On July 16, 2010, the Department of Labor (the “Department”), issued an interim final rule requiring certain service providers to defined benefit and defined contribution pension plans to disclose certain fee information to the fiduciaries of such plans. According to the Department, the purpose of the interim final rule is to assist plan fiduciaries with assessing the reasonableness of compensation for plan services and conflicts of interest affecting plan service providers. Failure to meet the new fee disclosure requirements could cause the service relationship between the plan and the service provider to constitute a non-exempt prohibited transaction under the Employee Retirement Income Security Act (“ERISA”). Given the various requirements under the interim final rule, services providers and plan fiduciaries should familiarize themselves with it well in advance of its effective date. When the interim final rule becomes effective on July 16, 2011, both new and existing service provider arrangements must be in compliance.

Background

Generally, ERISA Section 406(a)(1)(C) prohibits, among other things, the furnishing of services between a plan and a party in interest to the plan. Because a “party in interest” includes any person providing services to the plan, a service relationship between a plan and a service provider would generally constitute a prohibited transaction under ERISA. A prohibited transaction would have consequences for both the responsible plan fiduciary and the service provider. The responsible plan fiduciary (i.e., a fiduciary with authority to cause the plan to enter into, extend or renew the contract or arrangement) would be subject to personal liability for breach of fiduciary duty under ERISA. The service provider would be subject to excise taxes under the Internal Revenue Code (the “Code”). However, ERISA Section 408(b)(2) exempts a contract or arrangement between a plan and a service provider that otherwise would be prohibited under ERISA Section 406(a)(1)(C), provided that (i) such contract or arrangement is reasonable, (ii) the services are necessary for the establishment or operation of the plan, and (iii) no more than reasonable compensation is paid for the services. Thus, such a reasonable contract or arrangement between a plan and a service provider would not constitute a prohibited transaction.

On December 13, 2007, the Department issued proposed regulations amending the existing regulations under ERISA Section 408(b)(2) to clarify what constitutes a “reasonable” contract or arrangement. In response to a myriad of comments to the proposed regulations by various practitioners, the Department adopted the interim final rule, which differs significantly from the proposed regulations. Like the proposed regulations, the interim final rule requires certain service providers to furnish certain disclosures to a responsible plan fiduciary of a covered plan. However, unlike the proposed regulations, the interim final rule does not require such disclosures to be made in a formal written contract, and no disclosure needs to be made regarding conflicts of interest. Further, a “covered plan” is limited under the interim final rule to an ERISA-covered defined contribution or defined benefit pension plan, and does not include simplified employee pensions, simple retirement accounts, individual retirement accounts or annuities, or welfare benefit plans (for which the Department plans to adopt a separate disclosure framework in the future).

The interim final rule is one of several initiatives by the Department to enhance the transparency of fees paid to service providers of ERISA plans. In November 2007, the Department adopted final regulations governing fee disclosure by plan administrators to the Department on Schedule C to the Form 5500 annual report. While similar to the interim final rule in a number of ways, the Schedule C fee disclosure regulations, which are generally effective for 2010 filings covering the 2009 plan year, do not apply to pension plans with 100 or fewer participants (whereas the interim final rule applies to pension plans regardless of size), apply to large welfare benefit plans (whereas the interim final rule does not apply to welfare benefit plans at all), and apply to a much broader category of service providers than the interim final rule. Further, on October 14, 2010, the Department released a separate final rule that requires defined contribution plan administrators to communicate detailed information on plan investment options, and fees and expenses to plan participants who direct their own plan investments. We will analyze such final rule, which will become applicable beginning with the 2012 plan year for calendar year plans, in an upcoming article.  

