On July 16, 2010, the Department of Labor (DOL) issued interim final regulations under the Employee Retirement Income Security Act of 1974 (ERISA) that intend to shine a light on the still murky world of retirement plan fees. It remains difficult for plan fiduciaries to know exactly what many service providers are paid for their services, given the use of revenue sharing and arrangements that charge service provider fees against the investment return of an investment fund. In this context, DOL has issued interim final regulations (the Fee Disclosure Rules) that require certain service providers to retirement benefit plans to disclose information to plan fiduciaries in certain circumstances. Although the Fee Disclosure Rules technically are limited in scope (as discussed below), we expect them to have a broad impact. Indeed, we expect them to become the default standard for financial disclosure related to U.S. retirement plans.

This is particularly important for plan fiduciaries, as litigation over fiduciary decisions to enter into service contracts is likely to increase after the recent decision in Tibble v. Edison International,[1] where a plan fiduciary was found to have breached its fiduciary duties under ERISA by choosing retail-class funds for the plan’s investment menu, rather than institutional funds that offered the exact same investment at a lower fee.

The Fee Disclosure Rules amend the existing regulations under ERISA section 408(b)(2), which is the statutory prohibited transaction exemption governing the provision of services to plans by service providers who are also parties in  interests with respect to those plans.[2] One of the requirements for relief under ERISA section 408(b)(2) is that the contract with the service provider must be reasonable.[3] Prior to the Fee Disclosure Rules, there was little guidance as to what this requirement meant; the existing regulations under ERISA section 408(b)(2) provided only that a contract was reasonable if the plan could terminate the contract upon reasonably short notice without penalty .[4] Moreover, plan fiduciaries had few tools at their disposal to get straightforward fee information from their service providers in order to make a determination of reasonableness.

Background

The Fee Disclosure Rules are part of an ongoing effort by DOL to increase transparency of plan-related fees and expenses. In 2007, DOL finalized changes to the Form 5500 Schedule C (Schedule C) requiring plans to provide information about service providers who received, directly or indirectly, $5,000 or more in total compensation in connection with services rendered to the plan. Also in 2007, DOL issued proposed regulations under ERISA section 408(b)(2) (the Proposed Regulations) regarding the disclosures service providers were required to make to plan fiduciaries regarding fees and expenses in order for their service relationships to be eligible for relief under ERISA section 408(b)(2). The revised Schedule C and the Proposed Regulations, once finalized, were intended to work together.[5] However, prior to the issuance of the Fee Disclosure Rules, the only enforcement mechanism available to plans to get the compensation information required by the Schedule C was the market-based incentive that ERISA plans will contract only with funds and service providers that agree to provide the information necessary to satisfy the plans’ reporting requirements. [6]

Although the Fee Disclosure Rules do not dovetail with the Schedule C requirements as initially envisioned, as discussed below, the Fee Disclosure Rules do provide plan sponsors and fiduciaries a powerful new tool to get more comprehensive fee information from affected service providers. The Fee Disclosure Rules will require service providers to disclose to independent plan fiduciaries information regarding their services and the direct and indirect compensation they receive in connection with the plan services they provide. This disclosure is intended to assist plan fiduciaries in assessing whether a contract with a service provider is reasonable and whether any potential conflicts of interest that may affect a service provider’s performance exist. In fact, once the Fee Disclosure Rules become effective, a covered service contract or arrangement must satisfy the requirements of the Fee Disclosure Rules in order to be considered reasonable for purposes of ERISA section 408(b)(2).

Notably, the Fee Disclosure Rules do not address disclosures to participants.

When Do the Fee Disclosure Rules Take Effect? 

The Fee Disclosure Rules will take effect on July 16, 2011. All service contracts and arrangements that are subject to the Fee Disclosure Rules will be required to comply in all respects when the new rules take effect, including contracts and arrangements that pre-date July 16, 2011.

What is the Significance of the Fee Disclosure Rules Being “Interim” Final Regulations?

