Alert August 03, 2010

DOL Issues Interim Final Regulation Regarding Service Provider Fee Disclosure

In recent years, significant attention has been focused on the compensation paid to entities that provide investment management, recordkeeping, and other services to 401(k) plans and other retirement plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  (Such ERISA-governed retirement plans, along with entities that are deemed to hold “plan assets” of such plans, are referred to in this article as “Plans”.)  A perception has developed that greater fee transparency may be needed to enable fiduciaries of Plans (“Plan Fiduciaries”) to understand the relevant compensation arrangements better in connection with their selection and monitoring of service providers.  Recently, the Department of Labor (the “DOL”) issued an interim final regulation under Section 408(b)(2) of ERISA, as well as a corresponding ERISA prohibited transaction exemption, applicable to the provision of services to a Plan (including defined benefit pension plans and defined contribution retirement plans (e.g., 401(k) plans), but not including certain types of “SIMPLE” plans and accounts or individual retirement accounts).  Section 408(b)(2) of ERISA provides an exemption from ERISA’s prohibited transaction rules for reasonable arrangements with service providers.  The regulation will require certain Plan service providers to disclose to Plan Fiduciaries detailed information regarding fees and compensation.

The regulation will apply to the following types of service providers, which we refer to in this article as “Covered Service Providers,” if it is reasonably expected that such service provider (including its affiliates and subcontractors) will receive $1,000 or more in direct or indirect compensation:

  • Service providers who are fiduciaries under ERISA and who provide such ERISA fiduciary services either to the Plan itself or to a “plan assets vehicle” in which a Plan holds a direct equity interest, and investment advisers registered under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or under applicable state law and who provide such services directly to the Plan;
  • Providers of recordkeeping or securities brokerage services to self-directed individual account plans (e.g., most 401(k) plans) if investment alternatives are made available in connection with such services (e.g., through a platform); and
  • Service providers who receive indirect compensation (i.e., compensation received from any source other than directly from the plan, plan sponsor, the service provider or an affiliate or a subcontractor) for accounting, actuarial, appraisal, auditing, banking, custodial, insurance, investment advisory (plan or participant), legal, recordkeeping, securities brokerage, third-party administration, valuation services and/or certain types of consulting services.

Notably, the regulation does not apply to service providers who provide only non-fiduciary services to an investment fund (as contrasted to a retirement plan) that holds plan assets (e.g., a bank collective fund). 

The regulation would require Covered Service Providers to provide certain initial and ongoing disclosures in writing regarding their compensation arrangements.  These requirements are in addition to the existing requirements under ERISA Section 408(b)(2), including requirements that a service provider’s compensation be reasonable and that the Plan’s arrangement with the service provider be terminable on reasonably short notice without penalty to the Plan.  The disclosures that must be provided in writing reasonably in advance of whenever the service contract is entered into, extended or renewed include the following:

  • A description of all services to be provided to the Plan pursuant to the contract or arrangement (the “Covered Services”);
  • A statement, if applicable, that the Covered Service Provider or any affiliate or subcontractor reasonably expects to provide the Covered Services as a fiduciary under ERISA and/or the Advisers Act (or applicable state law);
  • A description of all direct compensation that the Covered Service Provider, an affiliate or subcontractor reasonably expects to receive in connection with the Covered Services;
  • A description of all indirect compensation (i.e., all compensation received from any source other than the plan, plan sponsor, the Covered Service Provider or an affiliate or a subcontractor) that the Covered Service Provider, an affiliate or a subcontractor reasonably expects to receive in connection with the Covered Services, including identification of the services provided for, and the payer of, such indirect compensation;
  • A description of any compensation for the Covered Services that will be paid among the Covered Service Provider, an affiliate, or a subcontractor if it is set on a transaction basis (e.g., commissions) or is charged directly against the Plan’s investment and reflected in the investment’s net value (e.g., Section 12b-1 fees), including identification of the services provided for, and the payer and payee of, such compensation, even if such compensation is otherwise disclosed;
  • A description of any compensation that the Covered Service Provider, an affiliate or subcontractor reasonably expects to receive in connection with the termination of the arrangement including how any prepaid amounts will be calculated and refunded;
  • A description of how the compensation will be received (e.g., billed to the Plan or deducted from the Plan’s account); and
  • In addition, there are additional specific disclosure requirements for certain types of Covered Service Providers, as follows:
    • Recordkeeping services:  If it is reasonably expected that there will be no explicit compensation for recordkeeping services, or that compensation for such services will be offset or rebated based on other compensation, a reasonable good faith estimate must be provided of the implicit cost of such services to the Plan, including a detailed explanation of the services and a description of how the compensation will be received.
    • Fiduciary services:  If a Covered Service Provider is a fiduciary to an investment contract, product or entity that holds plan assets and in which a Plan has a direct equity investment, 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 contract, product or entity (e.g., sales loads and redemption fees), the annual operating expenses (e.g., expense ratio) of the contract product or entity, and any on-going expenses in addition to annual operating expenses (e.g., wrap fees), unless such amounts are otherwise disclosed by the platform provider.
    • Investment disclosure for designated investment alternatives:  If recordkeeping or brokerage services are provided to a self-directed individual account plan and certain designated investment alternatives are made available (e.g., through a platform) in connection with such services, the fee disclosure detailed above regarding fiduciary services must be provided by the platform provider for each such designated investment alternative, which requirement can be met by providing current disclosure of the issuer if certain conditions are satisfied.

In addition, the Covered Service Provider must disclose any material changes in the required disclosures as soon as practicable, but not later than 60 days after acquiring knowledge of such material change.  The regulation does not provide for any specific format for the required disclosures.

Under the regulation, “compensation” is broadly defined in the regulation to include money or any other thing of monetary value.  Where the Covered Service Provider is not able to describe the compensation or fees in a specific monetary amount, it may provide a formula, percentage of Plan assets or per capita charge, provided such disclosure permits a reasonable Plan Fiduciary to evaluate the reasonableness of the compensation or fees.

While the regulation is similar in many respects to the guidance promulgated with respect to the new service provider fee disclosure requirements of Schedule C to the Form 5500, there are several notable differences.  For example, compensation received by service providers to an investment fund is required to be disclosed on Schedule C, while the regulation exempts non-fiduciary service providers to such an investment fund from the disclosure requirements of the regulation.  In addition, the threshold for disclosure on Schedule C is $5,000 of compensation received by a service provider in a plan year, while it is $1,000 of compensation under the contract or arrangement for purposes of the regulation.

The regulation becomes effective on July 16, 2011.  For existing contracts and arrangements, Covered Service Providers must provide the required disclosures before the effective date.  Comments on the interim final regulation are due by August 30, 2010. 

In addition, the DOL finalized a class exemption applicable to Plan Fiduciaries for situations where, unbeknownst to the Plan Fiduciary, the service provider fails to provide the disclosure required by the regulation.  In order for the relief under the class exemption to be available, the Plan Fiduciary must have reasonably believed that the disclosure requirements were satisfied, and must not have known or have had reason to know that the service provider failed to comply with the disclosure requirements.  The exemption would require that the responsible Plan Fiduciary, upon discovering the disclosure failure, request in writing that the disclosures be made, and if such disclosure is not made within 90 days, notify the DOL of such failure within 30 days following the end of such 90-day period.  The DOL also provided a model notice that Plan Fiduciaries may use for this purpose.