On July 16, 2010, the Department of Labor ("DOL") released interim final rules imposing explicit disclosure obligations on persons (and entities) providing services to pension, profit-sharing and similar plans substantively regulated by the Employee Retirement Income Security Act ("ERISA"). These disclosure rules will change the landscape for the private sector retirement plan industry. This Alert describes the impetus for the development of the regulations, summarizes the new disclosure regimen, and identifies what service providers and the sponsors and fiduciaries of such plans need to do to comply with the new rules.
This Alert is intended for use not only by fiduciaries of private sector retirement plans, and the service providers that provide services to such plans, but also by the sponsors of such plans. While the new DOL rules are specifically directed at private sector retirement plan fiduciaries and those service providers who fit the new rules' definition of a "covered service provider," the sponsors of such plans inevitably have an interest in ensuring that their plans (and those they appoint to serve as plan fiduciaries) remain in compliance with all relevant laws, including ERISA.
WHAT IS BEHIND THE PROMULGATION OF THESE NEW DISCLOSURE RULES?
DOL officials have expressed significant concern over the revenue sharing practices prevalent in the investment community that serves private sector retirement plans, especially those who promote bundled service arrangements which involve mutual funds, collective investment trusts and similar funds where revenue sharing and other fee payment practices obscure the actual economic activities. Often, it is not possible to determine whether fees or revenue sharing payments have been made or whether such fees and payments have been charged against the investment returns being generated for the plan. These revenue sharing payments may be added to commissions, annual service fees (commonly known as 12b-1 fees) and other fees and expenses that may be disclosed in the fund's prospectus fee table. Many times fees received by the service providers are not independently disclosed. Plan fiduciaries frequently are unaware of how much service providers are receiving as a result of arrangements they have made.
ERISA's general fiduciary rules require plan fiduciaries to act prudently and solely in the interest of the plan's participants and beneficiaries when selecting and monitoring service providers and plan investments. Additionally, ERISA requires fiduciaries to ensure that plan assets be used solely for the purposes of providing benefits to the plan's participants and beneficiaries and defraying reasonable expenses of plan administration. Bundled arrangements which include revenue sharing and other types of fees can make it difficult for plan fiduciaries to fulfill their general fiduciary duty to ensure expenses are reasonable and plan investment objectives are attained, due to the lack of transparency.
In addition, independent of ERISA's general fiduciary rules, ERISA has provisions which specifically prohibit financial transactions between a plan and a "party-in-interest" (such as a fiduciary or service provider) unless an exemption from those rules applies. One such exemption allows a party-in-interest to provide services to a plan if such services are necessary for the establishment or operation of the plan and the party-in-interest receives no more than reasonable compensation for those services.
Thus, ERISA's general fiduciary rules and the specific statutory prohibition against paying a party-in-interest for services (unless the conditions set forth in the exemption are all met) require plan fiduciaries to ensure that only reasonable compensation is paid to service providers. In order to make this determination, it is necessary that adequate information regarding the services, and the actual cost of those services, be provided to the plan's fiduciaries. The new DOL rules focus on this aspect of the relationship: determining when a "covered" service provider has satisfied the ERISA exemption by adequately disclosing its fees.
WHAT PLANS ARE SUBJECT TO THE NEW DISCLOSURE RULES?
The new DOL rules generally apply to certain services being provided to ERISA-regulated pension, profit-sharing and similar plans (both defined benefit and defined contribution plans), but not to welfare benefit plans. The new rules do not apply to pension plans excluded from coverage under ERISA (i.e., governmental plans, non-electing church plans, foreign nonresident alien plans, "Keogh" plans and similar plans maintained by self-employed individuals and unfunded excess benefit plans). The rules likewise do not apply to IRAs, SEPs and SIMPLE plans.
WHAT SERVICE PROVIDERS ARE SUBJECT TO THE DISCLOSURE RULES?
Service providers that provide services to a covered plan and expect to receive $1,000 or more in direct or indirect compensation are subject to the new rules. The service providers covered by the new rules fall into the following general categories:
Providers of Fiduciary or Registered Investment Adviser Services. This category includes services provided directly to a covered plan by a fiduciary as defined in ERISA (such as a trustee) or by an investment adviser registered under either the Investment Advisers Act of 1940 or state law. This category also encompasses services provided by a fiduciary to an investment vehicle which holds "plan assets" (as defined in ERISA) in which the covered plan has a direct equity investment.
