Employers that sponsor section 401(k), 403(b), and other types of retirement plans rely on third parties to conduct the day-to-day administrative functions of these plans. Investment managers, record-keepers, consultants, and other third parties all provide necessary plan services and are compensated for their efforts.

It is the responsibility of the plan fiduciaries—those ultimately responsible for the administration of the plan and the investment of plan assets—to pay those third parties no more than “reasonable” compensation. If a fiduciary pays a third party an unreasonable amount, the fiduciary could have liability and face excise tax penalties under the Employee Retirement Income Security Act of 1974 (ERISA), the federal employee benefits law.

ERISA does not define what constitutes “reasonable” compensation for services. The U.S. Department of Labor (DOL) has long been concerned that the increasing complexity and sophistication of service provider contracts make it difficult for a responsible plan fiduciary to determine whether compensation to be paid to a service provider is reasonable.

The DOL has issued a new regulation (under Section 408(b)(2) of ERISA), which:

  • Requires certain “covered service providers” to retirement plans subject to ERISA to make specific written disclosures to a plan’s responsible fiduciary regarding the scope of its services and all expected direct and indirect compensation, whenever a contract or arrangement for services is entered into, extended, or renewed
  • Provides that a covered service provider contract or arrangement will not be reasonable (and hence will be an ERISA-prohibited transaction) if the required disclosures are not provided to the fiduciary
  • Provides a class exemption protecting the responsible plan fiduciary from an ERISA violation, but only if (i) the fiduciary reasonably believes that all information required under the Regulation has been disclosed, and (ii) the fiduciary, upon discovering a failure to disclose, requests the required information from the service provider (and notifies the DOL if the requested information is not provided in a timely manner)

The new 408(b)(2) regulation takes effect on July 1, 2012. It will apply to service provider contracts entered into, extended, or renewed on and after that date. In addition, the responsible plan fiduciary must obtain the required disclosures for a plan’s existing contracts with covered service providers as of July 1, 2012.

To comply with the new 408(b)(2) regulation, we recommend that the responsible plan fiduciary develop procedures that will permit it to demonstrate that its arrangements with third-party service providers are reasonable. Documenting the process by which the required information is solicited, reviewed, and evaluated is the most effective means to achieve compliance. Some best practices may include the following:

  • Identify an individual or committee that will be responsible for identifying covered service providers and soliciting and evaluating the required disclosures. The disclosures must be received “reasonably in advance” of the date the service provider contract or arrangement is entered into, extended, or renewed.
  • Implement a written policy or procedure to identify the duties of the responsible individual or committee, the required elements of disclosure (which differ depending on the type of covered service provider), and the process to be followed if the required disclosures are not provided, in whole or in part.
  • Document the responsible individual’s or committee’s review of the information disclosed, and the report of its findings to the fiduciary with ultimate responsibility for entering into the service provider contract or arrangement. Document the process by which such fiduciary decision-making is made.
  • Consider engaging an independent expert to provide “benchmarking” services to allow the responsible plan fiduciary to evaluate and compare the service provider’s aggregate compensation with other comparable service providers and industry standards, and to otherwise assist in supporting the process by which the fiduciary determines and documents that a service provider’s compensation is reasonable.

Procedural due diligence is especially important in evaluating the performance of investment options offered under a 401(k) or 403(b) plan where participants can direct the investment of their own accounts. Direct and indirect fees and other charges affect the value of participants’ accounts, and the documentation of procedural diligence can provide an effective defense in the event of litigation claiming that the plan fiduciary has violated its duty to monitor fees and expenses.

Plan fiduciaries should have a process in place to periodically monitor the performance of a 401(k) or 403(b) plan’s investment options and to document that the plan continues to provide a broad range of investment options that conform to the plan’s investment policy and do not charge excessive fees.

Ballard Spahr’s Employee Benefits and Executive Compensation Group assists employers in understanding the 408(b)(2) regulation, and can help develop policies and procedures to document the exercise of your organization’s fiduciary responsibilities regarding the investment and administration of plan assets. If you have questions, please contact Brian M. Pinheiro at 215.864.8511 or pinheiro@ballardspahr.com or Kurt R. Anderson at 215.864.8432 or andersonk@ballardspahr.com. 

Copyright © 2012 by Ballard Spahr LLP.
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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.