The Wagner Law Group | Est. 1996

Sophisticated Legal Solutions And Boutique-Style Service

Tax Reform Proposals Regarding the Retirement System

On Behalf of | May 20, 2013 |

How Plans Affect the Deficit. Legislators and policymakers know that the amount of tax revenue forgone on account of retirement plans is very large and this makes 401(k) plans an easy target for revenue raising initiatives. The Congressional Joint Committee on Taxation has estimated that annual tax expenditures for 401(k) plans, IRAs and Keogh plans amount to $70.2 billion, and the Office of Management and Budget has projected that foregone revenue attributable to 401(k) plan contributions for the period 2011-2015 will be $361 billion. Retirement saving through a 401(k) plan is tax-advantaged because the government generally taxes neither the original plan contributions nor the investment returns on those contributions until they are paid as benefits. Since the budget process looks at revenues and expenditures within a ten-year window, and the payment of most retirement benefits occurs outside that window, the amount of taxes foregone because of 401(k) contributions tends to be viewed as a permanent expenditure. As pressure builds to control the federal deficit, legislative proposals will be considered to reduce the tax cost of the retirement plan expenditure. 

We will now review proposals that (i) focus on deficit reduction and tax reform or (ii) make larger systemic changes that will change how we all do business.

Tax Code Contribution Limits. The tax code already contains various limitations on plan contributions that could be adjusted from their 2013 levels for the purpose of reducing tax expenditures and raising revenue. For example, in the case of 401(k) plans, the maximum amount of annual contributions from all sources for any employee is $51,000, and the limit increases to $56,500 if the employee is at least 50 years old. The limit on annual contributions includes elective deferrals by participants which themselves are capped at $17,500. Another limitation subject to being reduced by legislation is the cap on the plan sponsor’s deduction for contributions to a 401(k) plan equal to 25% of the compensation otherwise paid during the taxable year to the plan’s participants. Further, compensation in excess of $255,000 cannot be considered in calculating contributions to a participant’s plan account.

Over the years, Congress has raised or lowered these amounts depending on the needs of the time. For example, the last major tax reform effort in 1986 reduced elective deferrals from $30,000 to $7,000. The Obama administration’s FY 2014 revenue proposals put a new spin on this age-old technique by seeking to cap the aggregate accumulation in all tax-favored retirement plans benefitting an individual at approximately $3 million. The limit is designed to provide a maximum annual annuity payment of $205,000. As a result, the limit on annual contributions would vary with age and have to be calculated annually. Plan sponsors and IRA trustees would be expected to report account balances and contributions so as to keep tabs on those making excess contributions. Taxpayers would be forced to withdraw any excess contributions or pay income tax on the excess amount both in the year contributed and when later distributed.

20/20 Proposal. Reform proposals driven by purely fiscal concerns are illustrated by the December 2010 report of the National Commission on Fiscal Responsibility and Reform that recommended limiting the maximum excludable contribution to a defined contribution plan to the lesser of $20,000 or twenty percent of income. This proposal, which covers the exclusion from taxable income of employee elective deferrals, as well as nontaxable employer contributions, is sometimes referred to as the “20/20 cap.” Under this formula, if you earn $100,000 per year, the most that can be put into your 401(k) account is $20,000. The 20/20 Cap is hard on high earners.

Brookings Proposal. Other proposals are motivated as much by policy concerns as by deficit reduction. William Gale of the Brookings Institution has designed a much-discussed mechanism to shift the demographics of those receiving the benefits of the retirement plan tax expenditure from a perceived slant favoring highly compensated employees. Advocates of this approach argue that all employer and employee contributions should be included in gross income and that existing deductions and exclusions should be replaced with a flat-rate refundable tax credit to be deposited directly into a plan participant’s retirement savings account. Under this proposal, contribution limits would not change. However, the refundable tax credit would benefit low earners at the expense of the more highly compensated. Critics have noted that this would seriously diminish the incentive many employers have to maintain qualified plans.

Obama Proposals to Reduce Tax Expenditures & Other Initiatives. The Obama Administration’s FY 2014 budget also takes a crack at the 401(k) tax expenditure, although it is cloaked in a more general tax increase. The Administration’s proposal limits the tax value of particular tax deductions and exclusions to 28% of the specified item’s amount that would otherwise reduce taxable income subject to the highest tax bracket of 39.6%. This is not an entirely new proposal; what is new is the inclusion of 401(k) contributions (as well as health care contributions), regardless of who makes them, in the list of affected tax exclusions. Thus, a taxpayer subject to the statutory rate of 39.6% would pay an 11.6% tax (39.6% – 28%) on the value of any 401(k) contributions. Under this regime, those receiving the highest contributions to their 401(k) accounts could be subject to an additional $6,554 in tax liability. When originally proposed in the 2013 budget, critics pointed out that this restriction results in double taxation, because the same plan contributions would be taxed again when withdrawn from the plan. The FY 2014 version of the proposal addresses this by adjusting a taxpayer’s basis in the retirement plan or IRA to reflect the additional tax imposed.

