Employers sponsoring ERISA-covered, participant-directed, individual account plans (such as 401(k) or 403(b) plans) are constantly reminded of their fiduciary duties. In recent years, almost any discussion of these duties has included the issue of fees that are charged to participants’ accounts (or that otherwise affect a participant’s account balance). Fiduciaries are being told that they must (i) know what fees are being charged to or paid from plan assets, (ii) understand what those fees are for, (iii) make sure that the fees paid are reasonable in relation to the services provided, (iv) disclose certain fees to plan participants, and (v) report certain fees to the government. But where are all of these requirements coming from? And why is there so much more focus on fees than there was 10 years ago?
The Department of Labor (“DOL”) is the federal agency charged with interpreting and implementing the Employee Retirement Income Security Act (“ERISA”), the 1974 legislation designed to protect the interests of participants and beneficiaries in employer-sponsored benefit plans, including tax-favored retirement plans. In recent years, both the DOL and members of Congress have become increasingly concerned about the effect that high fees can have on participant account balances in ERISA-covered retirement plans, particularly over the duration of the “accumulation phase” (the period during which participants are contributing to, rather than making withdrawals from, their retirement accounts).
The DOL has determined that, in many cases, neither the plan sponsor nor participants are fully aware of the actual “cost” of the plan’s investments or the services provided to the plan. The DOL has also noted that, as revenue sharing has became more common, many plan sponsors and participants mistakenly believe that certain services are “free,” when in fact the true costs of those services are hidden within the “expense ratio” associated with mutual funds or the “mortality and expense” fees charged on annuities and other insurance products offered as plan investment options.
In an effort to address this problem, the DOL has focused on three specific aspects of fee disclosure (although not necessarily in this order): (i) to plan fiduciaries by service providers and investment providers, (ii) to participants by plan fiduciaries, and (iii) to the government and the public by plan administrators (as a part of the Form 5500 annual reporting process). The result has been something of a three-ring circus. Unfortunately, fiduciaries and service providers would be well-advised to keep an eye on all three rings.
Ring #1: Disclosures to the Government and the Public
Because the last of the DOL’s three fee initiatives (increased disclosure of fees on Form 5500 annual reports) is already fully implemented, the action in that ring is now well underway. Beginning with the 2009 plan year, “large” plan sponsors (those with over 100 participants) have been required to disclose additional information about fees paid to service providers on Schedule C to Form 5500. Under these rules, a plan sponsor must report the identity of, and the amount paid to, any service provider that received (from plan assets) at least $5,000 in direct or indirect compensation for services provided to the plan, or due to that provider’s position with respect to the plan (e.g., for serving as a trustee or administrator). For certain types of service providers, this $5,000 threshold is reduced to $1,000.
Although the requirement to complete and file a Schedule C falls on the plan administrator (which is often the plan sponsor), service providers are required, under ERISA, to provide plan administrators with the information needed to complete the annual report. In addition, service providers often provide “signature-ready” Forms 5500 for the plans they serve. Therefore, much of the burden of the Schedule C reporting requirement has been shouldered by service providers.
Although the other two disclosure initiatives have not yet been fully implemented, they are scheduled to take effect in the very near future. Accordingly, plan fiduciaries and service providers will now want to pay closer attention to the other two rings of the circus.
Ring #2: Disclosures by Service Provider to Plan Fiduciaries
The DOL has already issued both proposed and “interim final” regulations setting forth new standards for disclosure of fees by service providers. These rules were promulgated under Section 408(b)(2) of ERISA, which (oddly enough) is one of the “prohibited transaction” rules. Under Section 408(b)(2), it is a “prohibited transaction” for a plan fiduciary to enter into a contract with a service provider unless the contract is a “reasonable” contract or arrangement. That is, the plan may not pay more than “reasonable” compensation for the services rendered to the plan and its participants.
