Exclusive Interview with Ron Rhoades: Revenue Sharing – Two Hats are Worse than One

January 31
00:12 2012

From time to time, makes an effort to go beyond the quotes and sit down with thought leaders in the fiduciary arena in hopes of getting them to share some of their deeper thoughts with our readers. This week we’ve been Ron_Rhoades_2010_02_ 01_300fortunate to catch up with Ron A. Rhoades, JD, CFP®, who shared the podium with our own Chief Contributing Editor at an FPA Ethics Symposium in Buffalo, NY last fall.

Dr. Rhoades is an Assistant Professor and Program Chair for the Financial Planning Program at Alfred State College, Alfred, New York. He is also President of ScholarFi Inc., a fee-only RIA firm. Dr. Rhoades has written extensively on the fiduciary obligations of investment and financial advisors. He was the recipient of the 2011 Tamar Frankel Fiduciary of the Year Award, for “changing the nature of the fiduciary debate in Washington.” He also was named one of the Top 25 Most Influential Persons in the advisory profession by Investment Advisor magazine for 2011. Ron currently serves on the National Board of NAPFA. Dr. Rhoades is the author of several books, and many published articles, and frequently contributes to comment letters to government agencies on issues affecting investment adviser compliance and fiduciary duties.

FN: Ron, first off, congratulations on your award. It’s an honor to have this opportunity to talk to you on the topic of fiduciary liability and conflicts of interest. Let’s start with revenue sharing, the popular industry practice where mutual funds pay the fees of broker-dealers, recordkeepers and other service providers in lieu of the plan sponsor paying those fees. Can you share with our readers your thoughts on revenue sharing, why it’s a problem and how it can increase fiduciary liability for the plan sponsor?
Dr. Rhoades: The largest problem with revenue sharing payments, from the standpoint of the plan sponsor, is that they can vary the compensation paid to the investment adviser. The amount of revenue sharing varies from fund company to fund company, and it can also vary based upon either the new assets brought by the broker-dealer to the fund or the assets maintained in the fund, or both. This leads to an inherent conflict of interest – so severe that a true fiduciary cannot effectively manage the conflict. In essence, the fiduciary advisor could receive greater compensation by recommending one fund over another.  Essentially, the broker-dealer would be wearing two hats – a circumstance the “sole interests” ERISA fiduciary standard and the prohibited transaction rules (as originally written, without exemptions) were designed to avoid.

FN: You bring up a good point when you say “as originally written.” The reality is the DOL has now carved out exemptions to the prohibited transaction rules all trustees must abide by. Short of re-establishing a pure fiduciary standard and reinstate these prohibitions, how can plan sponsors best maintain the fiduciary premise in the current regulatory environment?
Dr. Rhoades: In a true fiduciary environment, the compensation of the advisor is established in advance of any recommendations. This insures the compensation of the fiduciary will not vary based upon the recommendations made. The fiduciary acts as the sole representative of the plan sponsor, and is prohibited from wearing two hats. If compensation of any form is then received by the fiduciary from anyone other than the client, then that compensation so received should be credited (in full) against the fiduciary’s agreed-upon fee.

FN: OK, that’s how to deal with the current regulatory environment. But we all know the DOL wants to broaden the definition of “Fiduciary” under ERISA. Do you think this new DOL proposal will fix the current problem?
Dr. Rhoades: While the plain language of ERISA adopts the “sole interests” fiduciary standard – a tougher standard than the “best interests” standard applicable to registered investment advisers – and hence outlaws conflicts of interest, the DOL has provided numerous exemptions from the definition of fiduciary. Hopefully the new rulemaking in this area will rectify this situation, with very few exemptions and with a full implementation of the “sole interests” fiduciary standard of conduct.

FN: Of course, some rather large and entrenched players in the financial services industry have fought the DOL, as well as the SEC, on the issue of the fiduciary standard. Even politicians, many who have expressed concerns about regulations hampering business in a slow economy, have asked the regulators to restrain themselves. Do you believe it’s possible for regulators to create a fiduciary framework consistent with the traditional duties of fiduciaries (i.e., the “fiduciary standard”) that allows existing business models to continue?
Dr. Rhoades: There have been numerous calls by the broker-dealer industry for the DOL to adopt a “compensation-neutral” or “business model-neutral” fiduciary scheme. In reality, however, fiduciary standards act as a restraint on various forms of conduct, and compel certain other types of actions (e.g., extensive due diligence on both overall investment strategy and investment product selection). Hopefully the DOL will force the securities industry to adapt to the fiduciary standard of conduct – it can so adapt, by changing its compensation practices and eliminating revenue-sharing arrangements. Hopefully the fiduciary standard of conduct will not be diminished by seeking to adapt it to the business practices of an industry which remains largely composed of “manufacturer’s representatives.” Many a jurist has warned that, in the end, a true fiduciary cannot wear two hats.

