FEATURE ARTICLES Volume 18 • Number 3 - Wolters Kluwer

FEATURE ARTICLES

Volume 18 • Number 3

Spring 2011

COLUMNS

Focus On… Measuring Service Under Retirement Plans . . . . . . . . . . . . . . . . . 3David A. Pratt

Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International . . . . 12Stephen D. Rosenberg

Choosing a Path for Stable Value Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20Marshall J. Cobb

Best Practices in Applying Revenue Sharing. . . . . . . . . . . . . . . . . . . . . . . . . . . 25Pete Kirtland

Mental Health Parity and Our Inability to Make Forward Progress . . . . . 29Catherine Rische

New ERISA Fiduciary Definition…Smoke and Mirrors or a Meaningful Assignment of Accountability? . . . . . . . . . . . . . . . . . . . . . . . . . 37Jessica R. Flores

Most Common Nonconformities and Opportunities for Improvement in 401(k) Plans Found in Fiduciary Assessments. . . . . . . . . 46Michael M. Kane

DOL Final Rule on Participant-Level Fee Disclosure . . . . . . . . . . . . . . . . . . . 49Anthony L. Scialabba

Do Tax-Qualified Plans Still Make Sense?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60Allen Buckley

From the Editors • Ilene H. Ferenczy and Adam C. Pozek . . . . . . 1

Legal Developments • Elizabeth Thomas Dold . . . . . . . . . . . . 62A New Plan Design Feature for Qualified Plans: The Roth “In-Plan” Rollover

Plan Administration • J. Reed Cline . . . . . . . . . . . . . . . . . . . 66Preparer Tax Identification Number and the Independent Administration Firm

ERISA Litigation Update • Tess Ferrera . . . . . . . . . . . . . . . . . 68In My Humble Opinion: Some Things Are Best Left Alone

Q&As from the Technical Answer Group (TAG) • From the Specialists at TAG . . . . . . . . 72Target assumption date; Spin-off and applicable interest rate; PBGC, Professional Services Organization, and deduction limit; Ownership attribution from ESOP; Trusting your nose

Business Best Practices • Sarah L. Simoneaux and Chris L. Stroud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75SWOT Analysis: The Annual Check-Up for a Business

Plan Audits • Christopher E. Etheridge . . . . . . . . . . . . . . . . . . . 79Audit 101: A Guide to Employee Benefit Plan Audits Selecting the Right Auditor

J o u r n a l o f P e n s i o n B e n e f i t s

C o - E d i t o r s - i n - C h i e f E d i t o r i a l B o a r d

Ilene H. Ferenczy, Esq.Law Offices of Ilene H. Ferenczy, LLC2200 Century ParkwaySuite 560Atlanta, GA 30345404-320-1100Fax: 404-320-1105E-mail: [email protected]

Adam C. PozekDWC ERISA Consultants, Inc.5 Brook Pasture LaneSuite AEssex, MA 01929651-204-2600 x107Fax: 651-204-2700E-mail: [email protected]

EDITOR EMERITUS

Joan Gucciardi

PUBLISHER

Paul Gibson

EDITORIAL DIRECTOR

Ellen Ros

EDITOR

Amy Burke

SENIOR EDITORS

William F. Brown, Esq.Milwaukee, WI

Tess J. Ferrera, Esq.Miller & Chevalier, LLC Washington, DC

Gene Fife, MAAA, FSA, EABuck Consultants, an ACS CompanyAtlanta, GA

David A. Pratt, Esq.Albany Law SchoolAlbany, NY

Lawrence C. Starr, FMLI, CLU, CEBS, CPC, EAQualified Plan Consultants, Inc.West Springfield, MA

Martin Tierney, Esq.Deloitte Tax, LLPMilwaukee, WI

S. Derrin Watson, Esq.Tax AttorneyGoleta, CA

CONTRIBUTING EDITORS

Harold J. AshnerKeightley & Ashner LLPWashington, DC

J. Reed Cline, QPA, QKABenefit Consultants GroupDelran, NJ

Elizabeth Thomas Dold, Esq.Groom Law Group, Chtd.Washington, DC

Jay K. Egelberg, ASA, MAAA, EA

Buck Consultants, an ACS CompanySecaucus, NJ

Matthew D. HutchesonMatthew Hutcheson, LLCTigard, OR

Maureen Oster, CFAMBO Cleary Advisors, Inc.Milwaukee, WI

Eric Paley, Esq.Nixon Peabody LLPRochester, NY

EDITORIAL ADVISORS

Bruce L. Ashton, Esq.Reish & ReicherLos Angeles, CA

Jennifer A. Berg, CPC

Berg Retirement Plan Consulting, LLC

Pewaukee, WI

Edward E. Burrows (in memoriam)

Consulting Pension Actuary

Boston, MA

Jeff Chang, Esq.

Chang, Ruthenberg & Long PC

Folsom, CA

Debra A. Davis

Union Pacific Railroad

Omaha, NE

Robert J. Dema, CPA, CPC

CPI Qualified Plan Consultants

Great Bend, KS

Lloyd J. Dickinson, Esq.

Foley & Lardner

Milwaukee, WI

Anita Costello Greer

Hodgson Ross LLP

Buffalo, NY

Lawrence Grudzien, JD, LLM

Attorney at Law

Oak Park, IL

Craig P. Hoffman, JD, LLM

ASPPA

Jacksonville, FL

Kathryn Kennedy, FSA, Esq.

John Marshall Law School

Chicago, IL

Joseph J. Masterson

Diversified Investment Advisors

Purchase, NY

J. Michael Pruett, JD, CPC, QPA, APA

Cache Pension Services, Inc.

Anchorage, AK and Reno, NV

Anthony L. Scialabba, Esq.

Scialabba and Associates, P.C.

Marlton, NJ

Mark Stember, Esq.

Kilpatrick Stockton, LLP

Washington, DC

Charles Stipelman, FSPA, CPC

CMS Pension Associates, Inc.

Matawan, NJ

Copyright ©2011 CCH Incorporated. All Rights Reserved.

Journal of Pension Benefits (ISSN: 1069-4064) (USPS 017-742) is published quarterly by Aspen Publishers, a Wolters Kluwer business, 76 Ninth Avenue, New York, NY 10011. One year subscription $309; two years $525; three years $742; single issue $93. Address editorial comments to Journal of Pension Benefits, Aspen Publishers, 76 Ninth Avenue, New York, NY 10011. POSTMASTER: Send address changes to Journal of Pension Benefits, Aspen Publishers, 7201 McKinney Circle, Frederick, MD 21704. This material may not be used, published, broadcast, rewritten, copied, redistributed or used to create any derivative works without prior written permission from the publisher. Printed in U.S.A.Permission requests: For information on how to obtain permission to reproduce content, please go to the Aspen Publishers website at www.aspenpublishers.com/permissions.Purchasing reprints: For customized article reprints, please contact Wright’s Media at 1-877-652-5295 or go to the Wright’s Media website at www.wrightsmedia.com.For customer service requests, call 800-234-1660. To subscribe, call 800-638-8437.

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1

Ah, Spring. It is a word that elicits a multitude of reactions. To those in the northern parts of the country, it means seeing the lawn for the

first time in months as the snow melts. To those in the south, it means the bloom of dogwoods and azaleas. To many, it means the crack of the bat. To all of us, it means a new edition of the JPB!

Just as spring means the emergence of new things, this spring edition includes several new authors. Christopher E. Etheridge, partner at the CPA firm of Frazier & Deeter, LLC, joins us with his inaugural col-umn on employee benefit plan audits.

Stephen D. Rosenberg is an ERISA litigator and partner at The McCormack Firm, and he has pro-vided his insights in his article “Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International.”

The proper use of revenue sharing in participant-directed plans continues to be a perplexing topic, and Pete Kirtland of ASPire Financial Services, LLC, shares his thoughts in “Best Practices in Applying Revenue Sharing.”

Never fear, we still have many great contributions from the authors you have come to expect in these pages. Elizabeth Thomas Dold describes the new in-plan Roth conversion provisions added by the Small Business Jobs and Credit Act of 2010.

In the last edition, Anthony L. Scialabba discussed the new plan-sponsor-level fee disclosure regulations, and in this edition, Tony is back with his analysis of the recently finalized participant-level fee disclosure regulations.

Also in the world of new regulations, Jessica R. Flores takes a look at the proposed changes to the definition of fiduciary in her article, “New ERISA Fiduciary Definition…Smoke and Mirrors or a Meaningful Assignment of Accountability?”

Tess Ferrera also examines the proposed regula-tions redefining “fiduciary” and concludes that “In [Her] Humble Opinion: Some Things Are Better Left Alone.”

“Do Tax-Qualified Plans Still Make Sense?” Allen Buckley explores this question and how the possibility of higher tax rates driven by an increasing budget defi-cit may challenge the conventional wisdom.

Preparers of Form 5500 have been officially exempted from the requirement to obtain a Preparer Tax Identification Number (PTIN). J. Reed Cline

explains in his column why that collective sigh of relief may be premature and how many plan service provid-ers may still be on the PTIN hook.

Sarah L. Simoneaux and Chris L. Stroud continue their column on business best practices by remind-ing us that just as regular check-ups are necessary to maintain our individual health, we must also con-duct regular check-ups to ensure the health of our businesses.

Speaking of health, this edition brings you the sec-ond part of Catherine Rische’s in-depth article on the evolution of mental health parity in our health care system and what we might expect as a result of health care reform.

Michael M. Kane draws on his experience conduct-ing fiduciary assessments to describe some of the “Most Common Nonconformities and Opportunities for Improvement in 401(k) Plans Found in Fiduciary Assessments.”

Stable value funds hold more than $500 billion in assets, but there is a relative paucity of information about the funds and how they operate. Marshall J. Cobb shines some light on these often-used but little-known funds and explores how the recent financial reform legislation may impact them.

Our resident law professor David A. Pratt takes an in-depth look at an issue that impacts every aspect of every retirement plan but can be much more com-plicated than it appears on the surface…measuring service.

Last, but not least, the folks at the Technical Answer Group have provided us with a lineup of DB-related questions and answers with an ESOP/controlled group Q&A for good measure.

The Death of the Defined Benefit Plan One of the most fascinating political trends that we

see in this era of “nothing working as it should” is to question the necessity, in the first place, of whatever it is that is not working. If it’s working so poorly, maybe we should just get rid of it.

There’s some logic to that, but sometimes the thing itself is necessary, and the return to a life before it existed portends even worse circumstances. Such is the case, I fear, with the defined benefit plan.

In the nascent stages of retirement plans, the defined benefit plan is the pension that people envisioned—the promise of a consistent supplementary income of some sort after one stopped working for a living. It is the

From the Editors

2 JOURNAL OF PENSION BENEFITS

one that makes the most sense in terms of the retiree’s financial security, as it doesn’t stop until the retiree stops. Okay, there may be some problems with the effects of inflation, but that check just keeps coming and coming like the Energizer Bunny. What is the cli-ché describing elderly people? They are “old ladies on a pension.”

In theory, the defined benefit plan should be pre-dictable and affordable. You take the ultimate cost of someone’s pension, and you fund it over their working lifetime using a reasonable interest rate and mortal-ity assumption. Individual aggregate funding made sense—each person’s benefit is funded levelly over that person’s remaining working lifetime. Okay, so earn-ings are unpredictable, but you invest in a relatively balanced portfolio, and it all evens out in the long run. Smaller plans may have some insecurities, but larger plans should be safe as a result of the economies of scale that they represent; some participants will leave, some will die, some years’ investments will do well, some years’ investments will do poorly. But, in the end, it all makes sense.

So, why is the defined benefit plan world in such dis-array? You can point to the economy, but that is really just an excuse. It isn’t the economy. It’s the funding practices used by large plans—particularly governmental plans—that have created such a disaster. The fact is, employers and governmental entities have for years manipulated the funding pattern of the retirement plan so as to make big contributions when tax deductions were needed and make small contributions when busi-ness aims needed the money elsewhere. Unions were complicit—if management was rigid on not providing additional funds to labor, just get them to agree to up the pension. The funding would be spread over years in the future, and no one would be the wiser.

It was the functional equivalent of having a hole in your bucket, but having a hose continuously refilling what is lost, so that it gives the appearance that the bucket is full. Until someone turns off the hose.

My friend, Larry Starr, passed on to me an interview of Jeb Bush by the Wall Street Journal . The article states:

So new Republican governors should adopt rules for

countercyclical budgeting and fully funded pensions? Too

timid, Mr. Bush says. “I would argue for the elimination

of the defined-benefit system. Might as well get to the

end of the conversation, that’s where this is all going.”

Then, “figure out a creative way to deal with the unfund-

ed liabilities.”

It’s interesting that Mr. Bush notes that the next step is to figure out a way to deal with the unfunded liabilities, which is the short term problem. How does Mr. Bush intend to deal with the retirees who have no pensions in the future? How are we to ensure that elderly people have money to live on once their work-ing lives have ended?

It’s easy to say that people should save. But they don’t. And, even if they do, unstable economies destroy nest eggs. I have many friends who were the proverbial ants saving up for the winter while their grasshopper friends played in the sunshine. But, the economy of the last five to 10 years has destroyed the savings of almost every one of these families, as sig-nificant unemployment and the rising costs of college educations have wiped out what they thought was to be their retirement security. That doesn’t mean that we should wipe out savings because saving doesn’t work—God only knows what would have happened to these people in their unemployment distress if they didn’t have these savings. But, we need to acknowl-edge that even the best laid plans often go awry, and the need for money in our old age is an immutable fact.

Retirement security must be based on a promise of a pension, coupled with responsible funding. If we are to analyze how to replace the current retirement plan system, we need to envision a model where superannu-ated individuals are financially supported. Eliminating retirement programs without having some solution to replace them is a short term fix that will result in financial disaster.

Correction Notice: In the Winter 2011 print edi-tion, Dr. Gregory Kasten’s first name was inad-vertently listed as “George” in a citation in the article “Deconstructing the Discretionary Fiduciary Models: ERISA Section 3(38) Investment Managers vs. Discretionary Trustees” by Jason E. Grantz and Michael Samford. We apologize to Dr. Kasten, Jason, and Michael for the oversight and appreciate their contributions to the JPB. ■

3

A R T I C L E

Focus On… Measuring Service Under Retirement Plans B y D a v i d A . P r a t t

Prior to the enactment of the Employee Retirement

Income Security Act (“ERISA”) in 1974, qualified

plans often required an employee to complete a

lengthy period of service before being eligible to

participate (five years was common), excluded all

part-time employees, required a long period of

continuous service before an employee became

vested in his or her benefits under the plan, and

calculated benefits by reference to the most recent

period of continuous service.

Thus, in International Brotherhood of Teamsters, Chauffeurs, Warehousemen & Helpers of America v. Daniel, 439 U.S. 551 (U.S. Supreme Court, 1979), Daniel was ineligible for a pension, despite having more than 20 years of plan participation, because of a

seven-month break in credited service that occurred years before he applied for a pension. (The case was decided under the securities laws because the events preceded the effective date of ERISA.) Accordingly, to enhance the protection of employees and plan partici-pants, Congress included in ERISA detailed rules (1) for measuring periods of service for purposes of eligi-bility to participate, vesting, and benefit accrual, (2) reducing the length of service that could be required for eligibility and vesting, and (3) limiting the effect of interruptions in service.

These rules are highly complex, and require dense plan language to describe correctly the rules that apply to the particular plan, and careful plan admin-istration to ensure that the plan’s rules are applied correctly in operation. Even today, 36 years after ERISA was enacted, one cannot simply assume that the employer’s payroll system or an employee census provided by the employer accurately provides the required information.

If the plan covers employees of one or more of a group of affiliated entities, or if the intent is to cover some but not all employees of a participating employer (e.g., nonunion employees only), then the plan provisions defining the eligible employees and the participating employers must also be drafted with care.

Most of the rules discussed in this article appear in both ERISA and in the Internal Revenue Code of 1986 (the “Code”), both of which have been amended frequently since 1974. The ERISA rules apply to “pension plans” described in Section 3(2) of ERISA, qualified or nonqualified. Certain plans, notably gov-ernmental plans and nonelecting church plans, are exempted from ERISA by Section 4(b). The Code rules apply to plans intended to satisfy the qualifica-tion rules of Code Sections 401(a), 403(a), or 403(b), with exceptions for governmental plans, nonelecting church plans, and certain other arrangements [Code §§ 410(c), 411(e)].

The Basic Measurement Unit: The Hour of Service

The general method of calculating service is based on determining whether an individual has completed a sufficient number of Hours of Service, during the appropriate computation period, to be credited with a Year of Service. In general, one Hour of Service must be credited for each hour for which an employee is paid, or entitled to payment by the employer, directly or indirectly (e.g., from a trust fund) (1) for

David A. Pratt is a professor of law at Albany Law School. He

received his law degree from Oxford. Since 1976, he has special-

ized in retirement plans and other employee benefit programs.

David has written numerous articles and is co-author of two books.

He is also a frequent lecturer. In 2001, he was elected a fellow of

the American College of Employee Benefits Counsel. He is also

actively involved with the New York State Bar Association.


the performance of duties for the employer, or (2) on account of a period of time during which no duties are performed (irrespective of whether the employ-ment relationship has terminated) due to vacation, holiday, illness, incapacity (including disability), lay-off, jury duty, military duty, or leave of absence, or (3) for which back pay is awarded or agreed to by the employer. The same Hours of Service are not credited both under (1) or (2), as the case may be, and under (3) [DOL Reg. § 2530.200b-2(a)]. Under (2), (i) no more than 501 hours are required to be credited on account of any single continuous period during which the employee performs no duties, and (ii) an employee is not required to be credited with a greater number of Hours of Service than the number of hours regularly scheduled for the performance of duties during that period. No Hours of Service are required to be credited (a) for a payment that solely reimburses medical or medically related expenses incurred by the employee or (b) if payment is made or due under a plan main-tained solely for the purpose of complying with work-ers’ compensation, unemployment compensation, or disability insurance laws.

The regulations also specify how Hours of Service are credited to computation periods [DOL Reg. § 2530.200b-2(c)] and describe the provisions required to be included in the plan document [DOL Reg. § 2530.200b-2(f)].

Alternative Methods The basic Hours of Service method requires the

employer to have records that “accurately reflect the actual number of hours of service with which an employee is required to be credited” [DOL Reg. § 2530.200b-3(a)]. This may not be the case, with respect to some or all of the potentially eligible employees. The regulations do provide that “A plan may in any case credit hours of service under any method which results in the crediting of no less than the actual number of hours of service required to be credited…to each employee in a computation period, even though such method may result in the crediting of hours of service in excess of the number of hours required to be credited,” but it is hard to imagine situations where this would actually help. [ Id., empha-sis supplied.]

Because of the difficulty, and the fundamental importance, of calculating service correctly, the regulations permit the use of equivalencies, which “are designed to enable a plan to determine the amount of service to be credited to an employee in

a computation period on the basis of records which do not accurately reflect the actual number of hours of service required to be credited to the employee…. However, the equivalencies may be used even if such records are maintained. Any equivalency used by a plan must be set forth in the document under which the plan is maintained” [DOL Reg. § 2530.200b-3(c)(1)]. A plan may use different methods of credit-ing service for different classifications of employees or for different purposes, provided that the classifica-tions are reasonable and are consistently applied. The classification must not be designed to preclude an employee from attaining his or her statutory entitle-ment with respect to eligibility, vesting, or benefit accrual. Also, an action that is permissible under the DOL regulations may result in prohibited dis-crimination under Code Section 401(a)(4) [DOL Reg. § 2530.200b-3(c)(2), (3)].

Permitted Equivalencies Instead of crediting actual Hours of Service, the

plan may use any of the equivalencies described below. The price, as shown below, is that the number of Hours of Service required for a Year of Service, or to avoid a One-Year Break in Service, is reduced [DOL Reg. § 2530.200b-3(d)].

Method Year of Service Break in ServiceActual Hours of Service

1,000 501

Hours worked 870 436

Regular time hours

750 376

Alternatively, the plan may credit Hours of Service as follows for each period for which the employee would be required to be credited with at least one Hour of Service, for working or non-working time, under the basic method [DOL Reg. § 2530.200b-3(e)]:

Number of Hours of ServiceEach day of employment 10

Each week of employment 45

Each semimonthly payroll period 95

Each month of employment 190

If certain conditions are satisfied, a plan may deter-mine the number of Hours of Service on the basis of shifts, may combine an equivalency based on work-ing time with an equivalency based on periods of

FOCUS ON… MEASURING SERVICE UNDER RETIREMENT PLANS 5

employment, or may use equivalencies based on earn-ings [DOL Reg. § 2530.200b-3(e)(2), (7), (f)].

What Is a Year of Service Once the plan has determined the number of Hours

of Service, the next stage is to translate these into Years of Service. In general, an individual must be credited with one Year of Service for each 12- consecutive-month computation period for which he or she has at least 1,000 Hours of Service (or, if an equivalency is used, the lesser number of Hours of Service applicable to that equivalency). The plan may specify a lesser number.

Eligibility All qualified plans must satisfy minimum par-

ticipation standards [Code §§ 401(a)(3), 410]. Any retirement plan subject to ERISA must satisfy essentially identical requirements [ERISA § 202]. A qualified defined benefit plan must also satisfy an additional participation requirement, the 50 employee/40 percent of employees rule under Code Section 401(a)(26), which has no ERISA counterpart.

A plan may generally not require, as a condition of participation, that an employee complete a period of service, with the employer or employers maintaining the plan, greater than one Year of Service. Two Years of Service may be required if the plan provides full vesting after no more than two Years of Service [Code § 410(a)(1); ERISA § 202(a)(1)].

A qualified 401(k) plan may not require an employee to complete a period of service longer than one Year of Service before being eligible to make elec-tive deferrals [Code § 401(k)(2)(D)].

For purposes of eligibility to participate, the appli-cable 12 month period is the eligibility computation period. The first eligibility computation period must begin on the employee’s employment commencement date. The second and subsequent eligibility compu-tation periods can begin on (1) anniversaries of the employment commencement date or (2) the first day of the plan year, beginning with the first plan year that begins after the employment commencement date, provided that an employee who is credited with 1,000 Hours of Service in both the initial eligibility computation period and the plan year which includes the first anniversary of the employee’s employment commencement date is credited with two Years of Service for eligibility purposes [Code § 410(a)(3)(A); ERISA § 202(a)(3)(A); DOL Reg. § 2530.202-2(b)]. The employment commencement date is the date

on which an employee is first credited with an Hour of Service for the performance of duties for the employer(s) maintaining the plan [Treas. Reg. § 1.410(a)-7(b)(1]. A plan provision (e.g., one exclud-ing part-time employees) will be treated as violating Code Section 410(a) if the plan provision could result in the exclusion, by reason of a minimum service requirement, of an employee who has completed a Year of Service [IRS Employee Plans Determinations Quality Assurance Bulletin, FY-2006 No. 3 (Feb. 14, 2006); see also PLR 9508003 (Nov. 10, 1994)].

For vesting purposes, an individual is credited with a Year of Service as soon as he or she has com-pleted the requisite number of Hours of Service. In determining eligibility, an employee who completes 1,000 Hours of Service in an eligibility computa-tion period is treated as having satisfied the service requirement for eligibility to participate as of the last day of the eligibility computation period. In the case of a plan that requires two Years of Service for eligibil-ity, this rule applies only with respect to the second Year of Service required for eligibility [DOL Reg. § 2530.202-2(e)(3)].

Code Sections 410(a)(5)(D) and 411(a)(6)(D) permit a plan to disregard Years of Service that were disre-garded under the plan provisions satisfying those sec-tions (as in effect on August 22, 1984) as of the day before the Retirement Equity Act (REA) amendments apply to the plan [Treas. Reg. § 1.410(a)-8].

Vesting For vesting purposes, the computation period is a

12-consecutive-month period designated by the plan, and not prohibited under DOL regulations, during which the participant has completed at least 1,000 Hours of Service (or, if an equivalency is used, the lesser number of Hours of Service applicable to that equivalency). The plan may specify a lesser number of required Hours of Service for a vesting Year of Service [Code § 411(a)(5); ERISA § 203(b)(2)]. Generally, a plan may designate any 12-consecutive-month period. The period so designated must apply equally to all par-ticipants, but the actual 12-consecutive-month peri-ods need not be the same for all employees (e.g., the designated period could be the 12- consecutive-month period beginning on an employee’s employment com-mencement date and anniversaries of that date) [DOL Reg. § 2530.203-2(a)].

Generally, all of an employee’s Years of Service (or Periods of Service, under the elapsed time method, described below) must be taken into account for


vesting purposes. However, the following may be disregarded:

1. Service completed by an employee before the date on which he or she attains age 18;

2. If the plan requires mandatory employee contribu-tions, service that falls within the period of time to which a particular employee contribution relates, if the employee had the opportunity to make a contribution for such period of time and failed to do so;

3. Service during any period for which the employer did not maintain the plan or a predecessor plan [ see Treas. Reg. § 1.411(a)-5(b)(3)(ii)];

4. Service that is not required to be taken into account by reason of a Break in Service;

5. Service prior to January 1, 1971, unless the employee has at least three Years of Service after December 31, 1970;

6. Service completed before the first plan year Code Section 411 applied to the plan, if such service would have been disregarded under the plan rules in effect at that time; and

7. Certain Years of Service under a multiemployer plan [Code § 411(a)(4)].

Governmental plans, nonelecting church plans, and certain other plans are subject only to the pre-ERISA vesting requirements [Code § 411(e)].

If a plan amendment changes any vesting schedule, each participant with at least three Years of Service may elect to have his or her vested percentage computed without regard to the amendment [Code § 411(a)(10)].

Predecessor employers. Service with a predecessor employer that maintained the plan [Code § 414(a)(1)], and certain service with a predecessor employer that did not maintain the plan, is also treated as service with the current employer [Code § 414(a)(2); Treas. Reg. § 1.411(a)-5(b)(3)(iv)(A)].

Related employers. Service with an employer is treated as service for employers that are considered to be single employers under Code Section 414, for the period during which the employers are related [Treas. Reg. § 1.411(a)-5(b)(3)(iv)(B)].

Plan maintained by more than one employer. Service with an employer that maintains a plan is treated as service for each other employer that maintains that plan for the period during which the employers are maintaining the plan [Code § 413 (b)(4) and (c)(3); DOL Reg., 29 C.F.R. Part 2530; Treas. Reg. § 1.411(a)-5(b)(3)(iv)(C)].

Predecessor plan. If an employee was covered by a pre-decessor plan, there is a special rule under Treas. Reg. § 1.411(a)-5(b)(3)(v)(A). For this purpose, if (1) an employer establishes a qualified plan within the five-year period immediately preceding or following the date another such plan terminates, and (2) the other plan is terminated, the terminated plan is a predeces-sor plan with respect to the other plan [Treas. Reg. § 1.411(a)-5(b)(3)(v)(B)].

Vesting After a Distribution

1. Withdrawal of mandatory contributions. All or a portion of the employer-derived accrued benefit may be forfeited if a participant who is less than 50 percent vested withdraws any portion of the accrued benefit derived from his or her manda-tory contributions. The plan must generally allow the participant to restore the amount forfeited by repaying the full amount of the withdrawal, with interest if the plan is a defined benefit plan [Treas. Reg. § 1.411(a)-7 (d)(2)].

2. Cash-outs of accrued benefits. For vesting pur-poses, the plan may disregard service with respect to which (A) the employee receives a permissible distribution (voluntary or involuntary) of the pres-ent value of his or her entire vested benefit at the time of the distribution; (B) the distribution is made due to the termination of the employee’s participation in the plan; and (C) the plan has a repayment provision that satisfies the requirements of the regulations [Treas. Reg. § 1.411(a)-7(d)(4)]. A distribution is deemed to be made on termina-tion of participation in the plan if it is made not later than the close of the second plan year follow-ing the plan year in which the termination occurs.

3. Vesting after a distribution from a defined contri-bution plan. A special formula for calculating an employee’s vested interest applies if a defined con-tribution plan makes distributions attributable to employer contributions at a time when (A) the employee is less than 100 percent vested in such amounts, and (B) under the plan, the employee can increase his or her vested percentage in such amounts after the distribution [Treas. Reg. § 1.411(a)-7 (d)(5)].

Accrual of Benefits A defined benefit plan must satisfy one of three

benefit accrual rules [Code § 411(b)(1); ERISA § 204(b)(1)]. Two of them, the three-percent


method and the fractional rule, are based on Years of Participation in the plan. A “Year of Participation” means a period of service, beginning at the earliest date on which the employee is a participant in the plan and which is included in a period of service required to be taken into account as a Year of Service under the eligibility rules, as determined under DOL regula-tions that provide for the calculation of the period on a reasonable and consistent basis [Code § 411(b)(4)(A); ERISA § 204(b)(4)(A)]. A plan may designate any 12- consecutive-month period as the accrual computa-tion period, but the period must apply equally to all participants. The actual time periods need not be the same for all participants [DOL Reg. § 2530.204-2(a)]. Subject to certain conditions, a plan may determine service for benefit accrual purposes on a basis other than computation periods [DOL Reg. § 2530.204-3].

In the case of an employee whose customary employment is less than full time, the calculation of service on any basis that provides less than a rat-able portion of the accrued benefit to which he or she would be entitled under the plan if customary employ-ment were full time, will not be treated as made on a reasonable and consistent basis. However, if any employee has less than 1,000 Hours of Service (or, if an equivalency is used, the lesser number of Hours of Service applicable to that equivalency), during an accrual computation period, that service need not be taken into account [Code § 411(b)(4)(B), (C); ERISA § 204(b)(4)(B), (C); DOL Reg. § 2530.204-2(c)(1)]. If a defined benefit plan bases its normal retirement benefits on employee compensation, the compensation must reflect the compensation that would have been paid for a full year of participation. If an employee works less than a full Year of Participation, the com-pensation used to determine benefits under the plan for that year must generally be multiplied by the ratio of the number of hours for a complete year of participation to the number of hours credited for that year [DOL Reg. § 2530.204-2(d); Treas. Reg. § 1.411(a)-7(c)(5)].

The plan may defer accrual of benefits until the employee has two continuous Years of Service under the eligibility rules [ERISA § 204(b)(1)(E)].

Employment Status In general, employment at the beginning or the end

of a computation period does not affect whether the employee is credited with a Year of Service or a Year of Participation, or incurs a Break in Service, for the computation period. However, certain consequences

may follow from an employee’s failure to be employed on a particular date. For example, a defined contribu-tion plan may provide that an individual who has separated from service before the allocation date for contributions or forfeitures does not share in the allo-cation, even if the individual is credited with 1,000 or more Hours of Service for the applicable vesting com-putation period [DOL Reg. § 2530.200b-1 (b)]. For purposes of the coverage and nondiscrimination rules, an employee may be treated as an excludable employee for a plan year if he or she terminates employment during the plan year with no more than 500 Hours of Service, and the employee is not an employee as of the last day of the plan year. If one of the equivalencies is used for crediting service under the plan, the 500 hour requirement must be adjusted accordingly. A plan that uses the elapsed time method may use either 91 consecutive calendar days or three consecutive calendar months instead of 500 Hours of Service, provided that it uses the same convention for all employees during a plan year [Treas. Reg. § 1.410(b)-6(f)].

The statute provides for regulations for seasonal industries where the customary period of employment is less than 1,000 hours during a calendar year: no reg-ulations have been issued. In the case of any maritime industry, 125 days of service are treated as 1,000 Hours of Service [Code §§ 410(a)(3)(B), (D), 411(a)(5)(C), (D), 411(b)(4)(D), (E)]; ERISA §§ 202(a)(3)(B), (D), 203(b)(2)(C), (D), 204(b)(4)(D), (E)].

Breaks in Service Unlike pre-ERISA law, under current law, any

interruption in the employee’s period of continuous employment with the employer is generally irrelevant unless the individual has incurred one or more One-Year Breaks in Service. A One-Year Break in Service means a 12-consecutive-month computation period during which the participant has not completed at least 501 Hours of Service or, if the plan uses equiva-lencies for crediting service, the number of Hours of Service applicable to that equivalency. The computa-tion period depends on the purpose for which the Break in Service is being applied: for vesting purposes, the vesting computation period is applied; for eligi-bility, the eligibility computation period; and so on [Code §§ 410(a)(5), 411(a)(6); ERISA § 203(b)(3)(A)]. One very important point is that an employee can incur a Break in Service without terminating employment.

If any individual is absent from work for any period (1) by reason of the individual’s pregnancy, (2) by reason


of the birth of a child to the individual, (3) by reason of the placement of a child with the individual in connec-tion with the adoption of the child by the individual, or (4) for purposes of caring for a child for a period imme-diately following the birth or placement then, solely for purposes of determining whether a One-Year Break in Service has occurred, the individual must be credited with the lesser of (1) the hours of service which other-wise would normally have been credited to the indi-vidual, but for the absence, or, if the plan is unable to determine that number, eight hours of service for each day of absence or (2) 501 hours of service. The hours are credited in the year in which the absence begins, if needed to prevent a One-Year Break in Service in that year or, in any other case, in the immediately fol-lowing year. The plan may require the individual to provide information to the plan administrator [Code §§ 410(a)(5)(E), 411(a)(6)(E); ERISA §§ 202(b)(5)(E); 203(b)(3)(E)].

Effect of Breaks in Service The general rule is that all Years of Service with the

employer or employers maintaining the plan must be taken into account for eligibility and vesting purposes. However, there are some exceptions.

1. If an employee has a One-Year Break in Service before completing two Years of Service under a plan that requires two Years of Service for eligibil-ity, service before the break need not be taken into account for eligibility purposes.

2. If a participant has a One-Year Break in Service, service before the break need not be taken into account until he or she has completed a Year of Service after his or her return (the “one year hold-out” rule). If a participant in a defined contribu-tion plan, or a fully insured defined benefit plan, has five consecutive One-Year Breaks in Service, Years of Service after the five-year period are not required to be taken into account for purposes of determining the nonforfeitable percentage of the accrued benefit derived from employer contribu-tions which accrued before the five-year period.

3. In the case of a nonvested participant, Years of Service with the employer before any period of consecutive One-Year Breaks in Service need not be taken into account if the number of consecutive One-Year Breaks in Service equals or exceeds the greater of five, or the aggregate number of Years of Service before such period (excluding any Years of Service disregarded by reason of a prior Break

in Service) (the “rule of parity”). A nonvested par-ticipant means a participant who does not have any nonforfeitable right under the plan to an accrued benefit derived from employer contribu-tions so would not include any participant who has made elective deferrals under the plan [Code §§ 410(a)(5), 411(a)(6); ERISA §§ 202(b)(2), 203(b)(3)].

If the plan uses the one year holdout rule, and the individual does complete a Year of Service after the break, he or she must reenter the plan retroactively. This is particularly problematic with respect to elec-tive deferrals. If any individual is reemployed, there is no applicable break in service rule, and the individual has already satisfied the eligibility requirements, he or she must reenter the plan on the date of reemploy-ment. The plan administrator may not delay plan reentry until the next regular entry date.

