What Investment Advisors Need to Know About 408(b)(2)

In December 2007, a proposed rule was published concerning the disclosures that must be furnished to plan fiduciaries in order for plan services to be considered “reasonable.” Following a public comment period, public hearing, and interim final rule published in July 2010, the final rule became effective July 1. This regulation, Reasonable Contract or Arrangement Under Section 408(b)(2) – Fee Disclosure, which falls under 29 CFR Part 2550, affects pension plan sponsors, fiduciaries, and certain service providers, including investment advisers.

Scope

Under the rule, a “covered service provider” is any provider of certain services described in the rule that expects to receive $1,000 or more in compensation. Investment advisers are likely to fall into at least one of several categories, including, but not limited to, the following:

  • Providing services directly to the plan — This would include “direct” investment advice, which causes the investment adviser to become a fiduciary under the Employee Retirement Income Security Act (ERISA).
  • Providing services under the Investment Company Act of 1940 (’40 Act) or state law — This would include investment advice and also any other services covered by those regulations.
  • Providing services and receiving “indirect” compensation — This would include advisory and consulting services, such as assistance with the implementation of investment policies or monitoring other plan service providers.

Requirements

  • Disclosures in writing — Disclosures must be furnished to plan fiduciaries in writing.
  • Description of services — Plan fiduciaries must have the basic information necessary to make informed decisions about the plan. In that regard, service providers are required to furnish a description of the services they reasonably expect to provide. Although no format for the information is included, the regulation specifies that it should be clear and understandable.
  • Fiduciary status — Service providers are required to make a statement as to whether they will provide services directly to the plan as a fiduciary, or as to whether they will provide services to the plan under the ’40 Act, state law, or both. Investment advisers should be careful when making this statement in an agreement that includes both fiduciary and non-fiduciary (i.e. provider searches) services. From a risk-management perspective, it would be prudent to distinguish between those services.
  • Compensation — Service providers must disclose both direct and indirect compensation. For direct compensation, the description can either be in the aggregate or by service and must include compensation that is paid directly from a participant’s account. In order for fiduciaries to analyze potential conflicts of interest, indirect compensation has additional requirements. The disclosure must include a breakdown of the services for which the indirect compensation will be received. Furthermore, the disclosure must include the payer as well as the arrangement between the payer and the service provider and the manner of receipt (i.e. billed, directly deducted).

To the extent compensation is determined on a transaction basis (i.e. commissions) or is charged directly against the plan’s investment and reflected in the NAV (i.e. 12b-1 fees), a description of that compensation, including the associated services, is also required for the provider, an affiliate, or a subcontractor. These disclosures are required regardless of whether they have already been disclosed in connection with the direct and indirect compensation disclosures above. Moreover, termination fees must be disclosed, including an indication of how any prepaid amounts will be calculated and refunded.

  • Plan investments and investment options — Information about plan investments and investment options are required of fiduciaries to investment vehicles that hold plan assets and recordkeepers and brokers who facilitate the investment of the assets.  Any changes to investment information must be made at least annually.

Disclosure errors

To the extent a service provider was acting in good faith and discloses the correct information to the fiduciary as soon as practical, not to exceed 30 days from the time the error is known to the covered service provider, inadvertent errors or omissions will not cause contracts to be prohibited transactions.

Timing

Initial disclosures must be provided to fiduciaries reasonably in advance of an arrangement. Changes to the required information must be provided as soon as practical, not to exceed 60 days from the time the change is known to the covered service provider. Because of the effective date, the initial annual disclosure must be provided no later than August 30, 2012.  The first quarterly statement under the new rules must be provided no later than November 14, 2012.

In addition, to the extent a written request is made of a service provider, by a fiduciary, in relation to compensation, this must be provided by a service provider reasonably in advance of the date which the fiduciary indicates it must comply with its requirement. An example would be information needed to complete Form 5500, which is no later than 120 days after the end of the plan year.

Fiduciary exemption

Among various other requirements and notice provisions, fiduciaries have relief from the prohibited transaction provisions, so long as service providers are terminated for not disclosing information relating to future services within specified time periods.

An investment adviser may not suspect it is subject to the additional disclosures and requirements of this regulation. In addition, there are various other recordkeeping and compensation disclosures that may not necessarily apply to investment advisers but could be applicable to record keepers or firms dually registered as broker-dealers, and which have not been described in this article. It is important, even if the investment adviser’s only connection to retirement plans is through managed pooled funds, to review the regulation thoroughly and seek advice.

Craig B. Evans can be reached at Email or 215.441.4600.