Disclosure of 401(k) Fees: An Overview for TPAs

By Bruce L. Ashton and C. Frederick Reish

The pension world is changing. A little more than a decade ago, our world was, by and large, neatly divided between those who provided investments to plans and those who provided services. With the popularity of 401(k) plans and participant-directed investments, the activities of those two groups have become intertwined and their relationships have become complex and symbiotic. Even the language has changed, with our conversations being sprinkled with terms like "strategic alliances," "bundled products," "daily val" and "daily switching", "404(c)", "12b-1 fees" and "subtransfer agency fees."

The regulators have taken notice of the changes as well. Late last year, the Department of Labor held hearings on "current practices relating to 401(k) plan fees and expenses."¹ The PWBA subsequently announced that it would be publishing guidance on the disclosure of fees and expenses charged to such plans and ultimately to the accounts of the participants.² In addition, the PWBA announced that it was initiating 50 investigations in a nationwide project to examine the fees and expenses being charged to 401(k) plans. And, earlier in 1997, the DOL published several Advisory Opinions on whether it would be a prohibited transaction for a financial institution providing 401(k) investment options to retain certain types of fees, notably 12b-1 and subtransfer agency fees.

This article is an overview of the issues being looked at by the PWBA. In addition, the article discusses disclosure issues for third party administrators (TPAs) which receive compensation from investment providers.

The DOL Advisory Opinions
In March of 1997, the DOL issued Advisory Opinion 97-15A (the "Frost Letter") and Advisory Opinion 97-16A (the "Aetna Letter").³ The Advisory Opinions addressed whether the receipt by the financial institutions of 12b-1⁴ and subtransfer agency⁵ fees from mutual fund companies was a prohibited transaction under Title I of ERISA and the Internal Revenue Code (the "Code") provisions of Title II of ERISA. Briefly stated, the DOL took the position that a service provider (specifically, a provider of investment products) which is a fiduciary must contractually agree with the responsible fiduciary of the plan on the disposition of these payments. If the fees are to be paid to the fiduciary, it must disclose those payments and offset them against its fees or, alternatively, pay them to the plan. If the investment provider is not a fiduciary, it would still be a party-in-interest (under Title I of ERISA) and a disqualified person (under the Code), both of which, for convenience, are referred to as a "party-in-interest" in this article. However, disclosure and an offset are not required for a non-fiduciary party-in-interest to avoid prohibited transaction treatment, unless the failure to do so would result in the fees being "unreasonable." (Note that, as discussed later in this article, disclosure may be required for other reasons.)

In the Frost letter, the investment provider (Frost, which is a bank) was found to be a fiduciary under ERISA. It is critical to understand why the DOL concluded Frost was a fiduciary to understand the two Advisory Opinions.

First, Frost provided 401(k), participant-directed investment products. Frost gave the plan sponsor and the responsible plan fiduciaries a menu of investment options (e.g., mutual funds) and the sponsor/fiduciaries selected a limited number of these options to make available to the participating employees. However, Frost also gave investment advice on which funds should be selected by a particular plan from among the list of options, and Frost received compensation for doing so. In addition, Frost gave ongoing advice about which mutual fund investment options should be maintained by the plan. Under section 3(21)(A) of Title I of ERISA, anyone who gives investment advice for a fee is a fiduciary.

Second, Frost had the power (apparently without the consent of the sponsor or the plan) to remove funds from the list of investment options it offered to its customers and to add others. Under section 3(21)(A) of Title I of ERISA, anyone with discretionary authority or control with respect to management of a plan or who exercises any authority or control over the disposition of plan assets is a fiduciary.

Even if Frost had not given investment advice and had served only as a directed trustee, it would still have been a fiduciary in the DOL's eyes because of its discretionary power to change the investment options that the plans made available to their participants.