FN: Well, we’ve been talking pretty theoretically up to this point. That’s the professor side of you. Speaking of two hats, let me allow you to don your other hat and speak to the practical side of things. Many plan sponsors would rather focus on improving their business and don’t have a lot of time set aside to address issues important to their 401k. They would rest comfortably, though, if an expert such as yourself gave a few quick-and-easy rules of thumb to abide. With that in mind, what advice would give 401k plan sponsors that they could act upon right now?
Dr. Rhoades: Plan sponsors should not wait for the DOL to act. The DOL’s rules do not necessarily provide “safe harbors” for plan sponsors. Hence, I would advise plan sponsors to avoid any revenue-sharing arrangements, of any type, between the advisors and other vendors of the plan. This includes not only payment for shelf space, but also soft dollar compensation and other “back-channel” payments. Establish the compensation of the investment adviser in advance – before any investment recommendations are made – either as a flat fee, hourly fee, or percentage of assets (or some combination thereof). If revenue-sharing payments are in place, demand that they be credited, in full, against any fees paid to the broker-dealer firm acting as the fiduciary to the plan.

FN: Moving from the issue of revenue sharing, let’s talk about 12b-1 fees. If revenue sharing is sort of a back-door way for plan vendors to “hide” compensation, then 12b-1 fees are the front door. There’s no question there are much broader concern with 12b-1 fees. Indeed, for a time it appeared the SEC was on the verge of outlawing them. Recent studies by the ICI show the use of 12b-1 fees has tailed off considerably among 401k plans. Still, some plans continue to offer funds with 12b-1 fees. Do you have any straight-forward rules plan sponsors should adopt regarding 12b-1 fees?
Dr. Rhoades: If 12b-1 fees exist and are paid out to the broker-dealer firm, those should be credited (in full) against the amount of the agreed-upon compensation with the broker-dealer firm. If 12b-1 fees exist and are not fully paid out to broker-dealer firm (to be credited), then the plan sponsor should avoid the fund. There is no reason to pay 12b-1 fees to a mutual fund, which 12b-1 fees were originally designed to assist in the retail marketing of a fund, where there is no benefit to the plan sponsor.

FN: Wow, you’re pretty blunt. But that’s probably the kind of advice 401k plan sponsors most desire. Are there any other skeletons hiding in the conflict-of-interest closets plan sponsors need to be aware of?
Dr. Rhoades: In addition, if the broker-dealer is chosen by a fund company to execute a large amount of trades for the fund (which can be, even without payment of soft dollar compensation, a questionable practice, given the outlawing of directed brokerage and the rise of electronic trading platforms at very low fees), this is a “red flag” that highlights the need for greater scrutiny as to whether the investment adviser is truly acting on behalf of the plan sponsor, and not their own. Is directed brokerage, which was outlawed by the SEC several years ago, still a problem? A simple statistical analysis of the relationships between many mutual fund complexes and broker-dealer firms, relative to those of other fund complexes, would show that directed brokerage remains an insidious problem in many segments of the broker-dealer industry.

FN: That’s one many plan sponsors have probably never even heard of. It might be enough to have them question their existing relationships. With that in mind, what guidelines do you suggest 401k plan sponsors should require of their investment adviser?
Dr. Rhoades: When selecting an investment adviser, plan sponsors should focus on: (1) the amount of compensation paid to the investment adviser – because fees directly impact participants’ returns; (2) the quality of adherence to the duty of due care by the adviser – as to due diligence in overall investment strategies utilized, plus individual fund due diligence; (3) whether the investment adviser possesses any limits as to the funds which could be offered (because why would an plan sponsor choose an investment adviser who cannot recommend the entire universe of mutual funds and ETFs – including the very best offerings out there – to execute the strategies adopted); and (4) expertise on all matters relating to the selection of other vendors, the education of plan participants, and the fiduciary duties of plan sponsors. A failing in any one of these areas could subject the plan sponsor to unintended consequences – including potential liability for breach of the plan sponsor’s own fiduciary obligations.

FN: Ron, as always, it’s been a pleasure speaking with you. As expected, you’ve given readers several important points to ponder. Thanks and good luck on your continued efforts to promote all things fiduciary!
Dr. Rhoades: Hope this helps.  Good to hear from you. Thank you.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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  1. Stephen Winks
    Stephen Winks February 09, 11:22


    Ron Rhoades as usual is brilliantly incisive.

