Taking Aim
In July, the Department of Labor (DoL) published the long-awaited final interim regulations on Employee Retirement Income Security Act (ERISA) Section 408(b)(2)—the statutory exemption allowing plan service providers to be compensated for their services without engaging in a prohibited transaction.
The new rules focus on disclosures. To avoid having compensation from a plan be determined to be a prohibited transaction, some retirement plan service providers must make disclosures to the plans they service. Essentially, plan service providers will have to make disclosures if: 1) they are an ERISA fiduciary to the plan, 2) they are a registered investment adviser (RIA) providing services to the plan, or 3) they are operating as an investment adviser or in a brokerage capacity to the plan if getting indirect fees, says Brian Graff, Executive Director and Chief Executive Officer of the American Society of Pension Professionals & Actuaries in Arlington, Virginia.
The impact that these new rules will have on advisers is determined by business structure. Depending on whether a retirement plan adviser is an RIA, broker/dealer, insurance broker, or registered representative, the new rules will affect each type of retirement plan adviser differently, says Fred Reish, Partner and Managing Director, Reish & Reicher in Los Angeles.
Specifically, the new 408(b)(2) regulations provide that certain types of service providers to qualified retirement plans must make certain disclosures in writing to plan fiduciaries within certain time frames. Although the disclosures must be in writing, the final rules, unlike the proposed rules, do not require the agreement to be a formal written contract.
Retirement plan service providers required to make these disclosures include: 1) service providers providing investment-related services, 2) recordkeepers and brokers if at least one plan investment alternative is connected to the recordkeeper or broker, and 3) service providers receiving indirect compensation from the plan including accounting, appraisal, legal, investment brokerage, third-party administration, and banking. Service providers that reasonably expect to receive less than $1,000 from the plan are exempt from the disclosure requirements.
If a service provider is required to make disclosures, then, at a minimum, the following information must be disclosed to plan fiduciaries: 1) a description of the services provided, 2) if applicable, that the service provider, affiliate or subcontractor reasonably expects to provide services as a fiduciary and/or as an RIA, 3) a description of all direct compensation, 4) a description of all indirect compensation, 5) a description of all direct and indirect compensation paid among the service provider, affiliate, or subcontractor set on a transaction basis (e.g., commissions, soft dollars, or finder’s fees), or charged directly against the plan’s investments, (e.g., 12b-1 fees), 6) a description of any compensation the service provider, affiliate, or subcontractor expects to receive in connection with the termination of the contract or arrangement, 7) a description of the manner in which compensation will be received, 8) if the service provider is a fiduciary or provides recordkeeping or brokerage services providing investment options or alternatives, then the service provider must disclose compensation information concerning the investments and investment options.
These disclosures must be made in advance of any arrangement being entered into, says Graff, and within 60 days any time an agreement is renewed or extended, says Graff. For example, he says, if a fund changes the amount paid to the adviser, then a disclosure must be made within 60 days. Additionally, he adds, the new rules are effective July 16, 2011, and all advisers must make their initial disclosures by that date, even to existing clients.
The new various disclosure rules will affect various types of advisers differently, says Reish. For example, he says, RIAs already have written contracts in place and already are making written disclosures to their clients. So, he says, even if the original proposed regulations’ requirement requiring advisers to have written contracts stood, the new rules will not have much of an impact on the way RIAs operate. While RIAs may need to make some adjustments to their disclosures because of the final rules, it’s really not that big a deal, says Reish. RIAs probably will just make adjustments through their Form ADV Part 2, he says (see sidebar).
The requirement for initial disclosures to be made by July 16, 2011, even to existing clients, also will not be all that big a deal to RIAs. Typically, RIAs are based locally and regionally and have 50 to 500 clients, says Reish, so getting disclosures out will not be too large a burden.
For broker/dealers, complying with the new rules is more complex, says Reish. Many broker/dealers, he notes, cannot even identify all their ERISA clients. Broker/dealers, he explains, did not typically enter into ERISA-specific agreements with their ERISA clients. ERISA clients just opened regular accounts using regular forms.
So, the first step broker/dealers must take is to identify their existing ERISA clients across all advisers, says Reish. Depending on the number of ERISA plans the broker/dealer services, it will need a set of disclosures for each ERISA plan it provides services to during the transition period between now and July 16 of next year. So, if the broker/dealer has 500 ERISA plans, it will need 500 disclosure notices, he says.
The first disclosure that must be made is a description of services provided, he says. ERISA plan service providers have to describe what services they provide to the plan, such as making investment recommendations or having enrollment meetings. The more sophisticated retirement plan advisers are already doing this, says Reish, but the less sophisticated ones with only two or three plans generally have never done this. They now have to determine exactly what services they provide to each plan and describe them.
Disclosing compensation also may prove problematic to broker/dealer reps, because determining exactly what they are receiving from a plan is not as explicit. Normally, RIAs charge fees and nothing more, so making the appropriate disclosure should be fairly easy for most RIAs, he says.
For advisers at broker/dealers, on the other hand, who typically get 12b-1 fees, commissions, finder’s fees, and other types of fees, disclosing fees may be more complex, says Reish. If there are 30 different mutual funds, with 30 different 12b-1 fees, the broker/dealer will have to track down what it is receiving from each of these funds. It’s also more complicated because the broker/dealer adviser may get a commission on any assets transferred into the plan on top of 12b-1 fees. Additionally, for advisers receiving revenue-sharing from mutual funds, those fees will have to be tracked and disclosed by the broker/dealer to the plan as well.
Traditionally, broker/dealers and their advisers have not tracked or disclosed these fees, says Reish, so they will not have to adjust their processes to do so. Broker/dealers historically have delivered prospectuses, which contain 12b-1 fee information to clients, he says, but broker/dealers now will need to provide more detail about the compensation and services.
The historical mindset of the broker/dealer community, explains Reish, has always been more transaction-based. Fees were paid based on transactions. ERISA, however, requires that fees be based on services, he says. Thus, if an adviser is getting compensation year after year, he says, that adviser will now need to be providing services that correspond with fees received.
The new rules are not so favorable to captive advisers, agrees Graff, many of whom did not previously disclose payments received. For these advisers, he says, what they are paid will be more explicit then before. It will bring more attention to the adviser’s compensation and that exposure will foster competition. “I think that putting sunshine on advisory fees will stimulate questions at the plan sponsor level about what they pay, and what they are paying for,” says Graff. “It will be important for advisers to show their value.”
“In the future, advisers are going to need to be comfortable saying, ‘Here are the services I provide and the compensation I get,’” agrees Reish. “Sponsors will be saying ‘I see you’ve gotten $20,000 in 12b-1 fees. Show me what I’m getting for $20,000 and why it’s justified,’” he says. If it is a small plan that an adviser has provided few services to, but is getting large fees from, that adviser may have a problem, he says.
Initially, the new rules will favor advisers who offer many services to plans, and advisers who offer teams to plans to do enrollments, education, and other services. In other words, the new 408(b)(2) rules will favor the retirement plan specialist over the generalist, says Reish. Additionally, over time, says Graff, the new rules also will lead to more uniform fees for services.
Additionally, notes Graff, because fees will be explicit now, it will make it easier for advisers to provide information to clients about products and what they cost. Advisers, he says, will be able to make better apples-to-apples comparisons of 401(k) products for their clients.