New 408(b)(2) “Guide”: Not Necessarily What 401k Plan Sponsors Hoped For

May 08
00:02 2012

During fi360’s Annual Conference last month, well respected ERISA attorney Fred Reish offered to a house full of professional fiduciaries some rather startling revelations concerning the DOL’s new Fee Disclosure Rule. This much anticipated Rule, often referred to simply as 408(b)(2), goes effective as of July 1, 2012. As Reish said, the Rule may turn out to be more hazardous than helpful to 401k plan sponsors. He didn’t leave the crowd without some potential solutions, however, as the reader will soon discover.

As a hint, Reish began by reiterating how ERISA refers to plan expenses. He pointed out that, under ERISA section 404(a)(1)(A), a fiduciary’s duties must be carried out for the “exclusive purpose of… providing benefits to participants and their beneficiaries.” He reminded the audience, this section also contains specific language allowing plan sponsors to defray the “reasonable expenses of administering the plan.”

In referring to this section part, Reish noted 408(b)(2) permits normally prohibited transactions providing “contracting or making reasonable arrangements with a party in interest for… services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor.” Of course, with the new Fee Disclosure Rule, compensation to a covered service provider is no longer “reasonable” unless 408(b)(2) is satisfied. The DOL’s Fact Sheet on the rule defines “covered service provider” in this manner:

“The final rule applies to covered service providers who expect at least $1,000 in compensation to be received for services to a covered plan. The final rule applies to the following covered service providers:

ERISA fiduciary service providers to a covered plan or to a ‘plan asset’ vehicle in which such plan invests;

  • Investment advisers registered under Federal or State law;
  • Record-keepers or brokers who make designated investment alternatives available to the covered plan (e.g., a ‘platform provider’);
  • Providers of one or more of the following services to the covered plan who also receive ‘indirect compensation’ in connection with such services:
    • Accounting, auditing, actuarial, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities brokerage, third party administration, or valuation services.”

The disclosures include not just direct and indirect compensation, but also a specification of services and status.

Here’s the first concern Reish brought up: The regulation doesn’t currently require disclosures be made in any particular format. Since the presentation, the DOL has published a FAQ “guide,” but, again, that guide does not endorse any particular format. The result, warned Reish, is that multiple documents may be used. In an interview following his presentation, Reish told, “I am worried that many plan sponsors/fiduciaries will not make the effort to wade through hundreds of pages of printed materials to locate and understand the fees and costs….and therefore will not evaluate those costs.” He, however, leaves us with this hopeful expection: “Fortunately, advisers who are focused on retirement plans will help many of those sponsors by using benchmarking services.”

In fact, service providers are already starting to release disclosures in just such an expansive manner. Sam Paglioni, Partner at Integer Wealth Advisors Group, LLC in Kennesaw, Georgia, has firsthand experience of the consequences Reish warns of. Paglioni recently obtained a fee disclosure from an insurance company. Of the report, which “stretched out over 15 pages,” he says, “It will be left up to the client to try and parse the information.” He says the report also contains and extensive fee chart with a myriad of fees. “All I was looking for, for our client, was somewhere that organizes it all for the client: Here’s what we are paid, here’s what they are paid…..nothing, they do not ‘roll up’ anything into separate numbers,” says Paglioni. “Now, they do outline the mutual funds used and break that out accordingly, but they do not bother to ‘wrap it up’ for the client. The client will have to go and figure it all out (which is what I’ll do).”

At his fi360 presentation, Reish said, “Any description or estimate must contain sufficient information to permit evaluation of the reasonableness of the compensation.” Based on the materials Paglioni saw, the adviser says, “In the end, I believe if you have a plan with an insurance company….good luck figuring it out.”

Reish believes, once the Fee Disclosure Rule becomes effective, plan investment committees will need to engage in a “prudent process” to evaluate the following four issues:

  1. Is the compensation reasonable?
  2. Are the costs reasonable?
  3. Are the services adequate/appropriate?
  4. Are the conflicts manageable?

Because it’s the easiest to measure, Reish fears plan sponsors will place undue emphasis on fees alone, and not the value associated with those fees. He sees this as a “race to the bottom.” He told, “Some plan sponsors will never hear the correct message, which is that plan money must be used to buy value for the participants. However, for plan sponsors who are willing to listen, the message is that both the company and the employees will benefit from a plan with quality services that produce high participation rates, larger deferrals, and well invested participants (i.e., in portfolios)….and that it is ok to pay for that.”

Once DOL regulation 2550.404a-5 (reporting fees to participants) kicks in sometime after August 30, 2012, Reish sees the burden falling on recordkeepers. Unfortunately, this, like the fee disclosure to plan sponsors, has its own set of problems. For one thing, the DOL requires only direct expenses be reported to participants. Reish says this regulation “only applies to payments directly charged to participant accounts. It does not include the expense ratios of investments or anything paid from those expense ratios.” Since 12b-1 fees and revenue sharing can be part of the expense ratio, it’s not clear how the plan participant will be able to determine whether conflicts of interest exist within certain investment options.

In the May 7th 2012 release of the above mentioned FAQ, the DOL states: “Paragraph (c)(2)(ii)(C) of the regulation requires at least quarterly ‘[i]f applicable, an explanation that, in addition to the fees and expenses disclosed pursuant to paragraph (c)(2)(ii) of this section, 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 . . . [.]’ Some individuals have interpreted this provision to apply only if the plan allocates some fees or expenses to individuals’ accounts. Under this interpretation, if all administrative expenses are paid from such revenue sharing and there are no actual charges to individual plan accounts, the explanation is not required. The Department does not agree with this interpretation.”

Still, it is not clear if this will allow the plan sponsor to adequately communicate the relevant conflict of interest information caused by revenue sharing and 12b-1 fees to the participant. If the plan sponsor is aware of these conflicts of interest and fails to adequately communicate that fact to plan participants, well, let’s just say that’s not the best possible scenario.

Finally, Reish bluntly stated the most treacherous aspect of 408(b)(2) for 401k plan sponsors. A plan sponsor is obligated to give service providers only 90 days to comply with the new Fee Disclosure Rule. If the plan sponsor’s subsequent paper chase fails to produce the correct paperwork, then, per the DOL, the plan sponsor must fire the service provider. If the plan sponsor fails to fire a non-compliant service provider, then the plan sponsor is also non-compliant and is subject to punitive action on the part of the DOL.

At the close of his presentation, Reish showed the audience a cartoon with this caption: “Another advantage of increased regulations is creating thousands of jobs for lawyers.” After the chuckle, he left them with some good news. Complying with 408(b)(2) is rather straight-forward if you dot your i’s and cross your t’s. It’s only if your procedures are sloppy that you can get into trouble. Don’t place too much weight on fees, but instead concentrate on the value the plan derives from the services associated with those fees. In the end, despite allowances that may “justify” them, the safest thing to do is to avoid all conflicts of interest.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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