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Regulations Require Specific Disclosure of Fees Received by Service Providers

On July 15, 2010, the Department of Labor (“DOL”) issued “interim” final regulations regarding the fee information that service providers must disclose to fiduciaries of ERISA-covered retirement plans. This information is intended to assist fiduciaries in assessing the reasonableness of contracts or arrangements for the provision of services to the plan, including the reasonableness of the service provider’s compensation and the potential for conflicts of interest.

Under ERISA, any payment to a service provider out of plan assets is a prohibited transaction unless done pursuant to a “reasonable” contract or other arrangement. These new regulations provide that a contract for services to an ERISA-covered plan will not be considered “reasonable” unless the service provider discloses, in writing, specific information about the services it will provide, whether it will be providing those services as a fiduciary, and the amount of compensation (direct or indirect) that it will receive in exchange for those services. Failure to comply with these fee disclosure regulations (when they become effective in July of 2011) will have consequences for both the responsible plan fiduciary and the service provider. 

Fee Disclosure Initiative

These regulations are part of the DOL’s three-pronged approach to fee disclosure. The first prong dealt with the reporting of plan fees on Schedule C to the Form 5500 Annual Report. Those rules became effective for the 2009 reporting year. The regulations issued last month (concerning fee disclosure by service providers) are the second prong. They are scheduled to become effective, for both new and existing service provider contracts, on July 16, 2011. Guidance on the third and final prong of the fee initiative, which will require specific disclosure of fees (by plan fiduciaries) to plan participants, is expected to be issued later this year.

Covered Plans

The interim final regulations apply solely to contracts between service providers and ERISA-covered retirement plans, such as qualified defined contribution plans, qualified defined benefit plans, and Section 403(b) arrangements. Significantly, the regulations do not apply to individual retirement accounts or annuities (IRAs), simplified employee pension plans (SEPs), or SIMPLE plans. In addition, the regulations do not apply to governmental plans, church plans, or salary-deferral-only 403(b) arrangements that satisfy a regulatory exemption from ERISA. And unlike the 2007 proposed regulations, these interim regulations do not apply to welfare plans.

Covered Service Providers

Under these regulations, a “covered service provider” is a service provider that enters into a contract or arrangement with a covered plan under which the service provider reasonably expects to receive at least $1,000 in compensation, directly or indirectly, in return for providing one or more of the services described below – regardless of whether the services will be performed (or the compensation received) directly by the covered service provider or by an affiliate or subcontractor. The three categories of covered services are as follows:
 

  1. Services as a fiduciary or registered investment advisor. These include services provided:    

    a. directly to the plan as an ERISA fiduciary;

    b. directly to the plan as an investment advisor registered under the Investment Advisors Act of 1940 or any state law; or

    c. as a fiduciary to an investment contract, product, or entity that holds plan assets and in which the plan has a direct equity investment. 

  2. Certain recordkeeping or brokerage services . These include recordkeeping services or brokerage services provided to a participant-directed, individual account plan where one or more of the investment alternatives are made available (through a platform or similar mechanism) in connection with such recordkeeping services or brokerage services. 

     

  3. Certain other services for indirect compensation.These include accounting, auditing, actuarial, appraisal, banking, consulting (as defined below), custodial, insurance, investment advisory (for the plan or its participants), legal, recordkeeping, securities or other investment brokerage, third-party administration, or valuation services provided to a plan for which the service provider (or an affiliate or subcontractor) reasonably expects to receive either (i) indirect compensation (as defined below) or (ii) compensation (from an affiliate or subcontractor) that is set on a transaction basis or is charged directly against the plan’s investment and reflected in the net value of that investment. For purposes of this category of covered services, “consulting” means consulting with respect to investment policies or objectives, or with respect to the selection or monitoring of service providers or plan investments. 

     

  4. Accordingly, the service providers that will be subject to the new fee disclosure requirements include:  

a. ERISA fiduciaries (i.e., trustees, plan administrators, investment managers, named fiduciaries, and persons who provide investment advice for a fee) and registered investment advisors that provide services directly to the plan;

b. Companies (i.e., banks, insurance companies, mutual fund companies, brokers, and third party administrators) that provide recordkeeping and/or brokerage services in connection with making a “platform” of investment options available to participant-directed individual account plans;

c. Companies or individuals that act in a fiduciary capacity (such as an investment manager or investment advisor) to any investment fund (such as an insurance company separate account or an investment fund that is not registered under the ‘40 Act) that holds “plan assets”; and  

d. Companies or individuals (such as consultants, TPAs, brokers, or transfer agents) receiving “indirect” compensation in connection with the provision of services to the plan.

