United States: ERISA Newsletter For Retirement Service Providers - July 2012

Dear Reader:

This is a newsletter for service providers to ERISA-governed retirement plans. While this newsletter focuses on legal issues faced by service providers— such as investment advisers, broker-dealers, third party administrators, recordkeepers, and banks and trust companies, it also contains valuable information for plan sponsors and fiduciaries. That is because the issues faced by service providers ultimately impact plans.

For service providers, these are particularly challenging times, with mandated disclosures to plan fiduciaries and participants and with numerous lawsuits about indirect payments (such as revenue sharing) and unreasonable compensation. The articles in the newsletter touch on those issues. For example, Joe Faucher's article discusses whether service providers need to offset indirect compensation against their direct compensation—which is an issue raised because of the new plan-level disclosure rules under 408(b)(2). Bruce Ashton's and Joan Neri's articles discuss specific issues in the DOL's recent guidance about participant disclosures. Josh Waldbeser's article covers the litigation front by discussing how some service providers earn income, that is, "float," on plan money -- and the consequences.

Fred Reish
Chair, Financial Services ERISA Team

Participant Disclosure of Asset Allocations Models

By Joan M. Neri

Many broker-dealers, RIAs and recordkeepers have been struggling with whether the participant disclosure rules apply to asset allocation models (AAMs). The Department of Labor has now issued guidance on this issue in Field Assistance Bulletin 2012-02.

In that guidance, the DOL addressed whether an AAM that is presented to plan participants as an asset allocation strategy among investment alternatives is a designated investment alternative or "DIA." The significance of that question is that detailed information about DIAs must be provided to participants under the participant disclosure rules (404a-5), including the DIA's expense ratios and performance history and a website describing the DIA's principal strategies, risks and portfolio turnover rates. Even though this obligation is imposed on the ERISA plan administrator (typically, the plan sponsor or the plan committee), in many instances the plan administrator will look to its service providers for this information. To complicate matters, most service providers (e.g., recordkeepers) do not have systems that can capture and report the information about AAMs for those disclosures – and will not be able to do so for many months or perhaps even years – which could cause plan fiduciaries to be out of compliance.

Unlike investment education models (under DOL Interpretive Bulletin 96-1) that educate participants on ways of managing their own accounts, an AAM is presented to plan participants as an investment tool that allows them to allocate their accounts among the plan's investment line-up by simply electing to use the AAM's allocations. On occasion, AAMs may also include investment alternatives not available for participant selection under the plan. Most AAMs also have a rebalancing feature so that, after market fluctuations cause the allocations to change, the accounts are periodically restored to the original allocations. The question addressed by the DOL is whether an AAM is considered an investment subject to the disclosure rules governing DIAs, rather than merely an allocation service.

The DOL guidance on AAMs is addressed in a question which uses, as its example, a plan that offers 10 investment choices and three risk-based model portfolios comprised of different combinations of the plan's investment options. The DOL states that an AAM "ordinarily" is not required to be treated as a DIA if it is clearly presented to participants as a way of allocating among the plan's investment options and a description of how it functions and how it differs from the plan's investment options is provided to participants. This is good news for advisors that offer an AAM using only the core line-up. We refer to an AAM of this type as a "qualifying asset allocation service" because it is not viewed as an investment. It is important to note, though, that several conditions must be satisfied for the asset allocation service to "qualify," that is, to avoid DIA status.

But what about AAMs that allocate among investments that are not otherwise available to participants? The DOL response is not as clear as we would like; for example, at one point it says: "if a plan offers only model portfolios made up of investments not separately designated under the plan, each model would have to be treated as a designated investment alternative." While this statement could be read to mean that, if the AAMs have some investments from the core line-up and some "outside" investments, the AAMs are not DIAs, we believe there is risk in that interpretation. For example, the first sentence in the answer says: "A model portfolio ordinarily is not required to be treated as a designated investment alternative under the regulation if it is clearly presented to the participants and beneficiaries as merely a means of allocating account assets among specific designated investment alternatives." Because of that statement, we believe the safest interpretation of the DOL's intent is to require DIA status if any outside investments are used in the AAMs.

In conclusion, service providers, such as broker-dealers, RIAs, and recordkeepers who offer AAMs should restructure them as qualifying asset allocation services in order to avoid DIA status. For those advisers who want to use outside investments in participant accounts, one option is to offer such services as a 3(38) investment manager. If structured properly, the asset allocations of a 3(38) investment manager will avoid DIA status. The restructuring process should include reviewing all written and website material descriptions of the managed account services to make sure they are consistent with the DOL guidance.

Do Service Providers Have An Obligation To Offset Indirect Compensation?