DOL’s decision to issue the Fee Disclosure Rules as interim final regulations means that DOL is still accepting comments on the Fee Disclosure Rules. DOL is particularly interested in receiving comments on the scope of the service providers who are covered by the Fee Disclosure Rules and on the costs and benefits of requiring service providers to provide summary disclosure statements for some or all of the information that is required to be disclosed under the new rules. All comments are due by August 30, 2010.

Although DOL is still accepting comments, it is important to note that DOL has stated publicly that it does not anticipate making significant changes to the Fee Disclosure Rules in response to any comments it receives. Therefore, covered plans and service providers should feel comfortable taking the necessary steps for compliance by the July 16, 2011 effective date based on the Fee Disclosure Rules set forth in the interim final regulations.

What Types of Plans Are Affected?

The Fee Disclosure Rules currently apply only to retirement benefit plans. DOL intends to expand the Fee Disclosure Rules to welfare plans at a later date.

What is the Scope of the Fee Disclosure Rules?

As a threshold matter, the Fee Disclosure Rules are only applicable when a service provider relationship would otherwise be prohibited under ERISA because it constitutes a direct or indirect service relationship between a plan and a party in interest with respect to a plan. ERISA section 408(b)(2) exempts from ERISA’s prohibitions reasonable contracts or arrangements with service providers who are parties in interest if the services are necessary for the establishment or operation of the plan and no more than reasonable compensation is paid.

A service provider is generally a party in interest under a plan if the service provider or an affiliate provides any other services to the plan. For example, in a 401(k) plan, a newly hired record keeper to a plan would be a party in interest to the plan if its affiliate currently provided investment management services to the plan. In a defined benefit plan, a newly hired investment manager for the plan would be a party in interest if the investment manager was a 50 percent subsidiary of the plan’s trustee. On the other hand, due to the consolidation of the financial services industry and the broad and far reaching definition of party in interest under ERISA, it is difficult to determine with certainty that a party in interest relationship with the plan does not exist.

If a plan fiduciary hires a party in interest to the plan to provide services to the plan for direct or indirect compensation paid even in part by the plan, both the service provider and the plan fiduciary will be subject to potential liability for engaging in a non-exempt prohibited transaction unless the transaction is covered by an exemption.

If no portion of the fee paid to a covered service provider is paid by the plan, directly or indirectly, then the service provider transaction may not be prohibited. However, one of the premises of the Fee Disclosure Rules is that plans are subject to many hidden fees of which plan fiduciaries are not always aware. A plan fiduciary should have a very high degree of comfort that no plan assets are indirectly being paid to a service provider to conclude that it is not subject to the Fee Disclosure Rules on this basis.

Accordingly, because of the difficulty identifying parties in interest and whether any indirect compensation is being paid to service providers, the backdrop of plan fee litigation and increasing scrutiny of fees by regulatory agencies, many plan fiduciaries will choose to treat all service providers as if they were subject to the Fee Disclosure Rules.

Similarly, it stands to reason that most service providers will develop uniform methods of disclosing their fees which will satisfy the Fee Disclosure Rules.

So while the technical reach of the Fee Disclosure Rules is more limited in scope, the Fee Disclosure Rules seem poised to transform this portion of the retirement plan world.

Which Service Contracts Are Subject to the Fee Disclosure Rules?

The Fee Disclosure Rules apply to service contracts between a “covered plan” and a “covered service provider.”

