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408b2 A Look at the New DoL Disclosure and Reporting Rules

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  • 1. A Look at the Department of Labor Disclosure and Reporting Rules and Their Impact on Financial Service Providers Prepared by Sheldon H. Smith, Esq. Bryan Cave LLP Denver, Colorado
  • 2. March 2012 The Department of Labor (DoL) has focused on reporting, disclosure and transparency as critical components in the operation of account-type defined contribution plans, particularly 401(k) plans. After watching three decades of market shift from traditional defined benefit plans to participant direction-of-in- vestment 401(k) plans, the DoL has promulgated a series of rules and regulations aimed at its three-legged approach to assisting its Employee Benefits Security Administration (EBSA) in enforcing ERISA, in assisting plan fiduciaries in making proper investment structure decisions, and in assisting participants in directing their investments. Due to the growth in defined contribution plans generally and 401(k) plans particularly, and the proliferation of new investment vehicles, such as mutual funds and self-directed brokerage windows in 401(k) plans, plan fiduciaries and their participants are increasingly in need of sophisticated financial and other advisory services dealing with the plan’s assets and its operation. This need has led to the creation of significant “industries” that provide financial and recordkeeping services to ERISA pension plans of all types, particularly 401(k) plans. When ERISA was promulgated in 1974, the private retirement system was a traditional defined benefit system where the plans typically pay benefits in the form of an annuity. Payments from defined benefit plans are based on a combination of an employee’s age, years of service, and compensation. Employers bear both the funding and investment risk in defined benefit plans. Contrarily, in 401(k) plans, participants often bear all or most of the funding risk and all of the investment risk. When employers figured out that they could “shift” their risks to their employees, and the employees began to request, in some cases demand, control over retirement assets, it was easy for companies to move from a defined benefit universe to a defined contribution one using 401(k) plans as the primary form of tax-qualified plan. While this plan design change has been taking place, there has also been a change in the types of investment vehicles and services offered in the section 401(k) plan and IRA market. The most significant change has been the advent of mutual funds as the dominant form of investment vehicle available in the defined contribution plan and IRA marketplace. Financial institutions such as brokerage firms and mutual fund families now offer a wide array of mutual funds to IRA owners and to 401(k) plans. Participants in 401(k) plans are often provided with ten or more investment options from which to create an asset allocation. IRA owners may have more than seven thousand funds from which to make investment choices. Brokerage firms also offer “brokerage windows” to participants in 401(k) plans allowing participants to invest retirement plan assets in an almost unlimited array of mutual funds and publicly-issued debt and equity securities. With the growth in defined contribution plans and the IRAs that result from the rollover of assets from these defined contribution plans, together with the explosive addition of available investment products used to fund these plans, there has been an increasing demand for financial and recordkeeping services. Financial services that initially included only sales and brokerage now involve participant education, asset allocation assistance, and, increasingly, investment advice to both the plan fiduciaries and plan participants. Although it was probably not anticipated, the financial services industry has, to a large extent due to the number of participants in 401(k) plans, become America’s financial educators. 1
  • 3. The fiduciary responsibility provisions of Title I of ERISA protect plans and participants by imposing special duties and obligations on plan fiduciaries. Fiduciaries must act prudently and in the best interest of the plan, its participants, and their beneficiaries, and must avoid prohibited transactions.1 ERISA imposes prohibitions on certain transactions between a plan and a “party in interest” with respect to the plan. A “party in interest” includes, as here relevant, the employer sponsoring the plan and a service provider to the plan and certain of its affiliates.2 Among the prohibited transactions is the provision of services between a party in interest and a plan.3 The “services” exemption under ERISA § 408(b)(2) provides prohibited transaction relief from the prohibition against provision of services by a party in interest. Where a fiduciary engages in a prohibited transaction, a breach of an ERISA fiduciary duty occurs. ERISA will require correction of the transaction to return the plan to its status quo ante and Internal Revenue Code (Code) will impose punitive excise taxes. Where a non-fiduciary service provider engages in a prohibited transaction, the cost can be expensive taxation a well as correction. All tax-qualified plans and IRAs are “plans” subject to the prohibited transaction excise tax provisions of Code § 4975. These Code provisions are similar to the prohibited transaction provisions of ERISA § 406.4 These ERISA rules apply to advisory services. Assume the following common situation: A financial institution (“Advisor”) offers affiliated mutual funds, as well as selected unaffiliated mutual funds to 401(k) plans. The services include investment education, asset allocation recommendations, brokerage services, and recordkeeping, among others (“Advisory Services”). The Advisor charges a single fee for all Advisory Services. The affiliated mutual funds pay advisory fees and shareholder services fees to the Advisor and/or its affiliates. In addition, the Advisor (or an affiliate) also receives 12b-1 fees from the unaffiliated funds based upon the investment by the Advisor’s clients in those funds. These facts result in a number of potential prohibited transactions, each of which needs some sort of exemption relief in order for the Advisor to perform the identified services. For purposes of this paper, we focus on the rendition of Advisory Services that do not include the delivery of investment advice. Because the Advisor is a service provider to the plan, the Advisor is a party in interest with respect to the plan or IRA.5 ERISA prohibits the provision of services between a party in interest and a plan.6 Thus, the Advisor needs relief for its provision of Advisory Services under ERISA § 408(b)(2). Upon recognition that the service environment has changed dramatically over the life of ERISA, the DoL has determined that its reporting regime using the Form 5500, and particularly the Schedule C to the Form 5500, will provide it and the IRS with needed enforcement information pertaining to payments for services between a party in interest (a “disqualified person” for Internal Revenue Code purposes) and a plan. In theory this will assist the EBSA in enforcing ERISA and in making certain that fees for services are reasonable and appropriate. This results in the first leg of the DoL’s three-legged effort to make certain that participants are paying a not unreasonable amount for the level of services being provided. 2
