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Compensation and Benefits Alert

november 30, 2011


Sarah Downie
Of Counsel

Jonathan Ocker
Group Chair, Partner

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Department of Labor Finalizes Regulation Aimed At Improving Access to Investment Advice for 401(k) Plan Participants


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The Alert and Expected Impact:

The Department of Labor (DOL) recently issued final regulations (the “Regulations”) allowing employee benefit plan fiduciaries, including mutual fund houses and investment advisory firms, to receive compensation from investment vehicles they recommend to participants in 401(k) plans and other defined contribution plans and beneficiaries of IRAs, so long as the adviser satisfies certain conditions.

As we explain under "Practical Implications" below, despite the DOL’s good intentions, we do not expect that the Regulations will have an immediate significant impact on how plan sponsors provide investment support to plan participants. Because of the onerous conditions imposed on the investment advice arrangements sanctioned by the Regulations, there unfortunately appears to be little incentive for third-party service providers (including mutual fund houses and investment advisory firms) to establish these arrangements and for plan sponsors to engage these service providers to provide investment advice. We think further reform is needed to encourage the proliferation of much-needed investment advice arrangements to serve the needs of plan participants. The Regulations are effective December 27, 2011.

Current Practices of Plan Sponsors

Historically, plan sponsors have provided investment support to plan participants one of two ways: they have either provided "investment education" (which, according to the DOL, is not "investment advice") or outsourced the investment advice function to an independent expert under a DOL-sanctioned arrangement.

Providing "investment advice for a fee," within the meaning of ERISA Section 3(21), is one of the three ways to become an ERISA fiduciary. "Investment advice" as defined in DOL regulations, means information provided on a regular basis, pursuant to a mutual agreement, as a primary basis for investment decisions and individualized to the needs of the plan, a plan fiduciary or a participant or beneficiary. "Investment education," on the other hand, is information and materials about the benefits of plan participation, the benefits of increasing plan contributions, the impact of pre-retirement withdrawals on retirement income, the terms of the plan, or the operation of the plan. Investment education also includes descriptions of investment objectives and philosophies, risk and return characteristics, historical return information, and related prospectuses. This type of general information relating to the plan and the choices available thereunder does not constitute investment advice because it does not counsel participants on the appropriateness of an investment option for a particular participant.

The provision of investment advice to plan participants has long been problematic. It is generally considered a "prohibited transaction" under ERISA for 401(k) plan product and service providers (including mutual fund houses and investment advisory firms) to provide investment advice. To the extent those providers (or affiliates) are economically interested in the investment options they provide, the providers cannot provide investment advice since the provision of such advice would cause the provider to be an ERISA fiduciary (and the transaction would result in fiduciary self-dealing). To permit plan participants to receive some investment support, the DOL has issued guidance, including the Sunamerica model set forth in Advisory Opinion 2001-09A, which provides that advice may be provided if an independent financial expert develops the asset allocation model in use, plan participants are given the option of ignoring the advice and the models are developed in the best interests of plan participants. Many firms conform to this model and plan sponsors provide participants with this outsourced option.

The arrangements provided for under the Regulations, in contrast to the Sunamerica model, permit investment advice to be provided under a "level-fee" arrangement or a certified computer model arrangement, as described below. While these arrangements arguably offer more options to plan sponsors in terms of providing investment support to participants, the practical effect of the Regulations on plan sponsor conduct is uncertain. The conditions imposed on these arrangements are significant. As described below, the DOL's preexisting guidance may offer a more workable arrangement than the ones provided under the Regulations.

Practical Implications of the Regulations. The DOL has high hopes for the impact of the Regulations. According to a Fact Sheet accompanying the issuance of the Regulations, the DOL estimates that approximately 134,000 defined contribution plans covering 17 million participants and beneficiaries will offer investment advice pursuant to the statutory exemption and that approximately 3.5 million of these participants and beneficiaries will seek advice from investment advisory firms servicing their employer-sponsored retirement investment plan. The DOL also estimates that 16,000 investment advisory firms will provide investment advice pursuant to the statutory exemption.

We think that the DOL’s estimates are overly optimistic. It is unlikely that investment advisory firms will shift their business model to conform to the conditions of the exemption, especially if they are already providing investment advice pursuant to earlier guidance. It is unlikely that firms already providing investment advice under a previously sanctioned arrangement, or mutual fund houses not currently providing investment advice will be motivated to provide an arrangement pursuant to the exemption, especially since the exemption could pose significant roadblocks to efficient administration. For example, if a firm were to provide a level-fee arrangement, it would not be able to offer its own funds as part of the mix, unless all its funds had the same fees. It is often a practical impossibility for the proprietary funds of a firm to offer all the same fees. While a firm could arguably establish an affiliate to benefit from products sold under a level-fee arrangement without violating the exemption, we do not expect firms to rearrange their business to establish such an affiliate.

As well, the computer modeling alternative permitted by the Regulations is problematic. As described below, the Regulations require that any model take into account employer securities (under earlier proposed regulations, employer securities could be excluded). We presume that a computer model would not advise a plan participant to take a significant holding in employer securities, and that in most cases, the model would advise a reduction in employer securities. We do not expect that plan sponsors would be willing to cover the cost of an investment advice arrangement providing for a computer model that advised a reduction in employer securities. Therefore, we expect there will be little incentive for service providers to develop the computer model permitted by the Regulations.

