense becomes a deductible business expense. This is an opportunity for your clients who own smaller, closely held businesses where their assets make up a lion’s share of the total plan.
To illustrate this point, consider a plan that uses a level commission where all the funds kick off a 50-basis-point commission. On a $1 million plan, that amounts to a $5,000 commission that gets paid to the advisor. If the owners' account balance makes up 90 percent of the plan assets, they are responsible for $4,500 toward the advisor compensation. In this case, because they are paying the majority of the fee anyway, the owners should consider restructuring this plan so they can pay the fee out of business assets and thereby get a business deduction.
Enhanced transparency. In a typical commission arrangement, all plan expenses are captured in the expense ratio of the funds. Unfortunately, it’s not always clear to clients which slice of the pie goes to the various service providers that they are working with. A fee-based arrangement allows for enhanced transparency. Using the clean shares approach, for example, you can break down every expense to a line item. That way, clients know exactly how much they are paying for their investments, recordkeeping fees, TPA fees, and advisor compensation. Having this type of breakdown will help your plan sponsor clients fulfill their fiduciary obligation of making sure fees for plan-related services are reasonable.
Ready to Make the Switch?
If you’re considering making the switch to a fee-based model, be sure to speak with your broker/dealer so you can clearly understand your options. If you decide fee-based retirement business could work for you? Not only will you be keeping up with the trends in the retirement plan space, but you will have flexibility and opportunity not available in a typical commission arrangement.
What other benefits do you see in a fee-based arrangement? Do you think this switch could make you more competitive in the retirement plan space? Please share your thoughts with us below.