BNA Pension and Benefits Blog

Thanksgiving Feast or Famine? - DOL Withdraws its Investment-Advice Regulation

The DOL has withdrawn its investment-advice regulation, culminating a process that began with a firestorm of objection regarding the DOL's attempt to implement the PPA's new investment-advice exemptions. The PPA's exemptions were controversial when passed, and became more controversial when the Department interpreted certain fee-leveling requirements in a manner that was perceived to be narrow. Then, in the final regulations, the Department added a new administrative exemption that narrowed the requirements still further, touching off congressional accusations that questioned the regulatory process itself.

The shrillness of some of the rhetoric was, to me (see my prior post on this), unfortunate, as efforts over a long and arduous regulatory process by dedicated public officials became characterized and impugned as special-interest gifts bestowed on the eve of a change in administrations. In an interesting rhetorical twist, which had the intended public-relations consequences, what I would have more neutrally called "inside" advice came to be referred to pejoratively as "conflicted" advice.

With the change in administrations, those upset with the regulations became empowered, and their influence within the DOL increased dramatically, as one might expect. The Department's actions now indicate that there will be some narrowing of the rules, but it remains to be seen whether a reproprosed rule will so narrowly interpret the statutory exemption that it will essentially marginialize it altogether. That could happen if, for example, the level-fee requirements were to be interpreted so as to require structures that are so sanitized that the structures don't involve self-dealing at all, in which case no exemption would be necessary. (I would expect the prior work done regarding the computer-model exemption to be relatively less controversial, and would be surprised if the Department would propose dramatically reversing that aspect of the regulations; we'll have to wait and see.)

To me, what amounts to a regulatory repeal of the statutory exemption would be unfortunate. The PPA struck a legislative balance given the legitimate and crying need that participants have for this advice, on the one hand, and conflicts that may arise, on the other. The Department's new proposals will hopefully not, by fiat, effectively repeal the fee-leveling exemption.

I think it is critically important that a wide range of professional advice be made available to 401(k) participants, who are in desperate need of professional advice. I think that one of the great deficiencies in current retirement policy is that, with the move to a focus on participant-directed defined contribution plans, which is the result of a confluence of events over time, what may be among the most important of investment assets - retirement assets - are left under the management of those (like me) often utterly untrained in how to invest those assets.

The PPA struck a balance that would have facilitated the provision of additional types of advice. Was the balance struck in the statute the precisely correct one? That, of course, is always open to discussion, but Congress did act. There now are proposals in Congress that would recut the rules, in effect eschewing any effort to balance the competing considerations and deciding that no conflict is tolerable, and the approach taken in those proposals is extreme. I think it would be unfortunate if Congress were altogether to take away from employers the ability to arrange for reasonably crafted inside advice delivered with proper safeguards (what I've called "conflict-safe," as opposed to "conflict-free," advice). In any event, though, the Department should credibly implement the rules that have passed, unless and until Congress reverses those rules.

And to what point does that bring us? At a minimum, I would expect the DOL to cut back or reverse the administrative exemption that goes beyond the statute; but we'll have to see how much farther they go in trying to narrow the statutory rules that are already there. At the end of the day, wherever it all lands, I hope that we wind up with a system that permits participants and beneficiaries to have a reasonable shot at accessing a wide range of professional advice to help them through the investment of their retirement nest eggs.

Investment Advice—ERISA’s Culture War

The DOL’s recent proposed class exemption for the provision of investment advice has re-ignited the debate over the need for and the role of investment advice in participant directed plans. The proposal would strike a good balance between the need to offer investment advice to plan participants and the importance of participant safeguards.

The genesis of the issue comes from DOL’s broad interpretation of the prohibition on self-dealing in section 406(b). DOL takes the position that a fiduciary engages in self-dealing if it uses its authority to affect the amount or timing of its compensation. This, according to DOL, is an automatic, per se violation regardless of the terms of the transaction and whether it is in the interests of plan participants.

