If a mutual fund family does not pay to be included in a 401(k) plan, or does not pay enough, its funds will be dropped from the lineup, regardless of performance.

Vanguard’s low cost index funds, for example, which routinely rank at the top of their class but do not charge 12b-1 fees, often get excluded from 401(k) plans.

According to Vanguard’s director for institutional sales, brokers and TPAs routinely call to inquire about adding Vanguard funds to their clients’ 401(k) plans. But “when brokers realize they won’t be compensated for placing our funds in a plan, they will typically hang up on us.¹

To make matters worse, revenue sharing not only prevents 401(k) investors from selecting among low-cost investments but also charges them--albeit indirectly--for the privilege.

Mutual fund distribution companies pay brokers and TPAs revenue sharing directly. The mutual funds companies then charge investors increased management fees based on the asset value of an individual's account. The few mutual fund families that do not pay revenue sharing, on average, charge investors the lowest management fees.

Today, most revenue-sharing agreements are secret, and only a few TPAs even acknowledge accepting revenue sharing, in keeping with strict confidentiality agreements signed with fund distributors not to disclose payments.

In July 2004, however, the SEC launched an investigation into revenue sharing, and industry watchers believe payments may reach as much as 0.25%.

“We are concerned that mutual funds are paying for the privilege of appearing on 401(k) menus,” says David W. Brown, head of the investment protection bureau of the New York State Attorney General’s Office. “Is this in the best interest of 401(k) savers, and are these arrangements being disclosed?” Brown asks.²

Evidence indicates that the answer to both questions is a resounding “no!"

According to a recent survey, some 69 percent of 401(k) third-party administrators did not disclose to clients any information about profits stemming from revenue sharing payments.

"When my clients say ‘free,’ I hear ‘revenue sharing’. And, baby, when I hear ‘revenue sharing’ my heart sings because that means high, well-hidden and undisclosed costs,” explains fiduciary consultant W. Scott Simon.³

Investment News reporter Brooke Southall, reporting on a class-action lawsuit between 401(k) participants and the insurance company Nationwide, describes the adverse effects of revenue sharing on plan participants:

Nationwide responded to the charges of impropriety, stating that the company should not be considered as a a fiduciary under ERISA and its actions “…are in line with standard industry practice.”⁵

While a court may or may not ultimately find Nationwide culpable, the company’s rebuttal is disturbingly accurate: For example, A Wall Street Journal investigation published in January 2004 quoted brokers at brokerage house Edward Jones who admitted recommending certain funds based on the size of the kickbacks they would receive. The brokers also stated that most Edward Jones clients were unaware of any revenue-sharing agreements.

These are not isolated occurrences. Nearly all brokers and 401(k) plan providers participate in revenue sharing schemes. Although nearly all contend that they disclose this potential conflict of interest to clients, according to surveys, most employers remain unaware of the practice.

“Brokers market themselves to the public as if advice is the primary service they have to offer,” explains Barbara Roper, director of investor protection for the Consumer Federation of America. “Then you find out that they’re really just salespeople who are compensated like salespeople.”⁶