Fees: Disclosure, Disclosure, and Disclosure

Posted on 02/02/2010

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Everyone in the business of employee benefit plan servicing shares a common interest; they make money doing it.  Many service providers continue to benefit from the very flow of that money as a result of various “revenue sharing” agreements.  Take, for example, the case of an investment advisor who charges a plan a set annual fee but also receives an undisclosed share of the transaction fees charged for investing in the funds he recommends.  Such arrangements are common among advisors, broker dealers, fund managers, recordkeepers, etc., and the impact of their conflicting interests on plan account balances has been shown to be significant.  Indeed, the Government Accountability Office recently found “a statistical association between inadequate disclosure and lower investment returns.”[1]

Beginning in 2006, the U.S. Department of Labor (“DOL”) proposed several regulatory revisions designed to reveal hidden compensation and conflicts of interest among plan service providers.[2]  First, proposed amendments to DOL regulation section 2550.408b-2 (hereinafter “Prop. 408b-2”) will require disclosure of any and all conflicts of interest – as well as compensation received – in connection with a provider’s services to a plan.[3]  Second, proposed amendments to DOL regulation section 2550.404a-5 (hereinafter “Prop. 404a-5”) will require that plan participants be apprised of all expenses and fees related to their investments.[4]  And third, the now final revised Form 5500 Annual Return Schedule C (hereinafter “New Schedule C”) requires broader disclosure of service provider compensation than ever before.[5] 

The new rules are uniquely linked, in part because they so clearly complement one another.  Prop. 408b-2 will reveal all compensation and conflicts of interest, so as to help fiduciaries determine a contract’s reasonableness.[6]  Prop. 404a-5 will require that fiduciaries pass on that information to participants, allowing more informed decisionmaking with respect to their investments.[7]  And New Schedule C serves to confirm to DOL that the information has indeed been understood and provided.[8] 

The question that remains, however, is whether this new regulatory scheme will really bring about the transparency and clarity it seeks.  The debate surrounding this issue is heated.  Neither regulatory efforts of the DOL, nor those of Congress appear to be likeminded.  For example, Bradford P. Campbell, the former Assistant Secretary of Employee Benefits Security for the United States Department of Labor, said of recent legislative efforts: “[T]he legislative process is not as well suited as the regulatory process to addressing highly technical, multifaceted issues like these[.]”[9]  Further exemplifying the tension, Prop. 408b-2 and Prop. 404a-5 are currently frozen by a regulatory moratorium imposed by the Obama administration[10], while members in Congress keep pushing their own bills calling for mandated disclosures.[11]  

At the time of this writing, the New Schedule C remains the only vehicle currently requiring the sought after transparency.  Nevertheless, the new regulations are expected to become final soon, and practitioners, providers, and sponsors alike should become familiar with the sweeping Prop. 408b-2 and Prop. 404a-5 mandates.  Furthermore, and notwithstanding their apparent interdependency, each rule comes with its own somewhat unique set of requirements and definitions.  The following briefly describes their differences.

PROP. 408b-2

ERISA section 408(b)(2) exempts certain arrangements between plans and parties in interest (e.g.: service providers) that would otherwise be considered prohibited transactions under section 406(a)(1)(C).[12]  Regulations currently provide such relief only if the contract or arrangement is reasonable, necessary, and no more than reasonable compensation is paid for the service.[13]  To date, the regulation has deemed “reasonable” only those contracts that permit termination on reasonably short notice.[14]  Going forward, however, Prop. 408b-2 will require that all compensation, its manner of receipt, and any relationship which may create a conflict of interest, be disclosed and reported by the service providers prior to a plan entering into a contract.[15]  

The regulation will apply to: (1) providers acting as an ERISA fiduciary, or pursuant to the Investment Advisers Act of 1940;[16] (2) providers of banking, consulting, custodial, insurance, or investment advice services, as well as investment management, recordkeeping, brokerage, or other administration services;[17] and (3) providers who receive any indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal, or valuation services.[18]  Each provider will have to disclose whether it intends to bill the plan, deduct fees from plan accounts, or charge against the plan’s investments;[19] each must also describe any termination and refund calculations.[20] 