Similar rules apply to a plan that uses the elapsed time method [Treas. Reg. §§ 1.410(a)-7(d); 1.411(a)-6(c)(1)(iii)].

The Elapsed Time Method Under the statute, the only method of determining

service is based upon the actual counting of Hours of Service during the applicable computation period. The DOL regulations allow the use of the equivalencies described above. The Treasury regulations permit an alternative method, the elapsed time method, under which an employee’s length of service is generally determined with reference to the total period of time that elapses while the employee is employed with the employer or employers maintaining the plan, regard-less of the actual number of hours he or she completes during that period [Treas. Reg. § 1.410(a)-7(a)(1)]. The elapsed time method lessens the administrative burden of maintaining records of each employee’s Hours of Service and has been adopted by many large plans. The validity of the elapsed time method has consistently been upheld by the courts. [ See, e.g., Johnson v. Buckley, 356 F. 3d 1067 (9th Cir. 2004); Jefferson v. Vickers, Inc., 102 F.3d 960 (8th Cir. 1996); Montgomery v. PBGC, 601 F. Supp. 2d 139 (D.D.C. 2009); Apitz v. Teledyne Monarch Rubber Hourly Pension Plan, 800 F. Supp. 1526 (N.D. Ohio, 1992).]

Depending on individual facts and circumstances, the elapsed time method may be more or less favorable to an employee than the regular method. For vesting purposes, a plan using the elapsed time method must


provide that an employee is credited with a number of years of service equal to at least the number of whole years of the employee’s period of service, whether or not consecutive. Nonsuccessive periods of service must be aggregated and less than whole year periods of ser-vice must be aggregated on the basis that 12 months of service (30 days are deemed to be a month in the case of the aggregation of fractional months) or 365 days of service equal a whole year of service. After calculating an employee’s Period of Service in this manner, the plan may disregard any remaining less than whole year, 12-month or 365-day period of service. “Thus, for example, if a plan provides for the statutory three to seven year graded vesting, an employee with a period (or periods) of service which yields three whole year periods of service and an addi-tional 321-day period of service is 20 percent vested in his or her employer-derived accrued benefits (based solely on the 3 whole year periods of service)” [Treas. Reg. § 1.410(a)-9T(d)(1)(iv)].

Under a defined benefit plan that uses five-year cliff vesting, a full-time employee who quits after four years and 10 months is 0 percent vested under elapsed time but would almost certainly be 100 per-cent vested under the Hours of Service approach. For a participant in the same plan who had 750 Hours of Service in each of five consecutive vesting computa-tion periods, the elapsed time method would produce 100 percent vesting, the 1,000 Hours of Service approach 0 percent.

Under elapsed time, service is required to be taken into account for the period from the date the employee first performs an Hour of Service for the employer or employers maintaining the plan until the date he or she severs from service with the employer(s) [Treas. Reg. § 1.410(a)-7(a)(2)(i)]. The date the employee severs from service is the earlier of (1) the date the employee quits, is discharged, retires, or dies, or (2) the first anniversary of the date the employee is absent from service for any other reason (e.g., dis-ability, vacation, leave of absence, layoff, etc.) [Treas. Reg. § 1.410(a)-7(a)(2)(ii)]. Unless a plan provides for an “adjusted” employment commencement date or similar method of consolidating periods of service, Periods of Service must be aggregated unless they may be disregarded [Treas. Reg. § 1.410(a)-7(b)(6)]. The regulations include the following example: “Employee W, age 31, completed 6 months of service and was laid off. After 2 months of layoff, W quit. Five months later, W returned to service. For purposes of eligi-bility to participate, W was required to be credited

with 13 months of service (8 months of service and 5 months of severance). If, on the other hand, W had not returned to service within the first 10 months of severance (i.e., within 12 months after the first day of layoff), W would be required to be credited with only 8 months of service” [Treas. Reg. § 1.410(a)-7(c)(2)(v)].

For purposes of eligibility and vesting, an employee who has severed from service by reason of a quit, discharge, or retirement may be entitled to have a period of time of 12 months or less taken into account if the employee returns to service within a certain period of time and receives an Hour of Service for the performance of duties. In general, the period during which the employee must return begins on the date the employee severs from service and ends on the first anniversary of that date. However, if the employee is absent for any other reason (e.g., layoff) and then quits, is discharged, or retires, the period of time dur-ing which the employee may return and receive credit begins on the severance from service date and ends one year after the first day of absence (e.g., first day of lay-off) [Treas. Reg. § 1.410(a)-7(a)(2)(iii)].

For purposes of benefit accrual under the elapsed time method, an employee is entitled to have his or her service taken into account from the date he or she begins to participate in the plan until the sev-erance from service date. Periods of severance are not required to be taken into account [Treas. Reg. § 1.410(a)-7(a)(2)(iv)]. For purposes of benefit accrual, a plan may provide that a participant’s service will be determined on the basis of the participant’s total period of service, beginning on the participation com-mencement date and ending on the severance from ser-vice date [Treas. Reg. § 1.410(a)-7(e)(1)]. It must be possible to prove that, although benefit accrual is not based on computation periods, the plan’s provisions meet at least one of the three benefit accrual rules of Section 411(b)(1) under all circumstances. A plan may not disregard service performed during a computation period in which the employee is credited with less than 1,000 hours [Treas. Reg. § 1.410(a)-7(e)(2)].

Employment Commencement Date Under elapsed time, the employment commence-

ment date is still the date on which an employee first receives an Hour of Service for the performance of duties for the employer(s) maintaining the plan [Treas. Reg. § 1.410(a)-7(b)(1]. The plan may provide for an “adjusted” employment commencement date to reflect noncreditable periods of severance or a reemployment commencement date [Treas. Reg. § 1.410(a)-7(a)(3)(B)].


The “reemployment commencement date” is the first date, following a period of severance from service which is not required to be taken into account, on which the employee receives an Hour of Service for the perfor-mance of duties for the employer(s) maintaining the plan [Treas. Reg. § 1.410(a)-7(b)(3)].

“The format of the rules is designed to enable a plan to use the elapsed time method of crediting ser-vice either for all purposes or for any one or combina-tion of purposes under Sections 410 and 411. Thus, for example, a plan may credit service for eligibil-ity to participate purposes by the use of the general method of crediting service set forth in 29 C.F.R. 2530.200b-2 or by the use of any of the equivalences set forth in 29 C.F.R. 2530.200b-3, while the plan may credit service for vesting and benefit accrual purposes by the use of the elapsed time method of crediting service” [Treas. Reg. § 1.410(a)-7(a)(4)]. Also, a plan using the elapsed time method for some employees may use the general method or any of the equivalencies for other classifications of employees, provided that the classifications are reasonable and are consistently applied. A classification will not be deemed to be reasonable or consistently applied if it is designed to preclude an employee or employees from attaining his or her statutory entitlement with respect to eligibility to participate, vesting, or benefit accrual [Treas. Reg. § 1.410(a)-7(a)(4)(ii)]. There are additional rules for plan amendments to change the method of crediting service and for employees who transfer from one class of employees to another [Treas. Reg. § 1.410(a)-7(f), (g)].

Breaks in Service: Elapsed Time In applying the Break in Service rules under

a plan using the elapsed time method, the term “One-Year Period of Severance” is substituted for the term “One-Year Break in Service.” A One-Year Period of Severance is determined on the basis of a 12- consecutive-month period beginning on the sever-ance from service date and ending on the first anniver-sary of that date, provided that the employee during that period does not receive an Hour of Service for the performance of duties for the employer(s) maintaining the plan [Treas. Reg. § 1.410(a)-7(c)(4)]. In determin-ing the vested percentage of an employee who has incurred a One-Year Period of Severance, the Period of Service completed before the Period of Severance need not be taken into account until the employee has completed a One-Year Period of Service after return to service [Treas. Reg. § 1.410(a)-7(d)(4), (5)].

Limitations on Benefits Under a Qualified Defined Benefit Plan

Receipt of the maximum annual dollar benefit ($195,000 for 2010 and 2011) requires at least 10 years of participation in the plan. Receipt of the alternative maximum, 100 percent of average com-pensation, requires at least 10 years of service [Code § 415(b)(1); Treas. Reg. § 1.415(b)-1(g)].

Special Rules for 403(b) Arrangements A strict “universal availability” rule applies to any

403(b) plan that allows elective deferrals and is main-tained by a private tax-exempt organization other than a church: subject to limited exceptions, all employees must be allowed to make elective deferrals, without any waiting period [Code §§ 403(b)(1)(D), (b)(12)]. One permitted exception is for employees who “nor-mally work less than 20 hours per week”: employers wishing to take advantage of this exception must be careful to follow the limitations set out in the regula-tions [Treas. Reg. § 1.403(b)-5(b)(4)(iii)(B)].

Section 403(b)(4) provides that, “In determin-ing the number of years of service for purposes of [Section 403(b)], there shall be included (A) one year for each full year during which the individual was a full-time employee of the organization…, and (B) a fraction of a year (determined in accordance with regulations prescribed by the Secretary) for each full year during which such individual was a part-time employee of such organization and for each part of a year during which such individual was a full-time or part-time employee of such organization. In no case shall the number of years of service be less than one.” This rule is applied in determining (1) whether an employee has at least 15 years of service, and thus is eligible to make additional contributions [Code § 402(g)(7)] and (2) the amount of the individual’s “includible compensation” [Code § 403(b)(3)]. A year of service is based on the employer’s annual work period, not the employee’s taxable year [Treas. Reg. § 1.403(b)-4(e)].

Subject to a special rule for church employees, any period during which an individual is not an employee of the eligible employer maintaining the plan is disre-garded [Treas. Reg. § 1.403(b)-4(e)(3)].

The regulations include rules for determining whether an individual is employed full-time, and the fraction or fractions of a year to be credited [Treas. Reg. § 1.403(b)-4(e)(4), (5)]. The amount of work performed is generally based on the individual’s hours of service, as defined in Section 410(a)(3)(C)), “except


that a plan may use a different measure of work if appropriate under the facts and circumstances. For example, a plan may provide for a university profes-sor’s work to be measured by the number of courses taught during an annual work period in any case in which that individual’s work assignment is generally based on a specified number of courses to be taught” [Treas. Reg. § 1.403(b)-4(e)(6)].

Service Requirements for SEPs and SIMPLE Plans

Under a simplified employee pension plan (SEP), the employer must generally make a contribution for each employee who has attained age 21, has performed service for the employer during at least three of the immediately preceding five years, and received at least $550 (indexed) in compensation from the employer for the year [Code § 408(k)(2)].

Under a SIMPLE plan, the general rule is that all employees who (1) received at least $5,000 in com-pensation from the employer during any two preced-ing years, and (2) are reasonably expected to receive at least $5,000 in compensation during the year, are eli-gible to defer salary or receive a nonelective employer contribution [Code § 408(p)(4)].

USERRA In order to comply with the Uniformed Services

Employment and Reemployment Rights Act, an indi-vidual reemployed under the Act must be treated as not having incurred a break in service by reason of a period of qualified military service. Each period of qualified military service served is, upon reemploy-ment under the Act, deemed to constitute service with the employer for vesting and benefit accrual purposes [Code § 414(u)(8)].

Service Provisions and Other Employee Benefits

Group Term Life Insurance: In determining whether a plan is discriminatory, employees who have not

completed three years of service may be excluded [Code § 79(d)(3)(B)(i)].

Health Plan Coverage: In determining whether a self-insured medical expense reimbursement plan is discriminatory, employees who have not com-pleted three years of service may be excluded [Code § 105(h)(3)(B)(i)]. For this purpose, years of service may be determined by any method that is reasonable and consistent. A determination made in accordance with Code Section 410(a)(3) is deemed to be reason-able [Treas. Reg. § 1.105-11(c)(2)(iii)(A)]. This has become more important as the health care reform legislation has extended the nondiscrimination rule, and the three year exclusion, to insured plans [Code § 4980D; see also IRS Notice 2010-63, 2010-41 I.R.B. 420].

Cafeteria Plans: In determining whether eligibility rules are discriminatory, an employee may be required to complete three years of employment, if the employ-ment requirement for each employee is the same [Code § 125(g)(3)(B)(i)]. For this purposes, a year of employ-ment is determined by the elapsed time method [Treas. Reg. § 1.125-7(a)(12)]. Under a Simple Cafeteria Plan, all employees who had at least 1,000 hours of service for the preceding plan year must gen-erally be eligible to participate, but the employer may elect to exclude under the plan employees who have less than one year of service with the employer as of any day during the plan year [Code §125(j)(4)].

Dependent Care Assistance: Subject to rules similar to the rules of Code Section 410(b)(4), employees who have not completed one year of service (as defined in Section 410(a)(3)) may be excluded from consideration [Code §129(d)(9)].

Family and Medical Leave: To be eligible, an employee must have been employed for at least 12 months by the employer and for at least 1,250 hours of service during the previous 12-month period [29 USCS § 2611(2)(A)]. Hours of service are determined under the standards established under Section 7 of the Fair Labor Standards Act of 1938. ■

12

A R T I C L E

Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International B y S t e p h e n D . R o s e n b e r g

Of the many metaphors bequeathed to writers by

the American Civil War, perhaps none is as useful

in analyzing the development of legal doctrine as

the high water mark, understood in historic terms as

the farthest point north traversed by the Confederate

army. The concept is particularly apt when applied

to the development of excessive fee claims involving

401(k) plans under ERISA, and provides a ready

framework for understanding both the recent history

and the likely future development of that theory

of liability.

Viewed through that prism, the less than two year old decision by the United States Court of Appeals for the Seventh Circuit in Hecker v. Deere & Co.— trumpeted at the time as a major development in the defense of plan fiduciaries against such claims—can best be seen, in light of subsequent judicial and regu-latory developments, as the high water mark in the defense of such claims, with the still more recent deci-sion in Tibble v. Edison International demarcating the path down from that point. Buttressed by regulatory developments, Tibble v. Edison International shows us what is likely the future of these types of claims, and teaches, indirectly, not only how such claims need to be defended, but also how plan sponsors must prepare for them well in advance of any litigation.

Certainly the starting point for any discussion of this issue should be an understanding of the nature of excessive fee claims. ERISA lawyers, like other spe-cialists, tend to use shorthand to which only they are privy, and this type of claim is no exception. Pithy references to excessive fee claims, however, short-change the depth and complexity of what is at issue. Teasing out the phrase’s full meaning gives a much more nuanced picture of what is at stake, and how it impacts fiduciary liability.

The level of expenses in investment options offered to participants in company-sponsored 401(k) plans has become an issue of significant concern, as well as litigation. A series of interrelated issues involv-ing the expense levels in 401(k) plan investment options coalesce to simultaneously impact both the performance of participants’ plan investments and the performance of fiduciaries’ duties. The starting point for these problems is the accepted premise that greater fees severely reduce the growth in assets over time in individual participants’ account [Miller, Ross M., “Paying the High Price of Active Management: A New Look at Mutual Fund Fees,” World Economics, Vol. 11, No. 3, July-Sept. 2010].

To illustrate the impact of mutual fund fees in such accounts, the Department of Labor (“DOL”) prepared

Stephen D. Rosenberg, Esq., is a partner in The McCormack

Firm, a Boston litigation firm, where he heads the firm’s ERISA

Practice Group. He has extensive experience in ERISA litigation,

including breach of fiduciary duty cases and class actions, as well

as in commercial litigation and arbitration, insurance coverage and

bad faith, and intellectual property disputes. He publishes a blog

at www.bostonerisalaw.com.

RETREAT FROM THE HIGH WATER MARK 13

an example comparing two different levels of fees and their impact on a $25,000 investment in a 401(k) plan that provided annual investment growth of seven per-cent for a period of 35 years. The DOL analysis con-cluded that increasing the annual fee from 0.5 percent to 1.5 percent had “the effect of slicing nearly 28 per-cent off the value of assets” at retirement, or the differ-ence at retirement between $227,000 and $163,000.

Thus, obviously the amount of fees contained in mutual funds or other investment options in a 401(k) plan significantly impacts the long-term outcome for plan participants. However, the interrelated problem for plan participants, which significantly amplifies the risk posed to participants by high fees, is the corollary finding that higher fees do not correspond to equivalently higher returns under mutual funds, which make up much of the investment menu open to 401(k) plan participants. Accordingly, excessively high fees not only reduce returns, but appear to reduce returns without any substantial benefit to the plan participants that is sufficient to warrant paying fees any higher than is absolutely necessary.

A compounding and further interrelated problem for both plan participants and fiduciaries is that, under the operation of a 401(k) plan, large numbers of plan participants are limited to the investment options provided in a plan menu. Regardless of any other vari-able that could otherwise come into play with regard to fees, plan participants have limited, if any, control over the fees they pay to invest for retirement; they are, instead, at the mercy of the fee and expense deci-sions made by the plan’s fiduciaries, who, in turn, are expected to act both in their interest and as their stand-in in addressing the fees charged for the invest-ment options. This, in essence, is the foundation of a so-called “excessive fee” claim by plan participants against fiduciaries, which is that the fiduciaries had an obligation to avoid higher than necessary fees in the mutual fund options offered in a plan menu, and failed to do so.

The nature of this theory gives rise, as well, to a corollary for such claims—one that reflects yet another problem with potentially excessive fees that is inter-related with those discussed above. Many so-called “excessive fee” claims also attack the alleged problem of revenue sharing, in which a portion of the fees in the mutual fund options themselves are used to fund the administration of the plan. As one academic has explained it, revenue sharing is “an arrangement by which the administrative costs of the plan are neither covered by the employer nor billed directly to the

employee, but simply buried in the mutual fund fees.” The absence of a line item for the administration of the plan, or of an actual outlay from the employer directly related to the provision of the plan, has been said to leave “employees with the impression that they are getting something (the administration of the plan) for nothing.” From the perspective of a plan fiduciary, the issue of revenue sharing is interrelated with the problems posed by higher fees, in that revenue sharing can create a scenario in which higher expenses—and the selection of mutual fund options with higher fees—reduce or effectively eliminate the plan sponsor’s own costs in offering a 401(k) plan, which may not be the case with investment options that have sig-nificantly lower fees. This dynamic, at least in theory, creates a potential tension between the short-term financial interests of the plan sponsor and the long-term financial interests of plan participants; there is little doubt that favoring the former over the latter in this regard, if proven in court, would be construed as breaching the duties of loyalty and prudence imposed on fiduciaries.

Over approximately the past 18 months, a trilogy of judicial decisions have addressed the legal and factual issues inherent in this problem in depth. The three cases—Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009) (“ Hecker ”), Braden v. Wal-Mart Stores, Inc., 588 F.3d 585 (8th Cir. 2009) (“ Braden ”), and Tibble v. Edison International, 2010 Westlaw 2757153 (C.D. Cal. 2010) (“ Tibble ”)— serve as signposts on the road from the high water mark in defending excessive fee claims, which this article posits passed in the early part of 2009, to an uncharted but likely future. In February 2009, the Seventh Circuit decided Hecker, in which a putative class of plan participants sued the plan’s sponsor, Deere & Co., as well as Fidelity Management Trust Co. (“Fidelity Trust”), which was the plan’s trustee and recordkeeper as well as the manager of two of the investment options available under the plan; Fidelity Management and Research Co. (“Fidelity Research”), the investment advisor for mutual funds that were offered as investment options, was also named as a defendant. The putative class alleged that Deere had violated its fiduciary duties “by providing investment options that required the payment of excessive fees and costs and by failing adequately to disclose the fee structure to plan par-ticipants”; the putative class pursued the other two defendants on the theory that they were functional fiduciaries and thus, likewise, potentially liable for breach of fiduciary duty [ Hecker, 556 F.3d at 578].


Fidelity Trust had undertaken the obligations of advising Deere on selecting investments for the plan, administering the participant accounts, and performing recordkeeping for the plan; as noted, it also managed two of the investment funds offered in the plan. Fidelity Research, in turn, was the advisor for the Fidelity mutual funds offered as investment options. As the discussion of the nature of excessive fee claims above suggests, each of the funds offered as investment options “charged a fee, calculated as a percentage of assets the investor placed with it” and Fidelity Research, as the advisor to the mutual funds that were offered as investment options, shared the revenue from those fees with Fidelity Trust. Fidelity Trust then compensated itself for its services through those fees, rather than directly charging the plan or the plan’s sponsor for its services. Of significance, Fidelity Research was the investment advisor for 23 out of 26 investment options available to the plan participants, but none of those funds “operated exclu-sively for Deere employees; all were available on the open market for the same fee.” After finding that the two Fidelity entities did not qualify as fiduciaries, the United States Court of Appeals for the Seventh Circuit then proceeded to affirm the dismissal of the breach of fiduciary duty theories against Deere itself. Although the Court reached this conclusion on a num-ber of interrelated grounds, of interest for the future of “excessive fee” claims is the focus of the Court’s analysis on the “allegation that Deere violated its fiduciary duty by selecting investment options with excessive fees.” The Court focused on the fact that the funds in question were also offered to the retail mar-ketplace with the same expenses as were charged on those same funds when offered as investment options in the Deere plan. The Court isolated the fact that “all of these funds were also offered to investors and the general public, and so the expense ratios necessarily were set against the backdrop of market competition,” and found that there was no obligation on Deere as the fiduciary to seek other funds with lower expense ratios; indeed, the Court concluded that whether the fiduciary could have found such funds “is beside the point.”

In essence, the Court concluded that fund expenses set at the same level as those paid in the retail mar-ketplace as a whole were sufficient to discharge a fiduciary’s obligation with regard to the extent of fees contained in the plan, and strongly suggested that a fiduciary has no obligation to pursue superior pricing for plan participants. Note that Hecker ’s rejection, with

neither discovery or the development of an evidentiary record, of the plaintiffs’ cause of action for excessive fees is the aspect of that decision focused on in this article, and which the author believes is undercut by subsequent regulatory and judicial developments. The Hecker court also recognized a strong affirmative defense with regard to participant control of invest-ment selections, one that the Department of Labor rejects. The nature and future of that defense could justify an extensive article all its own, and is outside the scope of this piece, which instead focuses on the Seventh Circuit’s rejection in Hecker of the elements of the plaintiffs’ cause of action itself.

It is important to note a particular aspect of the Hecker decision, which is that the Seventh Circuit reached this conclusion at the motion to dismiss stage, meaning that no discovery had been conducted into either the actual facts concerning the expenses charged in the plan’s investment options, or into the question of what acts or omissions by the fiduciary may have led to an investment mix that, from a fee perspective, was no better—and no worse—than the plan partici-pants could have selected outside of the plan. Instead, the Seventh Circuit found the plaintiffs’ theory unten-able based on the simple fact that the marketplace as a whole had recognized the fees charged by the invest-ment options as acceptable. This becomes an impor-tant point when the case law progresses to Braden and eventually to Tibble , pursuant to which participants suing a plan’s fiduciaries appear to be free to examine the actual acts taken or not taken by fiduciaries to obtain an optimal level of fees and expenses, without regard to whether the marketplace as a whole accepts those same levels of fees and expenses for the same or a similar investment product.

Within months of the Seventh Circuit’s decision in Hecker , the United States Court of Appeals for the Eighth Circuit reached the essentially opposite conclu-sion in Braden , overturning—rather than affirming, as had the Seventh Circuit in Hecker —a district court’s dismissal on the papers of a putative class action alleging breaches of fiduciary duty arising from exces-sive fees on the investment options contained in a 401(k) plan. In short form, the United States Court of Appeals for the Eighth Circuit concluded that the plaintiff’s complaint alleged facts that, if true, indi-cated that the fees in the mutual fund options in the 401(k) plan were higher than necessary, that the plan sponsor had the market power to obtain lower fees, that revenue sharing had occurred without disclosure to the plan participants, and that the plan participants


had been injured as a result. Unlike the Seventh Circuit in Hecker , which essentially assumed that mar-ketplace forces would sufficiently police the expense levels in the investment options available under the plan, the Eighth Circuit found that the propriety of the fees was an issue that should not be decided prior to full development of the facts.

The 401(k) plan involved in Braden contained a far more limited range of mutual fund investment options than did the plan at issue in Hecker , and the Eighth Circuit acknowledged this distinction, noting that:

The district court in Hecker found it “untenable to sug-

gest that all of the more than 2500 publicly available

investment options had excessive expense ratios.” The far

narrower range of investment options available in this case

makes more plausible the claim that this Plan was impru-

dently managed. [ Braden, 588 F.3d at 596 n. 6.]

However, the allegations related to excessive fees in Braden revolved around the assertion that the mutual funds offered in that plan charged the same fees as those contained in the retail shares generally offered to individual investors, and that the plan was large enough to have instead obtained institutional shares with lower expenses. Logically, then, under the reason-ing of the Seventh Circuit in Hecker , the pricing on the mutual fund options contained in the 401(k) plan at issue in Braden could likewise be said to have been subject to marketplace discipline. The Eighth Circuit’s discussion of Hecker in its opinion establishes that the Eighth Circuit was well aware of the Seventh Circuit’s prior opinion on the same issues, and thus the Eighth Circuit, at least implicitly, departed from the Seventh Circuit’s proposition that marketplace discipline is suf-ficient to establish for purposes of an excessive fee claim that the fees in a mutual fund option are not excessive.

The Eighth Circuit further departed from the Seventh Circuit’s conclusion that neither revenue sharing itself nor the failure to disclose the revenue sharing to the plan participants can give rise to a breach of fiduciary duty. The Eighth Circuit discussed in detail the manner in which those events could give rise to such a breach, and noted in particular that such claims are “fact and context sensitive” and should not be decided as a matter of law [ Braden, 588 F.3d at 600]. Rather, such claims would need to proceed into discovery, with the putative class granted the opportu-nity to prove them.

Several months after the Seventh Circuit issued its opinion in Hecker and shortly before the Eighth

Circuit issued its opinion in Braden , Judge Stephen Wilson of the United States District Court for the Central District of California conducted a three day bench trial in Tibble, a class action asserting the same type of excessive fee claims. Subsequent to the trial, during the summer of 2010, with both Hecker and Braden available as a backdrop, Judge Wilson issued his 82-page findings of fact and conclusions of law. In its ruling after trial, the Court upheld several claims alleging breach of the duty of prudence with regard to the fees charged in certain investment options, while rejecting the same claims involving certain other investment options.

At the same time, the Court rejected claims that the fiduciaries had also breached their duty of loyalty—which essentially requires that the plan be managed for the benefit of the plan participants—by allowing revenue sharing. The Court recognized that the interaction of higher fees with revenue sharing meant that the plan’s expenses might be reduced for the plan sponsor itself as a result of increased fund expenses, but found that the actual evidence submit-ted to the Court did not support the conclusion that the fiduciaries had selected the investment options for that reason. Rather, the Court found that the evidentiary record was instead only consistent with the conclusion that the decision-making process was not influenced by a desire to decrease direct costs to the plan sponsor by means of higher investment option fees and correspondingly greater revenue sharing. The interesting point about this aspect of the Court’s findings and rulings is that the Court expressly rejected the revenue sharing portion of the excessive fee claims on the basis that the actual evidence concerning the fiduciaries’ investment choices did not support the underlying assumption of a revenue sharing claim, which is that higher expenses benefit the plan sponsor through increased revenue sharing and that the fiduciaries favor the plan sponsor’s interests in reducing administrative costs over the interests of the participants by select-ing investment options with unnecessarily high fees. The Tibble court found that the evidence did not support this conclusion with regard to the deci-sions concerning investment options made by the fiduciaries. It is important to recognize the converse, however, which is that an evidentiary record that did not demonstrate a lack of favoritism towards the plan sponsor with regard to the indirect benefit to it of greater fees and increased revenue sharing would likely have resulted in a finding of a breach of


the duty of loyalty by the fiduciaries, with fiduciary liability imposed for this reason.

With regard to the claims that certain investment options had far higher fees than were necessary—which is the excessive fee portion of the case as opposed to the revenue sharing portion of the case—many “quick” analyses of the Tibble decision shortly after its issuance reduced the Court’s conclusion to the fact that the fiduciaries were found liable for having included retail class shares rather than institutional class shares of the particular investment options. From this, many of those same analyses then recommended that plan sponsors respond by examining whether they had investment options in their plans that were hold-ing retail shares in circumstances where they could have instead been holding less expensive institutional shares, and to change that investment in that event. While this analysis and understanding of Tibble is true to a certain extent, looking behind the Court’s conclu-sion that the fiduciaries had breached their duty of prudence by including retail shares rather than institu-tional shares with regard to certain investment options is far more instructive. This is because the Court made clear in its analysis that the duty of prudence was not breached simply because the plan included retail shares rather than cheaper institutional shares; the Court instead focused on whether the prudence stan-dard’s requirement of adequate and thorough investi-gation into the investment had been satisfied by the fiduciaries. The Court found that the evidence did not establish this point and imposed liability for this rea-son, rather than simply because the investment option included more expensive retail shares rather than less expensive institutional shares.

Judge Wilson found that there was no evidence that the defendants had “even considered or evalu-ated the different share classes . . . when the funds [at issue] were added to the [p]lan” [ Tibble , 2010 Westlaw 2757153 at *25]. The Court specifically noted that “[n]ot a single witness testified regarding any discus-sion or evaluation of the institutional versus retail share classes” and that “the [p]lan fiduciaries respon-sible for selecting the mutual funds (the [i]nvestment [c]ommittees) were not informed about the institu-tional share classes and did not conduct a thorough investigation.” Proceeding from those factual determi-nations, the Court then concluded that, with proper investigation into the “relative merits of the institu-tional share classes against the retail share classes,” the fiduciaries would have found that the institutional share classes provided the same investment options at

a lower cost to the plan participants. Finding that, on the evidence before the Court, the fiduciaries could have obtained waivers that would have allowed use of the institutional share classes—rather than the retail share classes—the Court concluded that the fiducia-ries had, therefore, breached the duty of prudence. In short, the evidence showed that the institutional share classes were cheaper while providing the exact same investment option, that the plan could have obtained the institutional shares with their corresponding pric-ing had they sought to do so, and that the fiduciaries had included investment options with unnecessarily high fees because they did not investigate and under-stand that possibility.

The Court, then, did not simply find that retail shares were more expensive than the corresponding institutional shares and that there was no reason to have used the retail shares rather than the institutional shares, but rather found that the evidence showed that, in that particular plan, the fiduciaries had never considered the institutional shares or the fact that they could have obtained the institutional share pricing, and that the plan participants were harmed as a result. As with the revenue sharing aspect of the opinion, one can assume that the converse with regard to this issue would also be true: That an evidentiary record dem-onstrating consideration by the fiduciaries of whether to include retail share classes rather than institutional share classes that led to a defensible, even if arguable, selection of the higher cost option would not support a finding of a breach of the duty of prudence despite the inclusion of the higher-priced investment option. Under the facts detailed in the Court’s extensive opinion in Tibble , not only did no record of such an investigation exist, but it also appears that no defen-sible justification for having selected the higher-priced retail shares could likely have existed either. However, this will clearly not be the case in all circumstances in which a plan sponsor and its fiduciaries are charged with having included retail share classes rather than the cheaper institutional share classes. As the Hecker court noted and Judge Wilson echoed in Tibble , fidu-ciaries do not have an absolute obligation to locate and include the cheapest possible investment option. There could well be issues with performance, availability of information, investment minimums, or other concerns about institutional share classes in a particular plan that would justify a deviation from including them as investment options.

As a result, it is both simplistic and mistaken to read Tibble as simply requiring the use, or at least the


pursuit, of institutional share classes over retail share classes. Rather, what Tibble instructs, on both the duty of loyalty and the duty of prudence, is the need to take two steps. The first is to fully investigate the fee levels, as well as the possibility of reducing fee levels not just through the use of institutional shares but also through the use of other investment options that accomplish the same investment goals. The second is to document that investigation and the justification for the outcome in a manner that can be proved in court. It is particularly important to document these events at the time they occur in a manner that can be subsequently admitted into evidence in court under exceptions to the hearsay rule. The statute of limita-tions for breach of fiduciary duty claims is quite long, and the recollections of relevant events by the partici-pants may not be entirely accurate when questioned in court years later.

If one sets aside their provenance—the august bench of the Seventh Circuit versus a trial judge somewhere out in the middle of California (with no disrespect intended to Judge Stephen Wilson, as the contents of this article should make clear that the author holds the Court’s opinion in Tibble in high regard)—it becomes clear that, properly understood, Tibble , and not Hecker , likely represents the future course of excessive fee litigation under ERISA. In the first instance, the DOL is in the final steps of mandat-ing, through regulation, the disclosure to fiduciaries of both fee and revenue sharing information by service providers and vendors. This disclosure will, in the future, place in front of fiduciaries information about fees, and will likely result in counsel for participants structuring future excessive fee claims in a manner that perfectly mirrors and mimics the Tibble court’s handling of the issue. The likely theory against fidu-ciaries in the future will be that they were presented with information about the fees, as required by DOL regulations, and did not act in response to it in the manner required by the duty of prudence. The central liability questions will revolve in that instance around certain key questions concerning what the fiduciaries did in response to that information. Did they under-stand it, seek more information if it was not enough to be able to act, obtain further analysis of it from out-side experts if needed, and use it to either seek lower fees (whether from that vendor or a competitor) or to confirm that the fees were reasonable in comparison to an appropriate benchmark? Or did they not under-stand the information about fees provided to them, not interpret it, not act on it, and just accept the fees

as disclosed? The former, if documented, should lead to exoneration in an excessive fee case; the latter, to liability. A careful review of Tibble documents shows that the Court’s liability determination flowed along essentially this framework.

But what of Hecker and its rejection of such claims without a factual investigation into these issues? In the end, jurisprudential and regulatory developments that post-date the Seventh Circuit’s decision in Hecker significantly undercut the reasoning of that decision and the rationale for that approach. As noted, the DOL is finalizing regulations requiring the disclo-sure of fee information to fiduciaries. It is, in light of that, significant that one of the underlying premises of the Seventh Circuit’s opinion in Hecker was the absence of any regulatory obligations or duties with regard to fee levels and disclosures, with the Seventh Circuit expressly noting that the district court rul-ing was based in part on the absence of any regulatory obligations in this regard. The Seventh Circuit, in fact, noted that the plan sponsor believed that it was receiving the services of the trustee and recordkeeper for free when, in fact, revenue sharing payments were the actual source of compensation to the trustee and recordkeeper [ Hecker , 556 F.3d at 586]. Neither of these factual or legal aspects native to Hecker will or can exist in future cases once the DOL has, in fact, mandated disclosure to the fiduciaries of the com-pensation levels and manner of compensation of the service providers. It is worth noting that these facts created a scenario in which the district court, and thus the Seventh Circuit, believed that the plan spon-sor had no obligation to take steps to understand the nature of the plan’s fees and compensation arrange-ments. These regulatory changes preclude a repeat of the scenario that was before the court in Hecker and instead force any analysis of whether a breach of fidu-ciary duty has occurred in an excessive fee claim to start from the initial fact that the fiduciaries were on notice of information about fees and revenue sharing, and to proceed from there to the question of whether the fiduciaries breached their duties of loyalty and prudence by failing to act on that information. Hecker , in contrast, is in essence a decision about the lack of any obligation on the part of the fiduciaries to even uncover in the first instance, and then act upon, infor-mation about fees and their distribution.

