What is New in DC: The Most CriticalItems to the Obama Administration

Marcia S. Wagner, Esq.

What’s up in Washington?Outlook on U.S. Private Retirement System◦ Retirement security is a major priority.◦ Pushing for reform through Congress and DOL.

White House Task Force on the Middle Class◦ Newly created by President Obama in 2009.◦ Chaired by Vice President Biden, and includes

Secretaries of Labor and Treasury.◦ Used to coordinate Administration’s agenda.

Diverse, broad initiatives set by White House◦ Mandatory “automatic IRAs” for employers that

don’t sponsor retirement plans.◦ Improving the DC savings system.

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Improving the DC Savings SystemObama Administration’s proposals target

401(k) plans and providers.◦ Proposals are in the form of DOL regulations.◦ Blurring of lines between White House and DOL.◦ Coordinated actions to improve retirement security.

Washington is focusing on:1. Conflicts of Interest

(A) Participant Investment Advice (B) Broader “Fiduciary” Definition

(C) Service Providers

2. Default investments

3. Lifetime income options

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1. Conflicts of Interest (A) Participant Investment Advice

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How Can Inv. Advice Be Conflicted?Advisor recommends funds for 401(k) menu.Plan sponsor then asks advisor to give fiduciary

“investment advice” to participants.◦ Fiduciary duty requires any investment advice to be in

the best interest of participants.◦ Potential incentive to steer participants to funds with

highest fee for advisor (i.e., variable compensation).

ERISA’s prohibited transaction rules. ◦ Unlawful to give conflicted fiduciary advice.◦ Advice is tainted even if given in good faith.◦ DOL reg’s for PPA exemption are (1) proposed, (2)

finalized, (3) withdrawn, and (4) re-proposed on Feb. 26, 2010.

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Exemption for Participant AdviceERISA allows participant-level advice if conditions

of PT exemption are met.◦ Pension Protection Act of 2006 included statutory

exemption as a matter of law.◦ Industry awaits DOL’s interpretive regulations.

Regulatory “rollercoaster ride” ensues:◦ RFI soliciting info for anticipated reg’s in Dec. 2006.◦ Proposed reg’s issued in Aug. 2008, expanding scope of PT

exemption.◦ Reg’s are finalized in last days of Bush Administration.◦ Obama Administration immediately delays effective date of

final reg’s.◦ Reg’s are withdrawn in Nov. 2009.◦ New reg’s are re-proposed on March 2, 2010.

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Pension Protection Act of 2006PPA statutory exemption for Fiduciary Advisers

(e.g., RIAs, banks, insurers, B-Ds).◦ Eligible Investment Advice Arrangement must have (1)

fee-leveling or (2) computer model certified by independent expert.

◦ Annual audits, notice to participants are required.

DOL’s Field Assistance Bulletin 2007-1◦ Interpretive guidance on “fee-leveling.”◦ DOL states that PPA statutory exemption is clear.◦ Individual advisor and firm (but not firm’s affiliates) are

subject to fee-leveling.◦ If firm has affiliated funds, advisor can recommend that

participants invest in affiliated funds!

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First Iteration of Reg’s (Withdrawn)Highly unusual rulemaking by DOL in 2 parts.◦ 1) Proposed interpretive guidance with respect to PPA

statutory exemption (with no big surprises).◦ 2) Proposed “class” exemption with softer conditions for

providing conflicted participant-level advice!

Fee-leveling (proposed class exemption):◦ Only individual advisor is subject to fee-leveling! ◦ Firm itself can receive variable compensation (e.g., 12b-1

fees) when advising participants!

Computer model (proposed class exemption):◦ Once computer model advice has been provided, advisor

can follow up with individualized advice. ◦ Follow-up advice is not subject to fee-leveling!

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Second Iteration of Reg’s (New)First iteration was finalized on Jan. 21, 2009.◦ Reg’s in their entirety (including non-controversial

interpretive portion) withdrawn on Nov. 20, 2009.

Second iteration unveiled on Feb. 26, 2010.◦ Similar to interpretive portion under first iteration. (1) Fee-leveling for individual advisor and firm. (2) Computer model advice can not be followed by

individualized advice.◦ Computer model can consider (1) fees/expenses, and

(2) asset class performance, but not individual fund performance.

- Favors index funds? - Comment period for reg’s end on May 5th.

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1. Conflicts of Interest (A) Participant Investment Advice (B) Broader “Fiduciary” Definition

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ERISA and ConflictsFiduciary standards under ERISA are the

highest known to the law.◦ Conflicts can not be mitigated through disclosure.◦ Must eliminate conflict or meet conditions of a PTE.