  • 4. The second leg creates a regulatory exemption for the potential prohibited transaction that results when a party in interest provides services to a plan or IRA such as the Advisory Services described in the fact pattern above. The regulation is addressed to both the service provider and the plan fiduciary with an expectation that disclosures by the service provider to the fiduciary will enable the fiduciary to make proper decisions regarding both services and costs so that the new ERISA § 408(b)(2) exemption, allowing for the rendition of appropriate services for a proper fee, will apply. Finally, the third leg in the process addresses the need for the plan fiduciary to disclose relevant cost and service information directly to the participants with the expectation that participants in self-directed plans will have the information needed to make better investment decisions and to prevent the fiduciary from failing to act in the best interest of the participants and their beneficiaries. This paper analyzes each of the three legs and their possible impact on financial service providers to plans and IRAs. The First Leg - Schedule C to the Form 5500 The Schedule C to the Form 5500 rule was promulgated in 2007 by the DoL and became effective for the 2009 plan year for ERISA plans with more than one hundred participants. The rule affects service providers receiving, directly or indirectly, $5,000 or more in reportable compensation during an applicable reporting year. The rule establishes a complex structure for reporting items such as float, revenue sharing, 12b-1 fees, soft dollar payments, and commissions. The rule imposes this reporting obligation on the plan administrator, the ERISA fiduciary responsible for the operation and administration of the plan who also happens to be the party responsible for filing the Form 5500 and its schedules. Service providers, including financial services businesses, are incentivized to assist the plan administrator through both a requirement and a consequence: 4 A plan administrator must notify the DoL of the identity of any service provider that fails to provide the required information. 4 Failure to provide the required information could result in having the plan terminate its engagement with a noncompliant service provider. The observation we glean from our clients is that the financial services industry has figured out how to comply with the new rule, and we are not aware of any significant failures that existed for the 2009 Form 5500 filings. As we approach the deadline for 2010 Form 5500 filings, our expectation is that the process will be working as intended without creating difficulties in compliance for financial services firms. Although there may be some nuances in the manner in which reportable compensation was stated or some confusion about what is to be reported, the EBSA’s Frequently Asked Questions about the 2009 Form 5500 Schedule C found at: http://www.DoL.gov/ebsa/faqs/faq_scheduleC.html (July 2008) and the Supplemental FAQs About the 2009 Schedule C found at http://www.DoL.gov/ebsa/faqs/faq-sch-C-supplement.html (October 2009) are most helpful in assisting the party responsible to provide the information. 3
  • 5. What Gets Reported on the Schedule C? Amounts required to be reported under the revised rules fall into three categories: direct compensation, indirect compensation and eligible indirect compensation. Direct Compensation. Direct compensation is typically the compensation paid to a service provider directly from the plan. It also includes charges to a plan’s forfeiture account and charges to a participant’s account or the trust account. Indirect Compensation. Indirect compensation is a little less comprehensible. It includes any compensation that is paid to a service provider but not directly by the plan. It must be compensation received in connection with a person’s position with the plan or for services rendered to the plan. Indirect compensation requires that the recipient’s eligibility for a payment or the amount of the payment must be based, in whole or in part, on services rendered to the plan or on a transaction or series of transactions with the plan. One of the most common examples of indirect compensation is where a plan is “paid” (through revenue sharing) for recordkeeping services through 12b-1 fees or other compensation from an investment option offered under the plan. Other examples of indirect compensation include finders’ fees, 12b-1 fees, sub transfer (sub-TA) fees, soft dollar services and gifts and entertainment. The cited FAQs explain their inclusion and exclusion. The DoL tells us that indirect compensation includes, among other things, payment of “finder’s fees” or other fees and commissions by a service provider to an independent agent or employee for a transaction or service involving the plan. This means that commissions received from a person, other than those received directly from the plan or plan sponsor, in connection with the sale of an investment, product, or service to a plan would be reportable indirect compensation. The treatment of the commission as reportable indirect compensation is not dependent on whether the seller or the agent has any other relationship to the plan other than the sale itself. 7 Eligible Indirect Compensation. Eligible indirect compensation gets a bit more confusing. It is a subset of indirect compensation reported to the DoL where the plan administrator receives written disclosure of: 4 The existence of eligible indirect compensation; 4 The service provided for the eligible indirect compensation; 4 The amount or estimate of the compensation or a description of the formula used to calculate the eligible indirect compensation; and 4 The identity of the parties paying and receiving it. Eligible indirect compensation includes amounts that are paid or charged to an account subject to the reporting rules and are reflected in the value of the plan’s investment, such as asset based management fees, finders’ fees, soft dollar revenue, 12b-1 fees, float, and other transaction based fees reflected in the investment of the participating plan and which are not deemed operating expenses of an investment fund. The terms “operating expense” and “investment fund” are critical to understanding Schedule C disclosures. 4
  • 6. According to the DoL, brokerage costs associated with a broker dealer effecting securities transactions within the portfolio of a mutual fund or for the portfolio of an investment fund that holds ERISA “plan assets,” are treated for Schedule C purposes as an operating expense of the investment fund not reportable as indirect compensation paid to a plan service provider or in connection with a transaction with the plan.8 This “operating expenses” exception is often very helpful to the extent it applies to an “investment fund.” The term “investment fund” includes vehicles such as mutual funds, private investment funds, and bank collective vehicles in which multiple parties invest, and “separately managed investment accounts that contain assets of an individual plan.”9 Which Entities are Covered? The Schedule C rule covers entities not traditionally subject to ERISA. Guidance indicates that among the entities covered by the revised Schedule C compensation reporting requirements are: Registered investment companies (commonly referred to as mutual funds) and other investment funds that do not hold “plan assets.” Thus, for instance, fees paid to persons for management of a real estate hedge fund that is not a real estate operating company under 29 C.F.R. § 2510.3-101 (25% rule) would be reportable Schedule C compensation, but property management fees paid to persons managing the underlying properties owned by the funds would be treated as non-reportable ordinary operating expenses of the fund.10 Mutual funds, bank collective funds, ERISA-exempt hedge funds, real estate investment trusts, and separately managed accounts and insurance company pooled separate accounts are compelled to monitor amounts charged against the value of the fund or account or that are reflected in the value of the plan’s investment in order to comply with the rule. This has created an additional burden on these entities, but it appears today to be quite manageable. We have observed to no increase in costs to our client plans resulting from the need to perform this extra work. What Are Challenges for the Financial Services Industry? Financial service providers have found themselves having to provide more information than the Securities and Exchange Commission or other regulators traditionally have required. For example, with respect to soft dollars, the DoL states that “[i]f the disclosures that meet the securities laws’ requirements do not include the information necessary to meet the eligible indirect reporting option, additional disclosures would be required for a plan to take advantage of the alternative reporting option for eligible indirect compensation.”11 Complexity of certain commercial relationships many of which involve unaffiliated companies, can create difficult reporting issues. The DoL uses the following example: A mutual fund pays eligible indirect compensation to a fund administrator, advisor, or distributor (a “fund agent”). In turn, the fund agent pays fees to the recordkeeper for “compliance services” provided to one or more participating plans, including discrimination testing, QDRO administration, and Form 5500 preparation. The recordkeeper is not an affiliate of the mutual fund or the fund agent.12 5
