Lawsuits alleging that 401(k) plan investment fees are too high and have not been monitored by plan fiduciaries or disclosed to participants have been in the spotlight for some time. Although plaintiffs have not been prevailing in this litigation, there is still the potential for such cases, or for Congress or the Securities & Exchange Commission1 to make new law affecting plan fees. However, new regulations recently finalized by the United States Department of Labor have already changed the law by imposing new disclosure obligations not just on those who administer 401(k) plans, but on a large group of plan administrators and service providers. New requirements apply to administrators of all defined contribution plans subject to the U.S. Employee Retirement Income Security Act (ERISA) in which participants direct the investment of their accounts and to fiduciaries and service providers to all pension plans subject to ERISA.
This Osler Update summarizes the new rules that have already become law and contains recommendations for best practices to help limit the risk of civil penalties and lawsuits.
Who is Affected
Any fiduciaries responsible for hiring plan service providers for defined contribution or defined benefit plans, such as a 401(k) Plan Committee, will be required to get mandatory fee disclosure from the plan’s service providers. If the plan doesn’t designate a fiduciary responsible for hiring, the default fiduciaries will be the Company and its board of directors. Service providers include record keepers, third party administrators, trustees, brokers and investment managers and advisers. The regulations even apply on a limited basis to managers of private equity funds, including many hedge funds, that are treated as holding plan assets under Department of Labor regulations.
A second setof regulations finalized in October 2010 requires disclosure of investment and fee information to participants and beneficiaries. These regulations cover almost all defined contribution plans subject to ERISA in which participants may decide how their accounts will be invested. Their primary impact will be on 401(k) plans, but they could also affect profit sharing or money purchase plans, tax qualified employee stock ownership plans, and tax deferred annuity plans of tax exempt organizations. The new requirements will apply regardless of whether the plan’s fiduciaries have sought to protect themselves from liability for losses resulting from participant investment decisions under the safe harbor in Section 404(c) of ERISA, but expands upon those requirements. These disclosure requirements are imposed on the plan administrator, which will be the plan sponsor by default if the plan has not designated another administrator.
The New Service Contract Requirements
Covered plan service providers must now prepare to provide a large amount of new information. The requirements generally include:
- a description of all services provided to the plan and whether they will be provided as a fiduciary or registered investment adviser;
- all direct and indirect compensation that the service provider, any affiliate or subcontractor expects to receive;
- if the provider is an investment fiduciary, broker or record keeper, a description of any compensation such as 12b-1 fees that will be paid among related parties;
- a description of any compensation reasonably expected on termination of the contract, such as insurance contract surrender fees; and
- a description of the manner in which compensation will be received, such as by billing or direct deduction from plan assets.
Special rules for record keeping services will require disclosure of typical revenue sharing arrangements. If these services will be provided in whole or in part without explicit compensation, or if compensation is subject to offset or rebates, the record keeper must give a detailed explanation of the services provided and disclose the fees that would be charged for such services if no offsets or rebates applied.
While the regulations do not technically apply where all plan fees – including indirect fees – are paid by the plan sponsor, it is difficult to believe that such plan sponsors will not require service providers to give them at least the same information as is legally required when fees are paid from plan assets. Penalty Exposure
Plan fiduciaries, such as 401(k) or pension plan committee members, also need to know these rules, since ERISA prohibits entering into service contracts with parties in interest unless the services are necessary and the arrangement and compensation are reasonable. The regulations take the position that an arrangement is not reasonable if this mandatory information has not been obtained. Fiduciaries must request information from the service providers if it is not provided in a timely manner, and report non-compliance to the U.S. Department of Labor in order to avoid causing the plan to engage in a prohibited transaction exposing them to potential liability for losses. Service provider non-compliance will incur excise taxes.
Participants are not required to receive the same disclosure about service provider fees as plan fiduciaries will receive (described above). Instead, all eligible employees will now have access to the following specific information:
1. On first qualifying to participate in the plan and on an annual basis thereafter:
- For each available investment option, total operating expenses as a percentage and as a dollar amount for an assumed investment of $1000.
- Plan related expenses, such as administrative expenses, charges for using third party investment options and legal and accounting fees.
- Historical performance data for investment options, including one; five; and 10 year returns compared to appropriate benchmarks such as the S&P 500 or another broad-based market index appropriate for the type of investment.
The rules require information similar to that currently required to be prepared by mutual funds, such as expense ratios, to be provided by bank collective trusts and other arrangements not currently subject to these rules on the theory that uniform disclosure enables participants to more easily compare investments. There are some special and transition rules to cushion the impact of this change, as well as special rules for annuities.
A model chart to disclose this information in comparative form was also released. Although similar formats are acceptable, the model will probably become the format used by almost all plans.
2. The following will be itemized for participants on a quarterly basis:
- Fees actually deducted from their accounts for administration.
- Fees actually deducted from their accounts because of individual activity, such as because a loan or qualified domestic relations order was processed.
- Fees actually deducted from their accounts for investments e.g. loads and sales charges.
While the rules do not require the details of revenue sharing arrangements to be disclosed to participants, if revenue sharing payments or 12b-1 fees reduce or are applied against administrative costs, the participants must be told that in addition to the costs set forth on the quarterly fee statement, some of the plan’s administrative expenses for the preceding quarter were paid from the annual operating expenses of one or more available investment options.
Each plan must have information available on a website giving participants access to supplemental information, such as portfolio turnover, and provide a glossary of investment terms or make a glossary available through a website link. In general, changes require at least 30 days advance notice.
No specific excise tax or monetary penalty is assessed for noncompliance with the participant disclosure rules. However, by issuing these regulations under Section 404(a) of ERISA, which defines fiduciary responsibilities, the Department of Labor has created the potential for liability for losses caused by violations.
The service provider requirements apply in July 2011. The participant disclosure regulations will apply to most plans for the first time in 2012. Compliance will require coordination with vendors and substantial lead time.
Some Suggested Best Practices
- Request fees as a percentage of plan assets as well as a dollar amount. Monitor asset-related fees on an ongoing basis to make sure they do not become disproportionate as assets increase.
- Request and review information about revenue sharing payments, including investments that generate those payments and those that do not and the cost of services if no offsets or rebates apply. Explore alternatives to revenue sharing.
- Place fee review on the Plan Committee’s agenda on a regular basis and document the results of that review. If you select an investment or a service provider with superior performance and higher fees, document your analysis carefully in the records. A prudent process is the best defense against charges of breach of fiduciary responsibility.
- Understand the alternatives to mutual funds that are available in the market, including bank collective trusts and insurance company separate accounts and the fee arrangements for each.
- Consider index funds, which typically have lower fees, as well as actively-managed funds.
- Request fee information about different classes of funds, and request a waiver of the minimum balance requirements and any loads.
- Amend plan service agreements to spell out disclosure responsibilities and a calendar for compliance.
- Consult outside advisers if more expertise in evaluating fees in relation to performance or selecting investment options is needed.
- Monitor case law and legislation for new developments expanding disclosure obligations.