On July 15, 2010, the Department of Labor (“DOL”) took a significant step in finalizing a regulation meant to provide retirement plan fiduciaries with the information they need to determine the reasonableness of compensation paid to service providers and to assess how those services are affected by potential conflicts of interest. The interim final rule (“Rule”) was issued on July 15 and published in the Federal Register on July 16. The Rule requires certain service providers to retirement plans to disclose information to those plans, including compensation and conflicts of interest. This information is intended to assist plan fiduciaries in assessing the reasonableness of contracts or arrangements with those service providers. The Rule sets forth the requirements under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974 (“ERISA”) that retirement plan service providers must meet to exempt their service contracts or arrangements from ERISA’s prohibited transaction rules. Initially proposed on December 13, 2007 (see our February 2008 issue), the regulation becomes effective on July 16, 2011, at which time it will apply to all existing and future contracts or arrangements. The public comment period on the Rule ends August 30, 2010. While the DOL may make some changes to the Rule after the comment period, the Rule is considered final.
Background on ERISA section 408(b)(2)
ERISA section 408(b)(2), the statutory provision under which the Rule was issued, provides relief from the prohibited transactions described in Section 406 of ERISA related to service contracts or arrangements between a plan and a party in interest. ERISA section 406(a)(1)(C) prohibits a plan fiduciary from causing a plan to enter into a transaction which he or she knows constitutes the furnishing of goods, services, or facilities between the plan and a party in interest. Section 408(b)(2) provides an exemption to ERISA section 406(a)(1)(C) for a “reasonable” contract or arrangement for services necessary for the establishment or operation of the plan “if no more than reasonable compensation is paid.” The Rule provides that for a contract or arrangement to be reasonable, the service provider must disclose specific information to the fiduciary who has the authority to cause the plan to enter into, extend or renew the contract or arrangement (the “responsible plan fiduciary”). The Rule also incorporates the existing regulations under ERISA section 408(b)(2) (see 29 C.F.R. 2250.408b-2(c)) which provide that for a contract to be “reasonable” it must permit a plan to terminate the arrangement without penalty on reasonably short notice.
Content of the Rule
What Is a Covered Plan?
The Rule, unlike the 2007 proposed rule, applies only to ERISA-covered pension plans, and reserves issuance of a final rule on health and welfare plans to a later date. The Rule generally applies to all tax-qualified defined contribution and defined benefit plans (e.g., 401(k), profit sharing, money purchase, single employer and multiemployer defined benefit and ERISA covered 403(b) plans). It does not apply to plans such as severance plans, governmental plans or church plans that are not “pension plans” covered under ERISA. The Rule expressly does not apply to simplified employee pension plans under Internal Revenue Code (“Code”) section 408(k), SIMPLE retirement accounts under Code section 408(p), individual retirement accounts under Code section 408(a) or individual retirement annuities under Code section 408(b).
Who Is a Covered Service Provider?
Covered service providers under the Rule are not necessarily the same parties that must be reported as service providers for Form 5500 Schedule C purposes. The Rule applies to service providers that expect to receive $1,000 or more in indirect or direct compensation in connection with certain enumerated services to covered plans, regardless of whether such services will be performed by the service provider, an affiliate or a subcontractor and regardless of whether such compensation is received by the service provider, an affiliate or a subcontractor (“covered service providers”). The Rule does not state whether the $1,000 threshold is calculated over an annual or other basis, and this silence might lead to public comments and ultimately clarification by the DOL.
The Rule defines an affiliate as a party that directly or indirectly controls, is controlled by, or is under common control with a covered service provider. It defines a subcontractor as a party that is not an affiliate of the covered service provider and that, pursuant to a contract or arrangement with the covered service provider or an affiliate of the covered service provider, reasonably expects to receive $1,000 or more in compensation for performing one or more services covered under the Rule.