Administration’s campaign to reduce conflicts.◦ Proposal to change “fiduciary” definition to include

more consultants and advisors.◦ Would impose ERISA fiduciary standard on

consultants and advisors who do not meet current “fiduciary” definition.

◦ Would require new segment of providers to eliminate conflicts or comply with PT exemption.

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DOL’s Agenda on “Fiduciary” DefinitionDOL Unified Agenda (Dec. 7, 2009)◦ Announces that it will be publishing proposed reg’s on

“fiduciary” definition.◦ Will change “investment advice” definition used to

determine fiduciary status of provider.

DOL Fact Sheet on Proposal◦ Need to re-examine types of advisory relationships that

should be subject to fiduciary standards.◦ Fact Sheet specifically cites pension consultants and

financial asset appraisers.◦ DOL is concerned that current definition allows advisers

from whom plans expect impartial advice to evade fiduciary responsibility.

◦ Current definition has a 5-part test for fiduciary “investment advice.”

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What Does It Mean to be a Fiduciary?Statutory definition – ERISA 3(21)(A)(ii)◦ Any person who renders investment advice for

compensation is a fiduciary.

DOL definition of “investment advice” :◦ Advice on value or advisability of investments,◦ that is provided a regular basis,◦ pursuant to a mutual agreement or understanding,◦ that such services will serve as a primary basis for

investment decisions, and◦ that individualized advice will be based on the particular

needs of the plan.

DOL definition of investment advice is more narrow than federal securities law definition.

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Potential ImplicationsImplications of broader “fiduciary” definition.

◦ Dovetails with initiatives to improve transparency.◦ Broader definition increases impact of DOL’s other

mandates, including PT rules.

If regulatory change goes into effect, potential impact on providers:◦ Need to adopt fee-leveling.◦ Need to change nature of services so that they are

not deemed to include fiduciary advice.◦ Eliminate conflicts.

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1. Conflicts of Interest (A) Participant Investment Advice (B) Broader “Fiduciary” Definition (C) Service Providers

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When Are Service Providers Conflicted?Plan sponsor is looking for provider of

administrative services.Provider offers two options:

◦ Services ordered a la carte: $10,000.00◦ Pre-packaged services and menu: $ 4,000.00

Plan sponsor may incorrectly conclude pre-packaged option is best for participants. ◦ Doesn’t realize that provider receives “hidden”

compensation from funds and fund managers.◦ Full compensation may be more than $10,000.◦ Hidden cost is actually shifted to participants.

Provider has incentive to steer uninformed clients to more profitable option.

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Retirement Security InitiativeImproving transparency of 401(k) fees.

◦ Administration’s goal is to make sure workers and plan sponsors are getting services at a fair price.

◦ Pushing to finalize DOL’s 2007 proposed reg’s this year.

GAO reports provide political momentum.◦ Private Pensions: Changes Needed to Provide 401(k)

Plan Participants and the DOL Better Information on Fees (Nov. 2006).

◦ Fulfilling Fiduciary Obligations Can Present Challenges for 401(k) Plan Sponsors (July 2008).

◦ Private Pensions: Conflicts of Interest Can Affect Defined Benefit and Defined Contribution Plans (March 2009).

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DOL’s Reg. ProjectThree-pronged project to improve disclosure.◦ Form 5500: Reg’s finalized and effective from 2009

plan year.◦ Service providers: Proposed 408(b)(2) reg’s

scheduled to be finalized later this year. ◦ Participants: Proposed reg’s have been issued.

Rationale for proposed 408(b)(2) reg’s.◦ DOL efforts to educate plan sponsors about 401(k)

plan fees started with Nov’ 97 hearing.◦ Plan sponsors still not asking the right questions.◦ DOL will now require providers to furnish the info

sponsors should be requesting.

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Current Requirements for Service Providers

PT rules under ERISA prohibit use of plan assets with respect to many activities.◦ Fortunately, PT exemption allows use of plan assets

to pay for services if: (1) Contract or arrangement is reasonable, (2) Services are necessary for plan operation, and (3) No more than reasonable compensation.

Current DOL regulations.◦ Plan must be able to terminate the contract

without penalty on reasonably short notice.◦ Statute and current reg’s do not impose significant

burden on service providers.19

Proposed 408(b)(2) Regulations

Service providers affected by 408(b)(2) reg’s.◦ Fiduciaries under ERISA or Advisers Act.◦ Providers involved with plan administration or

investments.◦ Providers of accounting, actuarial, legal and other

professional services if they receive indirect fees.