  • 7. The DoL then asks whether the mutual fund payment to the recordkeeper is reportable indirect compensation, and if so, whether the fee received by the recordkeeper is eligible indirect compensation.13 The DoL answered those questions as follows: Plan recordkeepers may receive fees for shareholder services and recordkeeping services directly or indirectly from investment providers under a wide variety of arrangements. Among others, they may receive compensation from fund agents (such as fund administrators, advisers or distributors) as well as other agents, representatives or intermediaries such as mutual fund “platform” providers, broker-dealers, banks, and insurance companies. The fees for compliance services received by the recordkeeper from the mutual fund agent are reportable indirect compensation. The alternative reporting option for eligible indirect compensation would not apply to such payments because the payments are not among the categories listed in the Schedule C instructions for eligible indirect compensation. Instructions to Schedule C define “eligible indirect compensation”. Amounts received by a plan recordkeeper from fund agents would not constitute eligible indirect compensation on the basis of being “other transaction-based fees for transactions or services involving the plan” merely because the plan had to make an investment in the mutual fund before the recordkeeper would receive any fees.14 Broker-dealers face an additional complication depending on how their arrangements are structured. Each entity in a distribution chain may have a different way of recording, capturing, and maintaining the reportable data. It is common for a recordkeeper to enter into an arrangement (which the FAQs refer to as an “alliance”) with an independent broker-dealer to provide services offered together as a full service structure sold by agents of the broker-dealer under separate contracts with the plan. In this situation, it is common to see the broker-dealer pay compensation to the recordkeeper on either a flat fee basis or an asset-based fee basis on the assets sold to the plan by the broker-dealer. The broker-dealer might pay the compensation for plan administration and recordkeeping services that the recordkeeper provides to the broker-dealer’s plan clients. According to the DoL’s guidance, compensation paid by the broker-dealer to the recordkeeper is indirect compensation.15 The DoL stated in the Supplemental FAQs that “[r]evenue sharing payments often travel through the hands of several different service providers before getting to their ultimate intended recipient in a ‘chain’ of plan service providers,” and asked whether “only the ultimate recipient of the compensation need[s] to be iden- tified as having received the compensation.”16 The DoL’s answer to that question is “Not necessarily.”17 The DoL explained: One purpose of the Schedule C reporting structure is to provide plan fiduciaries with better information regarding the flow of amounts that represent fees received in connection with services provided to the plan. Accordingly, it is possible that a person could receive a fee that would constitute indirect compensation and pass some of that fee on to another person for whom the amount passed on would also represent reportable indirect compensation. In such a case, the information reported regarding the first and second person who received the fee could include a description of the total fee received and the portion of the fee passed on to the next level recipient. 6
  • 8. Alternatively, it may be that the consolidated bundled fee reporting option could be used instead of reporting revenue sharing compensation received by individual members of the bundle. On the other hand, if an intermediary fund agent is merely a conduit for transmission of the revenue sharing fee to the ultimate recipient, the conduit would not itself be receiving any reportable compensation by acting as the conduit.18 How Do Service Providers Deal with Reporting Unusual “Compensation”? Gifts, gratuities, and entertainment may be forms of reportable indirect compensation. In general, all amounts of gifts, entertainment, and other gratuities paid to or provided in respect of the plan’s assets need to be reported, unless the aggregate amount of gifts and gratuities received by a service provider with respect to the plan is less than $100 per year provided each gift or gratuity is less than $50 (ignoring in some cases items that are less than $10 for purposes of this test). The problem, of course, is keeping track of these amounts. Administrators are permitted to exclude from Schedule C non-monetary compensation of insubstantial value which is tax deductible for U.S. Federal income tax purposes and which would not be taxable to the recipient. This follows the structure of de minimis fringe benefits under section 132 of the Code. For Schedule C purposes, the non-monetary gift must be valued at less than $50 and the aggregate value of all gifts from one source in a calendar year must be valued at less than $100. Non-monetary gifts of under $10 are ignored. The DoL has expressly stated that items such as “coffee mugs,” “calendars,” “greeting cards,” “plaques,” “certificates,” “trophies,” and “similar items …displaying a company logo” may be viewed as presumptively (but not absolutely) de minimis. On the other hand, DoL indicates that a “luxury pen . . embossed with a company logo” is an item that would not benefit from the presumption. A luxury pen to one person may be a throw away to another, of course. The DoL requires reporting for “free business meals” and “entertainment;” “hospitality suites” and “conferences” sponsored by “brokerage firms” or “platform providers;” and “holiday gifts,” “refreshments,” “holiday baskets,” “audio-visual equipment,” “travel,” and “lodging.” Conference attendance presents interesting issues. Where the conference sponsor may provide attendees with items that are tangential to the educational function of the conference – such as dinner, transportation, or even an occasional round of golf or other seemingly de minimis activity, the rules are complicated and portend no bright lines. Additionally, financial services relationships are not always seg- regated between ERISA and non-ERISA business. The DoL posits the following questions with respect to gifts, gratuities, and entertainment that involve multiple “end” clients: “If a person providing services to the plan is provided a meal or other entertainment based on a general business relationship that includes both ERISA and non-ERISA business, is it required to be reported on the Schedule C ?”19 The DoL’s answer? “It depends,” and DoL guidance goes on to provide: 7