Of more importance is the extent to which sub-sequent events and jurisprudence have significantly undercut the key legal assumption underlying the Seventh Circuit’s conclusion that the fee levels were


appropriate, which was the belief that “all of [the] funds were also offered to investors in the general public, and so the expense ratios necessarily were set against the backdrop of market competition” [ Hecker , 556 F.3d at 586]. The Seventh Circuit assumed that the broad range of investment options offered by the plan, in light of their availability to the public, must have contained reasonable fee levels because they were subject to marketplace forces.

The assumption that the fees on the investment options were, by definition, appropriate because they were subject to marketplace discipline does not stand up to scrutiny after the Court’s careful fact finding, after trial, in Tibble . In Tibble , Judge Wilson was care-ful to explain that the fiduciaries had offered retail class mutual fund shares to the plan participants, rather than the identical but cheaper institutional class shares. While certainly retail pricing may be the same across the market and subject to the broad forces of the marketplace, it is not necessarily the case that the same holds true for institutional share pric-ing, which is not subject to the same broad market-place. Indeed, even within the 401(k) marketplace, not all plans are created equal and not all plans can obtain the same pricing, as Judge Wilson found after hearing the evidence in Tibble ; one of the key findings in that case was the conclusion, in essence, that size matters, in that large plans can obtain pric-ing improvements that smaller plans cannot obtain. Simply put, by conducting a trial into mutual fund pricing regarding fees—something the district court and the Seventh Circuit never allowed for in Hecker —the Tibble court documented the existence of submarkets in the pricing of mutual funds and the existence of different pricing structures. The Seventh Circuit’s opinion in Hecker does not account for this in its assumption that the fee levels were, by definition, appropriate because the investments were also sold to the general public at the same cost. As the Tibble court found, plans can and do get better pricing than the general public, a fact the Hecker court did not confront in its analysis. Further, and of significant import, the Tibble court found that it was that very fact that established a breach of the duty of prudence, in that the fiduciaries had failed to learn and act upon that fact to obtain lower fees. Unlike the court in Tibble , the Hecker court simply assumed the propriety of the levels of the fees themselves, without factual development or investigation to determine whether they were in fact consistent with fiduciary obliga-tions; the detailed fact finding in the subsequent

decision in Tibble documents the fundamentally unsound nature of that assumption.

Indeed, even aside from the questions of institu-tional versus retail pricing that was the central issue with regard to the findings of breach of fiduciary duty in Tibble , other aspects of that decision further document the ability of fiduciaries for larger funds to negotiate unique deals that surpass the market-place, simply by making use of their own marketplace power. In Tibble , the Court found that the fiduciaries had not breached their duties with regard to one par-ticular money market investment option because, in part, the fiduciaries had actively negotiated a reduc-tion in fees over time with that particular vendor. The Court’s detailed factual findings in this regard further establish that plan fiduciaries can do better than the marketplace, which in turn further establishes that it is inappropriate to use the retail costs of invest-ment options as a proxy for appropriate pricing, as the Seventh Circuit did in Hecker . Indeed, making retail pricing the benchmark for fiduciaries’ level of care with regard to the expense ratios on investment options offered by a plan is inherently inconsistent with the obligations imposed on a plan’s fiduciaries, which are to act as a reasonably prudent person who is knowledgeable with regard to the investment options, something often referred to as a “prudent expert” stan-dard. There is no credible reason to believe that a rea-sonable expert in mutual funds or similar investment options would not know that a large dollar investor can do better, simply by basic negotiation, than can the general public as a whole.

And so, in light of what we now know about fee setting in defined contribution investment options through the yeomen’s work of the Court and the litigants in Tibble , in conjunction with the changes in fee disclosure that are currently being established by the DOL, we are left with the conclusion that the seemingly impregnable wall built by the Hecker court against excessive fee claims is likely not to stand the test of time. Instead, we are likely looking at a future course for these types of claims that will far more resemble the Court’s processing of that theory in Tibble than anything else. In that, though, is both good news and bad news for plan sponsors and fidu-ciaries. The bad news, obviously, is the increased risk of exposure, something presented anytime a case pro-ceeds against a defendant past the motion to dismiss stage and into the merits. Of more import, though, is likely the good news, which is that the Court in Tibble lays out the steps to take to avoid having


liability imposed on fiduciaries at a later date based on the expense levels in the investment options they select. As the Tibble court made clear—and as Hecker likewise reflects—there is no obligation to find the cheapest investment option or even, for that matter, the fund that offers the optimum combination of fees and performance. Rather, what is required is a proper

process that will, as in horse shoes, get the fiduciaries close enough to that outcome to be both acceptable and defensible. Documenting that process is enough to win an excessive fee case when it does show up, down the road, the next time the market tanks and angry participants try to recoup their losses from a plan’s fiduciaries. ■

20

A R T I C L E

Choosing a Path for Stable Value Funds B y M a r s h a l l J . C o b b

Stable value funds, with over $560 billion in

collective assets, have long been a dominant fixture

within the 401(k) marketplace. Unfortunately, the

information available on the underpinnings of

these funds pales in comparison to that available

regarding the registered products they accompany

within the investment menus of many qualified plans.

While it is tempting to think that stable value funds (SVFs) are all the same, the reality is that they come in all shapes and sizes with significantly differ-ent underlying portfolios, expenses, and risk profiles. It is difficult to compare SVFs on an apples-to-apples basis because of some noteworthy variations, such as pooled versus separate account structures, the credit quality of the underlying portfolio, cash flow, wrap coverage via external insurers or via the sole insurer sponsoring the fund, participating versus nonpartici-pating contracts and, finally, 12-month put versus market value adjustment exit policies.

One aspect of the Financial Reform Bill (the Bill) still pending in Congress categorizes the wrap insurance used to prop up SVFs as a swap [http://www.washingtonpost.com/wp-dyn/content/article/201007/15/AR2010071500464.html]. Wrap insur-ance, which is applied to the underlying sleeves of

bonds in a SVF, is purchased to ensure that the SVF cannot produce a negative return (with a zero return as a worst case outcome if the hedging is done correctly). One goal of the Bill was to clean up the uncollateral-ized swaps without anything to back them up that could cause harm to investors expecting no reduction in principal. The Bill then takes reform one large step further by stipulating that the firm that issues the insurance contract would then have a fiduciary duty to the plan (and both the buyer and the seller in the transaction). The Securities and Exchange Commission (SEC) has been charged to review purchase decisions and, ultimately, to implement what it sees as the rem-edy for any harm suffered. While many think or hope that no action will ultimately come out of the SEC’s review, there is still a chance that the SEC’s action will ultimately unwind the SVF industry. In any case, the likelihood that the SVF industry will emerge from this evaluation unchanged is slim to none.

SVF Versus Money Market Funds Given the implications of the huge sums invested

by 401(k) plans in stable value funds, a comparison to their typical competition—money market funds—may be instructive.

Different Risks, Returns, and Volatility Money market funds are invested in short term,

high quality, highly liquid investments, such as cer-tificates of deposit and T-bills. They have an average maturity that is 60 days or less courtesy of recent changes to SEC Rule 2a-7. Stable value funds, on the other hand, are invested in a range of short-to-intermediate bonds, as well as the general accounts of insurance companies, with average maturities typically in the four-to five-year range.

By purchasing short-term investments with the highest ratings, money market funds take signifi-cantly less risk than SVFs, which usually means a lower return than SVFs over the long haul. SVFs, which invest primarily in the intermediate term bond market, take more risk and, hopefully, provide higher returns.

As short-term investments, money market funds are immediately affected by changes in interest rates. Not long ago, four to five percent interest rates on money market funds were common; as of this writing, the return is about 0.10 percent. SVFs purchase insur-ance “wrap” contracts to protect against losses and credit today’s rate based on a blend of past and present interest rates.

Marshall J. Cobb, CRSP, is founder and president of Cobb

Retirement Solutions, LLC, a fee-only firm offering qualified

plan analysis and oversight to corporations and organizations.

Based in Houston, Mr. Cobb can be reached at mcobb@ cobb-

retirement.com.

CHOOSING A PATH FOR STABLE VALUE FUNDS 21

When interest rates plummet, as they did recently, money market fund rates reflect 100 percent of the decline. The opposite is also true: money market funds paid double-digit returns when rates spiked in the 1980s. SVFs, on the other hand, smooth out the peaks and valleys of interest rate changes through the use of the insurance wrappers and crediting techniques. Cash flows also have a direct impact on rates of SVFs.

Availability and Information Disclosure Money market funds and SVFs may both invest in

bonds offered by the U.S. government, but neither offers a guarantee of principal, although there are a few exceptions on the money market side of the equa-tion. Neither type of investment is guaranteed by the federal or state government. While many provid-ers have tapped into fear by offering “FDIC insured” money market products, the reality is that the FDIC is so unstable that a massive failure of money mar-ket funds would not have the assets/backing to live up to their guarantees. While neither type of fund is designed to lose principal, it has happened on rare occasions.

Money market funds are offered to the general pub-lic, as well as to retirement plans. They are mutual funds and, as registered products, can be purchased in any type of account. SVFs are not mutual funds. They are collective investment trust products offered only within qualified retirement plans, such as a 401(k).

As a result of the public registration of money market funds, information on such funds is publicly available. On the other hand, investors in a SVF can only receive information on the fund directly from the offering company. That information is sometimes sparse.

In short, SVFs and money market funds have more differences than similarities. These differences do not necessarily make one superior to the other, but it is fair to say that over the long haul, the average SVF should provide a higher rate of return than the average money market fund. However, neither is designed to meaningfully outperform inflation. They are parking spots for money that offer less risk and significantly less return than the other options within a plan’s investment menu.

SVF Comparisons Net rate of return. With the correct software and

data feeds, it is possible to compare the net return of competing SVF products. Unfortunately, net returns are not innately helpful as the data can be driven

dramatically by other elements, such as cash flow and duration.

Expenses. The stated expense is another element of comparison among SVFs. The right cash flow at the right time can make an expensive SVF temporarily outperform a low-cost version.

Market value (MV) vs. book value (BV) ratio. SVFs make payments at their unit value, also called book value, which is typically $1. On the other hand, the market value, which is what the underlying bonds within the fund are worth, may be more or less than the book value. Why should investors care about MV? During the throes of the 2008–2009 down-turn when declines in the value of corporate bonds dramatically reduced their MV, it was not unusual to see a SVF with a MV of 92 percent of its BV. In practical terms, this meant that a SVF with less than 100 percent MV vs. BV could not afford to pay all of its obligations. In the fourth quarter of 2010, these ratios rebounded and most healthy SVFs now have a MV above 102 percent.

Duration. Much like a traditional bond fund, SVFs have durations. In a declining rate environment, dura-tion can help estimate the potential gains or further declines in short-term rates. In a rising rate environ-ment, duration can point to the amount of losses a portfolio would suffer as rates climb.

Credit quality. Prior to the 2008 collapse, it was not all that unusual to see some exposure to high yield or emerging markets debt within a SVF. Lately, overall credit quality has become somewhat homogenized due to the newer, tighter requirements of the wrap insur-ance provider community.

Number of clients/size of the largest clients as a percentage of the fund. In a pooled environment, it is worth not-ing not only how many others share the same pool but also the size of their position versus everyone else. A departure from the fund by an investor that holds 25 percent of a pool is a major event. Even more signifi-cant for those remaining in the pool is where rates are during liquidation of their portion of the portfolio.

Pooled vs. separate account structure. A pooled prod-uct is similar to a mutual fund where the assets of all investors are gathered in one pool. A true separate account is a completely different approach where the assets of one client are managed separately. In a true separate account the cash flows of other clients have no impact. As these are two distinct approaches it’s not possible to compare them on an apples-to-apples basis (more information on the separate account structure is found in the next section).


Pooled funds take in cash and upon termination pay out in cash. It is not safe to assume, however, that a true separate account SVF (belonging to only one client) will offer the ability to purchase an individual basket of securities that can later be moved to another manager. Some separate account managers actually utilize a building block approach, in which each cli-ent buys a vertical slice of the underlying funds. Notwithstanding this approach, upon termination, the investor in a fund using a building block approach will still typically receive cash and not a basket of securities, just as they would have under a pooled environment.

Management. The management structure of SVF products is nearly as diverse as their mutual fund brethren. Some vendors, such as Schwab, utilize a manager-of-managers approach to gain exposure to the various parts of the bond market through use of external managers who are, in turn, overseen by an internal team. Other vendors, such as T. Rowe Price, rely on internal management to build and run the portfolios. Several years ago, prior to the market col-lapse and dearth of wrap coverage, the manager-of-manager and internal management approaches could have distinct differences in their styles and underlying holding. Those differences are now being muted by the conservative terms of the existing wrap providers, which eliminates significant variances in holdings and duration, and the fact that most stable value funds have had to turn to a small group of insurers that are willing to manage new contributions under separate accounts that they also then guarantee (this is another way to handle cash flow in an environment where wrap insurance is difficult and expensive to obtain).

SVF Comparison Impediments Home cooking. Some bundled 401(k) providers offer

different sleeves of a single SVF product: their own. In

particular, there simply are no SVF options available in many of the bundled products offered in the small plan market. In the mid-market (defined loosely as plans of up to $500 million in total assets) the home cooking theme still dominates, depending on the ven-dor selected. For example, Vanguard currently offers only its Retirement Savings Trust SVF, and, in an effort to stem cash flows, even that is offered on a case-by-case basis. Other vendors have gone in the opposite direction, liquidating their proprietary SVF in favor of an extremely limited menu of nonproprietary products and, of course, proprietary money market funds.

Cash flows. Many vendors consider details regarding cash flow to be proprietary information. This is unfor-tunate, as this single factor can serve as the primary driver of the crediting rate. A given SVF fund might reflect a one year rate of return that is .75 percent higher than the bulk of the competition. It is easy to make the assumption that the higher rate of return is attributable to the prowess of the management team. Unfortunately, the real driver of excess perfor-mance may be the fact that cash flow within the SVF turned negative in a falling interest rate environment. Conversely, a fund that appears to be underperform-ing its competition in a falling interest rate climate may be the victim of too much positive cash flow. The chart below explains the nuances.

Separate accounts within pooled products. Insurers, such as New York Life and Prudential, have made signifi-cant inroads into the stable market over the past few years with separate account products managed and custodied by some or all of the staff that manages the general account of the insurer. There is no external wrap coverage, only a promise to pay that is tied to the general health of the insurer. How does a product that utilizes—and pays for—a traditional array of wrap providers compare with one where the “insur-ance” is a charge that is passed to another business

Market Interest Rates

Rise Fall

Positive Cash Flow

Good: Positive flows are reinvested at rising market interest rates causing the portfolio’s crediting rate to rise more rapidly than normal.

Bad: Positive flows are reinvested at low market rates causing the portfolio’s crediting rate to decline.

Negative Cash Flow

Bad: Maturities cannot be reinvested at higher market interest rates because they are used to pay distributions.

Good: Maturities are paid out rather than reinvested at lower market interest rates. This sustains the portfolio’s crediting rate above the market crediting rate.

Chart courtesy of Invesco Fixed Income and Invesco Ltd.

CHOOSING A PATH FOR STABLE VALUE FUNDS 23

unit of the same insurer? In short, it does not. The profitability of the separate account backed by the insurer has a significant advantage over competitors that have to find and pay for external wrap coverage. The insurer running the separate account also has the corresponding advantage of not being bound by external limitations as to the cash that it can accept (and underwrite). This is the reason many traditional funds are seeking out relationships with the insurers to establish separate accounts to handle additional flows. The insurers, particularly when offering their own bundled 401(k) products, use their increased profit-ability to their advantage when pricing a plan.

Even within the context of comparing two tradi-tional SVFs, the size and impact of expenses can be difficult to determine. The use of proprietary fixed income or cash management products can aid the underlying profitability of a SVF, masking fees and allowing the offeror to understate the true extent of its fees and profitability. In many cases, the single biggest driver, cash flow, can make what would ordinarily be considered an expensive product look extremely com-petitive when compared with peers with significantly lower fees.

Participating vs. nonparticipating contracts. In a parti-cipating contract, the client and its participants get exposure to the performance of the underlying portfolio in the form of a fluctuating return. Nonparticipating contracts (now somewhat rare) offer a fixed rate of return that is typically lower than that available from a similar participating contract.

Separate account SVF managers. This is a true, inde-pendent separate account for a single client, not a separate account offered by an insurer that is tied to its general account. Many managers willing to establish a separate account SVF for a single client now prefer at least $100 million in assets prior to agreeing to propose their services. The ability of this structure to offer upside versus a pooled environment depends on many factors, including expenses of the manager and the external wrap providers, manager skill, limita-tions imposed by the external wrap providers, and, of course, cash flow.

Three Paths Given an understanding of SVFs and the attempt to

differentiate them, let me frame our analysis using an analogy.

Suppose that there are three sets of hike-and-bike trails along the bayou near my home. Lest you think me ostentatious, I should point out that the word

“bayou” is a local euphemism for what would be known elsewhere as a drainage ditch.

Trail 1 is paved and serves as the conduit for spandex-clad individuals who want the illusion of the Tour de France minus the requisite training or the Alps. With the exception of a close encounter with a Lance Armstrong devotee, this is a fairly safe, uneventful trail.

Trail 2 mirrors the first but is unpaved and sits above the berm that theoretically keeps the adjacent neighborhoods from a close encounter with the bayou. Trail 2 does have an occasional bout of elevation and a stray rock or two, but the main danger comes in the form of unattended proof of prior dog walks.

Trail 3 actually winds within the banks of the bayou. It twists and dives, and is choked with vegeta-tion and mosquitoes. Portions of Trail 3 are frequently washed away when the bayou floods. In short, Trail 3 is a lot of fun for the mountain bike enthusiast—until it is not.

While this description might mistakenly give the impression that a huge range exists in the risk levels of these three trails, the reality is that even Trail 3 can be successfully navigated by a rank amateur or week-end warrior. It takes longer, and likely involves a few more bumps and scratches, but it is not something that someone who hails from a state with mountains or even hills would think about twice.

If we juxtapose our trails against the financial world, I submit that fans of Trail 1 prefer safety and predictability of returns. Many of these folks are cur-rently sitting in money market accounts, earning next to nothing in the way of interest but finding solace in the safety.

SVFs, on the other hand, historically resemble Trail 3. Unlike money market funds, they invest in intermediate-term bonds that have a fair amount of play in their market value. Some SVFs have, in the past, placed small amounts in subprime mortgages, high yield bonds, and emerging market debt.

In our post-2008 financial meltdown world, the insurers that provide wrap coverage on the bond port-folios within an SVF have tightened their restrictions to the point where many will only back investment in treasuries and the highest grades of the corporate bond market. To some extent, insurers have asked SVFs to look like Trail 1 while at the same time increasing the rates for coverage far in excess of what they previously charged for Trail 3. With the departure of SVF manag-ers who were either poor stewards or excessively risky and the institution of new requirements by the wrap


insurers, it is fair to say that nearly all of the SVF uni-verse now fits squarely on Trail 2.

While SVFs have become centered on Trail 2, it is worth noting that the transparency of the underly-ing components discussed earlier varies widely from one product to another. Almost none—sans a separate account SVF run for a single client—has anything close to the transparency of a money market fund/Trail 1. Even within a single client separate account, there are techniques such as the building block struc-ture that add vagary to the equation.

Trail 3 and the lure of higher returns still exist, but it does so primarily via a SVF tied to and insured directly by a single insurer. In these products it is still possible to find significant excess allocations to cor-porate, mortgage-backed securities, and longer-term maturities. It all depends on the risk appetite of the insurer offering the SVF. It is also reasonable to cate-gorize a more generic SVF that refuses to divulge basic data as something that belongs on Trail 3.

How to Choose In choosing a SVF, it is best to determine first

whether there exists an option. It may well be that the recordkeeping solution chosen for a plan has but one homegrown option when it comes to SVFs. If other options exist, then it is probably best to frame the

process by the three trails and by the time available to devote to the effort.

Those who want the clarity and predictability of a Trail 1 and who do not wish to spend a fair amount of time reviewing MVs, credit quality, and management structures should probably stick with a money market option.

Those who are willing to devote time and effort to the evaluation, but who need to identify and under-stand all of the points that were previously raised, will want to stay with the minority of the SVF uni-verse on Trail 2 that supplies this level of informa-tion. There is no simplistic scoring system that will provide a reliable outcome and it is best to seek a seasoned outside resource for this analysis. Those with assets in excess of $100 million in this category may want to pursue their own separate account SVF for the benefits this structure has in the way of control and exit terms.

Trail 3 still exists, but it serves as a resource pri-marily for those who seek higher returns without the desire to understand how those returns are achieved. On one hand, it is comforting to note that the insur-ers in business today survived the cataclysmic down-turn of 2008–2009. On the other hand, it is probably unwise to assume that any firm is truly too big to fail.

Choose your path carefully. ■

25

A R T I C L E

Best Practices in Applying Revenue Sharing B y P e t e K i r t l a n d

It’s all about doing the right thing for the plan and

its participants. The numerous rules, legislation,

and pressure in the retirement plan administration

environment come back to one issue: Are we doing

what is in the best interest of the plan participants?

Revenue sharing, including 12b-1 fees, finders fees, subtransfer agency (Sub-TA) fees, and shareholder ser-vicing fees (SSF), is a major aspect of how retirement plan services are funded. This article intends to review the various considerations about the awareness of these funds and how they are being used. Ultimately, responsible fiduciaries must understand how service providers treat revenue sharing as part of their selec-tion process.

What Is Revenue Sharing? Investment products, such as mutual funds, often

contain share classes with different, built-in revenue sharing components; and different share classes of the same fund are created to position them for use in dif-ferent investment products such as retirement plans or IRAs. Sometimes money is earmarked to incent investment professionals to use certain investments (12b-1 fees). Other times, it is used to compensate a recordkeeper for tracking activity in a single plan-level account on a participant-by-participant basis (Sub-TA fees). Fund companies also use SSFs to compensate the

recordkeepers for detailed participant services such as allocating dividends.

To an investment firm, such as a mutual fund company, retirement plans can be a very attractive or unattractive asset source. Participant accounts in retirement plans are typically smaller than investment accounts outside a plan. However, in aggregate, plans can represent a large, attractive pool of assets.

This is where the recordkeeper becomes critical. Its job is to manage the participant subaccounting and present the plan as a single unit to the fund company. In this case, the fund company gets to hold the plan assets in the name of the plan and, therefore, is respon-sible for one larger account rather than many smaller participant-level accounts.

Various mutual fund companies will compensate the recordkeeper for facilitating this efficiency. This is the purpose of Sub-TA fees and SSFs. It is the mutual fund company’s decision that this efficiency is of value to them; therefore, they will pay part of the fund management fee back in a “trailer” to the provider. It is this dynamic that has allowed retirement plans to become attractive to investment firms. As a result, small and micro plans are now able to attract invest-ment professionals and other advanced management that was historically unavailable to them.

In this light, revenue sharing is effectively allowing investment product firms to get access to more attrac-tive pools of assets, and smaller plans are able to get professional service that wasn’t available otherwise. By design, revenue sharing serves a good purpose. However, plan fiduciaries must be acutely aware of its existence and the impact it has on the overall perfor-mance of investments for its plan participants.

Where Does Revenue Sharing Come From? Revenue sharing is either directly (part of the

expense ratio) or indirectly (overhead to the fund) part of the overall cost of an investment product. Higher revenue sharing on a particular share class within the same fund will equate to a higher total expense ratio on that investment. This is a consideration that the plan sponsor must understand, as it has a direct impact on the overall performance of that investment.

“R share” classes, as an example, are designed largely for the use in retirement plans. The admin-istration of a retirement plan can be a difficult and costly endeavor. Again, to enable the plan to have access to professional investment managers, these share classes offer the opportunity to have the fund invest-ment selections effectively pay for the services. Upon

Pete Kirtland is the President of ASPire Financial Services LLC,

a national recordkeeper with over $3B in retirement assets.


reading this, it should be obvious that the plan par-ticipants are actually indirectly funding the cost of the service to their plans through this increased expense ratio. This is a critical point to remember when deter-mining how the plan will operate.

Use of Revenue Sharing The recently finalized regulations under ERISA

Section 408(b)(2) refer to three levels of services (Covered Services) and related expenses in plans. The entities providing the services are called Covered Service Providers.

They include:

1. Investment options, 2. Recordkeeping and administration, and 3. Other, i.e., consulting, brokerage, and advisory

services.

The investment options are the source of revenue sharing, while the other two items use the revenue sharing that is generated.

Is Revenue Sharing a Plan Asset? There is not a definitive answer to this question;

however, let’s look at this from the perspective of doing the right thing for the plan participants. As suggested above, the expense ratio within an invest-ment might include components used for revenue sharing. Since fund expenses impact investment performance by increasing overhead, it is difficult to argue that revenue sharing doesn’t indirectly make participants responsible for paying plan fees. If reve-nue sharing is, instead, passed back to the participants it would clearly be a plan asset.

The real key is how the revenue sharing is tracked, used, and disclosed. It is critical that the plan sponsor, as a fiduciary to the plan, has an awareness of these money flows and the dynamic the overhead creates for the participants. It is additionally important that the

plan sponsor is educated on the expense ratio of prod-ucts being used and any alternatives that exist. While revenue sharing serves a valuable purpose of offsetting plan expenses, the cost and impact on investment per-formance must be closely considered.

With the ever-increasing pressure and now regu-latory requirement to fully disclose plan fees, the flow and use of these funds is coming into focus. The 408(b)(2) regulations do not represent the first time that fee transparency has taken center stage, but it is forcing many to figure out how to ensure all direct and indirect compensation within a plan is disclosed.

Revenue Sharing—Example Let’s take an overly simplified example below to

illustrate using revenue sharing to pay plan expenses. Participant A is using the funds in the investment

line-up that generate revenue sharing, and participant B is using options that do not. If plan expenses are paid directly from revenue sharing without running through the participant accounts, participant A bears all of the plan costs, even though A’s account is smaller than B’s.

The most equitable manner, in many cases, is to return the revenue sharing to participant accounts. Plan expenses are then paid from plan accounts, usu-ally allocated proportionately among all participants based on account balance. This is a significant amount of work for many recordkeepers; however, it ensures that each participant in a plan is paying for the ser-vices provided to the plan.

Consider the example again, but this time follow-ing the approach of allocating revenue sharing back to the accounts that created it and paying plan fees as described above.

By allocating the expenses proportionally back to each participant, the participants pay their portion of the plan expenses based on the sizes of their accounts. This appears to be more equitable to the participants than the first illustration. Although in this illustration

Participant A Participant B Revenue Sharing (%)

Revenue Sharing ($)

Expenses

Fund A $100,000 $0 0.25% $250 $250

Fund B $50,000 $0 0.75% $375 $250

ETF A $0 $100,000 0.00% $0

Money Market Fund

$0 $100,000 0.00% $0

$150,000 $200,000 $625 $500

BEST PRACTICES IN APPLYING REVENUE SHARING 27

participant A appears to have a net inflow, in reality, the $625 they receive back in revenue sharing is an expense that is already reflected in the performance of Funds A and B.

ERISA Spending Accounts ERISA spending accounts are being more widely

adopted in the retirement plan space. Yet, to date, operation of these accounts is not specifically pre-scribed. As such, relatively few custodians support them. The concept is that an account, set up in the name of the plan, acts as the central collection reposi-tory for revenue sharing dollars. Plan sponsors are able to determine whether to use the funds to pay plan expenses or allocate them back to participant accounts. Since this is a plan account, it can only be used to pay expenses that are otherwise eligible to be paid from plan assets. Defined contribution plans are not permitted to hold unallocated funds, so ERISA spending accounts must generally be exhausted each year and not carried from one year to the next. Thus, if revenue sharing exceeds expenses, the excess should be allocated to participants. An ERISA spending account allows for greater transparency in which revenue shar-ing (inflows) and plan expenses (outflows) are managed through a single account.

Revenue Sharing in a Perfect World

Treat Revenue Sharing As a Plan Asset Plan participants generate revenue sharing and,

by doing so, they gain access to valuable professional services that otherwise may be unavailable or cost-prohibitive. Acknowledging revenue sharing as a plan asset is an effective way to have the plan pay for some of its expenses and have any excess returned to partici-pant accounts to optimize growth.

Utilize ERISA Spending Accounts ERISA spending accounts centralize the collection

and management of the revenue sharing that does not go directly to an investment professional (such as a 12b-1 to the registered rep on the plan). This gives the plan sponsor the ability to better manage these funds more appropriately on behalf of the participants.

The plan recordkeeper acts as the “hub” between the investment firm and the plan participants; there-fore, they are most capable to handle the flow of the revenue sharing. They can offer the ability to manage the ERISA spending account and facilitate payment of fees and/or reallocation of the excess. Since the account reflects the amounts collected by date, fund, and type of revenue sharing, it also allows for more accurate asset and transaction reporting on the Form 5500 and audited financials.

Pay Plan Expenses That Are of Equal Benefit to All Participants from the ERISA Spending Account

While there is good reason to pass most revenue sharing back to the participant accounts prior to pay-ing plan expenses, there are times where the ERISA spending account should be used directly to pay an expense. When plan expenses relate to activity that is more correlated to revenue sharing activities, it would be appropriate to pay the related fees from the central account. Since those fees were a result of revenue shar-ing activities, those that participate in revenue sharing should pay for them.

In addition, due to the complexity of running rev-enue sharing through the recordkeeper and into the participant accounts, it may be more cost-effective to directly pay plan expenses from the central account. Furthermore, if the plan sponsor is aware of addi-tional fees for the year, e.g., the plan auditor’s fee, it may choose to forecast those expenses and retain the

Participant A Participant B Proportion of Plan

Proportion of Expenses

Fund A $100,000 $0 28.6% $142.86

Fund B $50,000 $0 14.3% $71.42

ETF A $0 $100,000 28.6% $142.86

Money Market Fund

$0 $100,000 28.6% $142.86

Total Plan Costs Paid

($214.28) ($285.72) $500

Revenue Sharing Deposited

$625 $0


necessary amount in the account to use upon receipt of the invoice.

The plan sponsor must be aware of how equitable that practice is to each plan participant when deciding the appropriate course of action.

Allocate Remaining Excess Revenue Sharing Back to Participant Accounts

If the plan sponsor chooses to use the ERISA spend-ing account to pay plan expenses, excess revenue sharing should be allocated back to the participant accounts.

Be Transparent, Report It All! Now that the ERISA spending account exists, this

makes transparent reporting an easier endeavor. All

inflows and outflows that involve revenue sharing exist in this account, much like a bank account. The plan sponsor must be sure to obtain the necessary dis-closures from any Covered Service Providers that may have been compensated outside the account.

Summary Through revenue sharing, the retirement plan

industry has created an efficient method to allow all plans, regardless of size, access to professional services; however, there are many complexities that make tracking the flow of funds difficult. With man-datory fee disclosure on the horizon, the complexity is going to have to be unraveled. By adopting the practices outlined above, this process becomes more plausible. ■

29

A R T I C L E

Mental Health Parity and Our Inability to Make Forward Progress B y C a t h e r i n e R i s c h e

This article is the second of a two-part series. The

first part appeared in the previous edition of the

Journal of Pension Benefits.

IV. The Mental Health Parity and Addiction Equity Act of 2008

As part of the Emergency Economic Stabilization Act of 2008 (Stabilization Act), President Bush signed the Paul Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008 (MHPAEA), which amends ERISA. Generally, the MHPAEA prohibits group health plans from applying financial requirements that are more restrictive than those restrictions applied to the plan’s medical and surgical benefits. Such financial requirements include copayments and deductibles, or treatment limitations such as annual limits for days of outpatient visits or inpatient stays for mental health and substance abuse, etc. For example, if a plan pays 80 percent for medical services, it must also pay 80 percent for mental health or substance abuse services. If it does not limit the

number of inpatient stays that a covered person may have annually or during their lifetime for the treat-ment of a medical issue, the plan may not impose a two-time lifetime inpatient limit or 21-day outpatient limits for mental health or substance abuse treatment programs. Further, unlike the Paul Wellstone Mental Health Equitable Treatment Act of 2005 (MHETA), the MHPAEA does not distinguish between out-of-network and in-network coverage. A plan may not charge more or limit visits for treatment or services provided by an out-of-network provider of mental health services than those out-of-network visits to medical service providers.

Similar to the Mental Health Parity Act of 1996 (MHPA), the MHPAEA includes exemptions. These exemptions include the small-employer exemption (fewer than 50 employees) and the cost exemption (two percent the first year and one percent in subse-quent years). To qualify for the cost exemption, the plan actuary must certify actual costs, the plan must retain the actuary’s report for a period of not less than six years, and the plan must comply with the parity legislation for six months after the implementation date before seeking the exemption. Additionally, although the MHPAEA does subject substance abuse and chemical dependency treatments to parity rules (an added requirement from existing parity laws), there is no mandate for coverage. Accordingly, an employer sponsor is permitted to cover mental health benefits but discontinue coverage for chemical depen-dency and/or substance abuse rather than provide cov-erage for those benefits at medical/surgical levels.

Finally, the MHPAEA does not clearly define mental health or substance abuse disorder benefits. Regarding the types of conditions to which parity applies, the statute states, “the term ‘mental health or abuse disorder benefits’ means benefits with respect to services for mental health conditions, as defined under the terms of the plan and in accordance with appli-cable Federal and State law.” [ Id . at § 1185(e).]

V. The Aftermath of the MHPAEA Employers and insurers felt blindsided since the

MHPAEA was included as part of the Stabilization Act instead of being passed on its own. With most employers and insurers, there are two major concerns: (1) skyrocketing utilization rates that increase costs and overwhelm the advantages of the continued pro-vision of mental health benefits, and (2) the types of mental illnesses that must be covered under the new rules. Proponents of the legislation wonder if the

Catherine Rische is a Senior Associate with Johnson & Krol,

LLC in Chicago, where she focuses her practice on advising clients

regarding health and welfare and pension administration issues.

She earned her JD from DePaul University College of Law and her

LLM in Employee Benefits from the John Marshall Law School,

with honors.


MHPAEA goes far enough to ensure full parity or whether it will fall short of providing any real equity of access to services.

A. Utilization Uncertainties While advocates of mental health parity refute the

arguments of employers and insurers that parity will exponentially drive up costs as explained herein, those costs continue to be a driving factor in the resistance to full parity. Studies of indemnity insurance have found that moral hazard is a problem that is more pronounced for mental health care than it is for gen-eral medical care. “Moral hazard refers to the tendency for patients to demand more services as the price they pay for those services declines.” Additionally, “while generally health insurance incentivizes overuse by insulating patients from the total costs of care, research shows that the demand response to reduced cost sharing in mental health care is approximately twice as large as that observed in general medical care” [J.P. Newhouse and the Insurance Experiment Group, Free for All? Lessons from the RAND Health Insurance Experiment (Cambridge, Mass., Harvard University Press, 1993)].

It is reasonable to argue that the mental health and physical health utilization rates are an “apples and oranges” comparison because someone who has a nondebilitating mental illness may be more likely to overutilize benefits if they have full access and rela-tively low exposure to cost consequences. By contrast, if a covered person has a broken ankle, they are likely to seek the care and treatment regardless of cover-age and cost. However, if they do not have a broken ankle or some other condition with symptoms that interfere with their daily functioning, it is reason-able to assume that they are not likely to make regular appointments with their physician. This disparity may make the analysis of the cost implications difficult.

Proponents of MHETA also argue that full parity would not increase costs if employers and insurers implement managed care principles such as utilization review, financial incentives, preventive medicine, and treatment protocols. These proponents emphasize that parity may reduce costs to employers by improving productivity, reducing absenteeism, and eliminating the need for medical care and emergency visits that result if mental illnesses are left untreated. Proponents also note that large employers have had a net positive financial impact, pointing to Delta Airlines as an example. In 1994, Delta increased mental health benefits for its 69,000 employees when it switched

to managed care. Use of services increased, but costs remained flat. Spending in other areas of health care declined, and employees missed less work.

However, from my experience with health plans in evaluating managed care as a mental health cost-containment mechanism, the managed care approach also has obstacles. Many employees are distrustful of managed care principles due to negative publicity and/or personal experiences where managed care par-ticipants failed to receive the care necessary because of cost-containment and gate-keeper models. In some extreme and highly publicized cases, the results were devastating. Additionally, mental illnesses are more difficult to classify as medically necessary. A medical illness or injury is something that is more concrete—a broken bone is a broken bone. An insurer can predict the length of treatment necessary to cure or remedy the illness, whereas mental illness treatment timelines may be more difficult to predict. Depending on the severity of the condition or the underlying circum-stances giving rise to the condition, the treatment may be short term, but in most instances life-long treat-ment is needed. Further, the intensity of treatment may vary from individual-to-individual and condition-to-condition. Someone with bipolar disorder may need to be in weekly or even daily treatment for extended periods of time. Therefore, utilization trends are nearly impossible to determine.

B. Coverage Issues There are serious concerns about the types of men-

tal health benefits that should or must be covered under the parity rules, as evidenced by employer and insurer resistance to MHETA I and MHETA II. The definition of mental illness may be the crucial factor in whether employers and insurers continue to resist parity. Some employers and insurers believe that fed-eral parity legislation should cover only serious men-tal illnesses or illnesses that have been shown to be related to a biological functioning of the brain (e.g., schizophrenia, bipolar disorders). This approach would be consistent with most state laws. Those employers and insurers claim that extending coverage to all men-tal disorders listed in the Diagnostic and Statistical Manual of Mental Disorders, Fourth Edition (DSM-IV) opens the door to dubious complaints of less seri-ous problems by the “worried well.”

Proponents of parity maintain that there are issues with limiting coverage to serious mental conditions . Primarily, they argue that rather than limiting cov-erage, managed care approaches are a wiser avenue,

MENTAL HEALTH PARITY AND OUR INABILITY TO MAKE FORWARD PROGRESS 31

citing evidence that milder forms of emotional ill-nesses often worsen into more serious psychiatric dis-orders if left untreated. Further, proponents contend that using the DSM-IV will not open the floodgates, as it establishes a threshold for diagnosis by requiring evidence of “clinically significant impairment or dis-tress” and any claim that does not meet the threshold may be excluded on the basis of medical necessity.

As written, the MHPAEA is unclear about what types of mental illnesses must be covered. The law states that mental health or abuse disorder benefits means “benefits with respect to services for mental health conditions, as defined under the terms of the plan and in accordance with applicable Federal and State law” [29 U.S.C.A. § 1185(e)(4)]. This lan-guage is vague regarding whether self-insured ERISA plans exempt from state law are required to follow their state definitions of mental illness, or whether self-insured plans may arbitrarily define mental ill-nesses in the plan document. If plans may individu-ally determine the definition of mental illnesses, the legislation has left a gaping hole for employers and insurers to exclude coverage for most mental ill-nesses and substance abuse conditions. Employers may decide to cover a small list of the most serious men-tal or biological illnesses such as schizophrenia and autism and exclude less serious symptomatic disorders such as depression and substance abuse for fear of overutilization.

Even if the employers and insurers follow state law, existing laws defining mental health conditions vary from state to state, so the uniform treatment approach desired by proponents of parity legislation is lost. Only some states have comprehensive parity laws that apply to all mental health and substance abuse disorders under private insurance plans with no exemptions, with the remaining states falling some-where between the floor of no parity and the ceiling of comprehensive parity [Teddi Dineley, “Mental Health Advocates Laud New Federal Parity Law: Equal Coverage for Mental Health Care,” 2009, http://www.medscape.com/viewarticle/587571]. For example, a mentally ill individual who is treated in Vermont under its stringent parity laws may be transferred to a job in Wyoming with no parity requirements and could be forced to suspend treatment and suffer a loss of momentum, impairing his recovery.

As explained above, there are pervasive issues with the parity laws as drafted. In addition to those issues, there are many mental health advocates and studies that contend that even with the recent breakthroughs,

parity laws stop short of true parity. According to a July 2007 Congressional Research Service report, many mental health services do not have a counterpart in general medical care, and they are ultimately unaf-fected by parity legislation because they do not have to be included in covered services. Furthermore, pri-vate insurance usually does not cover day-hospital care, psychosocial rehabilitation, or residential treatment programs, all of which can be effective components of mental health care. In addition, health plans do not cover supervised housing or employment for patients with chronic mental health conditions.

The report ultimately concluded that mental health parity laws are an important step in improving the efficiency and fairness of insurance coverage for mental illness, but passing parity legislation is not sufficient to guarantee equal access to high-quality care and equal levels of financial protection for people with mental disorders.

C. The Expansive Regulations On April 28, 2009, the United States Department

of Labor (DOL) released a request for information (RFI) soliciting public comments in advance of devel-oping rules for group health plans [Department of the Treasury, Internal Revenue Service, 26 C.F.R. Part 54RIN 1545-BI70, Department of Labor Employee Benefits Security Administration, 29 C.F.R. Part 2590RIN 1210-AB30, Department of Health and Human Service Centers for Medicare & Medicaid Services, 45 C.F.R. Parts 144 and 146 [CMS4140-NC] RIN 0938-AP65 (April 29, 2009)]. The request sought public comments on the fol-lowing issues: (1) types of financial requirements or treatment limits plans currently impose, (2) terms in the statute that require additional clarification to facilitate compliance, (3) current disclosure practices by plans regarding medical necessity determinations and denials of mental health benefits, and (4) cur-rent practices regarding out-of-network coverage for mental health benefits [U.S. Labor Department seeks public comments on mental health and addiction law News Release (April 28, 2009), Release Number: 09-458-NAT, http://www.dol.gov/ebsa/newsroom/2009/09-458-NAT.html]. The regulations were due from the Department of Health and Human Services, Labor and Treasury Departments on October 3, 2009, in advance of the January 1, 2010, effective date (for all except collectively-bargained plans). However, with the change in administration and the complexity of the issues, the regulations were not issued until


February 2, 2010, and went into effect April 5, 2010. For collectively bargained plans, the law is not effec-tive until the later of the expiration of the last collec-tive bargaining agreement in place as of October 3, 2008, or July 1, 2010 [29 C.F.R. § 2590.712(i)(2)].

D. Highlights of the Interim Final Rules In the preamble to the regulations issued by the

Department of Labor, Department of Health and Human Services, and Internal Revenue Service (collec-tively, the Departments) the commentary focused on providing clarity on certain issues: (1) the mandate, or lack thereof, of coverage, (2) quantitative and qualita-tive parity in classifications, and (3) the exemptions.

The Departments appear to take an approach com-bining elements of all prior bills introduced to bor-row the strongest components of each. Following the line of reasoning of the MHPAEA, the regulations do not require any health plan to offer mental health/ substance abuse benefits. Additionally, plans may offer selective benefits [29 C.F.R. § 2590.712(e)(3)]. This means that plans may cover only serious conditions and can limit coverage based on the scope of diagno-sis. However, moving one step beyond the MHPAEA, the Departments’ approach to defining mental illness returns to the MHETA II approach of requiring that a plan’s definitions of mental illness must be consistent with generally recognized independent standards of current medical practice using state law and/or the DSM IV definitions.

However, like the MHETA I approach, for benefits that are provided, the benefits must be in total parity with the corresponding classification of medical ben-efit. The classifications of benefits are as follows: (1) in-patient, in-network, (2) in-patient, out-of network, (3) out-patient, in-network, (4) out-patient, out-of-net-work, (5) emergency care, and (6) prescription drugs [29 C.F.R. § 2590.712(c)(2)]. This limitation appears to be in a direct response to the cost-shifting mecha-nisms employed by plans after the MHPA. While plans have the flexibility to define the individual clas-sifications, the definitions must be applied uniformly to mental health/substance abuse benefits and medical benefits. This means that plans cannot implement a 20 percent coinsurance payment for out-patient, in-network medical benefits and a 40 percent coinsurance payment for out-patient, in-network mental health/substance abuse benefits. Additionally, if the plan cov-ers one classification of benefits for medical benefits, it must also provide that classification of benefits for mental health/substance abuse benefits. For example

a plan may not exclude out-patient, out-of-network, mental health/substance abuse benefits, but cover out-patient, out-of-network medical benefits. Finally, a plan may not distinguish between primary care and special-ist providers in applying parity requirements in a clas-sification [29 C.F.R. § 2590.712(c)(2), Pmbl. II(C)(2)].

Total parity means that insurers/plans may not impose separate, cumulative, and/or more restric-tive financial requirements (such as deductibles or limits on out-of-pocket expenses) on mental health or substance abuse benefits than those requirements imposed on substantially all (two-thirds) of medical benefits in the corresponding classification [29 C.F.R. § 2590.712(c)]. For example, a plan may impose a $300 deductible for emergency benefits but may not impose a $300 deductible for emergency mental health/substance abuse benefits and a separate $300 deductible for emergency medical services. Similarly, a plan may provide a $2,000 cap for out-patient, out-of-network, out-of-pocket expenses but not a separate out-of-pocket maximum for out-patient, out-of- network mental health/substance abuse expenses. Further, all expenses must be allowed to count towards reaching the $2,000 cap; a plan cannot exclude men-tal health/substance abuse charges from being applied towards meeting the cap.

Additionally, plans are permitted to impose sepa-rate annual and lifetime limits on mental health benefits. Such limits must not be greater than those offered for medical services [29 C.F.R. § 2590.712(b)]. This means that a plan may impose a $20,000 annual limit on in-patient, in-network mental health/substance abuse benefits. If it does so, the plan must impose a $20,000 annual limit on at least two-thirds of in-patient, in-network medical benefits. If the annual limit applies to between one-third and two-thirds of all medical benefits, the plan may apply an annual limit to the mental health/sub-stance abuse that is no less than the weighed-average limit on medical benefits. However, if the plan does not impose an annual dollar limit on at least one-third of all medical benefits, it may not impose an annual dollar limit on mental health/substance abuse benefits.

The parity rules are also qualitative, not just quan-titative. The qualitative parity requirements relate to treatment limitations. This means that a plan may not impose a 60-visit maximum on mental health visits if no similar maximum is in place for the same classification of medical benefits medical manage-ment standards, including prior authorization and


utilization review, prescription drug formulary, gate-keeper access, and step therapy protocols [29 C.F.R. § 2590.712(c)(4)]. This means that if a plan utilizes a qualitative method to control costs associated with mental health/substance abuse benefits, it must also apply those same methods and the administrative pro-cedures within such methods to medical benefits. This is a new area in the regulations, and the comment period on these issues ended May 3, 2010.

As provided in the MHPAEA, the regulations provide two general exemptions to the parity require ments, the small employer exemption and the increased cost exemption. Self-funded, non-federal government (state or municipality) plans may opt out, and plans that cover only retirees and no active employees may also opt out [29 C.F.R. § 2590.712(e)]. The small-employer exemption releases group health plans from required compliance if the employer employed no more than 50 employ-ees, on average, during the preceding calendar year. The increased-cost exemption is quite different than that allowed under the MHPA. The plan may apply for an exemption if the cost of compliance is expected to increase by two percent in the first year and one percent in subsequent years. Also, in a unique twist, the Departments are proposing that this exemption is only available during alternate years, so the plan must comply every other year [29 C.F.R. § 2590.712, Pmbl IV(C)(4)]. Accordingly, the cost exemption is rendered almost useless because the administrative burden and communication barriers associated with changing quantitative and qualitative measures from year-to-year may make the exemption practically unworkable. As a result, further comments were requested on this issue prior to May 3, 2010.

Finally, a plan may not escape these parity rules by offering separate plans for mental health/substance abuse benefits than medical benefits, or separate plans for different classifications of employees. All plans are aggregated for the purposes of determining parity.

E. Utilization Uncertainties Recognizing that plan sponsors and insurers are

hesitant to embrace parity, the preamble to the regula-tions also speaks to the costs associated with increased utilization of mental health/substance abuse benefits stating that “[t]he Departments are uncertain regard-ing the level of increased costs and premium increases that will result from MHPAEA and these regula-tions, but there is evidence that any increases will not be large.” The Departments referred to the RAND

Health Insurance Experiment discussing the concept of moral hazard, mentioned earlier, and stated that the RAND study was conducted over 30 years ago. Oppositely, recent research found the following: (1) individuals’ sensitivity to changes in cost-sharing may have changed significantly over time, (2) individuals’ price responsiveness of ambulatory mental health treatment is now slightly lower than physical health treatment, and (3) costs will not rise as much as expected using results from the RAND Experiment. As a result, it is the Departments’ view that compre-hensive parity implemented in the context of managed care would have little impact on total spending. [ See Meyerhoefer, Chad D. and Samuel Zuvekas, 2006, “New Estimates of the Demand for Physical and Mental Health Treatment,” Agency for Healthcare Research and Quality Working Paper No. 06008; Lu CL, RG Frank, and TG McGuire, “Demand Response to Cost Sharing Under Managed Care,” Contemporary Economic Policy , 27(l):1-15, 2009; Barry, Colleen, RG Frank, and TG McGuire, “The Costs of Mental Health Parity: Still an Impediment?” Health Affairs , No. 3:623 (2006).]

The Departments also utilize the experience of various states and the Federal Employees Health Benefits Programs with mental health parity. Studies conducted because of the fears of skyrocketing costs prior to implementation determined that actual costs decreased, and therefore, such fears were unfounded and exaggerated [Goldman, et al., “Behavioral Health Insurance Parity for Federal Employees,” New England Journal of Medicine (March 30, 2006) Vol. 354, No. 13; Melek, Steve, “The Costs of Mental Health Parity,” Health Science News (March 2005)].

However, it must be noted that throughout the dis-cussion of minimal cost increases and actual decreases in costs, the Departments refer to parity in conjunc-tion with managed care principles such as the use of behavioral health carve-outs. In fact, the Departments’ contention regarding the over-exaggeration of moral hazard hangs on the concept of behavioral health carve-outs. The Departments state: “there is exten-sive literature that has examined the cost savings and the impacts on quality of these organizations… [r]esearchers have reviewed this literature and esti-mated reductions in private insurance spending of 20 percent to 48 percent compared to fee-for-service indemnity arrangements. Also, it appears that the rate of utilization of mental health care rises under behav-ioral health carve-out arrangements. The number of people receiving inpatient psychiatric care typically


declines as does the number of outpatient visits per episode.”

Ultimately, the Departments’ view of moral hazard and its prediction of cost increases as trivial may be flawed. This view rests on the idea that managed care will solve the issue. The net effect of such position is that plans may be driven back to a managed care sys-tem of benefits like that seen in the HMO structure of medical benefit coverage which was popular when the parity debate began. Additionally, the Departments’ view ignores the fact that there are inherent costs asso-ciated with managed care of benefits and the result-ing trade-off in benefit costs for administrative fees and expenses incurred in such management (such as a per-person-per-month fee and participant education/ communication materials).

Further, this position ignores the nonquantitative aspect of the MHPAEA which requires that a managed care concept for mental health/substance abuse benefits may only be utilized by plans if the same requirement is in place for medical benefits and such programs are operated in parity. As discussed earlier, plans may not force participation in a mental health managed care program if the same mandatory utilization is not required for managed care case management of medi-cal benefits. This position ultimately encourages plans to require the use of managed care in both benefits, resulting in what could be a throw-back to the HMO system.

As a final point, separate corporate entities special-ize in the provision of mental health managed care programs from those who specialize in medical man-aged care programs. This separation may make con-gruity between behavioral managed care companies and medical review companies difficult to achieve from an administrative standpoint. Accordingly, fur-ther guidance is needed from the Departments regard-ing the nonqualitative parity requirements in order to fully realize the practical implementation and admin-istrative effect on the cost burden and policy issues associated with the recommendation of managed care programs as a viable way to control costs.

F. Coverage Issues The Departments address another pervasive issue in

the parity debate through the preamble to the regula-tions, responding to a number of comments regarding how to apply the parity requirements to cumulative financial requirements. These concerns highlighted deductibles and out-of-pocket maximums. Because the MHPAEA was not clear, the comments reflected

the following two opposing viewpoints: (1) plans may have deductibles that accumulate separately for medical benefits and mental health/substance abuse benefits (separate accumulating deductibles, so long as the amount of the deductibles were equal), and (2) both mental health/substance abuse and medical benefit expenses must be applied toward one deduct-ible (combined deductible). While the Departments note that a reading of the legislation supported either position, the Departments adopt the view of the commentators that allowing separate deductibles “undermines a central goal of parity legislation, to affirm that mental health/substance abuse benefits are integral components of comprehensive health care and generally should not be distinguished from medical benefits.”

Regarding qualitative limitations, the Departments acknowledge that it will be difficult to determine parity where the “acute versus chronic nature of a condition, the complexity of it or the treatment involved and other factors may affect the review” and that “[a]lthough the processes, strategies, evidentiary standards and other factors used in applying these limitations must generally be applied in a compa-rable manner to all benefits, the mere fact of disparate treatment does not mean that the treatment limita-tions do not comply with parity.” Accordingly, the Departments invited comments on these issues and will likely issue more guidance on the application of qualitative parity.

Additionally, the Departments note that commenta-tors requested guidance on the scope of services that must be provided to disorders. Specifically, clarifica-tion regarding whether a participant with a mental health condition must be offered the full scope of medically appropriate services to treat the condition or disorder if the plan covers the full scope of medi-cally appropriate services to treat medical conditions, even if some treatments or settings are not otherwise covered by the plan. The Departments acknowledge that this may be problematic because the range of services may not be comparable for medical condi-tions and mental health conditions. Accordingly, the Departments invited comments on whether and to what extent the MHPAEA addresses the scope of ser-vices. See id .

Finally, the regulations offer only slight clarity regarding the types of diagnoses and conditions that must be covered under plans in order to achieve par-ity. As noted above and similar to the MHPAEA, the regulations do not require any health plan to offer


mental health/substance abuse benefits. Addition-ally, plans may offer selective benefits [29 C.F.R. § 2590.712(e)(3)]. This means that under the MHPAEA, plans may decide to cover only serious con-ditions and can limit coverage based on scope of diag-nosis, so long as such definitions are consistent with generally recognized independent standards of current medical practice [29 C.F.R. § 2590.712(a)]. While the regulations do offer some insight by adding that plans may use “generally accepted independent standards” as provided by the DSM, ICD, or State guideline (utiliz-ing the definition offered in MHETA II), there is still ambiguity surrounding a plan’s flexibility in selecting diagnoses that will be covered under mental health definitions. Accordingly, this guidance does not end the debate on its own.

G. Reaction to the Regulations As expected, proponents of the parity movement

are pleased with the scope and breadth of the regula-tions, although they caution that there is still room for improvement [“APA Reacts to the Mental Health Parity Regulations,” Medical News Today , February 1, 2010, www.medicalnewstoday.com]. However, the opposing view is that the regulations go too far. A coalition of managed behavioral health care organiza-tions (“MBHOs”) have filed suit in federal court alleg-ing that the Departments exceeded their authority as permitted under the MHPAEA and did not follow proper procedures in issuing the regulations [ Lawsuit Challenges Validity of MHPAEA Regulations , Employee Benefits Institute of America, April 8, 2010, www.ebia.com/WeeklyArchives/GHPM/CourtCases/20148?Print=1].

However, due to the recent issuance of the regula-tions and the overshadowing of the MHPAEA by the Patient Protection and Affordable Health Care Act (PPACA) and the Health Care and Education Reconciliation Act of 2010 (Reconciliation Act) (col-lectively referred to as the Health Care Reform Act), there has been a lack of meaningful commentary and analysis on the suspected impact of the regulations. Accordingly, employers, consumers, commentators, and pundits anxiously awaited the final versions of the Health Care Reform Act to determine, what, if any, effect its passage would have on the MHPAEA and the regulations issued thereunder.

The Health Care Reform Act is a complex and broad piece of legislation with far reaching impli-cations and an in-depth analysis of the Act here is impossible. However, there are a few key provisions

that directly impact the MHPAEA, which must be noted. The Health Care Reform Act imposes the fol-lowing requirements that relate to the MHPAEA on all existing and new group health plans:

• The elimination of all lifetime limits, effective January 1, 2011, for calendar year plans [PPACA § 2711 and Reconciliation Act § 2301],

• The elimination of certain annual limits, effective for essential benefits as of January 1, 2011, for calendar year plans in existence upon the enact-ment of the act and all benefits effective January 1, 2014, for all plans,

• The provision of essential benefits, including men-tal health benefits, effective January 1, 2014, for nongrandfathered plans [PPACA § 2707 (2010)],

• Emergency services must be provided without prior-authorization and paid as in-network, effec-tive March 23, 2010, or loss of grandfathered status date,

• The prohibition of discrimination against providers acting within the scope of their license, effective January 1, 2014, for nongrandfathered plans, and

• The requirement that cost-sharing mechanisms cannot exceed the high deductible health plan lim-its as set by the IRS, effective January 1, 2014, for nongrandfathered plans.

These identified provisions are likely to have a significant impact on employer-sponsored health plans as they relate to the coverage and benefit levels of mental health. From a precursory review of the requirements identified above, the mandate left out of the MHPAEA is included after January 1, 2014, in the Health Care Reform Act for new plans and plans that lose grandfathered status via the essential ben-efits mandate which includes mental health/substance abuse and behavioral therapy benefits. The Health Care Reform Act does not spell out what benefits must be covered and the applicable regulations are also unclear. Additionally, any separate and/or lifetime limits are prohibited as early as January 1, 2011, or as late as January 1, 2014, thus rendering the coverage and application tests of the MHPAEA moot. When reviewed together, it appears that the Health Care Reform Act answers most of the questions left open after the MHPAEA regulations and the only issues left for clarification are: (1) what benefits will be required for coverage under the minimum essential benefits package required for the contemplated exchanges, and (2) what administrative and treatment processes


are necessary to achieve the qualitative requirements under the MHPAEA.

VI. Conclusion The advocates of mental health parity have been

aggressively fighting an uphill battle for over 13 years. The stigma, perceived abuses, and imagined ills sur-rounding the mental illness debate have declined with the general public’s exposure to information about mental illness. Nonetheless, such perceptions have not been overcome.

Moreover, the inability of employers and insurers to accurately predict trends and utilization patterns of mental illness has resulted in a fear of the unknown and significant resistance to any attempt to bring mental health benefits on par with core medical ben-efits. The effect of this unknown, especially in these troubled economic times, could have driven employers

to cut mental health benefits in lieu of the full parity contemplated under the MHPAEA. However, except in limited circumstances, the Health Care Reform Act requires employers to provide some level of mental health benefits without annual or lifetime dollar limits (not visit limits as of the date of this writing). This new legislation pushes parity further than ever before and expands the levels of coverage exponentially.

The remaining issues include (1) whether the final Health Care Reform regulations will provide spe-cific guidance on what conditions must be covered and fill the mandate hole left by the MHPAEA, (2) whether employers will respond by terminating their plans and providing vouchers and paying the penalty for employees to enroll in proposed “Exchanges” as established in the Health Care Reform Act, and (3) what benefits will look like in the aftermath of the MHPAEA and Health Care Reform. ■

37

A R T I C L E

New ERISA Fiduciary Definition…Smoke and Mirrors or a Meaningful Assignment of Accountability? B y J e s s i c a R . F l o r e s

The Department of Labor (the “Department”) has

focused its attention on clarifying the definition of

a fiduciary under the Employee Retirement Income

Security Act of 1974, as amended (ERISA) for the

first time in over 35 years. In its new proposal,

issued on October 21, 2010, policy makers attempt

to refine and strengthen the test for deeming a

person or entity a fiduciary under ERISA for reason

of providing investment advice to the plan or its

participants. In the new proposal, which amends

paragraph (c) of Section 2510.3-21, the Department

expands this fiduciary test.

The Department’s efforts have been met with mixed reviews. Plan fiduciaries seem to welcome the new assertion of fiduciary standing on those persons deliv-ering investment advice to their plans and partici-pants. Service providers on the other hand, while slow to submit official comments, have minimized the need for such clarities arguing that the definition is already stringent enough. Some industry critics however have expressed concern that after over 35 years of inad-equate attention to these issues, the Department has not put forth a sufficient proposal.

Is the Department’s attention to this matter a reactive rather than a proactive measure? Some have opined that the new proposal is an attempt to ward off threatened legislative actions in order to maintain full regulatory control. While the Department leaders claim that, despite the recent media, legislative, and investigative attention, it has been working internally to correct these issues for quite some time.

Oftentimes, when taking a reactive versus proac-tive approach, other similar areas in need of new regulatory measures go unaddressed. For example, the Department has addressed neither the provision of investment advice in relation to distributions nor the investment advice provided by investment companies that offer bundled retirement services in its descrip-tion of the types of services that give rise to fiduciary status. Undoubtedly, lobbyists for a broader definition of “fiduciary” will advocate this type of expansion, while industry representatives will likely look to steer the Department away from such inclusiveness.

Background The shift in the last two decades from employer-

funded retirement plans with guaranteed payment streams to employee savings plans has brought per-ceived threats to retirement security to the attention of our nation’s leaders. The catastrophes of 2008 involv-ing target date funds, structured investment vehicles, securities lending collateral pools, lower risk fixed income funds, money market and stable value funds, to name a few, have not been ignored or forgotten by legislators warning that they are prepared to intervene with new protective laws.

Many ERISA class action lawsuits filed in the recent decade have attached service providers to the list of defendants, claiming they acted in a fiduciary capac-ity and breached their duties under ERISA. However, many of these service providers were successfully able to escape the ERISA fiduciary claims by denying they acted in a fiduciary capacity. The outcome of some of

Jessica R. Flores is Managing Partner at Fiduciary Compliance

Center, LLC.


these decisions sparked significant industry debate over when a service provider is acting as fiduciary under ERISA.

The Department of Labor Office of Inspector General—Office of Audit (OIG), issued a report on September 30, 2010, finding that additional regulatory initiatives are necessary to protect participant retire-ment savings from costly conflicts of interest. Some interpretations were that this report implied that the fiduciary functionality test of the Department’s regula-tions has not been properly applied to many service provider situations during regulatory investigations, resulting in service providers inappropriately escaping fiduciary standing under ERISA.

This chain of events forced the Department to take notice of the continued concerns arising under service provider arrangements with ERISA retirement plans. It became clear that changes to the fiduciary test were imperative for proper identification of those providers who render services of a type that should give rise to fiduciary status under ERISA. Plan fiduciaries con-tinuously rely on service providers—including many of our leading financial institutions—to advise them and manage their plans; however, they do so often-times at their own risk, as these entities are commonly excluded from the fiduciary duties under ERISA. The Department recognized that, after 35 years of “busi-ness as usual,” it is time for the definition to catch up with the arrangements commonly offered in the retire-ment plan marketplace.

Rules for Deeming a Person or Entity a Fiduciary Under ERISA

Title I of ERISA sets forth three specific circumstances or activities that would deem a person or entity to be a fiduciary to a plan. Under ERISA Section 3(21)(A), a person is a fiduciary with respect to an employee benefit plan if such person does any of the following:

1. Exercises any discretionary authority or control over the management of a plan, or over the management or disposition of plan assets [ERISA § 3(21)(A)(i)];

2. Renders investment advice for a fee or other com-pensation, direct or indirect, over the disposition of plan assets, or has any authority or responsibility to do so [ERISA § 3(21)(A)(ii)]; or

3. Has any discretionary authority or discretionary responsibility in the administration of such plan [ERISA § 3(21)(A)(iii)].

4. Whether a person or entity is a fiduciary under ERISA is not merely a matter of title, although those named in plan documents as fiduciaries are, in

fact, fiduciaries under ERISA. Instead, a functional test applies to determine whether an otherwise unnamed person has acted as a fiduciary to the Plan. Certain activities that have been found to deem a person or entity a fiduciary include the following: • Appointing other plan fiduciaries; • Delegating responsibility to or allocating duties

among other plan fiduciaries; • Selecting and monitoring plan investment

vehicles; • Giving investment advice to the plan for a fee

or other compensation; • Selecting and monitoring third party service

providers; • Negotiating the compensation of third party

service providers; • Interpreting plan provisions; • Exercising discretion in denying or approving

benefit claims; • Setting one’s own compensation for services

rendered to a plan; and • Pursuing claims as an assignee of the plan.

The focus of the proposed regulation is to amend the fiduciary test—which is exclusively for the pur-pose of determining whether someone is a fiduciary under ERISA Section 3(21)(A)(ii) for giving invest-ment advice—is found in Labor Regulation Section 2510.3-21(c). The proposal expands the definition as examined further below in an effort to appropriately capture certain situations and arrangements.

Changes to the Definition The leaders of the Employee Benefits Security

Administration (EBSA), which is the agency under the Department that handles employee benefit plan mat-ters, responded in late September to the OIG’s con-clusions that the “EBSA needs to do more to protect retirement plan assets from conflicts of interest” by confirming that new fiduciary regulations were under-way and a proposal would be issued in the very near future. In addition, EBSA is said to have encouraged outraged legislative leaders who took strong public positions following the 2008 catastrophes involving target date funds to hold tight as their concerns would be addressed in this new proposal. While it did not confirm what modifications were going to be proposed and what aspects of the fiduciary definitions would be affected, EBSA’s response set a high expectation for the new proposed fiduciary definitions under ERISA.

However, upon the issuance of the new proposal, it was clear that EBSA’s focus to clarify the rules

NEW ERISA FIDUCIARY DEFINITION… 39

extended only to the fiduciary test for rendering investment advice. This narrow focus fell short of addressing the entirety of concerns expressed by the OIG and legislative leaders. Neither the OIG report nor the statements made by the legislative leaders were limited to those issues surrounding the provision of investment advice.

The original regulation, which has been in effect since 1975, deems a person or entity to be a fiduciary in relation to investment advice only if it renders advice as to the value of or recommends the consid-eration of a transaction involving securities or other property and either directly or indirectly :

1. Has discretionary authority or control with respect to purchasing or selling securities or other property for the plan; or

2. Renders advice: (a) on a regular basis to the plan, (b) pursuant to a mutual agreement, arrangement,

or understanding, written or otherwise, (c) between such person and the plan or a fiduciary, (d) that such services will serve as a primary basis

for investment decisions, (e) and that such person will render individual-

ized investment advice to the plan [Labor Reg. § 2510.3-21(c)].

In its attempt to reduce the ambiguity and misin-terpretation of the fiduciary test under the original regulations and to effectively include common service arrangements for plans that differ from those offered in the 1970s, EBSA issued proposed modifications to this provision. The modifications as they were expressed in the proposal seem to cast a wider net over the vari-ous service providers and arrangements being used in ERISA retirement plans.

The first change to the definition splits up the first provision of the test and adds to the list of individu-als who are acting as fiduciaries securities valuation appraisers and persons advising on the management of securities, including advising as to the selection of investment managers. This provision also now explic-itly applies to providers rendering advice to the plan fiduciary, plan participants, and beneficiaries to clarify “the Department’s longstanding interpretation of the current regulation.” The other changes expand the cir-cumstances or activities that would render the person or entity a fiduciary under the first provision of ERISA Section 3(21) [Prop. Labor Reg. § 2510.3-21(c)(1)(i)]. This expansion includes persons acknowledging their fiduciary status with respect to providing advice,

fiduciaries by the other measures under ERISA, or investment advisors under the Investment Advisers Act of 1940. The need to denote these persons are fiducia-ries under the definition is somewhat questionable, as any reasonable interpretation of the ERISA fiduciary definitions would include these persons; however, the Department sought to make their inclusion explicit.

The proposed changes that apply to the five-part test found in the existing regulation removes require-ments commonly found to exclude certain types of investment advisors that the DOL believed should fall under the definition. The provisions that advice is delivered on a regular basis and that parties have a mutual understanding that the advice will serve as the primary basis for plan related investment decisions are removed from the proposed regulation. The new language reads “such advice may be considered in con-nection with making investment or management deci-sions.” This change prevents the opportunity to escape fiduciary standing under ERISA by claiming the advice delivered was not the primary basis for mak-ing investment decisions or that there was no mutual agreement for the provision of investment advice on a regular basis. Many plan arrangements are structured in a way that advice may be delivered by multiple unique mediums where no single source may, in itself, serve as the primary basis for investment decisions. Also, many situations do not entail advice being deliv-ered on a regular basis; however, these circumstances do not mean that the advice was not relied upon in good faith by the plan fiduciaries, participants, or ben-eficiaries. Therefore, the Department has proposed to no longer exclude them from the definition.

Section 2510.3-21(c)(2) of the proposed regulations sets forth limitations on the application of these provi-sions. The first limitation excludes from the defini-tion of fiduciary persons who can demonstrate that the recipient of the advice knows or should reasonably know the person providing the investment advice is doing so in their own interests. This limitation will likely be the provision that many service providers that do not want to be found to be fiduciaries under ERISA will hide behind. In many, if not most, provider arrangements significant conflicts of interest are com-mon, and investment advice is generally related to the purchase or sale of a security in which the advisor has some sort of stake. Whether because it is offered pro-prietarily by the advisor’s employing firm or the advis-ing entity or because the advisor is acting in an agent or broker dealer capacity to sell securities on behalf of other issuers, the advisor could theoretically claim the recipient should have known they were not delivering


advice impartially. In a financial industry that is as embedded with intertwined service provider relation-ships as the current system, this provision offers a sig-nificant loophole to escape fiduciary standing for the most common service provider arrangements.

Other less concerning limitations stated in the pro-posal exclude specific activities from the definition of fiduciary, such as:

1. The provision of educational information and materials;

2. The offering of an investment platform that is not individualized to a plan or participants that a fiduciary may choose from to select investments to make available to participants;

3. The provision of general financial information con-cerning the investments; and

4. The preparation of account statements, which may include the value of securities.

Section 2510.3-21(c)(3) of the proposed regulation denotes that the fee or other compensation, whether direct or indirect, received for the provision of invest-ment advice as required to exist for purposes of ERISA Section 3(21)(A)(ii) may come from virtually any source. This provision includes any fee or compen-sation received in connection to a transaction that resulted from the investment advice that was rendered. This included compensation consists of sales commis-sions, as well as compensation received by the person, entity, or affiliate relating to the transaction.

Other Changes to the New Definition Under Consideration

The Department has requested comments and advice regarding the inclusion of investment advice delivered to participants and beneficiaries with respect to account rollover and distribution arrangements. Oftentimes, the advice regarding permissible plan distributions involves the recommendation of an investment product, account type, or service arrangement; however, the Department has previously not considered this advice to fall under the ERISA definitions. The Department recognizes that many service providers are delivering this invest-ment advice to retirement plan participants and ben-eficiaries through licensed call center representatives, Web site offers, financial advisors, planners, and other representatives seeking to capture the enormous assets available in the rollover marketplace. Commenters have expressed deep concerns regarding the abusive self deal-ing practices prevalent in the provision of this advice to participants and beneficiaries.

Capital Opportunities Created by Rollover Activities

Call centers and onsite “educators” who are often licensed financial advisors or securities representatives receive considerable compensation streams from the products sold during rollover processes. In most cases this advice is not delivered for the sole benefit of the recipient, but instead delivered to suit the licensed representatives’ performance and revenue production interests. These situations are similar to the other advice arrangements from which the Department seeks to protect plans and participants under the proposed fiduciary definition. Furthermore, the opportunity for these sorts of sales is often created by the service pro-vider arrangement with the plan and considered when predicting compensation receipts from the services offered to retirement plan clients. The exclusion of this investment advice fails to protect participant account assets from conflicted investment advice and self deal-ing which is already and likely to continue to be a growing concern for participants and beneficiaries.

Shortly following the turn of the century, it was pre-dicted that more assets will leave employer- sponsored retirement plans in the coming years as the Baby Boomers retire than will be contributed to such plans. This prediction caused the financial industry to take action to prepare for the opportunities presented by this forecast while mitigating the loss of assets under management. In 2004, like many other investment institutions, Lincoln Benefit Life Company published a broker/dealer sales piece which stated that, “Between 2003 and 2010, it is predicted that $2.4 trillion will be rolled over from employee-benefit plans to IRAs, with rollovers more than doubling from an estimated $188 billion in 2002, to more than $400 billion per year by the end of this decade.” As a result of these forecasts, financial service firms and investment com-panies began aggressive structuring, product manufac-turing, marketing, and training to capture their share of the market for lucrative IRA rollovers.

A study produced by the Treasury Inspector General for Tax Administration in August 2010 showed a total of $368 billion in employer-sponsored retirement plan contributions and a total of $453 billion in disburse-ments for the year 2007. That same year, according to data compiled by the Investment Company Institute (ICI), a total of $323 billion was rolled over from employer-sponsored retirement plans to IRAs. These figures confirm the accuracy of the industry’s projec-tions and demonstrate the sales opportunity created by the rollover marketplace. These charts have been extracted below (Figure 1, Figure 2, and Figure 3):


Figure 2. Employer-Sponsored Retirement Plan Contributions (in Millions) by Type (CYs 1997-2007)

$400,000

Employer-SponsoredRetirement Plans

Contribution(millions)

$300,000

$200,000

$100,000

$0

Defined Benefit Plan $31,197 $48,438 $29,793 $35,174 $26,862 $89,212 $68,310

$299,825

$368,135

$209,653

$298,865

$148,078

$177,940

$93,621

$128,795

$62,277

$92,070

$31,064

$79,502

$15,864

$47,061

CalendarYear 1977

CalendarYear 1982

CalendarYear 1987

CalendarYear 1992

CalendarYear 1997

CalendarYear 2002

CalendarYear 2007

Defined Contribution Plan

Total

Source: Department of Labor, Employee Benefits Security Administration, January 2010 “Private Pension Plan Bulletin” and February 2009 “Private Pension Plan Bulletin Historical Tables and Graphs,” from Statistical Trends in Retirement Plans, Treasury Inspector General for Tax Administration, August 9, 2010, Reference Number: 2010-10-097, Pages 28 and 29.

Figure 1. Employer-Sponsored Retirement Plan Disbursements (in Millions) by Type (CYs 1977-2007)

$500,000E

mp

loyer

-Sp

on

sore

d R

etir

emen

t P

lan

s D

isb

urs

emen

t(m

illi

on

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$400,000

$300,000

$200,000

$100,000

$0

Defined Benefit Plan $15,249 $33,875 $66,241 $77,853 $97,213 $135,824 $158,741

$294,105

$542,846

$178,740

$314,564

$135,266

$232,479

$74,588$56,013

$122,254 $152,441

$21,432

$55,307

$7,702

$22,951

CalendarYear 1977

CalendarYear 1982

CalendarYear 1987

CalendarYear 1992

CalendarYear 1997

CalendarYear 2002

CalendarYear 2007

Defined Contribution Plan

Total

Source: Department of Labor, Employee Benefits Security Administration, January 2010 “Private Pension Plan Bulletin” and February 2009 “Private Pension Plan Bulletin Historical Tables and Graphs,” from Statistical Trends in Retirement Plans, Treasury Inspector General for Tax Administration, August 9, 2010, Reference Number: 2010-10-097, Pages 28 and 29.


The bundled service providers recognized that participants terminating from their bundled clients’ retirement plans represented something of a captive audience for their rollover IRAs products. This led to the adoption of aggressive call center asset retention policies, mandatory licensing of call center representa-tives, and the increased placement of onsite licensed representatives. In addition, these product manufactur-ers realized they risked losing assets to intermediaries like financial advisors, planners, and broker dealers. In order to ensure they retained these assets in their proprietary products, investment companies spent unimaginable resources on advisor events, training, and sales teams to make certain their products were on the advisors’ shelves and at the top of their minds when counseling clients on IRA rollovers. This quickly became and remains the headlines prevalent

at industry conferences and company events, “IRA Rollovers may provide the opportunity to expand your retirement planning sales.”

The industry’s focus on asset gathering and reten-tion to take advantage of the significant product sales opportunities created by the growing rollover market-place was and is more about the growth desires of the industry instead of what is best for the participants. The marketing materials, media statements, and sales pitches delivered to participants appear to be all about the appropriate concern of effectively manag-ing preservation, distribution, and continued growth of retirement savings. Yet the materials and pitches delivered to financial advisors is all about commission and fee opportunities due to the prospect of growing assets under management through the use of certain products and services. An example from a Principal

Figure 3Rollovers Generate a Significant Portion of Flows into Traditional IRAsBillions of dollars, 1996–2009

Traditional IRAsContribution1 Roll-overs2 Withdrawals3 Total

assets4

Year-end

Of which: assets held in mutual funds

Year-end

1996 $14.1 $114.0 $45.5 N/A $557

1997 15.0 121.5 55.2 $1,642e 728

1998 11.9 160.0 74.1 1,974 881

1999 10.3 199.9 87.l 2,423 1,131

2000 10.0 225.6 99.0 2,407 1,103

2001 9.2 187.8 94.3 2,395 1,035

2002 12.4 204.4 88.2 2,322 912

2003 12.3e 205.0e 88.3 2,719e 1,146

2004 12.6 214.9 101.7 2,957 1,305

2005 13.6e 246.5e 112.3 3,259e 1,448

2006 14.4p 282.1p 124.7 3,722p 1,720

2007 14.4p 323.1p 148.0 4,223p 1,946

2008 N/A N/A 162.2 3,173e 1,351

2009 N/A N/A N/A 3,743e 1,6481 Contributions include both deductible and nondeductible contributions to traditional IRAs. 2 Rollovers are primarily from employer-sponsored retirement plans. 3 Withdrawals consist of taxable IRA distributions reported on Form 1040, which have been primarily from traditional IRAs. 4 Total assets are the fair market value of assets at year-end. e Data are estimated. p Data are preliminary. N/A – not available. Source: Investment Company Institute and Internal Revenue Service Statistics of Income Division, from The U.S. Retirement Market, Second Quarter 2010, ICI October 2010 Vol. 19, No. 3-Q2 Fundamentals, Page 7.


Financial Group marketing piece, “More than 77 mil-lion Baby Boomers are approaching retirement and new Individual Retirement Account (IRA) rollover contri-butions are projected to reach $306 billion in 2013. As a firm with a significant volume of employer- sponsored retirement plan business, it’s important to have a plan in place to capture participant rollovers at ben-efit event. The Principal Financial Group® can help you seize this opportunity with the Principal Asset Retention Program SM .” The piece goes further to state “There are two main components to the Principal Asset Retention Program,” “Compensation” and “Referrals.”

This is a concerning industry reality which can be con-cluded by performing a few minimal Internet searches to view permanently preserved sales materials distrib-uted to broker dealers involving this subject.

IRAs receive significant funding from the assets of employer-sponsored retirement plan rollovers and are growing rapidly as a percentage of the overall U.S. retirement assets. This upward trend is likely to con-tinue as Baby Boomers with large account balances continue to the retirement phase of life. This trend can be seen in the chart extracted from a report issued by the ICI below (Figure 4):

1 Annuities include all fixed and variable annuity reserves at life insurance companies less annuities held by IRAs, 403(b) plans, 457 plans, and private pension funds (including 401(k) plans).2 Federal pension plans include U.S. Treasury security holdings of the civil service retirement and disability fund, the military retirement fund, the judicial retirement funds, the Railroad Retirement Board, and the foreign service retire-ment and disability fund. These plans also include securities held in the National Railroad Retirement InvestmentTrust and Federal Employees Retirement System (FERS) Thrift Savings Plan (TSP).3 DC plans include 403(b) plans, 457 plans, and private employer-sponsored DC plans (including 401(k) plans).e Data are estimated.p Data are preliminary.Note: Components may not add to the total because of rounding.Source: Investment Company Institute, Federal Reserve Board, National Association of Government Defined Contribution Administrators, American Council of Life Insurers, and Internal Revenue Service Statistics of Income Division, from The U.S. Retirement Market, Second Quarter 2010, ICI October 2010 Vol. 19, No. 3-Q2 Fundamentals, Page 3.

2010:Q2

2010:Q1

2009:Q4

2009:Q3

2009:Q2

2008200720062005200420032002200120001999

Annuities1

Federal pension plans2

State and local pension plans

Private DB plans

DC plans3

IRAs

11.8 11.70.90.8

2.4

2.1

3.0

2.7

1.00.8

2.3

2.0

3.0

2.6

11.310.5

12.513.8

14.9

1.00.9

2.3

1.8

2.7

2.6

1.00.9

2.0

1.7

2.5

2.5

1.11.0

2.4

2.0

3.0

3.0e

1.31.0

2.6

2.2

3.3

3.3

1.41.1

2.8

2.3

3.6

3.7e

17.9

1.6

1.2

3.3

2.6

4.4

4.8p

16.7

1.5

1.1

3.2

2.6

4.1

4.2p

13.9

1.2

1.9

1.4

2.4

3.5

3.6e

14.4

1.2

1.9

1.4

2.5

3.6

3.8e

15.5

1.2

2.1

1.5

2.7

4.0

4.1e

16.1

1.3

2.1

1.5

2.8

4.1

4.3e

16.5

1.3

2.2

1.5

2.9

4.2

4.4e

15.7

1.3

2.1

1.5

2.6

4.0

4.2e

Figure 4

U.S. Retirement AssetsTrillions of dollars, end-of-period, 1999–2008, 2009:Q2–2010:Q2


If EBSA is to effectively protect retirement sav-ings and regulate the service providers that seek to capitalize on the employer sponsored retirement plan marketplace, it is obvious that it needs to expand its focus to cover the investment advice delivered to participants and beneficiaries regarding the rollovers and distributions of their accounts. These industry trends simply create too much economic opportunity for service providers that have and will continue to breed schemes to self deal at the expense of economic devastation of retirement savers. The expansion of the proposed fiduciary definition coupled with the new participant and sponsor fee disclosure rules would go a long way in effectively correcting these issues [Labor Regs. §§ 2550.404a-5, 2550.408b-2].

Appearance of Broad Application of Proposal Versus EBSA Leadership Public Statements

Upon initial review of the proposed changes to the definition of fiduciary, it appeared the provisions would cast a wide net over the majority of service pro-viders operating in the employer-sponsored retirement plan marketplace. There were no explicit omissions or exclusions offered to investment companies that com-monly perform the activities provided for in the defi-nition. This rule even seemed to apply to target date funds, as they fell under the Investment Advisers Act making them a fiduciary under the definition in the proposed rule.

Common industry practice is for target date fund providers to advise plan fiduciaries that their funds are suitable investment alternatives to use for qualified default investment alternatives (QDIAs), which are investments approved by the DOL for use as “defaults” for employees who elect not to direct the investment of their accounts. This advice is, in most cases, pack-aged as tailored specifically for the plan, considering its unique participant demographics, and is delivered individually to plan fiduciaries. The providers advise sponsors that the funds are managed according to a suitable asset allocation for participants at certain life points and made up of underlying funds that are suitable to fulfill such allocation. The advice that the investments are suitable for each participant is also individualized, because each of the target date funds is uniquely allocated according to a model that is represented as appropriate for participants retiring at specific points in time. These common industry investment advice activities could qualify target date fund providers as fiduciaries under Proposed Labor Regulation Section 2510.3-21(c)(1)(ii)(D).

While, at first blush, the limitations provided for in the proposal, could apply to these target date fund situations, upon further consideration, they may fail to include these providers in the proposed definition. The first opportunity to escape the wrath of the defi-nition is the argument that the plan fiduciary knows or should know the target date fund provider’s inter-ests may be adverse to the plan, as the advisor clearly represents the product provider. While a legitimate position, this argument may not be strong enough when examining the complete investment menu avail-able through the particular provider. In most cases, these target date funds are offered through bundled providers, many of which have both proprietary and nonproprietary funds to offer plans. The relationships the bundled provider has with unaffiliated fund fami-lies allow them access to nonproprietary target date funds, which could be recommended to plan fiducia-ries, notwithstanding that such advice is almost never given by the provider. Nonetheless, the presence of nonproprietary funds may give plan fiduciaries the impression that the advisor is neutral.

In the cases in which a platform provider may not offer proprietary target date funds, but instead formed arrangements to offer unaffiliated investment funds through a menu, they too may be covered by the new fiduciary definition. Under Proposed Labor Regulation Section 2510.3-21(c)(2)(ii)(B), making available a platform or menu of investments for plan fiduciaries to choose among that is not tailored to the specific plan does not constitute investment advice under the new definition. Again, on the surface, many platforms providers offering these sorts of arrange-ments could be excluded from the fiduciary defini-tion. However, the way in which the platform and its capabilities, services, and investments are sold to plan fiduciaries could obviate the exclusion. If the plat-form is recommending the use of a particular series of target date funds to use as QDIA vehicles in the same fashion as the bundled provider discussed previ-ously advises plan fiduciary clients, the platform pro-vider exemption may not apply. Arguably, the advice in that situation is marketed to the plan sponsor as “tailored” to the individual needs of the plan and its participants and the target date fund investments are advisably suitable for the investment of plan con-tributions. The sales process in which the platform provider engages and the limitations with respect to the target date funds it makes available for plan fidu-ciaries may make this exemption from the fiduciary definition inapplicable.


The broad application of the proposed fiduciary definition, coupled with the EBSA’s efforts to convince Congress to hold off on legislative activities addressing target date fund concerns pending the release of the promised new rule, gave the impression that it was the Department’s intent to address the target date issues in the proposal. However, immediately following the release of the new rule, the public media statements made by Assistant Secretary of EBSA, Phyllis Borzi, confirmed that the rule is not intended to apply to target date funds. A statement delivered by Borzi (as printed in Investment News on October 21, 2010) said, “The regulation would not include target date funds nor would it define mutual fund advisors as fiducia-ries.” This statement indeed provides limitations to the intended application of the rule to target date funds; however, it does not, in fact, confirm any intention of the Department to exclude target date fund “providers” that advise plan fiduciaries to invest plan contributions in target date funds from the new broad definition.

Likely Amendments to Proposal The broad application of this new proposed defini-

tion of fiduciary is guaranteed to cause quite a stir in the financial industry, and it should be expected that considerable lobbying efforts will be expended to water it down. The ICI has significant power and influence in Washington and will likely lead the effort to limit the application of the rule to protect bundled provider situ-ations. The influence of the ICI stretches much farther than government and extends deeply into the industry’s most prominent associations. It is to be expected that many industry associations will ban together and urge the Department to modify the definition considerably before finalizing the rule. If the industry is successful, the final rule will be less imposing than the existing definition. If the industry is not successful, then a lot must change to limit liability exposure.

What This Means for Plans The battle to effectively protect retirement sav-

ings from costly conflicts of interest, which includes investment advice delivered to plans for the primary

benefit of raising capital for financial institutions instead of for the best interests of the plan, prom-ises to be noteworthy. This is the first action by the Department in over 35 years to modify the definition of fiduciary and an action critically acclaimed by many as long overdue. It is imperative that the Department get the fiduciary definitions right to protect retire-ment savings with this amended rule, as it could be catastrophic to expose plans to these costly conflicts of interest for another 35 years.

Retirement savings offer the largest pools of invest-able assets available to financial institutions that profit from managing funds. These pools of assets have long been the relied-upon source for considerable financial industry revenue. The opportunity to earn significant compensation from the countless invest-ment activities—most of which have traditionally remained undisclosed to decision makers, regulators, and participants—has created an aggressive service provider marketplace. These service providers have designed operating structures to cash in on as many aspects of the management of retirement savings as possible and have done so quite successfully while being awarded questionable protections from liabil-ity for their actions. This regulation threatens to tear down those walls of protections and open the gates to hold service providers accountable for what many would argue should have been regulated all along.

It is counterintuitive to most that it is an accept-able financial industry model that financial institutions be permitted to manage someone else’s assets for their own benefit instead of for that of the investor. However, by exempting these institutions from liability under ERISA, it allows them to deal in their own self interests at the expense of plans, plan fiduciaries, participants, and beneficiaries. Closing the ERISA fiduciary escape tunnel for the industry’s service providers is imperative to stop the bleeding of the nation’s retirement savings and to protect the future of the economy. If lobbyists prevail in the battle to insulate investment companies that commonly service the employer- sponsored retire-ment plan marketplace, this opportunity to correct these concerns will have been lost. ■

46

A R T I C L E

Most Common Nonconformities and Opportunities for Improvement in 401(k) Plans Found in Fiduciary Assessments B y M i c h a e l M . K a n e

ISO (International Organization for Standardization

in Geneva) Standard 9000 for quality management

systems and Standard 19011 on assessments (audits)

provide the Guidance for these assessments. A

fiduciary assessment identifies possible weaknesses

in procedures and policies that could give rise

to a breach of duties and a resulting lawsuit by

participants or fiduciaries.

Our fiduciary assessment process contains three levels:

1. A Level I Self-Assessment of Fiduciary Excellence (SAFE) is conducted. This consists of the Plan Sponsor completing a survey of 22 questions. These questions elicit information about the extent of the sponsor’s compliance with the 22 prudent fiduciary practices that comprise a Global Standard of Fiduciary Excellence. These Practices are based on standards outlined by the government in legis-lation, court decisions, regulatory opinion letters, and advisory bulletins.

2. Once the Plan Sponsor has completed the responses to the Self-Assessment, we review the answers with the Plan Sponsor for accuracy. Next, we gather and review all the documents that relate to the retire-ment plan. After that, we interview all the plan’s key “players,” both internal at the Plan Sponsor’s offices and the outside advisors.

Based on our review and interviews, we prepare the initial draft of our fiduciary assessment. At that time, we arrange to meet with the key players to clarify any questions and to test our hypotheses.

Finally, a Level II Consultant’s Assessment of Fiduciary Excellence (CAFE) is prepared and pre-sented to the Plan Sponsor and Administrator. This report will contain any Plan Nonconformities (that is, procedures or processes of the Plan that do not meet our fiduciary standards), Plan Opportunities-for-Improvement findings, and recommenda-tions. Any Nonconformities must be addressed and eliminated before the final step, a Level III Certification, can be completed.

3. The last step in the fiduciary assessment is an independent review of the Level II CAFE Assessment and finally, Certification by the Centre for Fiduciary Excellence (www.cefex.org) that the Plan meets the Global Standard of Fiduciary Excellence. The Plan Sponsor is notified of the Certification by CEFEX. The Sponsor can place the Certification on its Web site for all to see, and is listed with CEFEX as having passed the Certification process.

During the Level I and Level II steps of the process, our findings almost always contain some

Michael M. Kane, CLU, ChFC, AIFA, is President of Michael

M. Kane and Associates, LLC, an independent retirement plan

consulting firm that is commonly hired by plan sponsors and

other fiduciaries to assess their compliance with ERISA’s fiduciary

obligations. As an Accredited Fiduciary Analyst (AIFA), Mr. Kane

has been certified by both the Center for Fiduciary Studies (www.

fi360.com) and the Centre for Fiduciary Excellence (www.cefex.

org/ industryexpertise) to conduct fiduciary assessments of retirement

plans. For more information, go to www.michaelmkane.com.

MOST COMMON NONCONFORMITIES AND OPPORTUNITIES 47

Nonconformities or Opportunities-for-Improvement. Here are some of the most common fiduciary concerns that we find:

The Investment Policy Statement (IPS) is too simplistic or a sample IPS was given to the Plan Sponsor by a Service Provider that does not address some of the key components of the IPS. These components are discussed further below.

The roles and responsibilities of the investment committee and other nonfiduciaries are not clearly delineated in the IPS. The IPS should give direction to the members of the Committee (assuming that there is one) and to functional fiduciaries who work with the plan on a daily basis (i.e., the benefits personnel).

Adequate Investment Measurement Standards for the selec-tion of monitoring of investments are not contained in the IPS. These standards should contain, at a minimum, regulatory oversight, minimum track record, stabil-ity of the organization, minimum Number of Assets in the investment, holdings consistent with Style, Correlation to Style or Peer Group, Expense Ratios/Fees, and Risk-Adjusted Performance.

The IPS does not have provisions for the controlling and accounting for expenses, including hidden or “soft” dollars. An income statement of revenues and expenses may be developed with the assistance of the advisor or service provider for a clear determination of what these dollars actually are.

The IPS does not contain a Watch List time horizon or alternative time horizon for the elimination of investments that fail the measurement standard criteria. While the Watch List criteria may be adequately addressed in the IPS, there should also be a time horizon, and perhaps a specification for how long the Committee will give the investment to meet the standards, such as four consecutive quarters of nonconformity with the invest-ment standards, or, as an alternative, six out of eight rolling quarters of nonconformity.

The absence of language or measurement standards for the selection of Qualified Default Investment Alternatives (QDIAs). Potential failures of QDIAs commonly have not been addressed for transparency, adequate fee disclosure, or suitability. As a result, these invest-ments may not be appropriate or prudent for the workforce.

The IPS is not signed by the current members of the Investment Committee. A failure of the members of the Investment Committee to acknowledge the policies outlined for its performance is an indication that such policies are not being taken seriously. It may be that the Investment Committee is not even aware it exists.

Committee members do not understand their fiduciary responsibility. There is a dearth of fiduciary education training. Committee members commonly “don’t know what they don’t know.” It is hard to comply with rules and standards that you do not know exist.

Investment Committee Bylaws either do not exist or are inadequate. If there are no Bylaws, the authority of the Investment Committee is unclear. Commonly, there is even vagueness as to who is really on the Committee. Bylaws make it clear who’s on first, what’s on second, and no one better be “I don’t know.”

There is inadequate Investment Committee documentation and/or minutes. One thing that case law has demon-strated over and over again is that compliance with ERISA is judged by the procedure undertaken by the fiduciary, not the results. Furthermore, courts find records of fiduciary action created contemporaneously with the action very probative; recollections created after the lawsuit is underway have very little proba-tive value. Therefore, a Committee’s actions should be properly documented and a fiduciary file kept on an ongoing basis.

There is little or no congruence between the IPS and the Monitoring Report of the Investments. The IPS represents the standard for Investment Committee decisions, as outlined by the Plan Administrator. A lack of congru-ence between the IPS and actual Committee action can be prima facie evidence of a breach of duty.

The Monitoring Report lacks an adequate number of Investment Measurement Standards. If there is no clear standard for performance, how can the performance be judged as successful or failed? If the Committee is not applying appropriate standards, then there is little value to its periodic analysis.

Investments that have failed the Watch List criteria and time horizon remain on the options menu. Evaluation of investments is only valuable if results are acted upon. A Committee that evaluates investments, finds them wanting, and then takes no ameliorative action will look silly defending its actions on the witness stand during the fiduciary breach lawsuit.

The Investment Monitoring is highly dependent upon Service Providers and not Independent Investment Monitoring. It is appropriate for the Committee to rely on professional advice to augment its own knowledge and qualifications. However, taking investment advice solely from those who make money off the investments is a little too much like letting the fox guard the henhouse. The Committee would do well to have some amount of independent advice.


There is a lack of due diligence on QDIAs . Too often, investments are summarily deployed as a QDIA at the recommendation of the Service Provider without proper due diligence. The protection offered by a QDIA choice may not be as effective as it could be.

The Committee and the Plan do not comply with ERISA 404(c) and the regulations underlying it. ERISA Section 404(c) enables Plan Sponsors to minimize their fidu-ciary liability with regards to participant-directed plan investments, if certain requirements are met. Most Plan Sponsors and even Service Providers think com-pliance is easy, when the regulations are significantly more complex than that. We send a 30-page question-naire to Service Providers to see how they help the Plan Sponsor to conform to these requirements. Very few do an adequate job of keeping the Plan Sponsor and the Committee on track.

There is no or inadequate due diligence on “safe” invest-ment options, e.g., Stable Value Vehicles or Money Market Investments. In 2008, this became a very critical issue. In some cases, there was a loss of book value due to a deterioration in the credit rating status of wrap insurers that insure the difference between book and market values. In others, there has been an exiting of wrap insurers from the market place due to their risk management concerns regarding their ability to sus-tain crediting rates.

A general lack of fee and performance benchmarking for the 401(k) plan and its service providers is apparent. Plan Sponsors have no idea whether the fees they are paying are competitive, whether the services they are receiving are sufficient, or an understanding that recordkeeping systems drive a lot of plan costs. Many benchmarking services are available that would give the Plan Sponsor some understanding and concern. In 2011, this will become especially critical with the

implementation of new Labor regulations in relation to ERISA Section 408(b)(2), under which Service Providers are obligated to provide information about what they do for the plan and what they charge the plan for their services. The assessment of conformity to this new regulation has become a focus of our more recent fiduciary assessments. In our experience, most Plan Sponsors are dealing with Advisors or Brokers who do not currently disclose their services and fees. This new regulation will also require these service providers to disclose whether they have affirmatively taken on some of the fiduciary responsibility for the investments in the plan. Failure to disclose this infor-mation properly could result in prohibited transac-tions for the service provider and a breach of fiduciary duty by the Plan Sponsor or Administrator. One solu-tion to this additional due diligence requirement is to have a Servicing Agreement outlining fees and service provided by the Service Provider, along with its taking fiduciary responsibility for the investments.

Negative findings in DOL investigations or verdicts of fiduciary breaches in lawsuits are very expensive ways of learning that the retirement plan fiduciaries are not operating in conformance with legal standards. Reviewing the above list of common problems, as well as possibly obtaining a fiduciary assessment by a private evaluation entity, can provide the proverbial “stitch in time.”

Securities and Advisory Services are offered through LPL Financial, a Registered Investment Advisor, Member SIPC/FINRA. This is for informational purposes only and is not intended to provide specific advice to any plan. For invest-ment advice on your plan, please talk to a financial advisor. For legal advice, please speak to your Legal Counsel prior to making any legal decisions. ■

49

A R T I C L E

DOL Final Rule on Participant-Level Fee Disclosure B y A n t h o n y L . S c i a l a b b a

On October 14, 2010, the Department of Labor

(“DOL”) issued its final regulation on participant-

level fee disclosure (“Regulation”) [DOL Reg.

§ 2550.404a-5 (2010)]. In this regard, it is the

DOL’s hope that this will help America’s workers

manage and invest the money they contribute to

“participant-directed” (i.e., a plan that provides

for the allocation of investment responsibilities to

participants and beneficiaries) individual account

plans [Preamble to DOL § 2550.404a-5].

The rule is part of a concerted effort by the DOL to have open disclosure of retirement plan fees. [ See DOL Reg. § 2550.408b-2 (2010) (plan spon-sor level fee disclosure rules); Testimony of Bradford P. Campbel, Assistant Secretary of Labor, before the House Education and Labor Committee (2007) (“Workers need useful, concise information options in their plans, while plan fiduciaries need more com-prehensive disclosures to enable them to fulfill their legal obligations to workers….); see also Scialabba “The Department of Labor Final Rule Under Section 408(b)(2)-Fee Disclosure,” Journal of Pension Benefits. ]

The rule does not apply to governmental and church plans, SEPs, SIMPLEs, or IRAs [DOL Reg. § 2550.404a-5(b)(2)].

With respect to the background of the Regulation, the DOL is responsible for administering and enforc-ing the fiduciary, reporting, and disclosure provisions of Title I of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The agency over-sees approximately 483,000 participant-directed indi-vidual account plans such as 401(k)-type plans. [ Id .] Thus, the Regulation will have broad application.

In April 2007, the DOL published in the Federal Register a Request for Information soliciting the views, suggestions, and comments from participants, plan sponsors, plan service providers, and members of the financial community, as well as the public in general. [ Id. ] In this regard, the DOL wanted to know whether and to what extent rules should be adopted or modified, or other actions should be taken, to ensure that participants and beneficiaries have the informa-tion they need to make informed decisions about the management of their individual accounts and the investments of their retirement savings. [ Id .]

In an October 14, 2010, conference call with reporters, Phyllis Borzi, DOL Assistant Secretary for the Employee Benefits Security Administration, gen-erally stated that the prior rules did not adequately ensure that all workers were given the necessary infor-mation about fees and expenses in formats that were consistent and accessible [comments by Phyllis Borzi during conference call with reporters (October 14, 2010) (hereinafter referred to as “DOL conference call”)]. DOL Secretary Hilda Solis said during the call that nearly 72 million participants enrolled in the “483,000” plans discussed above with aggregate assets totaling $3 trillion dollars will be positively affected by the new rule [comments by Hilda Solis during the DOL conference call]. In this regard, the DOL believes that the Regulation will ensure the following:

1. That workers in 401(k)-type plans are given, or have access to, the information they need to make informed decisions (including information about fees and expenses);

2. The delivery of invested-related information in a format that enables employees to meaningfully compare the investment options under these plans; and

3. That plan fiduciaries use standard methodologies when calculating and disclosing expense and the return information so as to achieve uniformity

Anthony L. Scialabba, Esq., is an executive of ExpertPlan, Inc.

and the Managing Shareholder of the law firm of Scialabba &

Associates, P.C.


across the spectrum of investments that exist among and within plans [Preamble to DOL § 2550.404a-5].

The DOL’s overall hope is this will facilitate “apples-to-apples” comparisons among participants’ retirement plan investment options and create a new level of fee and expense transparency.

The rule is effective December 20, 2010, but is not applicable until the first plan year beginning or after November 1, 2011 [DOL Reg. § 2550.404a-5(j)(2)]. Thus, for calendar-year plans, the rule will apply on January 1, 2012. In addition, the initial disclosures required to be provided on or before the date on which a participant or beneficiary can first direct his or her investment must be furnished no later than 60 days after the applicability date for participants and benefi-ciaries who had the right to direct their investments on the applicability date [DOL Reg. § 2550.404a-5(j)(3)]. This means that the initial disclosures are due on February 29, 2012, for participants and ben-eficiaries who are able to direct their investments on January 1, 2012.

I. Overview of Final Rule The final regulation provides that the investment

of plan assets is a fiduciary act, governed by the fiduciary standards in Sections 404(a)(1)(A) and (B) of ERISA [DOL Reg. § 2550.404a-5(a)]. This rule requires plan fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficia-ries. Therefore, unlike violations of ERISA’s general reporting requirements, violations of the final regu-lation will be addressed as a fiduciary breach [DOL Reg. § 2550.404a-5(a)]. Plan administrators who do not satisfy the disclosure requirements will not be shielded under Section 404(c). Thus, plan administra-tors and other fiduciaries can be liable for any invest-ments losses that participants suffer as a result of their investment selection. Such administrators could also be subject to fines, injunctive relief, and even crimi-nal penalties. These sanctions could cause a migration away from the use of participant-directed plans to trustee-directed plans.

The final rule provides that, when a plan allocates investment responsibilities to participants or ben-eficiaries, the plan administrator (which, for small plans, is often the plan sponsor) must take steps to ensure that such participants and beneficiaries, on a regular and periodic basis, are made aware of their responsibilities with respect to the investment of

assets held in, or contributed to, their accounts [DOL Reg. § 2550.404a-5(a) and (b)]. The Regulation also notes that such participants and beneficiaries must be provided sufficient information regarding the plan and the plan’s investment options. (For purposes of the Regulation, a “participant” means any employee eligible to participate in the covered plan, regardless whether the employee is participating in the plan, and a “beneficiary” means only beneficiaries with the right under the terms of the plan to direct investments held in their accounts. This includes fee and expense information needed to make informed decisions with regard to the management of their individual accounts. The Regulation provides that the current guidance on electronic distribution of plan informa-tion, as described in Regulation 2520.104b-1, applies to furnishing of information. However, the DOL has reserved final guidance on “manner of furnishing” pending request for information relating to electronic distribution to be released soon. The Department expects that the review and any new guidance will be published before the applicability date of this rule [Borzi, Speech at ASPPA Annual Conference (October 19, 2010)].)

To clarify the information that must be given, the Regulation states that a plan administrator (or its representative as defined in Section 3(34) of ERISA) must provide to each participant or beneficiary certain “plan-related” information and certain “investment-related” information [DOL Reg. § 2550.404a-5(c) and (d)]. All disclosures are based on the latest informa-tion available to the plan and in a written manner calculated to be understood by the average participant [DOL Reg. § 2550.404a-5(c), (d), and (e)(5)]. The cat-egories of information at issue are described below.

II. Plan-Related Information The first category of information that must be

disclosed under the Regulation is plan-related infor-mation [DOL Reg. § 2550.404a-5(c)]. This general category is further divided into the following three subcategories: “general plan information,” “admin-istrative expenses information,” and “individual expenses information” [DOL Reg. § 2550.404a-5(c)(1), (c)(2), and (c)(3)].