Provider must disclose fees in writing.◦ Must disclose services to be provided.◦ Must disclose fees and payment method, including

indirect compensation.◦ For “bundled” services, no need to disclose fees on

service-by-service basis.20

Proposed 408(b)(2) Regulations (continued)

Provider must disclose conflicts in writing.◦ Is provider a fiduciary under ERISA /Advisers Act?◦ Participation in transactions with the plan client?◦ Any material relationships creating conflicts?◦ Is provider able to affect its own compensation?◦ Any policies that address provider’s conflicts?

Disclosures must be provided in advance.◦ But need not be in service contract itself.◦ Any material change in provider’s information

during contract term must be disclosed within 30 days.

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Proposed 408(b)(2) Regulations (continued)

Ability to cure disclosure failures.◦ If provider fails to make 408(b)(2) disclosures, use of

plan assets to pay for plan provider’s services will trigger a PT.

◦ Fortunately, 408(b)(2) disclosure failures can be cured under a proposed class exemption.

No conflict of interest relief for fiduciary.◦ 408(b)(2) disclosure does not cure self-dealing

violations under ERISA 406(b).

Outlook for finalization soon.◦ Pressure from competing legislative proposals.

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1. Conflicts of Interest (A) Participant Investment Advice (B) Service Providers (C) Broader “Fiduciary” Definition

2. Default Investments

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Background on Target Date FundsPopular default investment vehicle for 401(k)

plans. Typically, formed as open-end investment

companies registered under the Inv. Co. Act.Defining characteristic – “glide path” which

determines the overall asset mix of the fund.Performance issues in 2008 raise concerns,

especially for near-term TDFs.◦ Based on SEC analysis, the average loss for TDFs with

a 2010 target date was -25%.◦ Individual TDF losses as high as -41%.

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Administration’s Proposals for TDFsImproving transparency of TDFs and other default

retirement investments.DOL and SEC at Senate Special Committee on Aging

hearing on TDFs (Oct. 28, 2009).DOL’s new guidance on TDFs.◦ DOL announces proposal for QDIA regulations.◦ Investor Bulletin jointly released by DOL and SEC.◦ “Best practices” fiduciary checklist is pending.

SEC proposal for TDF advertising materials.◦ If name has target date, “tag line” disclosure needed.◦ Advertising must include glide path information.

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Conflicts of Interest in TDFsConflicts arise when a “fund of funds” invests in

affiliated underlying funds.◦ Fees are payable to underlying fund managers.◦ TDF uses affiliated underlying funds for every single

asset class.

Conflicts regarding mix of funds also exist.◦ Equity funds typically pay higher fees.◦ Certain 2010 TDFs invested up to 68% of assets in

underlying equity funds.

TDF-related conflicts found in mutual funds would not be permitted if fund managers were subject to ERISA.

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Fund Managers Are Exempt from ERISAERISA Section 401(b)(1)

When a plan invests in a security issued by a mutual fund, “the assets of such plan shall be deemed to include such security but shall not, solely by reason of such investment, be deemed to include any assets” of such fund.

ERISA Section 3(21)A plan’s investment in a mutual fund “shall not by itself cause such [fund] or such [fund’s] investment adviser” to be deemed a fiduciary.

Combined effect of these provisions is to create a carve-out from ERISA’s fiduciary requirements for fund managers.

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Are Mutual Fund Managers Ever Subject to ERISA?

Fund managers are not automatically deemed to be fiduciaries.◦ But can they be ERISA fiduciaries in certain

circumstances?

ERISA Section 401(b)(1)When a plan invests in a security issued by a mutual fund, “the assets of such plan shall be deemed to include such security but shall not, solely by reason of such investment, be deemed to include any assets” of such fund.

ERISA Section 3(21)A plan’s investment in a mutual fund “shall not by itself cause such [fund] or such [fund’s] investment adviser” to be deemed a fiduciary.

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Request for DOL GuidanceFirm requested clarification on scope of exemption for

TDF mutual fund managers.◦ Adv. Op. 2009-04A on behalf of Avatar Associates.◦ DOL declined to rule that the TDF mutual fund managers should

be viewed as fiduciaries.

Implications of DOL guidance◦ Plan sponsors are alone in their fiduciary obligation.

Fiduciary duty to evaluate plan’s QDIA.◦ Participants responsible for default allocation choice.◦ Plan sponsors must ensure QDIA is prudent choice.◦ Must ensure TDF’s underlying investments are appropriate and

monitor TDF on ongoing basis.

