Publications

Labor Department reviews Revenue Sharing Arrangements

By Sheldon M. Geller, CPA, Geller Group Ltd.

SHELDON M. GELLER, CPA, pension attorney, is a shareholder in the benefits consulting firm of Geller Group Ltd. Mr. Geller wishes to acknowledge the assistance of J. Michael Bermensolo, a senior pension attorney with Geller Group Ltd., in preparing this article.

In an effort to determine what, if any, additional actions are needed to ensure employees receive value on their retirement investments, the Pension and Welfare Benefits Administration (PWBA) is reviewing a number of issues, including (i) whether a plan sponsor and participants understand the fees and expenses they are paying, (ii) what information is disclosed about fees and whether there is a need for more disclosure of fee information, and (iii) what practices plan sponsors are following to ensure that plan participants are not paying excessive fees for their investments.

This initiative includes determining whether plan sponsors are meeting their fiduciary responsibility, and thus the PWBA has developed a consumer publication to help employers and employees understand the costs associated with plan investments.

The popularity of 401(k) plans is part of the reason the PWBA decided to examine 401(k) plan fees. The number of plans has grown from 17,000 plans in 1984 to 175,000 in 1994, with more than 25 million workers putting more than $1 trillion into 401(k) accounts.

The PWBA attributes the examination of fees to a "robust economy and a booming stock market," which have resulted in double-digit returns for 401(k) plans. The PWBA is concerned the high returns earned on plan investments may be masking the fees paid for such investments.

Education vs. Mandatory Disclosure

The approach taken by the PWBA is one of education. The Employee Retirement Income Security Act (ERISA) already imposes a duty on plan fiduciaries to act prudently and solely in the interest of the plan's participants and beneficiaries. An inherent component of this requirement is that fees charged to a plan must be "reasonable." The tools released by the PWBA are designed to remind the fiduciaries of this responsibility and to provide a simple and uniform format to make the determination and comparison of fees as comprehensive as possible.

The tools consist of two components. First, the PWBA issued a pamphlet called "A Look at 401 (k) Fees . . . for Employers," that reminds employers of their fiduciary obligations, including the requirement that fees be reasonable. In addition, a list of 10 basic questions, as described below, is provided to help employees focus on the fees and expenses being charged.

The second tool available to employers is the "401(k) Plan Fee Disclosure Form." This is a worksheet that enables employers to fill in all fees being charged. The form is comprehensive and contemplates fees such as initial start-up costs, investment fees (including 12b-1 and management fees), recordkeeping and compliance costs, and costs associated with the termination of the use of a particular service provider. The expectation is that this form will enable employers to make an accurate comparison of all of the fees being charged to the plan.

Fiduciary Standards Pamphlet

The pamphlet, which employers may use in conjunction with the disclosure form, highlights the overall obligations employers must fulfill when operating a plan. It describes the various fiduciary standards that employers must comply with under federal pension law, including the employers' obligation to ensure that fees paid by 401(k) plans are reasonable. The pamphlet includes 10 basic questions employers should ask themselves in considering fees and expenses paid for services:

1. Has the employer given each of its prospective service providers complete and identical information with regard to its plan?

2. Does the employer know what features it wants to provide (e.g., loans, number of investment options, types of investments, Internet trading) ?

3. Has the employer decided which fees and expenses it, as plan sponsor, will pay, which its employees will pay, and/or which will be shared?

4. Does the employer know which fees and expenses are charged directly to the plan and which are deducted from investment returns?

5. Does the employer know what services are covered under the base fee and what services incur an extra charge? Does it know what the fees are for extra or customized services?

6. Does the employer understand that some investment options have higher fees than others because of the nature of the investment?

7. Does the prospective service arrangement have any restrictions, such as charges for early termination of the employer's relationship with the provider?

8. Does the prospective arrangement assist employees in making informed investment decisions for their individual accounts (e.g., providing investment education, information on fees, and the like) and the charge for this service?

9. Has the employer considered asking potential providers to present uniform fee information that includes all fees charged?

l0. What information will the employer receive on a regular basis from the prospective provider so that it can monitor the provision of services and the investments that it selects and make changes, if necessary?

Thus, the PWBA has provided employers with tools to ensure that fees charged to a qualified plan by service providers are reasonable and has thereby helped employers to satisfy their fiduciary responsibility to participants.

There is no type of mandatory fee disclosure at this time. It is the employer's obligation to review fees and use the new PWBA form and pamphlet. Perhaps some service providers will actually supply the form to prospective clients thereby encouraging employers to compare fees and services.

Fee Disclosure Form

The "401(k) Plan Fee Disclosure Form" is in a flexible format that employers can use in whole or in part, depending on its type of plan investments and services. In addition, the form provides employers with a handy way to make cost-effective decisions and compare the investment fees and administrative costs of competing providers of plan servlces.

