Sponsors of Participant-Directed 401(k) Plans Should Not Ignore the Proposed Disclosure Requirements

Employers sponsoring participant-directed 401(k) plans face a quandary with respect to all the new fee disclosure requirements being put forth by the Department of Labor. While it is clear that there will be extensive new rules for plan sponsors requiring disclosure of plan and service provider fees to participants, gathering of fee data from service providers in order to make reasonable decisions, and reporting of fee information to the government, it is far from clear when these rules will be effective.

The Department of Labor has proposed that these new rules be effective for plan years beginning in 2009. However, most of the regulations are not yet final and there is an intervening presidential election between now and Jan. 1, 2009. (Democratic leaders in the House of Representatives have made clear that they do not think the current proposed regulations go far enough.) The Department of Labor has made clear that it intends to try to issue all the regulations in final form by the time the Bush administration leaves office in January 2009, but even if they were issued tomorrow (and they won't be) it is already too late for sponsors and service providers to update reporting systems before the beginning of the 2009 plan year.

So let us assume, for reality's sake, that most of the guidance will not be effective until at least the 2010 plan year. The question then becomes whether there is something participant-directed 401(k) plan sponsors and service providers to 401(k) plans should be doing to be ready for the 2010 plan year. Making system changes seems premature. There are still too many unanswered questions and too much likelihood of changing requirements.

However, the Department of Labor, while specifically not taking a position on the issue of a fiduciary's obligation in the past, makes clear that it believes that sponsors of participant-directed 401(k) plans have a basic fiduciary duty to provide information on returns and fees to those participants. Thus, while it may be too early to change computer systems and reporting structures, plan sponsors should not wait for final guidance to take reasonable and prudent steps to gather and provide the earnings and fee information that is currently available. High 401(k) fees have been the subject of a number of large class action lawsuits, and further litigation is not going to wait for final regulations.

Background

The Department of Labor has approached fee disclosure as having three components. First, the Department made changes to the 2009 annual report (Schedule C of Form 5500) that plans must file with the government to require reporting of direct and indirect fees paid by the plan in the prior year. Second, the Department proposed a regulation and an amended class exemption addressing the information that plan fiduciaries must obtain (and service providers must provide) so that fiduciaries can determine that the fees the plan will be paying service providers will be reasonable and thus not prohibited. Third, the Department proposed regulations addressing the information on fees the plan must provide participants and beneficiaries who are directing their own investments.

Schedule C of Form 5500 Reporting to the Government

Generally, plan administrators of pension and welfare plans with 100 or more participants (“large plans”) must report fee information on the Schedule C as part of the annual Form 5500 financial reports. The 2009 Schedule C requires reporting of fees that the plan actually paid during the plan year whether those are direct or indirect payments (see below for a description of direct and indirect fees). While plan administrators do not need to complete the 2009 Schedule C until some time in 2010, the information reported is information for the plan year commencing in 2009.

The plan administrator must report all “direct compensation” and, with certain exemptions, all “indirect compensation” compensation if the amount exceeds $5,000 in the plan year. “Direct compensation” is essentially amounts paid directly by the plan to a service provider or amounts paid by the employer directly to the service provider and reimbursed by the plan. “Indirect compensation” is essentially fees once or more removed from the plan or employer. For example, if the mutual fund in which a plan invests pays fees that are charged against the fund and reflected in the fund's return, these are indirect fees. Generally, these include investment management fees, securities brokerage commissions (including “soft dollar” commissions), float revenue, and other asset-based fees such as shareholder servicing fees, 12b-1 fees, and wrap fees if charged in addition to the investment management fee. There is an exception for reporting in the case of certain “bundled” services and an alternative, simplified reporting option for certain types of indirect compensation.

In response to numerous questions regarding its instructions for completing the 2009 Form 5500 Schedule C, DOL issued, on July 14, 2008, 40 FAQs providing additional guidance. The most significant FAQ (FAQ-40) provides broad relief for situations where the service provider is unable to provide fee information to the plan administrator for the 2009
year despite good faith efforts to make necessary record keeping and information system changes in a timely manner. In that case, the plan administrator does not have to list the service provider on the Schedule C as failing to provide information if the service provider provides the plan administrator with a statement of its good faith efforts.