Who Must Comply

The interim final rule applies only to service providers that reasonably expect to receive (together with their affiliates and subcontractors) US$1,000 or more in compensation, direct or indirect, in connection with contracts or arrangements under which they provide certain types of services to covered plans (“covered service providers”). A party that provides services to a plan is a “covered service provider” only if it falls into one of the following three categories based on the type of plan services it provides (otherwise, it is not a “covered service provider” and accordingly is not subject to the disclosure requirements under the interim final rule):

  • ERISA fiduciaries or investment advisers registered under the Investment Advisers Act of 1940 or any state law. This category includes not only ERISA fiduciaries or investment advisers providing services directly to the covered plan, but also ERISA fiduciaries providing services to a first-tier investment contract, product, or entity that holds plan assets and in which the covered plan has a direct equity investment. We note that the interim final rule specifically excludes ERISA fiduciaries providing services to a second-tier investment vehicle in which that first-tier investment vehicle invests, even though such second-tier investment vehicle may also hold plan assets. Where a fund of funds that holds ERISA plan assets (the first-tier investment vehicle) invests in an unrelated fund that also holds plan assets (the second-tier investment vehicle), this helpful limitation would prevent the manager of the second-tier investment vehicle from being a covered service provider that must make the required disclosures to ERISA investors in the first-tier investment vehicle. However, there is some uncertainty on how the disclosure requirements will apply in the case of a master-feeder investment fund structure, as is commonly used in the hedge-fund context. A literal reading of the interim final rule is that these requirements apply only at the top level feeder entity (i.e., where the covered plan makes its direct investment). Where the feeder entity is a proprietary feeder fund of an underlying master fund that holds ERISA plan assets and no fiduciary services are provided at the feeder fund level (often the case when the feeder entity is hard-wired to invest in the master fund), the Department might take the position that disclosure is required by the fiduciary at the underlying master fund level. It is important to note that parties that provide services to an investment vehicle in which the covered plan invests, regardless of whether or not the investment vehicle holds plan assets, are not subject to these disclosure rules unless such parties provide ERISA fiduciary services. An investment manager of a US-registered mutual fund in which a plan invests would not be subject to these disclosure rules because a mutual fund is not deemed to hold plan assets.
  • Recordkeepers and brokers that offer a platform of investment options to participant-directed individual account plans. This category also includes service providers who provide recordkeeping or brokerage services that include designated investment alternatives independently selected by the responsible plan fiduciary and which are later added to the covered plan’s platform (e.g., in the case of a 401(k) plan). Under the interim final rule, “recordkeeping services” includes services related to plan administration and monitoring of plan and participant transactions and the maintenance of covered plan and participant and beneficiary accounts, records, and statements.
  • Service providers, or their affiliates or subcontractors, that reasonably expect to receive indirect compensation for specified services. The specified services are accounting, auditing, actuarial, appraisal, banking, 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 (whether provided by registered or unregistered investment advisers), legal, recordkeeping, securities or other investment brokerage, third party administration, or valuation services provided to the covered plan. The interim final rule requires only the party directly responsible for the provision of services to the covered plan to submit the required disclosures, even though some or all of such services may be performed by an affiliate or a subcontractor.  

What Information Must Be Disclosed

Regardless of the type of covered service provider, the interim final rule requires written disclosure to a responsible plan fiduciary of the following information:  

