Planners are facing considerable competition from brokers in the arena of retirement plans, and the reality that brokers typically don't work as fiduciaries is a thorn in planners' sides. Most clients aren't aware of this distinction; many of those who are don't seem to care.

More clients might care if they were aware of differences in the sources of compensation behind the advice they receive. In the coming months, these differences between the two types of advice will probably become crystal clear. Under a proposed Department of Labor regulation pertaining to ERISA Section 408(b)(2), anyone who provides services to qualified pension or profit-sharing plans must provide significantly expanded financial disclosure.

Broad Scope

The scope of this disclosure would go well beyond what most service providers currently reveal in their client contracts and disclosure documents. If you are an investment advisor, your ADV already provides much of the information covered by the new disclosure rule; even so, the proposed rule will definitely have an impact on you. If you are a broker or a rep, however, the new regimen would turn your practice upside down.

ERISA Section 408(b)(2) requires service providers to operate under a "reasonable contract or agreement" with the plan sponsor or they will be deemed to have engaged in prohibited transactions. Until the proposed regulation was introduced in December 2007, "reasonable" had gone essentially undefined. In the absence of clear guidelines from the DOL, this ERISA provision has received scant attention. Essentially, the only contracts deemed "unreasonable" were those including provisions making them difficult to terminate.

If, as some observers anticipate, this proposed regulation is adopted without significant modification in the coming weeks, then this narrow avenue of restriction could go into effect as early as New Year's Day of 2009. Service providers, such as financial planners, would be required to provide—in advance of establishing a contract—written disclosure of direct and indirect compensation and as well as potential conflicts of interest. The new definition is that a contract is inherently unreasonable if the "responsible plan fiduciary," (i.e., a retirement plan's named fiduciary) doesn't take into account complete and accurate information about compensation arrangements, service provider affiliations and potential conflicts.

If you have an unreasonable contract, under the new definition, you would be deemed to have committed a prohibited transaction. If plan sponsors fulfill their obligation to select service providers wisely and demand this disclosure, then they are in the clear. But if their disclosures are inadequate—incomplete or in error, to the best of the provider's knowledge—they will have undertaken/executed a prohibited transaction. Penalties typically require that the advisor refund all compensation and pay excise tax. Thus, you get fired, you're forced to refund the money and you get a nasty tax bill to boot.

Full Disclosure

In introducing the regulation, the department noted that "a plan fiduciary must have sufficient information regarding fees and compensation that the service provider receives regarding whether there are relationships or interests on the part of the service provider that may call into question the objectivity of the service provider in providing services to the plan." This is in keeping with the fiduciary obligations imposed on the plan under ERISA to prudently select and monitor service providers. If plan sponsors establish written agreements with service providers that conform to the terms of the proposed new regulation, they not only have evidence of their prudence, but they have also ensured that it is the ultimate responsibility of the service provider to avoid undisclosed sources of compensation and conflicts of interest.

As defined by the DOL, the proposed regulations will apply to any service provider who:

• Is a fiduciary under ERISA or the Investment Advisers Act of 1940.
• Provides banking, consulting, custodial or insurance services, or investment advice, investment management, recordkeeping, security or investment brokerage or third-party administration services, or
• Receives indirect compensation and provides accounting, actuarial, appraisal, auditing, legal or valuation services.
  

Almost all financial planners working with retirement plans may be subject to the proposed rule under either the first or second parts of the definition of covered service providers (or both).

The rule would require service providers to identify whether they would be providing their services in a fiduciary capacity. Based on the definition mentioned above, planners generally will be regarded as fiduciaries. Administrators, custodians and brokers, on the other hand, generally will not. The "responsible plan fiduciary" is obligated to understand who is and isn't a fiduciary and to take this into account when performing due diligence in selecting service providers.

As is typical with all proposed new regulations from the department, the implementation timetable is a matter of some speculation. The regulation would take effect 90 days after publication of the final rule. Based on reported comments from the department, it seems likely that the final regulation will have been released by Labor Day of this year. Therefore, new contracts between retirement plans and covered service providers established after Dec. 1, 2008 would have to comply.

Big Unknowns

One of the big unknowns is how long a transition period, if any, will be allowed to enable those affected to bring existing contracts into compliance. It is possible that the labor department expects this to occur during the 90-day period between the release of the final rule and the effective date, but this is unlikely. At the other extreme, existing contracts might not be subject to new requirements until they are up for renewal.

If you provide services to retirement plans, you should take steps to ensure that all contracts, agreements and disclosures reflect the provisions of the new rule immediately. Listed below are five of the rule's requirements that you should be sure to address, lest you be regarded as engaging in prohibited transactions.

While they apply to all covered service providers, they are presented here based on the presumption that the reader is a financial planner or registered investment advisor. These provisions would require you to:

• Prepare a contract. The contract must be authorized by the plan fiduciary and it must make clear that you are obligated to make the disclosures addressed in the remaining four requirements. While the disclosures must be provided to the responsible plan fiduciary before contracts are made, the disclosures may also be included in the final contract.
• List and describe all services that you intend to provide. Ideally, the services described should align with a similar list of service requirements prepared by the responsible plan fiduciary before selecting service providers. If your service description is in sync with the express expectations of the plan fiduciary, this not only will serve to fulfill a requirement of the 408(b)(2) regulation, but will also help to demonstrate procedural prudence of the part of the plan fiduciary in conducting due diligence.
• Prepare a set of written compensation disclosures. The disclosure set may consist of such existing documents as the ADV, fund prospectuses and other materials that collectively address requirements, or it can be a prepared consolidated document that includes information derived from other sources. In either case, the service provider must package the disclosures in a manner that adequately and clearly describes and explains the disclosed information. Hence, pointing to a stack of documents and inviting the plan fiduciary to find the disclosures won't pass muster with regulators.
• Describe all compensation that you and any affiliates will receive for each of the services provided. If separate fees are charged for each service, they should be disclosed for each. Bundled services paid for by an aggregated fee generally do not have to be unbundled for purposes of detailing fees. Compensation refers to both direct payments from the plan and indirect payments from third parties (such as commissions, 12b-1 fees, bonus payments, soft dollars, etc.).
• If you or your affiliates receive any prepaid fees, describe how they will be calculated and refunded if the agreement terminates before the fees are fully earned.
• State whether the plan will be billed, fees will be deducted directly from the plan or if some other billing and collection process will be used.
• Prepare a set of written disclosures to address the requirements concerning potential conflicts of interest. As in the case of compensation disclosures, the disclosures relating to potential conflicts may be made by reference to existing documents, such as an ADV or policy and procedure manuals. Note that these requirements generally relate to possible self-dealing. If a financial planner or investment advisor is providing services in a fiduciary capacity, any possible self-dealing activities should be addressed with legal counsel as they are prohibited for a fiduciary to an ERISA plan.
• State whether you or your affiliates have any interest in any transaction in which the plan may be involved (e.g., earning bonus compensation indirectly by recommending that the client make a particular investment); whether you or any affiliate have any material financial, referral or other relationship with a money manager, broker or other person or entity that creates a conflict of interest in performing services under the agreement; and whether you have the ability to affect your own compensation or that of an affiliate without the prior approval of a plan fiduciary (e.g., as a result of incentive, performance-based, float or other contingent compensation).
• Describe any policies you or your affiliates have in place to address conflicts of interest. Interestingly, the proposed regulation doesn't require the service provider to have a conflicts of interest policy but, if you do, you must disclose and describe it.
• State whether you and any affiliates will be providing services to the plan as a fiduciary either under ERISA or the Investment Advisors Act of 1940. If you or any affiliates will be acting as a fiduciary for some services but not others, the services and roles must be clearly differentiated.
  

Final Version

 

In addition to the proposed regulation, the department has released the final version of the form 5500 to be used by large retirement plans beginning in 2009. It is no accident that the changes to the form 5500 pertaining to service provider fees and expenses coincide with the 408(b)(2) regulation. The department is addressing improved disclosure on two fronts: The form 5500 changes improve disclosures by retirement plan sponsors to regulators; the new 408(b)(2) regulations improve disclosures by service providers to plan sponsors.

 

Finally, on July 31, 2008, the department introduced new required disclosures by plan sponsors to plan participants, all of which are very similar and all are likely to become effective by Jan. 1, 2009.

Congress, as well as regulators, is focusing on these issues. On Feb. 14, 2008, five representatives and senators holding leadership positions on key committees sent a letter to Assistant Secretary Bradford Campbell, of the department's Employee Benefits Security Administration, expressing their thoughts on the new regulation. The opening paragraph portends more regulation in this area: "...we believe [the DOL] must go much further than these proposed regulations in order to achieve clear and understandable disclosure of fees and conflicts."

Service providers should immediately assess their preparedness for the new regimen of compensation and conflict transparency, and the growing culture of fiduciary responsibility. Until the financial services community becomes more proactive in embracing and assuming leadership for these trends, we should continue to expect legislators and regulators to define how those who provide financial services should behave.

This new era will likely have positive consequences. Greater transparency will probably force service providers to simplify and reduce fees. Plan sponsors will be able to more fully consider costs and conflicts when they perform due diligence on service providers. And perhaps the requirement to disclose fiduciary status will encourage more practitioners to stop fighting the tide and embrace their responsibility to provide services that serve the exclusive best interests of retirement plan investors.

Blaine Aikin, AIFA, CFA, CFP, is president and CEO of fi360, headquartered in Sewickley, Pa.