In the wake of the strengthened fee disclosure regulations of the last decade, plan sponsors and other asset owners have come to give more thought to the absolute cost of accessing investments, as well as of recordkeeping and other services tied to retirement plans.
On the investment product side, this has resulted in more “R6” and institutional, or “I,” shares being offered at very low prices, with all the fees clearly spelled out—and often paid—upfront, disconnected from recordkeeping fees or other plan costs.
According to the latest issues of “The Cerulli Edge U.S. Monthly Product Trends Edition,” one overall theme that has continued this year has been the shift in assets to lower-cost share class offerings. Investment managers expect to see the biggest increase in use of I shares, R6 shares and/or a platform/wrap share class—64%, 55% and 50%, respectively.
“Amid a persisting trend toward lower-cost and more transparent share classes, as well as the recent Department of Labor (DOL) conflict of interest rule, the R6 share, which typically has no revenue sharing (e.g., 12b-1 fee, sub-TA [sub-transfer agency] fee), has witnessed significant asset growth,” the Cerulli report says.
“Moreover, the low-cost and transparent attributes of the share class resonate with DC [defined contribution] plan sponsors to the point that 64% of asset managers view large DC plans as the most popular channel for the R6 share class.”
According to Cerulli, the industry’s focus on lower-cost pricing, firms have plenty of reasons to scrutinize their share class offerings: demand from intermediaries for the lowest-priced share class, retirement plan sponsors’ efforts to offer lower costs, the DOL conflict of interest/fiduciary rule, and the Securities and Exchange Commission (SEC)’s 2016 share class initiative.
“Firms continue to offer an alphabet soup of share classes, but assets have shifted to lower-cost offerings,” Cerulli writes. “According to Morningstar, institutional share classes represented 31% of assets at the end of 2Q 2016, up from 16% in 2006. Conversely, A shares made up 16% of assets at the end of 2Q 2016, down from 28% in 2006.”
Cerulli suggests this phenomenon is confirmed through net flow trends and through its own 2016 proprietary Economics of Product Development and Pricing Survey, in which asset managers report that I shares made up an average of 49% of gross sales over the last 12 months.
Looking deeper at net flows, the picture grows even clearer: “Institutional and retirement share classes brought in positive net flows in 2015 and June 2016, $143.5 billion and $125.1 billion, respectively, while A shares had outflows of $91.3 billion and $68.9 billion for the same time frames.” Cerulli continues to believe that core share classes will prevail—a lean institutional share class, a non-12b-1 share class for platforms and wraps, a classic 25-basis-point share class, and a bare-bones retirement share class exclusive of a servicing fee (sub-accounting transfer agency fee).”
Cerulli’s data reflects growing distaste for the “old way” of paying for investments and services via revenue sharing, under which the adviser, broker and other players essentially all take a cut of fund returns or another potentially variable revenue stream associated with the plans’ investments and assets.
According to Strategic Insight (SI), the data and business intelligence company for the global asset management community and parent company of PLANSPONSOR, much of the recent growth in institutional pricing demand has come from fee-based advisory programs, which have seen demand shift rapidly toward funds’ lowest-cost available share classes, in anticipation of the new fiduciary paradigm.
“No-load shares with zero 12b-1 fees accounted for 66% of total mutual fund sales within fee-based advisory programs during 2015, rising significantly from just 36% in 2009,” Dennis Bowden, Strategic Insight managing director of U.S. research, says. “At the same time, A shares sold with the load waived, but carrying typically 25 basis points [bps] of 12b-1 fees, declined from 51% of total fee-based sales in 2009 to 27% in 2015.”
The findings come from SI’s recent report “Fund Sales Benchmarking: 2016 Perspectives on Intermediary Sales by Share Class and Distribution Channel,” based on the firm’s proprietary survey of 35 fund firms that distribute primarily through financial advisers. Survey participants managed to aggregate $5.2 trillion in U.S. open-end stock and bond fund assets as of the end of 2015 and reported more than $1 trillion in overall fund sales during the year.
“A noteworthy impact of the DOL fiduciary rule will be an acceleration of the existing movement toward lowest-cost share classes,” Bowden adds. “We have already seen this trend increasingly eliminate the use of 12b-1 fees within fee-based accounts, but, looking ahead, the potential for further ‘institutionalization’ of pricing demand is an important area to monitor.”Implications for DC Sponsors And Advisers
SI measures some additional implications from the DOL rulemaking that may be less intuitive but will have crucial implications for product offerings in the coming years. For example, at a high level, margins are being squeezed, but the trend of sponsors pushing for access to lowest-cost institutional pricing also implies they will rely on advisers to find great deals, to keep on top of the fee monitoring.
“Looking at complying with the DOL rulemaking, distributors need to equalize payment streams they receive from funds across their platform,” Bowden says. “This may be a more powerful impetus driving further externalization of fees outside of the fund expense ratio, including payments for asset servicing. Such evolution in pricing demand would impact not only the types of share classes that mutual fund managers need to offer but also carry potential profitability implications.”
For plan sponsors, the big consideration will be: How will costs such as those for asset servicing now be paid, and who will pay them?
“For investors, paying for certain services outside of fund expenses does not always equate to cost savings,” Bowden warns. “And for fund managers, different potential scenarios concerning ‘out of pocket’ payment demands by distributors can carry an important profitability impact.”
The SI report also suggests that share classes carrying point-of-sales commissions—i.e., commissionable A and B shares—continue to encompass a diminishing share of overall fund activity. Such classes accounted for just 11% of aggregate sales during 2015 and only 6% of sales for the median firm in SI’s study.
“At a broad level, I would say that the key pricing consideration in the context of the DOL rule is the need for price equalization up and down the value chain—between investors and advisers, funds and advisers, funds and distributor home offices, etc.,” Bowden observes. “This would definitely favor fee-based advisers from a compensation structure perspective, versus those still relying on variable point-of-sale commissions, although the Best Interest Contract [BIC] exemption would obviously allow for this, when executed properly. So the movement from brokerage to fee-based advisory will definitely be accelerated by the DOL rule.”