  • 9. The Schedule C instructions state that indirect compensation would not include compensation that would have been received had the service not been rendered to the plan or the transaction had not taken place with the plan and that cannot be reasonably allocated to the service(s) performed or transaction(s) with the plan. However, if a person’s eligibility for receipt of a gift (such as meals, travel, or entertainment) is based, in whole or in part, on the value (e.g., assets under management, contract amounts, premiums) of contracts, policies, or transactions (or classes thereof) placed with ERISA plans, the gift would constitute reportable indirect compensation for Schedule C purposes.20 The DoL also addresses the concerns where there is a business conferences at which a plan sponsor, investment manager, trustee, or custodian may be an invited participant: [W]here a service provider has received free attendance at a conference or seminar that constitutes reportable indirect compensation, is it adequate to report payments for meals, hotel, transportation costs, and other individual expenses? Must the plan administrator also report that portion of the expenses attributable to every conference attendee for costs such as guest speaker fees and other conference overhead?21 The answer, according to DoL guidance, is as follows: Waiver of any conference registration fee would also be reportable indirect compensation. Conference overhead expenses, such as guest speaker fees, conference space rental, continental breakfast and other refreshment expenses normally included in the cost of the conference registration fee, are not reportable indirect compensation for Schedule C reporting purposes.22 In a further effort to explain this murky area, the DoL states: “[I]f a brokerage firm invites employees of investment managers to a business conference, including reimbursement for travel, meals, and lodging, where eligibility for the invitation or the value of gifts provided is not based, in whole or in part, on whether the investment manager does business with ERISA plans or on the value or amount of business conducted that includes ERISA covered plans, the expenses for the conference, travel, meals and lodging would not constitute Schedule C reportable indirect compensation.”23 The DoL expects service providers to address the reporting on gifts and entertainment carefully and diligently. It even provides a cautionary statement repetitively in the supplemental FAQs: CAUTION …Filers are strongly cautioned that gifts and gratuities of any amount paid to or received by plan fiduciaries may violate ERISA and give rise to civil and criminal penalties.24 These issues become even more complex for those financial services businesses with separate business lines and with different points of contact with any given client. It is not unusual for separation of business units to occur due to regulatory constraints unrelated to ERISA. Nonetheless these companies need to develop and implement systems to aggregate potential items of gifts and entertainment for purposes of the reporting rules, and if applicable, to assure compliance with the de minimis limits. Many institutions deal with “undisclosed” or “omnibus” accounts, which can make tracking and good faith compliance with the reporting rules difficult. Managing these tasks for clients such as mutual funds or hedge funds, which may have “undisclosed” ERISA money, adds even more complexity. 8
  • 10. The end result is that the work of the financial services industry has been greater, but, for the most part, manageable. The industry appears to have “weathered” the 2009 Form 5500 filing season well and should have even fewer problems with the 2010 Form 5500 Schedule C disclosures. The Second Leg - Final Regulations on Fee Disclosure On July 16, 2010, the DoL released its regulations governing the fee disclosure requirements that must be satisfied in order that a contract or arrangement will qualify for the statutory prohibited transaction exemption for services under ERISA § 408(b)(2). These regulations were issued as “ interim final.” On February 2, 2012, the DoL finalized the regulations. The furnishing of goods, services, or facilities between a plan and a party in interest to the plan generally is prohibited under ERISA § 406(a)(1)(C). Accordingly, absent an exemption, a service relationship between a plan and a service provider would constitute a prohibited transaction because any person providing services to the plan is a “party in interest” to the plan under ERISA. However, a new regulatory exemption is provided for the rendition of services. ERISA § 408(b)(2) exempts certain arrangements between plans and a party in interest if three requirements are met: (1) the contract or arrangement is reasonable, (2) the services are necessary for the establishment or operation of the plan, and (3) no more than reasonable compensation is paid for the services.25 The regulations attempt to clarify what constitutes a “reasonable” contract or arrangement. The regulations establish a requirement that, in order for certain contracts or arrangements for services to be reasonable, the covered service provider must disclose specified information to a responsible plan fiduciary, defined as a fiduciary with authority to cause the plan to enter into, or extend or renew, a contract or arrangement for the provision of services to the plan. Understanding the final regulation requires an understanding of its critical terms: Necessary Service. This is a service for the establishment or operation of the plan if it is appropriate and helpful to the plan in carrying out the purposes for which the plan is established and maintained.26 These services must be described in the 408(b)(2) disclosure by the covered service provider. Contract or Arrangement. The final regulations do not require a formal written contract or arrangement delineating the disclosure obligations. However, the required disclosures themselves must be made in writing. As a practical matter, most covered service providers will likely still opt for the written contract. A best practices suggestion to financial service providers is that they have a comprehensive services agreement, a part of which will address the disclosure requirements.27 Covered Plans. The final regulations apply to both defined benefit plans and most defined contribution plans. The term “covered plan” is defined to mean an employee pension benefit plan or a pension plan within the meaning of ERISA § 3(2)(A) (and not described in ERISA § 4(b) ), with the exception of SEPs and SIMPLEs described in Code Sec. 408(p) , an individual retirement account described in Code Sec. 408(a), or an individual retirement annuity described in Code Sec. 408(b). Certain annuity contracts and custodial accounts described in Code Sec. 403(b) are excluded. These excluded contracts and accounts are ones issued to affected participants before 2009 where the sponsoring employer ceased making contributions, where rights or benefits of individual owners are enforceable against the insurer or custodian without employer involvement, and where the owners are fully vested in the account or contract. Some parts of the regulations only apply to participant-directed individual account plans.28 9