Less sweeping revenue raising proposals by the administration include repeal of the deduction for dividends paid with respect to employer stock held by an ESOP sponsored by a large (more than $5 million in annual receipts) C corporation and authorizing the PBGC to generate up to $25 billion through discretionary premium increases. 

NCPERS Proposal
. The National Conference on Public Employee Retirement Systems (NCPERS) has proposed amendments to ERISA and state laws allowing the establishment of state-sponsored multiple employer cash balance plans covering private-sector workers. The NCPERS proposal, or ones like it, are being considered by several state legislatures. The target group that this proposal seeks to benefit consists of employees of small employers that do not have access to pension plans. The assumption is that they would benefit from a state’s bargaining power, experience and expertise.

The NCPERS Secure Choice Pension (“SCP”) initiative is a bolder variation of prior proposals for state-run plans (involving voluntary contributions to DC plans) in that it entails a cash balance plan design requiring employer contributions to fund an annual salary credit of 6% of compensation plus minimum interest credits of 3% per year with potentially higher interest credits up to the yield on 10 year Treasury Bills plus 2%. Amounts contributed plus earnings credited to the participant’s account would be guaranteed, although the allocation and interest crediting rates can be adjusted prospectively to better reflect benefit and financial needs. Although employer participation would be voluntary, withdrawal liability would be assessed on terminating employers as under a multiemployer plan.

There is uncertainty as to how SCP plans would operate where assets are not sufficient to fund the promised lifetime benefit. One possibility that is mentioned in this regard is cutting back benefits, but this may not be realistic if employees have been promised state-backed benefits. Extending amortization periods for funding purposes is another technique that is mentioned. Ultimately, however, the states will be subject to the unfunded liabilities of SCP plans. The possibility that responsibility for private-sector pensions would be shifted to taxpayers at a time when states are struggling to meet the demands of public employee systems is a major political weakness of the SCP proposal.

California Secure Choice. In September 2012, California enacted an auto-IRA program to be administered by the state in which employers with 5 or more employees and no other retirement plan will be required to participate. Employees are automatically enrolled and contribute 3% of pay unless they opt out. There is a state-guaranteed investment return. Contributions will be pooled and invested by investment managers selected by the state which may end up being CALPERS. Implementation of the program is conditioned on receiving an IRS ruling that contributions will be pre-tax and DOL approval that the program is not an ERISA plan.

Other States. In Massachusetts, 2012 legislation authorizes the state treasurer to create a multiple employer defined contribution plan that will receive contributions from non-profit employers employing fewer than 20 persons as well as from their employees. The plan will be managed by the treasurer separately from the state’s public-employee pension fund and will allow employees to direct the investment of their accounts from an investment menu selected by the treasurer. The Massachusetts legislation requires the treasurer to obtain IRS approval of the plan and to ensure that it complies with ERISA.

According to the National Conference of State Legislatures, Connecticut, Illinois, Maryland, Michigan, New York, Pennsylvania, Rhode Island Washington State, Vermont, Virginia, and West Virginia have also considered pension legislation for private-sector employees, although in some cases such proposals only authorize study of the matter and in others the proposals were defeated or tabled.

Harkin’s Proposal. To help prepare workers for paying basic retirement expenses, Senator Tom Harkin has proposed a new universal retirement system built around the following principles:

  1. automatic and universal enrollment,
  2. a regular stream of income starting at retirement age,
  3. financing through the current payroll system by employee and employer contributions and government credits, and
  4. management by privately-run, licensed and regulated entities established pursuant to the legislation.

Although expected shortly, there is, as yet, no specific legislative proposal implementing these principles, but it is understood that the pensions to be paid would be based on a participant’s total contributions supplemented by investment performance and government credits for low-wage earners. Participants would be allowed to increase or decrease contributions or to opt out of the system entirely. The proposal is intended to appeal to employers by relieving them of any fiduciary responsibility, although employer participation is mandatory if the employer does not already offer a plan with a minimum level of employer contributions and some level of employer matching contributions to the new plans will be required. The Harkin initiative bears a similarity to current proposals being considered by state legislatures under which state governments would sponsor hybrid defined benefit-type plans covering private-sector workers, except that the new managing entities, dubbed “USA Retirement Funds”, take on the role of the state government in managing investments.