Prop. 408b-2 casts a broad and demanding net.  Further complicating matters is that Prop. 408b-2 will require disclosure of any compensation, whether received in a direct or indirect manner.[21]  Prop. 408b-2 defines direct compensation as “money and any other thing of monetary value received by the service provider or its affiliate in connection with the services provided to the plan or the financial products in which plan assets are invested.”[22]  The DOL anticipates such compensation being received in many forms, including employee gifts and awards, finder’s fees, soft dollar payments, subtransfer agency fees, Rule 12b-1 fees, fees based on a share of appreciation or percentage of a plan’s assets, and float income.[23]

Indirect compensation includes money or things of monetary value received from any source other than the plan, plan sponsor, or service provider[24], including any compensation or fees “received by their affiliates from third parties.”[25]  “Affiliate” is defined as any person directly or indirectly controlling or controlled by the service provider, or any other officer, agent, employee or partner of the service provider.[26]  Here, the DOL seeks to clarify that disclosure “cannot be avoided merely because such compensation is paid to an employee or agent of the service provider or an affiliate, rather than directly to such service provider or affiliate.”[27]

Prop. 408b-2 further requires that indirect compensation be described in a way that facilitates a responsible plan fiduciary in evaluating a contract’s reasonableness.[28]  Even where a specific monetary amount cannot be predetermined, the service provider must use a formula, percentage of plan assets, or per capita charge rate, to disclose the terms of compensation or fees under the contract.[29]

Finally, DOL notes that conflicts of interest are most likely to arise where service providers control direct types of services, such as banking, consulting, and recordkeeping.[30]  The preamble to Prop. 408b-2 further notes DOL’s belief that service providers who receive indirect compensation in connection with legal, accounting, auditing, actuarial, appraisal, or other valuation services, perform some of the most important and potentially influential services to plans.[31]  The new regulation’s provision on disclosure of conflicts of interest therefore requires description of any relationships that may give rise to a conflict of interest.[32]   

PROP. 404a-5 

ERISA sections 404(a)(1)(A) and (B), require fiduciaries to act prudently and solely in the interest of plan participants and beneficiaries.  In the case of participant directed investments under a 401(k) plan, ERISA section 404(c) offers to relieve fiduciaries of liability for investment losses when participants are given sufficient information concerning the plan’s investment options, including its fees and expenses.  404(c) compliance, however, is elective, so the provision of comprehensive fee and expense information is not always necessary under current regulations.  Prop. 404a-5 will make these disclosures mandatory, regardless of a 404(c) election.[33] 

Prop. 404a-5 will require plan fiduciaries to provide participants, who self-direct their investments, with sufficient information, including plan fees and expenses, so as to enable them to “make informed decisions with regard to the management of their individual accounts.”[34]  Such information would be deemed “sufficient,” in part, when it discloses plan-related information (e.g.: operational expenses charged against participants’ accounts)[35], and investment-related information (e.g.: fund strategies, risks, performance, and costs).[36] 

There are three categories of plan-related information: general;[37] administrative expense;[38] and individual expense.[39]  General plan information includes limitations on investment instructions, restrictions on transfers of investment alternatives[40], and information on voting, tender or other holding rights.[41]  This information must be provided no later than the participant’s entry date, and then annually thereafter.[42]  The summary plan description is an acceptable vehicle for this disclosure.[43]  Administrative expense information relates to costs such as accounting and recordkeeping that may be charged against individual accounts.[44]  Here, actual administrative costs being charged must be reported no later than quarterly[45], and must be “sufficiently specific to inform the participants or beneficiaries of the actual charge(s) to their accounts … [and enable] them to distinguish the administrative services from other charges.”[46]  Individual expense information is specific to an individual’s account charges.[47]  Notably, this regulation requires disclosure of even those expenses which might be assessed.[48]

