The U.S. Department of Labor (DOL) has finalized its regulation detailing the steps retirement plan fiduciaries and many service providers must take to avoid engaging in nonexempt prohibited transactions after June 30, 2012.
Overview
The Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (Code) generally prohibit using plan assets to directly or indirectly pay for services to an employee pension or welfare benefit plan, but section 408(b)(2) of ERISA affords an exemption for any contract or reasonable arrangement for necessary services "if no more than reasonable compensation is paid therefor." The regulation specifies that a service arrangement between a "covered plan" and a "covered service provider" won't be reasonable and cannot qualify for the statutory exemption unless the new fee disclosure requirements are satisfied.
The statute and regulation focus on the use of plan assets to pay for services. They do not apply to fees paid by a plan sponsor unless it is reimbursed by the plan.
Engaging in a nonexempt prohibited transaction can have disastrous consequences for service providers and plan fiduciaries. As a "disqualified person," a service provider is subject to excise taxes and may be required to refund its fees. In addition, a plan fiduciary that allows a violation to occur can be held personally liable for any loss incurred by the plan.
Covered Plans
The regulation covers most retirement plans that are subject to ERISA, including defined benefit plans as well as defined contribution or individual account plans. The exceptions are 403(b) accounts frozen prior to 2009 and individual retirement accounts, including those funded through simplified employee pension and SIMPLE arrangements.
ERISA does not apply to a plan covering the sole owner of a business and his or her spouse, so such a plan cannot be a covered plan. The same is true for governmental plans and some, but not all, church plans and 403(b) programs. Also, the regulation will not apply to an "unfunded" deferred compensation arrangement because the latter is not subject to ERISA's prohibited transaction rules.
Covered Service Providers (CSPs)
The regulation's disclosure obligations will be imposed upon any service provider which has a contract or arrangement with a covered plan and which reasonably expects that at least $1,000 in direct or indirect compensation will be paid to itself, an affiliate or a subcontractor for services in the following categories:
Category A. Services as a fiduciary or registered investment adviser, including: (1) services provided to the covered plan as an "ERISA fiduciary" (Section 3(21) of ERISA); (2) services provided as a fiduciary to an investment contract, product or entity with which a covered plan has a direct equity interest, but only if the underlying assets of that vehicle constitute "plan assets" under another DOL regulation; or (3) services provided directly to the covered plan as a registered investment adviser (RIA) under the Investment Advisers Act of 1940 or state law.
Category B. Recordkeeping or brokerage services provided to a covered plan that is an "individual account plan" which permits participants to direct the investment of their accounts in one or more "designated investment alternatives" through a platform or similar mechanism (not including a self-directed brokerage account).
Category C. Any other services for indirect compensation.
A service provider that does not provide category A or B services cannot be a CSP if it only receives compensation directly from a covered plan. Category C specifically requires indirect compensation.
Indirect compensation is compensation paid to a CSP, affiliate or subcontractor by someone other than a CSP, affiliate, subcontractor, the plan sponsor or the plan, itself. Common examples include the receipt of 12b-1, sub-TA and recordkeeping fees paid by mutual funds.
Nonmonetary compensation, such as gifts, trips and subsidized admissions, can be disregarded if it does not exceed $250 during the term of the arrangement.
Required Disclosures
A CSP must provide a responsible plan fiduciary with the following information:
- If the CSP will provide services as an ERISA fiduciary or as an RIA, a clear statement to that effect.
- A description of all services to be provided to the covered plan under the contract or arrangement.
- A description, in the aggregate or by service, of all direct compensation the CSP, an affiliate or a subcontractor reasonably expects to receive in connection with the services in #2.
- A description of all indirect compensation the CSP, an affiliate or a subcontractor reasonably expects to receive for the services in #2, including the services to be compensated, the payor and the arrangement with the payor.
- For compensation paid among the CSP, an affiliate or subcontractor (but not their employees), identification of the payer, recipient and services performed if the compensation is (a) determined on a transaction basis (e.g., commissions, soft dollars, finder's fees or similar incentive compensation based on business placed or retained), or (b) charged directly against the covered plan's investment and reflected in its net value (e.g., 12b-1 fees).
- A description of any compensation the CSP, affiliate or subcontractor reasonably expects to receive when the contractor arrangement terminates. If any fees are prepaid, there must also be a description of how such amounts will be calculated and refunded upon termination.