The 401(k) fee form contains basic information employers may use in calculating and accounting for the total costs of operating a plan, including an overview of the purpose of the form and general description on calculating 401(k) fees; a schedule which summarizes the total plan fees and expenses; and additional schedules providing information on investment product fees and estimates, plan administration expenses, onetime start up and conversion expenses and service provider termination expenses.

Although the use of the form is not legally required, the PWBA expects employer-sponsors of 401(k) plans to ask their current 401(k) plan providers, and competing providers, to use it.

Included with the form is a caveat that the service provider offering the lowest-cost services is not necessarily the best choice for a 401(k) plan. Cost is only one of teh criteria for making an evaluation. Other factors of equal or greater importance include the quality and type of services provided, the anticipated performance of competing providers and their investment products, and other factors specific to a plan's needs.

Types of Fees

In general, fees are calculated in four-ways:

Asset-based: expenses are based on the amount of assets in the plan and generally are expressed as percentages or basis points.

Per-person: expenses are based upon the number of eligible employees or actual participants in the plan.

Transaction-based: expenses are based on the execution of a particular plan service or transaction.

Flat-rate: fixed charge that does not vary, regardless of plan size.

Fees may be calculated using one or any combination of these methods. Plan administration-related expenses can also be charged as one-time fees or on-going expenses. One-time fees are typically related to start-ups, conversions (moving from one provider to another) and terminations of service. Ongoing fees are recurring expenses relating to continuing plan operation.

Keeping Organized

According to the PWBA there are several appropriate classes of fees that include, but are not limited to:

Administrative/recording expenses - include fees for daily valuation, payroll processing, balance inquiry, investment transfer, contract administration charge, distribution processing, qualified domestic relations order processing, participant statements, plan sponsor reports, and voice response unit/Internet services.

Participant education/advice expenses - fees for participant education materials and distribution, education meetings, and investment advice programs.

Trustee/custodial services expenses - fees for certified annual trust statement and safekeeping of plan assets.

Compliance services expenses - fees for nondiscrimination testing, signature ready form 5500, annual audit, plan amendment, plan document and determination letter submission.

Loan administration expenses - fees for loan origination, loan processing and loan maintenance and repayment tracking.

The understanding of fees and expenses is important in the prudent operation of a 401(k) plan. This responsibility is ongoing. After careful evaluation during the initial selection of service providers, a plan's fees and expenses should be monitored periodically to ensure that such fees continue to be reasonable. While the PWBA has not set a specific level of fees, it does require that fees to a plan be reasonable.

The 401(k) plan fee disclosure form is designed to assist employers in making informed cost-benefit decisions with respect to their plan. The purpose of the form is to help employers determine the total cost of the plan. It is also intended to provide them with a means to compare investment product fees and plan administration expenses charged by competing service providers, regardless of how a particular service provider structures its fees.

If an employer is considering a conversion from an existing plan service provider to a new service provider, the employer will need to provide the service provider(s) with certain information about the plan, including the number of plan participants, the number of eligible participants and the amount of plan assets in order for the service provider(s) to be able to complete this form.When providing potential service providers with information regarding a plan, it is critical that the employer provide identical information to all of the competing companies in order to ensure equivalent comparisons.

Bundled Serviees

Bundles of services typically include various recordkeeping services along with the investment packages offered by a financial institution. The fees from the investment of the plan's assets are used to offset charges for the administrative services. The Department of Labor (DOL) is reviewing such relationships and commenting on the impact these fees have on a fiduciary's duty to prudently invest the plan's assets and to place the participant's interest first.

So long as an investment professional or a fiduciary does not exercise any authority or control to "cause" a plan to invest in a mutual fund, the fiduciary will not violate the anti-kickback prohibition under ERISA by receiving fees directly from mutual funds in connection with plan asset investments.

Revenue Sharing

Mutual fund supermarkets, mutual fund companies, insurance companies and others who provide investment products for defined contribution plans, particularly 401 (k) plans, provide compensation to defined contribution service providers in the form of expense reimbursements. Expense reimbursements are paid at the direction of the retirement plan sponsor to the plan service provider.

These plan service providers include any person or company that receives payment for providing direct or indirect services to a plan, such as, third-party plan administrators, recordkeepers, accountants, investment management companies, brokerdealers and insurance companies.

The DOL intends to review whether the plan service provider is being paid appropriately and, if the service provider is a fiduciary, whether it is using plan assets for its own benefit. Self-dealing in plan assets by a fiduciary is a violation of ERISA.

Further, plan sponsors need to be aware and accountable as to the fees being paid on behalf of the plan and plan participants as part of their fiduciary responsibility.

Disclosure

As a result of the issuance of DOL guidance, entities providing expense reimbursements need to review disclosure of fees and expenses under their retirement programs. As part of this review, these institutions are likely to require that plan sponsors execute expense reimbursement agreements authorizing these payments made directly to third-party service providers. The reimbursements need to be used to defray direct and necessary expenses of the plan and not to increase the compensation paid to service providers.

