There has never been greater attention in Washington, D.C. to the issue of fees charged to individual participants in 401(k) plans, how those fees are shared among a plan’s service providers, and the disclosure of those fees/revenue sharing arrangements to plan sponsors and plan participants.
Since July of 2007, three different bills have been introduced in Congress dealing with the disclosure of 401(k) fees. In November of 2007, the Department of Labor (“DOL”) finalized regulations significantly expanding the types of fee information that must be disclosed on Form 5500 Annual Reports (beginning with the 2009 plan year). In January of this year, the DOL issued a controversial set of proposed regulations that would require service providers to make (and plan sponsors to obtain) specific disclosures regarding fees and potential conflicts of interest prior to entering into an agreement for services to the plan. Finally, the DOL has solicited comments, and intends to issue proposed regulations later this year, regarding the types of fee information that must be disclosed to plan participants.
This article discusses the DOL’s proposed fee disclosure regulations and how the regulatory process may be affected by the legislative proposals. BACKGROUND
Service provider fee arrangements have become increasingly complex in recent years. In many cases, neither plan participants nor plan fiduciaries are fully aware of (or fully understand) the types or amount of fees that are being charged to individual participant accounts, or how those fees are shared among the various service providers to the plan. However, plan fiduciaries have a duty under ERISA to make sure that the fees charged to participants’ accounts are “reasonable” in light of the type and amount of services provided to the plan. Plan sponsors cannot determine whether fees are reasonable unless they are aware of, and understand, the fees being charged to the plan and which service providers share in those fees.
Increasing the transparency of service provider arrangements, and educating plan sponsors regarding their fiduciary duties with respect to the management of fees, has been a DOL priority for some time. The proposed regulations are the second prong of the DOL’s three-tiered initiative to promote fee transparency and an understanding of fee arrangements. (The other two prongs are the final regulations regarding Form 5500 reporting and the future regulations regarding disclosure to participants).
OVERVIEW OF PROPOSED REGULATIONS
Under Section 408(b)(2) of ERISA, plan fiduciaries may enter into contracts with service providers (where some or all of the service provider’s fee is paid out of plan assets) only if the services are provided under a “reasonable” arrangement and the service provider receives no more than “reasonable” compensation. Under the DOL’s proposed fee disclosure regulations, a contract between a plan and a service provider will not be considered a “reasonable” arrangement unless the service provider is obligated to disclose to the responsible plan fiduciary all direct and indirect compensation the service provider will receive under the contract. Failure to comply with the “reasonable contract” requirement will be considered a “prohibited transaction” under ERISA and the Internal Revenue Code.
The proposed regulations cover contracts for:
- Fiduciary services (under either ERISA or the Investment Advisers Act of 1940);
- Recordkeeping or third-party administration services;
- Banking, consulting, custodial, insurance, investment management, investment advisory, or securities/brokerage services; and
- Accounting, actuarial, appraisal, auditing, legal or valuation services (but only if these providers receive indirect compensation under the arrangement).
All required disclosures will have to be made before the contract for services is signed, and if there is any material change during the course of the contract, the service provider will have to update its disclosure information within 30 days. All contracts will have to be in writing. Service providers will have to disclose, to the best of their knowledge:
- the services to be provided to the plan under the contract;
- for each service, the direct and indirect compensation that the service provider (and its affiliates) will receive. For this purpose, “compensation” includes money and anything of monetary value, and includes both amounts received directly from the plan or plan sponsor and amounts received indirectly from a source other than the plan or the plan sponsor (such as revenue sharing payments from a mutual fund provider or soft dollars from a broker);
- how the service provider will be paid (i.e., by the employer or from plan assets);
- whether the service provider (or any affiliate) will be providing any services as a “fiduciary” (either an ERISA fiduciary or a “40 Act” fiduciary);
- whether the service provider (or any affiliate) has any financial interest in any transaction that will be entered into by the plan in connection with the covered services;
- whether the service provider (or any affiliate) has any material financial, referral or other relationship or arrangement with any money manager, broker or other service provider to the plan that creates a conflict of interest for the service provider;
- whether the service provider (or any affiliate) will be able to affect its own compensation without the prior approval of a plan fiduciary (such as to receive “float” or other contingent compensation);
- whether the service provider has policies and procedures in place to address conflicts of interest, and if so, how those policies will operate in relation to the contract; and
- any information the plan sponsor or plan administrator needs to fulfill its ERISA reporting and disclosure requirements (including the reporting of direct and indirect expenses on Schedule C to Form 5500).
