By July 1, 2012, employers must have received written disclosures from most service providers to their retirement plans. Much of what is to be disclosed then has to be communicated in a different format to plan participants in participant-directed retirement plans on or before August 30, 2012. See our related article "Participant-Level Fee and Investment Disclosures are Greatly Expanded."
These 408b-2 Rules are the second step in the Department of Labor's efforts to increase the transparency of fee and compensation arrangements in the retirement plan industry. The first step was to make major modifications to the disclosures required in annual Form 5500's, particularly regarding "indirect" compensation arrangements. The 408b-2 Rules require more details be provided to employers who sponsor retirement plans, and put more "teeth" in the disclosure requirements by making non-compliance very costly.
If service providers do not comply, employers have an obligation to report their failures, or will themselves face stiff penalties—for a "prohibited transaction" at least, and perhaps also for delay in providing certain related disclosures to participants, if the employer sponsors a defined contribution plan that allows participants to direct investments of their accounts.
Which Plans are Covered by the 408b-2 Rule?
Generally, all employer-sponsored retirement plans that are covered by ERISA are required to receive service provider disclosures so that plan sponsors can meet their duty to determine that the plan pays no more than reasonable compensation for services. Welfare plans are not affected by these rules (at least not yet!). Also, the rules do not apply to governmental or non-electing church plans, IRAs, SEPs, or SIMPLEs, or 457(b) and (f) deferred compensation plans of tax exempt employers or nonqualified retirement plans exempt from most ERISA requirements as "top hat" plans.
There is also a very limited exception for 403(b) annuities and custodial accounts (generally covering employees of schools, hospitals or other charitable organizations), that applies if no contributions were made through an employer's payroll systems' (even employee contributions) after January 1, 2009, and then only if all legal rights and benefits under the annuity or custodial account are fully vested and enforceable directly by the participant without any employer involvement.
Which Service Providers are Covered by These Rules?
Virtually any service provider to a retirement plan who will be paid some type of compensation or revenue sharing either by the plan itself or by another vendor or investment provider (i.e., mutual fund), will be covered by these rules, unless the provider (plus all of its affiliates or subcontractors) expects to be paid less than $1,000. No fixed timeframe applies for measuring this $1,000 threshold, so a vendor who will be paid smaller amounts under an arrangement that is expected to continue for a period of years would generally be a covered service provider.
The 408b-2 Rule specifically focuses on the following types of service providers:
- Any registered investment advisor (RIA) providing services to a plan or its participants (whether or not considered a fiduciary to the plan).
- Any fiduciary to a plan as defined under ERISA.
- Any person/entity who is an ERISA fiduciary as a result of advising an entity which is deemed to hold plan assets as a result of a plan's direct equity investment (examples include the investment manager of a collective trust, certain hedge funds and private equity partnerships that are held 25% or more by retirement plans).
- Record keepers or brokerage firms that provide a platform on which accounts are allocated among designated investments at participant direction ("Platform Providers").
- Others—attorneys, accountants, actuaries, consultants, insurance agents, broker-dealers, appraisal firms, bankers, or custodians—who get "indirect" compensation (i.e., paid by third parties or affiliates for services they render to a plan, perhaps though revenue sharing, commissions, soft dollars or finder's fees).
Disclosures that are Required
408b-2 disclosure needs to include the following information:
- Description of services to be provided.
- Whether the service provider (or its affiliate or subcontractor) is either a fiduciary or an investment advisor registered under the Investment Advisors Act of 1940 or state law (RIA), and , if so
- A description of all direct compensation to be paid to such a service provider (or its affiliate or subcontractor) by the plan.
- A description of any "indirect" compensation paid to such a service provider (or its affiliate or subcontractor), who will pay the compensation, the services for which it is paid, and a description of the arrangement between the service provider and the payer.
- How any compensation will be shared among affiliates and subcontractors of the service provider, if the payments are measured on a "transaction basis" such as a commission arrangement, finder's fee, or other similar incentive based on business placed or retained, or if the payment is charged directly against the value of an investment the plan will hold (i.e., a 12b-1 fee).
- Any compensation that would be due upon termination of an investment contract or service arrangement, or how any prepaid fees will be prorated or refunded upon termination.
- If the service provider is Platform Provider, then the same types of disclosures that a fiduciary or RIA has to provide are required to be supplied, PLUS a good faith estimate of the dollar amount that the provider and its affiliates and subcontractors will be paid for the record keeping portion of its services (making and disclosing any assumptions used in the arriving at estimate).
- If the service provider is a fiduciary to an investment contract or entity that is in turn deemed to hold plan assets (for example, a collective trust, partnership or hedge fund or insurance company separate account), additional disclosures are required of any other costs that might be charged directly to the investment, such as commissions, sales charges, redemption fees, surrender charges, wrap fees, mortality changes, and other annual operating expenses.
- Any Platform Provider must also provide all of the information required for participant-level disclosures. See our related article "Participant-Level Fee and Investment Disclosures are Greatly Expanded"
- All disclosures must specify whether the compensation will be billed or directly deducted from investments.
This information does not require the parties have a service contract or amend their existing contracts (unless those contracts conflict with these rules, particularly with regard to restrictions on termination charges—see below). The information need not be in one place and generally will be found in multiple documents or web locations. The DOL included a sample chart in the new 408b-2 Rules that could be used as a template to guide sponsors, so they will know where to look for various parts of this information in currently-available web links or prospectuses or in existing service agreements. The guide is not mandated, but the preamble to the new rules implies a similar guide or template may be mandated at a later date.
