United States: A New Beginning for Allocating Defined Contribution Plan Expenses

In Field Assistance Bulletin (FAB ¹) 2003-3, released May 19, 2003, the U.S. Department of Labor ("DOL") provides new broad and flexible guidance that describes how fiduciaries might allocate a defined contribution plan’s (e.g., a 401(k) plan) expenses. In general, FAB 2003-3 clarifies that fiduciaries of these plans normally have considerable latitude in (1) allocating plan expenses to the plan as a whole (i.e., to all participants) or to various classes of participants and (2) allocating expenses to specific participant accounts whether the allocation is pro rata (typically based on individual account balances), per capita or based on some other method. This guidance provides an important supplement to DOL Advisory Opinion 2001-01A, released in January 2001 and previous other guidance, which addresses what types of expenses might be payable by a plan. Please visit our Web site at www.KilpatrickStockton.com. for a copy of our January 2001 Legal Alert on this prior guidance.

All plan fiduciaries must determine whether certain types of expenses incurred in connection with a plan’s establishment or operation are payable from plan assets. But fiduciaries of defined contribution plans who identify plan-payable expenses must take an additional step and determine how the expenses should be allocated to participants. Unlike defined benefit plans (and most welfare plans), assets of defined contribution plans are completely allocated to participants and the plan has no other assets with which to pay expenses. Every plan payment of an expense therefore reduces one or more participant’s account balances. Perhaps for this reason many sponsors pay defined contribution plan expenses out of non-plan assets, while paying defined benefit plan expenses out of plan assets.

Even if an expense is to be paid by a defined contribution plan, the plan’s fiduciaries must undertake a more detailed analysis. Specifically, defined contribution plan fiduciaries must determine whether the expense can be allocated to one or more specific participants, one or more classes of participants or to all participants (i.e., the plan overall). If the fiduciary determines the expense is to be allocated among multiple participants, the fiduciary must then determine whether the expense should be allocated pro rata (generally based on each participant’s respective account balance), per capita (generally a fixed dollar amount per affected participant regardless of account balance or other criteria), or by some other method.

As the FAB points out, there is little statutory guidance on this issue. Moreover, the few statutory provisions identified by the DOL either address personal expenses charged directly to participants, but not to participant accounts, or do not apply to defined contribution plans. For example, ERISA permits a plan to impose a reasonable charge to participants for furnishing copies of plan documents but that applies to all types of plans and doesn’t specifically permit (or prohibit) a charge to a participant’s account. Another example, a health care plan’s ability to charge for continuation coverage under COBRA, applies only to health care plans (and few health care plans are truly defined contribution plans) and applies to charges made directly to participants, not to a participant’s plan account. More pertinently, the DOL correctly notes that its regulation interpreting ERISA section 404(c) allows individualized charges only related to exercising options to direct investments or to take plan loans. The statute leaves all other situations to a fiduciary’s reading of the plan documents and judgment.

The main source of prior DOL guidance with respect to allocation of plan expenses between an individual participant and a plan was Advisory Opinion 94-32A issued in 1994, where the DOL explained that expenses related to the processing of a qualified domestic relations order ("QDRO") could not be charged to the participant and had to be charged to the plan since the QDRO involved a participant exercising a right to which he or she was legally entitled. Most fiduciaries and their counsel applied this guidance to other situations as well. For example, if a terminated participant with a plan account balance over $5,000 desired to exercise her right to keep her account with the plan, and a third party administrator charged a $25 annual fee for maintaining the account, most fiduciaries charged the fee to the plan overall (and thus indirectly to all participants) because the participant was merely exercising a right to which she was otherwise legally entitled. Although AO 94-32A announced the DOL’s views with respect to QDROs, it was not clear that the DOL’s interpretation was required by the statute. In addition, neither AO 94-32 nor any other DOL guidance directly addressed the allocation of expenses in other situations or whether any one particular allocation method was superior to another.

The DOL’s recent guidance addresses all these issues and concedes that the views announced in AO 94-32A were not necessarily required by ERISA. The FAB also provides that AO 94-32A is superceded by the guidance expressed in the FAB.

FAB 2003-3 first addresses how plan expenses may be allocated among all participants. The DOL begins with the observation that ERISA section 404(a)(1)(D) requires fiduciaries to discharge their duties "in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of [Title I of ERISA]." Therefore, a starting proposition is that fiduciaries must follow specific plan directions on allocation of plan expenses, even if such allocation favors or disfavors certain participants, because, according to the DOL, this "in effect becomes part of defining the benefit entitlements under the plan." In addition, it is important to keep in mind that fiduciaries are required to follow the prudence and rational basis principles described in the FAB whether they are allocating a particular expense to an individual participant or all participants.