  • 11. Covered Service Providers. The types of service providers covered by the final regulation fall into three categories. A service provider may be a covered service provider under the final rule even if some or all of the services provided pursuant to the contract or arrangement are performed by affiliates of the covered service provider or subcontractors. However, service providers do not become “covered service providers” solely as a result of services that they perform in their capacity as an affiliate of the covered service provider or a subcontractor.29 The first category of covered service providers includes those providing services as an ERISA fiduciary or as an investment adviser registered under either the Investment Advisers Act of 1940 or any State law. This category is itself split into three subsections, and it: (1) includes ERISA fiduciaries providing services directly to the covered plan; (2) includes ERISA fiduciaries providing services to an investment contract, product, or entity that holds plan assets and in which the covered plan has a direct equity investment; and (3) includes investment advisers providing services directly to the covered plan.30 The regulations further clarify that, other than providers of fiduciary services to an investment contract, product, or entity holding plan assets with respect to which the covered plan has a direct equity investment, the term “covered service provider” does not include a mere provider of services to an investment contract, product, or entity (regardless of whether or not the investment contract, product, or entity holds assets of the covered plan).31 An affiliate or subcontractor that is performing one or more of these services is not a “covered service provider” solely by providing the services.32 The second category of covered service providers includes providers of recordkeeping services or brokerage services to a covered plan that is an individual account plan and that permits participants and beneficiaries to direct the investment of their accounts, if one or more designated investment alternatives will be made available (e.g., through a platform or similar mechanism) in connection with such record- keeping services or brokerage services.33 This category encompasses recordkeepers and brokers that offer, as part of their contract or arrangement, a platform of investment options, or a similar mechanism, to a participant-directed individual account plan. This category also encompasses service providers who pro- vide recordkeeping or brokerage services that include designated investment alternatives independently selected by the responsible plan fiduciary and which are later added to the covered plan’s platform. Under the final regulation, covered service providers in this category must disclose to the responsible plan fiduciary compensation information regarding each of the designated investment alternatives for which they provide recordkeeping or brokerage services. The third category of covered service providers includes those providing specified services to the covered plan when the covered service provider (or an affiliate or a subcontractor) reasonably expects to receive “indirect” compensation or certain payments from related parties.34 The services included in this category are accounting, auditing, actuarial, appraisal, banking, consulting (i.e., consulting related to the development or implementation of investment policies or objectives, or the selection or monitoring of service providers or plan investments), custodial, insurance, investment advisory (for plan or participants), legal, recordkeeping, securities or other investment brokerage, third party administration, or valuation services provided to the covered plan. Generally, and unless otherwise stated in the regulation, service providers that only provide non-fiduciary administrative, legal, or other services to an investment vehicle, even one holding plan assets, are not covered service providers. For example, a recordkeeper servicing a collective investment fund is not a covered service provider to a plan investing in the fund merely because the fund holds plan assets. 10
  • 12. However, if that same recordkeeper provides services directly to a covered plan and receives indirect compensation or certain compensation from related parties, then it would be a covered service provider. Its status as a covered service provider results from the rendition of services to the plan, not to the fund. De MinimisThreshold. The final regulation establishes a $1,000 threshold for service providers otherwise coming within the definition of a covered service provider (regardless of whether the threshold is met by compensation received by the covered service provider, an affiliate, or a subcontractor that is performing one or more of the services to be provided under the contract or arrangement with the covered plan).35 It is assumed that the threshold amount is to be determined over the life of the arrangement. Timing of Disclosures. With regard to the timing of the required disclosures, the final regulations require that a covered service provider provide the initial disclosures required by the regulations to the responsible plan fiduciary reasonably in advance of the date the contract or arrangement is entered into, extended, or renewed.36 A special timing rule applies with respect to the provision of certain recordkeeping and brokerage services with respect to investment alternatives designated after the contract is entered into. In such a case, the disclosure must be made as soon as practicable, but not later than the date on which the investment alternative is designated by the responsible plan fiduciary.37 In addition to requiring that certain information be disclosed to responsible plan fiduciaries before the parties enter into, or extend or renew, a contract or arrangement, the service provider must disclose any change to the required information not later than 30 days from the date on which the service provider acquired knowledge of the change.38 Secondly, disclosure must be made as soon as practicable, but not later than 60 days from the date on which the covered service provider is informed of the change, unless the disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, in which case the information must be disclosed as soon as practicable.39 The service provider must disclose information within 30 days of a request by the plan fiduciary.40 The deadline for disclosure of all investment-related information is “at least annually.” Disclosure of Recordkeeping Services. The final regulations also contain a specific disclosure requirement for recordkeeping services not previously contained in the proposed regulations.41 Under this provision, if recordkeeping services will be provided to the covered plan, the covered service provider must furnish a description of all direct and indirect compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with such recordkeeping services. In addition, if the covered service provider reasonably expects recordkeeping services to be provided, in whole or in part, without explicit compensation for such recordkeeping services, or when compensation for recordkeeping services is offset or rebated based on other compensation received by the covered service provider, an affiliate, or a subcontractor, the covered service provider must provide a reasonable and good faith estimate of the cost to the covered plan of such recordkeeping services. The service provider must explain the methoDoLogy and assumptions used to prepare the estimate and describe in detail the recordkeeping services that will be provided to the covered plan. The estimate is to take into account, as applicable, the rates that the covered service provider, an affiliate, or a subcontractor would charge to, or be paid by, third parties, or the prevailing market rates charged, for similar recordkeeping services for a similar plan with a similar number of covered participants and beneficiaries.42 11
