New England Biz Law Update
From the Pension Protection Act of 2006 to fee disclosure regulations taking effect in 2012, employer-sponsored retirement plans have seen a flurry of changes from Congress and regulators. While these changes stand to improve retirement outcomes, they also impose a significant burden on employers and plan fiduciaries. In particular, the new fee disclosure regulations will open the door wider to breach-of-fiduciary lawsuits against plan sponsors who fail to negotiate reasonable service provider fees on behalf of participants.1To assist plan sponsors with negotiating reasonable fees, this article explains common but often hidden sources of service provider compensation.
ERISA basic responsibilities
The Employee Retirement Income Security Act requires that plan fiduciaries — trustees, officers and generally any person in a position to make decisions with respect to a plan — adhere to basic responsibilities, including: 2 • acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them; • carrying out their duties prudently; • following the plan documents (unless inconsistent with ERISA); • diversifying plan investments; and • paying only reasonable plan expenses. Adhering to these responsibilities can seem simple. But when one considers the ERISA requirement that fiduciary duties be carried out with the skill, care and prudence of an expert experienced in managing a plan, these responsibilities become complex. Then consider that a fiduciary’s failure to comply with these duties is a breach of fiduciary duty (and may be deemed a prohibited transaction) — resulting in personal liability — and you have real concern. 3 A service provider’s failure to comply with the new disclosure regulations is a prohibited transaction. Relief from the prohibited transaction rules is available for plan sponsors, but it is conditioned on plan sponsors becoming assertive with service providers and, if necessary, blowing the whistle to the U.S. Department of Labor. The DOL (through regulation) and plan participants (though litigation) have begun to focus on plan fees. In 2009, Caterpillar, Inc. paid $16.5 million to settle a case alleging that its plan paid excessive fees. Martin v. Caterpillar, No. 07-cv-1009 (C.D. Ill.). In 2010, General Dynamics Corp. paid $15.15 million, through its fiduciary liability policy, to settle a case alleging that it failed to capture and account for additional revenue from plan investments (see below) and that it had engaged in a prohibited transaction. Will v. General Dynamics Corp., No. 06-698-GPM. (S.D.Ill.). With high-profile cases paving the way for increased scrutiny, addressing plan fees should be a priority for fiduciaries.
Understanding retirement plan fees
Retirement plan fees can be extremely complex, due in large part to the lack of transparency surrounding plan fees and services, as well as the varying methods in which service providers are compensated. Recognizing this problem, federal regulators have passed new rules requiring service providers to disclose fees to plan fiduciaries. Although these rules will ultimately benefit retirement plans and participants, they place increased pressure on plan fiduciaries to interpret and evaluate the appropriateness of service provider compensation — a task many fiduciaries aren’t prepared to undertake. It is critical for plan fiduciaries to understand the various components of their retirement plans’ fees, particularly indirect fees. The following describes common ways in which money flows through retirement plans. Each provider may operate differently, so be sure to check with your provider for information specific to your plan.
Service provider compensation
In general, plan fees cover expenses resulting from services provided in four primary areas: • investments • recordkeeping • administration • advisory or brokerage services The fees for these services may be categorized as direct compensation, indirect compensation or both. Direct compensation: This type of compensation represents fees paid directly by the plan or plan sponsor to a provider for specific services rendered, typically paid as a flat dollar amount or as a percentage of plan assets. Fees in this category often cover plan-level expenses such as recordkeeping, administration or advisory services. Because the plan sponsor either pays these fees or specifically authorizes the trustee or custodian to use plan assets to pay the fees, the plan sponsor knows the amount of direct compensation paid to service providers. Indirect compensation: Commonly known as “revenue sharing,” indirect compensation refers to fees generally taken from plan investments and passed to service providers or intermediaries. Investment-related fees and expenses, including revenue sharing payments, often represent the majority of a plan’s total cost. Many plan sponsors are unaware that their service providers receive indirect compensation. That will change with new fee disclosure regulations taking effect on July 1. Plan sponsors will be held responsible for evaluating indirect compensation in their plan and using the information to determine reasonable compensation for services rendered to their plan. For example, a typical mutual fund found in a retirement plan may contain as many as four kinds of compensation, both direct and indirect, including: • Investment management — direct compensation paid to the fund’s manager for managing the investment portfolio • Sub T/A — indirect compensation paid to a subcontracted third party to account for each participant’s share of the mutual fund (T/A means Transfer Agent, another service provider) • 12(b)-1 — indirect compensation paid by the mutual fund to a broker for (1) selling the fund to the plan sponsor and (2) providing the plan sponsor with ongoing services (e.g., providing investment performance reports for the mutual fund) • shareholder servicing fee — indirect compensation paid by the investment manager for services such as recordkeeping and third-party administration
Revenue sharing uncontrolled by the plan sponsor
In the employer-sponsored retirement plan industry, all components of a mutual fund’s gross expense ratio, except for investment management fees, are generally classified as revenue sharing. This is true whether the source of revenue is the investment manager (i.e., sub T/A and shareholder servicing fees) or the mutual fund (i.e., 12(b)-1 fees). The attached chart describes common revenue sharing uncontrolled by the plan sponsor.