Since Frost was a fiduciary, it was subject to the prohibited transaction rules in section 406(b) which apply only to fiduciaries. Under section 406(b)(1), it is a prohibited transaction for a fiduciary to deal with plan assets in its own interest or for its own account; and under section 406(b)(3), a fiduciary is prohibited from receiving any consideration from a third party in connection with a transaction involving plan assets. (Similar prohibitions are found in Code section 4975.) The Frost letter concluded that, where a fiduciary receives 12b-1 and/or subtransfer agency fees from the mutual funds or their management companies, the retention of those fees would not be a prohibited transaction under sections 406(b)(1) or 406(b)(3) if the following criteria are met: (1) before entering into an arrangement with a plan, or recommending any particular mutual fund investments, the "investment fiduciary" (Frost, in this case) must disclose to the responsible plan fiduciary (e.g., the plan's administrative committee, the sponsor's board of directors, an independent trustee) the fact that it receives those fees from the mutual funds and their management companies; and (2) the agreement must expressly provide that any fees received by the investment fiduciary (Frost) would be used to pay all or a portion of the compensation the plan was obligated to pay Frost and any amount exceeding its fees would be paid by Frost to the plan.

The Frost letter does not say that the investment provider/fiduciary must disclose the actual amount of the fees it receives. On the other hand, the DOL explicitly says that the responsible plan fiduciary (e.g., the plan committee or the sponsor's board of directors) has the obligation to determine whether the fees being charged by a service provider (including an investment provider) are reasonable. It is difficult to imagine how the responsible plan fiduciary could contractually agree on the offset without a fairly specific understanding of the underlying fees—on at least a "net" basis. However, a general statement by an investment provider that it is receiving 12b-1 or subtransfer agency fees and that such fees will be used to reduce the plan's obligations to pay fees to the investment provider appears to be sufficient under the Advisory Opinions. Remember, too, that this obligation only applies to an investment provider which is a fiduciary.

What about non-fiduciaries? The Aetna letter dealt with that issue. Aetna describes it arrangement as follows: a plan purchases an annuity contract which offers mutual fund options, some of which are externally managed and others of which Aetna manages itself.⁶ In contrast to Frost, Aetna does not recommend any particular funds from those made available in the annuity contract. Aetna charges a fee for the administration of the external accounts and also receives subtransfer agency fees of 12b-1 fees from those mutual funds or their management companies. According to Aetna, it makes extensive disclosures concerning those fees and provides a toll-free telephone number for participants to call to receive more detailed information regarding the amount of the fees it receives. Unlike in the Frost situation, however, Aetna does not have the absolute discretion to switch fund options. Instead, if Aetna wishes to add or delete a fund option which has been selected by a particular plan, it gives notice to the responsible plan fiduciary who then has the opportunity to accept or reject the recommendation or to move the plan assets to a different investment provider within a reasonable timeframe.

On these facts, the DOL concluded that Aetna was not a fiduciary and could receive the 12b-1 and subtransfer agency fees without engaging in a prohibited transaction. The DOL states;

"It is the view of the Department that a person would not be exercising discretionary authority or control over the management of a Plan or its assets solely as a result of deleting or substituting a fund from a program of investment options and services offered to Plans, provided that the appropriate [independent] Plan fiduciary in fact makes the decision to accept or reject the change. In this regard, the fiduciary must be provided advance notice of the change, including any change in the fees received, and afforded a reasonable period of time within which to decide whether to accept or reject the change and, in the event of a rejection, to secure a new service provider."

Of course, the responsible plan fiduciary still has the affirmative duty to approve the compensation which the investment provider is receiving, so even if the investment provider has no duty to disclose, the plan fiduciary has the duty to know and understand the payments being made from plan assets to the investment provider. (PWBA officials have indicated, in informal discussions, that they would analyze the failure of a party-in-interest to disclose its fees to determine whether, as a functional matter, the party-in-interest had taken "control" of plan assets so as to have become an ERISA fiduciary.)

Disclosure of Commissions
Section 406 of Title I of ERISA and Section 4975 of the Code prohibit certain transactions between plans and parties in interest. Section 406(a)(1) of Title I prohibits a plan fiduciary from causing a plan to purchase investments from a party-in-interest or to obtain goods, services or facilities from a party-in-interest. And, as noted earlier, section 406(b) of Title I says that a fiduciary may not deal with plan assets for his own benefit or receive compensation for his own account from a third party in a transaction involving plan assets. The legal consequence of these restrictions means that a plan cannot buy insurance or annuity contracts (which we will refer to for convenience as "insurance contracts") or mutual funds, or pay a commission to an agent or broker if the investment provider or broker is also a service provider to the plan (e.g., a third party administrator) or a fiduciary (e.g., a person who gives investment advice for a fee) or is "affiliated" with one or the other.

