Participant Fee Disclosure Rules as Applied to Brokerage Windows

A considerable controversy has arisen regarding U.S. Department of Labor (the “DOL”) guidance on the participant disclosures a defined contribution plan sponsor is required to provide if the plan’s investment platform offers brokerage windows, self-directed brokerage accounts or similar arrangements (collectively referred to here as “brokerage windows”).

The core concerns are that the guidance may require plan sponsors:

  • to limit the investment alternatives a plan offers to a “manageable number,” and
  • to monitor and evaluate investment alternatives that become popular with participants investing through a brokerage window even if the plan sponsor has not actually designated them as available alternatives.

The general rule is that fee disclosures are only required for “designated investment alternatives” (“DIAs”). In Q&A 30 of DOL Field Assistance Bulletin No. 2012 – 02 (Q&A 30), the DOL first stated that a brokerage window “is not a ‘designated investment alternative’ [nor would a] platform consisting of multiple investment alternatives … itself be a designated investment alternative.” However, it then warned that whether a plan’s “individual investment alternatives are DIAs depends on whether they are specifically identified as available under the plan,” and that:

  • “the failure to designate a manageable number of investment alternatives raises questions as to whether the plan fiduciary has satisfied its obligations under section 404 of ERISA”; and
  • an investment alternative which is made available through a brokerage window should be deemed “designated” if as few as 5 participants and beneficiaries (or 1% of participants and beneficiaries in a plan having more than 500 participants and beneficiaries) select that alternative.

Number of Investment Alternatives
The DOL’s warning that “the failure to designate a ‘manageable‘ number of investment alternatives raises questions as to whether the plan fiduciary has satisfied its obligations under section 404 of ERISA” was unexpected and appears to be inconsistent with case law. That statement is followed by a citation to a 7th Circuit decision (Hecker v. Deere) which appears to be irrelevant to the principle for which it was cited. The Hecker Court specifically declined to opine on that issue, which the DOL had raised in its rehearing request in that case. The DOL’s view is also at odds with a decision made by many employers — to allow participants to select from the typically broad array of alternatives available through their plans’ brokerage windows. The DOL offered in Q&A 30 no guidance as to how employers are to decide what number of alternatives is too many. Nor has the DOL previously included such a fiduciary principle in any rule making. Indeed, the DOL had not even suggested previously that a plan sponsor’s decision to comply with section 404(c) by making available the broadest range of investment alternatives — through a brokerage window — somehow could be viewed as violating ERISA section 404(a) ( i.e., ERISA’s basic fiduciary standard). Until now, plan sponsors had, with good reason, believed that their duty was limited to determining whether the offered alternatives are prudent — not whether too many have been made available.

By stating this new fiduciary principle in the form of an answer to a question in the Q&A 30 (and without the public input involved in a formal rulemaking process) the DOL may have exposed plan sponsors to a potential risk of litigation — by plan participants or the DOL itself — involving the number of investment options offered by their plans. Until now, the fiduciary obligations involved in the construction of a 401(k) plan’s investment menu have generally been viewed as limited to ensuring that the plan’s designated investment options are prudently selected — not whether the number of available choices is too great or too small.

The Non-Designated Designated Investment Alternative
The DOL’s suggestion that plan sponsors may need to determine — on an on-going basis — whether any particular alternative that is made available through a brokerage window has become popular enough to require that it be treated as a DIA is inconsistent with existing DOL regulations under ERISA sections 404(c) and 404(a)(5), which exempt investments selected by individual participants investing through a brokerage window from treatment as DIAs.

If the DOL holds to the position stated in Q&A 30, plan sponsors will have to monitor their plans’ brokerage windows much more closely than has been typical to date. If any of a brokerage window’s available investment alternatives becomes popular enough to be deemed “designated,” ERISA’s fiduciary standards would obligate the plan sponsor to determine the prudence of the plan’s having offered that particular alternative. In addition, the new rules requiring detailed disclosures of fees and expenses would apply to that alternative. That would subject the plan sponsor to a continuing obligation to monitor the investment performance and operation of that alternative in the same manner as it must for the deliberately “designated” options made available as the plan’s core offerings on its investment platform. For plan sponsors, Q&A 30 could create fiduciary risks resulting from the difficulties they may have in deciding whether or not securities held through their plans’ brokerage windows are DIAs.

Since DOL Reg. § 2550.404c – 1 (the “404(c) regulation”) was adopted 20 years ago, 401(k) plan fiduciaries have understood that their fiduciary duties include the prudent selection and monitoring of DIAs. The 404(c) regulation defined that term to mean “a specific investment identified by a plan fiduciary as an available investment under the plan.” Few imagined that the definition includes investments selected and made by individual plan participants through a brokerage window. DOL Reg. § 404a – 5 also applies to DIAs, a term defined there (in a manner similar to the 404(c) regulation) as:

any investment alternative designated by the plan into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual account. The term “designated investment alternative” shall not include “brokerage windows,” “self-directed brokerage accounts,” or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan [emphasis added].

Similarly, another regulation states that ERISA section 404(c) “does not serve to relieve a fiduciary from its duty to prudently select and monitor any service provider or designated investment alternative offered under the plan [emphasis added].” Conspicuously absent is any hint of a duty to monitor any non-designated investment alternatives that are available to participants only through a plan’s brokerage window. Indeed, that regulation includes an example involving a 401(k) plan participant (“P”) who directs the plan fiduciary (“F”) to invest 100% of her account balance in shares of a single stock. It concludes that

  • P did not become a plan fiduciary by having exercised control over her account; and
  • F is not liable for any losses that directly result from implementing P’s direction.

The DOL gave no hint that its conclusions depended upon F’s having prudently monitored P’s investment decisions.

This emergence of a potential fiduciary duty to monitor a plan’s brokerage window to determine whether participants’ investment choices have inadvertently created DIAs is a surprise. If not modified, the DOL’s current stance would obligate 401(k) plan fiduciaries to monitor brokerage windows, identify popular choices, and assume significant evaluation and disclosure obligations for unintentionally designated DIAs. If a brokerage window’s routine operation — rather than the fiduciary’s deliberate decisions — can create DIAs, plan sponsors may prefer to close their plans’ brokerage windows rather than bear the increased, continuing and unpredictable disclosure obligations that would result.

Just how this controversy will play out is uncertain at this juncture. Formal comments on the DOL proposal have questioned the DOL guidance, and the retail brokerage industry, in particular, is strongly advocating that the DOL change its stance. For now, it appears that whether a plan’s more popular brokerage window investment selections will ultimately have to be treated as DIAs and subject to the DOL’s new fee disclosure regime will depend upon whether or not the DOL modifies the position stated in Q&A 30.

There is some reason for optimism that the controversy will be favorably resolved. Phyllis Borzi, Assistant Secretary of Labor and head of the DOL’s Employee Benefits Security Administration, has recently been quoted as stating that:

if you have either no DIAs or you have some DIAs in this brokerage account [ ( i.e., brokerage window) ], you need to look at what people are actually selecting, because if the point of this is disclosure, then you have to give people some information about the fees and other forms of compensation that are associated with their choices [emphasis added].

That statement gives one hope for the typical 401(k) plan, which does offer DIAs but offers them on the plan’s main investment platform — not in the plan’s brokerage window.