By Sheldon M. Geller, Esq., CPA
The Employee Retirement Income Security Act (ERISA) requires plan sponsors and other plan fiduciaries to act prudently and solely in the interest of plan participants when selecting and monitoring service providers and plan investments. Service provider arrangements for and compensation in employee benefit plans have become increasingly complex. Despite improved efficiencies and reduced costs, this increased complexity has made it more difficult for plan sponsors and ERISA fiduciaries to understand how and how much compensation should be paid to service providers.
Accordingly, the U.S. Department of Labor (DOL) published final regulations under ERISA Section 408(b)(2) effective as of July 1, 2012, that require service providers, including investment advisors, to disclose detailed information about services and compensation, as well as possible conflicts of interest. The final regulations also require plan sponsors to assess services and compensation to determine reasonableness as well as actual or potential conflicts of interest that may affect service quality.
Service providers subject to the new disclosure requirement include ERISA fiduciary service providers, registered investment advisors, brokers, record-keepers, platform providers, and third-party administrators. Covered service providers may also include accountants, auditors, actuaries, custodians, lawyers, bankers, appraisers, consultants, and insurance agents who receive indirect compensation. ERISA requires that the payment of direct compensation to professionals be necessary and reasonable.
The required disclosures are of particular interest to 401(k) plan sponsors because these plans are primarily funded by employee contributions and plan costs are customarily charged to employee accounts. In addition, participants will be receiving a quarterly disclosure of fees and expenses actually deducted from their 401(k) accounts.
The DOL encourages, but doesn’t require, the voluntary use of a sample guide or uniform format to assist plan sponsors in their review of the required disclosures. Plan sponsors will need to locate compensation information in multiple and complex documents, in a variety of formats, making it difficult for them to determine if they have enough information to determine reasonableness and assess actual or potential conflicts.
Many plan sponsors are unaware of their responsibilities as ERISA fiduciaries. Most are neither trained nor skilled to interpret vendor reports, monitor vendor services and fees, ask probing questions, and negotiate effectively on behalf of plan participants. Plan sponsors need to retain professional advisors to implement a strategy of compliance and procedural prudence to manage their plans.
ERISA permits a plan sponsor to use professional advisors and encourages the retention of experts to interpret service and fee disclosures. A plan sponsor will want to prudently investigate, document, and monitor all plan decisions. As a necessary corollary, ERISA permits plan sponsors to compensate professional advisors from plan assets. Plan sponsors are encouraged to retain a registered investment advisor to take advantage of ERISA’s exculpatory relief provisions.
Section 408(b)(2) Audit
The DOL and the Internal Revenue Service have a long history of encouraging the self-audit of employee benefit plans and the self-correction of ERISA violations. A 408(b)(2) audit by an independent fiduciary provides a plan sponsor with an objective examination of vendor processes, performance, services, compensation, and conflicts.
Though a plan sponsor may conduct the audit with in-house staff, outsourcing the audit permits the independent fiduciary, rather than the financial manager or human resource manager, to assume responsibility for ensuring that the plan sponsor complies with the final regulations and properly interprets the disclosures.
Plan sponsors will want to corroborate the compensation paid to key service providers set forth in Schedule C, made part of the Annual Report Form 5500, with the disclosure of compensation paid to covered service providers under the final regulations. Disclosures aren’t required for agents who earn commissions from the sales of annuities but provide no consulting services. Accordingly, plan sponsors will want to conduct due diligence and go beyond the scope of the final regulations.
Independent Named Fiduciary Structure
An investment advisor who assumes no discretion under ERISA offers limited value to a plan sponsor who wishes to delegate fiduciary and decision making responsibility. Such an advisor is not an ERISA fiduciary for any other plan purpose. A limited-scope fiduciary may not accept a delegation of fiduciary responsibility from the plan sponsor for matters other than investment advice.
The plan sponsor should appoint a full-scope ERISA Section 3(21) investment advisor who is therefore an ERISA Section 3(38) investment manager to select, monitor and replace investment options, as well as hire and monitor other investment related service providers. The plan sponsor should also appoint an ERISA Section 3(16) Plan Administrator to select, monitor and replace service providers.