Note that most mutual fund companies (and their investment managers) will not be covered service providers (unless the company or an affiliate is providing recordkeeping services or is otherwise serving as a fiduciary to the plan), because the underlying investments of a mutual fund are not considered “plan assets” under ERISA. Therefore, the party responsible for disclosing the fees associated with a plan’s mutual fund investment will generally be the service provider that made that investment available to the plan.

A covered service provider must disclose the following information, in writing, to a responsible plan fiduciary: 

  1. A description of the services to be provided to the plan;

  2. A statement as to whether the service provider (or any affiliate or subcontractor) reasonably expects to provide services as either (i) a fiduciary to the plan, (ii) a fiduciary to an investment fund that holds plan assets, or (ii) a registered investment advisor;

  3. A description of all direct and indirect compensation that the service provider (or any affiliate or subcontractor) reasonably expects to receive in connection with providing the “covered services” described above;

  4. A description of all compensation that will be shared among the service provider and its affiliates or subcontractors, if such compensation is either:   


    a. Set on a transaction basis (such as commissions, soft dollars, or finder’s fees); or
     

    b. Charged directly against the plan’s investment and reflected in the net value of that investment (such as 12b-1 fees); 
     

  5. Any compensation that the service provider (or its affiliates or subcontractors) reasonably expects to receive in connection with termination of the contract, and how any prepaid amounts will then be calculated and refunded;

  6. If recordkeeping services will be provided under the contract, the direct and indirect compensation that the service provider (or any affiliate or subcontractor) reasonably expects to receive in connection with those recordkeeping services. If the service provider expects to provide recordkeeping services without explicit compensation for those services (or when any fee for recordkeeping is offset or rebated based on other compensation the service provider may receive), the service provider must provide a reasonable, good-faith estimate of the cost to the plan of the recordkeeping services, including an explanation of how the estimate was derived and a detailed explanation of the recordkeeping services that will be provided; and

  7. A description of the manner in which the compensation will be received (i.e., whether the plan will be billed or the fees deducted from plan accounts).

    If a covered service provider is providing a platform of investment options (or is providing services as a fiduciary to an investment fund that holds plan assets), the service provider must also disclose the following information for each designated investment option: 

    1. A description of any fees that will be charged against the amount invested in connection with transactions involving the contract (i.e., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, or purchase fees);

    2. A description of the annual operating expenses (i.e., expense ratio) if the return is not fixed; and

    3. A description of any ongoing expenses in addition to the annual operating expenses (i.e. , wrap fees, mortality and expense fees).

      For service providers providing a platform of investment options, this requirement may be satisfied by providing the disclosure materials of the issuer of the designated investment alternative (i.e., by providing the prospectus of a mutual fund investment option), so long as the issuer of the investment product is not an affiliate of the platform provider, the prospectus or other disclosure materials are regulated by a state or federal agency, and the platform provider is not aware that the materials are incomplete or inaccurate. 

      When Fee Information Must Be Disclosed (or Updated)

      The initial fee disclosure information must be disclosed to the responsible plan fiduciary “reasonably in advance of” the date the services contract or arrangement is entered into (or extended or renewed). Although the fee disclosure must be in writing, it does not have to be part of, or included in, the actual written agreement between the service provider and the plan fiduciary.

      The service provider must disclose any change in the fee information as soon as practicable, but no later than 60 days from the date on which the service provider is aware of the change. Good-faith errors in disclosing fees will not cause a service agreement to fail to be a “reasonable” contract or arrangement, so long as the service provider corrects the error as soon as practicable, but no later than 30 days after becoming aware of the error.

      Covered service providers must also furnish (within 30 days of receipt of a written request by a responsible plan fiduciary) any information relating to compensation under the contract or arrangement that is required for the covered plan to comply with the reporting and disclosure requirements of Title I of ERISA (such as the information necessary to complete Schedule C to Form 5500).

