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401(k) Fee Disclosure Deadlines Extended Three Months; Other Changes Made in Final Regulations Under ERISA 408(b)(2)

On February 2, 2012 the Department of Labor issued a final rule under ERISA Section 408(b)(2), governing disclosures that plan service providers must make to plan fiduciaries to allow them to confirm that the providers receive only “reasonable” amounts of compensation from plan assets in exchange for their services. The types of providers affected include Registered Investment Advisors, certain broker-dealers, third party administrators, and other service providers receiving $1,000 or more in direct or indirect compensation from plan assets. The rule extends the deadline for the initial disclosure three months, from April 1, 2012 to July 1, 2012.

The plan-level fee disclosure rules originally issued in July 2010 with a one-year deadline for implementation deadline, but that deadline was extended to April 1, 2012 last July. This is probably the last such extension (though anything is possible in an election year).

There is no prescribed manner of providing the required disclosures other than that it is in writing. Because compensation information may be conveyed through multiple or complex documents, the final rule includes a placeholder for rules on a “guide or similar tool” that would help fiduciaries locate information in disparate sources. An appendix to the final rule also includes a Sample Guide to get service providers working towards a disclosure roadmap.

Another significant change in the final rule is that it carves out, from plans that are covered by the disclosure rule, “pre-2009” 403(b) annuity contracts or custodial accounts that meet all the requirements set forth in DOL Field Assistance Bulletins 2009-02 and 2010-1 providing limited relief from Form 5500 reporting duties. More information on how to identify a pre-2009 contract or account is found in the FABs.

Failure to comply with the fee disclosure requirements constitutes a prohibited transaction (PT) for the responsible fiduciary, whereas compliance qualifies the fiduciary for a PT exemption. The final rule changes one of the conditions for the PT exemption when a service provider has failed to provide compensation information and also has not responded to the fiduciary’s written request for the information within 90 days. If the information relates to futures services and is not disclosed promptly after the 90-day period, the final rule requires the fiduciary to terminate the service arrangement “as expeditiously as possible.”

The final rule cuts service providers some slack, however, allowing them to provide “reasonable and good faith estimates” of compensation or cost amounts that are difficult to itemize, so long as the service provider explains the methods and assumptions it used to arrive at the estimate.

Additionally, disclosures of indirect compensation paid by third parties to the service provider must be accompanied by a description of the arrangement between the service provider and the third party pursuant to whom the payments are made.

The three-month extension of the plan-level fee disclosure rule triggers an equal extension of the participant-level fee disclosure rules under ERISA Section 404(a)(2). Technically plan sponsors (employers) must make these disclosures to plan participants, but for practical purposes institutional investment providers will provide most of the content. The deadline to distribute the initial written disclosure has moved from May 31, 2012 to August 30, 2012, and the deadline to distribute the first quarterly statement under the rule has moved from August 14, 2012 to November 14, 2012.

Treasury Department Issues Guidance Easing Access to Lifetime Payout Options

On February 2, 2012 the Treasury Department issued guidance aimed at easing employee access to lifetime payout options from 401(k) and other defined contribution plans (IRAs and IRA-based arrangements are exempt) A link to the related fact sheet is here, and proposed regulations and a Treasury/IRS ruling will follow with more details. (An advance copy of the proposed regulation is available here.)

The Department’s fact sheet outlines the reason for the initiative – the “longevity risk” that results from increased life spans and the prevalence of lump-sum retirement plan distributions in the post-defined benefit plan era. Through a request for public comments, the Department gathered data and studied ways in which current provisions of the Internal Revenue Code discourage plan participants from choosing life annuity and other incremental payout options. The guidance package outlines both the regulatory barriers that they identified, and their proposals to make lifetime income options more accessible and popular among plan participants. The proposed changes are as follows:

1) To correct the “all or nothing” choice between a lump sum or an annuity payout, proposed regulations will simplify the manner of calculating a distribution that is part lump sum, part annuity, so that plans are more likely to offer this blended form of distribution;
2) To address retirees’ fears of outliving required minimum distribution payments that generally must begin at age 70 ½, proposed regulations would allow use of up to 25% of an IRA or 401(k) account balance (or $100,000, if less) to purchase a “longevity annuity” that will begin payment by age 85.
3) To expand access to cost-effective annuity forms of payout under the relatively few remaining defined benefit pension plan, a Treasury/IRS ruling will explain permit full or partial rollovers from a 401(k) plan, to a defined benefit pension plan sponsored by the same employer, in exchange for an immediate annuity from that plan.
4) To aid employers and third party administrators who are unsure of how spousal consent rules work in relation to deferred annuities, including longevity annuities, a Treasury/IRS ruling will identify plan and annuity terms that will automatically protect spousal rights without requiring spousal consent before the annuity begins, shifting the spousal consent compliance to the insurer issuing the annuity. (Many if not most 401(k) plans have opted out of rules requiring spousal consent under ERISA, however many investment providers in community property states require spousal consent to any loans or distributions.)

COLA Increases Raise 2012 Contribution Limits

A 3.6% Social Security cost of living increase for 2012 has triggered increases in annual contribution and other dollar limits affecting 401(k) and other retirement plans, the Internal Revenue Service announced on October 20, 2011. These dollar limits were static from 2009 through 2011 due to the floundering economy. Here are some of the key changes (citations are to the Internal Revenue Code):

–Salary Deferral Limit for 401(k), 403(b), and 457 plans increases from $16,500 to $17,000. (The age 50 and up catch-up limit remains unchanged at $5,500, however.)

–Maximum total contribution to a 401(k) or other “defined contribution” plans under 415(c) increased from $49,000 to $50,000 ($55,500 for employees aged 50 and older).

–Maximum amount of compensation on which contributions may be based under 401(1)(17) increased from $245,000 to $250,000.

–Compensation threshold for “highly compensated employee” increased from $110,000 to $115,000.

–Dollar limit defining “key employee” in a top-heavy plan increased from $160,000 to $165,000.

–Maximum annual benefit under a defined benefit plan increased from $195,000 to $200,000.

–Social Security Taxable Wage Base increased from $106,800 to $110,100.

–IRA contribution and catch-up limits remain $5,000 and $1,000, respectively.

Your 401(k) Plan’s Online Report Card — and What to do About It

Since 2009, a company called Brightscope has been compiling data on plan assets from retirement plan tax returns (Form 5500s) and providing on-line “scores” on plan investment performance, as measured against industry peers. I am surprised how often clients and even colleagues in the benefits world are unaware that this data is publicly available, and not just for larger ($10 million + in assets) retirement plans.

That is because, in addition to “scoring” retirement plan investment performance (including the impact of administrative and investment expenses), Brightscope translates poor investment performance into what it “costs” a hypothetical plan participant, in real dollar terms.

So, for instance, the Brightscope rating for a plan with a performance score of “60” as measured against its top-rated industry peer’s score of 84 will also state that this 24-point lag in scoring will “cost the average 401(k) plan participant” an additional 10 years of work, and up to $67,000 in lost retirement savings. Brightscope separately explains its statistical methodology, which assumes an “average participant” who is a 44-year-old, gender-neutral individual, earning an income of $44,000 a year, with a starting account balance of $40,000. However readers have to dig a bit for this information, and in the mean time the initial negative impact the numbers could make on a plan participant is considerable.

Brightscope also invites those “average 401(k) plan participants” who are not happy about their plan’s performance to “Help Improve this Plan” (by contacting the employer and other participants) and “Track this Plan” (by receiving updated plan performance data). It also provides a summary of participants’ legal rights under ERISA.

Needless to say, Brightscope is packaging information in a way that invites employees to challenge employers about plan investment performance, fees, and plan design. This is a timely development given the Department of Labor’s current (long-overdue) focus on fee disclosure regulations at both the plan- and participant-level. In fact some of the information Brightscope shares has always been required to be communicated to employees annually under existing Department of Labor regulations, in the form of a Summary Annual Report (SAR). Obviously, Brightscope is a boon to employers whose plans are at or near the top score for their respective industry. But what does it mean for employers whose plans are at the other end of the spectrum? If handled properly, a low Brightscope rating does not have to be an employee-relations disaster.