Bogle’s Unitary System. John Bogle, Vanguard’s retired founder, has for some years advocated a unitary defined contribution system whose twin goals would be to eliminate counter-productive speculation (in contrast to long-term investing) and to prevent premature leakage from the system by means of distributions and loans. To achieve these ends, the current array of retirement savings programs (including 401(k) and 403(b) plans and IRAs) would be consolidated and brought under the control of a Federal Retirement Board. The function of this board would be to limit investment choices to simple low-cost investments (e.g. index funds) and to severely limit loans and distributions prior to retirement. Retirement savings would continue to be tax-deferred, and low-cost annuities would be a mandatory offering into which some portion of a participant’s account balance would be deposited at retirement. Under this system, ERISA’s fiduciary standards would be extended to plan providers, including money managers. Bogle’s idea is to tame the influence of financial middle men and divert some of their profits to the retirement system, but it does not attempt to expand the retirement system to employees working for small employers who arguably lack access to retirement savings vehicles.

Spark Institute USERSP. Focusing on the under-served market of small employers, the Spark Institute has proposed a Universal Small Employer Retirement Savings Program (“USERSP”) for employers with fewer than 100 employees. USERSP features include automatic employee contributions and continued escalation with a participant opt-out. The simplified and pre-approved prototype plan receiving these contributions would not be subject to discrimination testing but would have lower contribution limits than regular 401(k) plans, although higher than IRAs so as to encourage small employers to establish new plans. However, unlike the NCPERS and Harkin proposals, the USERSP program entails no mandatory employer contributions.

To preserve assets within the system, there are no plan loans and hardship distributions would have to meet strict standards. Investment options could be chosen by either the employer or service provider, but, in either case, would be required to meet specified minimum requirements for broad based investment choices. Recordkeeping and Form 5500 reporting would be performed at the service provider level, eliminating employer responsibility for these tasks.

Proposals from Academia. Professor Teresa Ghilarducci would eliminate existing tax breaks for retirement plans and use the savings to subsidize a 5% contribution on behalf of all employees to retirement accounts serving as a universal supplement to Social Security. Participants in existing employer-sponsored plans could continue such participation if the plan met more stringent standards, such as a contribution rate of at least 5%, a ban on early withdrawals, and conversion into an annuity at retirement. Anyone without an employer plan would automatically be enrolled in a Guaranteed Retirement Account to which employees and employers would each contribute 2.5% of pay. The government would then provide everyone a modest tax credit to offset the employee contributions. The return would be guaranteed by the government at a rate approximating the growth rate in gross domestic product. Individual accounts resulting from this system would be pooled and professionally managed for fees anticipated to be lower than on conventional retirement accounts.

Professor Meir Statman (in a yet to be published paper) is calling for a system that is similar to the current British or Australian retirement structure, with mandatory participation and contributions from both employers and employees. Unlike Professor Ghilarducci’s program, there is no guaranteed benefit level under Statman’s proposal and payout depends heavily on individual investment decisions.

Summing Up.The private pension system is under pressure and may be significantly transformed either through tax reform seeking to reduce retirement savings incentives or through more direct efforts to transform the character of the system to a European statist model. 

Reaction to Tax Reform Proposals. Current tax incentives encourage employers to offer retirement plans on a voluntary basis and encourage individuals to save for retirement. Analysis by the Employee Benefits Research Institute projects that if this support is cut back under the 20/20 proposal so that maximum deferrals cannot exceed $20,000 or 20% of income, reductions in 401(k) balances at retirement will result at all levels of the income spectrum. It turns out that tax incentives are important for low-wage earners as well as higher-paid employees which may be why there was broad support for last year’s Gerlach-Neal bipartisan House resolution recognizing the impact of tax-deferral status for retirement savings.

Accordingly, there is a sense that the Administration’s proposal to limit tax exclusions (including 401(k) contributions) as a general matter may be gaining traction, since it does not specifically identify which deductions are being curbed and politicians cannot be attacked for targeting the retirement system. However, the end-result of a general limitation on exclusions, which has a more potent effect as tax rates approach 40%, will also jeopardize retirement security by reducing the amount employees save each year and shrinking the system. Congressional Democrats are probably more amenable to such a cutback than their Republican peers because of the perception that high wage earners derive a proportionately greater share of the tax expenditure benefit, although the fiscal cliff negotiations indicate that positions can quickly change. Nevertheless, certain senior Republican officeholders, such as Sen. Orrin Hatch, have expressed skepticism regarding proposals that would reduce existing contribution levels, because the current system is seen as having produced beneficial results.