Revenue sharing controlled by plan sponsor
Some recordkeepers are able to credit back revenue sharing fees to the plan. This is frequently done by creating a separate account, known as an ERISA budget account, within the plan. The recordkeeper deposits all revenue sharing payments that it receives into the ERISA account. The plan sponsor can direct the recordkeeper to use the ERISA account to pay for services such as recordkeeping, administration, and advisory or consultant-related work. Amounts paid from the ERISA account are offset against amounts otherwise due to the service provider. By controlling revenue sharing, plan sponsor can: • reduce conflicts of interest among service providers receiving revenue sharing payments; • determine the total compensation its service providers receive; and • facilitate the plan sponsor’s assessment of the total compensation that its service providers receive. Above all, when the plan sponsor controls the use of the revenue sharing, the transparency creates accountability on the part of service providers, which helps control plan costs.
Working with an advisor, a premium on independence
When evaluating the reasonableness of plan fees under ERISA’s prudent expert standards, plan sponsors need to ask themselves whether they have the skills, experience and time to perform their fiduciary responsibilities. For help navigating the complex revenue sharing arrangements, many plan sponsors partner with independent advisors who (i) do not receive revenue sharing or other indirect compensation or (ii) agree while negotiating the fee for their advisory work that any indirect compensation they receive will be offset against their fee. Unlike commission-compensated brokers, independent advisors have no financial interest in service providers’ products or services. Consequently, they can be plan fiduciaries, provide conflict-free advice, facilitate availability of ERISA budget accounts and prudently assess reasonableness of the fees of other service providers. Chad Gutner, CFP, AIF, and Steven J. Samuel, JD, LLM, are registered representatives and investment adviser representatives of, and offer securities and advisory services through, Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. They operate under the name Samuel Financial, Inc., 858 Washington Street, Suite 202, Dedham, MA 02026. Russell A Gaudreau, JD, MBA, AIF, is an attorney specializing in ERISA law with The Wagner Law Group, PC. “Revenue sharing” may also refer to additional compensation from fund companies to the broker/dealer in return for assistance in facilitating various marketing or educational activities, such as conferences. For more information on Commonwealth’s Revenue Sharing policies, please visit www.commonwealth.com/investors/revenue_sharing.asp. Mutual funds are sold only by prospectus. For more complete information about a fund, including investment objectives, risks, charges, and expenses, please see the current fund prospectus. Consider the information carefully before investing. Prospectuses contain this and other information and are available through your financial advisor. Read the prospectus carefully before you invest or send money.
Endnotes
1 The fee disclosure requirement for service providers is at 29 CFR 2550.408b-2 (75 Fed. Reg. 41599 (July 16, 2010). The fee disclosure requirement for plan sponsors is at 29 CFR 2550.404a-5 (75 Fed. Reg. 64909 (Oct. 20, 2010). The disclosure effective date was delayed until July 1, 2012, for service providers and until Aug. 30, 2012, for plan sponsors with calendar year plans. The delayed regulations are published at 77 Fed. Reg. 5632 (Feb. 3, 2012). 2. Meeting Your Fiduciary Responsibilities, U.S. Department of Labor, 2011, http://www.dol.gov/ebsa/publications/fiduciaryresponsibility.html. 3 ERISA Section 409 imposes personal liability for breach of fiduciary duty. ERISA Section 502(l) imposes a 20 percent civil penalty on a fiduciary who breaches his fiduciary duty based on the applicable recovery amount. See EBSA Enforcement Manual, Chapter 35: Civil Penalties, U.S. Department of Labor, 2011, http://www.dol.gov/ebsa/oemanual/cha35.html.
