Comment: Act Now to Dodge Labor Dept. Bullet on 12b-1 Fees

After years of declining market share, banks are taking advantage of strategic alliances with mutual fund companies to offer bundled defined- contribution products.

Banks today are poised to meet the growing demand for community-oriented providers of employee benefits plans for small businesses.

But an anticipated ruling by the Department of Labor that would prohibit mutual funds from paying 12b-1 fees to banks threatens to dampen the success banks are now beginning to enjoy through these alliances.

At stake is banks' ability to recoup expensive record keeping costs in alliances with third-party mutual funds.

In such arrangements, the bank receives investment management fees only on plan assets that are invested in the bank's proprietary products.

Mutual fund competitors often use investment management revenues to subsidize the costs of providing record keeping services. Without investment management fees from the bulk of the assets or alternative sources of revenue from their alliance partners, banks at an inherent disadvantage in pricing or profit.

The 12b-1 fees that mutual funds charge were originally intended to pay for fund marketing and sales. The fees, whose name comes from the SEC provision that established them in 1980, are paid out to shareholder servicers such as banks or outsourced record keeping providers.

Several sections of the Employee Retirement Income Security Act are open to interpretation that could prohibit payment of these 12b-1 fees.

There is reason for caution at this point. To strengthen their product offering, banks have forged ahead with alliances with outside mutual fund providers. They have done so with compensation schemes, such as 12b-1 or shareholder servicing fees, unanticipated by the retirement security act

But many consider an unfavorable ruling likely before the end of 1996, when the Labor Department is expected to clarify its position regarding 12b-1 fees. Signs include a footnote from a previous departmental ruling stating that 12b-1 fees are commissions (which are explicitly prohibited), as well as recent comments by representatives of the department consistent with stricter interpretations.

The legal community is taking a conservative approach, and most of our clients are being advised by their attorneys to position themselves for a negative ruling.

We recommend reviewing the relevant sections of the retirement security act and developing strategies now, in concert with legal counsel, to address possible upcoming restrictions.

The first section at issue, section 406(a), prohibits transactions between a plan and "parties in interest," including trustees, record keepers, or other providers of services to the plan. An exemption is carved out in cases of services "appropriate and helpful to the plan," but the key here is that transactions must be for services that are "ordinary, necessary, and reasonable." Moreover, fees must be in the range of what is considered "reasonable," commonly defined by market practice.

Steps you should consider include:

*Document the shareholder services you are providing in consideration of fees collected from mutual funds, to show that the fees are not a commission.

*Be certain that services rendered for fees meet the standard of being "ordinary, necessary, and reasonable."

*Make sure the fees you are collecting are within the range of what is considered reasonable. (12b-1 fees are typically 25 basis points.)

Also pertinent is section 406(b), which prohibits fiduciaries from acting in self-interest, or self-dealing. This is the more rigorous test posed to the compensation methods that most employee benefit alliances use, and its solutions are more complex.

Banks might be able to circumvent the self-dealing rule by structuring transactions to take advantage of specific gaps in the regulation. Also, by structuring and articulating limits to their fiduciary responsibilities, trustees might be able to argue that 12b-1 payments do not compromise their fiduciary integrity.

Steps you should consider include:

*Make sure the plan sponsor is choosing the funds made available to participants.

*Clarify responsibility for each fiduciary activity in the master document governing the relationships among the trustee, the plan sponsor, and the alliance partners.

If you are not already doing so, look at ways to credit 12b-1 fees against payments due from the plan, in order to avoid double-dipping. In such a scenario, 12b-1 fees are a revenue stream to the bank used to offset expenses incurred in support of the plan; if you aren't charging separately for these same services, you are not actually in receipt of commission fees as prohibited by the regulation. Further, such an arrangement improves shareholder disclosure, a top concern of the Labor Department.

Of course, the most conservative approach would be to not take any fee at all, but generally this is not a profitable option. In the long term, banks in strategic alliances with third-party mutual funds risk siphoning assets from their proprietary funds, and in turn depleting their own investment management revenues. Beyond brand recognition, there is little advantage to partnering with an outside provider of funds without another form of asset-based compensation.

Beyond the options outlined above, there is one other strategy banks certainly should be pursuing: educating the Labor Department about the serious implications of their 12b-1 policies.

The market is expressing an increased preference for local providers. But if the strategic alliances that make the employee benefits business profitable to banks are undermined, the number of 401(k) providers with a local community presence will undoubtedly shrink.

Mutual fund companies also have an incentive to educate the department on this issue.

The largest growth in the 401(k) marketplace is in very small plans, typically with fewer than 100 participants.

Banks, which have existing relationships with small businesses, are in a much stronger position than most mutual fund companies to meet this demand.

Mutual funds need distribution through the bank channel to garner new shareholders and new assets, and are relying increasingly on alliances with banks.

Mr. Walper is a consulting director and Ms. McBreen a consultant at Spectrem Group, a financial services consulting firm based in San Francisco. Both specialize in retirement services.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER