service provider compensation

Service Provider Compensation

Steve Saxon, Andrée St. Martin, Roberta Ufford

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Provider Compensation

… an issue for Plan sponsors and providers

… pension plans, DC plans, welfare plans

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ERISA regulates pension and welfare plans.

– pension plans - DB plans, DC plans (e.g., 401(k))

– welfare plans - health, disability, life

– insured and self-insured ERISA has highly technical rules regulating the conduct

of fiduciaries (e.g., employers, investment managers and advisers, and other fiduciary service providers), including prohibitions on fiduciary conflicts of interest.

It also has technical “prohibited transaction” rules that regulate, among other things, the provision of services to plans.

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Plan sponsor/fiduciary has a fiduciary duty to prudently select and compensate plan providers.

A plan “service provider” is any person rendering services to a plan.

A service provider may or may not be a fiduciary; and, is only a fiduciary “to the extent” of its fiduciary acts.

Under traditional analysis, a non-fiduciary service provider (a “mere” service provider) does not owe a direct duty to the plan.

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Provider Compensation –Two Forms

Paid by the plan, e.g., typical fees for plan administration and investment management, securities transaction costs. Some fees are invoiced; some costs are reflected

in investment return (e.g., unitized funds may "hide" expenses).

Provider compensation from third parties, e.g., commissions, soft dollars, 12b-1 and other fees from mutual funds, pharmacy rebates, "non-cash" compensation. Some third party payments are not “compensation” for

plan services.

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May a Provider Legally Accept Payments from a Third Party?

Key Consideration: Is the payment is made “in connection” with a "fiduciary" act on the part of the Provider?

Other Possible Considerations: If Provider is not acting as a "fiduciary" in causing

the payment, is the Provider a plan fiduciary for any other reason?

Is Provider's total compensation "reasonable"?

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Service Provider Compensation: Mutual Fund Fees

Plan

Service Provider(trustee, broker

or recordkeeper)

MutualFund

Investments (plan pays management and other fees)

Commissions/Other Fees • e.g., 12b-1 fees• paid by fund or agent

Plan Service Fees

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Fiduciary Provider May Not Receive Payments Absent Exemption

If a payment is in connection with a Provider’s fiduciary act, Provider cannot accept it (or must offset it against fees plan might otherwise pay). E.g., 401(k) plan recordkeeper/investment provider

with fiduciary authority to select plan investment options generally must rebate or offset fees received from mutual funds,

DOL Adv. Ops. 1997-15A (May 22, 1997) and 2005-10A (May 11, 2005).

Certain exemptions allow Providers to retain commissions/management fees, e.g., PTE 75-1, 77-4, 84-24.

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Provider May Receive Payments Not Connected with Fiduciary Act

A Provider may accept payments from third parties, IF the payment is not caused by a fiduciary act. E.g., plan recordkeeper/investment provider who

merely offers a "platform" of investments from which plan sponsors choose, is not a fiduciary and may retain frees from mutual funds.

See DOL Adv. Ops. 2003-09A (Aug. 25, 2005) and 1997-16A (May 22, 1997)

These opinions recognize that offering a typical 401(k) investment platform doesn’t make a recordkeeper a fiduciary.

Haddock may suggest a different result.

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Does Haddock Threaten Traditional Analysis?

Haddock v. Nationwide Financial Services, Inc. Civ. Action No. 3.01cv1552 (SRU) (D. Conn, February 24,

2006) Lawsuit by 401(k) plan sponsors filed in 2001 relates to

Nationwide’s receipt of fees from unaffiliated investment companies (“funds”) offered as investment options under variable annuity contracts.

Under a typical service arrangement, each plan sponsor chose a group of funds for its plan from those Nationwide made available under its annuity contract. Nationwide selected available funds based in part on

revenue sharing paid by funds.

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Does Haddock Threaten Traditional Analysis?

Haddock v. Nationwide Financial Services, Inc. (con’t) Denying Nationwide’s motion for summary judgment,

court held – Nationwide was a plan fiduciary because it retained

discretion to add/delete fund options. Nationwide may have been a fiduciary in choosing funds

for its platform. Revenue sharing payments from funds could constitute

“plan assets.” Even if revenue sharing payments are not “plan assets,”

Nationwide’s receipt of revenue sharing could have involved prohibited transactions.

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Service Provider Compensation:Pharmacy Rebates

Plan

PBM/TPA

Drug Co.

Drug Rebates

Service Fees

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DOL Settlement Suggests Different Standard for Welfare Plans?

DOL’s complaint against PCN alleges - PBM is a fiduciary PBM agreed to share drug rebates, but improperly

retained part of plan’s portion Pharmacy Manager settles with DOL (5/06)

PCN paid $721,000 to plans and penalties to DOL In future, PCN must disclose retained rebates and

account for them. Case suggests that a service provider may retain a

payment received in connection with a fiduciary decision This is not the approach taken on mutual fund fees.

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Duties Where Provider is Allowed to Receive Third Party Payments

When a Provider receives a third party payment in connection with plan services –

DOL’s longstanding view: the plan sponsor/fiduciary must "take the payment into account" in determining whether the plan’s payment to the provider is “reasonable compensation.”

See, e.g., DOL Adv. Ops. 97-15A and 97-16A. If services to plan and third party "overlap," plan

might reasonably request to pay less for services. If payments are for separate services by a provider to

a third party, plan fees ought not to be reduced.

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Plan Sponsor’s Duty to Take Third Party Payments into Account

A fiduciary (typically, employer/sponsor) must “prudently” select the plan’s service providers. The fiduciary — must “engage in an objective process designed to

elicit information necessary to assess the qualifications of the provider, the quality of services offered, and the reasonableness of the fees charged in light of the services provided. . . such process should be designed to avoid self-dealing, conflicts of interest or other improper influence.” - Field Assistance Bulletin 2002-3 (Nov. 5, 2002).

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No Corresponding ERISA Disclosure Duty for a Non-Fiduciary Provider

Currently, a non-fiduciary Provider has no affirmative ERISA duty to disclose its payments from third parties. DOL has "encouraged" disclosure in guidance on mutual

fund fees and "float." More recently, increased regulatory attention to

disclosure by Providers that are not ERISA fiduciaries. New York State Attorney General investigations of

insurance industry practices, including commissions and other payments

SEC investigations and enforcement (e.g., shelf space actions and pension consultant examinations)

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DOL is Developing a Provider “Incentive” to Disclose, if Not a Duty

Because a Provider is a “party in interest,” its provision of services to the plan requires an exemption. As a party in interest, Provider would be liable for excise

tax (pension) or section 502(i) penalties (welfare) if the services are not exempt.

Current 408(b)(2) regulations require — services are “necessary and appropriate,” the arrangement is “reasonable,” and no more than “reasonable compensation” is paid.

See 29 CFR § 2550.408b-2.

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Developing a Provider “Incentive” to Disclose: § 408(b)(2) Regs

DOL likely to make disclosure a condition of exemption. Likely to require disclosure of information sufficient to

permit plan fiduciary to consider whether – the plan pays reasonable fees for services, the service provider's total compensation

(including third party fees) is “reasonable,” and any conflicts of interest affect the service

provider's advice.“This amendment will ensure plan fiduciaries are provided or have access to information necessary to determine whether an arrangement is reasonable…this regulation is needed to eliminate the current uncertainty…”

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Developing a Provider “Incentive” to Disclose: § 408(b)(2) Regs

Possible Disclosure Model - FAB 2002-03 addresses disclosure of “float” income by service providers. To avoid potential prohibited transactions, service providers should disclose —

circumstances where float is earned, when “float” period may begin and end, and rate earned on float.

Unclear whether DOL will issue model or “safe harbor” format for service provider disclosure under 408(b)(2).

See Proposed Schedule C for “hints.”

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Schedule C - Reporting of Service Provider Compensation

Schedule C, filed by plan administrator, requires reporting on service provider compensation paid by the plan.

For years, Schedule C Instructions have required reporting of “indirect” compensation, including “finder’s fees” and other fees and commissions received in connection with plan transactions.

But, typically not reported … 2004 ERISA Advisory Council Report - Service

provider compensation paid indirectly by mutual fund revenue sharing typically not reported.

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DOL proposed changes to Schedule C (Service Provider Compensation).

Schedule C changes expected to “clarify” reporting requirements and ensure plan officials obtain information necessary to review reasonableness of compensation, taking into account “revenue sharing or other financial relationships” and potential conflicts of interest that might affect services.

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Proposed Schedule C changes would — Establish an elaborate scheme for reporting “indirect

compensation” received by most service providers. “Indirect compensation” would include all

amounts paid in connection with plan services, or the recipient’s position with the plan.

Require some third party payments to be reported on an unallocated basis.

Require “float” to be reported in dollars.

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Compensation Principles Applied: Class Actions vs. Plan Sponsors

New class actions allege plan fiduciaries imprudently allowed plan providers to receive “revenue-sharing” payments. Plaintiffs allege plan fiduciaries — caused plans to enter service arrangements under

which the plan and participants paid “unreasonable fees” and “hidden and excessive fees,”

did not understand/recognize revenue sharing arrangements, and

did not disclose to participants in “proper detail and clarity” the transactions, fees and expenses.

E.g., Loomis v. Exelon Corp., Case No. 1:06-cv-04900 (filed Sept. 11, 2006, N.D. Ill.).

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Service Provider Compensation: Disclosure to Plan Participants

DOL is considering changes to regulations for participant-directed plans under section 404(c).

DOL says that rulemaking is needed – “to ensure that the plan participants…are provided the information they need, including information about fees and expenses, to make informed investment decisions . . .”

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DOL review of 5500 filings of participant directed plans revealed that only 50% identify themselves as "404(c) plans" Currently, DOL is thinking about applying the same

disclosure requirements to all participant directed individual account plans, whether or not the plan is a 404(c) plan (requires finding a disclosure duty).

New guidance likely to include both automatic and on-request disclosure requirements.

DOL exploring possible role for electronic information in new disclosure regime.

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Possible changes based on 2004 ERISA Advisory Council Recommendations

Deliver a “profile prospectus” (or equivalent) for each plan investment option.

Require investment education for participants. Include investment expense information on annual

statements provided to participants. DOL should provide a sample model participant

disclosure format.

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Compensation Principles Applied: Spitzer Settlement with 403(b) Provider

Retirement Product Disclosure - Settlement Agreement In a settlement with the New York State Attorney

General, a 403(b) provider agreed to pay restitution and implement a standard format for retirement product disclosure. Settlement relates to 403(b) Retirement Program

endorsed by NY State Teacher's Union. The 403(b) provider and Union did not disclose to teachers expense reimbursements paid by provider to Union.

Provider’s 403(b) Program competed with 403(b) products offered to teachers by other providers.

Orders available at www.oag.state.ny.us/press/2006/0ct/oct10a_06.html

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Compensation Principles Applied: Spitzer Settlement with 403(b) Provider

NY Attorney General Settlement Agreement "One-Page Disclosure" to 403(b) Participants

States "all-in" investment cost, as a percentage of account balance.

Chart shows affect of fees on investor account balances over time.

Discloses that fund companies may pay 403(b) provider to be included as investment options, and that 403(b) provider and funds are seeking to make a profit.

Does not require disclosure of rates or amounts paid by funds, individual fund fees, or contract charges.

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Service Provider Compensation: Suggestions for Plan Sponsors?

Review Plan fee arrangements. Identify Providers’ direct/indirect compensation Consider benchmarking?

Review fiduciary process for legal sufficiency Adequate due diligence? Documentation?

Review governance/fiduciary structure. Review disclosure to participants about how plan fees

are paid, especially asset-based charges that support plan administrative costs.

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Service Provider Compensation: Suggestions for Service Providers?

Plan Providers, including 401k and Managed Care Review disclosure to plan sponsors of

direct/indirect compensation. Consider "plain language" disclosure of third party

revenue (not necessarily including rates of fees). Review contractual authority to make changes in

"401(k) fund platform" and other fee arrangements. Consider cost and issues relating to proposed

Schedule C reporting and comment to DOL.

service provider compensation

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