    Wouldn’t it be great if Ron actually ran a regulator, he would save millions if not billions in overhead, bring uncommon clarity and would greatly simplify the unnecessarily complex business.

    Instead we have very little depth of understanding in Washington that is vastly overpaid, very easily swayed that have forgotten their principle mission is to protect the best interest of the investing public rather than the best interests of the industry.


  2. Pedant
    Pedant February 12, 19:41

    If there were no exemptions to the prohibited transaction rules (Dr. Rhoades’ stated policy preference in the first question above), no plan would be able to renew their contracts with his company, ScholarFi. Under ERISA Sec. 3(14)(B), a service provider is a party in interest, and under Sec. 406(a)(1)(C), a fiduciary shall not cause a plan to engage in a transaction that will result in the furnishing of services by a party in interest.

    I assume Dr. Rhoades actually meant the he opposed the administrative, rather than statutory, exemptions to the prohibited transaction rules. Even there, though, one does not have to look very hard to find an endless parade of perfectly necessary administrative exemptions. My guess would be that if Dr. Rhoades offers any employee benefit plans to his employees, he probably utilizes quite a few administrative exemptions or DOL policy interpretations that undercut the purity of the prohibited transaction rules “as written.”

    Regardless of one’s views on the proper legal constraints on conduct by a financial advisor to an ERISA plan (a legitmate debate), surely we can all agree that the prohibited transaction rules without any exemptions (administrative or stautory) would simply not work?

  3. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author February 12, 20:21

    Perhaps we can get clarification on this, but I think Pedant is referring to a different type of situation than the “self-dealing” prohibited transactions referenced by Dr. Rhoades.

    Pendant appears to be referring to fees that are similar to those charged by trustees. This is generally a statutory fee promulgated at the state level for individual trustees. This is certainly a long tradition of service providers receiving compensation for providing their services to trusts (and, by extension, retirement plans). The only possible exception might be the prohibition against charging a fee to your own plan. Disclosure: I’m neither a trust attorney nor have I stayed at a Holiday Inn Express, so don’t take my word on this.

    The types of conflicted transactions Dr. Rhoades addressed aren’t the base fees, but fees augmented by making a self-interested transaction (i.e., getting paid a commission for the purchase of a security). This may or may not result in the same purchase that would result in a truly disinterested transaction. It is this different outcome that gives rise to the conflict of interest fiduciaries ideally would avoid.

  4. Pedant
    Pedant February 18, 11:45

    I was making the broader point that the prohibited transaction rules are not divine moral rules handed down on stone tablets that if only followed would make life better for all–they are overbroad and unworkable creations of Congress, and “as written” “without exemptions” their strict application would bring normal plan operations to a crashing halt. They would put Dr. Rhoades out of business.

    However, reading your reply has caused me to reread Dr. Rhoades’ original comment more closely, and I’ve now reached the conclusion he is simply attacking a straw man to further his argument in favor of a more broad fiduciary standard, something that has nothing to do with the prohibited transaction exemptions he incorrectly asserts are unnecessary.

    His basic thesis in the first paragraph is that “revenue sharing” results in variable compensation to the advisor, which would lead to conflicted fiduciary advice. To put it in the vernacular–well, duh! That’s been the longstanding view of everyone. What’s more, such conflicted advice by a fiduciary is already prohibited and there is no exemption. Why is he discussing it all? He is doing so to incorrectly assert that broker dealers are violating this standard, when the reality is that they generally are not fiduciaries under the current rule. This rule, by the way, is the regulatory definition of the term “fiduciary” that has nothing to do with prohibited transactions and their exemptions! (Yes, the application of the prohibited transaction rules depends on fiduciary status, but the definition of fiduciary is entirely separate from the PT rules–modification of the PT rules has no effect on the definition.)

    The Frost Bank Advisory Opinion (AO 97-15A) clearly lays out the issues relating to receipt of mutual fund service payments (or “revenue sharing”) and DOL clearly says that you cannot receive such payments from funds about which you provide fiduciary advice to a plan unless you offset the fees to remove any economic incentive that would influence your fiduciary advice. (This, by the way, is not an “exemption” from a prohibited transaction–offsetting prevents a PT from ever existing rather than excusing a PT that would otherwise occur).

    The issue, then, is whether one is a fiduciary. And under current DOL regulations (not prohibited transaction exemptions, but regulations interpreting 3(21)) you are a fiduciary advisor if you regularly give individualized advice for a fee subject to a mutual understanding that the advice will form the primary basis for the plan’s decision-making.
    Broker dealers typically are not fiduciaries under this definition. That seems to be what is really bothering Dr. Rhoades.