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Congressional Proposal for TDFsSenator Kohl announced his intent to

introduce new legislation (Dec. 2009).◦ Concerns over high fees, low performance or

excessive risk in many TDFs.◦ Would impose ERISA fiduciary status on TDF

managers when TDF used as QDIA in 401(k) plans.

Senator Kohl’s proposal differs from DOL approach to improve disclosures to employers and participants.

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1. Conflicts of Interest (A) Participant Investment Advice (B) Service Providers (C) Broader “Fiduciary” Definition

2. Default Investments

3. Lifetime Income Options

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Retirement Security and Annuitization

Obama Administration believes lifetime income options facilitate retirement security.◦ Initiative to reduce barriers to annuitization of 401(k)

plan assets.◦ DOL / IRS issued a joint release with requests for

information on Feb 2, 2010.◦ RFI addresses education, disclosure, tax rules,

selection of annuity providers, 404(c) and QDIAs.

The Retirement Security Project◦ Released 2 white papers on DC plan annuitization.◦ Proposed use of annuities as default investment.

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Other Recent Developments in DC Plan Annuitization

Two types of legislative proposals.◦ Encourage annuitization with tax breaks: Lifetime

Pension Annuity for You Act, Retirement Security for Life Act.

◦ Annual disclosure of what 401(k) plan balance would be worth as annuity: Lifetime Income Disclosure Act.

IRS addressed qualification requirements for DC plans in PLR 200951039.◦ Variable group annuity investment options◦ No “surprise” interpretations on age 70 ½ minimum

distribution and QJSA rules.33

Lifetime Income Hearing bySenate Special Committee on Aging

Senate hearing held on June 16, 2010.◦ The Retirement Challenge: Making Savings Last a

Lifetime.◦ Start of legislative debate on lifetime income

options.

DOL and Treasury provide early analysis on RFI concerning lifetime income options.◦ More than 800 responses to RFI.◦ Concerns expressed against government takeover

of 401(k) plans.◦ DOL and Senator Kohl clarify that there is no

interest in mandating lifetime income options.34

1. Conflicts of Interest (A) Participant Investment Advice (B) Service Providers (C) Broader “Fiduciary” Definition

2. Default Investments

3. Lifetime Income Options

4. Effects on Clients35

How Can I Use this Information?Final Rules vs. Proposed Rulemaking◦ Product changes often based on final rules only.◦ But leveraging your knowledge of current events in

Washington can help plan clients.

Employer’s Duty of Prudence◦ Prudent review process entails consideration of all

relevant factors.◦ If Washington announces investigations in an area,

plan sponsors should investigate for their own plans.

Demonstrating Your Expertise◦ Use knowledge to distinguish your level of service.◦ Discuss current DOL priorities: (1) conflicts of interest,

(2) default investments, (3) lifetime income.36

Prepare Your ClientsRegulatory change is very likely this year.◦ Retirement security is a priority.◦ Regulatory changes not subject to Congressional approval.

Nobody likes transitioning to new rules.◦ New agreements and forms.◦ New fiduciary procedures and practices.

Stay ahead of the curve.◦ Ensure clients will not be surprised when change is

required.◦ Incorporate “best practices” now, ahead of when

Washington is likely to mandate them in future.

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What are the “best practices”?Facilitate prudent review of target date funds.◦ Assist in the fiduciary review of the “fund of funds”

structure, glide path, underlying funds and risk.◦ Special review of TDFs for participants in or nearing

retirement (e.g., 2010 TDF).◦ Better education for participants, especially on risk.

Help plan sponsors evaluate “hidden” fees.◦ Duty to ensure fees paid from plan are reasonable.◦ All fees must be considered in light of services.◦ Fee monitoring should be a fiduciary review process, like

monitoring the plan’s investment menu.◦ Required for Form 5500 reporting purposes (beginning with

2009 plan year).

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What are the best practices?(continued)

Clarifying fiduciary vs. non-fiduciary services.◦ Policy goal to impose fiduciary standards when

there is expectation of impartial advice.◦ If fiduciary advice (especially to participants) is not

intended, be sure to clarify that it is education only.

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What is New in DC: The Most CriticalItems to the Obama Administration

Marcia S. Wagner, Esq.

99 Summer Street, 13th FloorBoston, MA 02110

Tel: (617) 357-5200 Fax: (617) 357-5250 Website: www.erisa-lawyers.com

marcia@wagnerlawgroup.com 40A0040541 ver 2