This issue is important to financial institutions who sell investment products to plans and are fiduciaries because they provide investment advice. If the advice results in investments in mutual funds that pay varying fees to the advisor, then under the DOL view, the giving of the advice would be a 406(b) violation since the advisor would be using its fiduciary authority to affect the amount of its compensation.

For a number of years, the financial services industry tried unsuccessfully to convince DOL to grant a class exemption for the provision of investment advice. The industry then went to Congress. The House several times passed an advice exemption based on disclosure, but the Senate refused to take any action. Such an exemption finally was passed as part of the Pension Protection Act. The exemption contains relief for advice that is provided through computer models, or where the fees or other compensation paid to the advisor are not affected by the investments selected by the participant as a result of the advice – i.e. fee leveling. These two approaches are intended to minimize the possibility of self-dealing, but have limited utility. Using computer models is not an effective way to provide individualized advice, and fee leveling is not workable for many firms. As a result, DOL proposed a class exemption to cover advice arrangements that involve neither a computer remodel nor fee leveling.

The proposal goes substantially beyond the bill passed by the House that was criticized for not being protective of plan participants, and contains detailed conditions to deal with potential self-dealing. The participant or IRA holder must first receive a computer model or general asset-allocation models. Advice provided under the class exemption cannot generate greater income for the adviser than other options of the same class unless the advisor prudently concludes that the recommendation is in the best interests of the participant and explains this to the participant. In addition, the advisor must document the basis for such conclusion, including an explanation as to how the recommendation compares to the computer model or model portfolios previously furnished. The advisor must also provide detailed disclosure of the fees and other compensation it receives as well as of any material affiliation or contractual relationship with those persons who have a role in the selection of investment options. Finally, the advisor must adopt procedures designed to assure compliance with the exemption and must obtain an annual compliance audit.

DOL has made a good-faith effort to provide an advice exemption with adequate safeguards. However, it will likely be criticized by those who think advice with any potential for abuse is bad. Because participants acutely need advice, and the proposal contains many safeguards, DOL should adopt grant the advice exemption. However, in today’s environment, members of Congress may be inclined to condemn any regulatory action that relies on the prudence and good judgment of a financial institution. It would be unfortunate if the advice proposal were the victim of this environment. Participants would be the losers.

A Report on Yet Another Reporting Issue for Private Equity and Other Investment Funds

Section 404(a)(1) of ERISA generally requires a fiduciary to act in the interest of participants and beneficiaries and to act prudently. ERISA also requires, under Section 103(b)(3)(A), an annual report which includes a financial statement containing, among other things, a statement of assets and liabilities "valued at their current value." Current value is to be determined in good faith by a trustee or named fiduciary.

A July 1, 2008, letter from James Benages of the DOL's Boston office has made its way around the market. There, he considers a plan which was invested in a number of alternative investments ("AIs" (no relationship to the Kubrick/Spielberg movie, at least I don't think so)), and which apparently took a fairly common approach to the Form 5500 reporting thereof. For example, one particular AI was valued at cost by the applicable committee "based on the general partner's unaudited Capital Account Balance Statement" for the period in question "and the accompanying audited financial statements." Another was valued according to the general partner's unaudited determination of fair market value.

The July 1 letter states that (i) not only has the committee "failed to establish a process to determine the most accurate fair market value," but cost and fair market value have been "equate[d]," (ii) such failure violates ERISA's "solely in the interest" requirement, and (iii) as a result, in the DOL's view, the committee "is in violation of ERISA and will remain so until it takes corrective action." Before discussing Section 502(l) and the possibility of action by other governmental agencies and third parties, the July 1 letter kindly comforts that, if corrective action is taken, no lawsuit will be brought by the DOL.

The issues implicated by the July 1 letter are significant. Many private equity and other investment funds provide valuations on the bases noted in the letter, and plan fiduciaries would not ordinarily be expected to have the information required to second-guess the available valuations or the expertise to do so even if they had the information.

