Traps for the Unwary

Assisting clients with their filing of Form 5500 is not usually something high on the to-do list of advisers, who prefer to leave it up to the third-party administrator (TPA) or recordkeeper. However, although advisers might not normally help clients with this, the changes to the 2009 Form 5500 will likely have plan sponsors asking questions—asking for help and for details about an adviser’s practice and compensation.

New Form 5500 regulations were issued in 2006 and, in 2007, the Department of Labor (DoL) imposed new reporting requirements for Form 5500’s Schedule C (see “Coming Soon,” PLANADVISER, Jan–Feb 2008). While some changes will be reflected on the 2008 plan year filing, the bulk of the impact will be on forms filed for the 2009 plan year—not due until 2010. Advisers, however, should not be complacent. Even though not due until 2010, new processes need to be implemented now to incorporate the changes.

The most significant change requires plan sponsors to disclose anything of value service providers receive directly or indirectly from service providers, including plan advisers, for servicing the plan, says Joan Bozek, Managing Director in the Merrill Lynch Retirement Group in Hopewell, New Jersey.

A “C” Full of Changes

The biggest change is to Schedule C, applicable to plans with more than 100 participants. Schedule C of Form 5500 requires plan administrators to identify plan service providers (including advisers) receiving $5,000 or more in compensation in connection with plan services and report the amount of compensation received by these service providers.

The 2009 Schedule C rules specifically require reporting of “indirect” compensation received by a plan’s service providers in addition to any direct compensation. “Indirect compensation” includes any compensation received by service providers other than directly from plan assets or plan sponsors “in connection with services rendered to the plan during the plan year or the person’s position with the plan.”

Examples of reportable indirect compensation include: fees and expense reimbursement payments received from investment funds, finder’s fees, float revenue, brokerage commissions, soft dollars, transaction-based fees received in connection with transactions or services involving the plan, and “nonmonetary” compensation such as trips, gifts, and meals. Investment fund payments also reportable as indirect compensation include: adviser asset-based investment management fees, fees relating to a plan’s purchase and sale of interests in the fund, fees for providing services to plan investors or plan participants, and fees relating to the administration of an employee benefit plan including fees for recordkeeping and compliance services.

For the first time, says Fred Reish, Managing Director of the Los Angeles law firm Reish Luftman Reicher & Cohen, indirect compensation paid to advisers servicing a plan will have to be recorded, including subtransfer agent fees, 12b-1 fees, as well as any other indirect payments such as bonuses, trips, or anything else related to the business that the adviser received because of business related to the plan.

Essentially, says Bozek, if individuals or firms are being compensated from plan assets because they service a plan, then the sponsor must disclose that revenue to the DoL, which means it first must be disclosed to the sponsor. For example, she says, if a consultant does a manager search for a plan, and a recommended manager is added to the plan menu, the consultant must disclose to the plan sponsor, and then, if the consultant received any direct or indirect compensation from the manager, the plan sponsor must report that on its Form 5500.

Eligible Indirect Compensation

There is an alternative reporting option (ARO) for indirect compensation that qualifies as “eligible indirect compensation (EIC).” To use the ARO, says Reish, the adviser must give the plan sponsor written materials that disclose and describe: 1) the existence of indirect compensation, 2) the services provided for that indirect compensation, 3) a description of the formula used to calculate the indirect compensation, and 4) the identity of the party paying the indirect compensation and the identity of the party receiving it.

If fees qualify as EIC, the plan administrator must report only that it received the required EIC disclosures and not report an amount of the EIC. Reish says that this alternative reporting option for eligible indirect compensation is the simplest reporting of all. In effect, the plan sponsor simply checks a box that says that it got the necessary information and then names the source of the information. As a result, there is no need to report what the information was. The plan sponsor just keeps that information in its files. That’s why it is sometimes called “check-the-box” reporting. However, the alternative reporting option does not apply to all indirect compensation; it only applies to the indirect compensation that is eligible for that treatment. It has to be a particular type of compensation, with the most common example being compensation that reduces the value of the investment—for example, 12b-1 fees that are paid to broker/dealers. In addition, certain disclosures about the existence, purpose, and calculation of those payments have to be made to the plan sponsor.

For example, says Janice Wegesin, President of JMW Consulting, Inc., in Petoskey, Michigan, if a recordkeeper only receives indirect compensation from a plan’s mutual fund investment option, the recordkeeper can give the sponsor the required disclosures for the ARO and is not required to disclose the exact amount of indirect compensation received. According to Wegesin, what is key is how the compensation actually flows to the recordkeeper. If it is directly from the mutual fund to the recordkeeper, then it could be EIC if disclosures are made. If there is an intermediary paying the recordkeeper, then it likely could never meet the “eligible” criteria.

However, says Wegesin, the ARO is generally only available for service providers receiving indirect compensation exclusively. If a service provider receives both direct and indirect compensation, the ARO option usually is not available.

Advisers should prepare now for the 2010 Form 5500 filing, say the experts. For example, if advisers receive eligible indirect compensation and want to take advantage of the alternative reporting option, they must give the required written disclosures to sponsors. If disclosures are not made in 2009 before the 2009 filing is due in 2010, the ARO is not available and advisers must collect and disclose all indirect compensation, says Wegesin.