The covered service providers who are subject to the Rule are those that are:
- Fiduciaries within the definition of Section 3(21) of ERISA that provide services directly to the covered plan
- Fiduciaries to an investment contract, product or entity that holds plan assets and in which the covered plan has a direct equity investment (i.e., those who serve as ERISA fiduciaries by providing services to a plan asset investment vehicle but who do not provide services directly to the covered plan)
- Investment advisers that are registered under the Investment Advisers Act of 1940 or state law and that provide services directly to the covered plan
- Providers of recordkeeping services or brokerage services to an individual account plan under ERISA section 3(34) that permits participants to direct the investment of their accounts, if one or more designated investment alternatives will be available through a platform offered in connection with such recordkeeping or brokerage services (A “designated investment alternative” is any investment alternative designated by a fiduciary into which participants may direct the investment of their individual accounts, and does not include brokerage windows, self-directed brokerage accounts or similar arrangements that allow participants to select investments beyond those specifically designated.)
- Providers of any of the following services, if the service provider, an affiliate or a subcontractor reasonably expects to receive indirect compensation or certain payments from related parties (including but not limited to commissions, soft dollars, finder’s fees or Rule 12b-1 fees) for these services: 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 (for plan participants), legal, recordkeeping, securities or other investment brokerage, third party administration, or valuation services
The Rule clarifies that only the party directly responsible to the covered plan for the services under a contract or arrangement is required to disclose the information required under the Rule, and not the affiliates or subcontractors that might actually be performing the services. Also, parties who provide only non-fiduciary services to an investment contract, product or entity in which the covered plan invests, even one holding plan assets, are not covered service providers under the Rule.
How Must Information Be Disclosed?
The Rule requires the disclosures to be made in writing but otherwise does not specify the format for the disclosures. The Rule makes no statement as to the means by which the disclosures must be made, but in the absence of such statement, disclosure in accordance with the DOL’s electronic disclosure regulations would likely be acceptable. Unlike the 2007 proposed rule, the Rule does not require covered service providers to have a formal contract or arrangement with the covered plan that is itself in writing. The DOL is considering whether to add a requirement that covered service providers furnish the responsible plan fiduciary with a summary disclosure statement (one or two pages in length) that provides an overview of the information required by the Rule and a roadmap of where details of such information may be found.
What Must Be Disclosed?
Description of Services
A covered service provider must provide a description of the services to be provided to the covered plan under the contract or arrangement, except that non-fiduciary services to investment vehicles holding plan assets need not be disclosed. The level of detail for the description of services is not specified in the Rule, but the DOL states in the preamble to the Rule that if the description of services lacks details sufficient for the responsible plan fiduciary to assess whether the compensation to be received is reasonable, the responsible plan fiduciary must request additional information about those services. (See the discussion below regarding the consequences of not disclosing.)
Fiduciary or Registered Investment Adviser Status
If applicable, the disclosures must state that the covered service provider, an affiliate or a subcontractor will provide, or reasonably expects to provide, services as an ERISA fiduciary to the covered plan, or to an investment vehicle that holds plan assets and in which the covered plan has a direct equity investment. Also, if applicable, the disclosures must state that the covered service provider, an affiliate or a subcontractor will provide, or reasonably expects to provide, services as an investment adviser registered under the Investment Advisers Act of 1940 or state law.
Compensation in General
The Rule requires disclosure of certain compensation the covered service provider expects to receive in connection with its services. It defines “compensation” as anything of monetary value excluding any non-monetary compensation valued at $250 or less, in the aggregate, during the term of the contract or arrangement (which could be for several years). Compensation may be disclosed as a monetary amount, formula, percentage of the covered plan’s assets or a per capita charge for each participant or beneficiary. If compensation cannot reasonably be described by any of these methods, it may be described by any other reasonable method. As a side note, payment received solely from the plan sponsor (and not derived from plan assets) is not subject to the disclosure requirements of the Rule.
The disclosures must include a description of all “direct” compensation — that is, compensation that the covered service provider, an affiliate or a subcontractor will receive or reasonably expects to receive, in connection with the services provided, directly from the covered plan. Direct compensation may be stated in the aggregate or on an itemized service-by-service basis, except that certain segregated disclosure of compensation is required of recordkeepers, as explained below.
The covered service provider must include a description of all “indirect” compensation – that is, compensation that the covered service provider, an affiliate or a subcontractor will receive, or reasonably expects to receive, in connection with the services provided, from any source other than the covered plan, the plan sponsor, the covered service provider, an affiliate or a subcontractor. In addition, covered service providers must identify the services for which the indirect compensation will be received and the payer of the indirect compensation.
