James B. Taylor, J.D., ERISA Advisory Manager & Vice President Regions Bank
A recent construction project beside our offices reminded me of the importance of architecture and design in the pursuit of utility and style.
I spend a good bit of time thinking about fiduciary issues and how they impact our clients and Regions, so it was natural for me to draw an analogy to mutual fund share class architecture, which defines the types and characteristics of mutual fund share classes.
In the same way architecture acts as a foundation for buildings, mutual fund share class architecture provides a platform for retirement plans to invest and for participants to save for retirement. There are many ways for a plan sponsor, usually the named plan fiduciary, to construct the plan’s investment mix. A separately managed account arrangement may be desirable if the asset size of the plan permits; however, most plans are not able to access such a solution and will opt for a plan investment portfolio made up of mutual funds. The initial decisions related to fund architecture can have an impact on participant directed retirement plans, in which asset allocation is selected by the participant from a menu of funds provided by the plan, as well as plans that are managed for participants.
Working to achieve efficiency and elegance in a retirement plan, in the best interests of the plan participants and beneficiaries, requires ongoing diligence and prudent action on many fronts, not just with respect to investments. In the context of fund architecture, simplicity is almost always the best approach and transparency is crucial. In order to make a reasonable decision related to plan design, fund selection and how mutual fund fees and other expenses affect a retirement plan, the plan fiduciary must first understand share class architecture. From there, an understanding of a fund’s expense ratio, investment returns and other fees must be ascertained in order to ensure proper due diligence and sound decision making when designing the plan’s investment and expense structure or when selecting and monitoring the service providers hired to advise or manage the plan’s investments.
There are a variety of mutual fund share classes for a plan fiduciary to consider and this decision will affect participant investment returns, plan costs and how fees are paid by a retirement plan and its participants. The choices related to mutual fund share class selection are fiduciary decisions and are precursors to decisions regarding risk tolerance and investment objectives for the plan and participants.
The retail class of mutual funds is broad and typically includes A, B and C shares, with some variations, depending on the company offering the funds. Retail shares apportion expenses and fees in different ways, but are generally designed for the individual investor that uses a broker to transact business. Retail and other shares incur expenses and generate indirect compensation in the form of 12b-1, Sub-Transfer Agent, Shareholder Servicing and other charges that are used to pay for the management, transactions and other activities of the mutual fund, such as research and marketing. This revenue is reflected in the expense ratio of a fund.
For some retail shares, there may also be a front-end sales load, common with A shares that takes a percentage right off the front-end of your investment as a direct charge for the sale of the fund. This front-end sales charge is used to compensate the broker for the transaction. While this direct charge may be high, the overall expense ratio (the ongoing expenses of the fund), which do not include the front-end load percentage, are usually relatively low for A shares. This class may be more appropriate for longer-term individual investors, as they will compensate their broker in this manner and ongoing expenses may be lower as compared to other mutual fund options available to the retail investor.
B shares typically carry a back-end load or a contingent deferred sales charge (CDSC), which means while you do not pay an upfront sales charge when buying a fund, you may pay a charge at the time that you sell the fund. Most back-end loads generally decrease over time and may not apply at all after a stipulated period of ownership. B shares usually carry a higher overall expense ratio, which does not include the CDSC, when compared to A shares and B shares can take significant time to reduce or eliminate the CDSC.
C shares can be similar to B shares in some ways, as they usually do not have a front-end sales load. However, C shares generally have a level load component, where a commission percentage is applied to the entire amount invested in the fund. This level load percentage is generally included in the overall expense ratio of a C share.
In addition to these common retail shares, there are other fund classes that may offer a level load option or a floor and ceiling with respect to front or back-end charges or some combination. There are also no-load fund classes, which do not carry a front-end sales load or a back-end load, but may have a higher overall expense ratio. These share classes may be called D shares or even Z shares and in some cases, no-load funds may not carry a class indicator.
Of course, the devil is in the details. In order to determine the cost of an A share, B share or any mutual fund, a plan fiduciary must understand the front-end load percentage, if any, the back-end load percentage or CDSC, if any, and the overall expense ratio of the fund and use this information to calculate how much a specific investment costs. While there are many types of mutual funds, the analysis of fund cost is similar and can be rather complex with some fund classes.
There are a variety of reasons a retirement plan may invest in retail class mutual funds; however, this is an exception to the general rule that retirement plans should use institutional or I shares, which are generally the lowest cost and have the lowest overall expense ratio when compared to other mutual fund classes. I shares may require a certain minimum asset level for investment, which can preclude some plans from investing in this share class. In such cases, the use of retail or other share classes can be structured in a way to reduce the overall expenses of the plan, using revenue generated by the funds, balancing the use of retail shares against other plan considerations, such as investment returns, record keeping and administrative costs.
In addition to I shares, there may be an R share or other retirement share class available. While many of these retirement shares may provide a low-cost option, the analysis should be the same as is performed for overall fund cost with retail class mutual funds. Expenses and other factors can vary widely so understanding these nuances in mutual fund architecture can be critical for a plan fiduciary to make a sound decision.
There are resources available online, ranging from Morningstar to the SEC and FINRA websites, which provide mutual fund expense calculators and are excellent starting points for mutual fund expense analysis. Alternatively, a plan fiduciary may choose to hire an investment advisor or investment manager to assist or to select the plan’s investments.
The use of I shares or other low-cost share classes can help to provide a clear picture of the plan’s fees and expenses and the actual cost of plan investments. With no complex front and back-end load calculations to perform and because I shares usually generate small amounts of mutual fund revenue, the analysis is simplified. As a result of this transparency, the plan fiduciary should have a better understanding of the cost of services provided to the plan and therefore, make better decisions in the selection of investment services and service providers for the plan.
Another additional benefit to a more transparent fund architecture and fee approach is ease of disclosure to plan participants. The 404(a)(5) participant disclosure rules require certain participant directed retirement plans to disclose a broad range of information to plan participants and this information can be quite confusing and technical. Where fees are clear, concise dollar amounts or percentages and mutual fund revenue has little impact on fee structure, the participant disclosure is often more simple and better understood by plan participants and they are therefore able to make more informed decisions.
Increasing the transparency (and thereby the efficiency and effectiveness with which a retirement plan performs) is a best practice. There are many ways to achieve this goal, but one of the easiest ways to start is to use Institutional or other low-cost investments or mutual fund share classes when designing a plan’s mutual fund investment line up. The long term benefit of lower costs and better, more informed decisions by the plan fiduciary and plan participants, is a big step in the right direction when saving for retirement and working to ensure fiduciary responsibilities related to plan fees and plan investments are properly met.
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