In many workplace retirement schemes, one of the main attractions has been the idea of choice. Employees are typically encouraged to believe they are selecting from a wide range of investment funds tailored to their risk preferences and long-term goals. On average, a 401(k) plan offers about 28 different investment options, which gives the impression of control and personal decision-making. Yet this sense of autonomy can be misleading. Recent academic research suggests that the menu of available funds is not always chosen purely for the benefit of the workers who rely on these plans. Instead, financial arrangements in the background can influence which funds are included.

A key factor behind these hidden influences is the practice known as revenue sharing. In this arrangement, certain investment funds pay fees to the companies that administer retirement plans, known as recordkeepers. These payments make the funds more likely to be offered as options within a plan. In other words, a fund can effectively “buy” visibility. Employees choosing from the list of offerings would have no obvious way to know whether one fund was selected for its payments rather than its performance or cost-effectiveness. This reveals a quiet conflict of interest: the organisation managing the plan has an incentive to allocate funds that pay them, not necessarily those that will give workers the best results over time.

Research conducted by Clemens Sialm of Texas McCombs, along with collaborators Veronika Pool and Irina Stefanescu, examined the 1,000 largest 401(k) plans in the United States over several years. They found that more than half of these plans included at least one fund that shared revenue with the recordkeeper. Not only that, but revenue-sharing funds were significantly more likely to be added to a plan and less likely to be removed, compared with funds that did not offer such payments. This suggests that revenue sharing plays a major role in shaping the line-up of investment options presented to employees. The advisers and administrators may speak of offering a curated menu of strong choices, but the research indicates that financial incentives can play a quiet, persistent role in the background.

The consequences for employees can be substantial, even if they remain unaware of what is happening. Revenue-sharing funds tend to charge higher fees, and these fees come directly out of the employee’s investments. Because part of the fees collected is passed on to recordkeepers, the employee indirectly covers the cost of the compensation. Worse still, the research found that funds engaging in revenue sharing generally deliver lower returns over time. This means that workers may be paying more and earning less simply because their plan administrator chose funds that benefit the recordkeeper rather than the participant. Given that retirement savings compound over decades, even small additional fees can erode a considerable amount of final savings.

Sialm argues that transparency is crucial. Many employees already struggle to understand the fee structures attached to their retirement plans. The problem becomes worse when important information is buried in dense documents or footnotes rather than presented clearly. A difference of just one percentage point in fees, spread over 30 years of contributions and growth, could cost an employee tens of thousands of pounds in their eventual retirement balance. Workers need straightforward disclosure that allows them to compare funds easily and understand which costs are associated with administrative work and which stem from hidden revenue-sharing arrangements.

The most effective way to address the issue, according to Sialm, may be for employers to pay recordkeepers directly rather than allowing part of the fees to be deducted through investment funds. This would make the cost of plan administration transparent and remove the incentive for recordkeepers to favour higher-fee funds. While this approach could require employers to take on greater responsibility and perhaps higher upfront costs, it would result in a fairer system for employees. Instead of paying indirectly through reduced investment returns, workers would genuinely benefit from the freedom of choice their retirement plans are meant to provide. In short, a more transparent and honest structure would help ensure that retirement savings remain focused on building security for employees, not on generating extra revenue for the intermediaries who manage the plans.

More information: Veronika K. Pool et al, Mutual Fund Revenue Sharing in 401(k) Plans, Management Science. DOI: 10.1287/mnsc.2023.01560

Journal information: Management Science Provided by University of Texas at Austin