Publications: Labor department unveils the new regulations behind 401(k) plans

With true pension plans gradually disappearing, most workers come to rely on savings in 401(k) plans.  Investment in 401(k) plans, however, does not come cheap.  The U.S. Department of Labor (DOL) has long voiced concerns about growing expenses and lack of transparency in 401(k) plans. 

Administrators of 401(k) plans (typically a committee comprised of officers and employees of the plan sponsor) are charged with a duty to select and monitor service providers and plan investment options in a prudent manner. Yet, until now, they did not have a complete picture of the fees that plan participants pay in connection with their investments.  Shrouded in even more mystery are various revenue streams that plan vendors receive from various sources in connection with the services they provide to 401(k) plans.

To alleviate concerns about high plan fees that eat into workers’ savings, the Department of Labor (DOL) in the last three years came out with two important pieces of regulatory guidance. As of July 1, certain providers of services to 401(k) plans must disclose all direct and indirect compensation they receive in connection with their services to the plans. In turn, administrators of 401(k) plans must advise plan participants of administrative and investment fees and expenses that may be charged to their accounts. For most plans, the initial participant-level disclosure will be made by Aug. 30 of this year. A real sticker shock, however, will come with quarterly statements that participants and beneficiaries in 401(k) plans will receive sometime this fall. The statements must show all plan expenses related to plan administration, participant-initiated transactions or participant investment choices.

To give teeth to the fee disclosure requirements, the DOL cautioned that any service arrangement with a noncompliant service provider would result in a “prohibited transaction.” An outright prohibition on certain types of transactions involving employer retirement plans (i.e., “prohibited transactions”) has been around since the enactment of the Employee Retirement Income Security Act of 1974 (ERISA). It is designed to prohibit the “fleecing” of retirement plans by greedy vendors or vendors who have “inside connections” with the plan’s fiduciaries.

A service relationship between an ERISA plan and its service provider gives rise to a prohibited transaction unless the service arrangement is reasonable as defined under Section 408(b)(2) of ERISA. According to the DOL regulations, an arrangement is not reasonable unless the service provider discloses its service compensation to a responsible plan fiduciary. A delinquent provider will be subject to a 15 percent excise tax on the amount involved in the transaction for each year of the failure, plus an additional 100 percent excise tax if the failure is not timely corrected.  Fiduciaries that cause the plan to enter into such service arrangement can face lawsuits and civil penalties. While the regulations allow for innocent mistakes, the service providers must act quickly to rectify mishaps in providing full disclosure of their compensation structure. Similarly, an innocent, well-meaning fiduciary may avoid penalties by promptly requesting the missing information, reporting the provider’s failure as a prohibited transaction and, if the service provider does not provide information within three months of the request, informing the Secretary of Labor of the failure. In addition, if the information is not forthcoming within the three-month period, the plan fiduciary must determine whether it is prudent to continue the service arrangement.  If the information in question relates to future services, the fiduciary must terminate the arrangement as expeditiously as possible.

Not all providers must disclose their compensation to plan fiduciaries.  The types of providers covered by the regulations (covered service providers or CSPs) include fiduciaries and registered investment advisers providing services directly to the plan. Record keepers and brokerdealers are subject to the disclosure requirements only if they offer investment options to a participant-directed individual account plan (e.g., a platform provider for a 401(k) plan permitting participants to direct their investments). Providers of other services are only covered if they receive compensation from any source other than the plan, the plan sponsor, any CSP or CSP’s affiliates or subcontractors under a subcontractor agreement (indirect compensation). For example, a plan’s investment consultant who receives 12 b-1 commissions from a mutual fund would be receiving “indirect compensation” and would be required to disclose it. Another category of vendors whose compensation may require disclosure includes investment advisors or managers of collective trusts, hedge funds or separate insurance accounts (and similar products issued by nonregistered issuers) if these products have a high volume of retirement plan investors. 

Information to be disclosed generally includes a description of the services to be provided and any direct and indirect compensation expected to be received by the service provider and its affiliates and subcontractors over the life of the service arrangement.  The DOL’s view of compensation to be received in connection with the services is very broad. For example, if an investment adviser holds a seminar for its clients (i.e., plan fiduciaries) in the course of which the adviser may recommend to the clients certain financial companies, and those financial companies happen to subsidize the seminar, the adviser would be required to disclose the subsidies to the clients. 

Compensation for these purposes includes all monetary and any nonmonetary compensation valued over $250 in the aggregate during the term of the arrangement. 

Although the DOL refrained from requiring a specific level of detail in some instances (e.g., in describing the services or broker compensation), it cautioned plan fiduciaries that as a matter of prudence they should seek help from CSPs or elsewhere to obtain additional information, evaluate the information received and identify any unreasonable compensation or conflict of interests. In most cases, vendors tend to be vague in describing their services. It behooves the plan fiduciaries then to demand a detailed list of services covered by the agreement, the types of compensation arrangements among service providers and the amount of compensation to be received in connection with the service arrangement.

Reprinted with permission from the Chicago Daily Law Bulletin.