Clean Shares' Popularity

The retirement plan industry has seen a pronounced increase in the offering of clean shares. According to research firm Morningstar, “clean shares help financial service companies that wish to shift to a ‘level fee’ model in which advisers’ compensation comes only from a level charge on a client’s assets and not from any varying third-party payments.”

However, there are disagreements about the definition of clean shares, it noted in a comment letter to the Department of Labor (DOL). As Aron Szapiro, director of policy research at the firm, in Washington, D.C., says, “At Morningstar, we don’t love the term ‘clean shares.’ There’s no commonly agreed upon definition and no regulatory definition, either.”

There is general agreement that clean shares do not have front-end loads or 12b-1 revenue-sharing fees, either of which are used to pay for a mutual fund’s distribution costs. When those are absent, investors pay an externalized fee for advice—that is, the broker or adviser charges it directly to the client. “But,” Szapiro says, “there is disagreement about whether clean shares should include sub-transfer agency—or, sub-TA—fees or other kinds of revenue sharing.”

According to Szapiro, Morningstar prefers two types of clean share labels: semi-unbundled—having no 12b-1 fees and no load; and unbundled—having no 12b-1 fees, no load, no sub-TA fees and no revenue sharing. With unbundled shares, the retirement plan sponsor is provided more transparency, because it pays for administrative expenses apart from share costs, he says.

“To the extent that there is payment to intermediaries, particularly revenue sharing and sub-TA, it can present some conflicts of interest,” Szapiro warns. “There is differential compensation for different products that can influence intermediaries. It doesn’t mean the structure wouldn’t work, but it is something people should be aware of.”

Jessica Sclafani, director of Cerulli Associates’ retirement research practice in Boston, says, according to Cerulli’s definition, “The clean share class aims to separate distribution fees from investment management fees. There are no 12b-1 or sub-TA fees and no embedded commission.” In other words, it is a true “triple zero” share class.

When There Is No Revenue Sharing

Cerulli research found that, among retirement plan specialist advisers—defined as those who generate at least 50% of their revenue from retirement plan business—40.2% of assets under management (AUM) are in R-share classes, 25.5% are in institutional shares and 20.5% are in what is called zero-zero share classes—i.e., having no 12b-1 or sub-TA fees.

“Based on Cerulli’s definition of clean shares, the zero-zero share class is not necessarily synonymous with a clean share class; however, in most cases it would be, assuming there is no commission attached to it,” Sclafani says.

Cerulli continues to see retirement specialist advisers in the small- and micro-plan markets use revenue sharing to subsidize plan administration costs, she says. “I would anticipate there will not be a complete shift to zero-zero share classes until we address how small plans can pay for administration.”

Both Szaprio and Sclafani note that if a plan does not use revenue sharing, the adviser can suggest the sponsor pay for administrative, recordkeeping and advisory fees itself, out-of-pocket, or pass the costs to participants. Some plan sponsors use forfeitures from participant accounts to pay for such fees.

But, Sclafani says, small-plan sponsors generally will not want to do that.

“We are still working on greater access to retirement plans for small-business employees, so revenue sharing encourages that—and encourages plan sponsors to offer employer contributions, as they won’t have to pay for all administration costs.”

According to PIMCO’s 2018 Defined Contribution Consulting Support and Trends Survey, for plans with assets greater than $1 billion, consultants almost evenly recommend that the employer pay out-of-pocket (29%) or use a flat-dollar charge per participant (28%). For smaller plans—i.e., those with less than $50 million or with $50 million through $200 million in assets—the majority of consultants recommend a basis point (bps) charge pro rata across plan assets—30% or 47%, respectively.

For plan sponsors that pass costs on to participants, deciding which is fairer—flat fee vs. asset-based fee—depends on the plan, Szapiro says. “A flat fee seems inherently fairer, but a $40 flat fee is high for new employees with low asset bases,” he says. “When the fee is based on assets, more tenured employees pay more, but as the plan matures, fees based on assets may go higher than the actual costs for managing the plan.” It definitely requires monitoring, he adds, observing that 408(b)(2) fee disclosures from providers have helped plan sponsors see what was being paid for and made them consider moving to flat-dollar fees.

John Faustino, chief product and strategy officer at Fi360 in Pittsburgh, says some advisers may think clean shares are less relevant now, in light of the DOL conflict of interest rule being vacated. However, he says, “Notwithstanding the movement by the Securities and Exchange Commission [SEC] to create new standards, I still feel that clean shares are the way of the future.”

Szapiro points out that the preamble to the proposed SEC rule about fiduciary standards for advisers mentions clean shares as an appealing way to eliminate conflicts of interest.

Faustino views introduction of this new share class as part of the broader fiduciary movement—putting the emphasis on disclosure and the importance of being clear to clients about the mechanics of compensation. “This will be a market demand. Even if some broker/dealers [B/Ds] aren’t interested in pushing for clean shares, now that the DOL rule has faltered, there is still the broader industry competition pressure to be transparent and fair about the compensation infrastructure,” he says.

The introduction of the new shares is also tied into adviser fee compression, Faustino believes. “We see that the same fiduciary advisers who are happy to be charging explicit advisory fees rather than commissions are the same ones who are happy to talk about and use clean shares,” he says. “When you have commissions and revenue sharing, there can be the perception that this muddies the water, and there is less clarity and transparency about what is being paid for investments versus advice and other services.”

Matt Wolniewicz, Fi360’s president, makes a broader point. “If you think about the challenge the DOL was—and now the SEC is—facing to clean up who is and who is not a ‘financial adviser’ versus who is a broker—and what the different client treatment standards are for these two groups—another massive area of investor confusion surrounds this topic of share classes,” he says.

“There has been a proliferation of share classes in recent years. Even if you are an expert institution, you’re faced with such a complex array of terminology and choices. Are you going to get R4 shares or R6 shares? Or Z shares? Or I shares? I think clean shares could be a way to simplify a lot of this,” he says.

Art by Doris Liou