First, I recommend that clients periodically check their plan’s information on Brightscope. Originally only larger plans with $10 million in assets or more were rated, but Brightscope is adding ratings on smaller plans every day. (And for smaller plans without a rating, Brightscope conveniently summarizes information from the plan’s latest Form 5500 data, including beginning- and end-of-year plan asset totals, and responses to questions about fiduciary breaches.)

Second, employers can challenge the methods by which Brightscope derives its ratings (by following prcedures described in the FAQ) and this is appropriate to correct an obvious error in plan data. Absent that, however, I don’t think it is helpful for an employer with a low rating to go on the defensive this way. It is better for the employer to confront the low score head-on, share their Brightscope rating with their investment advisor, and take steps to address the source problem, which may be higher than average costs/fees, low-performing mutual funds, or both. It won’t be possible to immediately close a 20-point gap in scoring, but it is possible to answer complaints on the current score by saying that the company is aware of it and is taking steps to improve the situation.

For more information about how Brightscope came about, other ventures its founders are working on, and its perception in the retirement plan industry, I recommend this New York Times article.

IRS Questionnaire Sent to College, University Plans Does Not Put Plans “Under Examination” but EPCRS Availability Remains Unclear

The IRS Employee Plans Compliance Unit (“EPCU”) is in the process of sending over 300 written questionnaires to a random sample of small, medium, and large institutes of higher education, including private and public colleges, universities, and trade and vocational schools. The questionnaire – on IRS Form 886-A – contains 18 separate questions but mainly focuses on one issue: whether the organization’s Section 403(b) plan satisfies the “universal availability” requirement. Under that rule, if one employee has the opportunity to defer a portion of salary under the plan, then generally all employees must be offered the same opportunity. (Very limited exceptions apply.) The questionnaire seeks to identify plans that are not making the deferral opportunity universally available, either because the limited exceptions are misapplied, or the employer imposes additional conditions on deferring that are not permitted under law. A number of the questions refer specifically to exclusion of groups of employees unique to educational organizations, such as medical residents, and different categories of instructors, professors or lecturers. An IRS announcement on the project as well as links to the questionnaire, instructions for filling out same, and a glossary of terms, can be found here.

Organizations have 25 days to complete and return the questionnaire by fax, mail or e-mail. Upon review of the questionnaire, the IRS will either deem a plan to be compliant and issue a “closing letter,” or will request additional information from the organization. If a problem is found the IRS will work with the organization to correct it, for instance by making fully vested employer contributions to restore the lost opportunity to make tax deferrals in prior plan years. (Generally the employer contribution requirement is equal to half of the deferral the employee would have made (the “lost opportunity” cost), but specific correction methods are not set forth in the questionnaire or in the IRS announcement of the program. Correction methods will be specified in a follow-up letter sent to organizations whose initial responses require follow-up.

Receipt of the questionnaire will not mean that a plan sponsor is “Under Examination” and thus barred from using the Voluntary Correction Program under the Employee Plans Compliance Resolution System (“EPCRS”) to correct 403(b) operational errors currently identified in EPCRS (for instance, failure timely to implement an employee’s salary deferral election). This was confirmed by the IRS, with regard to a similar 401(k) questionnaire project, in a recent issue of Employee Plans News. That said, the current version of EPCRS, set forth in Revenue Procedure 2008-50, does not provide as many corrections for Section 403(b) plans as are available to other types of qualified plans, largely because Rev. Proc. 2008-50 was drafted before Section 403(b) plans were required to be set forth in writing. For instance, VCP is not available for sponsors that lack a written Section 403(b) plan document or that have failed to operate the plan in accordance with its written terms, nor is it available for employer eligibility failures. The IRS is expected later this year to release an updated version of EPCRS that covers Section 403(b) corrections in greater detail. However, it is not known whether or not the new Revenue Procedure will contain relief for sponsors that failed to timely put a plan document in place or failed to operate a plan in accordance with its written terms.

