In July 2010, the Department of Labor released an “interim final regulation” (hereafter, the “interim regulation”) under section 408(b)(2) of ERISA — the “service provider exemption” — providing a comprehensive and fully articulated set of rules governing provider-to-sponsor fee disclosure. Because of the significance of changes in the interim regulation from the (2007) proposed regulation, the regulation, while “final” was also “interim.” Interested parties were invited to comment on the regulation, and it was understood that at some point DOL would issue a “final final” regulation.
On February 2, 2012 DOL released a “final final” 408(b)(2) regulation (hereafter, the “final regulation”). In this article we review the final regulation in detail.
This regulation is part of DOL’s comprehensive revision of rules with respect to the disclosure of plan-related fees. That project also included a revised Form 5500 Schedule C, requiring plans to provide to DOL extensive information on direct and indirect fees paid by the plan and a new set of sponsor-to-participant fee disclosure rules.
ERISA generally prohibits any service provider from providing services to a plan, and then provides an exemption — the 408(b)(2) “service provider exemption” — for services provided under a “reasonable” contract. The regulation in place under this provision prior to the release of the interim regulation generally only required that the contract be terminable on reasonably short notice. The interim regulation replaced that simple rule with a comprehensive set of provider-to-sponsor fee disclosure rules. This final regulation makes certain changes to that interim regulation.
The new rules affect sponsors in two ways. First and most obviously, plans will generally be prohibited from entering into service provider relationships — e.g., retaining an investment manager, recordkeeper or trustee — unless disclosures conforming to the regulation have been made. And second, the fee information supplied to plan fiduciaries will provide the basis for a fiduciary review of the reasonableness of fee arrangements and any possible conflicts of interest.
The final rule
Generally, the regulation requires that, with respect to a “covered plan,” “covered service providers” must provide certain fee-related information to a responsible plan fiduciary.
Which plans are covered
The final regulation applies to most ERISA pension plans, including 401(k) plans. The issue of its application to employer health plans has been reserved. In this article we will generally focus on the effect of the new rule on defined contribution plans (including 401(k) plans).
Which service providers are covered?
Generally, a “covered service provider” is a service provider (1) with a direct relationship with the plan (i.e., one “that enters into a contract or arrangement with the covered plan”), (2) with respect to which it (or an affiliate or subcontractor) reasonably expects to receive $1,000 or more in direct or indirect compensation, (3) in connection with the provision of covered services.
So, as a general matter, service providers (e.g., certain subcontractors) that do not deal with the plan would have no direct disclosure obligation under the rule. Thus, the regulation states that no person or entity is a “covered service provider” solely by providing services: (1) as an affiliate or a subcontractor; or (2) to an investment contract, product, or entity in which the covered plan invests, unless they are fiduciaries with respect to the initial-level investment.
As we’ll see, however, the provider that does deal directly with the plan may have an obligation to disclose details about amounts paid, e.g., to subcontractors.
The final regulation added language clarifying the application of this rule in the context of multiple parties. Quoting from the preamble:
The party entering into the contract or arrangement with the covered plan is the covered service provider responsible for making the rule’s disclosures, even if other parties perform some of the services. For example, in cases when a “bundled” arrangement of multiple services is offered to the covered plan, only one service provider would need to furnish the required disclosures for the bundled services. For example, a recordkeeper (Recordkeeper) who enters into a contract with a covered plan to furnish specified recordkeeping services and to make available a platform of investments may outsource some of the recordkeeping and plan administration services, and pay transaction-based compensation, to an affiliated third party administrator (TPA). The TPA does not have any separate contract or arrangement with the covered plan. Although both the Recordkeeper and the TPA provide services that are described in the categories of covered service providers under the final rule …, only the Recordkeeper is the covered service provider. The Recordkeeper is the “covered” service provider because he or she is the party entering into the service contract or arrangement with the covered plan. Multiple service providers that furnish services pursuant to a single contract or arrangement with a covered plan may agree among themselves who will enter into the contract or arrangement with the covered plan and be the covered service provider. The other service providers may be affiliates of or subcontractors to the covered service provider; and covered service providers’ disclosures would reflect their status in accordance with the final rule.
The regulation does not formally define the term “covered services,” but it does limit its scope to the provision of certain defined services. Thus, the provider of, e.g., certain office services (e.g., a copy or messenger service) would not be covered. Providers of the following services are covered:
A. Fiduciary services. Providers of fiduciary services are divided into three subcategories:
1. Those providing services directly to the plan as an ERISA fiduciary.
2. Those providing services as a fiduciary to an investment contract in which the plan has a direct equity investment (a direct equity investment does not include investments made by the investment contract, product, or entity in which the covered plan invests). These persons typically are, of course, also ERISA fiduciaries, but they have been placed in a separate subcategory because they have an additional obligation to disclose compensation information about the investment vehicle for which they serve as a fiduciary (see below). This subcategory is limited in the new rule to the first-tier direct investment. Thus, it includes fiduciaries to the initial-level investment vehicle in which a covered plan makes a direct equity investment but does not include fiduciaries to that initial vehicle’s underlying investments, even though such down-level investment vehicles also may hold “plan assets.”