The 408b-2 Rule also includes a general catch-all that requires service providers provide any additional information the plan sponsor believes is necessary for it to meet ERISA's reporting and disclosure requirements as soon as practicable after written request (for example, additional information required by a plan's auditor or for the Form 5500).
Service Provider Challenges
Service providers who get anything of value of more than $250 from a third party who also provides some services or investments to a plan (i.e., free or subsidized attendance at an investment conference) need to disclose those added benefits to plan sponsors. Determining how to allocate that value among a variety of plans will be a challenge. A third party administrator, accounting firm or law firm which is not a Platform Provider and which typically bills and is paid by a plan sponsor or a plan directly, could suddenly be getting "indirect" compensation and become a "covered" provider by virtue of gifts or conference attendance subsidies like this.
Service providers will need to be honest with themselves and with their customers for the first time, by admitting in writing if they perform functions or make judgment calls that make them a "fiduciary" under ERISA's very broad definition. A fiduciary (as currently defined) includes anyone who has control or authority over either or both plan assets or plan administration. A TPA who, for example, decides whether a QDRO is qualified before implementing it, and knows its clients will rely exclusively on their judgment, may need to admit to being a fiduciary for at least that limited purpose. While in the past it was common for a vendor to say that they just make recommendations and not final decisions, if that is not in fact how the plan services are being performed, the vendor risks engaging in a prohibited transaction if its disclosures do not admit to fiduciary status.
Service providers in category 5 above (someone not an RIA or fiduciary, and not a Platform Provider), who bill and get paid a fee for services and are paid directly by a plan or plan sponsor are not specifically subject to the 408b-2 Rule. However, disclosure of the services they provide and their compensation arrangement in a similar fashion to that required by "covered" providers will likely become the norm for these providers as well, for a number of reasons.
- There is always a risk that these types of "other" providers might be factually considered a fiduciary (a determination that is based on what people actually do or have authority to do, not just on what capacity a legal contract says they have), in which case 408b-2 disclosure is mandatory.
- These providers have typically been very transparent about the terms of their arrangements in any case, and employers who pay fees directly will not want to make fine distinctions between types of providers and would instead prefer to simply get similar disclosures from all possible covered service providers, in an excess of caution.
- The 408b-2 Rules arguably require disclosures from providers whose fees are billed to the plan sponsor, if the plan sponsor in turn directs the plan to pay the bill (or seeks reimbursement), from an ERISA administrative budget (i.e., under an agreement with a another service provider to pay up to a designated amount of "other" expenses from revenue sharing or other compensation that service provider receives). Since these category 5 providers often do not know where the funds will come from to pay their fees, it may be safest to simply provide the required disclosures.
Certain Termination Restrictions are Prohibited
All service provider arrangements must be terminable by a plan on short notice without "penalty." The 408b-2 Rules make clear that a minimal fee (not defined) that is designed to recover reasonable start-up costs, or to cover the service provider's actual losses if the arrangement is terminated before a stated term, and where the service provider is required to try to mitigate damages, are not penalties. Note that these two exceptions are essentially the same as those provided in older regulations, but the new requirement to specifically disclose termination charges will give plan sponsors the tools, for the first time in many cases, to understand and evaluate whether surrender charges and market value adjustments that have historically been included in insurance company retirement plan service and investment arrangements are "minimal" or limited to direct losses that must be mitigated and therefore allowed, or are penalties or prohibited restrictions on termination of an arrangement.
Service provider disclosures are required to be made for all existing covered service arrangements on or before July 1, 2012. Service arrangements entered into after that date must include these written disclosures "reasonably in advance" of the date the arrangement is entered into. Investment-related disclosures for plans that allow participant-direction of investments must be made before July 1, 2012 for existing arrangements, and disclosures for any new investments added later must be made before the investments are designated as available under a defined contribution plan, and then be renewed once annually to allow plans to provide the required participant-level disclosures. See our related article"Participant-Level Fee and Investment Disclosures are Greatly Expanded."
After initial disclosures, any changes (other than with respect to new investment options in a participant-directed plan, as noted above) must be disclosed within 60 days after the service provider is aware of the change, and new disclosures need to be supplied each time an arrangement is renewed.
Employers/Plan Sponsors are Now the "Cops"
The 408b-2 Rules require employers to police the industry and report any service-provider failures to comply.
July 2012 Action Item: If a plan sponsor doesn't get these disclosures or gets incomplete disclosures, it must send a written request to each provider.
If the service provider refuses to provide the information, or simply doesn't send complete information within 90 days of that written request, the plan sponsor MUST send notice to the DOL of the delinquency or it will be deemed to have engaged in a prohibited transaction. Then, the plan sponsor must terminate the service arrangement as "expeditiously as possible."
A prohibited transaction is costly: those involved can be assessed an excise tax of 15% of the "amount involved" for each year that the transaction goes uncorrected, or 100% of the amount involved if the DOL cites the parties and it is not corrected immediately. Correction involves restoring to the plan all fees paid directly by the plan or indirectly by others who made profits from or received amounts with respect to the plan's investments. Clearly, an employer does not want to be responsible for a service provider's failure to comply with these rules, so must take its duty to report non-compliance seriously.
Plan sponsors of participant-directed defined contribution plans (like a 401(k)) shouldn't wait until July 1, 2012 to check on how their providers will address these new rules. Rather, they should survey what they already have and consider sending a written demand for disclosure to all service providers no later than June 1, 2012. That would give the plan sponsor the 90-day response window to pressure service providers to deliver clear and complete information, and help assure that the plan sponsor can comply with the participant-level fee and investment disclosures by its August 30, 2012 deadline. See our related article"Participant-Level Fee and Investment Disclosures are Greatly Expanded."