The U.S. Department of Labor (DOL) has issued an interim “final regulation” (the New Regulations) under the Employee Retirement Income Security Act of 1974, as amended (ERISA), requiring improved fee disclosure for pension plans.1 The new regulation is effective for contracts or arrangements that are in place between plans and service providers as of July 16, 2011, whether they were entered into before or after that date.

Pepper Point: Who does this new directive potentially affect?

  • registered investment advisers who directly provide services to pension plans
  • fiduciaries to investment vehicles holding plan assets (i.e., the general partner or manager of a hedge fund)
  • pension plan fiduciaries
  • providers furnishing accounting, actuarial, appraisal, auditing, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third-party administration, or valuation services to pension plans who also receive “indirect” compensation or share compensation among related parties, 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).

What must be done?

  • Significant disclosures of compensation, direct and indirect (including compensation of affiliates and subcontractors) must be made.
  • A fiduciary to a fund with direct pension plan investments must generally provide: (a) 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 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); (b) a description of the annual operating expenses (e.g., expense ratio) if the return is not fixed; and (c) a description of any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees).

When must procedures be in place and disclosures made?

  • Generally, no later than July 16, 2011.

Pepper Point: ERISA requires plan fiduciaries, when selecting and monitoring service providers and plan investments, to act prudently and solely in the interest of the plan’s participants and beneficiaries. Responsible plan fiduciaries must also ensure that arrangements with their service providers are “reasonable” and that only “reasonable” compensation is paid for services. Fundamental to the ability of fiduciaries to discharge these obligations is the ability to obtain information that is sufficient to enable them to make informed decisions about the services to be provided, the costs involved, and the service providers themselves.

Special Disclosure Required for Entities in Which a Plan Invests Directly

A fiduciary to such an entity (i.e., a hedge fund) with direct plan investments must provide: (a) 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 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); (b) a description of the annual operating expenses (e.g., expense ratio) if the return is not fixed; and (c) a description of any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees), unless such information is otherwise disclosed to the responsible plan fiduciary by a covered service provider providing recordkeeping services or brokerage services.

Required Timing for Disclosures

The required disclosures generally must be made in advance of the date the contract or arrangement is entered into, and extended or renewed. With respect to contracts or arrangements entered into prior to the effective date of the Interim Final Regulations, the required disclosures must be furnished no later than July 16, 2011. However, when a covered plan invests in an investment contract, product or entity that was not required to comply at the time of investment (i.e., did not have pension money), the required disclosures must be made as soon as practicable thereafter, but not later than 30 days from the date the covered service provider knows such investment contract, product or entity has become subject to the New Regulations. A service provider generally must disclose a change to the initial information required to be disclosed as soon as practicable, but no later than 60 days from the date on which the covered service provider is informed of such change.

General Parameters of the New Regulations

ERISA generally prohibits the furnishing of goods, services, or facilities between a plan and a “party in interest” to the plan (which includes, among others, plan fiduciaries and service providers). Any service relationship between a plan and a service provider to the plan would constitute a “prohibited transaction” unless an applicable exemption applies. An exemption is provided for service contracts or arrangements between a plan and such a party in interest, if (a) the contract or arrangement is “reasonable,” (b) the services are necessary for the establishment or operation of the plan, and (c) no more than reasonable compensation is paid for the applicable services.

The New Regulations expand existing requirements in the case of a contract or arrangement between “covered service providers” and “covered plans,” by providing that a contract between a covered service provider and a covered plan is not reasonable unless the covered service provider discloses to that plan certain specified information regarding the compensation that the service provider will derive from the contract.

The New Regulations apply to ERISA-covered “employee pension benefit plans” and “pension plans,” which includes both defined contribution and defined benefit plans, but the New Regulations do not apply to IRAs, individual retirement annuities, “simplified employee pensions,” “simple retirement accounts” or “employee pension benefit plans” and “pension plans” that are exempt from coverage under ERISA pursuant to Section 4(b) of ERISA (such as governmental plans, church plans, etc.).

Covered Service Providers

The New Regulations apply to “covered service providers.” These are defined as plan service providers that expect to receive at least $1,000 in compensation (directly or indirectly) in connection with their services to the plan (regardless of whether such services will be performed, or such compensation received, by the service provider in question, an affiliate, or a subcontractor) and who provide one or more of the following services:

  1. services provided directly to the covered plan by a fiduciary
  2. services provided directly to the covered plan by an investment adviser registered under either the Investment Advisers Act of 1940, as amended, or any state law
  3. services provided as a fiduciary to an investment contract, product, or entity that holds plan assets (i.e., a fund) and in which the covered 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. As a result, this category does not include a company that provides services to an entity one or more levels removed from the investment (i.e., a plan invests in hedge fund X and hedge fund X invests in fund-of-funds entity Y).
  4. recordkeeping services or brokerage services provided to a covered plan that is an individual account plan, as defined in section 3(34) of ERISA, and that permits participants or beneficiaries 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
  5. 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 a plan or participants in the plan), 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 “compensation paid among related parties.”