    Thus, I’m back where I started. If you want to have a legitimate debate about the conduct of advisors, including when and how the fiduciary standard should apply, that’s a legitimate debate. But to couch this question in terms of exemptions from the prohibited transaction rules, or as a departure from the intended purity of those rules, is simply incorrect. If you want to fight about the regulatory definition of an ERISA fiduciary advisor (a current debate that is the subject of a DOL regulation likely to espouse Dr. Rhoades’ policy view that we anticipated seeing in May) then do so honestly.

  5. R. Rhoades
    R. Rhoades March 18, 22:58

    While I thank my colleague for his comments, I believe they are misdirected and seek to obfuscate the advice I sought to provide to plan sponsors.

    The question posed in the interview concerned how plan sponsors can better protect themselves. To put it bluntly, plan sponsors should INSIST that the advisor to the plan, undertaking recommendations with respect to vendors or any forms of investment, be a fiduciary. The gravest mistake a plan sponsor can make is not insisting on fiduciary status – thereby opening the door to many types of “hidden” fees and costs.

    The basic issue is caused by the often-confusing use of terms such as “advisor,” “investment adviser,” and “financial consultant.”. No doubt my comments could have more accurately stated whether I was referring, in the context of each concept, to fiduciary or non-fiduciary advisors.

    One might try to opine that a “sophisticated” plan sponsor need not require fiduciary status. But if the plan sponsor were truly sophisticated, fiduciary status would always be bargained for.

    One might also try to opine that fiduciary status results in higher fees and costs, as greater liability to the advisor attaches. Yet in all my many reviews of plans it is the non-fiduciary “advisors” whose “solutions” result in higher fees and costs for the plan participants. Simply put, fiduciaries represent the plan (and have duties to its participants), and part of these duties include insuring that fees and costs are reasonable. Non-fiduciaries are free to recommend more expensive products – which product sales are more profitable for the non-fiduciary.

    One might try to argue that higher-cost products, because of the higher fees paid, perform better. But knowledgeable plan sponsors are well aware that higher fees are closely, and negatively, related to participant’s investment returns, on average. A great deal of academic research supports this conclusion.

    My colleague sought to infer that my comments were self-serving. Yet, I routinely refer (for no compensation) plan sponsors to fiduciary investment advisers, TPAs, and custodians who provide exceptional – and low-cost – services. My firm is not currently accepting any more clients, due to capacity constraints resulting from my desire to serve only a select few clients.

    Yes, (nearly) all those who provide investment recommendations to a plan sponsor should be a fiduciary. And when the DOL re-defines “fiduciary” more broadly, as I believe Congress originally intended, great care should exist to conform the conduct of broker-dealers to the fiduciary standard, NOT to conform fiduciary standards to the existing businesses practices of broker-dealer firms and insurance companies.

    The many issues surrounding the application of fiduciary status are complex and intricate. But for the issues of concern to plan sponsors – the subject of this interview – the solution to their need for protection is clear. Avoid variable compensation arrangements and the incestuous conflicts of interest created thereby. And yes – plan sponsors should insist on fiduciary status, which largely require the avoidance of such conflicts.

    I suspect that the only persons in this world who would argue against fiduciary protections for plan sponsors are the North Korean and Cuba dictators, and perhaps those non-fiduciary “advisors” whose excessive siphoning of the returns of the capital markets away from the retirement nest eggs of our fellow Americans is jeopardized by the expansion of the protections of the fiduciary standard of conduct.

    While my comments were originally directed to plan sponsors, there are larger issues at stake, as my colleague suggests.

    I implore the DOL to not, as the BD and insurance industries desire, grant exemptions from the prohibited transaction rules – when those rules and ERISA’s fiduciary protections are applied in full to those who are currently not fiduciaries (often inexplicably, given the plain language of the statute itself).

    Lastly, kudos to Ms. Phyllis Borzi and others at DOL for courageously standing up for plan sponsors and plan participants in the face of HUGE pressures bought to bear by Goldman Sachs, Merrill Lynch, and the other investment banks and monied interests of Wall Street. Powerful forces oppose the disintermediation (and lowering of fees and costs) which occurs when fiduciary standards are imposed upon providers of financial services.

    The future financial security of tens of millions of our fellow Americans is at stake. And if the returns of the capital markets remain largely diverted from consumers, due to often-hidden, high fees and costs, governments will be further strained as they try to provide for the needs of retirees.

    All that fiduciary advocates ask is that the interests of the consumers of financial services be protected from the greed of Wall Street’s investment banks and the giant insurance companies by the application of the true fiduciary principles. It is what consumers want. It is their reasonable expectation. It is what America needs, to restore trust in our financial services system, promote investments in our capital markets, and thereby provide the fuel for a new era of U.S. economic expansion.

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