Prop. 404a-5 also requires that investment-related information like cost, performance, fees, and expenses, be automatically furnished.[49]  Specifically, Prop. 404a-5(d)(1)(ii-iii) requires performance data accompanied by a current broad-based benchmark.[50]  Moreover, Prop. 404a-5(d)(1)(iv) requires disclosure of fees charged on the purchase, holding, or sale, for each of the plan’s designated investment alternatives.[51] 

Finally, all shareholder-type fees must be disclosed, regardless of their name.  In other words, any fees which operate as “sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, purchase fees, and mortality and expense fees” will fall under Prop. 404a-5’s coverage.[52]  For investments with non-fixed return rates, total annual operating expenses must be expressed as a percentage.[53]  Information should be furnished “in a chart or similar format that is designed to facilitate a comparison of such information.”[54]

THE NEW SCHEDULE C  

Plans covered by ERISA must report annually to DOL via the Form 5500.  Plans with more than 100 participants must also file the Schedule C to identify providers receiving fees of $5,000 or more.  New Schedule C expands the definition of which service providers must be identified, as well as what constitutes reportable compensation.  While only those providers who had received compensation above the limit as a direct result of their services used to be identified in annual reporting, now even those individuals or entities providing services to service providers may be reportable.  In other words, if a service provider is compensated from a source other than the plan, but as a result of his service to that plan (eg: by way of revenue-sharing), the compensation must be reported.  Thus, like New 408b-2, New Schedule C demands disclosure of both direct and indirect forms and avenues of compensation.  Unlike New 408b-2, however, the burden of comprehending and reporting the information falls upon the plan sponsor.

Reportable direct compensation is that which is paid directly to the service provider from the plan.[55]  The sponsor must identify every service provider receiving $5,000 or more, describe the provider’s relationship to all persons known to be parties in interest, report the total amount of direct compensation paid, and state whether the service provider received any indirect compensation.[56] 

Indirect compensation is any which is not direct compensation and which is received in connection with services provided to the plan or in connection with a person’s position with a plan.[57]  Compensation is received “in connection with” services or position if payment is at least partly based upon a provision of service or transaction involving the plan.[58]  Exceptions may apply where the compensation is deemed eligible indirect compensation, or where the services are provided in a bundled format.

Eligible indirect compensation is indirect compensation received as fees charged by a service provider to investment funds when such fees are reflected in the value of the investment and constitute payment for distribution, investment management, recordkeeping or shareholder services, or that constitute commissions, finder’s fees, float revenue, other transaction-based fees, or “soft dollar” revenue.[59]  This exception requires the plan sponsor certify it has received written or electronic notice of: (1) the eligible indirect compensation; (2) the purpose of the indirect compensation; (3) the amount of compensation or formula used to calculate the compensation; and (4) the identity of those parties paying and receiving the compensation.[60] 

Another exception is available to sponsors who deal with providers of arrangements that include multiple service products, such as brokerage, recordkeeping and custodial services, under one contract for an aggregated fee.  If services are provided through a so-called bundled service arrangement, then all direct compensation received through that arrangement may be reported by the primary service provider.[61]  Nevertheless, if compensation is received for a service provided under a bundled arrangement but is reflected as a separate direct charge against a plan investment’s net value, or is received on a transactional basis, it must be separately reported.[62]  Lastly, any and all indirect compensation received by providers to bundled arrangements also must be separately reported.[63] 

CONCLUDING: BUSINESS AS USUAL?

Understandably, these heightened reporting requirements have unleashed considerable debate within the retirement plan industry, as they threaten to disrupt so many customary business operations across so many fields.  While participant advocates accuse providers of purposely hiding fees and expenses, the industry complains these disclosures will be cost prohibitive, overwhelming, and nearly impossible to explain to investing participants and sponsors.  Still, proponents of disclosure are not swayed.

The practical application and impact of these changes are unclear.  Indeed, it remains to be seen whether government intervention can ensure this newly valued transparency in such a fast-paced and self-interested market.  It could turn out that these fresh regulations bring nothing but new slights of hand to a tried and true shell-game.  Nevertheless, the comfort may lie in our knowing that this regulatory scheme has an eye on every shell.


