Updates
June 2008
For Better or Worse?
How should plan sponsors react to the Department of Labor's new requirements for service provider disclosures? They should celebrate, cautiously.
When finalized, the new rules will require almost all service providers to disclose, at the beginning of their relationship with a plan, their total compensation from the plan, direct and indirect, as well as potential conflicts of interest. In addition, service providers will be required to have a written contract or arrangement with the plan.
To appreciate the new rules fully, plan sponsors need to understand the impact of the changes. In essence, these rules take the burden off the employer to investigate the expenses, revenue-sharing, compensation, and conflicts of its plan providers and will transfer the burden onto the providers to disclose that information.
This is a significant change. In the past, ERISA placed the burden for knowing and evaluating fees and conflicts of interest on the primary fiduciary for the plan—that is, on the plan sponsor and its officers and committee members.
More than 10 years ago, the DoL issued guidance that specifically pointed out that plan sponsors needed to know what their providers were being paid, taking into account both the amounts paid directly by the plan and the amounts that were paid indirectly (for example, through revenue-sharing from mutual funds). Unfortunately, in most cases, there was no corresponding burden on providers to disclose those payments.
As a result, ERISA had placed plan sponsors in a difficult position. The party that controlled the information about the indirect fees and potential conflicts of interest—the service provider—was under no obligation to disclose, but the plan sponsor was under an obligation to know.
Also, in many cases, the provider was a financial service company with internal expertise in these areas, while the plan sponsor (and particularly small-plan sponsors) had little, if any, knowledge about the complicated financial transactions between the plan investments and providers.
It seems obvious that the shoe has been on the wrong foot.
So, from a plan sponsor's perspective, the changes are good news—for the most part. While plan sponsors will be able to manage their 401(k) plans better, because they will be receiving more complete information, they will be expected to read, understand, and evaluate that information.
While the responsibility has been shifted, the benefit of disclosure carries with it the burden of properly using the disclosed information.
Plan sponsors need to evaluate the direct and indirect compensation to ensure that the plan is not paying more than reasonable amounts for what it is receiving.
However, plan sponsors also have a duty to evaluate the potential conflicts of interest to make sure that they are not adversely affecting the plan and its participants. For example, is a provider's compensation more if it makes certain recommendations than if it makes other recommendations? If so, the plan sponsor must take that into account in evaluating the advice.
Second, plan sponsors must understand both new concepts and new terminology. The conflict of interest disclosures will introduce a new concept to many plan sponsors. For example, even though an adviser has great integrity and only gives recommendations that are in the best interest of the participants, if there is a theoretical financial advantage to making a recommendation, that is a potential conflict of interest, and the fiduciaries must consider it in making their decisions.
Then, once the information is evaluated, plan sponsors and their fiduciaries must make a decision. After all, the final steps of a prudent process are to make informed and reasoned decisions and to implement those decisions.
To protect the plan sponsor, as well as for future reference, both the process and the decision should be documented.
When finalized, the new rules will require almost all service providers to disclose, at the beginning of their relationship with a plan, their total compensation from the plan, direct and indirect, as well as potential conflicts of interest. In addition, service providers will be required to have a written contract or arrangement with the plan.
To appreciate the new rules fully, plan sponsors need to understand the impact of the changes. In essence, these rules take the burden off the employer to investigate the expenses, revenue-sharing, compensation, and conflicts of its plan providers and will transfer the burden onto the providers to disclose that information.
This is a significant change. In the past, ERISA placed the burden for knowing and evaluating fees and conflicts of interest on the primary fiduciary for the plan—that is, on the plan sponsor and its officers and committee members.
More than 10 years ago, the DoL issued guidance that specifically pointed out that plan sponsors needed to know what their providers were being paid, taking into account both the amounts paid directly by the plan and the amounts that were paid indirectly (for example, through revenue-sharing from mutual funds). Unfortunately, in most cases, there was no corresponding burden on providers to disclose those payments.
As a result, ERISA had placed plan sponsors in a difficult position. The party that controlled the information about the indirect fees and potential conflicts of interest—the service provider—was under no obligation to disclose, but the plan sponsor was under an obligation to know.
Also, in many cases, the provider was a financial service company with internal expertise in these areas, while the plan sponsor (and particularly small-plan sponsors) had little, if any, knowledge about the complicated financial transactions between the plan investments and providers.
It seems obvious that the shoe has been on the wrong foot.
So, from a plan sponsor's perspective, the changes are good news—for the most part. While plan sponsors will be able to manage their 401(k) plans better, because they will be receiving more complete information, they will be expected to read, understand, and evaluate that information.
While the responsibility has been shifted, the benefit of disclosure carries with it the burden of properly using the disclosed information.
Plan sponsors need to evaluate the direct and indirect compensation to ensure that the plan is not paying more than reasonable amounts for what it is receiving.
However, plan sponsors also have a duty to evaluate the potential conflicts of interest to make sure that they are not adversely affecting the plan and its participants. For example, is a provider's compensation more if it makes certain recommendations than if it makes other recommendations? If so, the plan sponsor must take that into account in evaluating the advice.
Second, plan sponsors must understand both new concepts and new terminology. The conflict of interest disclosures will introduce a new concept to many plan sponsors. For example, even though an adviser has great integrity and only gives recommendations that are in the best interest of the participants, if there is a theoretical financial advantage to making a recommendation, that is a potential conflict of interest, and the fiduciaries must consider it in making their decisions.
Then, once the information is evaluated, plan sponsors and their fiduciaries must make a decision. After all, the final steps of a prudent process are to make informed and reasoned decisions and to implement those decisions.
To protect the plan sponsor, as well as for future reference, both the process and the decision should be documented.
The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.
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