12b-1 fees and other revenue sharing arrangements have really become the guts and glue of the retirement plan business. The marketplace has come to rely upon these critical arrangements to subsidize plan administration, investment advice and a whole range of services enjoyed by plans and participants. The fees are now subject to prior disclosure rules under 408b-2 and (very limited) reporting under schedule C. They have become such a fixture in marketplace that there seems to be a growing sense that these fees belong to  the plans whose assets generate them, and that fiduciaries are somehow entitled to them.

Except that this isn’t quite so. There is actually another competing set of fiduciary rules which need to be considered when dealing with revenue sharing, and 12b-1 fees in particular.

Remember the true nature of 12b-1 fees: they are paid from mutual funds to distributors under their selling agreements with an investment company to promote the mutual fund.  Payments are made from a mutual fund’s assets under that fund’s 12b-1 program, authorized by the SEC’s Rule 12b-1 to the  Investment Company Act of 1940,  in order to  promote that mutual fund and to  defray the related distribution costs.   It must be approved initially by the investment company’s board of directors as a whole, and separately by the investment company’s “independent” directors. If the 12b-1 plan is adopted after the sale of fund shares to the general public, it also must be approved initially by a vote of at least a majority of the mutual fund’s voting securities.  

The mutual fund’s Board members are under the fiduciary obligation to the fund shareholders to make sure that those 12b-1 fees are being used for the benefit of promoting and distributing the fund’s shares. I invite you to read the preamble to the 2010 proposed changes to the 12b-1 fees which outlines this obligation in detail. It also contains some great statistics on the use of these fees.

So how is it, then, that a fund’s self-serving distribution payment designed solely to promote the best interest of the mutual fund become subject to the ERISA rule that compensation generated by the plan be paid in the interest of the plan?

Its important to parse out just how this works.  

Starting with the basics, it is the fund distributor who is contractually entitled to the 12b-1 payment, not the plan, and for very specific distribution purposes. The mutual fund’s Board has already had to make a fiduciary determination that the fee is reasonable, in the best interest of the mutual fund shareholders, and that its payment complies with Rule 12b-1.  

Separately, the ERISA plan’s fiduciary can only permit the purchase a mutual fund which has a 12b-1 program if the amount of the 12b-1 fee is reasonable from the plan’s point of view, regardless of whether the mutual fund feels its reasonable.  Going into this determination of reasonableness, however, would be things like how the particular 12b-1 charge stacks up against other competing funds that the plan may be able to purchase and whether, or to what extent, the mutual fund’s distributor (who really does now control the use of the 12b-1 fee to which it is entitled under its selling agreement with the mutual fund) will be used to offset service or other costs incurred by the plan.

It is so easy to presume that the 12b-1 fees belong to the plan, especially because of their pervasive nature in the marketplace. But don’t make this mistake. In the end, a plan’s ability to benefit from 12b-1 fees is only a derivative one.  A plan has no inherent right to a 12b-1 fee generated by the assets it purchases. The right to those fees belong solely to distributor, one who is paid under a selling agreement for promoting the interests of the mutual fund-not the plan.  The plan ‘s fiduciaries obligation is to make sure that the fee is reasonable, that the total amount a distributor receives off of the plan (including 12b-1 fees) is reasonable and, if the distributor commits to sharing the fee, that the commitment is properly honored.  

By the way, It is also important to understand that there can be an element of sales commission built into that fee, payment of which is also  acceptable under ERISA as long as certain conditions are met- a point I have noted in the past.  



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