Covered Plan. A plan is a “covered plan” if it is a defined benefit or defined contribution retirement plan that is subject to Title I of ERISA. IRAs that are not sponsored by an employer are not covered plans.[7] 

Covered Service Provider. A service provider is a “covered service provider” if it reasonably expects to receive at least $1,000 in compensation, directly or indirectly, under a contract or arrangement for any of the following services:

  • Services as either an ERISA fiduciary (either directly to the plan or to a Plan Asset Entity) or as an investment adviser registered under the Investment Advisers Act of 1940 (1940 Act) or any state law. A “Plan Asset Entity” is an investment contract, product or entity that holds plan assets within the meaning of ERISA and in which the covered plan has a direct equity investment. 
  • Recordkeeping or brokerage services provided to an individual account plan that permits participants or beneficiaries to direct the investment of their accounts, if one or more designated investment alternatives will be made available in connection with such recordkeeping or brokerage services. A “designated investment alternative” is any investment alternative designated by a fiduciary into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts. The term does not include brokerage windows, self-directed brokerage accounts or similar plan arrangements that enable participants and beneficiaries to select investments beyond those specifically designated. 
  • Accounting, auditing, appraisal, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third party administration, valuation services provided to the covered plan, for which the service provider, an affiliate or subcontractor reasonably expects to receive indirect compensation or compensation paid among the service provider, an affiliate or a subcontractor.

    What Disclosures Are Required by the Fee Disclosure Rules?

    The Fee Disclosure Rules require a covered service provider to give the following written disclosures to a covered plan before entering into a service contract or arrangement with the plan.

    Description of Services. The service provider must provide the plan with a description of the services it will provide under the contract or arrangement in a fiduciary capacity. (Those service providers to Plan Asset Entities are not required to describe non-fiduciary services, e.g., directed brokerage services, provided to those entities). If the service provider’s description lacks sufficient detail to enable the fiduciary negotiating the contract for the plan to determine if the compensation that will be paid for the services is reasonable, the fiduciary must request additional information regarding the services to be provided. The Preamble to the Fee Disclosure Rules provides that the plan fiduciary’s duty to request sufficient information to conclude the cost of plan service is reasonable extends beyond the requirements of ERISA section 408(b)(2) and has an independent basis in the fiduciary duty rules under ERISA section 404(a).

    Disclosures of the Status of Service Providers, Affiliates and Subcontractors. The description of the services must also state, as applicable, that the service provider, or its affiliate or subcontractor, will provide services as an ERISA fiduciary (either directly to the plan or to a Plan Asset Entity), an investment adviser registered under the 1940 Act or state law, or both.

    Disclosures Regarding Compensation. The service provider must make the disclosures described below regarding the compensation it receives under the contract with the plan. The Fee Disclosure Rules set forth three categories of compensation that must be disclosed independently of one another.


    • Direct and Indirect Compensation. The service provider must disclose all direct and indirect compensation that it or its affiliate or subcontractor reasonably expects to receive from the plan for services performed under the contract. “Direct compensation” is compensation received directly from the covered plan. “Indirect compensation” is compensation received from any source other than the plan or the plan sponsor, the covered service provider, or an affiliate or subcontractor of the service provider. The disclosure must also identify the payer of the indirect compensation and the services to which it relates.
    • Compensation Paid to Related Parties. The second category of related party compensation disclosures seems aimed to illuminate for plan fiduciaries those actual or potential conflicts of interest among service providers that may impact the quality of services provided to a plan, which is one of DOL’s stated purposes underlying the Fee Disclosure Rules. The service provider must disclose compensation paid among the service provider, its affiliates and subcontractors if the compensation is set on a transactional basis (e.g., commissions, soft dollars, finder’s fees or other similar incentive compensation based on business placed or retained) or is charged directly against the covered plan’s investment and reflected in the net value of the investment (e.g., Rule 12b-1 fees). The service provider must identify the services for which the compensation will be paid, the payers and recipients of the compensation and the status of each payer and recipient as an affiliate or subcontractor. These disclosures must be made even if the compensation in question is required to be disclosed separately under the rules for direct or indirect compensation. Notably, compensation paid by a service provider, affiliate or subcontractor to their employees for employee services is not disclosed.
    • Compensation Paid In Connection with the Termination of the Service Contract. The service provider must disclose compensation that an affiliate or a subcontractor reasonably expects to receive in connection with the termination of the contract and how any prepaid amounts will be calculated and refunded upon termination.

