United States: SEC Scrutinizes Defined Contribution Plan Payments in It´s Continuing Examination of Mutual Funds

The Securities and Exchange Commission (SEC) announced in early July 2004 that its ongoing inquiry into the mutual fund industry is now targeting the disclosure and use of payments between mutual funds and defined contribution pension plans (DC plans), such as 401(k) plans, in order to better understand the role such payments may play in the selection of service providers and of funds to be included in DC plan investment menus. The SEC has reportedly asked several mutual fund companies, including some of the largest providers of retirement plan services, for extensive information about such payments in a broad sweep examination to explore payment practices between mutual fund companies and their DC plan clients.

Mutual fund shares reportedly represented almost half of the assets held in 401(k) plans at the end of 2003, valued at more than $900 billion. Since a plan sponsor who acts as plan administrator is customarily responsible for both the hiring of service providers and the choice of investments (including mutual funds) to be offered to plan participants, mutual fund payments made to or on behalf of plans may raise conflict of interest issues. In addition to fee disclosure questions, the SEC has apparently also chosen a "follow the money" approach. The SEC is inquiring about both direct and indirect payments, i.e., those deducted from the mutual fund’s asset pool before calculating share net asset value, and those paid by mutual fund affiliates from their corporate assets, including finder’s fees, sub-transfer agency fees, marketing fees (such as 12b-1 fees), reimbursement of plan expenses, and the use of soft dollars and directed brokerage. Although these questions are directed to mutual fund companies over which the SEC can claim some jurisdiction, the responses are likely to disclose much about the potential influence of payments in a plan’s decision-making about service providers and investment options.

The SEC has not released the actual text of the DC plan questions put to mutual fund companies, but a number of indirect sources have described the types of questions being asked. Mutual fund companies (respondents) are reportedly being asked by the SEC to provide information covering a broad range of fee arrangements, including:

• payments made by mutual fund companies and their affiliates, but also payments received by mutual fund affiliates who provide services to DC plans;

• payments deducted directly from mutual fund assets, such as management fees and 12b-1 distribution fees, but also payments made from corporate assets of a mutual fund affiliate, such as finder’s fees paid by an advisor to a broker or other sales entity;

• plan expense reimbursement programs, regardless of the identity of the recipient (plan sponsors, record-keepers, third party administrators, consultants, affiliated or unaffiliated plan service providers); and

• indirect payments in the form of soft dollar and directed brokerage arrangements.

Further detail is requested about payment arrangements for a respondent’s 25 largest DC plan clients and ten largest plan reimbursement arrangements.

It is too early in the process to predict the outcome of the SEC’s examination of the role of mutual fund payments in DC plan administration. There can be no doubt, however, that the SEC is taking seriously its mandate to protect shareholders. Earlier this year, the SEC concluded that the payment of 12b-1 fees to cover mutual fund distribution costs produces certain benefits to mutual fund management companies but that such benefits are not passed on to shareholders in those funds, and that the use of fund assets to pay marketing costs involves an inherent conflict of interest between the shareholders who are bearing that expense and the fund companies who are benefiting. Similarly, the SEC has proposed the modification or elimination of directed brokerage arrangements in which fund companies use commissions to compensate brokers for their sales efforts.

The difference between the current SEC examination and these recent activities is that arrangements involving plans, and plan fiduciaries, are now being scrutinized. The SEC is focusing on payments by mutual fund companies and their affiliates but the Department of Labor (DOL), which has jurisdiction over private defined contribution plans, has indicated that it is also examining DC plan fees and disclosures from its own regulatory perspective. Regional offices of the DOL have contacted a number of mutual fund companies and advisors, asking for information about direct and indirect payments made with DC plan clients. In addition, the ERISA Advisory Council, which provides informal advice to the DOL, is addressing possible additional fee disclosures to be made by plan sponsors to plan participants and in a plan’s annual Form 5500 filing. Under the Employee Retirement Income Security Act of 1974, as amended (ERISA), a DC plan sponsor, when acting as a fiduciary such as a plan administrator, has a number of responsibilities, including the duty to act prudently in making fiduciary decisions. Fiduciary decisions include the choice and monitoring of plan service providers, the payment of reasonable plan expenses and the selection of a diverse menu of potential investments to be made available to participants.

The DOL has stated, in its handbook for plan sponsors, Meeting Your Fiduciary Responsibilities," that "[p]rudence focuses on the process for making fiduciary decisions." Accordingly, the DOL recommends careful documentation of fiduciary decisions and the basis for such decisions. Plan sponsors are encouraged to do a thorough job of comparison shopping in understanding what services are being provided and what compensation arrangements are involved. The DOL has recently developed a Plan Fee Disclosure Form for this purpose, while also acknowledging that low cost service providers are not necessarily the best plan choice. Because fees are generally calculated in a number of different ways, a plan sponsor must ask specific questions and obtain comparable information from potential service providers in order to make a valid comparison. DC plan sponsors and participants will benefit from any improvement in mutual fund and service provider fee disclosures that result from the SEC’s current examination.

A plan sponsor, acting in its fiduciary capacity, may need to look further at the quantity and quality of information being provided by mutual funds, in order to satisfy the process of prudent decisionmaking. A plan sponsor should be prepared to make a periodic re-examination of the fee, reimbursement and plan expense arrangements under its ERISA plans, particularly defined contribution plans where the plan sponsor is responsible for the choice of mutual funds available for investment by participants. Such menu of investment choices should be examined from time to time, if possible with the assistance of an independent mutual fund advisor, to determine that the mutual funds included in the menu remain prudent investment choices. This determination should take into consideration the fund’s performance and the reasonableness of the compensation arrangements.

A Plan sponsor should ask mutual fund companies to explain not only the fees paid from mutual fund assets (which affect the investment results of the mutual fund itself), but also any payments made in connection with the distribution of such fund. If different classes of shares are offered, how does the compensation vary and is the class of shares offered to the plan the appropriate one? If plan expenses are subject to reimbursement by the mutual fund company, what fees are reimbursed and in what order of offset? A degree of due diligence to understand the services obtained and the fees incurred has never been more advisable.

If you wish to obtain more information on what DC plan administrators should ask mutual fund providers, please contact one of the members of the Pillsbury Winthrop executive compensation and benefits team. Questions regarding this alert may be directed to Mary Jenkins or Susan P. Serota or Peter J. Hunt in New York, and Jan H. Webster in Carmel Valley.

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.