However, no person or entity is a “covered service provider” solely by providing services (a) as an affiliate or a subcontractor that is performing one or more of the services to be provided under the contract or arrangement with the covered plan or (b) to an investment contract, product, or entity in which the covered plan invests, regardless of whether or not the investment contract, product, or entity holds assets of the covered plan (other than services as a fiduciary as noted above).

Pepper Point: In other words, the concept of a “covered service provider” captures only the party directly responsible to the covered plan for the provision of services under the contract or arrangement, even though some or all of such services may be performed by an affiliate or subcontractor. In the view of the DOL, the service provider directly responsible to the plan for the provision of services is the appropriate party to ensure that the required disclosures under the regulation are made.

Required Disclosures

The covered service provider is required to disclose, in writing, the following information to the “responsible plan fiduciary” who is the fiduciary with authority to cause the covered plan to enter into, or extend or renew, the contract or arrangement:2

  1. Services Provided

A description of the services to be provided to the covered plan under the contract or arrangement (but not including non-fiduciary services).  

  1. Fiduciary Status

If applicable, a statement that the covered service provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services under the contract or arrangement directly to the covered plan (or to an investment contract, product or entity that holds plan assets and in which the covered plan has a direct equity investment) as a fiduciary, and, if applicable, a statement that the covered service provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services under the contract or arrangement directly to the covered plan as an investment adviser registered under either the Investment Advisers Act of 1940 or any state law.  

  1. Compensation

Direct:

A description of all direct compensation paid by the covered plan (either in the aggregate or by service), that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with the services.

Indirect: A description of all indirect compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with the services (including identification of the services for which the indirect compensation will be received and identification of the payer of the indirect compensation). “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.

Compensation paid among related parties: A description of any compensation that will be paid among the covered service provider, an affiliate, or a subcontractor, in connection with the services 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).

Pepper Point: This “compensation paid among related parties” provision does not apply to compensation received by an employee from his or her employer on account of work performed by the employee.

Compensation for termination of contract or arrangement: A description of 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.

Recordkeeping services: If recordkeeping services will be provided to the covered plan,

  1. 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, and
  2.  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.

Pepper Point: A description or an estimate 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 beneficiary or, if the compensation cannot reasonably be expressed in such terms, by any other reasonable method is required, as is a description of the manner in which the compensation will be received (e.g., deduction from account, direct billing, etc.). There is no requirement that any information supplied be on a particular form or in a particular format.

If a covered service provider is providing recordkeeping or brokerage services to an individual account plan and will be making available one or more designated investment alternatives, then, with respect to each designated investment alternative, the covered service provider must provide effectively the same information as noted above that is required of entities in which a plan invests. The DOL recognizes that recordkeepers and brokers, unlike fiduciaries to investment vehicles holding plan assets, are not directly involved in the day-to-day management of the investment vehicles they represent, but rather, merely serve as intermediaries between plans and the issuers of these investment vehicles for purposes of furnishing such information. As such, a covered service provider may comply with investment-related disclosure requirements if the covered service provider provides to the responsible plan fiduciary current disclosure materials of the issuer of the designated investment alternative that include the information required, provided that such issuer is not an affiliate, the disclosure materials are regulated by a state or federal agency, and the covered service provider does not know that the materials are incomplete or inaccurate.

The New Regulations also require a service provider to provide, upon request of the responsible plan fiduciary or plan administrator, “any other information relating to the compensation received in connection with the contract or arrangement that is required for the covered plan to comply with the reporting and disclosure requirements of Title I of ERISA and the regulations, forms and schedules issued thereunder.”

Relief for Disclosure Errors

The DOL has provided that no contract or arrangement will fail to be reasonable under the New Regulations solely because the covered service provider, acting in good faith and with reasonable diligence, makes an error or omission in disclosing the information required by the New Regulations. However, the covered service provider must disclose the correct information as soon as practicable, but not later than 30 days from the date on which the covered service provider knows of such error or omission. This relief applies to both the responsible plan fiduciary and the covered service provider.