An Overview for Plan Sponsors and Fiduciaries of the New Requirements for Service Provider Arrangements

August 26, 2010

The Department of Labor (DOL) has issued new rules requiring disclosure of information in connection with services provided to ERISA-covered employee benefit plans. The rules consist of new regulations that interpret Section 408(b)(2) of ERISA and include a new prohibited transaction exemption.

Section 408(b)(2) requires that a service provider arrangement and the compensation payable under the arrangement be reasonable in order for the arrangement not to violate ERISA’s prohibited transaction rules. The new regulations impose disclosure obligations that a service provider must meet for the Section 408(b)(2) exemption to apply. The prohibited transaction exemption provides relief for plan fiduciaries who are responsible for engaging service providers (responsible fiduciaries), if they unknowingly fail to receive all of the information required to be disclosed under the regulations. This WorkCite provides an overview of the new regulations and the prohibited transaction exemption from the perspective of their impact on responsible fiduciaries and plan sponsors.

What is the Importance of Section 408(b)(2) for Responsible Fiduciaries?

ERISA Section 406(a)(1)(C) prohibits the furnishing of goods, services or facilities between a plan and a party in interest to the plan. Because a “party in interest” includes any party that provides services to a plan, service arrangements generally are prohibited unless they qualify for an exemption.

Section 408(b)(2) provides such an exemption by permitting plans to arrange for a party in interest to provide office space, legal, accounting or “other services” if:

  • the contract or arrangement is reasonable,
  • the services are necessary for the establishment or operation of the plan, and
  • no more than reasonable compensation is paid for the services.

The new regulations revise existing Section 408(b)(2) regulations that describe conditions which must be met for a services contract or arrangement to be “reasonable.” Other provisions of existing regulations continue to apply, such as standards for determining when a service is “necessary,” what is “reasonable compensation,” and special considerations for arrangements that involve conflicts of interest for plan fiduciaries. In addition, the new regulations do not affect other prohibited transaction exemptions that may be available for certain services, such as exemptions for specific types of services provided by a bank or an insurance company.

What Do the New Regulations Generally Require?

The regulations impose information disclosure requirements on providers of certain types of services to certain types of ERISA plans. The regulations also explain what are reasonable termination provisions for services contracts.

What Plans are Subject to the New Regulations?

The new regulations apply to all ERISA “employee pension benefit plans.” This includes Section 401(k) plans and other types of retirement plans, such as defined benefit pension plans, employee stock ownership plans, profit sharing plans, and ERISA-covered Section 403(b) plans. SEPs, SIMPLE plans and IRAs are not subject to these regulations.

The new regulations also do not apply to welfare benefit plans. The DOL has reserved the possibility of expanding the rules to cover welfare benefit plans in the future. Until further guidance is issued, responsible fiduciaries of welfare benefit plans must continue to comply with the other requirements of existing regulations and must generally determine whether a service provider arrangement is “reasonable,” but are not required to obtain the new information that covered service providers must disclose to fiduciaries of retirement plans.

Which Service Providers are Covered by the New Regulations?

The regulations apply to arrangements for services rendered on behalf of a plan for compensation. Compensation means money and other forms of payment for services, other than a non-monetary payment that is less than $250 in value. In addition, only arrangements under which the service provider is expected to receive $1,000 or more in compensation are covered by the new requirements.