Reaction to Systemic Reform Proposals. Advocates of centralization who distrust financial markets recognize the deficit reduction debate as a once-in-a-generation opportunity to enlarge the role of government in the retirement benefits arena with the ultimate goal of eliminating the role of employers, except as a funding source. The issue is often framed as one of providing access to retirement savings vehicles by low-paid workers of small employers which may be seen as a laudable goal, although these employees have always had the ability to establish IRAs on their own. Generally speaking, the various state and federal proposals provide for auto-enrollment, mandate employer contributions and either create government responsibility for funding shortfalls or establish a guaranteed minimum return. Creating such entitlements will result in the formation of interest groups that will lobby for benefit enhancements and extending the scope of these programs. Government influence in choosing investment managers or its outright control of investments (e.g., by commingling private plan assets with state pension funds) has the potential to drive many investment providers out of the retirement industry.

The state-sponsored initiatives raise an additional problem in that a multitude of state-backed retirement programs covering the private-sector workforce, each with its own unique rules, has the potential to break down the nationwide uniformity in pension laws that was achieved by the 1974 enactment of ERISA. To the extent that they remain subject to ERISA’s fiduciary standards, state programs will need to be careful to avoid engaging in prohibited transactions and will also need to establish the appropriate balance of how much administration will be performed by the state and how much, if any, responsibility will be allocated to employers.

DOL Offers Tips on TDFs

As of this writing, the stock market is at all-time highs, and the share of 401(k) assets invested in target date funds (“TDF”s) continues to increase, obscuring troubling aspects of these plan investments that were exposed in the recent economic downturn. Many plan participants lack the time, ability or inclination to properly manage the investment of their plan accounts, and TDFs provide a simple means of obtaining appropriate investment allocation and periodic rebalancing that results in an increasingly conservative asset mix as a participant nears retirement. The simplicity, however, is deceptive, and the nature of these funds (e.g., their fund of funds structure as well as their blueprint for changing the asset mix over time known as the glidepath) has fiduciary implications.

Fiduciary Duties. 401(k) plan fiduciaries, like other retirement plan fiduciaries, are governed by the duty to act solely in the interest of participants and beneficiaries and to carry out their responsibilities “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise with like character and like aims.” As applied to the selection of plan investment options, this prudence standard requires an objective process to obtain information about the investment, thereby enabling its evaluation.

Proposed Regulations. On November 30, 2010, the DOL published proposed revisions to its qualified default investment alternative (“QDIA”) and participant-level fee disclosure regulations specifying information that will have to be provided to participants regarding TDFs. The proposal, which has not been finalized, also announced that the DOL would publish a series of tips to assist plan fiduciaries in obtaining and evaluating relevant information when selecting and monitoring TDFs. This commitment was fulfilled on February 28, 2013 by the release of general guidance on “What to Remember When Choosing Target Date Funds.”

Comparing and Selecting TDFs. The DOL suggests that the process for comparing and selecting a TDF should entail consideration of its prospectus which would include the fund’s historical performance as well as fee and expense information. Other characteristics of a particular TDF revealed in its prospectus, most obviously its target date, glidepath and the point at which it reaches its most conservative asset allocation (the “landing point”), would enable the plan fiduciary to determine how well the investment aligns with the ages and likely retirement dates of participants.

Beyond the prospectus, the DOL recommends that TDF providers be questioned on the impact that plan demographics, such as defined benefit plan participation, salary levels, turnover rates and withdrawal patterns, will have on the investment. For example, if participants typically cash out shortly after retirement, it would be important for the fund to have reduced its potential volatility by reaching its landing point at such time. The glidepaths of some funds reach their most conservative investment allocation earlier than others, and some reach this point only a number of years after retirement or the target date. The latter are more suited for plans in which participants tend to receive lifetime installments.

Periodic Review. Noting that plan fiduciaries are required to periodically review a plan’s investments to determine their continuing suitability, the DOL gives its strong view (stating it more forcefully than a mere tip) that the review should examine whether there have been any significant changes to the TDF’s characteristics or the plan’s objectives since the TDF’s original selection. TDF modifications requiring attention include changes in the management team or a shifting of the fund’s investment strategy, as well whether or not the original investment strategy has been effectively implemented. A change to the TDF or to the plan’s objectives for the TDF could require that the fund be replaced.

Understanding TDF Investments. The DOL wants plan fiduciaries to understand the strategies and risks, not only of the TDF, but also its underlying investments and the asset classes into which they are divided. It is also critical to understand the TDF’s glidepath (including the rate at which it shifts its portfolio from equities to fix income investments in order to reduce risk) as well when it reaches its landing point and whether that occurs at or after the target date. Much of this information can be obtained from the fund’s prospectus and other offering materials. The DOL points out that employees should also understand these TDF features so that they can know if the TDF is an appropriate investment for them.