- Providers of Recordkeeping and Brokerage Services.
This category includes recordkeeping and brokerage services provided to a participant-directed individual account plan, if one or more designated investment options (e.g., mutual funds) are made available in connection with the provision of the recordkeeping and/or brokerage services.
- Providers of Other Services for Indirect Compensation.
This category includes those who provide a plan with accounting, auditing, actuarial, appraisal, banking or consulting services (but only relating to the development or implementation of investment policies or the selection or monitoring of service providers or plan investments), custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third-party administration or plan asset valuation services, where (i) "indirect compensation" is to be received by the service provider (or its affiliates and subcontractors); or (ii) which are to be compensated on a transactional basis (e.g., commissions, soft dollars, finder's fees or similar compensation based on business placed or retained), where the compensation is to be charged directly against the plan's investments and reflected in the net value of the investments (e.g., Rule 12b-1 fees) as part of a bundled service arrangement. "Indirect compensation" consists of compensation received from any source other than the plan, the plan sponsor or a covered service provider (or its affiliates or subcontractors).
WHAT INITIAL DISCLOSURES MUST BE PROVIDED TO THE PLAN FIDUCIARY?
A covered service provider must initially disclose the following information:
A description of the services that will be provided to the covered plan pursuant to the contract or arrangement. The level of detail must be sufficient for the plan fiduciary to determine whether the compensation charged for those services is reasonable.
If applicable, a statement that the covered service provider (or its affiliates and subcontractors) will provide such services as a fiduciary under ERISA and/or as a registered investment adviser.
- Direct Compensation. A description of all compensation to be received directly from the covered plan, either in the aggregate or by service, by the covered service provider (and its affiliates and subcontractors) in connection with the provision of services. The description may be expressed as a monetary amount, formula, percentage of the covered plan assets, or per capita charge for each participant or beneficiary. If the compensation cannot be expressed in these terms, it may be described by any other reasonable method.
- Indirect Compensation. A description of all compensation that the covered service provider (and its affiliates and subcontractors) is to receive indirectly in connection with the provision of the covered services, along with the identification of the services for which the indirect compensation will be paid and the payer of such indirect compensation.
- Compensation Paid Among Related Parties . A description of all compensation to be collectively paid under a bundled service arrangement to or among the covered service provider and its affiliates and subcontractors (if any) in connection with the provision of the covered services, including a description of how it is to be paid (e.g., determined on a transaction basis based on business placed or retained, such as commissions, soft dollars and finder's fees, charged directly against the plan's assets and reflected in the net value of the investments, etc). The identification of the services being compensated and the recipients of such compensation (including the relationships between recipients, if any) are also to be part of the disclosure.
- Compensation for Termination of Contract or Arrangement. A description of all compensation that the covered service provider (and its affiliates and subcontractors) reasonably expect to receive in connection with the termination of the contract or arrangement, and how any prepaid amounts are to be calculated and refunded upon such termination.
- Recordkeeping Services.
In addition to the disclosures described above, if recordkeeping services are to be provided, a description of all direct and indirect compensation that the covered service provider (and its affiliates and subcontractors) reasonably expects to receive in connection with the recordkeeping services. If recordkeeping services are to be provided through a bundled service arrangement where there is no explicit compensation to be paid for recordkeeping, or if the arrangement contemplates that compensation for such services is to be offset or rebated through revenue-sharing arrangements with investment options provided under the plan, a reasonable, good faith estimate of the stand-alone costs the covered plan would be likely to bear as a result of receiving such recordkeeping services must be provided, along with an explanation of the methodology and assumptions used to prepare the estimate and a detailed explanation of the expected recordkeeping services. The estimate must take into account, as applicable, the rates the covered service provider (or its affiliate or subcontractor) would have charged third parties for providing the services, or the prevailing market rate a recordkeeper would have charged for providing similar services to a similar plan with a similar number of participants and beneficiaries.
- Manner of Receipt.
A description of the manner in which the compensation is to be received (i.e., whether the plan will be billed for the services or whether the compensation will be deducted directly from the plan's assets).
- Investment Disclosure -- Fiduciary Services.
Where the services are to be provided in connection with a two-tiered or "fund of funds" arrangement, additional information must be provided with respect to each investment contract, product or entity that holds plan assets in which the plan has a direct equity investment and for which the covered service provider is being called upon to provide fiduciary services. The additional information that must be provided includes descriptions of: (i) any compensation that will be charged directly against the invested amounts (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, purchase fees, etc.); (ii) the contract's, product's or entity's annual operating expenses (i.e., the expense ratio) if the return is not fixed; and (iii) any other ongoing expenses (e.g., wrap fees, mortality and expense fees, etc.).