The information in the aforementioned subcat-egories must be provided to participants or ben-eficiaries on or before the date they can first direct their investments, and then again annually (once in any 12-month period) thereafter [DOL Reg. § 2550.404a-5(c)(1)(i), (c)(2)(i)(A), and (c)(3)(i)(A)].

DOL FINAL RULE ON PARTICIPANT-LEVEL FEE DISCLOSURE 51

The requirement to provide disclosures before the initial investment may be satisfied by providing the most recent annual disclosure with any updates issued pursuant to the requirement to disclose any changes [DOL Reg. § 2550.404a-5(c)(4)]. The disclosures may be provided as part of the Summary Plan Description (“SPD”) or the quarterly benefit statement [DOL Reg. § 2550.404a-5(e)(i)]. However, these docu-ments must meet the timing requirements of this rule. [ Id .] One concern that may influence how the disclosure is provided is that the required disclosure information is likely to change more frequently than other information typically contained in an SPD. Furthermore, SPDs are not required to be distributed until 90 days after an employee becomes a participant [ERISA § 104(b)]. Thus, this may not be a practical solution for a plan administrator because this would often require accelerated or more frequent delivery of the SPD to comply than is otherwise required. The DOL notes that the “statement/SPD” methods do not preclude other means of satisfying disclosure requirements [Preamble to DOL Reg. § 2550.404a-5]. A notice and description of any change in the plan-related information must be provided at least 30 days, but not more than 90 days, in advance of the effective date of such change, or as soon as reasonably practi-cable in the case of unforeseen events or circumstances beyond the control of the plan administrator [DOL Reg. § 2550.404a-5(c)(3)(B)].

General plan information consists of information about the structure and mechanics of a plan. [ See DOL Reg. § 2550.404a-5(c)(1)(i).] This includes an expla-nation of how to give investment instructions under a plan [DOL Reg. § 2550.404a-5(c)(1)(i)(A)]. Any spe-cific limitations on such instructions under the terms of the plan, including any restrictions on a transfer to or from a designated investment alternative (which is a plan investment into which participants or benefi-ciaries may direct an investment in their individual account, but not a brokerage window, self-directed brokerage account, or similar arrangement that enables participants or beneficiaries to select invest-ments beyond those designed by the plan) [DOL Reg. § 2550.404a-5(c)(1)(I)(B)].

In addition to investment instructions, general plan information includes:

1. Any plan provisions relating to the exercise of voting, tender, and similar rights related to a des-ignated investment, and any restrictions on such rights;

2. The identification of any designated investment alternatives offered under the plan;

3. The identification of managers of designated investment alternatives; and

4. A description of any self-directed brokerage account (i.e., “brokerage windows”) or simi-lar arrangements that enable participants and beneficiaries to choose investments beyond those designated by the plan [DOL Reg. § 2550.404a-5(c)(1)(B), (D), and (F)].

Administrative expenses information consists of an explanation of any fees and expenses for general administrative services to a plan, to the extent not reflected in the total operating expenses of any des-ignated investment alternative, that may be charged to or deducted from all individual accounts [DOL Reg. § 2550.404a-5(c)(2)]. Examples of this include fees and expenses for legal, accounting, and record-keeping. [ Id. ] Except as explicitly required, fees and expenses discussed throughout the Regulation may be set forth in terms of monetary amount formula, percentage of assets, or per capital charge. The notice must describe how the charges will be allocated (i.e., pro rata or per capital) to, or affect the balance of, each individual account. [ Id .] If applicable, disclosure also must be made that some of the plan’s administrative expenses for the preceding quarter were paid from the total annual operating expenses of one or more of the plan designated investment alternatives (e.g., through revenue sharing, 12(b)-1 fees, or subtransfer agent fees). [ Id .] Unlike some of the rules that concern plan-sponsor level fee disclosure, the Regulation does not require plan administrators to identify how fees are being allocated among various plan service providers. For example, if a participant’s account is charged an aggregate flat fee that pays for services provided by the plan’s recordkeeper, third-party retirement plan administrator (“TPA”), and investment consultant, disclosure of the aggregate fee still meets the require-ments of the Regulation.

Individual expenses information entails an expla-nation of any fees and expenses, to the extent not reflected in the total operating expenses of any des-ignated investment alternative, that may be charged to or deducted from the individual account of a specific-participant or beneficiary of a plan, as opposed to a plan-wide basis, based on the actions taken by that person. Examples include fees and expenses for processing plan loans or qualified domestic relations orders and investment advice fees, broker window fees,


commissions, front or back-end loads or sales charges, redemption fees, transfer fees and similar expenses, and optional rider charges in annuity contracts. The dis-closure of all the commissions paid inside self-directed brokerage accounts will be hard to do, if not impos-sible. This is because there are hundreds or thousands of arrangements which cannot be easily disclosed in short form. Compliance with the Regulation with respect to some common types of investments (e.g., as mutual fund or stock brokerage commissions), may be manageable [DOL § 2550.404a-5(c)(3)(i)(A)].

In addition to the aforementioned information that must be furnished up front and annually, a plan par-ticipant must receive statements showing the dollar amount of the plan-related fees and expenses (whether “administrative” or “individual”) actually charged to or deducted from his or her individual account [DOL Reg. § 2550.404a-5(c)(2)(A) and (3)(ii)(A)]. This includes a description of the services for which the charge or deduction was made [DOL Reg. § 2550.404a-5(c)(2)(B) and (3)(ii)(B)]. The statements at issue must be provided to a plan participant at least quarterly [DOL Reg. § 2550.404a-5(c)(2)(ii) and (3)(ii)]. These disclosures concerning actual charges or deductions may be included in quarterly benefit state-ments that are required under Section 105 of ERISA [DOL Reg. § 2550.404a-5(e)(2)].

The “quarterly statement” requirement raises some interesting issues. For example, if the plan makes a charge that will be offset later on by revenue sharing, it will have to be shown on the quarterly statement. However, in the past, it might not have been shown at all since it was a “wash.” Even though the revenue sharing payment could then be shown as a credit on the next quarterly statement, it could still cause con-sternation on behalf of participants. Service providers may have to charge participant accounts differently, such as not charging until the revenue sharing is paid. Regardless of this, participants will have to pay atten-tion to their statements, because some service provid-ers only charge once a year.

Another issue that concerns the quarterly disclo-sures is that they must give an explanation as to what the charge concerns. However, there are no require-ments in the Regulation for how specific that expla-nation has to be. This can cause misconceptions as to what service a given charge is for.

III. Investment-Related Information The second category of information that must be

disclosed under the Regulation is investment-related

information [DOL Reg. § 2550.404a-5(d)]. This category contains the several subcategories of core information about each investment option under a plan. Investment-related information must be pro-vided to participants or beneficiaries on or before the date on which they can first deduct their invest-ments, and then again annually thereafter [DOL Reg. § 2550.404a-5(d)(1)]. The plan administrator (or its designee) must provide to each participant the fol-lowing information with respect to each designated investment alternative.

A. Identifying Information The plan administrator must set forth the name of

each designated investment alternative and the cat-egory of the investment (e.g., money market fund, balanced fund, large cap stock fund, employer stock fund, employer securities) [DOL Reg. § 2550.404a-5(d)(1)(i)(A) and (B)]. The final rule purposely omitted a self-directed brokerage account from the definition of a designed investment alternative [Preamble to DOL Reg. § 2550.404a-5]. Thus, all of the invest-ments that a participant purchases through such an account are not subject to the “investment-related information” rules. Some industry experts, such as Brian Graff, executive director of the American Society of Pension Professionals and Actuaries (ASPPA), have conjectured that there may be a movement in the retirement plan industry toward plans provid-ing investments only through brokerage accounts. However, much of what is required by the Regulation is information that many plan fiduciaries are already providing to participants to comply with ERISA Section 404(c). In addition, many service providers are already providing most of the required information to participants. Thus, compliance with Regulation may not be a big undertaking. Furthermore, TPAs typi-cally charge more when they have to deal with broker-age accounts. This is because a participant may invest in a myriad of investment types, such as shares of stock, precious metals, or commodities, and the TPA needs to obtain investment valuation information from different sources to properly account for these vari-ous investments. Thus, although there could be some movement to providing investments only through the use of self-directed brokerage accounts to avoid the Regulation’s reporting requirements, the migration may not be as large as some expect.

As participant-directed accounts include more nontraditional investment alternatives including bro-kerage accounts, determining whether a particular


investment option is a designated investment alterna-tive could become more difficult. C. Frederick Reish, an industry attorney, stated at a recent benefits confer-ence that, “as we move away from pure mutual fund options and we get other variations of investments, it’s going to take some analysis for determining whether or not a particular vehicle for investing is a designated investment alternative and if so, what the annual oper-ating expense ratio of that investment is” [Webcast Speech with Society of Professional Asset-Managers & Record Keepers (November 17, 2010)].

B. Performance Data With respect to investments without a fixed rate of

return, the average annual total return of the invest-ment for the preceding one, five, and 10 calendar year periods (or the life of the investment, if shorter) must be disclosed, along with a statement indicating that the past performance is not necessarily an indica-tor of future performance [DOL Reg. § 2550.404a-5(d)(1)(ii)(A)]. Average annual total return means the average annual compounded rate of return that would equate an initial investment in a designated investment alternative to the ending redeemable value of that investment calculated with the before-tax methods of computation prescribed in Securities and Exchange Commission Form N-1A, N-3, or N-4, as appropriate. However, this method of computation may exclude any front-end, deferred, or other sales loads that are waived for the participants and benefi-ciaries of the covered individual account plan [DOL Reg. § 2550.404a-5(h)(3)].

Both the fixed or stated annual rate of return and the term of the investment must be disclosed for an investment with respect to which the return is fixed or stated for the term of the investment. A special rule exists if the issuer reserves the right to adjust either (1) the fixed or stated rate of return prospectively during the term of the contract or agreement, (2) the current rate of return, or (3) the minimum rate guar-anteed under the contract, if any. In this case, there must also be a statement provided to the participants and beneficiaries that advises them that the issuer may adjust the rate of return prospectively and how to obtain (e.g., telephone or Web site) the most recent rate of return [DOL Reg. § 2550.404a-5(d)(ii)(B)].

Examples of investments with a fixed rate of return include certificates of deposit, guaranteed invest-ment products, guaranteed insurance contracts, variable annuity fixed accounts, and similar interest- bearing contracts from banks or insurance companies.

However, the DOL states that money market funds and stable value funds are investments without a fixed rate of return [Preamble to DOL Reg. § 2550.404a-5].

The Regulation provides relief for plan admin-istrators that do not have the information available on expenses attributable to the plan that are neces-sary to calculate five and 10-year total annual returns for investments that are not registered under the Investment Company Act of 1940. For plan years beginning before October 1, 2021, a plan administra-tor may use a reasonable estimate of such expenses or the most recently reported total annual operating expense of the designated investment alternative as a substitute for such expenses; provided that partici-pants and beneficiaries are notified as to the basis on how the estimate was made if this approach is utilized [DOL Reg. § 2550.404a-5(j)(3)(ii)].

Benchmarks can be used for investments without a fixed rate of return. A plan administrator can utilize the name and returns of an appropriate broad-based securities market index of the preceding one, five, and 10-year calendar years (or the life of the investment, if shorter). Unless the index is widely recognized and used, the benchmark cannot be administered by an affiliate of the investment issuer, its advisor, or a principal underwriter [DOL Reg. § 2550.404a-5(d)(iii)]. In the preamble to the Regulation, the DOL notes that the plan administrators may blend various benchmarks to reflect the composition of blended investments such as balanced and target date funds [Preamble to DOL Reg. § 2550.404a-5].

C. Fee and Expense Information The following information must be disclosed for

investments without a fixed rate of return:

1. The amount and a description of each shareholder-type fee (fees directly charged against the invest-ment, such as commissions, sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, and purchase fees that are not included in the total expenses of the investment);

2. A description of any restriction or limitation that may be applicable to a purchase, transfer, or with-drawal of the investment in whole or in part (e.g., round trip, equity wash, or other restriction);

3. The total annual operating expenses expressed as a percentage (i.e., expense ratio);

4. The total annual operating expense of the invest-ment for a one year period expressed as a dollar


amount of a $1,000 investment (assuming no returns and based on the total annual operating expense);

5. A statement that fees and expenses are only one factor to consider when making an investment decision;

6. A statement that the cumulative effect of fees and expenses can substantially reduce the growth of accounts; and

7. A statement that participants and beneficiaries can visit the DOL EBSA site for a demonstration of the long term effect of fees and expenses [DOL Reg. § 2550.404a-5(d)(1)(iv)].

For purposes of the Regulation, “total operating expenses” means different things depending on the type of investment. With respect to a designated investment alternative that is registered under the Investment Company Act of 1940, it means the annual operating expenses and other asset-based charges prior to waivers and reimbursements (e.g., investment management fees, distribution fees, ser-vice fees, administrative expenses, separate account expenses, mortality and expense risk fees) that reduce the alternative’s rate of return, expressed as a per-centage, calculated in accordance with the required Securities and Exchange Commission form, e.g., Form N-1A (open-end management investment companies) or Form N-3 or N-4 (separate accounts offering vari-able annuity contracts) [DOL Reg. § 2550.404a-5(h)(5)(i)]. For a designated investment alternative that is not registered under the Investment Company Act of 1940, it means the sum of the fees and expenses described immediately below before waivers and reimbursements, for the alternative’s most recently completed fiscal year, expressed as a percentage of the alternative’s average net asset value for that year:

1. Management fees as described in the Securities and Exchange Commission Form N-1A that reduce the alternative’s rate of return;

2. Distribution and/or servicing fees as described in the Securities and Exchange Commission Form N-1A that reduce the alternative’s rate of return; and

3. Any other fees or expenses not included above that reduce the alternative’s rate of return (e.g., externally negotiated fees, custodial expenses, legal expenses, accounting expenses, transfer agent expenses, recordkeeping fees, administrative fees, administrative fees, separate account expenses, mortality and expense risk fees). This excludes

brokerage costs described in Item 21 of Securities and Exchange Commission Form N-1A [DOL Reg. § 2550.404a-5(h)(5)(ii)].

The information that must be disclosed for invest-ments that have a fixed return for their entire term includes the amount and description of any shareholder-type fees and a description of any restric-tion or limitation that may be applicable to a purchase, transfer, or withdrawal of the investment in whole or in part [DOL Reg. § 2550.404a-5(d)(1)(iv)(5)].

D. Special Rules

1. Special Rules for Employer Securities With respect to designated investment alternatives

designed to invest primarily in “qualifying employer” securities as defined in Section 407 of ERISA:

1. The requirement to describe principal strategies and risks in the Web site is not applicable. [See Section III.E.1. below.] However, it is replaced by a requirement to give an explanation of the impor-tance of a well-balanced and diversified portfolio. In the preamble to the Regulation, the DOL said it anticipates that plan administrators will use the language provided in Field Assistance Bulletin 2006-03 to meet this requirement. This language states: To help achieve long-term retirement secu-rity, you should give careful consideration to the benefits of a well-balanced and diversified invest-ment portfolio. Spreading your assets among dif-ferent types of investments can help you achieve a favorable rate of return, while minimizing your overall risk of losing money. This is because mar-ket or other economic conditions that cause one category of assets, or one particular security, to per-form very well often cause another asset category, or another particular security, to perform poorly. If you invest more that 20 percent of your retirement sav-ings in any one company or industry, your savings may not be properly diversified. Although diversifi-cation is not a guarantee against loss, it is an effec-tive strategy to help you manage investment risk.

2. The requirement to disclose portfolio turnover in the Web site is not applicable.

3. The requirement to disclose fees and expenses in the Web site is not applicable except if the employer securities are in a unitized fund.

4. The requirement to disclose total annual operat-ing expenses, both as a percentage and as a dollar


amount per $1,000 invested, is not applicable except if the employer securities are in a unitized fund.

5. With respect to nonunitized investments holding securities publicly traded on a national exchange or generally recognized market, “average annual total return,” for purposes of reporting one, five, and 10-year performance, is defined as the change in value of an investment in one share of stock on an annu-alized basis over a specified period, calculated by taking the sum of the dividends paid during the measurement period, assuming reinvestment, plus the difference between the stock price (consistent with Section 3(18) of ERISA) at the end and at the beginning of the measurement period and dividing by the stock price at the beginning of the measure-ment period; reinvestment of dividends is assumed to be in stock at market prices at approximately the same time actual dividends are paid.

6. The alternate definition of average annual total return also applies to nonunitized investments in employer securities if they are not publicly traded on a national exchange or generally recognized market. In the preamble to the Regulation, the DOL expects that many of these securities do not declare dividends and that plan administrators will utilize Form 5500 valuation data in their calcula-tion [DOL Reg. § 2550.404a-5(i)(1)].

2. Special Rules for Certain Annuities If a designated investment alternative is part of a

contract, fund, or product that permits participants or beneficiaries to allocate contributions toward the future purchase of a stream of retirement income payments guaranteed by an insurance company, additional dis-closure requirements that are detailed under “Special Rules-Certain Annuities” also apply. The disclosures under the special rule must be made to the extent the disclosures are not provided under the general requirements for the disclosure of Fee and Expense Information [DOL Reg. § 2550.404a-5(d)(1)(vii)]. The DOL believes the application of the two rules will result in the disclosure of both the annuity and port-folio components of a variable annuity [Preamble to DOL Reg. § 2550.404a-5].

With respect to a designated investment alternative that is a contract, fund, or product that permits partic-ipants or beneficiaries to allocate contributions toward the current purchase of a stream of retirement income payments guaranteed by an insurance company, the plan administrator must, in lieu of providing the

investment-related disclosures regarding identifying information, performance data, benchmarks, fee and expense information, and Web site address, give each participant or beneficiary the following information:

1. The name of the contract, fund, or product; 2. The alternative’s objectives or goals (e.g., to pro-

vide a stream of fixed retirement income payments for life);

3. The benefits and factors that determine the price (e.g., age, interest rates, form of distribution) of the guaranteed payments;

4. Any restrictions on the ability of a participant or beneficiary to withdraw or transfer amounts allocated to the option (e.g., lock-ups) and any fees or charges applicable to such withdrawals or transfers;

5. Any fees that will abate the value of amounts allo-cated by participants or beneficiaries to the option, such as surrender charges, market value adjust-ments, and administrative fees;

6. A statement that guarantees of an insurance com-pany are subject to its long-term financial strength and claims-paying ability;

7. An Internet Web site address that is sufficiently specific to provide participants and beneficiaries the ability to obtain the following information: (a) the name of the option’s issuer and of the con-tract, fund, or product; (b) a description of the option’s objectives or goals; and (c) a description of the option’s distribution alternatives/guaranteed income payments (e.g., payments for life, payments for a specified term, joint and survivor payments, optional rider payments), including any limita-tions on the right of a participant or beneficiary to receive such payments;

8. A description of costs and/or factors taken into account in determining the price of benefits under an option’s distribution alternatives/guaranteed income payments (e.g., age, interest rates, other annuitization assumptions);

9. A description of any restrictions on the right of a participant or beneficiary to withdraw or transfer amounts allocated to the alternative and any fees or charges applicable to a withdrawal or transfer; and

10. A description of any fees that will abate the value of amounts allocated by participants or beneficia-ries to the alternative (e.g., surrender charges, mar-ket value adjustments, administrative fees) [DOL Reg. § 2550.404a-5(i)(2)].


3. Special Rules for Fixed Return Investments The Regulation includes special rules that clarify and

limit the information that must be made available at the required Web site address for each designated invest-ment option with respect to which the return is fixed for the term of the investment in this regard. These rules require disclosure of the following information:

1. The name of the alternative’s issuer; 2. The alternative’s objectives or goals (e.g., to pro-

vide stability of principal and guarantee a mini-mum rate of return);

3. The alternative’s performance data described in “disclosure of investment-related information” updated on at least a quarterly basis, or more fre-quently by other applicable law; and

4. The alternative’s fee and expense information described in disclosure of investment-related infor-mation [DOL Reg. § 2550.404a-5(i)(3)].

4. Special Rules for Target Date or Similar Funds The Regulation reserves a place for pending sepa-

rate guidance on target date-type funds [DOL Reg. § 2550.404a-5(i)(4)].

E. Rules Designed to Promote a Better Understanding of the Investment-Related Disclosures

1. Internet Web Site Plan fiduciaries must provide an Internet Web site

address that is sufficiently specific to provide partici-pants and beneficiaries with access to the following information regarding the designated investment alternative:

1. The name of the alternative’s issuer; 2. The alternative’s objectives or goals in a man-

ner consistent with Securities and Exchange Commission Form N-1A or N-3, as appropriate;

3. The alternative’s portfolio turnover rate in a manner consistent with Securities and Exchange Commission Form N-1A or N-3, as appropriate;

4. The alternative’s performance data (described above) updated on at least a quarterly basis, or more fre-quently if required by other applicable law; and

5. The alternative’s fee and expense information (described above) [DOL Reg. § 2550.404a-5(d)(1)(v)].

A plan administrator may include additional infor-mation on the site. In addition, the DOL expects that

the Web site will be accurate and updated by the plan administrator “as soon as reasonably possible following a change, or notification thereof” [Preamble to DOL Reg. § 2550.404a-5].

2. Glossary A plan administrator must provide a general glos-

sary of terms to assist participants and beneficiaries in understanding the designated investment alternatives, or an Internet Web site address that is sufficiently spe-cific to provide access to such a glossary and general explanation of the purpose of the address [DOL Reg. § 2550.404a-5(d)(1)(iv)].

3. Comparative Format Participant and beneficiaries must be provided with

a chart or similar format to foster comparison of the investment-related information described above and other disclosures as discussed previously with regard to the “Special Rules” of the Regulation. [ See DOL Reg. § 2550.404a-5(d)(2).] The design of the compara-tive document must facilitate a comparison of such information for each designated investment alternative available under the plan. In addition, the document must prominently display the date and include:

1. The name, address, and telephone number of the plan administrator (or their delegate) to contact for the provision of information available upon request (see below);

2. A statement that additional investment-related information (including more recent performance data) may be available at the listed Web site; and

3. A statement that explains how to request and obtain free paper copies of information provided on the Web site, special disclosures about annui-ties, and special disclosures relating to fixed return investments.

A model chart is provided in the Regulation [Appendix to DOL Reg. § 2550.404a-5]. So long as it is not incorrect or misleading, a plan admin-istrator may include additional information that the plan administrator deems appropriate [DOL Reg. § 2550.404a-5(d)(2)(ii)]. The Preamble to the Regulation notes that charts from various service providers may be combined to form a single chart. However, distribution of separate component charts is not allowed [Preamble to DOL Reg. § 2550.404a-5]. If a plan administrator accurately uses the model com-parative chart, he or she will be deemed to meet the


requirements to disclose investment-related fees and expenses. [DOL Reg. § 2550.404a-5(e)(3)].

F. Investment-Related Disclosure Timing Rules The initial disclosure to a participant or ben-

eficiary may be met if the plan administrator pro-vides the most recent annual disclosure [DOL Reg. § 2550.404a-5(c)(4) and (e)(1)(viii)]. It is important to note that the preamble of the Regulation states that the annual disclosure must be accompanied with “any required updates furnished to participants and benefi-ciaries” [Preamble to DOL Reg. § 2550.404a-5].

After the investment in a particular designated plan investment, each investing participant or beneficiary must be given any materials provided to a plan that concern the exercise of voting, tender, or similar rights to the extent such rights are passed on to such partici-pant or beneficiary under the terms of the plan [DOL Reg. § 2550.404a-5(d)(3)].

A plan fiduciary must provide either at the time a participant or beneficiary can direct the investment of his or her account, or upon request, the following information relating to designated investment alterna-tives to each participant or beneficiary:

1. Copies of prospectuses or any short form or sum-mary approved by the SEC under the ‘33 or ‘40 Acts, or a similar document from entities not under SEC jurisdiction. This means that the “auto prospectus” rule under Section 404(c) that requires a participant to receive the prospectus on his or her initial investment will no longer apply. This is because the DOL realized that participants rarely seem to read them.

2. Copies of financial statements or reports, such as a statement of additional information and share-holder reports, and any other similar materials relating to a designated plan investment to the extent such materials are provided to the plan.

3. A statement of the value of a share or unit of each designated investment alternative and the valua-tion date.

4. A list of assets that concern the portfolio of each designated investment alternative that constitutes plan assets within the meaning of DOL Reg. § 2510.3-101; and

5. The value of each of such assets or its proportion of the investment alternative (mutual funds and some other investment products are not “plan assets” under DOL Reg. § 2510.3-101) [DOL Reg. § 2550.404a-5(d)(4)].

Interestingly, the Regulation does not define a time-frame for providing investment-related information that is available upon request of a participant.

IV. Amendments to Section 404(c) Regulations The Regulation makes conforming changes to the

disclosure requirements for plans that elect to comply with the existing regulations under Section 404(c) of ERISA. The DOL amended the Section 404(c) regula-tions to remove provisions made redundant by the new rule. (Many of the new required disclosures were pre-viously made by plan sponsors on a voluntary basis to conform to the Section 404(c) regulations.) References to the appropriate disclosures under the new rule in those cases replace the current 404(c) provisions. [ See DOL Reg. §§ 2550.404a-5, 2550.404c-1.]

The 404(c) regulations were also amended by the Regulation to specifically include the DOL’s long-standing position that Section 404(c) does not provide any relief from the 404(a) requirements concerning the prudent selection and monitoring of a desig-nated investment alternative under a plan [DOL Reg. § 2550.404c-1(d)(2)(iv)]. This assertion was previously found in a footnote to the preamble of the Section 404(c) regulation [Preamble to DOL Reg. § 2550.404c-1 at note 27].

The impetus for clearly stating that Section 404(c) does not provide any relief from the requirement of prudent selection and monitoring of a designated investment alternative may have been caused by recent case law. Section 404(c) sets forth that it is a defense to liability when the loss is “the direct and necessary result of that participant’s or beneficiary’s exercise of control” [ERISA § 404(c); DOL Reg. § 2550.404c-1(d)(2)(i)]. In Langbecker v. Electronic Data Sys. Corp., participants sued the fiduciaries of their plan because one of the investment options selected by the participants was employer stock, which declined in value. In this case, the issue was whether the losses “result from” the participants’ exercise of control pursuant to Section 404(c). [ Id. at 304.] The participants argued that the footnote in the 404(c) regulations mentioned earlier meant that, when a plan loses money by reason of a fiduciary’s inclusion of an imprudent investment option, none of the loss is the direct and necessary result of the participant’s exercise of control. The Langbecker court held that despite the footnote and the fact that the fiduciaries committed a breach of duty in their inclusion of an imprudent investment option, the plan fiduciaries may not be held liable because the loss resulted from


the participants’ exercise of control. This was because it was the participants themselves who chose to make the investment at issue [47 F.3d 299 (5th Cir. 2007)].

The Langbecker case was followed by Hecker v. Deere & Co. [556 F.3d 575 (7th Cir. 2009)]. In Hecker , the participants sued the plan fiduciary because it lim-ited the plan’s investment options only to funds that charged excessively high fees. The court distinguished Langbecker by stating that:

Even if § 1104(c) [§ 404(c)] does not always shield a fidu-

ciary from an imprudent selection of funds under every

circumstance that can be imagined, it does protect a fidu-

ciary that satisfies the criteria of § 1104(c) and includes

a sufficient range of options so that the participants have

control over the risk of loss.

The Hecker court ruled in favor of allowing the fidu-ciary to use the 404(c) shield because the plan offered a broad range of investments.

In the recent case of In re Tyco Int’l, Ltd. Multidistrict Litig., the district court was confronted with a fact pattern similar to that of Langbecker and ruled in the favor of the participants [606 F. Supp. 2d 166 (D.N.H. 2009)]. The court stated that it was unpersuaded with the reasoning in Langbecker and that the DOL’s interpretation of its own regulations was reasonable.

It is quite possible that the result in these three cases is the reason why the DOL amended the 404(c) regulation to specifically state that Section 404(c) does not provide any relief from the 404(a) requirements concerning the prudent selection and monitoring of a designated investment alternative under a plan. Perhaps the Department believes that, by putting the language at issue specifically in the 404(c) regulations, as opposed to a footnote in their preamble, that the government’s position may have greater weight in a court of law. In addition, the DOL’s action here may cause more consistent holdings among the courts.

V. Miscellaneous The Regulation states that is not intended that a

fiduciary will be relieved from its duty to prudently select and monitor service providers or investment alternatives [DOL Reg. § 2550.404a-5(f)].

The Regulation provides plan administrators pro-tection from liability for the incompleteness or inaccu-racy of information provided to participants, provided that the plan administrator reasonably and in good faith relies upon information provided by a service

provider [DOL Reg. § 2550.404a-5(b)]. Plan adminis-trators must often rely on the expertise of their service providers. Thus, the “good faith” provision should be welcomed by the plan administrators because it may provide a measure of protection. This may also mean that plan administrators will be urging service provid-ers to provide the requisite information.

The Regulation interacts with other ERISA regula-tions. For example, the general disclosure regulation of DOL Reg. Section 2520.104b-1 applies to material furnished under this regulation [Preamble to DOL Reg. § 2550.404a-5]. This includes the safe harbor for electronic disclosures at paragraph (c) of the regu-lation. In addition, the Regulation made changes to Section 404(c) regulations, as discussed above.

VI. Economic Benefits of the Regulation The DOL estimates that the Regulation will be

economically significant. The anticipated cost of the Regulation is $425 million in 2012 (2010 dollars) [Preamble to DOL Reg. § 2550.404a-5]. It is pre-dicted these costs will arise from legal compliance review, time spent consolidating information for par-ticipants, creating and updating Web sites, preparing and distributing annual and quarterly disclosures, and material and postage costs to distribute the disclosures. The DOL believes that a significant benefit of this rule is that it will lower the amount of time participants spend on collecting fee and expense information and organizing the information in a format that allows key information to be compared. This time savings is esti-mated to total nearly 54 million hours valued at nearly $2 billion in 2012 (2010 dollars). The DOL predicts that the present value of the benefits provided by the Regulation over the 10-year period 2012–2021 will be approximately $14.9 billion and the present value of the costs will be approximately $2.7 billion.

VII. Conclusion Although the Regulation will undoubtedly have

a big impact on ERISA participant-directed defined contribution plans, they unfortunately do not resolve some pressing issues. Issues exist with regard to dis-closing expenses paid out of unallocated accounts such as forfeiture accounts and expense recapture accounts. For example, if a fee is paid through a forfeiture account, it is uncertain whether that is an amount that is charged to a participant’s account. This type of fee is not paid directly from a participant’s account. However, it does result in an abatement of year-end allocation to a participant.


The Regulation also fails to define the term “administrative” as it relates to services or expenses. Although the final rule provides that services such as legal, accounting, and recordkeeping are administra-tive services, the Regulation fails to define what is considered to be administrative in nature. One prob-lem with this is whether, and how, RIA fees need to be disclosed. These fees could be charged separately or amalgamated into an administrative expense.

In addition, the Regulation does not specifically state that revenue sharing must be disclosed. However, the Regulation does provide that a plan administra-tor must explain that some of a plan’s administrative expenses were paid from the total annual operating expenses of one or more of the plan’s investment options. [ See DOL Reg. § 2550.404a-5(c)(2)(ii)(C).] Arguably, this would include revenue sharing. The Regulations lack of clarity in this area is disappointing because the issue is unresolved in the courts. [ C.f., Hecker v. Deere, 556 F.3d 575 (finding that partici-pants only need to know the expense that would be charged for an investment fund and not if or how some part of that charge should be used to make rev-enue sharing payments to a recordkeeper) with Braden v. Wal-mart Stores, Inc., 588 F.3d 585 (8th Cir. 2009) (reversing the dismissal of a fiduciary breach case brought against the fiduciaries of Wal-Mart’s profit sharing and 401(k) plan because the failure to disclose revenue sharing information may mislead participants in making their investment decisions)].

Finally, the Regulation fails to define what a participant-directed account is. This causes an issue if a plan provides for loans. Often, plans require that participant loans be considered to be an investment of the participant’s own account—with that partici-pant’s account being the recipient of all interest and principal payments. If a participant or beneficiary has the power to take a loan from a plan, arguably this could be an investment selection by a participant or

beneficiary—that is, a participant-directed invest-ment. It is unclear from the Regulation if this is considered to be the participant-direction of invest-ments. This issue is even more poignant in a situ-ation where the only power that a participant or beneficiary has to direct investments is the ability to take a loan from a plan. One would hope that the ability to take a loan would not mean that a plan has participant-direction and is, as a result, subject to the extensive reporting and disclosure requirements of the new Regulation. However, the Regulation does not address this issue.

The Regulation will likely achieve its stated goal of disclosing fees to participants. Moreover, when par-ticipants, particularly executives, actually see the fees, this may “drive down” costs [“If the head of sales calls up human resources screaming, they’re likely to go shopping for a plan,” Quote of Lou Harvey in Eleanor Laise, “Shining a Light on Murky 401(k) Fees,” Wall St. J., Nov. 13, 2010, at B8]. The disclosure of fees could cause more “excessive fee” lawsuits to occur. This could further reduce costs.

Some industry experts have conjectured that compliance with the Regulation may require sig-nificant industry efforts. For example, Brian Graff stated in BNA Pension & Benefits Daily published October 15, 2010, that “the most striking feature of the Regulation is its applicability to all types of investment options offered in participants-directed 401(k)-type plans.” Graff opines that compliance with the Regulation will be a major undertaking for this industry. When the amount of compliance work with respect to the Regulation is combined with such efforts to comply with the plan-sponsor level fee dis-closure rules, this could require significant resources. Regardless of whether compliance with the Regulation will require a great amount of work, the applicabil-ity date is soon. Therefore, service providers and plan administrators need to start preparing now. ■

60

A R T I C L E

Do Tax-Qualified Plans Still Make Sense? B y A l l e n B u c k l e y

Given the financial problems of our nation, the big

picture “What’s it all about, Alfie?” question must

be asked: Do tax-qualified retirement plans still

make sense?

Conventional wisdom essentially has been that, with few exceptions, retirees will be in lower income tax brackets in retirement than they were while work-ing. The combination of relatively low brackets and compounded tax-free growth has made utilization of tax-qualified plans a prudent financial action. The fact that retirement plan benefits are outside the reach of creditors of employees and employers is another plus.

For example, an employee who is in a 33 percent combined federal and state income tax bracket while working but will be in a 15 percent incremental income tax bracket in retirement would benefit by making a tax-deductible contribution to a 401(k) plan that grows tax-free until distributed, with further tax-free growth following distribution via rollover to an IRA. For employers, the benefit of tax-qualified plans for their employees has made having them a logical decision. Profitable employers subject to the income tax regime receive an additional benefit of reduced current taxes attributable to contributions deductions.