Fees and Expenses. An essential part of a fiduciary’s duty is to determine whether an investment’s fees and expenses are justified by its performance. In the case of a TDF, an understanding of such charges should be acquired not only with respect to the TDF but also as to its underlying funds. Thus, it is assumed that the plan fiduciary will examine the expense ratios of the underlying funds and that if their total is substantially less than the overall fees and expenses charged by the TDF, the fiduciary will ascertain the reason for the difference and seek justification.

Proprietary vs. Non-Proprietary Funds. TDFs typically have a “fund of funds” tiered investment structure under which the TDF actually invests in other mutual funds, which in turn invest in portfolio securities. A conflict of interest arises under this structure, because many TDF’s invest exclusively in affiliated mutual funds. From a product development perspective, when a fund family creates a TDF, it has a financial incentive to include as many affiliated underlying funds as possible in the TDF, thereby increasing its aggregate compensation through the fees paid to the underlying fund managers. The DOL recommends that a plan fiduciary ask the plan’s investment provider if it can create a customized non-proprietary TDF consisting of the plan’s existing core funds. Such a non-proprietary TDF would provide the advantage of diversifying the fund’s investment managers. The DOL notes that this might result in additional costs and administrative complexity, but interestingly, does not mention the potential for eliminating excessive fees that might result from manipulation of a proprietary TDF’s underlying investments.

Employee Communications. The DOL requires plan fiduciaries to furnish participants with general information about TDFs, as well as details relating to the particular TDFs that are actually offered by the plan. Participants need this information to determine if a TDF would be a good fit for them. Moreover, the participant-level disclosure regulations that went into effect in 2012 require the delivery to participants of specific fee and expense information about TDFs.

Information Sources. As a matter of prudence, if a plan fiduciary does not possess the necessary expertise to evaluate an investment, the fiduciary must seek outside advice or assistance, as necessary. The DOL notes that TDFs are a relatively new investment option but that there are a number of commercially available sources of information and services relating to TDFs to assist fiduciaries in the review process.

Documentation. Finally, the DOL indicates that the selection and review process for a TDF should be documented, including how the fiduciary reached its decision to make a TDF available.

Frequently Asked Questions & Answers

Definition of Fiduciary

Q. The DOL has promised to redefine the term, “investment advice fiduciary.” Who qualifies as a fiduciary? What does it means to be one? What kind of changes do you see making their way into the DOL’s new proposed regulation?

A. The DOL’s proposal to expand the regulatory definition of who is an “investment advice fiduciary” is part of its campaign to eliminate conflicts in the 401(k) industry. Under this definition, your actions control your status, and you are deemed a fiduciary if you provide any “investment advice.” The existing definition of investment advice imposes a five-factor test under which a person receiving a fee or other compensation from a plan must: (i) render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or property, (ii) on a regular basis, (iii) pursuant to a mutual agreement, arrangement or understanding, with the plan or its fiduciary that (iv) the advice will serve as a primary basis for investment decisions with respect to plan assets, and (v) the advice will be individualized based on the particular needs of the plan.

The regular basis and primary basis prongs of this test are particularly important. This was illustrated in the 2007 case of Ellis v. Rycenga Homes which applied these factors to a set of facts where periodic meetings between a broker and a plan trustee over the course of a 20-year relationship resulted in the plan’s consistently following the broker’s suggestions. This led to the court’s holding that the broker was a fiduciary, because of the regularity of the advice and the plan’s heavy reliance on the adviser.

Under the DOL’s proposed rulemaking, however, an adviser would have been deemed a fiduciary if there were any understanding that the advice could be considered in connection with the plan’s investment decisions, even if not provided on a regular basis. Thus, even one-time casual advice could trigger fiduciary status. The DOL’s September 19, 2011 announcement that the fiduciary advice regulations would be re-proposed signaled that certain problematic areas of the original proposal would be addressed, if not fixed. If the re-proposed regulations are similar to the original, many non-fiduciary advisers could, for the first time, find themselves subject to ERISA’s fiduciary standards. Among other things, these new ERISA fiduciaries would not be able to receive variable compensation, including 12b-1 fees and other similar types of compensation.

Given the DOL’s desire for fundamental change, the “primary basis” standard of the current rule is not likely to be retained, even though the DOL appears to recognize that investment advice under the revised rule should exclude advice not delivered on an individual basis. The American Bar Association Section of Taxation recently recommended a compromise solution, some form of which could well be adopted. Under this proposal, there would have to be an understanding on the part of a provider that the advice to be rendered will be a “substantial consideration” by a plan or a plan fiduciary in connection with an investment management decision. For this purpose, “substantial consideration” would not rise to the level of a “primary basis” but would be more than a “material consideration.”