- Investment Disclosure -- Recordkeeping and Brokerage Services.
For those covered service providers that provide recordkeeping and/or brokerage services, the information listed above must be provided with respect to each designated investment alternative for which recordkeeping services or brokerage services are to be provided. These disclosure requirements may be satisfied by using the disclosure materials currently being used by the issuer of the designated investment alternative, so long as: (i) the issuer is not an affiliate; (ii) the disclosure materials are regulated by a state or federal agency; and (iii) to the best of the covered service provider's knowledge, the materials are not incomplete or inaccurate.
TO WHOM DO THE DISCLOSURES HAVE TO BE MADE?
The covered service provider must make the disclosures to the "responsible plan fiduciary." The "responsible plan fiduciary" is the one that has the authority to cause the plan to enter into, extend or renew the contract with the covered service provider.
WHO IS RESPONSIBLE FOR MAKING THE REQUIRED DISCLOSURES?
The "covered service provider" is the party responsible for making the required disclosures to the responsible plan fiduciary. The "covered service provider" is the party directly responsible to the plan for the provision of services under the contract or arrangement, even if an affiliate or subcontractor provides some or all of the contracted-for services.
WHEN DO THE INITIAL DISCLOSURES HAVE TO BE MADE?
The new DOL rules take effect on July 16, 2011. For contracts or arrangements entered into prior to July 16, 2011, the disclosures must be furnished no later than that date. Thereafter, a covered service provider must disclose the required information reasonably in advance of the date that the contract or arrangement is entered into, extended or renewed, so the responsible plan fiduciary has an opportunity to take into account the information before entering into the contract or arrangement.
There are two exceptions to this advance notice rule. The first exception applies in "fund of funds" and collective investment fund arrangements, where a covered service provider becomes a fiduciary of the plan as a result of the "plan asset" rule (in which case the provider has 30 days to make the disclosures). The second exception applies to new investment opportunities, where a designated investment alternative was not a designated option at the time the contract or arrangement was initially entered into; there, the disclosures must be made no later than the date the investment alternative is designated by the responsible plan fiduciary.
HOW ARE THE DISCLOSURES REQUIRED TO BE MADE?
The disclosures the covered service provider makes are to be made in writing. However, the new rules do not establish any prescribed format in which the disclosures must be made. Covered service providers may disclose using different documents from separate sources, as long as all the required information is disclosed.
WHAT ARE THE ONGOING DISCLOSURE OBLIGATIONS OF A COVERED SERVICE PROVIDER AFTER THE INITIAL DISCLOSURES HAVE BEEN MADE?
The covered service provider generally must disclose any changes to the initial required disclosures as soon as practicable, but no later than 60 days from the date on which the covered service provider is informed of such change. There is only one exception to that rule: where disclosure is precluded due to extraordinary circumstances beyond the covered service provider's control. In those instances, the information must be disclosed as soon as practicable.
The covered service provider must also provide, upon request of the responsible plan fiduciary or a plan administrator, any information relating to compensation the provider has received in connection with the contract or arrangement which the plan administrator needs in order to comply with ERISA's reporting and disclosure requirements. That information must be disclosed no later than 30 days following receipt of a written request from the responsible plan fiduciary or plan administrator. (Again, an exception permits disclosures to be made as soon as practicable if extraordinary circumstances prevent the covered service provider from responding in a more timely fashion.)
Finally, if a covered service provider inadvertently makes an error or omission in the information disclosed, corrected information must be provided to the responsible plan fiduciary as soon as practicable, but no later than 30 days after the discovery of the error or omission. If correction is not accomplished within that time, the contract or arrangement will be deemed a prohibited transaction.
WHAT HAPPENS IF THE COVERED SERVICE PROVIDER DOES NOT PROVIDE THE REQUIRED DISCLOSURES?
Under the new rules, if a covered service provider fails to provide the required disclosures, the contract or arrangement is considered to be a prohibited transaction. A prohibited transaction is considered a statutory violation, as well as a breach of fiduciary duty by those plan fiduciaries responsible for the contract or arrangement. A prohibited transaction generally produces significant adverse federal tax and other consequences for both the responsible plan fiduciary and the covered service provider.
