Retail mutual fund shares are classes A, B and C. They differ in the amounts of internal 12-b1 fees and also on the loads, or sales charges. Read about it here: The ABCs of Mutual Funds. There is another class offered for many funds: Class I, which stands for institutional class. Class I shares are offered only to large investors, typically investment firms and minimum purchases are often more than $500,000. Class I shares’ fees are typically 40% less than those of classes A, B and C.
What does this have to do with you and me? The connection is that our 401(k) managers can make Class I funds available as investment options for our retirement account. Since Class I funds have exactly the same underlying investment positions as the A, B, and C class shares (ABCs), you would expect the fund manager would go with the better deal for us. Wouldn’t you be upset if he were paying higher fees than he had to?
Think about it this way. You want to buy a car. There are two identical cars on the dealer’s lot. One costs $5,000 more than the other. Which one would you buy?
Why would you pay $5,000 for an identical car? Why would a fund dealer provide ABCs which carry a higher fee instead of Class I shares? Maybe carelessness. Or maybe because the additional fee charged benefits the fund manager or plan sponsor. That is exactly what happens when your 401(k) investment manager provides retail (ABCs) mutual funds for you. They call it "revenue sharing". The plan sponsor receives "offsets" from retail mutual funds, that is, the 12-b1 fees. They don’t call it a kickback.
A recent court case should make 401(k) plan sponsors think twice before offering retail funds as investment options in the plan when investment class shares, Class I, are available with lower expenses. In a case in the middle district of California, Tibble vs Edison International, a group of plan participants went to federal court to complain about the plan buying non-institutional shares. Judge Stephen V. Wilson ruled that the company violated its duty of prudence by selecting retail shares instead of Class I shares for three of the funds held by the plan.
The Edison International Trust Investment Committee made retail share classes of three mutual funds available to participants in the Edison 401(k) Savings Plan. In deciding which funds to offer, the committee did not consider, let alone evaluate, other share classes of the funds. However, it did solicit and rely upon the advice of Hewitt Financial Services, an affiliate of the plan’s third-party record keeper. A class of plan participants sued the committee, Edison International, and others seeking damages under ERISA for alleged financial losses suffered by the plan, in addition to injunctive and other equitable relief on account of breaches of fiduciary duty.
Judge Wilson stated, "In light of the fact that the institutional share classes offered the exact same investment at a lower fee, a prudent fiduciary acting in a like capacity would have invested in the institutional share classes."
Daniel Sonin reported this case on dailyfinance.com on July 28. He reported that Edison is not an isolated instance. He asserts that "over ninety percent of the funds he has examined have purchased retail class funds when institutional class funds of the same content were available."
If Class I shares’ fees are typically 40% less than those of classes A, B and C, what would a 40% reduction in fees by offering Class I shares look like? Consider a fund of $200,000. For simplicity, assume no additions or withdrawals. Assume a rate of return of 8% minus annual fees of 2% for a net annual return of 6%. If the fees of 2% were forty percent lower, they would be just 1.2 % per year, allowing the fund to grow at a net 6.8 % per year. After ten years at 6%, it would grow to $358,170. At 6.8 %, it would grow to $386,138, a difference of almost $28,000.
If Judge Wilson is correct and the company is liable for lost income, that would make many fund advisors think twice about recommending retail funds.