3. Those providing services as an investment adviser registered under either the Investment Advisers Act of 1940 or State law.
B. Recordkeeping or brokerage services. Providers of recordkeeping or brokerage services to a DC plan that permits participants to direct the investment of their accounts, if one or more designated investment alternatives will be made available (e.g., through a platform or similar mechanism) in connection with such recordkeeping services or brokerage services. (Hereafter, a provider of “recordkeeping+investment platform services.”)
A “designated investment alternative” is generally everything in a fund menu — mutual funds, separate accounts, collective trusts, GICs. The only exclusion is brokerage windows.
While this language may be a little awkward, it’s clear what is intended: arrangements between, e.g., a recordkeeper and a plan in which the recordkeeper presents a fund menu or a group of funds from which to construct a menu. As we’ll see (below), recordkeeping+investment platform service providers have special disclosure obligations with respect to the funds in their platform.
C. Other services for indirect compensation. Accounting, auditing, actuarial, appraisal, banking, consulting (i.e., consulting related to the development or implementation of investment policies or objectives, or the selection or monitoring of service providers or plan investments), custodial, insurance, investment advisory (for plan or participants), legal, recordkeeping, securities or other investment brokerage, third party administration, or valuation services provided to the covered plan, for which the covered service provider, an affiliate, or a subcontractor reasonably expects to receive (i) indirect compensation or (ii) “compensation paid among related parties” (as described below).
Initial disclosure requirements
As a general matter, a plan cannot enter into a relationship with a “covered service provider” unless certain information is provided in writing to a responsible plan fiduciary, as follows:
1. Services — a description of the services to be provided.
2. Status — if applicable, a statement that the covered service provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services as a fiduciary or as an investment adviser registered under the 1940 Act or any State law.
3. Compensation — a description of compensation to be received including:
Direct compensation — all direct compensation, either in the aggregate or by service, that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive.
Indirect compensation — all indirect compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive; including identification of the services for which the indirect compensation will be received and identification of the payer of the indirect compensation. The final regulation added a requirement that the description of indirect compensation also include “a description of the arrangement between the payer and the covered service provider, an affiliate, or a subcontractor, as applicable, pursuant to which such indirect compensation is paid.”
Compensation paid among related parties — any compensation that will be paid among the covered service provider, an affiliate, or a subcontractor, if it is set on a transaction 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); including identification of the services for which such compensation will be paid and identification of the payers and recipients of such compensation (including the status of a payer or recipient as an affiliate or a subcontractor).
Again, while this language is complex, what is intended is an arrangement where, e.g., indirect fees are paid out of plan assets or plan investments.
Compensation for termination of contract or arrangement — any compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with termination of the contract or arrangement, and how any prepaid amounts will be calculated and refunded upon such termination.
Compensation is generally defined as anything of monetary value (for example, money, gifts, awards, and trips); “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, an affiliate, or a subcontractor.
A description of compensation may be expressed as a monetary amount, formula, percentage of the covered plan’s assets, or a per capita charge for each participant or, if the compensation cannot reasonably be expressed in such terms, by any other reasonable method. The description may include a reasonable and good faith estimate if the covered service provider cannot otherwise readily describe compensation or cost and the covered service provider explains the methodology and assumptions used to prepare such estimate. Any description or estimate must contain sufficient information to permit evaluation of the reasonableness of the compensation.
4. Special rules with respect to recordkeeping services — if recordkeeping services will be provided to the plan —
A description of all direct and indirect compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with such recordkeeping services.
If the covered service provider reasonably expects recordkeeping services to be provided, in whole or in part, without explicit compensation for such recordkeeping services, or when compensation for recordkeeping services is offset or rebated based on other compensation received by the covered service provider, an affiliate, or a subcontractor, a reasonable and good faith estimate of the cost to the covered plan of such recordkeeping services, including an explanation of the methodology and assumptions used to prepare the estimate and a detailed explanation of the recordkeeping services that will be provided to the covered plan. The estimate shall take into account, as applicable, the rates that the covered service provider, an affiliate, or a subcontractor would charge to, or be paid by, third parties, or the prevailing market rates charged, for similar recordkeeping services for a similar plan with a similar number of covered participants and beneficiaries.
This recordkeeping disclosure requirement is clearly designed to require explicit pricing of recordkeeping in “bundled” and “fully integrated” arrangements.
5. Manner of receipt — the manner in which the compensation will be received, such as whether the covered plan will be billed or the compensation will be deducted from plan accounts or investments.