Compensation Paid Among the Covered Service Provider, an Affiliate or a Subcontractor
Compensation reasonably expected to be paid among a covered service provider, an affiliate or a subcontractor must be disclosed if the compensation is set on a transaction basis (e.g., commissions, soft dollars or 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., 12b-1 fees). In addition, the covered service provider must identify the:
- services for which the related-party compensation will be received;
- payer and the recipient of the related-party compensation; and
- status of the payer and recipient as an affiliate or a subcontractor.
Compensation for Termination of Contract or Arrangement
The disclosures must include compensation that the covered service provider, affiliate or subcontractor reasonably expects to receive for the termination of the contract or arrangement with the covered plan, and how any prepaid compensation will be calculated and refunded upon termination.
Special Segregated Disclosure for Recordkeeping Services
Unlike the 2007 proposed rule, the Rule provides for a separate disclosure of recordkeeping services. The Rule defines recordkeeping services as including plan administration, monitoring of plan and participant and beneficiary transactions, and maintenance of covered plan and participant and beneficiary accounts, records and statements. If recordkeeping services are provided to the covered plan (even if in a bundled arrangement), the covered service provider must furnish a description of direct and indirect compensation that the covered service provider, an affiliate or a subcontractor reasonably expects to receive for those recordkeeping services. If the recordkeeping services are reasonably expected to be provided in whole or in part without explicit compensation for recordkeeping services or if compensation for those services is offset or rebated based on other compensation received by the covered service provider, affiliate or subcontractor, the covered service provider must also furnish a reasonable and good faith estimate of the cost to the covered plan of those recordkeeping services. The disclosure must include a description of the methodology used for the estimate and a detailed explanation of the recordkeeping services. The estimate should consider 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.
Manner of Receipt of Compensation
The disclosures must describe the manner in which the compensation will be received (e.g., whether the covered plan will be billed or whether the compensation will be deducted directly from the covered plan’s account or investments).
While investment products themselves are not covered service providers under the Rule, certain disclosures regarding investments of a covered plan must be made by:
- fiduciaries to an investment vehicle that holds plan assets; and
- any recordkeepers and brokers that make available designated investment alternatives on a platform for covered plans that are participant-directed individual account plans.
For each investment contract, product or entity that holds plan assets and in which the covered plan has a direct equity investment, the covered service provider (the fiduciary to such investment vehicle) must provide descriptions of the following:
- Any compensation that will be charged directly against the covered plan’s investment in connection with the acquisition, sale, transfer of, or withdrawal from the investment contract, product, or entity (e.g., sales charges, sales loads, redemption fees, surrender charges or exchange fees)
- The annual operating expenses (e.g., expense ratio) if the return is not fixed
- Any ongoing expenses in addition to annual operating expenses
The same items of information must be provided by any covered service provider who is a recordkeeper or broker that makes available designated investment alternatives for covered plans that are participant-directed individual account plans. These items of information must be provided for each such designated investment alternative. A recordkeeper or broker may satisfy this disclosure requirement by providing current disclosure literature from the provider of the designated investment alternative, so long as the provider is not an affiliate, the disclosures are regulated by a state or federal agency and, to the recordkeeper/broker’s knowledge, the literature is not incomplete or inaccurate.
When Must the Disclosures Be Made?
Consistent with the goal of providing responsible plan fiduciaries with information that will enable them to assess the reasonableness of contracts or arrangements, the Rule requires a covered service provider to disclose the information “reasonably in advance” of the date the contract or arrangement is entered into, extended or renewed. The DOL has left “reasonably in advance” undefined, to be determined by the responsible plan fiduciary and the covered service provider in each case.
There are two exceptions to the general timing of disclosures. First, when an investment contract, product or entity in which the covered plan has a direct equity investment does not initially hold plan assets, but later in the course of the covered plan’s continued investment is determined to hold plan assets (for example, by reaching or exceeding the 25% threshold for significant equity participation by benefit plan investors in any class of equity interest), disclosure must occur as soon as practicable, but not later than the 30 days from the date on which the covered service provider knows that the contract, product or entity holds plan assets. Second, for recordkeepers and brokers to a participant-directed individual account plan that add a designated investment alternative to the platform for the covered plan after the recordkeeping or brokerage contract or arrangement is entered into, disclosure must occur as soon as practicable, but not later than the date the responsible plan fiduciary selects the investment alternative for the covered plan.