      Key Definitions

      Under the regulations, “compensation” is defined as anything of monetary value (e.g., money, gifts, awards, or trips), but does not include non-monetary compensation valued at $250 or less (in the aggregate) during the term of the contract or arrangement. “Direct compensation” is compensation received directly from the covered plan. “Indirect compensation” is compensation received from any source other than the covered plan, the plan sponsor, the covered service provider, or an affiliate or subcontractor of the service provider.

      “Recordkeeping services” means services related to plan administration and monitoring of plan and participant transactions. Examples include enrollment, payroll deductions and contributions, offering designated investment alternatives and other plan investments, loans, withdrawals, and distributions. This phrase also includes the maintenance of plan and participant accounts, records, and statements.

      Consequences of Failure to Follow Disclosure Requirements

      As noted above, any contract or arrangement between an ERISA-covered plan and a service provider is a “prohibited transaction” under both ERISA and the Tax Code unless the contract or arrangement is “reasonable.” The regulations now provide that, after July 16, 2011, a contract or arrangement will not be considered “reasonable” unless the service-provider fee-disclosure requirements are satisfied.

      There are significant penalties – both for plan fiduciaries and for contracting service providers – if the fee-disclosure requirements of the interim final regulations are not satisfied. A fiduciary that causes a plan to enter into an “unreasonable” contract for services to an ERISA-covered plan commits a prohibited transaction under Section 406 of ERISA. Such a violation may subject the responsible plan fiduciary to a 20% civil penalty. A service provider that enters into an “unreasonable” contract with an ERISA plan will also have committed a prohibited transaction, and will be subject to a 15% excise tax under Code Section 4975.

      Relief for Innocent Fiduciaries

      Although these new regulations are quite stringent, they do offer a bit of leeway for “innocent” plan fiduciaries. If a covered service provider fails to make the fee disclosures required by these regulations, a fiduciary will not be considered to have committed a “prohibited transaction” so long as: 

      1. The fiduciary did not know that the service provider failed, or would fail, to make the required disclosures, and reasonably believed that the required disclosures had been made;

      2. Upon discovering the failure, the fiduciary makes a written request that the service provider furnish the required information;

      3. If the service provider fails to comply with such a written request within 90 days, the fiduciary notifies the DOL of the service provider’s failure;

      4. This notice satisfies specific content and timing requirements set forth in the interim regulations; and

      5. The fiduciary makes a determination as to whether to terminate or continue the contract or arrangement (taking into account the nature of the failure, the availability and cost of replacement service providers, and the service provider’s response to the notification).  

      Disclosure Requirements

      A covered service provider must disclose the following information, in writing, to a responsible plan fiduciary: 

      1. A description of the services to be provided to the plan; 

         

      2. A statement as to whether the service provider (or any affiliate or subcontractor) reasonably expects to provide services as either (i) a fiduciary to the plan, (ii) a fiduciary to an investment contract that holds plan assets, or (ii) a registered investment advisor; 

         

      3. A description of all direct and indirect compensation that the service provider (or any affiliate or subcontractor) reasonably expects to receive in connection with providing the “covered services” described above; 

         

      4. A description of all compensation that will be shared among the service provider and its affiliates or subcontractors, if such compensation is either:    

        a. Set on a transaction basis (such as commissions, soft dollars, or finder’s fees); or

        b. Charged directly against the plan’s investment and reflected in the net value of that investment (such as 12b-1 fees); 

      5. Any compensation that the service provider (or its affiliates or subcontractors) reasonably expects to receive in connection with termination of the contract, and how any prepaid amounts will then be calculated and refunded; 

         

      6. If recordkeeping services will be provided under the contract, the direct and indirect compensation that the service provider (or any affiliate or subcontractor) reasonably expects to receive in connection with those recordkeeping services. If the service provider expects to provide recordkeeping services without explicit compensation for those services (or when any fee for recordkeeping is offset or rebated based on other compensation the service provider may receive), the service provider must provide a reasonable, good-faith estimate of the cost to the plan of the recordkeeping services, including an explanation of how the estimate was derived and a detailed explanation of the recordkeeping services that will be provided; and 

         

      7. A description of the manner in which the compensation will be received (i.e., whether the plan will be billed or the fees deducted from plan accounts).

