The time for service providers to comply with the disclosures of services, compensation and fiduciary status required by the ERISA §408(b)(2) regulation is upon us. Presumably, most covered service providers – such as third party administrators that receive indirect compensation, broker-dealers, recordkeepers and registered investment advisers – have taken steps toward complying with their disclosure obligations.
As the reality of making the disclosures has set in, we have fielded a stream of questions about how, exactly, the disclosure requirement might affect service providers’ arrangements with their clients. One source of confusion concerns when and whether service providers may need to offset or reduce the compensation they would otherwise receive from plans and plan sponsors as a result of indirect compensation they may receive from other service providers. The purpose of this article is to clear up some of the confusion.
Whether direct compensation should be reduced or offset by indirect compensation turns largely on whether the service provider is a fiduciary – such as a registered investment adviser (RIA) that renders investment advice for a fee – or a nonfiduciary. Unlike fiduciary service providers, nonfiduciaries provide services that do not involve discretion over the plan’s assets or administration, or investment advisory services.
Fiduciaries and nonfiduciaries are held to very different standards. ERISA prohibits a fiduciary from dealing with the assets of the plan in his own interest or for his own account, and from receiving any consideration for his own account from any party dealing with the plan in a plan-related transaction. So, it is a prohibited transaction for a fiduciary to increase his own compensation in a transaction involving the plan. For example, if an RIA recommends an investment option to the plan client, and the investment generates indirect compensation payable to the RIA (such as a commission), a prohibited transaction occurs. By reducing the direct compensation paid by the plan to the extent of the indirect compensation the RIA will receive, the RIA “levelizes” his compensation and negates the prohibited transaction.
Conversely, nonfiduciaries – such as third party administrators (TPAs) that do not provide recordkeeping services -- are not bound by ERISA’s prohibitions against fiduciaries acting for their own account in connection with plan transactions. As a result, TPAs are not required to (though we are aware that a number voluntarily do) offset their direct compensation by any indirect payments they receive. Indeed, many nonfiduciary service providers set their fees in anticipation of receiving indirect compensation from insurance companies and mutual fund companies. Once the 408(b)(2) regulation takes effect, their obligation will be to disclose to their plan clients all direct and indirect compensation they expect to receive.
Nonfiduciaries will, however, still be subject to the requirement that their overall compensation be reasonable. Consider, for example, the circumstance in which a TPA charges a reasonable fee to its plan client. When the TPA receives significant additional indirect compensation from the insurance company that provides the plan’s investments, it may cause the TPA’s overall compensation in connection with its services to the plan to exceed a reasonable amount. In that case, it may be appropriate for the TPA to offset or reduce the compensation from the plan or the plan sponsor, or to pay a portion of the indirect compensation to the plan. Otherwise, the reasonableness of the compensation may be called into question. To the extent the compensation exceeds a reasonable amount, it is a prohibited transaction.
Recognize, however, that the issue isn’t always so clear cut. Consider, for instance, a TPA firm that provides nonfiduciary services that is under common ownership with – and has clients in common with -- a fiduciary registered investment adviser. In that setting, issues may arise when the fiduciary investment adviser recommends an insurance company that pays the TPA indirect compensation. In that case, the TPA may need to levelize its compensation and negate the impact of the indirect compensation that it will receive as a result of its affiliate’s investment recommendation.