      Disclosures Related to the Fees and/or Costs of Recordkeeping Services. The Fee Disclosure Rules require certain disclosures specific to recordkeeping services, which reflect DOL’s belief that costs for recordkeeping services are particularly tricky for plan fiduciaries to assess with any degree of confidence. Accordingly, if a covered service provider will perform recordkeeping services for the covered plan, the covered service provider must furnish a description of all direct and indirect compensation that the covered service provider, an affiliate or subcontractor reasonably expects to receive in connection with the recordkeeping services.

      Even if the covered service provider reasonably expects recordkeeping services to be provided, in whole or in part, without explicit compensation for the recordkeeping services, or when compensation for the recordkeeping services is offset or rebated based on other compensation received by the covered service provider, an affiliate or subcontractor, the covered service provider must furnish a reasonable and good faith estimate of the cost to the covered plan of the recordkeeping services. This covered service provider must explain the methodology and assumptions used to prepare the estimate and describe in detail the recordkeeping services that will be provided to the covered plan. The estimate must take into account, as applicable, the rates that the covered service provider, affiliate or subcontractor would charge third parties, or the prevailing market rates charged for similar recordkeeping services for a similar plan with a similar number of participants and beneficiaries. The Fee Disclosure Rules do not directly address whether the service provider is required to update any estimate that later turns out to be inaccurate. However, this arguably would be required by the rule in the Fee Disclosure Rules requiring changes to a service provider’s initial disclosures (discussed below).

      Disclosures Regarding the Manner of Receipt of Compensation. The covered service provider must disclose the manner in which the compensation it receives under the contract will be received, such as whether the covered plan will be billed or the compensation will be deducted directly from the covered plan’s accounts or investments.

      Investment Disclosures – Fiduciary Services and Recordkeeping and Brokerage Services. The Fee Disclosure Rules require fiduciaries to Plan Asset Entities and recordkeepers and brokers that make available investment alternatives for participant-directed individual account plans to disclose the following information to the covered plan:


      • A description of any compensation that will be charged directly against the amount invested in connection with the acquisition, sale, transfer of, or withdrawal from, the investment contract, product or entity (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees and purchase fees);
      • A description of the annual operating expenses (e.g., expense ratio) if the investment return is not fixed; and
      • A description of any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees).

        Fiduciaries to Plan Asset Entities must make these disclosures to their direct investors who are covered plans.

        For recordkeepers and brokers that make available investment alternatives for participant-directed individual account plans, these disclosures must be made with respect to each designated investment alternative for which recordkeeping or brokerage services will be provided pursuant to the contract with the covered plan. On the other hand, these recordkeepers and brokers will be allowed to “piggyback” on the fund’s disclosure documents (e.g., the fund’s prospectus for a registered mutual fund) if the fund or fund manager is not affiliated with the recordkeeper or broker and the recordkeeper or broker does not know the material to be incomplete or inaccurate.

        When Must the Required Disclosures Be Made?

        Timing of Initial Disclosures. In general, a covered service provider must provide the disclosures discussed above to the responsible plan fiduciary reasonably in advance of the date the contract is entered into, extended or renewed. There is no specific deadline for making the disclosures before the contract takes effect.

        Special Timing Rule Disclosures Required After a Contract Takes Effect. If a covered plan invests in a non-Plan Asset Entity which subsequently becomes a Plan Asset Entity, any fiduciary to the Plan Asset Entity will be a new covered service provider and must make the disclosures described above as soon as practicable, but not later than 30 days from the date on which the fiduciary knows that the entity has become a Plan Asset Entity. For example, if a privately offered hedge fund which was operating under the “insignificant benefit plan investor” exception to the plan asset rule falls out of compliance and is deemed to have “plan assets” under ERISA, any fiduciaries of the hedge fund would be subject to the foregoing rule.[8]

        In the case of the required disclosures relating to recordkeeping and brokerage services, when an investment alternative is made available under the plan after the date the contract between the covered plan and covered service provider takes effect, the required disclosures must be made as soon as practicable, but not later than the date on which the investment alternative is designated by the responsible plan fiduciary.