General Categories of Service-Provider Relationships Covered by the Regulations

  1. Fiduciaries and investment advisors. The new regulations apply to any arrangement where a provider renders services either as an ERISA fiduciary, or as an investment advisor registered under state law or the Investment Advisors Act of 1940. The fiduciary category includes persons who provide services directly to the plan, or who provide fiduciary services to an investment contract, product or entity in which a plan makes a direct equity investment. This would include, for example, a discretionary investment manager who is hired by a plan to invest its assets, as well as an investment manager who has discretionary investment authority over an investment account in which the plan makes a direct investment. This category does not include a provider of investment management services to asset pools that do not consist of ERISA “plan assets,” such as mutual funds registered under the Investment Company Act of 1940. Investment advisers are covered in this category by the new regulations only if they provide services directly to the plan. Therefore, an adviser retained by a participant to invest only the participant’s account for a fee would not be covered.
  2. Certain providers of recordkeeping or brokerage services. Providers of recordkeeping or brokerage services to individual account plans (such as Section 401(k) plans) that permit participants to direct the investment of their plan accounts are subject to the new regulations if the service provider also arranged for one or more of the investment alternatives available under the plan. For this purpose, “recordkeeping” includes a broad array of services, including enrollment, payroll deductions and contributions, offering plan investment options, processing of loans, withdrawals and distributions, as well as maintaining participant accounts, records and statements. Therefore, a bank, brokerage firm or mutual fund company that provides an administrative platform for a Section 401(k) plan will generally be required to comply with the new regulations. However, a firm that solely provides recordkeeping services to a plan but does not provide plan investment options (either directly or through an affiliate or subcontractor), generally would not be a covered service provider in this category.
  3. Providers of certain services who receive indirect compensation. Providers of certain other specified services are included as covered service providers if they reasonably expect to receive indirect compensation from the plan or receive certain types of payments from related parties. For this purpose, indirect compensation means compensation received from a source other than the plan, the plan sponsor, the covered service provider, an affiliate or a subcontractor, or compensation paid by a related party. The categories of included services are accounting, auditing, actuarial, appraisal, banking, custodial, insurance, investment advice (to the plan or participants), legal, recordkeeping, brokerage, plan administration or valuation services. Covered services also include consulting services related to the development or implementation of investment policies or objectives, or the selection or monitoring of service providers or plan investments. As a result, a firm that provides actuarial services to a plan and which is paid directly by the sponsor of the plan for those services would not be subject to the new information disclosure requirements, so long as the firm does not receive any other compensation from other parties with respect to the plan.

What Information Must Covered Service Providers Disclose?

The following items of information must be provided by a covered service provider:

  • Description of the services to be provided. The regulations provide flexibility in determining how specific the description must be. However, the DOL has cautioned that responsible fiduciaries have a duty to determine whether the description is sufficiently detailed to enable them to determine whether the compensation payable for the services is reasonable. As a result, responsible fiduciaries will need to determine whether a services description is sufficiently detailed, and may need to request additional information in some cases.
  • Statement of service provider’s status. Covered service providers must disclose their status to the plan, specifically status as a fiduciary or registered investment advisor.
  • Compensation to be paid. The regulations require that all compensation, whether direct or indirect, be disclosed to the plan fiduciary. Covered service providers must disclose the services to which any indirect compensation relates and from whom they receive such compensation. This requirement also applies to indirect compensation paid among covered service providers and their affiliates and subcontractors, such as commissions, soft dollars, finder’s fees and Rule 12b-1 fees. The regulations require specific identification of the services for which such fees are paid, and the payers and recipients of such compensation. Finally, the regulations also require disclosure of any compensation that the service provider, an affiliate or a subcontractor reasonably expects to receive in connection with the termination of the contract or arrangement, and how any amounts that were prepaid by the plan will be calculated and refunded at the time the contract is terminated.
  • Manner of payment. The disclosure must describe whether the plan will be billed directly or plan participants’ accounts will be charged by the provider.
  • Investment-related information. Any covered service providers who are fiduciaries of investment vehicles which hold plan assets must disclose to the responsible fiduciary of an investing plan any compensation which will be charged against the invested amounts (e.g., sales loads, redemption fees, surrender charges and account fees), the annual operating expenses if the return is not fixed (e.g., expense ratio), and any ongoing expenses, aside from the annual operating expenses (e.g., wrap fees, mortality and expense fees).

What Additional Disclosures Must Recordkeepers and Brokers Provide?

In addition to the general disclosure requirements described above, covered providers of recordkeeping services must describe all direct compensation (i.e., plan-paid) and indirect compensation that the provider, an affiliate or a subcontractor reasonably expects to receive under the recordkeeping arrangement. In addition, if the provider of recordkeeping services is not expected to receive explicit compensation for its services, or if its compensation will be offset or rebated based on other compensation it will receive (or that an affiliate or subcontractor will receive), the disclosure must include a “good faith estimate” of the cost of those recordkeeping services. The DOL’s stated intent behind this requirement is to provide responsible fiduciaries with more complete and meaningful information to evaluate recordkeeping services, especially in cases where these services are “bundled” with other services.