With a nonexempt prohibited transaction, for example, the covered service provider is subject to a non-deductible excise tax of 15%, based on the amount of compensation involved. (In general, this would be the full compensation paid under the contract or arrangement.) If the transaction were not corrected in the taxable period, the excise tax conceivably could increase to 100% of the amount involved. In addition, a suit can be brought against the covered service provider under ERISA to recover the compensation paid under the transaction, on the grounds that the transaction was illegal (and therefore capable of being rescinded).
While the responsible plan fiduciary would not be subject to the excise tax, it could be held personally liable for any losses the plan incurs as a result of the prohibited transaction. The DOL also could assess a 20% penalty on any amounts recovered for the plan or paid under a settlement agreement involving the plan.
IF THE RESPONSIBLE PLAN FIDUCIARY ENTERS INTO A CONTRACT OR ARRANGEMENT WITH A COVERED SERVICE PROVIDER WHO FAILS TO COMPLY WITH THE NEW DISCLOSURE RULES, ARE THERE CIRCUMSTANCES WHERE RELIEF IS AVAILABLE?
The new DOL rules provide that a responsible plan fiduciary will not be subject to the prohibited transaction rules if the plan fiduciary (i) did not know the covered services provider has failed to make the required disclosures and reasonably believed that the disclosures had been made; (ii) upon discovering a disclosure failure, makes a written demand seeking the disclosures; and (iii) notifies the DOL, if the disclosures are not produced, in 90 days. A model notice, published with the new rules, can be used to notify the DOL.
The responsible plan fiduciary also is obligated to determine whether the service provider's failure to disclose warrants the termination of the contract or arrangement, taking into account a number of factors (all, specified in the new rules).
WHAT SHOULD PLAN FIDUCIARIES DO TO COMPLY WITH THE NEW DISCLOSURE RULES?
Plan fiduciaries need to familiarize themselves with the new DOL rules in order to be able to comply with them by July 16, 2011. Although the disclosure obligations under the new rules fall upon the covered service providers, plan fiduciaries are responsible for avoiding prohibited transactions -- and thus are obligated to make sure the disclosures are made in a timely manner and are adequate. At a minimum, we recommend that fiduciaries take the following steps to implement the new rules:
- Identify which service providers are providing "covered services," and what information needs to be disclosed under the new rules.
- Determine whether existing service providers will be providing the necessary information well in advance of the June 16, 2011, effective date.
- Develop a process to track all disclosures being provided and determine their adequacy, and verify that the compensation being paid (once fully disclosed) is, in fact, "reasonable."
- Identify the responsible plan fiduciary for each covered service and make sure the required disclosures are sent to the identified fiduciary for review.
- Modify all formal contracts with covered service providers to include the disclosure obligations and specify the consequences of noncompliance.
WHAT SHOULD COVERED SERVICE PROVIDERS BE DOING TO COMPLY WITH THE NEW DISCLOSURE RULES?
All service providers need to become familiar with the new rules to ascertain whether they are subject to the new rules. Covered service providers will need to take the following steps:
- Determine the information to be provided to responsible plan fiduciaries, and how best to make the required disclosures.
- Determine how best to periodically update the information being disclosed (e.g., services, compensation, investments from affiliates, subcontractors, etc.).
- Update their systems to ensure that they will be able to provide the necessary disclosures and updates in a timely manner.
WHAT CAN BE EXPECTED FROM DOL IN THE FUTURE?
The DOL's interim final rules take effect without the need for modifications. However, the DOL has invited public comments on all aspects of the new rules, including:
- Whether $1,000 is a reasonable threshold to use, when determining which service providers are to be covered by the new rules; and
- Whether a model disclosure should be adopted, or whether the disclosures should be conveyed in a summary or consolidated fashion.
DOL also is expected to publish a rule in the future that will provide guidance on the disclosures that will need to be made for service contracts or arrangements involving welfare plans.
The new DOL rules significantly change the disclosure landscape for the private sector retirement industry. Most large plan fiduciaries currently obtain the required information through their consultants and vendors, but mid-size and small plan fiduciaries may not be aware of the various payments received by their retirement plan vendors, or the fact that they need to obtain this information from service providers and verify that the compensation being paid is reasonable. The new rules thus provide a road map for plan fiduciaries to identify potential conflicts of interest and to determine with greater accuracy how much plan participants and their beneficiaries are being charged for the services they (and their plans) receive.