  • 13. Disclosure of Investment Fiduciary Services. Additional information with respect to each investment contract, product, or entity that holds plan assets and in which the plan has a direct equity investment is required to include: (1) a description of the compensation that will be charged directly against the amount invested in connection with the acquisition, sale, transfer, or withdrawal from the investment contract, product, or entity (these include sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, accounting fees and purchase fees; (2) a description of the annual operating expense (expense ratio) if the return is not fixed; and (3) a description of ongoing expenses in addition to annual operating expenses such as wrap fees, mortality and expense fees.43 Compensation. The fees and other remuneration that must be disclosed are broken down into four categories: direct compensation, indirect compensation, related party compensation and termination compensation. Note that the definitions are similar to, but not exactly the same as, those provided for Schedule C reporting of the First Leg. A covered service provider is allowed to use a “reasonable and good faith” estimate of compensation or cost if the covered service provider cannot otherwise readily describe the compensation or cost.44 Direct Compensation. The covered service provider must identify all direct compensation (that is, compensation received directly from the plan), either in the aggregate or by service, that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with the services described.45 Indirect Compensation. The covered server provider must provide a description of all indirect compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with the services including identification of the services for which the indirect compensation will be received and identification of the payer of the indirect compensation.46 The regulations require a description of the arrangement between the payer and the covered service provider pursuant to which the indirect compensation is paid. Compensation paid among related parties. The covered service provider must provide a description of any compensation that will be paid among the covered service provider, an affiliate, or a subcontractor, in connection with the services if it is set on a transaction basis (e.g., commissions, soft dollars, finder’s fees or other similar incentive compensation based on business placed or retained) or is charged directly against the covered plan’s investment and reflected in the net value of the investment (e.g., rule 12b-1 fees); including identification of the services for which such compensation will be paid and identification of the payers and recipients of such compensation (including the status of a payer or recipient as an affiliate or a subcontractor). Compensation must be disclosed pursuant to this paragraph regardless of whether such compensation also is disclosed pursuant to the disclosure rules governing direct or indirect compensation or otherwise required to be disclosed under the regulations investment disclosure rules. The related party compensation disclosure rule does not, however, apply to compensation received by an employee from his or her employer on account of work performed by the employee.47 Termination Compensation. The covered service provider must describe any compensation that the covered service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with termination of the contract or arrangement, and how any prepaid amounts will be calculated and refunded upon such termination.48 12
  • 14. Manner of Receipt. The covered service provider must also describe the manner in which the compensation will be received, such as whether the covered plan will be billed or the compensation will be deducted directly from the covered plan’s account(s) or investments.49 Investment-Related Disclosures. The final regulations require disclosure of total annual operating expenses for a designated investment alternative expressed as a percentage, calculate in accordance with the DoL’s regulations for participant disclosure in participant-directed individual account plans. The rules allow a covered service provider to comply with requirements of investment-related disclosures related to designated investment alternatives by providing current disclosure materials of the issuer or information replicated from those materials. Investment-related information must be provided at least annually. The Guide. Covered service providers anxiously awaited the DoL’s promulgation of a chart that would assist them in presenting the items to be disclosed in an acceptable format. Unfortunately, when the regulations were finalized in February 2012, the DoL failed to provide that expected chart. Instead, it provide a “guide” and reserved a place for a more definitive tool that may or may not be promulgated later. The guide is generally viewed as less than helpful. Effective Date. The Final Regulations are scheduled to go into effect on July 1, 2012. Thus, the initial disclosures for plan arrangements in effect on that date must be accomplished by that date. For arrangements that are made following that date, the disclosures must be made reasonably in advance of the contracting date. TheThird Leg - Final Fiduciary Disclosure Regulations Governing Participant-Directed Plans On October 14, 2010, the DoL released its final regulations on fiduciary requirements for disclosure to participants and beneficiaries participating in participant-directed plans.50 The Fiduciary Burden. The basic approach of the regulations is recognition that the investment of plan assets is a fiduciary act subject to ERISA’s prudent person standard and the requirement that fiduciaries act solely in the interest of participants and their beneficiaries. The regulation provides that when a fiduciary allocates investment authority to a participant or beneficiary, the plan administrator must take steps to ensure that such participants and beneficiaries, on a regular and periodic basis, are made aware of their rights and responsibilities through the provision of sufficient information so that they can make informed decisions. The information that must be provided includes information regarding plan fees and expenses as well as information regarding the designated investment alternatives available under the plan.51 Covered Plans. Plans subject to these requirements include all participant-directed individual account plan other than IRAs, simplified employee pensions, or SIMPLE retirement accounts under Code Sec. 408(p).52 Compliance. This obligation to disclose is satisfied by disclosure of both plan-related information and investment-related information. However, a plan administrator is not liable for the completeness and accuracy of information used to satisfy these requirements when the plan administrator reasonably and in good faith relies on information received from or provided by a plan service provider or the issuer of a designated investment alternative.53 13
  • 15. Plan-Related Information. The plan-related information that must be disclosed is divided into three categories: (a) general plan information, (b) administrative expenses information, and (c) individual expenses information. Timing. Plan-related information must be provided on or before the date on which a participant or beneficiary can first direct the investment of his/her account and at least annually thereafter. If there is a change in any of this information, each participant and beneficiary must be furnished a description of such change at least 30 days, but not more than 90 days, in advance of the effective date of such change, unless the inability to provide such advance notice is due to events that were unforeseeable or circumstances beyond the control of the plan administrator, in which case, notice of such change must be furnished as soon as reasonably practicable. Plan-related information must also be provided on request.54 General Plan Information. General Plan Information consists of basic information regarding the structure and mechanics of the plan including: (1) An explanation of the circumstances under which participants and beneficiaries may give investment instructions; (2) An explanation of any specified limitations on such instructions, including any restrictions on transfer to or from a designated investment alternative; (3) A description of or reference to plan provisions relating to the exercise of voting, tender, and similar rights appurtenant to an investment in a designated investment alternative, as well as any restrictions on such rights; (4) An identification of any designated investment alternatives offered under the plan; (5) An identification of any designated investment managers; and (6) A description of any brokerage windows, self-directed accounts, or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.55 Administrative Expenses Information. This category requires an explanation of any fees and expenses for plan administrative services (for example, legal, accounting recordkeeping), which may be charged against the participants’ accounts and not reflected in the total annual operating expenses of any designated investment alternative, as well as the basis on which such changes will be allocated (for example, pro rata, per capita) to, or affect the balance of, each individual account. In addition, at least quarterly, the plan administrator must provide a statement that includes: (a) The dollar amount of the fees and expenses actually charged during the preceding quarter to the participant’s or beneficiary’s account for administrative services, (whether by liquidating shares or deducting dollars) and (b) A description of the services to which the charges relate (e.g., plan administration, including recordkeeping, legal, account services) and 14
