New Regulations Under ERISA Refine and Develop Fiduciary Duties Regarding the Investment of Plan Assets Maine Employee Benefits Council December 4, 2008 Eric D. Altholz Verrill Dana, LLP Background There are numerous cases pending in Federal courts against plan sponsors and investment fiduciaries involving failures to investigate, understand or monitor fees charged by fund vendors, or arising out of improper revenue sharing arrangements among vendors, and between vendors and plan sponsors. 1 The cases brought by plan participants against employers and investment fiduciaries generally allege breaches of fiduciary duties under 404(a) of ERISA, and raise the following specific questions: Procedural Prudence: Did the plan fiduciaries exercise due diligence in their consideration and approval of the plan s compensation arrangements? Reasonable Compensation: Did the plan fiduciaries cause the plan to pay excessive compensation to service providers (directly or indirectly)? Disclosure: Did the plan fiduciaries violate ERISA in what they disclosed (or failed to disclose) to participants about fees charged to the plan? Against that backdrop (and prompted by legislative activity in Congress 2 ) the U.S. Department of Labor has developed new rules that expand certain duties imposed on plan This summary is provided for general information only. It does not constitute and cannot be relied upon as legal advice. The material contained in the summary is incomplete without the discussion that accompanied the presentation of the material. 1 Revenue sharing is a common practice in the retirement services industry by which mutual funds pay fees (including 12b-1 fees and the like) to companies that act as record keepers or other service providers to defined contribution plans. In some cases, a portion of these fees may be rebated to plan sponsors. 2 The Pension Protection Act of 2006 amended Section 404(c) of ERISA to augment the notice and disclosure requirements that apply to changes in investment options that occur in connection with a black out period, create new requirements governing default investment arrangements, and add a new exemption to the prohibited transaction rules to allow for the engagement of qualified fiduciary advisers to provide tailored investment advice to participants in individual account plans. In July 2008, the 401(k) Fair Disclosure for Retirement Security Act (H.R. 3185) was approved by the House Education and Labor Committee. Much of the content of the bill relating to fee disclosures is addressed in the proposed regulations discussed below so the fate of the bill is undetermined. 1 of 8
fiduciaries, but also help plan fiduciaries fulfill their obligations by imposing new requirements on plan service providers. The new rules are intended to make the arrangements through which a wide variety of services are provided to plans with their attendant fees more transparent. The emphasis is on plan investments and investment-related services, but a much wider range of services and service providers are implicated under the new rules. The message is clear, plan fiduciaries must: Recognize that excessive or hidden fees charged by service providers impair the benefits delivered to plan participants; Be mindful of all forms of compensation and fees received by plan service providers in selecting, and monitoring the performance of, service providers; and Protect the interests of the plan and plan participants by carefully assessing the performance of service providers and their compensation and fees, and by disclosing all pertinent fees and expenses in a meaningful way. Overview of Duties Imposed on Investment Fiduciaries The new rules governing the duties of investment fiduciaries build on the basic framework contained in Part 4 of ERISA. The new regulations refine and expand some of the basic obligations of plan fiduciaries: (1) under Section 404(a), to abide by the prudent expert and exclusive benefit rules, and diversif[y] the investments of the plan so as to minimize the risk of large losses ; (2) under Section 404(c), regarding the administration of investment arrangements for individual account plans; and (3) under Section 408(b), with respect to the terms under which a plan may engage service providers. In that sense, the new rules represent another step in the continuing evolution of fiduciary duties. 3 By way of summary, to fulfill their duties under ERISA with respect to the investment of individual account plan assets, and enjoy the protections afforded to fiduciaries of plans that allow for participant-directed investments, investment fiduciaries should: Make a prudent selection of a diversified array of investment funds, taking into account a variety of factors (including fee and expense ratios); 3 In the preamble to the new regulations under Section 404(a) of ERISA, the DOL stated its view that inherent in the provisions of Section 404(a) is the duty to furnish participants and beneficiaries in individual account plans the information necessary to carry out their account management and investment responsibilities in an informed manner. The new regulations simply make that duty more explicit and provide the guidance necessary to fulfill the duty. 2 of 8