Disclosure of Changes
Any change to the information required by the Rule must be disclosed as soon as practicable, but generally no later than 60 days of the date on which the covered service provider first learned of the change. If disclosure within this 60-day period is precluded due to extraordinary circumstances that are beyond the covered service provider’s control, the information must be disclosed as soon as practicable thereafter. Unlike the 2007 proposed rule, the changes need not be “material” to trigger the obligation to disclose. The requirement to disclose any changes is significant, especially where changes are made frequently (as, for example, changes in investment fees).
Plan Fiduciary’s Right to Request Disclosure
A responsible plan fiduciary or plan administrator has the right to request that a covered service provider disclose information regarding compensation that the covered plan needs in order to comply with Title I of ERISA’s reporting and disclosure requirements. Generally, a covered service provider must furnish the requested information no later than 30 days after such a request is made in writing. If disclosure within this 30-day period is precluded due to extraordinary circumstances beyond the covered service provider’s control, the disclosure must occur as soon as practicable thereafter.
Disclosure Errors and Omissions
Unlike the 2007 proposed rule, the Rule provides limited relief for certain disclosure errors or omissions, allowing a covered service provider to disclose the correct information as soon as practicable, but no later than 30 days from the date on which it first knows such error or omission occurred. To qualify for the relief, the covered service provider must be acting in good faith and with reasonable diligence.
What Relief is Afforded to Responsible Plan Fiduciaries if a Service Provider Does Not Meet Its Disclosure Requirements?
The Rule incorporates a class exemption from prohibited transaction restrictions for responsible plan fiduciaries where a covered service provider fails to comply with the disclosure obligations. (A class exemption had been originally proposed by the DOL separately from the 2007 proposed rule.) Where a covered service provider fails to comply with the disclosure requirements, the responsible plan fiduciary may still be exempt from the prohibited transaction rules if satisfies the following conditions:
- It did not know that the covered service provider failed or would fail to make the required disclosure and reasonably believed that the covered service provider disclosed the required information
- Upon discovering the failure, it submits a written request to the covered service provider to supply the information
- If the covered service provider does not comply with such request within 90 days of the request, the responsible plan fiduciary notifies the DOL, providing certain required information (see sample notice at www.dol.gov/ebsa/DelinquentServiceProviderDisclosureNotice.doc) within 30 days of the earlier of:
- the covered service provider’s refusal to provide the requested information; or
- the end of the 90 day period following the responsible plan fiduciary’s written request for the information
- It determines whether to terminate or continue the contract or arrangement with the non-complying covered service provider
What Effect Will the Requirements of the Rule Have on State Laws Requiring Certain Disclosures?
The Rule explicitly provides that it does not preempt any state laws that govern disclosures by parties that provide services to covered plans, except to the extent that any of those laws prevent the application of the rule.
What Is the Rule’s Effect on the Prohibited Transaction Rules under Section 4975 of the Internal Revenue Code?
The Rule also explicitly provides that the all references in the Rule to ERISA section 408(b)(2) and regulations thereunder are to be construed to include reference to the parallel provisions of Code section 4975(d)(2) and that Code section’s corresponding regulations. This explicit reference to the Code’s parallel provisions clarifies that if covered service providers do not comply with the Rule (once effective), excise taxes under Code section 4975 will apply. The DOL expects that covered service providers will comply with the Rule in light of:
- The requirement that the responsible plan fiduciary report covered service provider disclosure failures (including the identification of the covered service provider) to the DOL
- Imposition of excise taxes under Code section 4975
Any contracts or arrangements in existence as of the July 16, 2011, effective date must comply with the Rule. In particular, covered service providers in those existing arrangements must disclose all information required to be disclosed no later than July 16, 2011. Covered service providers have just under a year to prepare the information required to be disclosed under the Rule, but that preparation period may be shorter for any changes the DOL makes to the Rule after receiving public comments. Although the requirements of Form 5500 Schedule C differ from the requirements of the Rule, covered service providers who are assisting plans with their Schedule C reporting requirements may already be on alert (if not already prepared) to provide much of the information required by the Rule.
As stated above, the 2007 proposed rule had included welfare benefit plans but the Rule excludes them for now. Service providers and plan fiduciaries to those plans should anticipate future guidance from the DOL concerning required disclosures.