April 1, 2012, is a significant date for plan sponsors and their plan committees. By that date, they should have received – and will need to begin evaluating – information from their plan's service providers under a newly effective U.S. Department of Labor (DOL) regulation. That regulation (the 408(b)(2) regulation) requires plan service providers to make disclosures – about their services, compensation and fiduciary status – to their clients (the responsible plan fiduciary) by April 1 of next year. As a result, starting next spring, plan sponsors will face heightened expectations and legal responsibilities.
The regulation initially imposes an obligation only on service providers to make written disclosures, and does not explicitly impose duties on plan sponsors or fiduciaries. However, as explained in the preamble to the regulation, under the general fiduciary rules of the Employee Retirement Income Security Act (ERISA), once the responsible plan fiduciaries get the information, they will have a duty to evaluate it. (More accurately, fiduciaries have always had that obligation under ERISA; however, now that the disclosures must be made by service providers, the importance of fiduciary compliance is highlighted.)
The purpose of this Bulletin is to identify the key issues for plan sponsors and provide an overview of the fiduciary responsibilities. (The obligation to review information provided by service providers falls on the fiduciary with the power to engage the service provider, who is referred to in the 408(b)(2) regulation as the "responsible plan fiduciary." That fiduciary may be the plan committee or some other person or group appointed by the plan sponsor or by the named fiduciary designated in the plan. Because the plan sponsor is ultimately responsible for the plan, for ease of reference, we sometimes use the term "plan sponsor" when referring to the obligations of the responsible plan fiduciary.) Before exploring the issues, let's start with a review of where we are.
Fiduciaries of retirement plans must evaluate the expenses paid by their plans for services and investments. In fact, it is both a fiduciary breach and a prohibited transaction to allow your plan to pay more than reasonable expenses. However, many plan sponsors are not aware that they must also evaluate the reasonableness of the compensation of their plans' service providers. But, you may be thinking, aren't costs and compensation the same thing? Not necessarily. For example, reasonably priced mutual funds may pay "revenue sharing" (such as so-called subtransfer agency fees) to a recordkeeper. The obvious cost to the plan for recordkeeping is the direct fee that the recordkeeper charges, if any. But the compensation of the recordkeeper includes that direct fee and the indirect revenue sharing payments. When all of those fees are collected by the recordkeeper, its total compensation could be more than reasonable. Similarly, reasonably priced mutual funds may pay 12b-1 fees and revenue sharing to a plan's broker-dealer, which, in the aggregate, are excessive compensation for the size of the plan and the services rendered, even though there may be no discrete direct cost to the plan.
Plan sponsors have a fiduciary duty to know about the compensation of their service providers, including money received indirectly (like the 12b-1 fees and revenue sharing discussed above).1 However, in our experience, some plan sponsors are not aware of those payments or how they are calculated, much less the total amount actually being received by the providers. In addition, those payments may indicate conflicts of interest, which have the potential to hurt the plan and the participants. The responsible plan fiduciaries — typically the plan committee members — have to be aware of those conflicts and mitigate any potentially harmful effects.
New DOL Regulation
Historically, the DOL has taken the position that fiduciaries had the duty to obtain and evaluate information about the costs to the plan and the compensation of the service providers;2 but there was no parallel duty on the part of service providers to disclose the information. The DOL has now issued a regulation that requires your plan's service providers to disclose information about their services, status and compensation. The regulation explains the requirement in section 408(b)(2) of ERISA that service providers must be "reasonable" in their dealings with retirement plans. That guidance is commonly referred to as the 408(b)(2) regulation.3
The new requirements apply to "covered services" for "covered plans." Without going into great detail, the definitions are:
- A "covered plan" is a retirement plan that is subject to ERISA and, as a practical matter, includes 401(k) plans, pension and profit-sharing plans, and many 403(b) plans (but it does not apply to government or most church plans).
- A "covered service" includes ERISA fiduciary services, registered investment adviser (RIA) services, 40(k) recordkeeper and brokerage services and, if they receive indirect compensation, the services of almost all other providers who work with plans, e.g., broker-dealers, third party administrators and consultants.
- "Indirect" compensation means any money or other things of value received by the service provider in connection with the plan, other than payments directly from the plan or the plan sponsor.
What must be disclosed? There are three separate disclosure requirements: services, status and compensation.4
The first requirement is that the service provider provide a description of its services to the plan. The regulation requires that the disclosures be made to the "responsible plan fiduciary," who is the person with the power to hire and fire the service provider on behalf of the plan. For small plans, that is typically the plan sponsor, often represented by the president of the company (or other key officers, or an owner or partner). For mid-sized and large plans, it is usually a plan committee.