        Changes to the Initial Disclosures. A covered service provider is required to disclose any changes in the information initially disclosed to the covered plan as soon as practicable, but not later than 60 days from the date on which the covered service provider is informed of such changes. The 60-day deadline can be waived if disclosure of the changes is precluded due to extraordinary circumstances beyond the control of the covered service provider, in which case the information must be disclosed as soon as practicable.

        Can a Plan Request Additional Information from the Service Provider?

        A covered service provider is obligated to provide, upon request by the responsible plan fiduciary or plan administrator, any other information relating to compensation received in connection with the service contract that is required for the covered plan to comply with the reporting and disclosure requirements of Title I of ERISA. Such additional information is not limited to information required for the covered plan’s Form 5500 annual report. Moreover, the parties that will be covered service providers for purposes of the Fee Disclosure Rules are not necessarily the same service providers whose direct and indirect compensation must be reported on a plan’s Schedule C; nor is the category of covered service providers under the Fee Disclosure Rules more inclusive than the Schedule C service providers as the category was, as envisioned under the Proposed Regulations. For example, the direct and any indirect compensation received by a nonfiduciary service provider to a Plan Asset Entity is required to be reported on an investing plan’s Schedule C if the plan is required to file a Schedule C and the compensation threshold is $5,000 or above. However, such nonfiduciary service provider would not be subject to the Fee Disclosure Rules. Nevertheless, the DOL seems unconcerned about this apparent disconnect.[9]

        So the initial fee disclosure regime, as envisioned by DOL when the Schedule C changes and the Proposed Regulations were issued, has not come into effect. Nevertheless, this provision gives plan fiduciaries a powerful enforcement tool to get information in order to comply with the requirements set forth in Schedule C at least with respect to covered service providers.

        What if the Service Provider Fails to Provide All the Required Information?

        The Fee Disclosure Rules provide that a service contract will not fail to be reasonable under ERISA section 408(b)(2) if the service provider, acting in good faith and with reasonable diligence, makes an error or omission in disclosing the required information, provided the covered service provider discloses the correct information as soon as practicable, but not later than 30 days after the date on which the covered service provider becomes aware of the error.

        Is a Plan Fiduciary Who Reasonably Believes It Has Received Sufficient Service Provider Disclosures Protected?

        The Fee Disclosure Rules provide additional exemptive relief to a plan fiduciary who reasonably believed it received sufficient disclosures from a service provider, provided that the plan fiduciary (i) upon discovering it did not receive required information, requests the missing information in writing, and (ii) if the service provider fails to timely provide the information to the plan fiduciary, the plan fiduciary reports the service provider to DOL. Obviously, this required reporting to DOL of service providers who make insufficient disclosures will serve as a compelling motivator for service providers to get the disclosure right and to be extremely responsive to plan fiduciaries who request additional information.

        What if a Service Contract is Not Subject to the Fee Disclosure Rules?

        If the Fee Disclosure Rules do not apply, either because the plan is not a covered plan or the service provider is not a covered service provider, the service contract still must be reasonable in order for ERISA section 408(b)(2) to apply. Additionally, ERISA section 404(a) independently imposes a duty on plan fiduciaries to obtain and digest information related to plan services in order to assess the plan services, the reasonableness of the fees and expenses being paid for the services and any related conflicts of interest that may impact the services. Guidance issued by DOL prior to the issuance of the Fee Disclosure Rules continues to apply when assessing the reasonableness of contracts not covered by the Fee Disclosure Rules.[10]


         


        [1]  Tibble v. Edison Int'l, CV 07-5359 (C.D. Cal. 2010).

        [2] “Party in interest” is the term used by ERISA and is defined in ERISA section 3(14). Parties in interest are referred to as “disqualified persons” under the Internal Revenue Code of 1986, as amended (the “Code”).