To make it possible for plans to engage in reasonable commercial dealings, when ERISA was adopted, various exceptions were written into the law, and the Secretary of Labor was given the authority to grant other exemptions, either on a blanket basis ("class" exemptions) or an individual basis. (Section 408(a) of Title I) None of the statutory exemptions applies to the receipt of commissions by a service provider or fiduciary. As a result, in 1977, the Department of Labor issued Prohibited Transaction Class Exemption (PTCE) 77-9 which permits agents and brokers who are service providers or fiduciaries to assist plans in purchasing insurance contracts and mutual funds, and to receive commissions, so long as certain requirements are met. In 1984, the exemption was restated in PTCE 84-24.

Basically, the exemption permits an insurance agent, broker or pension consultant (appropriately licensed under state law) who is a fiduciary to a plan, a service provider to a plan or affiliated with a fiduciary or service provider to receive a sales commission when a plan buys insurance contracts or mutual funds so long as the transaction is fair to the plan, the compensation received by the plan is reasonable and certain disclosures are made to an independent plan fiduciary. Note that the insurance agent, broker or pension consultant may not be (a) a trustee of the plan (except for a non-discretionary trustee who does not render investment advice), (b) a plan administrator (as defined in section 3(16)(A) of Title I of ERISA—which does not include a third party administrator), or (c) a fiduciary who is expressly authorized in writing to manage, acquire or dispose of assets on a discretionary basis. In other words, the broker may not be in a position to select itself or sell the product to the plan.

In the case of insurance contracts, the insurance agent, broker or pension consultant must provide to an independent fiduciary, prior to the execution of the transaction, all of the following information (which must be in writing and in a form calculated to be understood by a plan fiduciary who has no special expertise in insurance or investment matters):

1. If the agent, broker or consultant is an affiliate⁷ of the insurance company, or if the ability of the agent, broker or consultant to recommend insurance or annuity contracts is limited by an agreement with the insurance company, the nature of the affiliation, limitation or relationship must be disclosed;

2. The sales commission, expressed as a percentage of gross annual premium payments for the first year and for each of the succeeding renewal years which will be paid by the insurance company to the agent, broker or consultant in connection with the purchase of the recommended contract must be disclosed; and

3. A description of any charges, fees, discounts, penalties or adjustments, which may be imposed under the recommended contract in connection with the purchase, holding, exchange, termination or sale of the contract must be disclosed.

Following receipt of this information and prior to the execution of the transaction by the plan, the independent fiduciary must acknowledge in writing receipt of the information and approve the transaction on behalf of the plan.⁸ The independent fiduciary may not be the insurance agent, broker, or pension consultant involved in the transaction; and the fiduciary may not receive, directly or indirectly, any compensation or other consideration for his own personal account from any party dealing with the plan in connection with the transaction. (Note that mutual funds, as opposed to annuity or insurance contracts, are subject to similar but not identical rules.)

Thus, licensed agents who are already fiduciaries to the plans they serve, are already service providers to those plans or are affiliated with a fiduciary or service provider—such as where a firm provides record keeping services to a plan and one of the principals of the firm is an insurance agent who receives a commission in connection with the sale of insurance contracts to plans for which the firm provides such services—must comply with the disclosure requirements of the exemption and must obtain a written acknowledgment before the sale is consummated from an independent fiduciary.

Other Disclosure Requirements

Schedules A and C
Schedules A and C to the Form 5500 require disclosure of commissions and fees paid to service providers, including both insurance agents or brokers and third party administrators. The 5500 Form and these schedules are to be completed filed by the plan's ERISA administrator (typically the employer or the plan committee). While the preparation and filing of the Schedules are the obligation of the ERISA plan administrator, they are, as a practical matter, often prepared by the third party administrator.