Getting in Front of Clients

Mark W. Dundee, a Principal and National Director of Compliance at Buck Consultants, an ACS Company in Los Angeles, recommends that, if advisers are helping to prepare the 5500, they should go to clients as soon as possible to ensure systems are in place to collect the information needed to complete the form. “It’s a good opportunity to get in front of clients to tell them what new information is needed, to avoid the “midnight shuffle” to get information at the last minute,” says Dundee. At a minimum, he says, advisers should put together a check list for clients to get the data (see below).

Most importantly, advisers need to understand what information they have to provide to plan sponsors. “The bottom line,” says Wegesin, “is that advisers need to get a handle on how Schedule C works and what needs to be reported so that they can provide that information to their clients.” Specifically, advisers must be prepared to deliver information to clients regarding indirect compensation, she says, which may be difficult to ascertain. For example, she says, mutual funds may compensate advisers for setting up and running plans and these payments are not always visible because the expense is just part of the investment’s expense ratio reflected in the net asset value of the fund.

This means that advisers may need to do extensive work to get new systems in place to track indirect compensation, says Bozek. The role of the recordkeeper, according to Bozek, depends on what the recordkeeper has signed on for. At the very least, it needs to provide the plan sponsor with any revenues the recordkeeper receives from plan assets. If the recordkeeper has signed on to prep the 5500, then it needs to complete the Schedule C as well, and may need to reach out to other service providers to obtain any other information needed to complete the Schedule C.

A pure investment adviser may receive only direct compensation, Bozek notes, but, if an adviser delivers bundled services, he may need new systems to track all the direct and indirect compensation he receives. For example, Bozek says, Merrill Lynch has reported to its clients the direct compensation it receives for several years now in various channels, including disclosure documents, contracts, service agreements, and statements, she says. However, its systems did not disclose the specific amount of indirect revenue received from certain financial sources, such as the float—which DoL regulations now require. Merrill Lynch is working quickly now on identifying and reporting revenue from indirect sources, specific to each client and, beginning in 2010, the company will provide them with a consolidated information mailing that will include any revenues Merrill Lynch received from the plan in the prior year from plan assets.

Unfortunately, many questions remain as to how Schedule C should be filled out and what does and does not have to be reported. The good news is that the DoL is allowing advisers to implement a “best efforts’ approach for the 2009 plan year. Basically, says Bozek, the DoL is saying that it understands that advisers may not be able to pull off the changeover in one year but, if the service provider makes an effort and basically states “we know we receive some indirect revenue but cannot fully determine the exact amount per participant; here’s what we think it is,” then that will pass muster with the DoL for the 2009 plan year.

There can be consequences to not reporting. At the end of both Schedules A and C, note Reish and Mary Miller, a senior compliance consultant at Buck Consultants in New York, there now will be a section where sponsors are required to report any service provider who failed or refused to give the required disclosure information. “So, the 5500 will be used for enforcement not just disclosure,’ says Reish. “It’s almost as if the DoL is saying “tell us who to investigate.””

Once the information is revealed, advisers should expect clients to be asking more direct questions around all forms of revenue received for services to the plan, says Bozek. Sponsors, she says, will begin to ask pointed questions as to how an adviser is paid and what compensation it receives from any other service provider. For example, she says, many advisory firms pay their financial advisers for services they provide the plan, including activities such as participation in investment committee meetings, from revenues received by the firm. Sponsors now are likely to ask the financial adviser: “How are you paid? What do you get paid? If an investment goes down in price, then do you get paid less?”

In the past, notes Dundee, a lot of information was lumped together under “administrative expenses.” Now, says Miller, sponsors will want a more detailed breakdown of what is being paid by the plan to whom and for what. Advisers should be up front in discussing all administrative expenses, says Dundee, and should keep better track of expenses paid by the master trust and by the plan. Dundee says this is important for two reasons: First, to make sure that administrative expenses are not double reported on the Schedule C, either report the applicable administrative expenses on the plan level or master trust level. Alternatively, these expenses can be divided between the plan and master trust (for example, a plan-level expense would include accountant or actuarial fees and a master trust-level expense would include investment manager and trustee fees). Second, commencing with the 2009 plan year, the administrative fees reported on the Schedule C will be more complex because the plan sponsor will need to break out the direct and indirect compensation for service providers that received compensation of $5,000 or more. So, it is important to examine procedures in which the administrative expenses are recorded and calculated.

Noninsured plans will get information on compensation of advisers, broker/dealers, and other providers that they have not received in the past, notes Reish, including information on revenue-sharing.

Wegesin, however, questions if advisers will be all that surprised. Even with the new rules, a lot of compensation that advisers receive will not be all that apparent. It will be indirect, she says, and still, in many cases, will not have an actual dollar amount disclosed on Schedule C, only a formula because, to the extent the indirect compensation is “eligible,” there is no requirement on Schedule C that a dollar value be reported.