        [3]  The other requirements for relief under ERISA section 408(b)(2) are: (i) the contract for the services must be necessary for the establishment or operation of the plan, and (ii) no more than reasonable compensation can be paid for the services.

        [4]  This requirement has been retained under the Fee Disclosure Rules.

        [5]  DOL acknowledged in the Preamble to the Proposed Regulations that the service providers subject to the proposed disclosure requirements may not be same as those service providers whose compensation was required to be reported under the Schedule C requirements. Nevertheless, DOL anticipated that the category of service providers subject to the disclosure requirements of the Proposed Regulations would be broader than those service providers who would be reported on the Schedule C. Accordingly, the Proposed Regulations, which included a provision requiring those service providers subject to the Proposed Regulations to provide all compensation requested by a plan to comply with the reporting and disclosures requirements of Title I, were envisioned by DOL in part as an enforcement tool to obtain the information for the Schedule C reporting requirements.

        [6] An ERISA plan is also required to identify all service providers to DOL that it believes failed to provide required fee reporting information in the plan’s Form 5500 on Schedule C. But because prior to the Fee Disclosure Rules, the service providers were under no general legal obligation to provide Schedule C information to plans (apart from any contract obligation), the identification of those service providers who failed to report this information to DOL appeared to be a specious enforcement mechanism.

        [7]  Specifically, the term “covered plan” does not include simplified employee pension plans described in Code section 408(k), simplified retirement accounts described in Code section 408(p), or individual retirement accounts or annuities described in Code section 408. Also, top hat plans and governmental plans are not subject to Title I of ERISA and thus are not brought within the purview of “covered plans”.

        [8] For an in depth understanding of how the plan asset rules works, please refer to DOL regulations set forth in 29 C.F.R. Section 2510.3-101  (http://edocket.access.gpo.gov/cfr_2009/julqtr/pdf/29cfr2510.3-101.pdf), as amended by ERISA section 3(42), 29 U.S.C. section 1102(42) (http://frwebgate.access.gpo.gov/cgi-bin/usc.cgi?ACTION=RETRIEVE&FILE=$$xa$$busc29.wais&start=2243456&SIZE=63148&TYPE=PDF). The plan asset rule provides that when a plan subject to Title I of ERISA (“ERISA Plan”) or Code section 4975 of the Code (an “IRA”) acquires an equity interest in an entity (other than a publicly-offered security or registered investment company security under the 1940 Act), the interests of the ERISA Plan or IRA include its investment and the underlying assets (as opposed to the interest of the ERISA Plan or the IRA alone, for example) of the entity unless an exception is available. The plan asset rule contains two exceptions to this look through treatment: (i) if the entity is an “operating company.” and (ii) if the equity participation by “benefit plan investors” in the entity is not “significant”.

        [9] In the Preamble to the Fee Disclosure Rules, DOL notes that the scope of service providers covered by the Schedule C reporting requirements and the Fee Disclosures Rules will not necessarily be the same. As mentioned above, DOL welcomes comments from interested persons on the scope of the Fee Disclosure Rules in this regard, but appears to be comfortable that the scope of covered service providers subject to the Fee Disclosure Rules makes sense.

        [10] Such prior DOL guidance includes: Field Assistance Bulletin 2002-3 (regarding agreements under which directed trustees and custodians retained “float” earned in omnibus accounts maintained to facilitate employee benefit plan transactions) at http://www.dol.gov/ebsa/regs/fab_2002-3.html, DOL Advisory Opinion 97-15A (regarding the payment of fees by a mutual fund in which an ERISA plan had invested to a bank serving as the plan’s trustee) at http://www.dol.gov/ebsa/programs/ori/advisory97/97-15a.htm and DOL Advisory Opinion 97-16A (regarding the receipt of fees by a plan service provider from a mutual fund in connection with a transaction based on a percentage of the plan’s assets invested in the mutual fund) at http://www.dol.gov/ebsa/programs/ori/advisory97/97-16a.htm.

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