By Joseph C. Faucher

The time for service providers to comply with the disclosures of services, compensation and fiduciary status required by the ERISA §408(b)(2) regulation is upon us. Presumably, most covered service providers – such as third party administrators that receive indirect compensation, broker-dealers, recordkeepers and registered investment advisers – have taken steps toward complying with their disclosure obligations.

As the reality of making the disclosures has set in, we have fielded a stream of questions about how, exactly, the disclosure requirement might affect service providers' arrangements with their clients. One source of confusion concerns when and whether service providers may need to offset or reduce the compensation they would otherwise receive from plans and plan sponsors as a result of indirect compensation they may receive from other service providers. The purpose of this article is to clear up some of the confusion.

Whether direct compensation should be reduced or offset by indirect compensation turns largely on whether the service provider is a fiduciary – such as a registered investment adviser (RIA) that renders investment advice for a fee – or a nonfiduciary. Unlike fiduciary service providers, nonfiduciaries provide services that do not involve discretion over the plan's assets or administration, or investment advisory services.

Fiduciaries and nonfiduciaries are held to very different standards. ERISA prohibits a fiduciary from dealing with the assets of the plan in his own interest or for his own account, and from receiving any consideration for his own account from any party dealing with the plan in a plan-related transaction. So, it is a prohibited transaction for a fiduciary to increase his own compensation in a transaction involving the plan. For example, if an RIA recommends an investment option to the plan client, and the investment generates indirect compensation payable to the RIA (such as a commission), a prohibited transaction occurs. By reducing the direct compensation paid by the plan to the extent of the indirect compensation the RIA will receive, the RIA "levelizes" his compensation and negates the prohibited transaction.

Conversely, nonfiduciaries – such as third party administrators (TPAs) that do not provide recordkeeping services -- are not bound by ERISA's prohibitions against fiduciaries acting for their own account in connection with plan transactions. As a result, TPAs are not required to (though we are aware that a number voluntarily do) offset their direct compensation by any indirect payments they receive. Indeed, many nonfiduciary service providers set their fees in anticipation of receiving indirect compensation from insurance companies and mutual fund companies. Once the 408(b)(2) regulation takes effect, their obligation will be to disclose to their plan clients all direct and indirect compensation they expect to receive.

Nonfiduciaries will, however, still be subject to the requirement that their overall compensation be reasonable. Consider, for example, the circumstance in which a TPA charges a reasonable fee to its plan client. When the TPA receives significant additional indirect compensation from the insurance company that provides the plan's investments, it may cause the TPA's overall compensation in connection with its services to the plan to exceed a reasonable amount. In that case, it may be appropriate for the TPA to offset or reduce the compensation from the plan or the plan sponsor, or to pay a portion of the indirect compensation to the plan. Otherwise, the reasonableness of the compensation may be called into question. To the extent the compensation exceeds a reasonable amount, it is a prohibited transaction.

Recognize, however, that the issue isn't always so clear cut. Consider, for instance, a TPA firm that provides nonfiduciary services that is under common ownership with – and has clients in common with -- a fiduciary registered investment adviser. In that setting, issues may arise when the fiduciary investment adviser recommends an insurance company that pays the TPA indirect compensation. In that case, the TPA may need to levelize its compensation and negate the impact of the indirect compensation that it will receive as a result of its affiliate's investment recommendation.

Participant Disclosures for Brokerage Accounts

By Bruce L. Ashton

The first participant fee disclosures under the 404(a) (5) regulation are due by August 30. Much of the focus is on a plan's "designated investment alternatives" (or DIAs), which excludes brokerage windows, self-directed brokerage accounts and the like (which we refer to as "brokerage accounts"). But the story doesn't end there.

The DOL has issued Field Assistance Bulletin 2012-02 in the form of FAQs. The FAQs provide additional guidance on the required disclosures. Several questions bear on brokerage accounts and appear to create new challenges for broker-dealers.

Keep in mind that, since brokerage accounts are not DIAs, the disclosure requirements regarding performance, benchmarking, expenses, turnover ratio etc. required for DIAs, don't apply.

So what has to be disclosed? The DOL explains that in Q&A 13. First, the DOL acknowledges that the regulation does not specify exactly what information is required. Instead, it points out that the description must provide "sufficient information" to enable participants to "understand how the [account] works (e.g., how and to whom to give investment instructions; account balance requirements, if any; restrictions or limitations on trading, if any; how the window, account, or arrangement differs from the plan's designated investment alternatives) and whom to contact with questions."

The DOL also makes it clear (in Q&A 14) that this information must be furnished – both initially and annually – to all eligible employees, not just to those who elect to use the account and not even just those with account balances.