But what if individual income tax rates revert to where they were in the 1950s, 1960s, or 1970s, so that relatively high income tax brackets kick in with respect to relatively low taxable income thresholds? For example, adjusting the 1954 Internal Revenue Code rates for inflation to 2010 using the Consumer Price Index (CPI), a 30 percent federal income tax rate would apply on taxable income between $48,780 ($6,000 in 1954) and $65,040, and a 50 percent tax rate would apply on income in excess of $130,080 ($16,000 in 1954) but not in excess of $146,340. (The 1954 highest rate of 91 percent applied to taxable income in excess of $200,000–$1,626,000 in 2010 dollars.) Perhaps it is a fear of the return of such rates that is the primary cause of the growing appeal of Roth IRAs, Roth 401(k) provisions, and Roth in-plan conversion options.

Recently, the financial problems of the federal gov-ernment have come to light for a large percent of the general public. In February of 2011, the public debt equals approximately $10 trillion (probably much greater at the time you’re reading this article). Throw in Social Security and other government programs and the total hits approximately $14 trillion. Gross Domestic Product (GDP) for 2010 was $14.9 trillion.

Federal deficits for 2009 and 2010 were, respec-tively, approximately $1.4 trillion and $1.3 trillion. Revenue for these years was approximately $2.1 tril-lion and $2.2 trillion, respectively. The Congressional Budget Office (CBO) reported in January of 2011 that it anticipates deficits of $1.5 trillion and $1.1 trillion in 2011 and 2012, respectively.

The first batch of Baby Boomers is entitled to receive their Medicare benefits beginning this year. For 18 straight years hereafter, additional batches will be added. Do not forget about the Boomers’ Social Security benefits—with respect to which there are no assets to make up the cash shortfalls already being experienced.

In 2007, before the recent run-up in debt, the U.S. Government Accountability Office (GAO) said: “GAO’s long-term simulations continue to show ever-larger deficits resulting in a federal debt burden that ultimately spirals out of control.”

If debt burden did spiral out of control, would that mean the federal government would collapse? Or, would it simply mean significantly increased interest rates, with corresponding negative implications for investments (and plan returns)? Would people be able to access the investments in their retirement plans? Would those investments have lost tremendous value

Allen Buckley is a partner in the Atlanta office of the Saylor Law

Firm LLP (www.saylorlaw.com) where he practices in the areas

of employee benefits, tax, estate planning, and business law.

Mr. Buckley has authored or coauthored more than 25 professional

articles and one book and has spoken on benefits and tax topics

on numerous occasions.

DO TAX-QUALIFIED PLANS STILL MAKE SENSE? 61

due to the collapse of the U.S. government, presum-ably with the collapse of many western Europeans gov-ernments in advance thereof? If the debts will spiral out of control and result in a collapse, would a 401(k) participant have been better off not participating, keeping the cash net of tax, and investing the money in assets that would survive the collapse?

In late 2010, The National Commission on Fiscal Responsibility and Reform (the “Commission”) issued its report titled “The Moment of Truth.” If the Commission’s proposal had become law, the debts would have been placed under control. However, the 14 votes needed to move the proposal to Congress for a vote were not received. Thus, the proposal was effec-tively killed.

While the Commission’s report never made it to a vote in Congress, it may be important to note that the Commission’s proposal called for spending cuts and reduced income tax rates, deductions, and cred-its. One of the reductions was an individual limit on contributions to tax-qualified plans equal to the lesser of $20,000 or 20 percent of compensation (apparently on employer and employee contributions, combined). With variances, three relatively low income tax brack-ets were proposed, thus continuing the progressive nature of the income tax that has contributed to the value of tax-qualified plans.

The Commission’s proposal did not call for addition of a value added tax (VAT) or sales tax to supplement the income tax. Thus, it is still possible to craft a fix to our nation’s financial problems that would preserve much of the current value of tax-qualified plans.

Another commission also recently issued a proposal. The Bipartisan Policy Center Task Force issued its comprehensive plan to reduce debt and create jobs. The plan would eliminate most income tax deduc-tions, implement two tax brackets (15 and 27 percent), and establish a 6.5 percent sales tax in the nature of a VAT. For 2012, the proposed break-point between the 15 and 27 percent brackets would be $51,000 for single persons and $102,000 for married persons fil-ing jointly. Identical to the Commission’s report, an individual limit of the lesser of $20,000 or 20 per-cent of compensation would apply to contributions to tax-qualified plans. Accordingly, this plan would not destroy the current value of tax-qualified plans. However, both the Task Force’s proposal and the

Commission’s proposal would reduce the appeal of tax-qualified plans.

As time goes on without significant change, the severity of changes needed to address the nation’s financial problems increases, thus reducing the abil-ity of legislators to provide deductions as part of the income tax system. Of course, the addition of a VAT would ease much of the pressure on the income tax system because less revenue would be needed from the income tax system.

In 2005, the President’s Advisory Panel on Federal Tax Reform considered a VAT as a possible replace-ment for part of the income tax. The Panel did not reach a consensus with respect to the VAT, but deemed it to be “worthy of further consideration.” Importantly, the Panel noted: “The VAT has been adopted by every major developed economy except the United States.” Would implementation of a VAT cause income tax rates to drop enough so that tax-qualified plans are no longer cost-efficient? Or, would the income tax remain intact basically in its present state?

Studies show that tax-qualified plans induce sav-ing for retirement. For example, in 1997, in a Joint Committee of Taxation study, Eric Engen and William Gale stated: “Over the last twenty years, while the personal saving rate has declined, the rate of tax- preferred retirement saving has risen but other net personal saving has vanished.”

If the per-participant annual contribution rate decreased to the lesser of 20 percent of compensation or $20,000, it is unlikely that many small employers would create new plans. It is likely that the adminis-trative costs and hassles of having a plan would out-weigh the benefits to owners of small companies, thus causing them to opt to save outside employer-based tax-qualified plans, including saving through IRA contributions. It is difficult to gauge whether existing plans would be terminated. Given economies of scale, it would seem likely that most large and mid-sized employers would continue to maintain existing plans. However, they would very likely seek to simplify their plans and administration thereof as much as possible.

As of now, tax-qualified plans continue to make economic sense. However, the changing financial sta-tus of the U.S. and the changing tax landscape will necessitate reevaluation of the issue as Congress (hope-fully) acts to deal with our nation’s financial woes. ■

62

C O L U M N

Legal Developments

A New Plan Design Feature for Qualified Plans: The Roth “In-Plan” Rollover

Effective on or after September 28, 2010, Section 2112 of the “Small Business Jobs and Credit Act

of 2010” (H.R. 5297) (the “Act”) added a new design option for 401(k) and 403(b) plans effective

September 29, 2010, and for governmental 457(b) plans effective January 1, 2011. That option is the

ability to permit a conversion of certain non-Roth amounts to a designated Roth account within the same plan.

A summary of the prior law is set forth below, along with a summary of the new provision and

the IRS guidance issued in Notice 2010-84 to facilitate implementing this provision. Lastly,

the article reviews the key implementation steps when adding the new Roth rollover feature.

B y E l i z a b e t h T h o m a s D o l d

Elizabeth Thomas Dold is a principal attorney at Groom Law Group, chartered in Washington, D.C. For over 15 years, her work has focused on employee benefits and compensation matters, including employment taxes and related reporting and withhold-ing requirements. She regularly advises Fortune 500 companies (including corporate and tax-exempt employers, financial institu-tions, and third party administrators) on plan qualification and employment tax issues. Ms. Dold is the Chair of the Information Reporting Program Advisory Committee (IRPAC) and a member of the American Society of Pension Professionals and Actuaries (ASPPA). She is an editorial contributor for the “Employee Benefits Corner” in Taxes , a CCH publication, and a former adjunct professor at Georgetown Law Center.

Summary of Prior Law

A participant is permitted to make salary deferral contributions under a 401(k) or 403(b) plan as after-tax Roth contributions

to a designated Roth account. This provision, enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), was initially effective in 2006, and all participants, regardless of income, are eligible to make these deferrals. These Roth contributions combined with pre-tax deferrals are subject to an annual limit under Code Section 402(g), which is $16,500 for 2011. The investment growth of Roth accounts is never taxed, provided that the ultimate distribution from the plan constitutes a “qualified distribution.” In general, the contributions must be held in the account for at least five years and the participant

must have reached age 59½, died, or become disabled in order for the distribution to be qualified. However, employer contributions (e.g., matching and profit sharing contributions) were not eligible for Roth treatment, nor could they be converted to a designated Roth account inside the qualified plan.

Under prior law, the only way to convert employer contributions into a Roth account was via rollover to a Roth IRA. Beginning in 2008, all qualified plans were required to permit direct rollovers of non-Roth amounts in the plan to a Roth IRA. The rollover resulted in taxable income to the participant/benefi-ciary (except to the extent of distribution of after-tax contributions), and income limits and filing status restrictions were imposed on such rollovers. However, in 2010, these restrictions were elimi-nated; and for 2010 for in-plan Roth rollovers only, a participant/beneficiary could claim the resulting tax-able income in two equal installments in 2011 and 2012. Moreover, the 10 percent early distribution tax does not apply to rollovers to a Roth IRA. All of these changes made it attractive for participants/ beneficiaries to consider taking distributions from their retirement plan.

Understanding these incentives, various groups urged Congress to allow 401(k) and 403(b) plans to offer this same conversion option without forcing par-ticipants to remove the funds from their emp loyers’ plans to prevent a leakage of plan assets and loss of ERISA protections. The Act adopts such a provision, effective after September 27, 2010.

LEGAL DEVELOPMENTS 63

Summary of the Roth “In-Plan” Rollover Features

An overview of the new “in-plan” rollover feature is set forth below, along with important guidance from IRS Notice 2010-84 and the November 26, 2010, IRS Employee Plans Newsletter that summarizes the rules and the available guidance.

It is important to note that, although the statute refers to this provision as a “rollover,” the funds are not really moving from the plan to another plan, which is normally the case in a rollover. In the in-plan rollover, the funds are rolling over from one type of account to another. Nonetheless, the effect is that of distributing the funds from the pre-tax account (which necessitates a distributable event) and then depositing those funds into the after-tax Roth account, as if it were “rolled over.”

Optional provision. The Roth in-plan rollover is a dis-tribution after September 27, 2010, from an individu-al’s plan account that is rolled over to the individual’s designated Roth account in the same plan. The Roth “in-plan” rollover feature is optional and can be added to an eligible plan via plan amendment.

Types of plans covered. As discussed, this feature is limited to 401(k) plans, 403(b) plans, and beginning in 2011, governmental 457(b) plans. The provision does not apply to money purchase pension plans, profit sharing plans, or defined benefit plans (e.g., traditional or cash balance plans). Moreover, in order to add this feature, the plan must permit participants to make salary deferrals to a designated Roth account. Plans cannot simply add the rollover feature without allowing participants to make after-tax salary deferrals to a Roth account, and the salary deferral feature must be in place at the time the rollover is first offered.

Amounts eligible for rollover. The rollover extends to all vested amounts in the plan that are eligible for dis-tribution and constitute an eligible rollover distribu-tion. For an active employee who has not yet reached age 59½ , the rollover feature will not be available for pre-tax deferrals, as these amounts would not be cur-rently distributable; however, the plan may provide for distribution and rollover of certain employer contribu-tions. Moreover, the following distributions will not be eligible for rollover because they are not eligible rollover distributions:

• Hardship distributions, • Required minimum distribution (“RMD”)

payments, • Lifetime payments,

• Installment payments of 10 years or more, and • Certain corrective distributions.

Importantly, a plan may be amended to add the in-plan Roth rollover option for amounts the Code per-mits to be distributed. For example, if the plan does not currently permit in-service distributions of pre-tax deferrals by a participant who has reached age 59½ , the plan can be amended to permit such distribution. An employer can amend the plan to permit certain in-service distributions generally, or may limit the dis-tributions to in-plan Roth rollovers, thereby avoiding leakage of funds from the plan.

Eligible participants and beneficiaries. The feature is available to any participant (including an active or for-mer participant with an account balance in the plan), alternate payee that is a spouse or former spouse, and surviving spouse beneficiary who is eligible to receive an eligible rollover distribution from the plan. Importantly, the feature does not extend to nonspouse beneficiaries; they can only elect a rollover to an inher-ited traditional or Roth IRA.

Direct or indirect rollover. The rollover is made through a direct or indirect rollover. With a direct rollover, no actual distribution occurs; the accounts are transferred within the plan. The direct rollover is not treated as a distribution for the following purposes: (1) no spousal consent is required, (2) a plan loan transferred in the rollover without changing the repay-ment schedule is not treated as a new loan, (3) notice of the participant’s right to defer receipt of the dis-tribution (IRC § 411(a)(11)) is not required, (4) the amount rolled over continues to be taken into account for purposes of determining whether the participant’s total accrued benefit exceeds $5,000 under the auto-matic cash-out rules, and (5) any distribution right before the rollover cannot be eliminated.

For an indirect rollover, all the regular distribution rules apply (including 20 percent withholding), and the participant/spousal beneficiary can elect within 60 days to have the distribution returned to the plan to a designated Roth account. The ability of a ter-minated employee or a beneficiary to do an indirect rollover can be hampered, however, if the amount dis-tributed is the entire account, as the plan sponsor may elect not to permit the plan to receive rollovers from individuals who are no longer participants or beneficia-ries with accounts. As a result, a plan may provide that only direct rollovers to Roth accounts are permitted.

No recharacterization. There is no ability for a participant/beneficiary to later unwind the Roth


in-plan rollover once his or her election is made. Unlike rollovers to a Roth IRA, the recharacteriza-tion rules of Code Section 408A(d)(6) do not extend to Roth in-plan rollovers.

Summary of Applicable Taxation and Reporting Rules

The taxable amount of the rollover is determined as if the participant/beneficiary elected a rollover to a Roth IRA. The taxable amount is the fair market value of the distribution, reduced by the participant’s basis (e.g., after-tax employee contributions). Notably, if the distribution includes employer securities attrib-utable to employee contributions, the fair market value includes any net unrealized appreciation. The fair market value also includes any outstanding loan balance that is rolled over. Additional complexities are outlined below.

Qualified distribution. The key draw of this feature is the ability of participants/beneficiaries to convert non-Roth assets into Roth assets under the current tax rates, and holding those accounts until they are eligible for a “qualified distribution” so that earnings accrued after the rollover date are tax-free (i.e., never subject to federal income tax). Therefore, it is impor-tant to determine the requirements for a “qualified distribution.” The Code provides that, to have a “qualified distribution,” the participant must receive a distribution (1) that is made after a five-year period (generally beginning with the first taxable year in which the participant contributed to a Roth 401(k) account under the plan or under a prior plan that was directly rolled over to the current plan), and (2) made on account of (i) death, (ii) disability, or (iii) after attainment of age 59½ . Importantly, it appears that this same five-year period applies to the rolled-over amounts. For example, suppose a 60-year old partici-pant first made a Roth deferral in 2006. On December 18, 2010, the participant makes an in-plan Roth roll-over. The participant can take a qualified distribution of the entire amount in 2011.

Special 2010 distribution election. For distributions made in 2010 that are rolled over in a Roth in-plan rollover, the participant has the option to include the taxable amount in gross income in two equal install-ments in 2011 and 2012, in lieu of electing full taxation for 2010. The election applies to all of the individual’s 2010 Roth in-plan rollovers but is inde-pendent of the participant’s Roth IRA conversion elec-tion. This election will be made on Form 8606 by the individual as part of his tax return filing, and does not

affect the plan’s reporting of the distribution on Form 1099-R. There are complex income acceleration rules set forth in Notice 2010-84 that apply if an indi-vidual takes a distribution in 2010 or 2011 before the amount is subject to tax under the special election.

10 percent early distribution tax recapture. Upon sub-sequent distribution of the rolled over amount within a five-year period—running from the first day of the participant’s taxable year in which the rollover was made—the 10 percent early distribution tax (Code § 72(t)) applies as if the rolled over amount were tax-able income unless the participant qualifies for an exception from that tax (e.g., the participant is over age 59½). If the distribution is rolled to a Roth IRA or another designated Roth account, the 10 per-cent tax does not apply (but continues to apply to any subsequent distribution from such Roth IRA or designated Roth account). Notice 2010-84 contains complex rules for computing whether a distribution is subject to the 10 percent tax, particularly during 2010 and 2011. [ See Notice 2010-84, Q&A-13.]

No 20 percent withholding for direct rollovers. There is no mandatory 20 percent withholding for an in-plan Roth direct rollover. However, the underpayment penalty may arise in the event that the participant/beneficiary does not increase his or her withholdings or make estimated tax payments to account for the conversion. Presumably, the plan sponsor may agree to enter into a voluntary withholding arrangement under Code Section 3402(p) for such direct rollovers, similar to what is permitted for conversions to a Roth IRA. However, for Roth conversions through an indirect rollover, the mandatory 20 percent withholding con-tinues to apply. As noted above, plans may elect not to permit indirect rollovers in this setting.

Reporting. For an in-plan Roth rollover through a direct rollover, the fair market value of the rolled over funds shall be reported on the current year Form 1099-R:

• The gross distribution is reported in Box 1; • The taxable portion of the rollover (determined

as if the amounts were actually distributed) is reported in Box 2a;

• No federal income tax is withheld or reported in Box 4;

• Any basis recovery is reported in Box 5; and • Code “G” is entered in Box 7 (G4 for a surviving

spouse) (these codes reflect a direct rollover/death and indicate that the 10 percent early withdrawal tax does not apply to the rollover).

LEGAL DEVELOPMENTS 65

Importantly, the fact that the participant treats a 2010 in plan Roth rollover as taxable over the two-year period under the special election described above does not impact the Form 1099-R reporting. For indirect rollovers, the Form 1099-R reporting should follow the regular rules. For a direct rollover, if the plan does withholding, report that on a separate Form 1099-R.

Upon a subsequent distribution from the in-plan Roth rollover account, a separate Form 1099-R is used to report the distribution. Moreover, the Form 1099-R must reflect the portion of a distribution from a des-ignated Roth account that is allocable to an in-plan Roth rollover. Specifically, the distribution should be reported the same as any other distribution from a designated Roth account; however, in the blank box to the left of Box 10 (renumbered Box 10 for 2011 Form 1099-R), the amount of the distribution allocable to the in-plan Roth rollover is entered. (The recently released 2011 Form 2011-R provides additional details.)

Action Steps for Adding the Roth “In Plan” Rollover Feature

The following action steps should be considered (and coordinated with the plan’s recordkeeper) when adding this new feature:

1. System Changes to Track the Rollovers and Special Tax Treatment. The plan’s recordkeeping system will need to be modified to track the in-plan rollovers and appropriately report any distributions of such amounts. It appears that a new account can be established to hold these rollovers, or a subaccount under the designated Roth account can be used. Any expansion of the current distribution rights must also be programmed, along with consider-ation of anticutback and nondiscrimination rules. Moreover, additional changes will be needed if the plan does not already offer Roth deferrals. The five-year period after the rollover must also be tracked to properly apply the Code Section 72(t) 10 per-cent additional tax.

2. Plan Amendment. For a nonsafe harbor 401(k) plan, a plan amendment reflecting the feature must be adopted by the later of December 31, 2011, or the last day of the plan year in which the amend-ment is effective. For a 401(k) safe harbor plan, the amendment must be adopted by the later

of December 31, 2011, or the time specified in Treasury Regulation Section 1.401(k)-3(e)(1) (gen-erally, before the first day of the plan year in which the provision is effective). Lastly, for a 403(b) plan that has a remedial amendment period pursuant to Announcement 2009-89, the amendment must be adopted by the later of the end of such remedial amendment period or the last day of the plan year in which the amendment is effective.

These deadlines apply to adding (1) the Roth in-plan rollover feature, (2) a Roth 401(k) feature to an existing 401(k) plan (but it doesn’t apply if adding a 401(k) feature to the plan), (3) acceptance of rollover contributions by the designated Roth account, and (4) any new distribution right added to the plan with a Roth in-plan direct rollover option.

The plan, however, must be in operational compli-ance with the amendment as of the effective date of the amendment. The IRS has not provided any sample plan amendment language to adopt this provision.

The employer may wish to consider the distribu-tion options that will apply to the in-plan Roth rollover account. For most rollovers, many plans allow in-service distributions at any time. If the plan wishes to avoid leakage, the plan may wish to restrict the ability to withdraw in-plan Roth roll-overs (subject to anticutback rules).

3. Update Distribution Procedures and Participant Notices. The plan’s distribution procedures and notices must be updated to reflect the new feature (includ-ing any new distribution rights). Also, participant communications regarding the plan terms need to be updated to reflect these changes without giv-ing tax advice. For example, the 402(f) (rollover) notice must be updated to describe the new fea-ture. Notice 2010-84 includes sample language. Safe harbor 401(k) plans must also update their annual safe harbor notices to reflect the new fea-ture. There are informal indications that the IRS will not require notices for the 2010 and 2011 years to reflect this new provision. Similarly, a “Summary of Material Modification” or “Summary Plan Description” should also describe the new plan feature and any changes in the distribution rights. Moreover, the Form 1099-R reporting and withholding procedures will need to be modified to reflect the special rules described above. ■

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Plan Administration

Preparer Tax Identification Number and the Independent Administration Firm

How will the new Preparer Tax Identification Number (PTIN) affect you and your organization? A lot.

B y J . R e e d C l i n e

J. Reed Cline, QPA, QKA, is a technical consultant at Benefit Consultants Group. Since 1974, he has been making ERISA work for his clients, designing and troubleshooting qualified plans. He is a graduate of the University of Pennsylvania, a current member of ASPPA, and earned his QPA and QKA from ASPPA. Any opin-ions expressed herein are solely those of the author and not neces-sarily those of the author’s employer or of the publisher.

By now you should have applied for, paid for, and received your PTIN. If you prepare Form 5330 then you clearly are preparing tax

forms. The IRS wants to create a database to research and track those who prepare returns and, when there are complaints, take whatever actions are necessary to determine if a particular preparer has consistently made errors, even if not reported. Overall, this is a good thing. When Johnny Local opens a business every year to do 1040s for local people, he really knows nothing about doing a competent job. Without a PTIN, he can no longer be in business. If he continually does a bad job, then he will lose his PTIN and be out of business.

There is no quibble with having CPAs, PAs, Attorneys, Enrolled Agents, and their brethren getting and using PTINs on the returns they prepare. Just like Johnny Local, if they practice outside their specialty and mess up, they could lose their ticket for even working within their specialty. This is a strong incen-tive for them to either improve their knowledge or stay within their respective specialty. The Continuing Education requirements of 15 hours per year will help keep them from getting stale. These hours are broken down to two (2) hours of ethics, three (3) hours of fed-eral tax updates, and ten (10) hours of other tax topics annually. There is no good explanation of what “other tax topics” covers—more on that later.

So, what does this have to do with those of us who are service providers to various retirement plans?

Do you ever calculate contributions to plans? If you do, of course, you refer your client to its professional to determine deductibility. Nonetheless, you are providing—in some sense of the word—tax informa-tion, or information to be used on the tax return. Well, that does not require you to have a PTIN. How about the Enrolled Actuaries who calculate the fund-ing in a defined benefit plan and sign the Schedules SB or MB for the Forms 5500? They may need a PTIN, but the PTIN never appears on the form—at least not yet. So who gets the PTIN?

In Revenue Procedure 2009-11, the IRS slipped Form 5500 into the list of tax returns. The Form 5500 had always been treated as an information return all the way back to 1976 when Form EBS-1 replaced the Form 990-T for plan reporting. It is a compilation of information and not the development of numbers used for tax purposes. At least this is the opinion of most people who do the forms. Then, in Notice 2011-6, the IRS specifically removed preparers of Forms 1099 and 5500 from the list of those who are required to obtain a PTIN. This was done in part through the advocacy of ASPPA and other organizations. While this may have been a victory for some, for most it was a victory in name only.

Form 5330 requires a PTIN. Most who prepare any of the Forms 5500 may also prepare a Form 5330 for excise taxes for such items as corrective distributions, late contribution of employee contributions, nonde-ductible contributions, or late contributions to defined benefit plans. They will have to obtain a PTIN to complete those forms.

So, now the IRS gets an annual “annuity” of $50 and the processing firm gets $14.25 for the regis-tration of each person in your office who works on the Forms 5500 because they might prepare a Form 5330. If your person is one of the chosen who are actually licensed to practice before the IRS (CPA, actuary, attorney, ERPA, or enrolled agent), he or she will not have to take an exam to get or keep the

PLAN ADMINISTRATION 67

PTIN, and existing continuing education require-ments for those designations are sufficient. If you do not have such a designation but maybe obtained a QKA, CPC, QPA, or any of the industry designa-tions, then you may have to take an exam. (Funny thing about the exam as it is currently structured: it covers personal and some business returns, but noth-ing for Form 5330.) Back to the continuing education credits—how many of the credits we have to get for ASPPA or NIPA will count toward the PTIN credits? And, in the reverse, how many of the special tax cred-its required for the PTIN will count as ASPPA/NIPA credits? Will this actually increase the number of courses/credits required to stay current in our indus-try with an increase in costs for our firms, which will increase the costs to our clients? Or will the IRS rec-ognize the preparation of the Form 5330 as a special case with its own requirements?

Not to be overlooked are those firms with employ-ees who are quite competent, but have never received any “official” designation. Now that these employ-ees are subject to having a PTIN, and may have to take the exams and be subject to continuing educa-tion requirements, how will these firms pay for the

additional expenses? If you review the regulations on the PTIN and Circular 230, even those who gather the information, especially if they speak with the client, will have to have a PTIN, although it will never be reported anywhere. The IRS is on record as saying that having only one person with a PTIN in a firm will not be acceptable if anyone else is “assisting” in prepar-ing the Forms 5500 (which then leads to the PTIN required 5330).

Based on my review of the regulations, an Enrolled Actuary will be required to have a PTIN because he or she is responsible for a portion of the Form 5500 and the development of tax deductions, but their PTIN will not be reported.

The only good news is that if you do not have a PTIN, get one before the exams come out. If you do, you will have until 2013 to pass the exam. If you don’t, you will have to pass the exam before you get a PTIN. Oh, by the way, you cannot prepare a Form 5330 after January 1, 2011, unless you have a PTIN. Hopefully, the IRS will not require an exam in the future for preparers of the 5330 form and therefore will not require expensive continuing education credits. ■

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ERISA Litigation Update

In My Humble Opinion: Some Things Are Best Left Alone

On October 21, 2010, the U.S. Department of Labor (the “DOL”) proposed regulations that

would significantly alter the regulatory landscape that has been in place for about 35 years and

grossly expand who will be deemed a fiduciary under ERISA Section 3(21)(A)(ii).

B y T e s s F e r r e r a

Tess Ferrera, Esq., is a member with Miller & Chevalier, LLC, in Washington, D.C., and a senior editor of the Journal of Pension Benefits.

Under ERISA Section 3(21)(A), a person is a fiduciary with respect to a plan “to the extent” the person:

1. Exercises any discretionary control or discretionary authority respecting management of such plan or has any authority or control respecting manage-ment or disposition of its assets;

2. Renders investment advice for a fee or other com-pensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or

3. Has any discretionary authority or discretionary responsibility in the administration of such plan.

ERISA’s definition of fiduciary is very broad and has expanded—beyond formal trusteeship—the uni-verse of persons subject to fiduciary status [Mertens v. Hewitt Assocs., 508 U.S. 248, 262 (1993)]. The Second Circuit has distinguished subsection (i) from (iii) by explaining that (i) is meant to capture those persons who exercise discretionary authority over the plan or its assets irrespective of whether those persons were actually granted authority. Subsection (iii) captures those to whom discretionary authority has been granted regardless of whether such author-ity is ever exercised [Bouboulis v. Transport Workers Union of America, 442 F.3d 55 (2d Cir. 2006)]. Subsection (ii) has required less distinguishing from the other two prongs because (1) regulations exist to give it meaning; and (2) persons implicated are

limited to those involved in activities that relate to plan investments.

Courts apply the so-called functional test to deter-mine whether a person is a fiduciary under ERISA. The functional test is fact-intensive, requiring a deter-mination that the action taken by the person accused of being a fiduciary is a function described in ERISA’s definition of a fiduciary. As one court stated:

[i]n every case charging breach of fiduciary duty…the

threshold question is not whether the actions employed to

provide services under a plan adversely affected a plan ben-

eficiary’s interest, but whether that person was acting as a

fiduciary . . . when taking the action subject to complaint.

[ See Seaway Food Town, Inc. v. Medical Mut. of Ohio,

347 F.3d 610, 617 (6th Cir. 2003), quoting Pegram v.

Herdrich, 530 U.S. 211 (2000).]

DOL regulations have also made it plain that some titles, by their very nature, carry the authority to perform fiduciary functions, and, accordingly, certain positions, by their very nature, carry fiduciary status. [ See DOL Reg. § 2509.75-8, FR-3.] This is consistent with ERISA Section 3(21)(A)(iii), which captures a person’s failure to act when that person has a position of authority with respect to a plan that inherently gives that person discretion to act on behalf of the plan. The titles that fall within this category, how-ever, have been narrow and include the usual suspects: Trustees, Plan Administrators, and Named Fiduciaries. All three of these titles are defined in ERISA, and ERISA gives all these titles what amounts to fiduciary obligations in various provisions.

The Current Regulations The existing regulations set a high bar for who

can be deemed a fiduciary in the investment advice

ERISA LITIGATION UPDATE 69

context and has been in force since 1975 [29 C.F.R. § 2510.3-21(c)]. For persons who do not have discre-tion to effect the sale or purchase of securities or other property for a plan, the current regulations create a five-part test that must be satisfied before a person can be a fiduciary under ERISA Section 3(21)(A)(ii). The regulations provide that a person without investment discretion shall be deemed a fiduciary giving “invest-ment advice” if he/she:

(1) Renders advice as to the value of securities or other

property or makes recommendations as to the advisability

of investing in, purchasing, or selling securities or other

property, (2) on a regular basis, (3) pursuant to a mutual

understanding, written or otherwise, that (4) the advice

will serve as the primary basis for investment decisions

with respect to plan assets, and that (5) the advice will be

individualized based on the particular needs of the plan.

The regulations have not been the topic of a lot of litigation over the years. There are only a handful of cases that apply the regulations. [ See Farm King Supply, Inc. Integrated Profit Sharing Plan & Trust v. Edward D Jones & Co., 884 F.2d 288 (7th Cir. 1989) (court found no fiduciary status applying test); Consolidated Beef Indus. Inc. v. New York Life Ins. Co., 949 F.2d 960, 965 (8th Cir. 1991), cert. denied , 112 S. Ct. 1670 (1992) (applying test, court found that selling product and getting commission was insufficient to make agent a fiduciary); Thomas, Head & Greisen Employees Trust v. Buster, 24 F.3d 1114 (7th Cir.), cert. denied , 115 S. Ct. 935 (1994) (court found no fiduciary status applying test); Damasco & Assocs. 401(k) Profit Sharing Plan v. Manufacturers Life Ins. Co., 1999 WL 672322 (N.D. Cal. Aug. 20, 1999) (applying test, court found that selling prod-uct and getting commission was insufficient to make agent a fiduciary); Ellis v. Rycenga Homes , 484 F. Supp. 2d 694 (S.D. Mich. 2007) (court found fiduciary status applying test).] The existing regulations have worked well and should be left alone.

One force driving the DOL’s desire to revise the cur-rent regulations is that the DOL does not believe that they sufficiently protect participants and beneficiaries from conflicted “consultants that receive compensation from the investment companies whose products they recommend to the plan, which could lead them to steer the plans toward products for which they receive additional compensation” [Preamble to the Proposed Regulation, 75 Fed. Reg. 65,263, 65270 (Oct. 21, 2010)]. The DOL has released three sets of disclosure

regulations recently to address this very concern. [ See 75 Fed. Reg. 64910 (Oct. 20, 2010) (final rule for participant disclosures); 75 Fed. Reg. 41600 (July 16, 2010) (final rule for 408(b)(2) regulation); 72 Fed. Reg. 64710 (Nov. 16, 2007) (final rule for the Form 5500 Schedule C disclosure).] Why mess with the definition of fiduciary? The DOL also notes that the current regulations make it easy for pension consul-tants to “insulate” themselves from being considered a fiduciary simply by arguing that they did not provide advice on a “regular basis,” and that the advice did not serve as the “primary basis” for the investment deci-sion [Preamble to the Proposed Regulation, 75 Fed. Reg. 65,263, 65271]. Moreover, the DOL believes the current regulations have had a “detrimental impact on [its] allocation of resources” because investigators spend too much time trying to establish the elements of the five-part test, “rather than focusing on the pre-cise misconduct at issue in particular cases.” [ Id. ] For these and other reasons, the DOL believes it is appro-priate to update the “investment advice definition to better ensure that persons in fact providing investment advice to plan fiduciaries and/or plan participants and beneficiaries are subject to ERISA’s standards of fidu-ciary conduct.” [ Id. ]

The Proposed Regulations To begin, the proposed regulations expand the types

of advice covered. The current regulations cover advice pertaining to the value of securities or other property or recommendations pertaining to the advisability of investing in, purchasing, or selling securities or other property. The proposed regulations provide that cov-ered advice includes any of the following if provided to a plan, a plan fiduciary, or a plan participant or beneficiary:

• Advice, or an appraisal or fairness opinion, concern-ing the value of securities or other property;

• Recommendations as to the advisability of invest-ing in, purchasing, holding, or selling securities or other property; or

• Advice or recommendations pertaining to the man-agement of securities.

The proposed regulations would cover the following persons who render advice either directly or indirectly through affiliates, if the person:

• Represents or acknowledges that he/she is acting as a fiduciary within the meaning of ERISA;


• Exercises any discretionary authority or control with respect to the management of the plan or disposition of its assets, or has any discretionary authority over the administration of the plan. In other words, a person that is a fiduciary under ERISA Section 3(21)(A)(i) and (ii);

• Is an investment advisor within the meaning of Section 202(a)(11) of the Investment Advisers Act of 1940; or

• Provides advice or makes recommendations: — pursuant to an agreement, arrangement, or

understanding written or otherwise; — that such advice may be considered in connec-

tion with making investment or management decisions with respect to plan assets; and

— that such advice will be individualized.

Gone is the requirement that the agreement, arrangement, or understanding must be mutual or that the “advice” given will serve as a “primary” basis for the investment decision. All that is necessary under the proposed rule is that the advice given may be con-sidered in connection with making an investment or a management decision with respect to plan assets. The proposed regulations leave intact that the advice must be “individualized,” but most of the time, investment discussions will be individualized. The breadth of this proposed rule is hard to overestimate. Under these facts, an informal conversation with a covered person could expose the covered person to fiduciary liabil-ity, if the person receiving the “advice” unilaterally decides that he/she is getting individualized advice that he/she may use to make an investment decision. The person giving advice could be liable even if the person did not know that the person that received the advice might use it to make an investment or manage-ment decision. This is a sure recipe for litigation and a trap for the unwary.