Proposed Regulations: Disclosure to Fiduciaries

ERISA (and the Internal Revenue Code) prohibits transactions between an employee benefit plan and a “party-in-interest” (“disqualified person”) even if that transaction is at fair market value. Anyone providing services to the plan (such as keeping records, advising on investments, processing benefit payments, etc.) is a party-in-interest (disqualified person) and thus is prohibited from providing the services absent the existence of an exemption. Section 408(b)(2) of ERISA provides a statutory exemption if the contract entered into between the plan fiduciary and the service provider is reasonable, the services are necessary for the establishment or operation of the plan, and the plan does not pay more than reasonable compensation for the services.

The Department's proposed regulation expands on the meaning of the requirement that any contract be “reasonable.” Current regulations essentially interpret “reasonable” as meaning that the plan could terminate the contract on reasonably short notice without penalty. The Department is now proposing that for a contract to be “reasonable,” it must require that the service provider disclose to the plan fiduciary entering into or renewing the contract (the “responsible fiduciary”) certain specified information on investment returns and fees. It believes that without information on all compensation to be received by the service provider (directly or indirectly) and any conflicts of interest that may adversely affect the service provider's performance under the contract, the responsible fiduciary cannot carry out its fiduciary duty. Accordingly, the proposed regulation conditions the availability of the statutory exemption from prohibited transactions on the service provider providing such information prior to the fee being imposed.

Proposed Regulations: Participant Disclosure

The Department interprets Section 404(a)(1) of ERISA as requiring plan fiduciaries to take steps to ensure that participants and beneficiaries who have been allocated responsibility for investing their accounts are made aware of their rights and responsibilities with respect to the investment of the assets in the account. Plan fiduciaries must also provide participants with sufficient information regarding the plan and designated investment alternatives available under the plan, including in both cases fees and expenses, so that participants can make informed decisions before entering into an investment.

In the preamble to the proposed regulation, the Department makes clear that it believes that fiduciaries of self-directed plans under Section 404(c) of ERISA should have been complying with similar requirements already. However, the Department specifically states that it is expressing no views with respect to self-directed plans that did not comply with Section 404(c) as to the specific information that should have been furnished to participants and beneficiaries in any time period before the new regulation is finalized.

Under the proposed regulations, plans must provide participants with “plan-related” information, which the regulations separate into general plan information, administrative expense information, and individual expense information. Administrative expense information includes any fees and expenses for plan administrative services (e.g., legal, accounting, record keeping) that to the extent not included in investment-related fees and expenses may be charged against the individual accounts. Individual expense information is defined as fees charged on an individual basis such as fees related to processing loans to participants or qualified domestic relations orders.

Plans must also provide investment-related information. The plan must provide certain basic information with respect to each designated investment alternative offered under the plan. The information must include the name and category (e.g., money market mutual fund, balanced fund) of the investment alternative, and whether the investment is actively or passively invested. The plan must also provide the address of the Web site for the investment at which the participant may get more information and performance data for each investment alternative.

The proposed regulation includes an Appendix providing a model comparative format. Plans are not required to use the model; however, those that do will be considered to have satisfied the requirements of the regulation.

Conclusion

Plan sponsors cannot simply ignore the proposed regulations hoping they will go away or be weakened. While it is highly likely that the final regulations will have a delayed effective date and quite possibly require different information breakdowns than the proposed, it is clear that disclosure will be required and indeed may already be required under general fiduciary principles even in the absence of final regulations. This is especially true with respect to participant-directed 401(k) plans.

The most prudent course at this time is for plan sponsors of participant-directed 401(k) plans to talk with their service providers to see what fee information the service providers can, or are willing, to provide immediately. If service providers are not willing to provide more detailed information, sponsors should consider whether they need to change service providers. It is possible that while we wait for final regulations, market competition may lead some service providers to try to compete by promising greater fee disclosure. Whether switching service providers for a short-term information advantage is prudent is something plan sponsors will have to weigh.

Stuart A. Sirkin is an Executive Director in the Compensation and Benefits practice of Ernst & Young LLP's National Tax Office. Sirkin joined Ernst Young LLP in January 2007 after retiring from the federal government, where he held senior positions in the pension programs of Labor, IRS, and the Pension Benefit Guaranty Corporation. He also served on the Senate Finance Committee during passage of the Pension Protection Act of 2006. Sirkin is Vice-Chair of the ABA's Tax Section's Subcommittee on Defined Benefit Plans and a charter fellow of the College of Employee Benefits Counsel.