The interim final Section 408(b)(2) regulations provide that, effective January 1, 2012, a contract between a plan and a service provider will be deemed to be an “unreasonable” contract unless the service provider discloses (in advance) certain information about the services that will be provided to the plan, along with the direct and indirect compensation the service provider will receive in exchange for providing those services. These regulations reflect the DOL’s belief that a responsible plan fiduciary cannot determine the reasonableness of an arrangement (or the reasonableness of the fees paid for services to the plan) unless the service provider fully discloses the fees it will receive — either directly from the plan or indirectly from other parties related to the plan — for the services it is promising to provide.
Failure to satisfy these Section 408(b)(2) service-provider fee disclosure requirements (once they become effective) will have consequences for both the service provider and the responsible plan fiduciary. The parties will be deemed to have entered into a prohibited transaction, under both ERISA and the Internal Revenue Code. This would constitute a breach of fiduciary duty by the plan fiduciary (which could subject the fiduciary to civil penalties and personal liability for losses associated with that breach), and would also subject the service provider to a 15% excise tax. Therefore, both service providers and plan fiduciaries have a vested interest in satisfying the fee disclosure requirements of Section 408(b)(2).
Service providers and plan fiduciaries are currently awaiting “final” DOL regulations detailing exactly what information must be disclosed, as well as how and when that information must be provided to the responsible plan fiduciary. We understand that those regulations will soon be sent to the Office of Management and Budget for final review, meaning that they should be issued within the next few months. If they are not issued soon, however, it may be difficult for service providers to fully comply by the (currently proposed) effective date of January 1, 2012.
Ring #3: Disclosures by Plan Fiduciaries to Participants
The third initiative in this three-ring, fee-disclosure circus will require plan fiduciaries to disclose certain information about fees (including the fees associated with investment options) to plan participants. This is essentially an expansion of the fiduciary responsibility rules found in Section 404 of ERISA. The DOL has issued both proposed and final regulations setting forth the types of fee information that must be disclosed to participants, and those regulations are scheduled to become effective for plan years beginning on or after November 1, 2011 (i.e., January 1, 2012, for calendar-year plans).
Under the final regulations, fiduciaries of participant-directed, individual-account plans must notify participants — when they first become eligible to participate in the plan and annually thereafter — of the fees associated with both (i) the operation and administration of the plan (such as recordkeeping fees, loan origination fees, or QDRO review fees), and (ii) the investment options available under the plan. In addition, these regulations will require quarterly disclosure of any fees that have actually been charged to a participant’s account during the previous quarter. Although these disclosures are technically the responsibility of a plan fiduciary, many fiduciaries will be looking to their investment providers and/or service providers to help them satisfy these fee disclosure requirements.
Once the participant fee disclosure regulations become effective, many of the disclosures that are now required only if a plan intends to satisfy the requirements of ERISA Section 404(c) (which limits the liability of plan fiduciaries when participants exercise control over the investment of their accounts) will now apply to any plan that allows participants to direct the investment of their accounts.
After the Big-Top Comes Down: What Does It Mean?
So what effect will all these disclosures have on plan sponsors and participants? Only time will tell. The DOL hopes that the service-provider fee disclosure rules will give plan fiduciaries the information they need to make more informed (i.e., prudent) decisions when purchasing plan services and selecting investment providers.
For example, a “bundled” service provider may have formerly sold its services to plan sponsors by claiming that it will provide “free” recordkeeping and year-end testing and reporting services, so long as the plan chooses the provider’s “proprietary” investment options (or an array of investment options that provide significant “revenue sharing” to the provider). Now, that same provider must disclose not only the amount of direct compensation it receives from the plan, but also the amount of revenue it expects to receive from third parties (such as the mutual funds selected as investment options under the plan).
In addition, under the separate participant fee disclosure rules, participants must be advised that, even if there are no fees explicitly assessed against their accounts for “recordkeeping” or “administration,” a portion of the “investment management” fee (or “expense ratio”) attributable to the plan’s investment options is actually being paid to the plan’s recordkeeper or other service provider to compensate them for providing those services.
This additional information should, in theory, allow participants to make more informed investment decisions with respect to the options available under the plan. Unfortunately, it could also lead to increased litigation by participants who feel that their plan fiduciaries are not prudently managing the plan’s fees and expenses. Again, only time will tell, so stay tuned!