In addition to relaxing the five-part test of the current regulations, the proposed regulations add “appraisal and fairness opinions” to the list of activi-ties that will be deemed investment-related advice, reversing a long-standing DOL position that fair-ness valuations in the ESOP context will not consti-tute investment advice. [ See DOL Advisory Opinion 76-65A.] While the provision applies more broadly than just to valuations in the ESOP context, the oppo-sition to this provision by ESOP valuation firms has been swift and bountiful. [ See http://www.dol.gov/ebsa/regs/cmt-1210-AB32.html.] The new rule would make a new category of persons—those rendering

appraisals and fairness opinions—fiduciaries and expose these persons to fiduciary liability. Although one might think that, absent the new regulations, an appraiser who delivers a sloppy, fraudulent, or incom-plete appraisal will get off scot-free, such is not the case. Professional appraisers are subject to their own standards of professional responsibility and attendant liability for malpractice. ERISA need not and should not provide a remedy for every wrong that harms a plan. There are other causes of action under which a plan, a fiduciary, or participants and beneficiaries can seek redress for a real or perceived harm and obtain relief when warranted. In general, ERISA does not preempt malpractice actions, and that is the proper forum for addressing the types of harm that arise from incompetent professional work. Moreover, if the harm to the plan involves a prohibited transaction, the non-fiduciary party-in-interest can be sued to recover that portion of the transaction that constitutes more than reasonable compensation.

The DOL notes that, since the proposed rule makes some service providers fiduciaries that are not fidu-ciaries under the existing rule, those service provid-ers will modify their “business practices to ensure that they act” in accordance with ERISA’s exacting standards of conduct for fiduciaries [Preamble to the Proposed Regulation, 75 Fed. Reg. 65,263, 65273]. The DOL then asserts that “plans will receive better value for the service fees they pay.” [ Id. ] But, there are always those annoying unintended consequences to overbroad regulations that either are not considered or are considered and intentionally ignored. If the affected service providers decide the exposure to liabil-ity and litigation outweighs any economic gain they just may exit the market entirely (leaving plans unser-viced) or the cost to the plans of these types of service may skyrocket.

There are numerous other points of criticism that can be directed at the proposed regulations. Some industry experts have noted that the proposed regula-tions, if finalized without significant changes, might affect the application of any number of prohibited transaction class exemptions. Prohibited transaction class exemptions are written very narrowly and tai-lored very specifically as to both the covered persons and the described transaction. Any change that affects the status of a service provider in a prohibited transac-tion class exemption might dramatically impact the availability and utility of the exemption. This would then have a chilling effect on those types of service providers and transactions, which may, in turn, harm

ERISA LITIGATION UPDATE 71

the plan’s ability to get the assistance and advice it needs.

Limitations The breadth of the proposed rule is tempered by

limitations that will need careful consideration should the proposed rule become final. My favorite limita-tion allows a service provider, other than a covered service provider that represents that it is a fiduciary for the purpose of providing investment advice, to escape fiduciary status if the service provider tells the recipient of the advice that it is conflicted. This raises an interesting question: Is the goal of the new rule to describe when a person can be a fiduciary or to force early disclosures of potential conflicts? Either way, we will take it. The burden is on the service provider to show that the “recipient of the advice knows or, under the circumstances, reasonably should know, that the person is providing” conflicted advice [Proposed Regulation, 75 Fed. Reg. 65,263, 65277].

Other limitations include:

• The giving of investment education within the meaning of ERISA’s investment education regula-tions. [ See 29 C.F.R. Section 2509.96-1(d).]

• Recordkeepers that offer a platform of investment options, as long as the platform is made available without regard to the individualized needs of the plan.

• Service providers that are fiduciaries under ERISA Section 3(21)(A)(i) and (ii), if all they do is provide general financial information to a plan fiduciary to assist the fiduciary in the selection or monitoring of plan investments.

In both of the last two bullets’ situations, the ser-vice provider must disclose in writing that it is not undertaking to provide impartial investment advice [Proposed Regulation, 75 Fed. Reg. 65,263, 65277].

In the case of a person that values securities and other property for a plan, the valuation will not be deemed giving “advice” or an appraisal or fairness opinion if the information is prepared only for the purpose of compliance with the reporting and disclo-sure requirements of ERISA. If the valuation, however, is used for the purpose of valuing an asset for which there is no generally recognized market and the valu-ation serves as a basis on which a plan may make

distributions, the person making the valuation is back in the fiduciary bucket.

Conclusions This regulation is ill advised. Informally, the DOL

has stated that the proposed rule will be made final with few changes. Hopefully, the DOL will change its mind after it has the opportunity to consider written comments and hear the regulated community testify at the March 1, 2011, hearing scheduled to address this issue. It does appear that there will be an amendment to the existing regulations. The financial community will have to carefully review its operations and revise many well-settled methods of conducting business with ERISA plans, fiduciaries, participants, and ben-eficiaries. Very likely, there will be unintended results. Undoubtedly, some providers will exit the market or stop providing certain services, or continue to provide the services, but raise their fees to compensate for the increased potential risk of liability. One thing seems certain should this rule become final: there will be more parties sued for alleged breaches of fiduciary duties. Even if ultimately the service provider is found not guilty, the cost of defending a fiduciary breach lawsuit is significant and this will do nothing more than increase the costs to run plans. To what end?

So why not just withdraw the 1975 regulations and allow the functional statutory definition of fiduciary to be applied in the factual context of the situation? It may be true, as the DOL states, that the five-part test under the current regulations is not “compelled” by ERISA’s definition of fiduciary. The point of the cur-rent regulations in part was to ensure that the sellers of investment product were not deemed fiduciaries, indeed likely protected from fiduciary status in a safe harbor of sorts. The proposed regulations would radi-cally alter the settled landscape and greatly expand the persons that may be deemed a fiduciary with the attendant potential ERISA liability that position brings.

ERISA simply should not be used to remedy every alleged “wrong” involving an employee benefit plan. The investment advice activity and the sales of invest-ment products and other activities captured under the proposed regulations are regulated elsewhere. Let those regulations continue to be the avenue available to plans to seek redress from an alleged wrong. Leave the current regulatory scheme alone. ■

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Q&As from the Technical Answer Group (TAG)

Target assumption date; Spin-off and applicable interest rate; PBGC, Professional Services Organization,

and deduction limit; Ownership attribution from ESOP; Trusting your nose

In this issue and future issues, we will highlight questions that

have been submitted to the TAG specialists.

F r o m t h e S p e c i a l i s t s a t T A G

TAG—Retirement Plan Answer Group is a technical support service that currently offers answers to pension-related ques-tions. TAG subscribers have access to an array of links to primary source materials, a database of over 4,000 FAQs asked by pen-sion professionals, tools, and current news items. Subscribers also receive an e-mail update daily to keep up-to-date on new developments in the industry. A subscriber can also send TAG an e-mail with a question, and a TAG specialist will respond with an answer within 24 hours. For more information about TAG, go to: http://www.tagdata.com. TAG is part of Wolters Kluwer Law & Business, which also includes CCH, Aspen Publishers, and FTWilliam.com.

Facts For defined benefit (DB) plan funding, the target

assumptions were required to be either the assump-tions for the valuation date or any of the prior four months elected.

Questions and Answers Has this requirement changed effective January 1,

2010? No, the election is available for 2010 (and later) plan

years under Treas. Reg. Section 1.430(h)(2)-1(e)(2).

Facts A DB plan used applicable interest rate for the prior

December to determine lump sum payments for the following plan year. A portion of the plan was spun off in July to create a new plan. The new spin-off plan document references the use of the interest rates in effect for the preceding November to determine lump sum payments.

Questions and Answers Can the new spin-off plan simply use the rates from the

prior November (pursuant to its plan document) for pay-ments for the first short plan year (July 1–December 31)? Is there a Code Section 411(d)(6) issue if the spin-off plan does not make payments for the one year period ending on June 30, 2011, using the rate in effect for either the prior November or December, whichever is more favorable to the participants? For example, if the December rate produces a larger distribution than the November rate, must the spin-off plan use the December rate for a participant through June 30, 2011?

Yes, the rule to which you refer applies. If the December rate produces a larger distribution than the November rate, the spin-off plan must use the December rate for a participant through June 30, 2011 [Treas. Reg. § 1.417(e)-1(d)(10)(ii)].

Facts I have a mechanical engineering company with

fewer than 25 employees looking to establish a Cash Balance Offset Plan.

Questions and Answers How do I determine if this is a Professional Services

Organization? If it is, it is my understanding that it would not be

covered by the PBGC because there are fewer than 25 employees. Correct?

If this is the case, it is my understanding that they would be limited to a contribution of six percent in the Profit Sharing Plan. Correct?

If they are subject to the PBGC, then my under-standing is that the PS plan contribution may be as

Q&AS FROM THE TECHNICAL ANSWER GROUP (TAG) 73

high as 25 percent without impacting the cash balance maximum contribution. Correct?

1. How do I determine if this is a Professional Services Organization?

Under ERISA Section 4021(c)(2)(B), a professional service employer is any entity owned or controlled by profes-sional individuals where both the entity and the professionals controlling it are engaged in the performance of the same pro-fessional service. ERISA specifically considers “professional individuals” to include physicians, dentists, chiropractors, osteopaths, optometrists, other licensed health practitioners, attorneys, public accountants, public engineers, architects, draftsmen, actuaries, psychologists, social or physical scien-tists, and performing artists. This is not an exclusive list. An individual is considered to be a professional individual if they provide services that require knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized instruction. Opticians, food brokers, artist-designers, real estate brokers, insurance agents, funeral directors, advertising and public relations firms, foresters, and riverboat pilots are not considered professional service employers.

2. If it is, it is my understanding that it would not be covered by the PBGC because there are less than 25 employees. Correct?

That is correct. 3. If this is the case, it is my understanding that

they would be limited to a contribution of six percent in the Profit Sharing Plan. Correct?

Professional service organizations not covered by the PBGC are subject to the 25 percent combined deduction limit of Code Section 404(a)(7) unless employer contribu-tions to the DC plan are limited to six percent of eligible compensation. To the extent the total contributions to the two plans do not exceed 25 percent of eligible compensation, the contribution to the Profit Sharing Plan is not limited to six percent.

4. If they are subject to the PBGC, then my under-standing is that the PS plan contribution may be as high as 25 percent without impacting the Cash Balance maximum contribution.

That is correct. The combined plan limitation does not apply if the DB plan is covered by the PBGC [IRC § 404(a)(7)(C)(iv)].

Facts I have recently been asked to work on a plan with

an unusual pattern of amendments. At the beginning of each year, the plan has been amended to freeze accruals. At the end of the year, when the employer is comfortable that they have the financial resources for

the funding, the plan is again amended to reinstate the accruals retroactively to the beginning of the year. Each of the amendments has a Code Section 412(d)(2) election so that it can be recognized in the funding for the year. The plan is well enough funded that Code Section 436 is not a barrier to the amendment. The formula is not discriminatory, and no participant is losing accruals as a result of the series of amendments. Still, this does not smell right to me.

Questions and Answers Other than not passing my smell test, can you

guide me to concrete IRS guidance that I can provide to the TPA to explain that this pattern is not a good idea? Or, in the alternative, is it okay, and I am need-lessly concerned?

Trust your nose. The issue is the AFTAP certification. An amendment to unfreeze benefits will require a new AFTAP certification for the plan year after the amendment is adopted. If the actuary does not certify the (new) AFTAP by October 1 of the plan year, the presumed AFTAP for the year is less than 60 percent, retroactive to the first day of the plan year. The preamble to the final regulations provides that this will either result in a plan document violation or a violation of Code Section 436, either of which could result in plan disqualification.

Facts Company A and Company B were owned 50/50 by

the same two individuals, forming a controlled group. Company A has a 401(k) plan. Company B establishes a 100 percent ESOP and no longer forms a controlled group with Company A. Both plans recognize service with the other company for eligibility and vesting. When a participant terminates from Company A and moves to Company B, the client would like to transfer the individual participant accounts by source (deferral and match) from the Company A plan to the Company B plan (or vice versa). The employer would like the participant to continue to accrue vesting in both companies; they do not want the nonvested money forfeited.

Questions and Answers Is this allowed if Company A and Company B do

not form a controlled group? If we do not consider this to be a controlled group because

the ESOP owns Company B, the client does not own Company B. I do not see any basis for your client to move the account of a Company A participant to the Company B plan. However, Code Section 414(b) provides that for


qualified plan purposes, controlled group status is deter-mined under Code Section 1563, except that Code Section 1563(e)(3)(C) is ignored. Code Section 1563(e)(3) provides for attribution from trusts. Code Section 1563(e)(3)(C) pro-vides that Code Section 1563(e)(3) does not apply to stock

owned by a qualified plan under Code Section 401(a). So, for purposes of Code Section 414(b), ownership attribution applies to stock owned by a qualified plan trust. Therefore, Companies A and B are a controlled group, which means the transfer is allowed. ■

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Business Best Practices

SWOT Analysis: The Annual Check-Up for a Business As individuals, we recognize the importance of scheduling an appointment for an annual

physician’s check-up to protect our health. Similarly, successful business owners and

managers understand the importance of scheduling an annual SWOT (Strengths, Weaknesses,

Opportunities, and Threats) analysis to ensure optimum business health.

B y S a r a h L . S i m o n e a u x a n d C h r i s L . S t r o u d

Sarah L. Simoneaux, CPC, and Chris L. Stroud, MSPA, MAAA, EA, provide consulting services to third party admin-istrators and financial institutions through Simoneaux & Stroud Consulting Services. The firm specializes in strategic business planning, general consulting, industry research, customized brain-storming sessions, and professional development workshops and Webcasts for the retirement services industry. They are both past presidents of ASPPA.

A SWOT analysis is an important aspect of strategic business planning and should always be performed in conjunction with the

initial creation of a company’s business plan. On an ongoing basis, performing an annual SWOT review to update the business plan ensures that the business plan will remain a living, breathing document that the firm and the employees can follow.

The information learned through the analysis creates the business plan’s goals, objectives, and strategies. A company-wide SWOT analysis should be performed at least once a year. A more limited SWOT analysis can be conducted as needed to tar-get a single business unit or a specific item, like the potential launch of a new product or consider-ation of an acquisition. One of the key advantages of the SWOT process is that it promotes proac-tive thinking and planning rather than reactive decision-making.

The SWOT Framework In today’s retirement services industry, change is

the only constant. The SWOT analysis is an effec-tive tool for managing change, determining strategic direction, and setting realistic goals and objectives. The analysis requires a comprehensive environmental

scan—a look “in the mirror” (internal) and “out the door” ( external)—paying particular attention to key factors that determine a successful retirement services business. The SWOT analysis allows a company to assess where it is today and where it wants to go, which are integral components of a living, breathing business plan. Once the current position is defined, milestones can be set to help get the company to where it needs to be.

Before diving into the details, review the vision, mission, and values statements of the company described in the business plan. These timeless state-ments serve as a moral compass to help guide com-pany decisions and direction and to keep the SWOT process from veering off-track. For example, the goals and objectives of a firm valuing price and effi-ciency (the “Wal-Mart” model) will be different from one who values consultative customer service (the “Nordstrom’s” model).

Key Factors to Consider The key factors to be considered can vary depend-

ing on the type of company and its primary focus. For most businesses in the retirement services indus-try, the following areas are worthy of review and evaluation:

• Corporate culture • Management team • Depth of staff • Experience/knowledge level of staff • Operational efficiency • Utilization of technology • Ability to innovate • Quality of work • Customer service • Cost/benefit of products and services • Marketing and distribution channels


• Sales • Financial stability • Reputation • Client base

You can start identifying strengths and weak-nesses at a high level by looking at each of the factors listed above, adding or deleting categories as desired. Assign a rating for your firm in each area (i.e., excel-lent, good, needs improvement). Then drill down into details for each item and look at specific strengths and weaknesses related to each topic.

Strengths and Weaknesses The “internal” review to determine strengths and

weaknesses consists of an honest assessment of the company’s structure, capabilities, resources, and skills. Just like many of us don’t like to see ourselves in pho-tographs, we don’t always like what we see when we do an in-depth look into our own company. However, when it comes to a company’s self-analysis, it is nec-essary to identify the good, the bad, and the ugly. Ideally, the internal review will be conducted with a 360 degree concept—considering viewpoints from employees, outside consultants or advisors, customers, and also factoring in how the company measures up against its competitors.

The strengths should identify positive charac-teristics that give the business a competitive edge. Weaknesses are areas that can put the firm at a dis-advantage if they are not corrected. The goal is to maintain and leverage strengths in ways to benefit the company and to determine which weaknesses need to be remedied in order to improve the company’s position.

In some firms, a characteristic may represent a strength in one case and a weakness in another. For example, having a large number of older, more expe-rienced (Baby Boomer) employees can be a strength when it comes to work quality and knowledge level; however, if it also signifies a lack of younger employ-ees (Gen Y), the company might have a weakness rela-tive to innovation and utilization of new technologies.

Opportunities and Threats An external review should be conducted to identify

opportunities and threats, which are typically created by “external” forces. They can be attributed to such things as political climate, economic shifts, laws and regulations, technology, industry trends, target mar-kets, distribution channels, competition, etc. A critical

part of the external environmental scan is to identify and recognize not just the current opportunities and threats but also potential future considerations.

Opportunities typically represent areas in which the company could grow or increase profitability or efficiency. Threats are typically comprised of external forces that could cause significant stress or economic downturn to a business.

Since a company can only handle a finite number of initiatives at any one time, it is extremely impor-tant to prioritize opportunities and threats in order to determine the most critical strategies for success.

The SWOT Process By following these simple steps, a company can

conduct a very efficient SWOT analysis meeting.

Step 1: Select a Facilitator The facilitator can be someone who works at the

company (typically a high level manager) or an outside consultant. Although additional costs are involved when utilizing an outside consultant, the advantages often outweigh the cost. A consultant is more willing to address tough issues and can offer a more objective opinion about many issues. Also, employees are often more willing to speak their mind when talking to an external facilitator instead of talking directly to a superior.

Step 2: Create a SWOT Team Don’t worry—no need for weapons with this

SWOT team! Simply assemble a group of employees, representing different business units and job functions. Teams are typically at least five people and can be as large as the entire company.

Step 3: Select the Venue for the SWOT Analysis The SWOT analysis can be conducted in an open

meeting environment if the team selected is a rela-tively small group. If most or all of the employees are participating, then an off-site company retreat is ideal. A brainstorming session environment is also very effective, where a larger team can be broken down into smaller teams for “brainstorming” and then reas-sembled for analysis and prioritization.

Step 4: Assemble the Tools At a minimum, a number of flip charts (with adhe-

sive on backs of each page), markers, and easels are needed. Each smaller group (if breaking into multiple groups) should have at least one flip chart and easel.

BUSINESS BEST PRACTICES 77

Step 5: Perform the Environmental Scan Utilize the SWOT Framework to identify

Strengths, Weaknesses, Opportunities, and Threats and document the lists of each on the flipcharts. Some firms also choose to analyze several of their primary competitors using the SWOT technique to determine how the firm stacks up against the competition.

Step 6: Summarize As the meeting progresses, flip charts can be stuck

to the walls and moved around the room as needed

to facilitate summarization of ideas from multiple groups. Look for common themes and summarize the items into a more refined list.

Step 7: Analyze and Prioritize The analysis can often be as simple as “matchmak-

ing” Strengths and Weaknesses with Opportunities and Threats. Separate the strengths into two groups—those that can help the firm capitalize on opportuni-ties and those that can help you counter potential threats. Similarly, you can divide the weaknesses into two groups—those that require improvements to

Figure 3. “Matchmaking” Strategies Matrix ExampleStrengths (S) Weaknesses (W)

Opportunities (O) Consider acquisition of local TPA operation. (Local TPA operation being sold by CPA.) Take advantage of extra capacity (experienced workers/excellent skill levels and straight-thru-processing) to handle increased workload.

(No proactive marketing efforts/large national service provider moving local admin/RK to home office.) Develop proactive marketing outreach to plan sponsors in local area currently serviced by large national service provider.

Threats (T) Develop communication strategies to tout strengths/benefits (excellent reputation) to customers so they appreciate value and are not as susceptible to low cost vendors (low cost providers may undercut).

(Lack of open architecture solution/plan sponsors seeking open architecture solution.)Partner with open architecture daily valuation TPA to offer open architecture platform.

Figure 1. Excerpt: Initial SWOT Summary MatrixStrengths (S) Weaknesses (W) Opportunities (O) Threats (T)Experienced workers with excellent skill levels

Older workforce not as technologically advanced

Local CPA looking to sell TPA operation (doesn’t have enough employees to support)

Outside firm may buy local competitor and ramp up marketing efforts in our region

Excellent reputation with customers

No proactive marketing efforts

Large national service provider is moving local administration/recordkeeping to home office

Low-cost providers may undercut our prices

Straight-thru-processing capability

No open architecture platform

Fee disclosure may cause plan sponsors to review existing TPA relationships

Plan sponsors may seek open architecture platforms

Figure 2. SWOT Strategies MatrixStrengths (S) Weaknesses (W)

Opportunities (O) S/O strategies W/O strategies

Threats (T) S/T strategies W/T strategies


allow you to take advantage of opportunities and those that should be addressed quickly in order to avoid immediate or potential threats.

Lastly, narrow down the lists. Identify the priorities and create strategies that will incorporate what has been learned from the SWOT analysis. The SWOT strategies matrix can be used to document the strate-gies that were identified during the “matchmaking” process of the SWOT analysis.

As strategies are solidified, goals and objectives to carry out each strategy will need to be developed.

The Outcome Just having a list of things you are good at is not

enough. The SWOT process forces you to focus and capitalize on the firm’s strengths that are most valued by customers. You will also be better able to articulate your firm’s core competencies after going through the

SWOT exercise, which can help you in marketing and communication efforts.

A successful SWOT analysis will help you recognize areas where your capabilities and resources are strong and your potential to capitalize on opportunities is the greatest. Of course, you will need to factor in your company’s financial strength and corporate culture before undertaking any new strategy.

Most importantly, involve your employees! If you fail to communicate the goals and objectives that arise from the SWOT analysis, the employees will be working in the dark. Set aside a half day for a structured brain-storming session specifically focused on the results of the SWOT exercise. Ask for staff input on development of new goals to fulfill the strategies and ask how they can help get you there. The employees are the engine that drives the train of your business, and they are an essential part of implementing SWOT strategies. ■

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C O L U M N

Plan Audits

Audit 101: A Guide to Employee Benefit Plan Audits Selecting the Right Auditor

Financial statement audits of employee benefit plans represent a critical portion of the many audits

performed by Certified Public Accountants (CPAs) each year. Over the next year, our Audit 101 series

will provide guidance for retirement plan practitioners who must either select an audit firm for their pension,

health and welfare, 401(k) and 403(b) plans, or assist their clients in selecting an audit firm.

We will also introduce readers to the planning and fieldwork phases of the audit

as well as discuss audit review procedures and related audit communications.

B y C h r i s t o p h e r E . E t h e r i d g e

Christopher E. Etheridge is a partner in the CPA firm of Frazier & Deeter, LLC where he heads up the firm’s employee benefit plan audit practice. Chris is his firm’s representative on the AICPA Employee Benefit Plan Audit Quality Center, and he is a member of the Georgia Society of CPAs Peer Review Committee.

Generally, benefit plans with 100 or more participants at the beginning of the plan year are required to have an audit performed

annually in conjunction with the filing of their Form 5500. In accordance with the Employee Retirement Income Security Act of 1974 (ERISA) and the Department of Labor (DOL) requirements, the plan administrator has the task of hiring an independent qualified public accountant (IQPA) and ensuring the plan has obtained a quality audit. The DOL, thru ERISA, holds plan sponsors responsible to ensure that plan financial statements are properly audited in accordance with generally accepted auditing standards (GAAS), the framework under which auditors exercise their professional responsibility. This responsibility represents a significant risk to plan sponsors and due care should be exercised during the selection process. High priority should be given to the selection of the plan auditor.

Unfortunately, many of the audits performed on employee benefit plans are deficient. Plan sponsors need to know that their IQPA is actually qualified to perform this type of work. Since 1992, the DOL has performed multiple studies to assess the quality of audit work performed by IQPAs with respect to

financial statement audits of employee benefit plans covered by ERISA. The DOL reviewed the audit programs and working papers for various accounting firms to determine compliance with established audit and accounting standards. The results of these studies have not been favorable. As a result of the findings, the DOL has referred hundreds of practitioners to the American Institute of Certified Public Accountants (AICPA) Professional Ethics Division and/or the State Boards of Accountancy for potential disciplinary action due to deficient work.

During the reviews, the DOL identified certain fac-tors that it believes contribute to whether employee benefit plan audits comply with professional stan-dards and GAAS. The professional auditing standards are typically viewed as the minimum guidelines or requirements for the performance of an audit engage-ment. The factors the DOL identified include:

• The size of the CPA firm performing the engagement;

• The adequacy of technical training and knowledge on the part of the IQPAs conducting plan audits;

• Awareness of the IQPAs of the uniqueness of plan audits;

• Whether IQPAs have established adequate quality review and internal process controls; and

• The extent of audit work performed by the IQPA.

The AICPA launched the Employee Benefit Plan Audit Quality Center (EBAQC), a firm-based voluntary membership center for firms that audit employee benefit plans. This center was established to


help CPAs meet the challenges of performing quality audits in this unique and complex area. This includes making available to its members various practice aids and tools, discussion forums, training seminars, Webcasts, and Webinars that otherwise would not be available to many firms. Additionally, the DOL has provided a resource entitled, Selecting an Auditor for Your Employee Benefit Plan. This can be obtained via the DOL Web site and can be helpful in the selec-tion process [http://www.dol.gov/ebsa/publications/ selectinganauditor.html].

The following are questions to ask a current or pro-spective employee benefit plan audit firm to ensure that the firm is a quality audit firm.

Is the firm a member of the AICPA EBAQC and to what other professional organizations does it belong? Compliance with rigorous standards and practices specific to employee benefit plan audits, including establishing a program to ensure that all ERISA employee benefit plan audit personnel possess knowledge of such standards and practices, is central to the EBAQC. There are also national affiliations of independent accounting firms formed specifically to act as forums to share technical resources. A good firm will have established professional relationships with attorneys, actuaries, and consultants, within their local benefits community and nationally.

What percent of the audit practice is comprised of employee benefit plan work? It is helpful to know how much experience the firm has in auditing employee benefit plans and how many plan audits they have performed in the last two to three years. One of the most common reasons for deficient plan audits is the failure of the auditor to perform tests in areas unique to employee benefit plan audits. The more training and experience that an auditor has with ben-efit plans, the more familiar the auditor will be with plan practices and operations, as well as the special auditing standards and rules that apply to such plans. Consider an audit firm that views employee benefit plan audits as a core industry and not as “summer work.” It should be treated as a core industry with regards to both practice management and scheduling decisions.

What is the size of the audit firm? The DOL noted a correlation between the size of an IQPA and the probability of audit deficiencies. Most notably, firms with 20 or fewer employees were responsible for almost two-thirds of the deficient audits reviewed. Many firms utilize their staff as both tax and audit professionals, meaning the staff perform tax work

during tax season and then perform employee benefit plan audits during the summer. A good firm will have professionals whose sole focus is on audit matters and audit standards. An even better firm will have audit professionals specifically devoted to employee benefit plan audits.

Does the firm have a dedicated employee benefit plan department and is there a specific employee benefit group audit team within the organization? A good firm should have some full-time employee benefit plan specialists. When a firm has invested resources in full-time, dedicated employee benefit plan quality control specialists, their clients’ needs are better served.

Have the firm’s plan audits undergone an AICPA peer review or review by the Public Company Accounting Oversight Board (PCAOB) or the Department of Labor? Peer reviews are done to assess professional competence and audit quality. Firms belonging to the AICPA are required to have their practice reviewed by an outside CPA firm every three years. The plan sponsor should also inquire as to how many employee benefit plan audits were selected in the review process and the outcome of the reviews. Ask to see the Peer Review report letter and see if the firm received a rating of “pass.” Firms that audit pub-lic companies that file a Form 11-K with the SEC are subject to inspection by the PCAOB. Ask to see the public portion of that report. Finally, the DOL may perform various levels of review of plan audit work-papers. Ask to see the results of such reviews or if they received a clean “no change” letter.

Does the firm have in-house ERISA expertise to assist in resolving operational, demographic, and plan document issues, or do individuals out-side of the group have to be consulted? Employee benefit plan teams should have experience with quali-fied plans, welfare benefit plans, and 403(b) plans. This experience is evidenced by a solid understand-ing of ERISA, DOL, and IRS compliance require-ments including, but not limited to, correction of plan defects and reporting and disclosure. Having this expertise in-house can assist in the timely reso-lution of any operational, demographic, and/or plan document issues encountered during an audit. This industry specific knowledge allows the auditors to effectively and efficiently work with the plan’s other service providers to assist the client in resolving any plan related issues.

How thorough is the firm’s training program, and how does the firm keep current with changes

PLAN AUDITS 81

in laws and regulations? One of the basic tenets of GAAS requires that IQPAs possess adequate technical competence to complete the engagement. Every certi-fied public accountant must receive a certain amount of continuing education hours each year to maintain their professional license. Audit teams should be receiving intensive training each year, including spe-cialized training for audits of employee benefit plans. This training should also include education related to legislative changes and current events in the employee benefits industry. The firm’s service team professionals should be constantly monitoring new auditing stan-dards and legislative changes.

What are the firm’s internal processes used for quality assurance? The accounting and audit-ing practice for every firm should be governed by a Quality Control Document (QCD). This document states the guidelines governing a firm’s practice on a day-to-day basis. A good firm will have a section of the QCD specifically related to the audits of employee benefit plans. This section should state who is respon-sible for the quality control of employee benefit plan audits, specify continuing education requirements for the plan audit team members, and designate the firm leaders for the employee benefit plan practice. We recommend that all audits be reviewed by the engagement partner and an independent quality con-trol reviewer prior to issuance. It is important that the independent quality control reviewer specialize in employee benefit plan audits. The DOL notes that firms that performed grossly deficient work had not implemented an adequate system of internal quality control.

What are the key areas of the firm’s audit work and what will be examined during the audit? Frequently, audits are found to be deficient because of the failure of the auditor to conduct tests in areas

unique to employee benefit plans. The most common reason for an IQPA to have failed a given audit area was that the IQPA did no work or substantially no work in that area. Audit areas related to participant data, plan obligations, participant loans, benefit pay-ments, and party-in-interest/prohibited transactions are unique to employee benefit plans and are the areas where most audit failures occur. An auditor with limited employee benefit plan experience might not be aware of the significance of these areas to the plan audit. Accordingly, plan sponsors should make sure that the auditor considers the following areas:

• Whether plan assets covered by the audit have been fairly valued;

• Whether plan obligations are properly stated and described;

• Whether contributions to the plan were timely received;

• Whether benefit payments were made in accor-dance with plan terms;

• If applicable, whether participant accounts are fairly stated;

• Whether participant loans were made in accor-dance with plan terms;

• Whether issues were identified that may impact the plan’s tax status; and

• Whether any transactions prohibited under ERISA were properly identified.

In summary, it is the plan sponsor’s fiduciary duty to ensure that a quality audit is performed and that the annual report of the plan is complete and accurate. These inquiries directed to the current or prospective IQPA should assist the plan sponsor in making sure that they have chosen the correct plan auditor for the audit(s) of their employee benefit plan(s). ■

Publication Policies andGuidelines for Authors

Manuscripts submitted for publication and inquiries about the suitability of a manuscript should be addressed to:

Journal of Pension BenefitsIlene H. FerenczyThe Law Offices of Ilene H. Ferenczy2200 Century Parkway, Suite 560Atlanta, GA 30345404-320-1100 x100Fax: 404-320-1105Email: [email protected]

For business and production matters, contact:

Amy Burke, EditorJournal of Pension BenefitsAspen Publishers76 Ninth Avenue7th FloorNew York, NY 10011212-771-0831Email: [email protected]

Editorial Calendar for Journal of Pension Benefits:

Journal of Pension Benefits is published quarterly and accepts only by-lined feature articles. Manuscript is due by the following dates:

No. 1 Autumn Issue: June 1No. 2 Winter Issue: September 1No. 3 Spring Issue: December 1No. 4 Summer Issue: March 1

The Journal of Pension Benefits publishes articles that contribute to professional practice and substantive information in the area of pension benefits planning, administration, design, funding, and compliance. Our readers include pension plan administrators and executives, benefits managers and executives, and financial and legal managers and execu-tives. The Journal encourages submissions of manuscripts from experts in the field.

The Journal emphasizes quality and clarity of exposition. Reviewers consider the following criteria in assessing potential contributions: the value of the information to the Journal’s audience, the substantive con-tribution to the broadly defined field of pension benefits management, and the overall quality of the manuscript. The decision to publish a given manuscript is made by the editors, relying on the recommenda-tions of reviewers.

Submission of a manuscript clearly implies commitment to publish in the Journal. Previously published papers and papers under review by other journals are unacceptable except in very rare cases. Articles adapted from book-length works in progress will be considered for prior publica-tion with attention given to the necessary copyright arrangements.

Manuscript Specifications. Manuscripts submitted for consideration generally should not exceed 20 typewritten pages. Do not use your computer’s automatic footnote insert option. Citations should be placed in brackets, positioned where a footnote superscript would normally be placed. All citations must be complete. Improperly prepared manuscript will be returned to the authors for repreparation.

Authors should include a 25–50 word abstract at the beginning of the article and provide a brief biographical statement. Articles should be submitted without special formatting. Quoted material should be indented and set off from regular text.

Within the article, use headings and subheadings to break up text and emphasize points; type them flush left. Contributors should attach a cover sheet giving title, author’s name as it should appear in print, company affiliation, and author’s title or position description, current mailing address, fax number, and telephone number. To ensure anonym-ity in the review of manuscripts, the first page of the text should show only the title of the manuscript at the top of the page.

Exhibits. All exhibits (graphs/figures/art) should be provided as either TIFF or EPS files, grayscale with at least 300 dpi. If possible, values for all exhibits should be provided, i.e., the original Excel file. Exhibits embedded in Word are unusable.

Each exhibit should be positioned on a separate page at the end of the article. The point of insertion of the exhibit should be indicated at the proper place in text (e.g., “Exhibit 2 about here”). Include cross-references in the text for each exhibit used.

Acceptance. Copyright will be retained by the publisher, and articles are subject to editorial revision. There is no payment for articles; authors will receive three copies of the issue in which the article is pub-lished. Manuscripts not accepted for publication will not be returned. Authors are advised to keep the original copies of their manuscripts for their files. Manuscripts submitted for publication and inquiries about the suitability of a manuscript should be addressed to Ilene H. Ferenczy at [email protected].

Reprints. For article reprints and reprint quotes contact Wright’s Media at 1-877-652-5295.

FEATURE ARTICLES Volume 18 • Number 3 - Wolters Kluwer

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