The more common situation is that a fiduciary faces an expense allocation decision where plan documents are silent or ambiguous. Here the DOL expressly indicates that an expense allocation method that disfavors one class of participants may be acceptable as long as "a rational basis exists for the selected method." As might be expected, the key is that fiduciaries must exercise prudence in selecting an allocation method. In this context, the FAB states that ERISA’s prudence requirement compels fiduciaries to understand how each allocation method affects various classes of participants and to select an allocation method that has a reasonable relationship to the expense incurred. Moreover, the FAB provides that a fiduciary who uses a prudent process to select an allocation method that reasonably but unfavorably affects one class of participants does not violate ERISA’s requirement that fiduciaries act "solely in the interest of participants."

In contrast, a fiduciary who establishes an allocation method with "no reasonable relationship to the services furnished or available to an individual account" may violate ERISA. In extreme cases, the DOL cautions that a fiduciary’s allocation decisions may raise self-dealing issues under ERISA’s prohibited transaction rules if the fiduciary is also a participant and adopts an allocation practice that uniquely benefits the fiduciary. However, a prudent approach to allocation decisions should minimize if not eliminate these issues.

When a fiduciary is evaluating a pro rata versus a per capita expense allocation method, the DOL acknowledges that pro rata will often be an acceptable allocation method, but won’t necessarily be the only appropriate method. The DOL specifically provides examples of when per capita allocation may be appropriate, such as recordkeeping and claims processing expenses. However, the DOL also offers that "where fees or charges to the plan are determined on the basis of account balances, such as investment management fees, a per capita method of allocating such expenses among all participants would appear arbitrary." In addition, an issue that is generating increased interest in light of Enron and other related situations is investment advice services. On this issue, the DOL indicates that a pro rata allocation, a per capita allocation or an allocation based on the utilization of the investment service should all be appropriate.

The FAB illustrates five examples where ERISA does not preclude allocation of related expenses to an individual participant: 

The FAB clarifies the opportunity sponsors have to provide specific directions on how certain defined contribution plan expenses are to be allocated. Most significantly, FAB 2003-3, and particularly its insistence that fiduciaries must follow plan terms, suggests that plan sponsors may amend their defined contribution plans to outline expenses to be paid by the plan as a whole (and the basis of allocating those expenses – per capita, pro rata, or other) and those charged to specific participants. In general, a plan sponsor should consider amending its plan document if the expense is regular and routine in nature and it intends to allocate the expense to individual accounts. For example, a plan may now be amended to expressly state that all expenses incurred in making determinations of the "qualified" status of a domestic relations order or in making a hardship withdrawal be allocated to the participant to whom the order or request relates. Other expenses, such as general legal and administrative expenses, may be less important when it comes to amending the plan document. However, amendments to plan documents are not required in order to take advantage of the FAB.

In adopting any allocation method, a fiduciary must be able to defend the allocation strategy as rational and point to a prudent process in determining the allocation method actually adopted. In this regard the FAB also notes that a tax qualified plan (i.e., almost all defined contribution plans) has a duty to ensure that the plan’s allocation method does not jeopardize the plan’s tax qualified status. For example, plan terms that allocate QDRO expenses to the plan overall with respect to highly compensated employees, but to the affected participants with respect to non-highly compensated employees would almost certainly be viewed as discrimination that could lead to the plan's disqualification.

Despite the broad new discretion granted by the FAB, the ultimate reality of allocating defined contribution plan expenses is that any allocation will reduce participant account balances. For this reason, some plan sponsors may decide to continue to pay plan expenses out of non-plan assets, rather than risk raising the ire of participants. In addition, before allocating expenses to participants, plans are required to include certain items in the plan’s summary plan description ("SPD"). Specifically, the FAB notes that a SPD must include (1) a summary of plan provisions that could result in fees or charges imposed on a participant or his or her individual account and (2) a statement indicating the circumstances when an offset or reduction of any benefits will occur. As a result, any expense allocation that results in participants paying a greater share of expenses must be reflected in the SPD. Therefore, plans should review their SPD language before taking advantage of the FAB and making any determination to allocate plan expenses to participants.

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