Covered providers of recordkeeping and brokerage services must also furnish the specific investment disclosures described above for each of the investment alternatives that they provide under the plan. This obligation can be satisfied by providing current disclosure materials from those investment providers, such as prospectuses for registered mutual funds.

When Must the Disclosures be Made?

The disclosures must be made “reasonably in advance” of the date on which the contract or arrangement is first entered into. Disclosure must again be provided when the contract or arrangement is extended or renewed. Special timing rules apply for disclosures that must be provided if an investment vehicle which did not previously hold ERISA “plan assets” later holds plan assets, and when new investment alternatives are added to a plan under a recordkeeping or brokerage arrangement.

If there is a change in any of the information required to be disclosed, the covered service provider must report such change to the plan fiduciary as soon as practicable, but generally not later than 60 days after the covered service provider is informed of the change. The regulations do not limit this obligation to instances of “material” changes.

How are the Disclosures to be Made?

The disclosures must be provided in writing. The DOL has not developed any model format for making the disclosures. However, the DOL has indicated that it is considering adding a requirement that covered service providers provide a one- or two-page summary of the key information required to be disclosed, with instructions as to where the responsible fiduciary can locate more detailed information.

What Other Requirements Apply under the Regulations?

As was required under prior law, a plan must have the ability to terminate the arrangement without penalty on reasonably short notice in order for the exemption to apply. The new regulations did not make any changes to this requirement.

How Do the Rules Impact a Plan’s Reporting Obligations?

Responsible plan fiduciaries and plan administrators may receive upon request from covered service providers any other information relating to the compensation received under a contract or arrangement for services, to the extent that information would be required for the covered plan to comply with ERISA’s reporting and disclosure rules. This requirement is designed in part to help plans complete Schedule C of Form 5500, which requires disclosure of certain compensation received by service providers. The requirement is also designed to allow responsible fiduciaries to respond to participants’ requests for additional information, which may be necessary for a plan to meet the requirements of ERISA Section 404(c). Covered service providers must generally respond to these requests within 30 days.

Is There Any Relief Available for Errors Made in the Disclosure?

Assuming that good faith efforts and reasonable diligence was used by the covered service provider in making the disclosures, the regulations provide that the contract will not fail to be reasonable as a result of an error or omission in the disclosure, as long as the covered service provider provides the correct information to the plan fiduciary as soon as practicable, but no later than 30 days after the covered service provider knows of the error or omission.

What Relief Does the Prohibited Transaction Exemption Provide?

The regulations include a limited class exemption from ERISA’s prohibited transaction rules where the requirements of the regulation are not met due to a covered service provider’s failure to make the proper disclosures. The class exemption protects a responsible plan fiduciary if the fiduciary did not know of the disclosure failure, the plan fiduciary makes a formal request to the covered service provider for the necessary information, and if the covered service provider does not furnish the requested disclosures within 90 days, the plan fiduciary notifies the DOL of the failure. The regulations provide that specific information, such as the covered service provider’s contact information and details of the plan fiduciary’s formal request for information, be provided in the notice to the DOL.

When are the Regulations Effective?

The regulations are effective July 16, 2011, and will apply to contracts and arrangements in place prior to the effective date, as well as those signed on and after that date. The DOL has solicited comments on these regulations and may modify them prior to next year. As a result, plan sponsors and fiduciaries should continue to monitor developments in this area.

What Other Issues Must Responsible Fiduciaries Consider when Contracting for Plan Services?

In addition to considering the requirements of the new regulations, responsible fiduciaries must also act prudently and in the sole interest of participants and beneficiaries when entering into service provider arrangements. Compliance with the requirements of the Section 408(b)(2) prohibited transaction exemption does not itself establish that responsible fiduciaries have fulfilled these duties. Instead, responsible fiduciaries must generally show that they obtained and carefully considered information necessary to evaluate the services of a proposed provider, the reasonableness of the fees for that provider’s services, and whether there are any potential conflicts of interest that could affect the quality of those services. This may be accomplished by showing that responsible fiduciaries engaged in a selection process that took into consideration these and other pertinent factors.

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