Schedule A, Insurance Information, must be filed as an attachment by all plans which are required to file a 5500-series form, except for those which may file a 5500EZ. Schedule C, Service Provider and Trustee Information, is only required to be filed for plans which file the 5500 Form, that is, plans which cover 100 or more participants. Parts I and II of Schedule A request information insurance contracts purchased by retirement plans, including "insurance fees and commissions paid to agents and brokers," as well as "payments by insurance carriers to agents and brokers for items other than commissions (e.g., service fees, consulting fees, and finders fees)." The instructions to Schedule A indicate that "fees paid by insurance carriers to persons other than agents brokers should be reported in Parts II and III on Schedule A (Form 5500) as acquisition costs, administrative charges, etc., as appropriate. For plans with 100 or more participants, fees paid by employee benefit plans to agents, brokers, and other persons are to be reported on Schedule C (Form 5500)."

Thus, to the extent a service provider is receiving a commission, this must be reported on the Schedule A, along with payments other than commissions, such as service fees, consulting fees and finders fees. This is true whether or not the service provider must comply with the advance disclosure requirements of PTCE 84-24. In addition, amounts paid to persons other than brokers and agents in connection with the acquisition of an insurance contract should be reported as acquisition costs, administrative charges, etc. (Note that, for plans with 100 or more participants, the fees, as opposed to the commissions, paid to brokers, agents and others should be reported on Schedule C.)

Schedule C seeks information on persons receiving, directly or indirectly, compensation for services rendered to a plan (unless reported on Schedule A). "Indirectly " is defined as:

"Generally, indirect compensation would not include compensation would not include compensation that would have been received had the service not been rendered and that cannot be reasonably allocated to the services performed. Indirect compensation includes, among other things, the payment of "finders' fees" or other fees and commissions by a service provider to an independent agent or employee for a transaction or service involving the plan."

Unfortunately, this guidance is less than clear. Presumably, it refers only to the payments which are chargeable to the investment contract, that is, paid out of plan assets.

Professional Standards of Conduct
ASPA has adopted ethical standards for its actuaries and other members. For actuarial members who are members of the major U.S. actuarial societies (including ASPA) are subject to the Precepts of the Code of Professional Conduct for Actuaries. The rules relating to disclosure of compensation provide:

Precept 7
An actuary shall make full and timely disclosure to a principal (i.e., present or prospective client or employer) of the sources of all direct and indirect compensation that the actuary or the actuary's firm may receive in relation to an assignment for which the actuary provides professional services for the principal.

Annotation 7-1. An actuary who is not financially and organizationally independent concerning any matter related to the subject of an actuarial communication should disclose to the principal any pertinent relationship which is not apparent.

Annotation 7-2. 'Indirect compensation' is any material consideration received from any source in relation to an assignment for which the actuary provides professional services, other than direct remuneration for those services.

Annotation 7-3. Actuaries employed by firms which operate in multiple sites are subject to the requirement of disclosure of sources of compensation which the actuary's firm may receive in relation to professional services with respect to a specific assignment for that principal, regardless of the location in which such compensation is received."

ASPA has adopted a similar rule in a Code of Professional Conduct for its nonactuary members:

Disclosure
An ASPA member shall make full and timely disclosure to a principal of all sources of compensation or other material consideration that the member or the member's firm may receive in relation to an assignment for such principal.

"A member who is not financially and organizationally independent concerning any matter related to the performance of professional services shall disclose to the principal any pertinent relationship which is not apparent."

The receipt of commissions, finders fees, or other compensation from an investment vendor arguably falls within the definition of "compensation" and "material consideration" that a member receives in relation to an assignment. In addition, such consideration would raise the issue of financial independence.

404(c) Disclosures
In addition to the foregoing disclosure requirements, it may be necessary to disclose some of the charges related to investments in insurance contracts and mutual funds in order for a plan to comply with section 404(c) of Title I of ERISA. That section provides the responsible plan fiduciaries with a defense against liability for losses incurred by participants who direct the investments in their own accounts. In that sense, the disclosures needed for 404(c) compliance are not "mandatory" (in contrast to the disclosure requirements under PTCE 84-24), but they are necessary if the responsible plan fiduciaries seek 404(c) protection.