Tax-exempt employers who receive a questionnaire strongly are advised to consult with their professional tax advisors before submitting a response to the IRS. An incorrect response – or an accurate response – could trigger potential contribution and tax liability on a significant scale, and the availability of EPCRS is uncertain. Such discoveries are better made – and resolutions discussed – with private advisors before the IRS is part of the conversation. If additional time to complete the questionnaire is necessary, employers should request it of the IRS before reaching the 25-day deadline.

DOL Sanctions Plan Sponsor Purchase of Real Property from Plan

Last February, noted fiduciary guidance counsel Peter Gulia alerted me to a prohibited transaction exemption application involving a 401(k) plan sponsor’s purchase of troubled real property from the plan. At the time Peter observed that the application, if granted, would allow the sale on the opinion of an appraiser without requiring any supervision by an independent fiduciary.

The exemption was granted, and is published in the Federal Register on May 11, 2011. The property was an antique home used as a bed & breakfast. The B&B represented 93% of the value of the assets of a 401(k) plan maintained by a professional medical corporation, the sole participants of which plan were the doctor, his wife (another doctor), and their three children. Despite the significant investment of Plan assets, the property yielded only small amounts of net income to the Plan. The family was not able to afford the third party management fees and tried to manage the property themselves. Due to poor cash flow, significant maintenance and safety issues went unaddressed. Ultimately, the Plan’s aggregate net income from the property between 2004 and 2010 (purchase price, less aggregate net acquisition and holding costs) was determined to be only $141,648.

In order to get the Plan out from under the burden of running the property at a loss, the doctor and his wife sought to purchase the property from the plan and obtained the lender’s approval to assume the loan from the bank. The stated rationale for the exemption was that the sale would allow the plan fiduciaries to “divest the Plan of an asset that has been difficult to manage within the Plan as a result of adverse economic conditions.” The conditions of the sale included all of the following:

1) All terms and conditions of the sale were at least as favorable as the Plan could obtain in an arm’s length transaction with a third party. (This was almost assured under the circumstances due to the depressed real estate market and drop in tourism.)
2) The applicants either personally assume the loan on the property, which represented less than half of its value, or paid the loan off from the sale proceeds. (The applicants had obtained the lender’s consent to their assuming the loan, or obtaining another loan.)
3) The Plan receive the greater of (a) the property’s fair market value as determined by a qualified independent appraiser, less the loan principal assumed by the applicants, or (b) the property’s net acquisition and holding costs, less the loan principal. (In this case the FMV was higher.)
4) The FMV be updated by the appraiser on the date the sale is consummated.
5) The sale be a one-time transaction for cash.
6) The Plan pay no real estate commissions or fees in connection with the sale.
7) The Plan fiduciaries, who were also the applicants, do all of the following:
a. Determine whether the sale was in the interest of the Plan;
b. Review and approve the appraisal methodology; and
c. Ensure that the appraiser uses the methodology to determine the FMV.

Several factual points, although not expressly cited by the Department of Labor as grounds for their ultimate approval of the exemption, no doubt contributed to the application’s favorable outcome:
➢ The parties used a highly qualified appraiser. He had state and national appraisal credentials and had spent 20 of his 25 years of professional experience appraising commercial properties. The appraiser’s valuation methods (combination of sales comparison and income approach) were logical and clearly explained. It no doubt helped that in there were comparable sales transactions in the community as well as numerous B&B businesses from which to draw income figures.
➢ The Plan covered only five members of the same immediate family. Were there non-family member participants in the Plan, it is likely that the initial fiduciary decision to invest over 90% of Plan assets in a single property would not have passed muster.
➢ The Plan would fare much better in a sale to interested parties than it would if the property were sold on an open market; depressed real estate values would have meant a lower-than-FMV sale price as well as a hefty sales commission and other transaction expenses. By contrast the terms of the exemption required a FMV sale (with an appraisal update on the transaction date) with no fees or commissions paid by the Plan. In addition, if the applicants assumed the loan from the plan they would indemnify the Plan and hold it harmless from any future liability for payments.

