Plan Sponsors Must Now Obtain Information About Usually “Hidden” Costs

July 2010

The Department of Labor (DOL) issued “interim final” fee disclosure regulations that apply to ERISA pension plans, including most notably 401(k) plans. The new regulation requires each plan service provider to disclose specified information in writing to the plan sponsor. The disclosed information includes:

1. A description of the services to be provided;
2. All direct and indirect compensation to be received by the service provider, its affiliates and subcontractors ; and
3. Whether the service provider is a fiduciary to the plan.

When multiple "bundled" services are provided as a package, the compensation for each service must be separately disclosed. Such separate disclosure includes commissions, soft dollars, finder's fees, 12b-1 fees, or other compensation based on business generated, including those charged directly against the plan's investments. Such disclosure must identify (i) the services for which the compensation is paid, and (ii) when affiliates or subcontractors are involved, the payer and the recipient. If recordkeeping services are provided in the bundle, the service provider must furnish (i) an estimate of the cost to the plan of such recordkeeping services and (ii) an explanation of the methodology and assumptions used to prepare the estimate. Estimates must take into account rates the service provider charges to unrelated third parties or the prevailing market rates charged for similar services to similar plans.

This new rule amends the regulation under ERISA section 408(b)(2) regarding the meaning of a ‘‘reasonable’’ contract. The existing regulation states only that an arrangement is not reasonable unless it permits the plan to terminate without penalty on reasonably short notice. In other words, one could previously be otherwise entirely unreasonable, so long as the plan could get out of the arrangement relatively quickly. As before, if the new ERISA section 408(b)(2) rules are not followed, the transaction will be a prohibited under ERISA, which is then subject to excise taxes under Code Section 4975.

The rules apply to any service provider who is paid more than $1,000. The rules will take effect July 16, 2011 for new and existing contracts.

The new rule finalizes the regulation originally proposed in 2007 by the Bush administration, although now changed to address substantial comments received about the initial proposal. Additional comments on the “final” rules will be accepted until August 30, 2010. However, don’t expect any important changes at this point.

Parts of these rules are similar to legislation proposed by Representative. George Miller (D-CA), who was unsuccessful in getting 401(k) fee legislation passed. Reports at the time Miller’s legislation was stripped from a larger bill said Congress was letting the DOL address the issue of fee disclosure. That is now happening. With this in mind, a second regulation is expected to be finalized in a few months that will require plan sponsors to provide workers with details of costs that employee accounts are directly or indirectly charged.

Recent Court Case Causes Additional Concern for 401(k) Sponsors

Plan sponsors have an additional incentive for addressing plan costs based on a July 2010 ruling from a Central District of California court in re: Tibble vs. Edison International (SCE) (case CV 07-5359 SVW). Judge Stephen Wilson became the first judge to rule for plan participants, and thereby buck the trend established by most other courts that supported plan sponsors. For background information see 401(k) Fee and Disclosure Litigation Gets a Boost.

The situation that gave rise to SCE’s situation is common. The Court described the background as follows:

““Before the addition of the mutual funds to the Plan in 1999, SCE paid the entire cost of Hewitt Associates’ record-keeping services. These services include things such as mailing prospectuses, maintaining individual account balances, providing participant statements, operating a website accessible by Plan participants that allows participants to conduct transactions and obtain information about the Plan’s investment options, and answering inquiries from Plan participants regarding their investment options. The fees for these services were paid by SCE, not the Plan participants.

With the addition of the mutual funds to the Plan, however, certain “revenue sharing” was made available to SCE that could be used to offset the cost of Hewitt Associates’ record-keeping expenses. “Revenue sharing” is a general term that refers to the practice by which mutual funds collect fees from mutual fund assets and distribute them to service providers, such as recordkeepers and trustees - services the mutual funds would otherwise provide themselves. Revenue sharing comes from so-called “12b-1" fees, which are fees that mutual fund investment managers charge to investors in order to pay for distribution expenses and shareholder service expenses….In short, revenue sharing offsets some of the fees SCE would otherwise pay. …”

The 12b-1 fees and related revenue sharing occurs with retail mutual fund share classes. (See 12b-1 fee for background and other changes being required by the SEC.) Like any large investor, an identical mutual fund investment is often available to “institutional” investors. The Court objected to the use of higher-cost retail shares, which in turn provided the opportunity for revenue sharing, as follows:

“The Court concludes that Defendants violated their duty of prudence under U.S.C. § 1104(a) by choosing to invest in the retail share class rather than the institutional share class … The Plan fiduciaries simply failed to consider the cheaper institutional share classes when they chose to invest in the retail share classes ... Defendants have not offered any credible explanation for why the retail share classes were selected instead of the institutional share classes. In light of the fact that the institutional share classes offered the exact same investment at a lower fee, a prudent fiduciary acting in a like capacity would have invested in the institutional share classes.”

Prior to the Tibble decision, plaintiffs in a number of other recent cases were unsuccessful in claiming that plan fiduciaries breached their duties under ERISA by offering only retail share classes as investment options. In light of Tibble, retirement plan fiduciaries should revisit their retail-class fund offerings to determine whether the investigations behind those offerings were prudent. Regardless of how past decisions occurred, the plan sponsor should approach the investment vendor to determine the availability of institutional share classes.

Critics have long charged that 401(k) participants do not have a clear sense of the fees and expenses charged by plan providers. Over time, these costs make a sizable difference in the amount of money left in the account for retirement. Plan sponsors will need to scrutinize the cost disclosures they will receive from their vendors, and address whether changes are appropriate.

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