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.