Mutual Fund Share Class Evaluation: A Focus on "Net" Costs
Increasingly, retirement plan sponsors are looking to attain the lowest share class available for participants; however, in some cases, that decision requires careful analysis. Below, we explore the expense ratios associated with mutual funds that offer multiple share classes.
An expense ratio is defined as the total percentage of fund assets used for administration and investment management of a portfolio. Mutual fund companies offer multiple share classes, each with a different expense ratio. While the investment process is the same for all share classes of a particular fund, there may be different amounts of revenue sharing included in the total cost. Revenue sharing is typically used to help plan sponsors offset the cost of managing and administering the retirement plan on behalf of participants. While the most common type of revenue sharing is the 12b-1 fee, there are other types of fees as well, such as Sub-Transfer Agent fees, Shareholder Servicing fees and/or Finder’s Fees.
Including the fund with the lowest expense ratio (i.e., R6 or I share) has been the recent trend for plan sponsors. Typically, these share classes do not contain any revenue sharing in their expense ratio. As a result, the plan expenses may need to be paid by the plan sponsor or directly by plan participants. Therefore, many plan sponsors are re-examining revenue sharing and exploring new methods to pay for the administration of their retirement plans.
This decision should be simple, considering the net cost should be the cost of management and administration of the mutual fund portfolio; however, this is not always the case. The lowest expense ratio share class may only be available with investment restrictions, which are typically asset-based (i.e., a minimum initial investment) or at a potentially higher net cost (i.e., overall expense ratio minus the revenue share expense) than other share classes.
The net cost is an important consideration when comparing multiple share classes of the same fund. In Exhibit 1 below, all of the share classes have identical net costs, but different quoted expense ratios.
This is typically to be expected when comparing share classes. However, due to costs associated with creating a new share class, legacy revenue sharing agreements between mutual fund companies and recordkeepers, and/or proprietary funds offered by the recordkeeper, the net cost often varies among multiple share classes. Mutual fund companies may also negotiate different revenue sharing agreements with each recordkeeper. Thus, plan sponsors and their consultants must regularly monitor the structure of revenue sharing agreements, expense ratios, and share class differences among the funds offered by the plan’s recordkeeper.
In Exhibit 2, “Large Cap Value A” has a total expense ratio of 0.80 %, with revenue sharing of 0.50%, for a net cost of 0.30%. In comparison, “Large Cap Value I” has a total expense ratio of 0.30%, with 0.05% revenue sharing, hence the net cost to the plan is 0.25%. Large Cap Value R6 has a low expense ratio of 0.30%, but does not share any revenue.
Based on this example, the “I” share is actually less expensive, when factoring in 0.05% of revenue sharing to the plan. Depending on how a plan allocates expenses, “I” shares could have the lowest net cost to the plan as a whole.
The R6 share class is the latest offering from many mutual fund companies. Targeted towards the retirement plan market, the R6 funds offer a low-cost, zero-revenue share structure and, most importantly, no minimum investment requirements for retirement plans. Since the R6 share class is relatively new, it may have a smaller amount of assets under management. Mutual funds have certain fixed costs and benefit from economies of scale; therefore, the expense ratio of the R6 share may be higher than older share classes that have more assets under management. Some asset managers have already addressed this issue and the net cost to the plan is the same in all share classes. It is expected that, over time, as the assets in the fund increase, the expense ratios should decrease.
- The share class with the lowest expense ratio may have a high minimum initial investment to enable economies of scale.
- Expense ratios change; as assets grow in a share class, expense ratios tend to decline.
- Recordkeepers may have different revenue sharing rates, as they are independently negotiated with fund managers.
- Revenue sharing agreements between recordkeepers and fund managers may change or be renegotiated at any time.
- Share classes, expense ratios, and minimum asset requirements should be reviewed on a regular basis to identify potential savings opportunities.
- Recordkeepers that are also fund managers may offer a higher reimbursement rate for their funds when recordkept on their own proprietary platform.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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