- An indication whether each category of compensation will be billed to the covered plan or deducted directly from plan accounts or investments.
Some CSPs will be subject to additional disclosure requirements. For example, if a CSP falls within category A(2) because it provides fiduciary services to an investment contract, product or entity, the underlying assets of which constitute "plan assets," it must describe any compensation that will be charged directly against the amount invested (e.g., sales loads or charges, redemption or surrender charges), annual operating expenses (e.g., expense ratio) if the return is not fixed, and any ongoing expenses in addition to annual operating expenses. A category B CSP may have to disclose the same types of information for each designated investment alternative. In some cases, category B recordkeepers will be required to provide additional information about the scope and estimated cost of the recordkeeping services.
Delivery
The regulations generally require that all disclosures be provided in writing, but that does not preclude the use of electronic media. For example, information can be posted on a website if it is readily accessible to plan fiduciaries who have received clear access instructions.
Required disclosures can be provided from multiple sources. For example, DOL's sample "Guide to Services and Compensation" (posted at www.dol.gov/ebsa/pdf/408b2sampleguide.pdf) cross references sections in the service agreement, pages in a prospectus and websites. The regulation also allows a description or estimate of compensation to be expressed 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 expressed in such terms, any other reasonable method will suffice so long as it allows the plan fiduciary to evaluate the reasonableness of the compensation.
Deadlines
July 1, 2012 is the deadline for required disclosures regarding contracts or arrangements in existence on that date. Thereafter, so-called "initial disclosures" are due a reasonable period of time before a contract is entered into, extended or renewed, so a plan fiduciary has adequate time to determine whether an arrangement will be reasonable and qualify for the prohibited transaction exemption. The regulation identifies specific circumstances that justify reasonable delays.
If a CSP learns of a change in information previously disclosed, it must report the change as soon as practicable, generally within 60 days. However, there is an exception allowing changes in certain investment information to be disclosed annually.
Failures
The final regulation holds that a contract or arrangement will not be unreasonable solely because the CSP erred when disclosing required information, provided it acted in good faith, with reasonable diligence. The CSP must also disclose the correct information as soon as possible, but in no event more than 30 days after it learns of the error.
A CSP's failure to disclose required information will not subject the plan fiduciary to liability if the fiduciary was not aware of the failure and reasonably believed the disclosure rules were satisfied. However, once a plan fiduciary discovers a failure it must make a written request for the CSP to provide the necessary information. If the CSP refuses or does not respond within 90 days, the plan fiduciary will lose the benefit of the prohibited transaction exemption unless it notifies DOL. The agency has posted a model notice at www.dol.gov/ebsa/DelinquentServiceProviderDisclosureNotice.doc. The filing deadline is 30 days after the earlier of (a) the CSP's refusal to furnish the information, or (b) the 90th day after the written request was made. In addition, if the failure relates to future services, the plan fiduciary must terminate the contract or arrangement "as expeditiously as possible."
Observations
CSPs must mobilize to comply with these disclosure requirements for existing arrangements with covered plans by July 1, 2012. Contracts or arrangements initiated or renewed thereafter will require advance disclosures so fiduciaries have adequate time to determine the reasonableness of proposed service arrangements.
Over time service agreements may change to include more of the required disclosures, but it seems unlikely that any service agreement will satisfy all of the requirements. A separate disclosure summary, such as the DOL's sample "Guide to Services and Compensation," is a more practical solution.
The duration of a service agreement deserves special attention. An arrangement that has no set term, but which can be terminated at any time, will require just one initial disclosure because there is no extension or renewal. On the other hand, a contract that runs year-to-year but automatically renews unless one party notifies the other will require a new set of disclosures each year in time for the plan fiduciary to determine whether it should issue a notice of nonrenewal.
Plan fiduciaries can expect to be held to a higher standard because of the additional information they will receive. Also, they will need to devote additional time to checking whether they have received all required information and following up with CSPs (and perhaps DOL) when they believe disclosures may be deficient.
Finally, the new July 1 deadline for disclosures by service providers effectively delays another deadline for the initial investment and fee disclosures that many retirement plans will have to provide to participants. That deadline is now extended to August 30, 2012, or later if the plan year begins on or between July 2 and October 31.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.