Make a prudent selection of plan investment advisers and other service providers and enter into reasonable contracts when engaging them; Monitor the performance of the investment funds, investment advisers and service providers; Understand and disclose (in a meaningful way) the fee and compensation arrangements with advisers and service providers; Engage expert (and independent) assistance as needed to do those things; DOCUMENT THE PROCESS TO DEMONSTRATE COMPLIANCE. DOL Proposed Regulations Under ERISA 404 (July 23, 2008) New regulations issued primarily under Section 404(a) of ERISA will require more robust disclosure of certain plan and investment-related information (including fee and expense information) to participants under individual account plans that allow participant-directed investing. The new regulations close a perceived gap in the disclosures already required under Section 404(c) of ERISA and recognize that participants need much more information (particularly with respect to fees and expenses) in order to make informed and prudent investment choices. The new regulations will require plan fiduciaries to provide expanded disclosure of the plan-related information, administrative expense information, individual expense information and investment related information some of which is already required under Section 404(c). 4 In particular, the regulations provide guidance regarding the content and timing of disclosure in the following areas: General plan information, such as: designated investment alternatives, any restrictions on transfers, how to provide investment directions and exercise any related rights (such as voting rights); With respect to each designated investment alternative, the fees and expenses associated with the investment alternative, performance data, comparable benchmark returns, and a web site address; A description of the fees and expenses charged to participants and beneficiaries for plan administrative services (to the extent not included in 4 The preamble to the new regulations under Section 404(a) suggests that if a plan sponsor has been complying with the disclosure requirements of the current regulations under Section 404(c) of ERISA, that plan sponsor would typically be in compliance with the core requirements of the new regulations. The basic requirements of Section 404(c) and the DOL regulations under Section 404(c), prior to the application of the new regulations, are summarized in the Appendix to this outline. 3 of 8
investment-related fees and expenses otherwise disclosed), and how these charges are allocated to their individual accounts; and A description of the fees and expenses charged to specific participant accounts based on actions taken by the participant (e.g., loan origination fees, QDRO processing fees or investment advice). Fee and expense disclosures must be made on a chart or similar format that will help participants easily compare the investment options. The DOL has developed a model chart for plan sponsors to use. The chart is attached as an appendix to the regulations and is also available on the DOL website. In general, disclosures must be provided to an individual before he or she becomes eligible to participate in the plan and at least annually thereafter. However, the actual dollar amount charged to the participant s account for administrative services (along with a general description of the services provided) must be disclosed on a quarterly basis. In addition, participants must receive a description of any material changes to required information not later than 30 days after the adoption of such changes. These regulations become effective January 1, 2009. DOL Proposed Regulations Under ERISA 408 (December 13, 2007) Proposed regulations under Section 408 of ERISA impose new disclosure obligations on benefit plan service providers designed to promote transparency in compensation and fee arrangements (and relationships with affiliates), and help plan fiduciaries make informed decisions about services and costs. These new regulations expand upon the requirement under Section 408(b)(2) that plan fiduciaries enter into a reasonable arrangement when selecting a plan service providers in order to qualify for the contracted services exemption to the prohibited transaction rules. The proposed regulations target service arrangements between plans and: (1) providers of trust and other fiduciary services; (2) providers of consulting, custodial, investment advisory, investment management, brokerage, recordkeeping and TPA services; and (3) any other service providers who may receive indirect compensation or fees for accounting, actuarial, appraisal, audit or legal services. Under the proposed regulations, affected service providers are required to provide services under a written contract that provides for both initial and ongoing disclosures, including: All services to be provided to the benefit plan; The direct and indirect compensation and fees to be received by the service provider for each service; and 4 of 8
The manner in which the compensation and fees will be received (e.g., by direct deduction from participant accounts). Service providers would also have to make special disclosures regarding actual or potential conflicts of interests that could affect the services to be provided. The service provider would have to disclose whether it or any affiliate: will provide services as a fiduciary with respect to the plan; will participate or otherwise acquire any financial interest in connection with any transaction in which the plan may participate; has any material financial or other relationship with any other service provider (such as a broker, money manager, or other entity) that could create a conflict of interest for the service provider in performing the contracted services; would be in a position to affect its own compensation or fees without prior approval of an independent plan fiduciary; and has any policies or procedures that address actual or potential conflicts of interest, or prevent compensation or fee arrangements from adversely affecting any services to be provided to the plan. A failure to comply with the proposed regulations would create a prohibited transaction under ERISA. But the DOL has proposed a new class exemption to relieve plan fiduciaries of the prohibited transaction that would result from the failure of a service provider to comply with the applicable disclosure requirements, so long as the plan fiduciary approved the arrangement in good faith and can demonstrate that it met certain criteria in proceeding with the arrangement. The new rules will become effective 90 days after the publication of Final Regulations. Revised Schedule C for Form 5500 and DOL FAQ s (July 14, 2008) Effective for PY2009, Schedule C requires the plan administrator to identify plan service providers receiving more than $5,000 or more in compensation for plan services and report amount of compensation paid (directly or indirectly) to the service providers Direct compensation is paid by the plan. Indirect compensation includes compensation received by the services from sources other than the plan or plan sponsor in connection with services rendered to the plan during the plan year examples include fees and expense reimbursements received from mutual funds, brokerage commissions, finder s fees, float revenue and various soft dollar payments. 5 of 8