In order to meet the 404(c) requirements, DOL Reg §2550.404c-1(b)(2)(i)(B)(1)(v) requires that the designated plan fiduciary provide the participants with "a description of any transaction fees and expenses which affect the participant's or beneficiary's account balance in connection with purchases or sales of interest in investment alternatives (e.g., commissions, sales loads, deferred sales charges, redemption or exchange fees)." What this means is that you have to give participants, whether they request it or not, information regarding transaction fees which affect their account balances. This would include, for example, a deferred sales charge or "termination fee."

Further, subsection (B)(2)(i) of the regulation specifies that, upon request, the designated fiduciary must provide the participants with "a description of the annual operating expenses of each designated investment alternative (e.g., investment management fees, administrative fees, transaction costs) which reduce the rate of return to participants and beneficiaries and the aggregate amount of such expenses expressed as a percentage of average net assets of the designated investment alternative."

To the extent any other charges by the investment provider actually affect the rate of return on the investments in a participant's account, they would need to be disclosed upon request by the participants. Such charges might include any "asset charges" in a group annuity contract and the management fees charged on the funds managed.

Conclusion
The focus of the Department of Labor is on greater disclosure of the compensation being paid by plans. We believe that will result in more formalized procedures for disclosing information to plan fiduciaries and participants. And, as this article demonstrates, there already are number of requirements for disclosure of most fees being paid by plans and being reviewed by service providers (including investment providers and TPAs).

ENDNOTES

¹The DOL's Pension and Welfare Benefits Administration (PWBA) published a notice of the hearing and issued a press release raising the following questions: Do plan sponsors and participants understand what fees and expenses they are paying? Is there a need for more disclosure of fee information? Are plan sponsors doing enough to protect plan participants from excessive fees?

²The DOL Committee of the ASPA Government Affairs Committee, chaired by Mike Canan, has been following this process and has given comments to the DOL advocating, among other things, that the DOL require disclosures which will permit plan fiduciaries to compare the cost of all of the products and services they will be receiving on an "apples to apples" basis.

³A third letter, Advisory Opinion 97-19A, was issued (again to Aetna); and although it is sometimes referred to along with the Frost and Aetna Letters, it has limited applicability because it dealt only with Aetna's own plan.

⁴A "12b-1 fee" is a fee paid by a mutual fund to third parties in connection with the "distribution" (i.e., marketing) of the mutual fund's shares. Such fees are permitted under Rule 12b-1 issued by the Securities and Exchange Commission under the Investment Company Act of 1940, which governs the conduct of mutual funds.

⁵A "subtransfer agency" fee is a fee paid by a mutual fund management company for record keeping in connection with the buying and selling of mutual fund shares. In order to keep track of the thousands of persons or entities who hold its shares, a mutual fund will employ a transfer agent to maintain a register of holders. Where the shares are held by an entity on behalf of others, such as a 401(k) plan which holds the shares for the benefit of participants in the plan, keeping track of the shares on a participant-by-participant basis is often delegated to a third party, such as an insurance company that is marketing the mutual funds to its plan customers, which becomes a "subtransfer agent."

⁶Often the annuity contract will offer, as investment options, mutual funds managed by unaffiliated management companies as well as "funds”—referred to as "separate accounts”—which are managed by the insurance company itself. For ease of reference, we refer to both mutual funds and separate accounts as mutual funds.

⁷The term "affiliate" for purposes of the PTCE includes any person who directly or indirectly controls, is controlled by or under common control with another person; any officer, director, employee or relative of any such person; and any corporation or partnership of such person is an officer, director, employee or partner. Note that (i) "control" for this purpose means actual control and is not the same as the mathematical standards found in Code sections 414(b) and (c) and (ii) "relative" includes not only the usual ERISA definition of spouse and lineal descendants and ancestors but also siblings. PTCE 84-24, section VI(c), (d) and (e).

⁸Note that the requirements are slightly different for the sale of mutual funds to plans. Similar disclosures must be given to the responsible fiduciary of the plan prior to execution of the trade, but approval of the terms of the arrangement "may be presumed if the fiduciary permits the transaction to proceed after receipt of the written disclosure." PTCE 84-24, section V(c)(2).

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