      If a covered service provider is providing a platform of investment options (or is providing services as a fiduciary of an investment contract that holds plan assets), the service provider must also disclose the following information for each designated investment option:  

      1. A description of any fees that will be charged against the amount invested in connection with transactions involving the contract (i.e., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, or purchase fees); 

         

      2. A description of the annual operating expenses (i.e., expense ratio) if the return is not fixed; and 

         

      3. A description of any ongoing expenses in addition to the annual operating expenses (i.e., wrap fees, mortality and expense fees).

        For service providers providing a platform of investment options, this requirement can be satisfied by providing the disclosure materials of the issuer of the designated investment alternative (i.e., by providing the prospectus of a mutual fund investment option), so long as the issuer of the investment product is not an affiliate of the platform provider, the prospectus or other disclosure materials are regulated by a state or federal agency, and the platform provider is not aware that the materials are incomplete or inaccurate. 

        When Fee Information Must be Disclosed (or Updated)

        The initial fee disclosure information must be disclosed to the responsible plan fiduciary “reasonably in advance of” the date the services contract or arrangement is entered into (or extended or renewed). Although the fee disclosure must be in writing, it does not have to be part of, or included in, the actual written agreement between the service provider and the plan fiduciary.

        The service provider must disclose any change in the fee information as soon as practicable, but no later than 60 days from the date on which the service provider is aware of the change. Good-faith errors in disclosing fees will not cause a service agreement to fail to be a “reasonable” contract or arrangement, so long as the service provider corrects the error as soon as practicable, but no later than 30 days after becoming aware of the error.

        Covered service providers must also furnish (within 30 days of receipt of a written request by a responsible plan fiduciary) any information relating to compensation under the contract or arrangement that is required for the covered plan to comply with the reporting and disclosure requirements of Title I of ERISA (such as the information necessary to complete Schedule C to Form 5500).

        Key Definitions

        Under the regulations, “compensation” is defined as anything of monetary value (e.g., money, gifts, awards, or trips), but does not include non-monetary compensation valued at $250 or less (in the aggregate) during the term of the contract or arrangement. “Direct compensation” is compensation received directly from the covered plan. “Indirect compensation” is compensation received from any source other than the covered plan, the plan sponsor, the covered service provider, or an affiliate or subcontractor of the service provider.

        “Recordkeeping services” means services related to plan administration and monitoring of plan and participant transactions. Examples include enrollment, payroll deductions and contributions, offering designated investment alternatives and other plan investments, loans, withdrawals, and distributions. This phrase also includes the maintenance of plan and participant accounts, records, and statements.

        Consequences of Failure to Follow Disclosure Requirements

        As noted above, any contract or arrangement between an ERISA-covered plan and a service provider is a “prohibited transaction” under both ERISA and the Tax Code unless the contract or arrangement is “reasonable.” The regulations now provide that, after July 16, 2011, a contract or arrangement will not be considered “reasonable” unless the service-provider fee-disclosure requirements are satisfied.

        There are significant penalties – both for plan fiduciaries and for contracting service providers – if the fee-disclosure requirements of the interim final regulations are not satisfied. A fiduciary that causes a plan to enter into an “unreasonable” contract for services to an ERISA-covered plan commits a prohibited transaction under Section 406 of ERISA. Such a violation may subject the responsible plan fiduciary to a 20% civil penalty. A service provider that enters into an “unreasonable” contract with an ERISA plan will also have committed a prohibited transaction, and will be subject to a 15% excise tax under Code Section 4975.

        Relief for Innocent Fiduciaries

        Although these new regulations are quite stringent, they do offer a bit of leeway for “innocent” plan fiduciaries. If a covered service provider fails to make the fee disclosures required by these regulations, a fiduciary will not be considered to have committed a “prohibited transaction” so long as: 

        1. The fiduciary did not know that the service provider failed, or would fail, to make the required disclosures, and reasonably believed that the required disclosures had been made; 

           

        2. Upon discovering the failure, the fiduciary makes a written request that the service provider furnish the required information; 

           

        3. If the service provider fails to comply with such a written request within 90 days, the fiduciary notifies the DOL of the service provider’s failure; 

           

        4. This notice satisfies specific content and timing requirements set forth in the interim regulations; and 

           

        5. The fiduciary makes a determination as to whether to terminate or continue the contract or arrangement (taking into account the nature of the failure, the availability and cost of replacement service providers, and the service provider’s response to the notification).