The DOL announcement that the fiduciary regulation would be re-proposed stated that the revised rules would, among other things, clarify that fiduciary advice is limited to individualized advice directed to specific parties. Assuming the mutuality requirement of the current regulation is also eliminated, the ABA Tax Section also recommended an express requirement that advice be individualized, thereby incorporating the concept of privity between plan and adviser. This would address the fear that liability claims could be asserted based on the proffer of general information that happens to be used by a plan in the context of a securities purchase, even though the information is available to all comers. Without such a privity requirement, plans are likely to find that sources of information to which they now have access will no longer be available and that investment professionals will be far less free in offering their views.

If an individualized advice requirement is adopted, the DOL may seek to protect plans from a misunderstanding as to whether an adviser is acting in a fiduciary capacity by conditioning exclusion from fiduciary status on delivery of a notice that the information or advice is not intended to be fiduciary advice. The ABA Tax Section thinks that this notice could be incorporated in the 408(b)(2) disclosure materials, but one can imagine the DOL requiring such notice closer to the time the advice is given.

Re-Enrollment Default Investments: Bidwell v. University Medical Center

Q. Many recordkeepers offer re-enrollment services that require participants to provide new or updated investment instructions for their accounts. Employees who fail to re-enroll are defaulted into a qualified default investment alternative (“QDIA”). Recordkeepers have relied on the preamble to the QDIA regulations as legal authority to support the re-enrollment default investments. How will a recent court decision support the practice of re-enrollment default investments?

A. Preamble to QDIA Regs. The preamble to the QDIA regulations explains that “it is the view of the Department that nothing in the final regulation limits the application of the fiduciary relief to investments made only on behalf of participants who are automatically enrolled in their plan.” The preamble then explains that the QDIA regulations also apply to the failure of a participant to provide investment direction following the elimination of an investment alternative or change in service provider (i.e., plan conversions) as well as any other failure of a participant to provide investment instruction. When a participant has “the opportunity to direct the investment of assets in his or her account, but does not direct the investment of such assets, plan fiduciaries may avail themselves of the relief provided” by the QDIA regulations so long as all of its conditions have been satisfied.

6th Circuit Bidwell Case. In its June 29, 2012 decision in Bidwell v. University Medical Center, the U.S. Court of Appeals for the Sixth Circuit relied on the QDIA regulations and its preamble to provide relief for an employer that implemented default investments following a re-enrollment. The facts in Bidwell are as noteworthy as the court’s legal analysis.

Facts. In 2008, the employer changed the default investment under its 403(b) plan from a stable value fund to a target date fund. The employer instructed the recordkeeper to send a notice of the change by first-class mail to all participants who were 100% invested in the stable value fund. The notice also advised these participants that their investments would be moved to the target date fund unless the participants gave instructions otherwise by a specified deadline. Two participants who had affirmatively elected to invest in the stable value fund did not respond by the deadline and were defaulted into the target date fund. When these participants received their next quarterly statement, they directed their investments back into the stable value fund. In the interim, one participant suffered an $85,000 investment loss; the other participant incurred a $16,900 investment loss. They filed claims for reimbursement with the plan administrator. After the plan administrator and federal district court rejected the claims, the participants appealed to the 6th Circuit.

Arguments. On appeal, the participants argued that QDIA regulations should not shield the employer from claims of plan participants who had affirmatively elected to invest in the stable value fund. In other words, because they affirmatively elected into the stable value fund, they had a right to have their investment remain within the stable value fund until they explicitly directed otherwise. In relying upon the preamble to the QDIA regulations, the 6th Circuit said: “In essence, the DOL explained that, upon proper notice, participants who previously elected an investment vehicle can become non-electing plan participants by failing to respond. As a result, the plan administrator can direct those participants’ investments in accordance with the plan’s default investment policies and with the benefit of the [QDIA fiduciary liability] protections.” The 6th Circuit also rejected the participants’ argument that the QDIA regulations did not apply to a transfer of funds but only a failure to provide instructions with respect to contributions. Although the participants alleged that they did not receive a QDIA notice, they did not allege that the employer’s delivery method was inadequate. In any event, the 6th Circuit noted that it is not the actual receipt of notice that is relevant, but the acts of the fiduciary in attempting to ensure that notice is delivered. In this case, it was reasonable for the employer to rely on the dependability of the first-class-mail system.

Impact. Although the Sixth Circuit’s decision is binding in only Kentucky, Michigan, Ohio and Tennessee, it is likely that courts in other jurisdictions will cite it favorably.