The description should have enough detail that you can determine if the provider is delivering the services you expect and need for your plan. If you need more information, ask for it. In the preamble to the regulation, the DOL makes a point of saying that fiduciaries are responsible for asking for additional information if they need it to properly evaluate the services and the compensation.
The second disclosure requirement is whether your service provider is serving as an ERISA fiduciary and/or as a registered investment adviser. If the service provider "reasonably expects" to be a fiduciary to your plan, it must affirmatively say that it is. For example, if an adviser is making recommendations regarding the selection and monitoring of the plan's investments, it is most likely serving as a fiduciary to the plan and, under the 408(b)(2) regulation, must tell you in writing that he is. On the other hand, if a service provider is not acting as a fiduciary, it is not required to state that. Thus, if a provider is silent on the issue, you can assume that it is not acting as a fiduciary. This raises an issue: if you believe that the adviser is a fiduciary, or if you expect the provider to serve the plan in that capacity, you should request written confirmation of fiduciary status.
Similarly, if a provider is acting as an RIA (i.e., a registered investment adviser), the provider must affirmatively state that fact in writing.
The third disclosure is compensation. Compensation is defined very broadly. It is anything of monetary value, such as gifts, awards, trips, etc. (However, non-monetary compensation totaling $250 or less does not need to be reported to you.) It also includes certain payments to affiliates or subcontractors of your provider (that is, if the payments are transactional, like commissions, or if they are charged directly against the investments). In the preamble to the regulation, the DOL makes a point that, in addition to determining the reasonableness of compensation, those payments may indicate conflicts of interest that the fiduciaries must evaluate.
Compensation is divided into four categories: direct, indirect, related parties and termination.
- Direct compensation: This category covers any payments made directly from the plan or trust. For example, if a service provider sends you a bill and you pay it from plan assets, that is direct compensation.
- Indirect compensation: This category covers all payments from any source other than directly from the plan or the plan sponsor. While direct compensation is fully transparent (e.g., a bill is presented to the plan, reviewed, authorized and paid), indirect compensation was not previously required to be disclosed to plan sponsors. As a result, one of the main reasons for the 408(b)(2) regulation is to make sure fiduciaries are receiving information about indirect compensation.
- Compensation among related parties: As a general rule, your service provider does not need to break out its revenue to show how much each of its affiliates and subcontractors is receiving. However, the DOL believes that you, as the responsible plan fiduciary, need detailed information on certain types of compensation. As a result, to the extent that an affiliate or subcontractor receives "transaction compensation" (such as commissions or incentive compensation based on business placed or retained with your plan) or compensation "charged directly" against the investments (such as 12b-1 fees that might be paid to a recordkeeper or broker-dealer), those types of compensation must be broken out and reported to you separately. The disclosure will tell you how much (as a dollar amount or formula) they are getting, who is paying it and what it is for.
- Compensation on termination: This requires a description of any amounts the plan must pay if the arrangement is terminated. It also includes the treatment of prepaid amounts, i.e., whether they will be prorated if the agreement is terminated and how that will happen. It also includes charges that may be imposed if the plan terminates the service provider or removes an investment (e.g., surrender charges).
- Manner of receipt: The disclosures must also specify how the compensation will be paid. Will the plan be billed? Will it be deducted from the participant's accounts or investments?
Obviously, fiduciaries must understand and evaluate these disclosures.
Special Disclosure Issues
In addition to the three main categories of services, status and compensation, there are other disclosures required in certain special situations:
- Recordkeeper disclosures: Your recordkeeper will need to make additional disclosures. The recordkeeper, or bundled providers that include recordkeeping services, will need to:
- Describe all direct and indirect compensation it receives; and
- If its compensation is offset or rebated, or otherwise adjusted, for any compensation it, or its affiliates or subcontractors, receives, the recordkeeper will need to give you a reasonable estimate of what it would charge your plan without those factors. In other words, you must receive a clear statement about what you are paying for recordkeeping—directly, indirectly and through credits for proprietary investments and products. As a fiduciary, your plan committee must then evaluate the reasonableness of the total charges, credits and compensation for these services. The two primary independent methods for doing that analysis are through an RFP (request for proposal) process or a benchmarking service that identifies an appropriate peer group of plans (based primarily on total assets and number of participants).
- Plan investments: Special disclosures will be made to you concerning your plan's investments. Those are:
- Transaction compensation: Fees that are charged against the investments for, e.g., commissions, redemption fees, surrender charges.
- Operating expenses: Charges against the investments for their ongoing operation. e.g., expense ratios.