Employers sponsoring participant-directed 401(k) plans face a quandary with respect to all the new fee disclosure requirements being put forth by the Department of Labor. While it is clear that there will be extensive new rules for plan sponsors requiring disclosure of plan and service provider fees to participants, gathering of fee data from service providers in order to make reasonable decisions, and reporting of fee information to the government, it is far from clear when these rules will be effective.

The Department of Labor has proposed that these new rules be effective for plan years beginning in 2009. However, most of the regulations are not yet final and there is an intervening presidential election between now and Jan. 1, 2009. (Democratic leaders in the House of Representatives have made clear that they do not think the current proposed regulations go far enough.) The Department of Labor has made clear that it intends to try to issue all the regulations in final form by the time the Bush administration leaves office in January 2009, but even if they were issued tomorrow (and they won't be) it is already too late for sponsors and service providers to update reporting systems before the beginning of the 2009 plan year.

So let us assume, for reality's sake, that most of the guidance will not be effective until at least the 2010 plan year. The question then becomes whether there is something participant-directed 401(k) plan sponsors and service providers to 401(k) plans should be doing to be ready for the 2010 plan year. Making system changes seems premature. There are still too many unanswered questions and too much likelihood of changing requirements.

However, the Department of Labor, while specifically not taking a position on the issue of a fiduciary's obligation in the past, makes clear that it believes that sponsors of participant-directed 401(k) plans have a basic fiduciary duty to provide information on returns and fees to those participants. Thus, while it may be too early to change computer systems and reporting structures, plan sponsors should not wait for final guidance to take reasonable and prudent steps to gather and provide the earnings and fee information that is currently available. High 401(k) fees have been the subject of a number of large class action lawsuits, and further litigation is not going to wait for final regulations.

Background

The Department of Labor has approached fee disclosure as having three components. First, the Department made changes to the 2009 annual report (Schedule C of Form 5500) that plans must file with the government to require reporting of direct and indirect fees paid by the plan in the prior year. Second, the Department proposed a regulation and an amended class exemption addressing the information that plan fiduciaries must obtain (and service providers must provide) so that fiduciaries can determine that the fees the plan will be paying service providers will be reasonable and thus not prohibited. Third, the Department proposed regulations addressing the information on fees the plan must provide participants and beneficiaries who are directing their own investments.

Schedule C of Form 5500 Reporting to the Government

Generally, plan administrators of pension and welfare plans with 100 or more participants (“large plans”) must report fee information on the Schedule C as part of the annual Form 5500 financial reports. The 2009 Schedule C requires reporting of fees that the plan actually paid during the plan year whether those are direct or indirect payments (see below for a description of direct and indirect fees). While plan administrators do not need to complete the 2009 Schedule C until some time in 2010, the information reported is information for the plan year commencing in 2009.

The plan administrator must report all “direct compensation” and, with certain exemptions, all “indirect compensation” compensation if the amount exceeds $5,000 in the plan year. “Direct compensation” is essentially amounts paid directly by the plan to a service provider or amounts paid by the employer directly to the service provider and reimbursed by the plan. “Indirect compensation” is essentially fees once or more removed from the plan or employer. For example, if the mutual fund in which a plan invests pays fees that are charged against the fund and reflected in the fund's return, these are indirect fees. Generally, these include investment management fees, securities brokerage commissions (including “soft dollar” commissions), float revenue, and other asset-based fees such as shareholder servicing fees, 12b-1 fees, and wrap fees if charged in addition to the investment management fee. There is an exception for reporting in the case of certain “bundled” services and an alternative, simplified reporting option for certain types of indirect compensation.

In response to numerous questions regarding its instructions for completing the 2009 Form 5500 Schedule C, DOL issued, on July 14, 2008, 40 FAQs providing additional guidance. The most significant FAQ (FAQ-40) provides broad relief for situations where the service provider is unable to provide fee information to the plan administrator for the 2009
year despite good faith efforts to make necessary record keeping and information system changes in a timely manner. In that case, the plan administrator does not have to list the service provider on the Schedule C as failing to provide information if the service provider provides the plan administrator with a statement of its good faith efforts.