Two alternative reporting mechanisms are available to mitigate the burden of reporting indirect compensation: If the plan administrator receives certain mandated disclosures from service providers about their receipt of eligible indirect compensation, the plan administrator may simply identify the providers and report on Schedule C that it received such disclosures. In the case of bundled service arrangement, the plan administrator need only report amounts paid directly from the plan to the primary service provider. Schedule C completes a coherent pattern of disclosure: service providers to plan administrators (or plan sponsors); plan administrators (or plan sponsors) to participants; plan administrators to DOL. 6 of 8
APPENDIX ERISA Section 404(c) Compliance Checklist Under Section 404(c) of ERISA, plan fiduciaries are relieved from liability for losses resulting from investment choices made by a participant (or beneficiary) in an individual account plan if the participant (or beneficiary) was able to exercise control over the investment of assets in his plan account. This protection does not extend to the selection of the investment funds available under the plan or to transactions involving voting, tender, and similar rights to the extent those rights are not passed through to plan participants. In order to provide the relief from liability afforded by Section 404(c), an individual account plan must meet certain plan design and administrative disclosure requirements. Plan Design Requirements The plan must provide three or more investment funds that are diversified, have materially different risk and return characteristics, enable the participants to achieve aggregate risk and return characteristics within the range normally appropriate for each participant, and enable participants to minimize risk through diversification. Plan participants must be given the opportunity to give investment instructions (in writing or otherwise with an opportunity to receive written confirmation of instructions) to an identified plan fiduciary who is obligated to comply with such instructions. Plan participants must be given the opportunity to make investment changes at least quarterly and with a frequency that is appropriate in light of market volatility. Disclosure Requirements 5 The following information must be provided to participants automatically: An explanation that the plan is intended to be a Section 404(c) plan. An explanation that plan fiduciaries may be relieved of liability for any loss that is the direct and necessary result of investment instructions given by the participant. An explanation of how participants may give investment instructions and any limitations on those instructions, including restrictions on transfers and restrictions on the exercise of voting, tender, and similar rights. A description of each of the investment alternatives, including the type and diversification of assets, investment objectives, and risk and return characteristics. Identity of any designated investment managers. A description of any transaction fees and expenses chargeable against the participant's account in connection with purchases or sales. 5 Prior to impact of Final Regulations under Section 404(c) taking effect January 1, 2009. 7 of 8
The name, address, and phone number of the plan fiduciary responsible for giving information upon request and a description of the information available upon request (see below). A copy of the most recent prospectus provided to the plan for investment alternatives subject to the Securities Act of 1933 (which must be given immediately before or after an initial investment) and information provided to the plan relating to voting, tender, and similar rights and reference to plan provisions relating to exercising those rights to the extent rights are passed through to participants. If the plan offers employer securities, a description of the procedures for maintaining the confidentiality of transactions and the exercise of voting, tender, and similar rights, and the name, address, and phone number of the plan fiduciary responsible for ensuring compliance with the procedures. The following information must be provided to participants upon request: A description of the annual operating expenses of each investment alternative that reduces the participant's rate of return and the aggregate amount of such expenses expressed as a percentage of average net assets of the investment alternative. A copy of any prospectuses, financial statements, and reports and materials relating to the available investment alternatives to the extent the information is provided to the plan. A list of assets comprising the portfolio of each investment alternative, the value of each such asset and, if the asset is a fixed-rate investment contract, the name of the issuer, the term, and the contract's rate of return. Information on the value of shares or units held in the participant s own account. Information on the value of shares or units in available investment alternatives and the past and current investment performance of the investment alternatives, net of expenses. 1291009_1.DOC 8 of 8