6. Special rules with respect to investment disclosure — fiduciary services — if the covered service provider is providing services as a fiduciary to an investment contract in which the plan has a direct equity investment, the following additional information must be provided with respect to each investment contract, product, or entity that holds plan assets and in which the covered plan has a direct equity investment, and for which fiduciary services will be provided pursuant to the contract or arrangement with the covered plan, unless such information is disclosed to the responsible plan fiduciary by a covered service provider providing recordkeeping services or brokerage services (see 6, below):
Sales and termination charges. Any compensation that will be charged directly 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).
Operating expenses. A description of the annual operating expenses (e.g., expense ratio) and any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees), or, for an investment contract, product, or entity that is a designated investment alternative, the total annual operating expenses expressed as a percentage and calculated in accordance with the sponsor-participant disclosure regulation.
Additional information needed for sponsor-participant disclosure. For an investment contract, product, or entity that is a designated investment alternative, any other information or data about the designated investment alternative that is within the control of, or reasonably available to, the covered service provider and that is required for the covered plan administrator to comply with DOL’s sponsor-participant disclosure regulation. (We provide a more lengthy discussion of this requirement in our highlights article.)
7. Special rules with respect to investment disclosure — recordkeeping and brokerage services — A provider of recordkeeping+investment platform services must provide the information described in 5 (i.e., sales and termination charges, operating expenses and additional information needed for sponsor-participant disclosure) with respect to each designated investment alternative for which recordkeeping or brokerage services will be provided. It may do so by providing current disclosure materials of the issuer, provided that:
The issuer is not an affiliate.
The issuer is a registered investment company, an insurance company qualified to do business in any State, an issuer of a publicly traded security, or a financial institution supervised by a State or federal agency.
The covered service provider acts in good faith, does not know that the materials are incomplete or inaccurate and furnishes the responsible plan fiduciary with a statement that the covered service provider is making no representations as to the completeness or accuracy of such materials.
Generally the covered service provider must provide the foregoing information to the responsible plan fiduciary reasonably in advance of the date the contract or arrangement is entered into, extended or renewed. Changes must be disclosed as soon as practicable, but not later than 60 days from the date on which the covered service provider is informed of the change, unless the disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control. Investment related changes, however, may be disclosed annually.
Information provided on request
Generally, upon written request from the responsible plan fiduciary or plan administrator, the covered service provider must furnish any other information relating to compensation that is required for the plan to comply with the reporting and disclosure requirements of ERISA (e.g., required for completion of Form 5500, Schedule C). This information must be disclosed reasonably in advance of the date upon which such responsible plan fiduciary or covered plan administrator states that it must comply with the applicable reporting or disclosure requirement, unless such disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, in which case the information must be disclosed as soon as practicable.
Reasonable good faith disclosure errors are generally not penalized provided that the covered service provider discloses the correct information to the responsible plan fiduciary as soon as practicable, but not later than 30 days from the date on which the covered service provider knows of the error.
Exemption for responsible plan fiduciary
Of particular interest to sponsors is the liability of the plan fiduciary for non-compliance. A violation of the new rule may result in a prohibited transaction, and the responsible plan fiduciary, by causing the transaction, may have violated ERISA. The regulation provides an exemption, in certain cases, for such a violation, provided:
The responsible plan fiduciary did not know that the covered service provider failed or would fail to make required disclosures and reasonably believed that the covered service provider disclosed required information;
The responsible plan fiduciary, upon discovering that the covered service provider failed to disclose the required information, requests in writing that the covered service provider furnish such information;
When applicable, a notice shall be filed with DOL not later than 30 days following the earlier of: (1) the covered service provider’s refusal to furnish the required information; or (2) 90 days after the fiduciary’s written request; and
If the covered service provider fails to comply with the plan fiduciary’s written request within 90 days, the responsible plan fiduciary shall determine whether to terminate or continue the contract or arrangement consistent with its duty of prudence. If the requested information relates to future services and is not disclosed promptly after the end of the 90-day period, then the responsible plan fiduciary shall terminate the contract or arrangement as expeditiously as possible, consistent with such duty of prudence.
Application to DB and welfare plans
In this article we have discussed the new regulations with a view to their application to DC plans. We note, however, that they also apply to DB plans, and sponsors of DB plans will want to consider the implications of the new regulations to them. Ultimately, DOL intends to provide rules for the disclosure of fees with respect to welfare plans, but this final regulation does not do so.
The interim regulation was to have been effective on July 16, 2011 — one year from publication in the Federal Register. That date was subsequently extended to April 1, 2012. The final regulation extends the effective date further, to July 1, 2012.
* * *
By way of conclusion we will simply repeat what we said in our highlights article — the process of complying with new fee disclosure rules is going to be a difficult one, for providers and sponsors. While the final regulation increases (in some respects) the burdens on providers (and, arguably, makes sponsor compliance marginally easier), overall the best news is probably simply that we now have final rules. Hopefully the long and arduous process of reconfiguring how providers and sponsors capture and disclose information about fees is finished.