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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.
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.
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