Additionally, notes Bozek, the new disclosures will lead to greater inquiries into services provided and more thorough investigations as to whether the plan receives value for what it pays. The new disclosure rules, she says, will permit sponsors to conduct more thorough side-by-side comparisons of the cost of services. “It will lead to a much more value-oriented shopping experience for the plan sponsor,” she says.

Advisers, says Bozek, should use this as an opportunity to document their services and the value that they bring to a client, particularly how compensation relates to the services delivered. Advisers, she says, should quantify the value they added to the plan, for example, documenting the dollar value of any increase in assets because of a new manager the adviser or investment consultant brought to the plan.

Other Significant Changes

There are also changes made to Schedule A, which is given by insurance companies to report any payments to advisers and third-party administrators, to insurance contracts and retirement plans. On Schedule A, some forms of compensation not reported in the past will be recorded now, says Fred Reish. Thus, he says, if an insurance brokerage firm qualified for a bonus, reimbursement, or trip because of business with the insurance company, it now has to be reported on Schedule A. Plan sponsors, he says, will see the entire compensation the insurance brokerage firm or the insurance broker receives, not just the direct compensation. In order to avoid duplicative reporting, the Department of Labor has created an exception from Schedule C reporting where the same information is reported on Schedule A. Also, while Schedule C only applies to plans with 100 or more participants, Schedule A applies to all plans that are funded with insurance contracts, regardless of the size.

Among the more significant changes is the move to electronic filing. The 2009 plan year Form 5500 cannot be filed on paper, says Janice Wegesin. How electronic filing will work, however, is a bit of a mystery. The DoL is still developing the software, so advisers will not know how the new electronic system will work until sometime next year, says Mark W. Dundee. However, a hard copy of the proposed 2009 Form 5500 is on the DoL Web site for advisers to review, notes Mary Miller.

Additionally, beginning with the 2009 plan year, 403(b) plans will be required to file Form 5500 completely, says Wegesin, including audited financial statements for large plans. Prior to 2009, 403(b) plans were subject to limited reporting—just the Form 5500 with no schedules, says Miller. In 2010, however, 403(b) plans will have to fill out the full 5500 including all the schedules.

Advisers working with 403(b) plans now should also be discussing with clients the new filing requirements. Advisers working with 403(b) plans, says Wegesin, will have to become more involved to help sponsors collect data to prepare the 5500, because, historically, 403(b) plans have not kept good records. Particularly if a 403(b) sponsor is using an auditor for the first time, says Dundee, the sponsor should be aware what information needs to be provided to the auditor long before the time to fill out the form.

Another significant change, at least for micro plans, is a new simplified, short-form, annual reporting form for plans with secure, easy-to-value investments with regulated financial institutions. Plans with 25 or fewer employees at the beginning of the year will have the option of filing the new Form 5500 SF. Previously, says Miller, micro plans have been subject to limited reporting on the Form 5500. Beginning with the 2009 plan year, however, micro plans will have a separate simplified form. The DoL estimates that approximately 594,000 small plans will be eligible to file the new Form 5500-SF. Additionally, unlike Form 5500 filers, Form 5500-SF filers can exempt themselves from electronic filling and retain the option of filing a hard copy with the IRS, says Miller. —ERD

Check Lists for Clients

Mark Dundee recommends that advisers put together check lists of information that they need to get for clients. What type of information depends on the client. Advisers first should contact the plan sponsor/plan administrator for this information. Most likely, they will give the adviser permission to contact their vendors directly (for example, actuary, accountant, trustee, insurance carrier, et al.).

The check list for retirement plans should consist of a request for the following information:

1. Participant data to complete lines 6 and 7 of the Form 5500 and line 3 of the Schedule R (if applicable).
2. Financial data to complete Schedule E, G, H, or I (whichever is applicable)—(this information is obtained from trustees’ statements, audited financial statements, etc.)
3. If any assets of the plan are held in insurance contracts, a copy of the Schedule A information for each contract from the insurance carrier.
4. Actuarial information that consists of a signed and dated Schedule SB or MB along with—commencing with the 2008 plan year—an attachment to the Schedule R (for single-employer, multiple-employer, and multiemployer plans with 1,000 or more participants) if applicable.
5. Service provider information for providers that received compensation from the plan of $5,000 or more (as well as the sum total of all providers who received compensation from the plan of less than $5,000) to complete the Schedule C (if applicable—only for large plans).
6. If there was a termination of an accountant or enrolled actuary, you will need to find out the reason for termination.
7. Direct filing entity information to complete Schedule D (if applicable)—if any of the plan’s assets were held in common collective trusts, pool separate accounts, master trust investment accounts, or 103-12 investment entities.
8. Funding information to complete Part II of the Schedule R (if applicable).
9. If there were participants that terminated employment with deferred vested benefits and are required to be reported on the Schedule SSA, you will need the name and Social Security number of each participant, along with the type of annuity code, payment frequency code, and the benefit amount or account balance (if applicable).
10. The date the most recent 410(b) coverage testing and the coverage test the plan satisfied (if applicable).

Illustration by Nigel Buchanan