408b-2 and 404a-5 Disclosure Aftermath

Q. What should financial advisors be telling their plan sponsor clients now that the 408b-2 and 404a-5 disclosures have been made?

A. Disclosure Failures. If a service provider has failed to provide the required 408b-2 disclosures to the plan sponsor, the plan’s fee payment to the service provided can be a prohibited transaction. However, a plan sponsor can obtain relief from the prohibited transaction penalties by taking steps to cure a known disclosure failure. First, the plan sponsor must make a written request for information, and the delinquent service provider is obliged to respond within 90 days. If the service provider refuses or is unable to respond to the request for information, the plan sponsor must notify DOL no later than 120 days after requesting information, and decide whether to terminate the service arrangement. The DOL has announced that plan sponsors can provide the notice online. In addition, if the requested information relates to future services and is not disclosed promptly after the end of the 90-day period, the plan sponsor is obliged to terminate the service arrangement-consistent with the duty of prudence-as expeditiously as possible. 

Fee Reasonableness Now Becomes Key Issue. All plan sponsors have a specific duty to assure that the plan’s fees for investment and administrative services are reasonable. Now that ERISA Section 408(b)(2) requires investment vendors and recordkeepers to provide comprehensive fee information, plan sponsors have a corresponding responsibility to review and understand this information. Thus, as a practical matter, the fiduciary bar is being raised for plan sponsors to evaluate the reasonableness of the service provider’s compensation. One of the keys to making a proper evaluation is establishing a prudent fee review process, which will most likely require plan sponsors to ask for additional information beyond what is included in a service provider’s 408(b)(2) fee disclosures.

Fee Policy Statement. It is now standard practice for plans to maintain an investment policy statement or IPS. Like an IPS, plan sponsors should seriously consider establishing and adopting a fee policy statement or FPS. The written procedures maintained in a formal FPS can give plan sponsors the procedural discipline necessary to conduct a proper view of a plan’s fees and services. The plan’s FPS should be customized to the plan’s circumstances and objectives, and the FPS’s procedures should complement the plan’s IPS procedures. That is to say, the plan’s review under the IPS should be coordinated with the plan’s review under the FPS. And like an IPS, a solid FPS can help plan fiduciaries demonstrate that they are acting with the procedural prudence required under the law.

Value Proposition. Rather than seeking a service provider with low fees, plan sponsors should seek out the service provider with the best “value proposition.” In order to evaluate the reasonableness of the service provider’s fees, the plan fiduciary should make appropriate inquiries about the service offering. Is the service provider genuinely committed to helping both the plan sponsor and the plan participants on an ongoing basis? If so, is the service provider willing to make that commitment in writing? Consistent with DOL’s guidance, a service provider’s fees should always be evaluated in light of the services provided. Plan fiduciaries should make an effort to work with service providers that are open and forthcoming about the types of services they offer and the fees for such services.

Fee Disclosures to Participants. If a plan sponsor has fee-related concerns because of the reaction of participants to the fee disclosures, the plan sponsors may need assistance from advisors in meeting or communicating with participants in order to clarify the investment and fee information with educational materials. The plan sponsor may also need assistance in enhancing its fiduciary review process.

Brokerage Accounts

Q. In light of the DOL’s original and revised guidance on offering brokerage accounts under 401(k) plans, what should plan sponsors be concerned about? 

A.There is no bright line test for determining whether the proper fiduciary review of brokerage accounts has been undertaken, or whether “sufficient information” has been disclosed. It will be a facts and circumstances analysis, case by case. However, financial advisors should help their plan sponsor clients maintain good documentation of efforts to satisfy the unique rules applicable to brokerage windows.

Original FAB. On May 7, 2012 the DOL issued a Field Advice Bulletin (“FAB”)that was intended to primarily clarify the participant disclosure requirements. Nevertheless, the FAB included a question and answer (“Q&A”) that imposed an “affirmative obligation” on a plan sponsor to examine the investments available within brokerage account and determine whether any should be treated as a designated investment alternative (“DIA”). The Q&A was controversial and the retirement industry persuaded the DOL to revise it.

Revised FAB. On June 30, 2012 the DOL revised the FAB to eliminate the “affirmative obligation” duty to examine the investments available within brokerage account. However, the revised FAB explains that the general ERISA duties of prudence and loyalty would require consideration of the nature and quality of services provided in connection with the brokerage account. In addition, a plan’s failure to offer any DIA (as a means to avoid the disclosure rules for DIAs) would “raise questions” under those ERISA fiduciary duties. The DOL intends to further examine the fiduciary obligations of plan sponsors with brokerage accounts.