I want to thank Peter Gulia first for alerting me to the exemption application and also for sharing his opinion – which I share – that lack of non-family member participants likely contributed to the Department not insisting on more stringent conditions, such as supervision by an independent fiduciary.

DOL Extends Compliance Deadline for Plan-Level Fee Disclosure Rules

The rules governing retirement plan fee disclosures at both the plan and participant levels are undergoing a major overhaul. The complexity of the issues at hand has led the Department of Labor’s Employee Benefits Security Administration (EBSA) to extend by several months the compliance deadline applicable to interim final regulations on plan-level disclosures under ERISA Section 408(b)(2). The reason for extending the applicable date is that EBSA did not have sufficient time to take into account the many public comments it received on the interim final regulations.

The regulations, originally slated to go into effect on July 16, 2011, will now become applicable January 1, 2012. They will apply to “covered service providers” that reasonably expect to receive $1,000 or more in direct or indirect compensation from a retirement plan in a given plan year.

Covered service providers, including third party administrators, registered investment advisors, broker-dealers and recordkeepers, have always had to disclose the services they provided to plans, and the compensation they received, however such disclosures largely have been limited to the service agreement the provider entered into with the plan fiduciary (if any), and information required to be reported on Schedule C (Service Provider Information) to the Form 5500 Annual Return/Report (a Schedule only required for plans with 100 or more participants).

The new regulations will require these entities to provide a written, detailed disclosure of services provided to, and fees and expenses received from, all qualified retirement plans they serve. The new rules are intended to bring to light fees and charges that formerly were hidden to plan sponsors in a variety of ways, including “bundled” plan service arrangements.

Technically, the disclosures are required to be made to plan sponsors and other fiduciaries in order for the fiduciary to conclude that the service arrangement is “reasonable” in light of the services provided; only “reasonable” service provider arrangements are exempt from “prohibited transaction” rules that otherwise apply to the use of plan assets. In their proposed form, the regulations required that service providers enter into a specific written agreement with plan fiduciaries; the interim final regulations require that the disclosures be made in writing but do not specify the format.

The regulations are the second in a three-part effort by the Department of Labor to improve fee transparency and disclosure, particularly with respect to 401(k) fees. First, they revised Schedule C to the annual Form 5500 Return/Report, which reports Service Provider Information. The revisions, which required disclosure of indirect forms of compensation for the first time, took effect for plan years beginning on or after January 1, 2009. The second part is the plan-level disclosures discussed above, and the third part is participant-level disclosures that plan sponsors must make under ERISA Section 404(a)(1). Final regulations describing these disclosures go into effect on January 1, 2012, although it is possible that this will be pushed back as well.

Each of these developments – Schedule C revisions, plan-level disclosure rules, and participant-level disclosure rules, are extremely important and will be the subject of further discussion on this blog. In addition I hope to address the following related regulatory changes in the coming weeks and months:

• Proposed regulations expanding the definition of an ERISA fiduciary (the first such change in over 30 years);
• Proposed regulations related to target date retirement funds and “qualified default investment alternatives” or QDIAs, two categories that overlap to a degree; and
• Regulations related to lifetime income options, including recently re-introduced Senate Bill, the Lifetime Income Disclosure Act, which would require plan account balances to be reported not just in a lump sum but as a projected stream of retirement income.

If there could be said to be a common thread among all these pieces of legislation, it is that the disclosure and fiduciary rules that sufficed when traditional pension plans prevailed, are no longer adequate in the age of the 401(k). The 401(k) model largely leaves participants on their own when it comes to savings goals, investment choices, and in-service access to retirement savings, and the end result is that the average 401(k) account balance in America today is scandalously low.