- Other ongoing expenses: Items such as wrap fees, mortality and expense fees. Other General Rules
- Timing of disclosure: The written disclosures for your current providers must be given by April 1, 2012. Thereafter, as you seek to hire new or additional providers, the disclosures must be given to you reasonably in advance of the time at which the arrangement is entered into. "Reasonably" means that you need time to study the materials and make informed decisions before you sign the agreement. For a straightforward arrangement, that may be just a few days. For a more complex agreement, you may need longer. As a word of advice, make sure these disclosures and the service agreements are reviewed by an experienced benefits attorney. The documents often include provisions that would be unacceptable to a prudent fiduciary, if the fiduciary were aware of them.
- Additional disclosures: If there is a change to the information that was given to you, the service provider should, in almost all cases, notify you in writing within 60 days of learning of the change. In addition, if you need information about a service provider's compensation in order to satisfy ERISA's reporting and disclosure requirements (for example, to complete the Form 5500), the service provider must give you that information within 30 days of receiving your written request, unless there are extraordinary circumstances that justify a delay.
Plan Sponsor Responsibility
Of course, the regulation and the disclosures are not the end of the story. When you receive the disclosures, you have a duty to review and evaluate them. Is the compensation reasonable in relation to the services being received? Are the services appropriate for the plan? Are they meeting the needs of the fiduciaries and the participants? Are there conflicts of interest and, if so, are they being managed properly? It is your fiduciary duty to engage in a prudent process to review the information and answer those questions.
Those are difficult questions for plan sponsors to answer. After all, plan sponsors are not in the 401(k) business, and the process for evaluating this information may be somewhat different from the work your committee has done in the past. As a result, they should work with experienced consultants and lawyers who can help them understand the issues and reach informed decisions. For example, it may be helpful for your benefits attorney to participate in a meeting to educate your committee on the information needed and the evaluation process. Many courts have said that the use of knowledgeable advisers is evidence of a prudent process.5
Failure to Make the Disclosures
What happens if the service provider fails in its obligation to make the required disclosures? ERISA §406(a) says that an arrangement between a plan and a service provider is prohibited unless the arrangement is reasonable, the compensation being paid to the service provider is reasonable, and, effective April 1 of next year, the service provider has made the required disclosures. Without these disclosures, the arrangement is a prohibited transaction, which means that it must be "corrected" and that an excise tax may be imposed under section 4975 of the Internal Revenue Code.
As a general proposition, under ERISA, the parties engaging in the prohibited transaction are the service provider who failed to make the required disclosures and the fiduciary who entered into the arrangement without obtaining the disclosures. Since the intent of the 408(b)(2) regulation is to impose an obligation on the service provider and not to penalize the fiduciary who is supposed to receive the disclosures, the regulation contains an exemption for the responsible plan fiduciary in this situation. In order for the exemption to apply, certain conditions must be satisfied:
- First, the fiduciary must not know that the service provider failed to make the required disclosures and must reasonably believe that it did disclose the required information. Clearly, this condition could not apply where no disclosures have been made. In that case, the fiduciary will be equally responsible with the service provider for correction of the prohibited transaction.
- The fiduciary must request the missing or incomplete information in writing as soon as it discovers the failure. No time limit is provided, so it would appear that the request would need to be made within a very short time after discovery.
- If the service provider fails to provide the information within 90 days, the fiduciary must send a written notice to the DOL.
The regulation details the information that must be provided in the notice and specifies that the notice must be filed within 30 days after the service provider's refusal to supply the information or at the end of the 90 day period. The regulation also reminds the fiduciary that it has one additional obligation, and that is to decide whether to terminate or continue the contract with the service provider. In making that decision, it must "evaluate the nature of the failure, the availability, qualifications, and cost of replacement service providers, and the covered service provider's response to notification of the failure." We read this to mean that if the failure to disclose was egregious and/or the service provider refuses to correct the problem, the contract should probably be terminated. But absent either of these factors, the fiduciary should take into account whether it can obtain comparable services and the cost of those services before deciding to terminate the contract. In other words, the fiduciary must act prudently in deciding what to do.
1 See, e.g., U.S. Department of Labor Advisery Opinions 97-15A and 97-16A.
3 ERISA Reg. §2550.408b-2.
4 See, 75 Federal Register 41608 (July 16, 2010).
5 See, e.g., Liss v. Smith, 991 F.Supp. 278, 297 (S.D.N.Y. 1998); United States v. Mason Tenders Dist. Council of Greater New York, 909 F.Supp. 882, 886 (S.D.N.Y. 1995); Trapani v. Consolidated Edison Employees' Mutual Aid Society, 693 F.Supp. 1509, 1516 (S.D.N.Y. 1988).
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.