Proposed Regulations: Disclosure to Fiduciaries

ERISA (and the Internal Revenue Code) prohibits transactions between an employee benefit plan and a “party-in-interest” (“disqualified person”) even if that transaction is at fair market value. Anyone providing services to the plan (such as keeping records, advising on investments, processing benefit payments, etc.) is a party-in-interest (disqualified person) and thus is prohibited from providing the services absent the existence of an exemption. Section 408(b)(2) of ERISA provides a statutory exemption if the contract entered into between the plan fiduciary and the service provider is reasonable, the services are necessary for the establishment or operation of the plan, and the plan does not pay more than reasonable compensation for the services.

The Department's proposed regulation expands on the meaning of the requirement that any contract be “reasonable.” Current regulations essentially interpret “reasonable” as meaning that the plan could terminate the contract on reasonably short notice without penalty. The Department is now proposing that for a contract to be “reasonable,” it must require that the service provider disclose to the plan fiduciary entering into or renewing the contract (the “responsible fiduciary”) certain specified information on investment returns and fees. It believes that without information on all compensation to be received by the service provider (directly or indirectly) and any conflicts of interest that may adversely affect the service provider's performance under the contract, the responsible fiduciary cannot carry out its fiduciary duty. Accordingly, the proposed regulation conditions the availability of the statutory exemption from prohibited transactions on the service provider providing such information prior to the fee being imposed.

Proposed Regulations: Participant Disclosure

The Department interprets Section 404(a)(1) of ERISA as requiring plan fiduciaries to take steps to ensure that participants and beneficiaries who have been allocated responsibility for investing their accounts are made aware of their rights and responsibilities with respect to the investment of the assets in the account. Plan fiduciaries must also provide participants with sufficient information regarding the plan and designated investment alternatives available under the plan, including in both cases fees and expenses, so that participants can make informed decisions before entering into an investment.

In the preamble to the proposed regulation, the Department makes clear that it believes that fiduciaries of self-directed plans under Section 404(c) of ERISA should have been complying with similar requirements already. However, the Department specifically states that it is expressing no views with respect to self-directed plans that did not comply with Section 404(c) as to the specific information that should have been furnished to participants and beneficiaries in any time period before the new regulation is finalized.

Under the proposed regulations, plans must provide participants with “plan-related” information, which the regulations separate into general plan information, administrative expense information, and individual expense information. Administrative expense information includes any fees and expenses for plan administrative services (e.g., legal, accounting, record keeping) that to the extent not included in investment-related fees and expenses may be charged against the individual accounts. Individual expense information is defined as fees charged on an individual basis such as fees related to processing loans to participants or qualified domestic relations orders.

Plans must also provide investment-related information. The plan must provide certain basic information with respect to each designated investment alternative offered under the plan. The information must include the name and category (e.g., money market mutual fund, balanced fund) of the investment alternative, and whether the investment is actively or passively invested. The plan must also provide the address of the Web site for the investment at which the participant may get more information and performance data for each investment alternative.

The proposed regulation includes an Appendix providing a model comparative format. Plans are not required to use the model; however, those that do will be considered to have satisfied the requirements of the regulation.

Conclusion

Plan sponsors cannot simply ignore the proposed regulations hoping they will go away or be weakened. While it is highly likely that the final regulations will have a delayed effective date and quite possibly require different information breakdowns than the proposed, it is clear that disclosure will be required and indeed may already be required under general fiduciary principles even in the absence of final regulations. This is especially true with respect to participant-directed 401(k) plans.

The most prudent course at this time is for plan sponsors of participant-directed 401(k) plans to talk with their service providers to see what fee information the service providers can, or are willing, to provide immediately. If service providers are not willing to provide more detailed information, sponsors should consider whether they need to change service providers. It is possible that while we wait for final regulations, market competition may lead some service providers to try to compete by promising greater fee disclosure. Whether switching service providers for a short-term information advantage is prudent is something plan sponsors will have to weigh.

Stuart A. Sirkin is an Executive Director in the Compensation and Benefits practice of Ernst & Young LLP's National Tax Office. Sirkin joined Ernst Young LLP in January 2007 after retiring from the federal government, where he held senior positions in the pension programs of Labor, IRS, and the Pension Benefit Guaranty Corporation. He also served on the Senate Finance Committee during passage of the Pension Protection Act of 2006. Sirkin is Vice-Chair of the ABA's Tax Section's Subcommittee on Defined Benefit Plans and a charter fellow of the College of Employee Benefits Counsel.