  • 16. (c) If applicable, an explanation that, in addition to the fees and expenses disclosed, some of the plan’s administrative expenses for the preceding quarter were paid from the total annual operating expenses of one or more of the plan’s designated investment alternatives (e.g., through revenue sharing arrangements, Rule 12b-1 fees, sub-transfer agent fees).56 Individual Expenses Information. This category requires an explanation of any fees and expenses that may be charged against the individual account on an individual, rather than on a plan-wide basis (e.g., fees attendant to processing plan loans or qualified domestic relations orders, fees for investment advice, fees for brokerage windows, commissions, front or back-end loads or sales charges, redemption fees, transfer fees and similar expenses, and optional rider charges in annuity contracts) and which are not reflected in the total annual operating expenses of any designated investment alternative. (Any change is subject to the same updated disclosure requirement as discussed above). In addition, the plan administrator must provide, at least quarterly, a statement that includes: (a) The dollar amount actually charged during the preceding quarter to the participant’s or beneficiary’s account for individual services, whether by liquidating shares or deducting dollars, and (b) A description of the services provided to the participant or beneficiary for such amount (e.g., fees attendant to processing plan loans).57 Investment-Related Information. This second category of information requires that the plan administrator (or a person designated by the plan administrator to act on its behalf), provide several subcategories of investment related information, based upon the latest information available to the plan, including: Identifying Information (i) The name of the designated investment alternative; (ii) The type or category of the investment (e.g., money market fund, balanced fund, stocks and bonds, large-cap stock fund, employer stock fund, employer securities).58 Performance Data The plan administrator must essentially provide historical investment performance information, including 1, 5, and 10 year returns (or if shorter, the life of the investment) for each designated investment alternative. In addition, there must be a statement indicating that an investment’s past performance is not necessarily an indication of how the investment will perform in the future. In the case of designated investment alternatives with respect to which the return is fixed for the term of the investment, both the fixed rate of return and the term of the investment.59 15
  • 17. Benchmark Information This requirement applies only to investments without a fixed rate of return. With respect to designated investment alternatives with respect to which the return is not fixed, the name and returns of an appropriate broad-based securities market index over the 1-, 5-, and 10- calendar year periods, and which is not administered by an affiliate of the investment issuer, its investment adviser, or a principal underwriter, unless the index is widely recognized and used.60 Fee and Expense Information For designated investment alternatives without a fixed rate of return, the total annual operating expenses expressed as both a percentage of assets and as a dollar amount for each $1,000 invested, and any shareholder-type fees or restrictions on the participant’s ability to purchase or withdraw from the investment. In the case of designated investment alternatives with respect to which the return is fixed for the term of the investment, the amount and a description of any shareholder-type fees and a description of any restriction or limitation that may be applicable to a purchase, transfer or withdrawal of the investment in whole or in part.61 Internet Website Address. An Internet Website address that is sufficiently specific to lead participants and beneficiaries to supplemental information regarding the designated investment alternative, including the name of the investment’s issuer or provider, the investment’s principal strategies and attendant risks, the assets comprising the investment’s portfolio, the investment’s portfolio turnover, the investment’s performance, and related fees and expenses and other information.62 Glossary. In addition, the regulations require the provision of a glossary to assist participants in understanding the investment alternatives, or an Internet Web site address that is sufficiently specific to provide access to such a glossary along with a general explanation of the purpose of the address.63 Comparative Format Requirement for Investment-Related Information. The regulations contain rules governing the manner in which the required investment-related information must be provided. The information must be provided in a chart or similar format that is designed to facilitate a comparison of the information.64 The regulations include a Model Comparative Chart in the appendix, which plans may use. Effective Date. With the latest extension for compliance with initial disclosure under the second leg, the deadline for compliance with participant-level disclosures for most plans is extended to August 30, 2012, i.e., sixty days after the effective date of the plan level disclosures of the second leg. The Last Leg – How to Comply? Much has been written about the impact of the disclosure, reporting and transparency impact on the financial services firms that provide services in the ERISA pension plan space. Some authors are apprehensive while others view the promulgation of these requirements as opportunities. In the final analysis, it would appear that, for the effort and cost that will be involved for most financial service providers, opportunities will be abundant. However, to take advantage of them, a service provider will need ample assistance. The foregoing description of the rules should make it evident that they are complex and worthy of attention to detail. 16