  • Services. A covered service provider must provide a description of the services to be provided to the covered plan pursuant to the contract or arrangement, but not including non-fiduciary services provided to a plan asset investment vehicle.  
  • Status. If applicable, a covered service provider must provide a statement that it (or its affiliate or a subcontractor) will or reasonably expects to provide services as an ERISA fiduciary and/or as a registered investment adviser.  
  • Direct compensation. A covered service provider must provide a description of all compensation, either in the aggregate or by service, that it (or its affiliate or a subcontractor) reasonably expects to receive directly from the covered plan in connection with its services pursuant to the contract or arrangement. Note that under the interim final rule, compensation for these purposes, including indirect compensation, refers to anything of monetary value, including non-monetary compensation (such as gifts, awards, and trips) that is valued at more than US$250 in the aggregate during the term of the contract or arrangement. Further, any compensation disclosed under the interim final rule, including indirect 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 beneficiary, or by any other reasonable method. Direct compensation does not include compensation paid by a plan sponsor or compensation received from a plan asset vehicle in which the covered plan has a direct equity investment.  
  • Indirect compensation. A covered service provider must provide a description of all compensation that it (or its affiliate or a subcontractor) reasonably expects to receive from any source other than the covered plan, the plan sponsor, or the covered service provider (or its affiliates or subcontractors). The description must identify the services for which the indirect compensation will be received and the payer of the indirect compensation.  
  • Compensation paid among related parties. A covered service provider does not need to disclose compensation paid among related parties (i.e., the covered service provider and its affiliates and subcontractors) unless such compensation is (i) 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 (ii) charged directly against the covered plan’s investment and reflected in the net value of the investment (e.g., Rule 12b-1 fees, which are generally fees charged by mutual funds to cover marketing and distribution expenses). The description of such compensation must identify the services for which such compensation will be paid and the payers and recipients of such compensation (and their status as an affiliate or a subcontractor). However, compensation received by an employee from his or her employer on account of work performed by the employee does not need to be included. Compensation paid among related parties under other circumstances need not be disclosed because, according to the Department, such payments affect only how compensation is allocated among the parties and generally do not affect the total costs of services to the plan. Further, the interim final rule does not require, as the proposed regulation did, narrative disclosures about potential conflicts among the related parties. According to the Department, the disclosure of indirect compensation and certain compensation paid among related parties as required by the interim final rule is intended to enable plan fiduciaries to assess (1) the reasonableness of compensation paid for services to the plan by taking into account all of the compensation being received in connection with such services, and (2) actual or potential conflicts of interest that may impact the quality of services provided to the plan.  
  • Compensation for termination of contract or arrangement. A covered service provider must provide a description of any compensation that it (or its 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.  
  • Manner of receipt. A covered service provider must provide a description of the manner in which the service provider will receive its compensation, such as whether the plan will be billed or fees will be deducted directly from plan accounts or investments.

The interim final rule requires additional disclosures in the following cases:

  • Recordkeeping services. A covered service provider that provides recordkeeping services must provide the following additional disclosures: (i) a description of all direct and indirect compensation that the covered service provider (or its affiliate or a subcontractor) reasonably expects to receive in connection with recordkeeping services; and (ii) if the covered service provider reasonably expects to provide recordkeeping services without explicit compensation or if its fees are offset or rebated by fees received by it (or its affiliate or a subcontractor), it must provide a reasonable good faith estimate of the cost of those services and 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. Such estimate must take into account rates that would be charged to third parties or prevailing market rates for similar services provided to similar plans of a similar size. Recordkeeping services may not be paid for by fees separately charged to the plan. These and other services may be paid for through charges that reduce the value of plan investments or through revenue-sharing. The recordkeeping services-related disclosures required by the interim final rule are intended to enable plan fiduciaries to make informed evaluations of plan recordkeeping costs.
  • Investment disclosure by ERISA fiduciaries. A covered service provider that is an ERISA fiduciary to a plan asset investment vehicle in which the covered plan has a direct equity investment must provide the following additional disclosures, unless such information is disclosed to the responsible plan fiduciary by a covered service provider providing recordkeeping or brokerage services: (i) 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 investment (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, and purchase fees); (ii) a description of the annual operating expenses (e.g., expense ratio) if the return is not fixed; and (iii) a description of any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees). These disclosures are intended to enable plan fiduciaries to understand and assess investment-related fees and expenses (which can significantly affect the value of a plan’s investment) in, among other things, selecting and monitoring investment options made available in participant-directed individual account plans, such as 401(k) plans. Note that separate disclosures are not required with respect to non-fiduciary service providers to these plan asset vehicles.
  • Investment-related disclosures by recordkeepers and brokers. The interim final rule requires the same investment-related disclosure described in the preceding paragraph from recordkeepers and brokers that make available investment alternatives for participant-directed individual account plans. This information must be provided with respect to each designated investment alternative (which does not include brokerage windows, self-directed brokerage accounts or similar plan arrangements that enable participants and beneficiaries to select investment beyond those specifically designated). Recognizing that recordkeepers and brokers merely serve as intermediaries between plans and issuers of these investment vehicles, a recordkeeper or broker may satisfy this investment-related disclosure requirement if it provides to the responsible plan fiduciary current disclosure materials of the issuer of the designated investment alternative that include the information described above, provided that (i) such issuer is not an affiliate, (ii) the disclosure materials are regulated by a state or federal agency, and (iii) the covered service provider does not know that the materials are incomplete or inaccurate.