Further, while plan sponsors not currently offering an investment advice option under prior DOL advice may wish to comply with the Regulations in offering an arrangement, plan sponsors may be deterred by some features of the Regulations. For example, a plan sponsor’s selection of a fiduciary adviser is itself a fiduciary act, and compliance with the exemption set forth under the Regulations does not relieve a plan sponsor from its fiduciary obligations to plan participants to prudently select and monitor the adviser. Plan sponsors may be reluctant to take on this responsibility. Since the Regulations do not offer plan sponsors more relief than what is currently provided under DOL guidance regarding investment advice, we do not expect that plan sponsors will rush to implement arrangements sanctioned under the Regulations.

Background. The Pension Protection Act of 2006 (PPA) expanded the availability of fiduciary investment advice to participants in individual account plans, and allowed “fiduciary advisers” to receive fees from investment providers whose products they recommend to plan participants. In particular, the PPA added Section 408(b)(14) of ERISA (and parallel Section 4975(d)(17) of the Code). Without the addition of these sections, the receipt of fees would be prohibited under ERISA and Section 4975 of the Code. These sections provide a prohibited transaction exemption that permits a “fiduciary adviser” to provide investment advice to participants or beneficiaries in participant-directed individual account plans and IRAs if the investment advice is offered under an “eligible investment advice arrangement,” as defined in Section 408(g) of ERISA (and parallel Section 4975(f)(8) of the Code).

To qualify as an “eligible investment advice arrangement” under the exemption, either (i) the adviser must be compensated on a “level-fee basis,” (i.e., fees charged to the participant remain consistent irrespective of the investment options (recommended or not recommended) that they select), or (ii) the advice provided must be based on a computer model under an investment advice program certified as unbiased and as applying generally accepted investment theories. Under either type of advice arrangement, the fiduciary adviser must disclose to advice recipients all the fees that the adviser or any affiliate is to receive in connection with the advice. The computer model must be certified by an “eligible investment expert” consistent with DOL rules.

On February 2, 2007, the DOL issued Field Assistance Bulletin 2007-01 addressing certain issues presented by the new statutory exemption. On January 21, 2009, the DOL issued final regulations on the prohibited transaction exemption. These original final regulations were to take effect on March 23, 2009, but were ultimately withdrawn by the DOL. On March 2, 2010, the DOL issued a set of proposed regulations. The Regulations do not differ substantially from the proposed regulations.

The Regulations. The Regulations permit two kinds of eligible investment advice arrangements that are exempt from the prohibited transaction rules under ERISA and Section 4975 of the Code.

In a “level-fee” arrangement, the fees or other compensation (including salary, bonuses, awards and commissions) to be earned by an adviser or received, directly or indirectly, by an adviser’s employee, agent or registered representative that provides investment advice on behalf of the adviser, must not vary depending on the investment option selected by a participant.

The other alternative, the unbiased computer model arrangement, sanctions the use of an adviser’s proprietary modeling program to provide advice to plan participants, subject to certain conditions. While the DOL has, in the past, granted individual exemptions permitting computer modeling, these exemptions generally permitted only the use of models by third parties separate from the adviser. The DOL requires that the model meet the following conditions:

  • The model must avoid bias; it must be designed and operated to avoid investment recommendations that inappropriately favor investment options offered by the adviser, and not give undue weight to any particular investment option, taking into account.
  • The model must be certified by an “eligible investment expert.” This expert must be independent from the fiduciary adviser and the creator of the computer model. An eligible investment expert will not be deemed a plan fiduciary under ERISA; however, the act of selecting such an expert is a fiduciary act by the fiduciary adviser, so the selection must be prudent.

Notable Provisions of the Regulations. The Regulations provide clarification on certain issues first described in the proposed regulations, and set forth a number of safeguards designed to minimize conflicts of interest on the part of the fiduciary adviser.

As mentioned above, with respect to “level-fee” arrangements, the Regulations provide that the fees or other compensation to be earned by an adviser or received by an adviser’s employee, agent or registered representative that provides investment advice on behalf of the adviser, must not vary depending on the investment option selected by a participant. The Regulations clarify that this requirement does not mean that affiliates of the fiduciary adviser other than employees, agents or registered representatives cannot receive fees or compensation that varies depending on the investment option selected by a participant (unless the affiliates provide investment advice themselves to plan participants). This means that an affiliate of the fiduciary adviser may receive fees related to products implicated by the advice provided to plan participants by the fiduciary adviser’s employee.

In addition, the Regulations clarify that, with respect to computer model arrangements, the advice provided by a computer model must take into account employer stock and certain asset allocation funds (such as target-date funds) if they are available as investment options to the plan participant. We assume that the participant is able to instruct the fiduciary adviser to exclude such options from consideration. This requirement is a departure from the proposed regulations, which provided that the computer model could have ignored such investment options even without direction from the participant. Given the variation in value among employer securities, it may be difficult for computer models to take this option into account if a participant does not instruct the adviser to exclude it from consideration.

As well, the Regulations clarify that other DOL guidance with respect to investment advice is not preempted as a result of the exemption provided in the Regulations. For example, the guidance contained in Advisory Opinion Nos. 2011-08A, 2005-10A (Country Trust Bank), 2001-09A (SunAmerica Retirement Markets) and 1997-15A (Frost National Bank) continues to apply.