  • 18. Much of the data that was required for the Schedule C is already structured for 408(b)(2) disclosure. With limited exception, it is created and maintained electronically. That data, while not exactly similar to the data needed to meet the 408(b)(2) exemption, is similar enough to have given many financial services firms a “head start” with 408(b)(2) compliance. It has allowed them to identify and categorize their compensation. Many of the large providers are geared up to make this happen, but the other providers will likely struggle to deal with all the complexity without appropriate assistance. Industry companies that assist the bulk of service providers in structuring their ERISA pension plan products and services are providing electronic disclosure platforms that will assist them in describing their services and in disclosing the compensation received for them. These rules are likely to bring the service providers “closer” to their clients, and the rules may weed out service providers whose fees appear to be unreasonable or force them to be more competitive. The rules will surely weed out those who cannot properly comply with them. The penalties for the providers and the plan fiduciaries are simply too great for tolerance. It is likely that competition will stiffen, but those service providers in the financial services industry with good products and a solid service base should compete well. The regulations may also stimulate new modes of electronic recordkeeping and reporting that will better mechanize the structure of the individual account retirement system and yield a better product. Financial service providers, already America’s financial educators, will become our fiduciary financial educators. This will create an additional burden, and hopefully the financial services firms will figure out a fair way to charge for this additional and valuable service. The service will also require that the service providers assist the fiduciaries in preparing their participant disclosures. This also results in an additional service that should result in more fee income. Financial service providers should contract for these services directly with the plan sponsor and have them paid by the plan sponsor in order not to implicate the 408(b)(2) rules. Having comprehensive administrative services agreements with correct parties will be important for all financial services providers. Due to the complexities that these rules create and the penalties for failure, it is of utmost importance for the service agreement to be in writing and to spell out all obligations, duties, responsibilities, compensation, proper indemnifications and a myriad of other practical and legal matters. A financial services provider in the plan space must protect itself contractually. It will be wise to include the needed initial disclosures in the agreement. Some financial services providers have stated that they would not be able to set forth the amounts of their compensation until their contract is finalized and they have had a chance to analyze the new client’s plan and operation. The rules do not permit an exception, but they do permit the compensation to be stated in a myriad of different ways: monetary amount, formula, percentage of plan assets, per capita charge and any other reasonable method. If a formula is used, its assumptions must be disclosed. It is hoped that this flexibility will permit all financial services providers to be able to comply. The “request for proposal” process that is common in the industry will necessarily be tailored by the issuing plan sponsor or fiduciaries to seek and obtain the information that must be disclosed in order for the prohibited transaction exemption to apply. This may result in some modification of the process that financial services providers have come to know, but it will surely assist them in “getting their ducks in a row” when seeking new business. This should be helpful to all “bidders”. 17
  • 19. If a financial service provider is providing services in a fiduciary capacity, it must disclose that status under 408(b)(2). The payer of compensation to the service provider must then be disclosed. The disclosures, therefore, will be a little more comprehensive for fiduciaries. All in all, these rules portend opportunities to better organize a financial services provider’s function, to obtain additional avenues of revenue and to develop closer client relationships. To take advantage of the opportunities, financial service providers must be able to comply with the new rules in a cost effective way. The amount of effort needed to comply can be mitigated through various affiliations with industry support providers so that the process is smooth and complete. This information is provided for informational purposes only and should not be interpreted as legal, financial or other form of advice and no legal or business decision should be based on its content. About Broadridge Broadridge is a technology services company focused on global capital markets. Broadridge is the market leader enabling secure and accurate processing of information for communications and securities transactions among issuers, investors and financial intermediaries. Broadridge builds the infrastructure that underpins proxy services for over 90% of public companies and mutual funds in North America; processes more than $3 trillion in fixed income and equity trades per day; and saves companies billions annually through its technology solutions. For more information about Broadridge, please visit www.broadridge.com. 1 ERISA §§ 404 and 406 . 2 ERISA § 3(14). 3 ERISA § 406(a)(1)(C) . 4 For an IRA, the prohibited transaction “penalty” can be extreme, i.e., loss of its tax-exempt status. 5 ERISA §§ 3(14)(A) and 3(14)(C). 6 ERISA § 406(a)(1)(C). 7 FAQs About the 2009 Schedule C, Answer 6 (July 2008). 8 FAQs About the 2009 Schedule C, Answer 4 (July 2008). 9 Id. at Answer 3. 10 Supplemental FAQs About the 2009 Schedule C , Question and Answer 6 (October 2009); FAQs About the 2009 Schedule C, Answer 7 (July 2008). 11 Supplemental FAQs About the 2009 Schedule C, Answer 22 (October 2009). 12 FAQs About the 2009 Schedule C, Question 8 (July 2008). 13 FAQs About the 2009 Schedule C, Question 8. 14 Id. at Answer 8. 15 Id. at Answer 9. 16 Supplemental FAQs About the 2009 Schedule C , Question 8 (October 2009). 17 Id. at Answer 8. 18 Id. at Answer 8. 19 FAQs About the 2009 Schedule C , Question 35 (July 2008). 20 Id. at Answer 35. 21 Id. at Question 33. 22 Id. at Answer 33. 23 Supplemental FAQs About the 2009 Schedule C Answer 3 (October 2009). 24 Supplemental FAQs About the 2009 Schedule C Questions and Answers 2, 3 and 4 (October 2009). 25 ERISA Reg. 29 C.F.R. § 2550.408b-2(a). 26 ERISA Reg. 29 C.F.R. § 2550.408b-2(b). 27 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(i). 28 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(ii). 29 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii). 30 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii)(A). 31 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii)(D)(2). 32 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii)(D)(1). 33 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii)(B). 34 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iii)(C). 35 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1) (iii). 36 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(v). 37 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(v)(A)(2). 38 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(v)(A)(1). 39 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(v)(B). 40 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(vi)(A). 41 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(D). 42ERISA Reg. 29 C.F.R. § 2550.408b- 2(c)(1)(iv)(D)(1) and (2). 43 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(F). 44 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(viii)(B)(3). 45 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1) (iv)(C)(1). 46 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(C)(2). 47 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(C)(3). 48 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(C)(4). 49 ERISA Reg. 29 C.F.R. § 2550.408b-2(c)(1)(iv)(G). 50 http://www.ofr.gov/OFRUpload/OFRData/2010-25725_PI.pdf. 51 ERISA Reg. 6051(a)(14). 52 ERISA Reg. 2550.404a-5(b) (2). 53 ERISA Reg. 2550.404a-5(b)(2). 54 ERISA Reg. 2550.404a-5(d)(4). 55 ERISA Reg. 2550.404a-5(c)(1). 56 ERISA Reg. 2550.404a-5(c)(2). 57 ERISA Reg. 2550.404a-5(c)(3). 58 ERISA Reg. 2550.404a-5(d)(1)(i). 59 ERISA Reg. 2550.404a-5(d)(1)(ii). 60 ERISA Reg. 2550.404a-5(d)(1)(iii). 61 ERISA Reg. 2550.404a-5(d)(1)(iv). 62 ERISA Reg. 2550.404a- 5(d)(1)(v). 63 ERISA Reg. 2550.404a-5(d)(1)(vi). 64 ERISA Reg. 2550.404a-5(d)(2). ©2012 Broadridge Financial Solutions, Inc. Broadridge and the Broadridge logo are registered trademarks of Broadridge Financial Solutions, Inc. All rights reserved. 18

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