How Information Must Be Disclosed

The interim final rule requires only that the disclosures be in writing and prescribe no particular manner or format for the disclosures. Covered service providers may satisfy the written disclosure requirement by providing plan fiduciaries with a variety of documents from different sources. However, the Department is considering adding a requirement to the final rule that covered service providers furnish a summary disclosure statement, for example, limited to one or two pages, that would provide an overview of the key information required to be disclosed, and a roadmap for finding the more detailed information required to be disclosed.

When Information Must Be Disclosed, Updated, or Corrected

A covered service provider must disclose the required information reasonably in advance of the date the contract or arrangement is entered into, and extended or renewed. Further, upon request, a covered service provider must provide such other information relating to compensation as is required for the covered plan to comply with any disclosure and reporting obligation under Title I of ERISA within 30 days of such request. If such disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, the 30-day deadline does not apply and the requested disclosure must be made as soon as practicable. This requirement for covered service providers to provide information upon request appears to be particularly burdensome, and whether it can be contractually restricted in scope remains to be seen.  

Covered service providers must disclose any changes (not just material changes) to required information previously provided as soon as practicable but no later than 60 days from the date it learns of such change. However, if such disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, the 60-day deadline does not apply and the updated disclosure must be made as soon as practicable. If an investment fund is determined not to hold plan assets upon the plan’s direct equity investment but is subsequently determined to hold plan assets (e.g., equity participation by ERISA investors exceeds 25%), the covered service provider may provide the required disclosures as soon as practicable but no later than 30 days from the date it learns of such change. Further, when a new investment is designated by the plan fiduciary, the required disclosures must be made as soon as practicable but no later than the designation date.  

The interim final rule provides that inadvertent errors in disclosure will not automatically cause a contract or arrangement to fail to be reasonable, provided that the covered service provider was acting in good faith and with reasonable diligence, and discloses the correct information as soon as practicable but no later than 30 days from the date it learns of such error.  

Exemption for Responsible Plan Fiduciaries

The interim final rule includes a prohibited transaction class exemption for responsible plan fiduciaries. The class exemption provides relief from fiduciary liability for causing a covered plan to enter into a non-exempt prohibited transaction, provided that all of the following conditions are met:

  • 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 the required information.
  • Upon discovering that the covered service provider failed to disclose the required information, the responsible plan fiduciary requests the required information in writing.
  • If the service provider fails to provide the required disclosure within 90 days, the fiduciary notifies the Department (the interim final rule sets forth the content, timing, and other requirements applicable to such notice).
  • The fiduciary does not need to terminate the contract or arrangement, but it must decide whether to continue it, taking into consideration (i) the nature of the failure; (ii) the availability, qualifications, and cost of replacement service providers; and (iii) the covered service provider’s response to notification of the error.

The Department provided this class exemption to responsible plan fiduciaries because it recognizes that an otherwise diligent plan fiduciary should not be penalized for a covered service provider’s failure to make the required disclosures. However, regardless of whether the responsible plan fiduciary is protected by the class exemption, covered service providers who fail to make the required disclosures will nevertheless generally be subject to excise taxes under the Code resulting from their participation in non-exempt prohibited transactions.  

Effective Date

The interim final rule will become effective on July 16, 2011. However, the Department has solicited additional comments that were due on August 30, 2010, so changes could be made before the effective date. When effective, the new rule will apply to both new and existing service arrangements. Covered service providers must provide all required disclosures for existing arrangements no later than the effective date.  

With the effective date of the interim final rule less than a year away, plan fiduciaries and service providers should begin to consider adding or revising their disclosure documents now. Compliance with these rules will likely require significant effort by ERISA plan fiduciaries and service providers.