Plan Sponsor Fiduciary Duties
The new disclosures will vary in format from provider to provider, challenging plan sponsors to carefully evaluate the information contained in these disclosures. Plan sponsors must verify that they’ve received the appropriate vendor disclosures, tested these disclosures, and determined whether the disclosed fees are reasonable for the services rendered to the plan.
They also need to evaluate bundled service providers, calculate net yield on stable value investments, identify float associated with contribution deposits and benefit payments, review plan reimbursement accounts, scrutinize revenue sharing agreements, and understand annuity contracts. Failing to evaluate and act upon disclosure information exposes the plan sponsor to additional fiduciary liability.
Fee and Expense Transparency
The final regulations are intended to make it easier for a plan sponsor to understand the compensation paid to their service providers and advisors and to highlight potential conflicts of interest that may affect service performance.
While plan sponsors are under no obligation to select the lowest-cost service provider, they need to make certain that no more than reasonable compensation is paid for services rendered to a plan.
Bundled service providers must now provide a good-faith estimate of record-keeping costs. It’s insufficient to state that revenue from investments is equal to record-keeping fees without an estimate and the methodology used to calculate the estimate. Plan sponsors also need to understand estimated record-keeping cost increases if investment options change in bundled service arrangements.
Record-keeping fees that are offset by investment revenue, or based on a percentage of plan assets, automatically increase as plan assets increase. However, record-keeping services don’t necessarily increase as plan assets increase. Record-keeping fees should be calculated based on plan complexity, service arrangement, participant count and time, or be expressed as a flat fee.
Investment advisor compensation for retirement plan professionals may be based on a percentage of plan assets under management, fixed fees, or hourly fees. Investment advisory fees are generally calculated based on a percentage of plan assets and thus automatically increase as plan assets increase. Nevertheless, the need for investment services for participant- directed 401(k) plans doesn’t necessarily increase as plan assets increase. Accordingly, investment fees for larger plans have more recently been expressed as a fixed fee. The large- plan market has embraced fixed fees.
If investment fees increase as plan assets increase, then the plan sponsor needs to review these fees annually to determine competitiveness and reasonableness. Plan assets generally increase over time as a result of contributions and market valuations.
Providers to small plans (less than $50 million in assets) have not had to succumb to marketplace demand for lower fees. 408(b)(2) audit will uncover fees that employers and employees will no longer tolerate, favoring providers who can deliver quality services and low fees.
Plan participants may transfer to lower-fee investments or stop making 401(k) contributions as a result of the new fee disclosures. Meaningful participation is critical for the success of a small plan. Even employer contributions and automatic enrollment may not ensure plan success if unreasonable fees are charged to participant accounts.
Registered Investment Advisors (RIAs)
Plan sponsors will likely call on RIAs with ERISA experience to assist in complying with the disclosure rules, presenting new opportunities for fee-based advisors. The 408(b)(2) audit, which may be performed by the advisor, will enable the plan sponsor to avoid excessive fees and expenses, and improve service deliverables. Further, the 408(b)(2) audit will assist in the development of practices to establish that the plan is compliant, reducing audit testing procedures, audit risks, and audit fees.
Plan Governance and Best Practices
The best possible result for plan sponsors and plan participants is to appoint a named fiduciary for plan investment and a named fiduciary for plan administration.
An ERISA Section 3(21) investment advisor would be the named fiduciary for plan investments and act as an ERISA Section 3(38) investment manager. This named fiduciary would select, monitor, and replace investment options, as well as hire and monitor other investment related service providers.
An ERISA Section 3(16) professional advisor would be the named fiduciary for plan administration and act as plan administrator. This named fiduciary would select, monitor, and replace service providers.
The ERISA Section 3(21)/3(38)/3(16) named fiduciary structure creates a full service solution and a compliance strategy to manage fiduciary responsibility, outsource decisions, and delegate day to day plan operation to independent fiduciary experts.
Sheldon M. Geller, Esq., CPA is a consultant in Muttontown, N.Y.