Consequently, if the regulations are finalized as proposed, service providers will have to disclose, in writing, all compensation that they or their affiliates will receive under the contract, including such items as gifts, awards and trips. This includes “indirect” compensation from sources other than the plan or plan sponsor (such as revenue sharing payments, rebates, kickbacks, etc.), so long as the compensation relates to the services under the contract or stems from the service provider’s position with the plan.
If a service provider offers a “bundled” set of services (provided by several parties) as a single package, the service provider does not have to disclose how its “bundled” service fee is allocated among the parties providing the services unless the fees are transaction-based fees (such as finder’s fees, brokerage commissions, or “soft dollars” in connection with securities transactions) or are separately charged against the plan’s investments (such as management fees, 12b-1 fees, wrap fees, and float revenue).
A service provider will also have to disclose, in writing, any financial or other interest it may have in transactions involving the plan, and any relationships it may have with third parties that a “reasonable plan fiduciary” would consider significant in screening for conflicts of interest. Failure to comply will cause the responsible fiduciary to be in violation of the prohibited transaction provisions of ERISA, and will subject the service provider to excise taxes under Section 4975 of the Code.
The DOL has proposed a class exemption to protect innocent plan fiduciaries from liability if they enter into a contract with a service provider who does not provide all of the information necessary to comply with the regulation. However, to avail themselves of this relief, “innocent” plan fiduciaries will have to take corrective steps with the service provider after discovering the problem, and report uncooperative providers to the DOL.
The regulations are proposed to be effective 90 days following publication of the final rules, and the DOL has hinted that it would like the regulations to be effective no later than January 1, 2009 (when the final regulations regarding Form 5500 disclosure become effective). The proposed rules would apply to contracts entered into, renewed or extended after the effective date, but how the regulations will apply to existing contracts is not clear. Although 401(k) plans were clearly the major focus of the DOL’s fee disclosure initiative, the proposed rules would apply to all ERISA-covered plans, including pension, health and welfare plans. STATUS OF LEGISLATIVE PROPOSALS
As noted above, Congress is apparently also feeling pressure to take action regarding the disclosure of fees in participant-directed, individual account plans. On July 26, 2007, Representative Miller introduced the 401(k) Fair Disclosure for Retirement Security Act of 2007 (HR 3185), which would amend ERISA to (i) require plans to obtain advance disclosure of fees and services, and (ii) mandate certain disclosures to plan participants. In October of 2007, Representative Neal introduced the Defined Contribution Plan Fee Transparency Act of 2007 (HR 3768), which would amend the Internal Revenue Code to require (as an obligation of the service provider) similar disclosures. Finally, in December of 2007, Senators Harkin and Kohl introduced the Defined Contribution Fee Disclosure Act of 2007 (S 2741), which would amend ERISA to require disclosures to both plan sponsors and plan participants.
Until recently, there had been little action on these bills. Representative Miller introduced a substitute for HR 3185 that was passed out of committee on April 16, 2008 and should go to the House floor in late spring or early summer. However, there are no current plans for the Senate to address the bill. At the same time, the DOL has finished gathering comments and has held a two-day hearing regarding its proposed regulations. As recently as April 7, 2008, Robert Doyle, Director of Regulations and Interpretations for the DOL, indicated that there is “a good possibility” that the Department’s fee disclosure regulations will be in place before any fee disclosure legislation can be passed. He was “fairly optimistic” that the Department will finalize the regulations regarding disclosure to plan sponsors, and will issue proposed regulations regarding disclosure to participants, by the end of the year.
Plan sponsors and service providers may soon be subject to new rules when contracting for services to ERISA-covered plans. These rules will undoubtedly require the service provider to provide, and the plan sponsor to obtain, detailed information about the services provided under the contract and the direct and indirect compensation that the service provider will receive. As of this date, it is more likely that these new rules will be in the form of regulations issued by the DOL under the “reasonable contract” exception from the prohibited transaction rules, but there is also an outside chance that Congress may make certain disclosures a matter of law.
Once these new rules become effective, plan sponsors will not only have a duty to obtain certain fee information before they enter into a contract for plan services, but also to review and consider such information as a part of their fiduciary obligation to their ERISA-covered benefit plans and the employees who participate in such plans.