[1] Defined Benefit Pensions: Conflicts of Interest Involving High Risk of Terminated Plans Pose Enforcement Challenges, at 15 (GAO 07–703, June 2007).

[2] See Reasonable Contract or Arrangement Under Section 408(b)(2) – Fee Disclosure; Proposed Rule, 72 Fed. Reg. 70,988 (December 13, 2007); Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Proposed Rule, 73 Fed. Reg. 43,014 (July 23, 2008); Notice of Adoption of Revisions to Annual Return/Report Forms, 72 Fed. Reg. 64,731 (Nov. 16, 2007); Annual Reporting and Disclosure; Revision of Annual Information Return/Reports; Final Rule and Notice, 72 Fed. Reg. 64,710 (Nov. 16, 2007).

[3] See Reasonable Contract, supra, note 2.

[4] See Fiduciary Requirements, supra, note 2.

[5] See Revisions to Annual Return, supra, note 2.

[6] See Reasonable Contract.

[7] See Fiduciary Requirements.

[8] See Revisions to Annual Return.

[9] Telephone interview with Bradford P. Campbell, former Assistant Secretary of Employee Benefits Security for the United States Department of Labor (June 19, 2009).

[10] See Memorandum for the Heads of Executive Departments and Agencies, 74 Fed. Reg. 4435 (Jan. 26, 2009).

[11] See, e.g., the 401(k) Fair Disclosure for Retirement Security Act of 2009, H.R. 1984, 111th Cong, (April 21, 2009); the Defined Contribution Fee Disclosure Act of 2009, Sen. 401, 111th Cong, (February 10, 2009); the Defined Contribution Plan Fee Transparency Act, H.R. 2779, 111th Cong, (June 9, 2009).

[12] ERISA § 408(b)(2).

[13] Id.

[14] 29 CFR § 2550.408b.

[15] See Reasonable Contract, supra, note 2.

[16] Fiduciary Requirements, supra, note 2, at 43,039.

[17] Id.

[18] Id..

[19] Reasonable Contract, at 71,004.

[20] Id.

[21] Id.

[22] Id. at 70,990.

[23] Id. at 71,004.

[24] Id.

[25] Id. at 70,990.

[26] Id. at 71,004.

[27] Id. at 70,990.

[28] Id.

[29] Id.

[30] Id. at 70,989.

[31] Id.

[32] Id. Service providers must also disclose whether they can affect their own compensation without a fiduciary’s approval.

[33] Fiduciary Requirements, supra, note 2, at 43,042-43.

[34] Id.

[35] Id.

[36] Id.

[37] Id. at 43,039.

[38] Id.

[39] Id.

[40] Id.

[41] Id.

[42] Id.

[43] Id. at 43,040.

[44] Id.

[45] Id. at 43,039.

[46] Id. at 43,016.

[47] Id. at 43,039.

[48] Id.  An SPD could disclose these conditional assessments. Id. at 43,040 (proposed § 2550.404a-5(e)).

[49] Id. New 404a-5 requires identifying information which names the designated investment alternative, provides a web site address that names the investment’s issuer, describes its principal strategies, risks, assets, turnover, and performance, and discloses related fees and expenses.  It also requires information regarding the type or category of the investment, and how the investment is managed. (Id. (proposed § 2550.404a-5(d)(1)(i)(A – D))).

[50] Id.

[51] Id.

[52] Id. at 43,017. The regulation’s preamble anticipates a design that “permit[s] straightforward comparison[.]”

[53] Id. at 43,040.  

[54] Id.

[55] Revisions to Annual Return/Report Forms, “2009 Instructions for Schedule C (Form 5500) Service Provider Information” 72 Fed. Reg. 64731, 64825 (Nov. 16, 2007).

[56] Id.

[57] Id.

[58] Id.

[59] Id.

[60] Id.

[61] Id.

[62] Id.

[63] Id.

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