Many plan administrators are seeking new sources of revenue to offset administrative costs. Certain mutual fund companies provide recordkeeping expense reimbursements paid directly to third party plan administrators for plan-assets invested in certain share classes. These mutual fund programs are designed to provide their recordkeeping partners with the revenue and resources needed to compete effectively in the retirement plan marketplace. These programs create a competitive advantage by providing investment flexibility, revenue sharing and educational support.

The investment flexibility includes a selection of householdname mutual funds with low management fees. The revenue sharing arrangements help recordkeepers offset plan expenses and provide low trustee fees and comprehensive distribution, tax reporting and tax withholding services. The educational support includes access to comprehensive educational materials and personnel.

Recordkeepers have made these revenue sharing programs successful, given their desire to associate with nationally respected brand names and to provide investment fund flexibility to plan sponsors.

The DOL has placed a major emphasis on the need for plan participants and employers to have a full and complete understanding of the fees and charges associated with self-directed employee benefit plans. The DOL's recent focus has been particularly on 401(k) plans that include participant-directed investment accounts.

Fiduciary Responsibility

The DOL is emphasizing fee disclosure because it is making clear its view that the fiduciary who is charged with taking a written plan document and creating a reality has significant fiduciary responsibility where designing the investment and administrative features of a plan. The DOL's position is merely a restatement of the fiduciary's duties under ERISA to act with care, skill, prudence and diligence.

The method by which mutual funds are distributed has changed rapidly over the past several years with the development of the mutual fund supermarket and revenue sharing arrangements. Although the plan fiduciary receives services from the supermarket or financial institution without actually being charged by that entity, the arrangement effectively permits the plan fiduciary to recapture fees that are otherwise being paid to defined contribution service providers.

The DOL's initiative is intended to make certain that plan sponsors receive adequate disclosure of revenue sharing arrangements and thereafter acknowledge that payments may either be allocated to participants or beneficiaries or used solely to reimburse direct and necessary expenses of the plan. Plan sponsors, through their named fiduciaries, need to authorize the mutual fund companies and others to make these revenue sharing payments to the plan's service providers such as recordkeepers for reimbursement of plan recordkeeping expenses.

Employers are advised as fiduciaries to look closely at the fees associated with their retirement plans. Employers may face increased liability if they do net avoid high fees, or otherwise received investment-related services commensurate with their fee arrangement.

Relevant Litigation

In Marshall v. Synder (430 F. Supp. 1224, (2nd Cir. 1978)), the court held that fiduciaries of a qualified plan had a duty to pay only reasonable amounts for services. In this case, the Secretary of Labor commenced a civil cause of action against employee benefit plan trustees who permitted the expenditure of unwarranted sums of money from plan assets, including among others, making payments totaling over $1,000,000 to a trustee for pension administration services (allegedly an amount far in excess of reasonable compensation for any services he actually rendered).

The court noted that a fiduciary of an employee benefit plan under ERISA (29 U.S.C.A. 51104(a)(1)) is required to discharge his duties with respect of a plan solely in the interests of the participants and their beneficiaries and for the exclusive purpose of (i) providing benefits to participants and their beneficiaries, and (ii) defraying reasonable expenses of administering the plan. Under 29 U.S.C.A. ¤1106(a)(1) a plan fiduciary may not cause the plan to engage in a transaction if he knows or should have known that the transaction directly or indirectly constitutes the furnishing of services or facilities between the plan and a"party in interest".

"Party in interest" is defined elaborately and inclusively in 29 U.S.C.A. 51002(14):

it includes, in the case of employee benefit plans (a) any fiduciary (including without limitation any administrator, officer, trustee or custodian) or employee of an employee benefit plan, (b) any person providing services to such plan, and (c) an employee organization any of whose members are covered by such plan and (d) an employee or officer or director (or person holding similar responsibilities) of (i) a person providing services to such plan or (ii) an employee organization any of whose members are covered by such plan.

The court concluded that the excessive salary paid to the trustee for pension plan administration services was a prohibited transaction within the meaning of 29 U.S.C.A. 1106(a)(1)(C)

ERISA Violation

Fiduciary responsibilities include selecting and monitoring defined contribution plan service providers and negotiating the compensation payable to these providers, whether by the plan sponsor, the plan or financial institutions providing services to the plan. Plan sponsors and named fiduciaries need to obtain sufficient information regarding any fees paid directly or indirectly by the plan and to make certain that compensation payable to service providers is reasonable. Unless revenue sharing payments are credited directly to the plan or used to offset other fees the plan or the plan sponsor is obligated to pay, ERISA fiduciaries could be faced with a breach of fiduciary responsibility for allowing a transaction that violates ERISA's prohibited transaction provisions.