Implications. In light of the revised FAB, here are some of the more important points for financial advisors to remember when assisting their plan sponsor clients:

  • Where a plan sponsor has determined a brokerage account would be a prudent investment option for the participants, financial advisors should assist with the implementation.
  • Even though brokerage windows are not subject to the specific DIA disclosure requirements (e.g., benchmarking or performance data), financial advisors should be prepared to help with the following general disclosure requirements for brokerage accounts offered by a plan:
    • A general description of the brokerage account that includes how investment instructions are to be provided, special restrictions or limitations if any, how the brokerage window is different from the plan’s DIA, and to whom questions may be directed.
    • Detailed fee and expense information that is chargeable to the participant’s account rather than on a plan-wide basis, including commissions and per-trade charges.
    • Preparation of quarterly fee statements that include a description of the related services.
    • Financial advisors should be careful to provide accurate brokerage account information requested by their plan sponsor clients. Although the plan sponsor is ultimately responsible for compliance with the participant disclosures, the plan sponsor is not liable where there has been reasonable and good faith reliance on information provided by service providers.

>New Areas of Potential Litigation

Q. We know that we live in a litigious society. We further know that Americans are woefully underprepared for retirement. Where do you believe liability exists in our industry and where will litigation be focused in the next few years?

A. Effect of 408(b)(2) Regulations. Before considering new areas of liability, we should think about the impact recent developments will have on existing liability theories. The predominant threats of litigation in the last decade have been stock drop cases and excess fee cases. The new disclosures required by ERISA Section 408(b)(2) are likely to highlight conflicts of interest and compensation payments that were previously hidden, which may be used to support such claims.

The new 408(b)(2) rules became effective July 1, 2012, and all plan sponsors must now receive comprehensive disclosures from their service providers concerning the hard-dollars and soft-dollars (such as 12b-1 fees) that they receive as compensation. These disclosures are designed to support the plan sponsor’s fiduciary duty to manage plan fees, and to ensure that they understand the indirect or “hidden” compensation of providers. If these tools are not utilized to negotiate competitive fees, the 2012 case of Tussey v. ABB, Inc. shows that a plan sponsor may be held liable. Further, the DOL has issued pronouncements to the accounting industry that plan auditors should be looking for 408(b)(2) compliance, or lack thereof, as part of the annual audit process.

Going forward, the new 408(b)(2) fee disclosures will force plan sponsors to monitor and benchmark all plan service provider compensation, both direct and indirect. If there are plan sponsor failures in this regard, there are likely to be claims of fiduciary breach and assertions of prohibited transactions. However, I think it will take the plaintiffs’ bar a year or two to evaluate whether the new disclosures help their cause.

In order to protect themselves against these kinds of claims, a plan sponsor selecting a new provider should consider obtaining relevant information about the provider’s services and fees by soliciting bids from multiple providers. If the provider utilizes one or more subcontractors, their information should also be requested and reviewed. Reviews of providers should be conducted at reasonable intervals (e.g., annually). To demonstrate that these reviews are part of an ongoing process, findings should be documented including a brief summary of the information gathered and the areas of fiduciary review. A well-documented review of the reasonableness of fees and expenses helps demonstrate that the plan sponsor has prudently fulfilled its fiduciary duties under ERISA.

TDFs – A New Litigation Frontier? If I had to predict a potentially new area for litigation, I would identify the selection of target date funds for a plan’s investment menu. In November 2010, the DOL showed its concern about these investments by issuing proposed regulations that would require participant notification as to how the asset allocation of any fund selected as a default investment changes over time (i.e., the fund’s glidepath) and when its most conservative asset allocation is reached (i.e., the fund’s landing point). This notice would need to include an illustration of the fund’s glide path, and if the name of the target date fund includes a reference to a particular date (e.g., “Retirement 2050 Fund”), it would also need to explain the relevance of the date and the intended age group. The SEC is proposing similar TDF changes.

Target date funds typically have a “fund of funds” tiered investment structure. This fund of funds structure creates conflicts of interest, because many target date funds invest in affiliated mutual funds. There is a natural incentive to include as many related funds as possible in the underlying fund mix and to have an excessive concentration in funds with the highest fees, such as equity funds. As a result, target date funds tend to have higher expense ratios than other 401(k) plan investments. In addition, many of them are excessively volatile, even as they approach their target dates.

The DOL, however, has advised that ERISA’s statutory structure insulates mutual fund investment managers from fiduciary liability. Since the managers of target date funds do not have any fiduciary duty under ERISA with respect to the plans investing in them, plan sponsors alone are responsible for the evaluation, selection and monitoring of these funds. Thus, another recession, or even a stock market correction, could trigger a waive of law suits against plan sponsors that have not adequately evaluated the target date funds in their plan’s investment menu.