The disclosures must include a description of "any commissions or fees (e.g., per trade fee) charged in connection with the purchase or sale of a security, including front or back end sales loads if known; but would not include any fees or expenses of the investment selected by the participant or beneficiary (e.g., Rule 12b-1 or similar fees reflected in the investment's total annual operating expenses)." In the FAB, the DOL says that "in some circumstances the specific amount of certain fees associated with the purchase or sale of a security through a window, account, or arrangement, such as front end sales loads for open-end management investment companies registered under the Investment Company Act of 1940, may vary across investments available through the window or may not be known by the plan administrator or provider of the window, account, or arrangement in advance of the purchase or sale of the security by a participant or beneficiary." In recognition of that, the DOL concludes that it would be sufficient to tell the participant that such fees exist and may be charged against the account and to explain how to obtain the information from the investment provider, along with an admonition to ask for the information.

Now comes the hard part. The regulation requires quarterly disclosures of individual expenses that were charged against a participant's account, expressed in dollar amounts. For brokerage accounts, the DOL says that the plan administrator must provide a statement of the dollar amount of fees and expenses actually charged during the preceding quarter against the individual account, which must include a description of the services to which the charge relates. The description of services must clearly explain the charges (e.g., $19.99 for brokerage trades, a $25.00 minimum balance fee, a $13.00 wire transfer fee, a $44.00 front end sales load).

The additional guidance provided by the FAQs is welcome and largely helpful, but these examples related to brokerage accounts indicate some of the difficulties the financial services industry will face, difficulties that were not previously anticipated or even contemplated.

Handling "Float" Income

By Joshua J. Waldbeser

When funds flow in and out of 401(k) and other ERISA plans, they are sometimes held on a short-term basis in general accounts established by a service provider. This occurs, for example, when contributions are held pending investment, and when checks for benefit distributions are awaiting deposit. These accounts generate interest known as "float" or "float income." Some recordkeepers retain float as part of their compensation from plans.

In a recent lawsuit, 401(k) plan participants were awarded $1.7 million from a bundled recordkeeper that the court found to have violated ERISA with respect to its use of float. (The service provider in question has indicated that it is considering appealing the verdict.) In that case, the court ruled that the provider was a fiduciary to the plan with respect to its discretion over the disposition of float income, and that it improperly exercised that fiduciary authority to use float income for its own benefit and that of other parties.

This case illustrates an important lesson: Under ERISA, any service provider with the power to determine how plan assets (including float) are used cannot unilaterally exercise its fiduciary authority over those assets to pay itself additional compensation without triggering a prohibited transaction for fiduciary self-dealing.

As a consequence, to retain float income, a service provider must be permitted under the terms of its contract to retain the float. The Department of Labor ("DOL") has noted that the service provider should "openly negotiate" with the responsible plan fiduciary and "provide full and fair disclosure regarding the use of float" to help ensure that independent fiduciary approval will be deemed to have been given. More specifically, the DOL has stated that the service provider may avoid prohibited transactions in this context by following these steps:

• Disclose, to the responsible plan fiduciary, the circumstances under which float will be earned and retained;
• For float on contributions pending investment, disclose and stick to established time frames for when investment will occur;
• For float on distribution checks, disclose when the float period begins (e.g., the date check is written) and ends (e.g., when the check is deposited), including time frames for mailing and other practices that might affect the float period; and
• Disclose the rate of the float or the manner it will be determined.

Ordinarily, this information would be set forth in the service contract. There may be other ways for a provider to ensure that it is not unilaterally determining its own compensation as a fiduciary with respect to retention of float – the key is ensuring that the plan's internal fiduciary has approved the additional compensation.

Where these requirements are satisfied, retaining float will not cause a prohibited transaction for fiduciary self-dealing because the payment of the compensation has received independent fiduciary approval. However, even in this case, the service provider is not automatically "off the hook." This is because any service arrangement that is not "reasonable" under ERISA Section 408(b)(2), or that pays a provider more than reasonable compensation, will likewise result in a prohibited transaction.

Under the 408(b)(2) disclosure regulations, no service contract with a "covered service provider," a term which includes recordkeepers to most 401(k) and other defined contribution plans, will be considered reasonable unless all the 408(b)(2) disclosures are furnished to responsible plan fiduciaries no later than July 1, 2012 (and in the future, with respect to new contracts or changes, extensions, and renewals). Thus, covered service providers should ensure that they account for compensation they expect to receive from float income as part of these disclosures. If required disclosures are not provided, the service arrangement will automatically be deemed to have resulted in a prohibited transaction. It is important to reiterate that all service providers, regardless of whether they are covered service providers subject to the 408(b)(2) disclosure regulations, are required to enter into reasonable arrangements and to receive no more than reasonable compensation to avoid prohibited transactions.

If the DOL finds that a service provider has participated in a prohibited transaction, it will likely require the provider to return the compensation it has received, and the provider may also be liable for civil penalties and for excise taxes under Section 4975 of the Internal Revenue Code. Thus, service providers should review their contracts and practices relating to float income to ensure they meet the requirements discussed above.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.