The DOL's approach seems to raise the specter that making an investment not practically susceptible to ready valuation is somehow a per se violation of Section 404(a)(1) of ERISA. The July 1 letter seems expressly to tie the "sole purpose" requirement to the reporting requirement, although the connection isn't particularly clear. There's also a more oblique reference to the Section 404(a)(1)((B) prudence requirement, not tied specifically to the reporting issue. Is the DOL implying that it is per se imprudent for a fiduciary to invest in a difficult-to-value investment, without special valuation efforts?

What would be the effect of there being a Section 404(a)(1) violation merely because an investment is not subject to valuation? Several alternatives seem possible.

Maybe the plan would demand that the fund provide appraised valuations. A number of funds, however, would presumably not be anxious to engage an appraiser, whether because of an unwillingness to develop and distribute the valuation, an unwillingness to spend the time and money on the valuation or an unwillingness to share the underlying information with the appraiser.

Maybe the plan would do its own analysis. However, any number of plans presumably would not have the time or inclination to do so.

Maybe the plan would ask for additional factual information to facilitate the plan's valuation efforts. It is by no means clear that the fund would provide such information.

Or maybe the plan would simply decide it's not worth the effort. To someone who does not appreciate AIs, maybe this result is somehow acceptable.

But is it? It is not up to non-experts to decide that a class of investments is suboptimal, whether or not there are experts out there who might agree. Clearly, AIs have enthusiastic support as a part of an overall portfolio from a wide range of investment professionals, and it is up to the responsible fiduciary to make the actual investment decision. The fact that support is not unanimous is a fact to be taken into account by the responsible fiduciary.

I recognize that there are those who will disagree, even vehemently. (I'm ducking already.)  Some have made the argument that there is no possible way that an unvalued/unvaluable investment can be prudent. I would point out that almost by definition such a conclusion has been rejected as a business matter by substantial portions of the market - the investments are in fact being made, often by the most sophisticated of investment professionals. (If Warren Buffett were to offer me the opportunity to invest in a black box of managed investments for a 10-year term with no information and a de minimis fee, would I be imprudent to make the investment? Maybe I'd be imprudent not to do so.)

To me, one of the areas (the only one?!) in which ERISA has consistently been lauded is its use of modern portfolio theory and deference to the expert fiduciaries regarding portfolio choices. Notwithstanding the apparent trend of some in the government to pretend that they are competent to decide what plans can invest in, as evidenced by the recent and possibly continuing commodities-legislation debacle, ERISA arguably has no legitimate role in trying to identify specified types of investments as imprudent per se. ERISA should not be responsible for depriving the most sophisticated managers from being unable to access, on behalf of ERISA plans, the most sophisticated investments.

A potential gut reaction is that this whole issue is a tempest in a teapot - if plans are made unable to invest in AIs in the absence of developed valuation information, the funds will naturally come up with improved information. However, the dust-up of several years ago where governmental investment put funds' confidentiality at risk, resulting in an unwillingness of some funds to accept government-plan investment, shows that there could come a point at which funds will indeed turn their back on money over regulatory issues. Further, even if the market would adjust, there is a question of whether it should have to adjust.

To me, the first step is to limit the analysis to where it belongs. The level of valuation information to be given over time by a fund should be considered another factor, not some super-factor, taken into account by a court in analyzing whether, on all facts and circumstances, the fiduciary has satisfied its Section 404(a)(1) obligations. It is suggested here that the lack of a draconian penalty for violating Part 1 requirements doesn't mean that those violations are somehow magically converted into Part 4 violations (any more so than would be in the case of, for example, a failure to distribute an SPD).

That still leaves Section 103(b)(3)(A), which applies on its face to require fair-value reporting. The reporting obligations help get information out to participants and beneficiaries, and bear upon the plan's funded status. In this latter regard, if the valuation information is inaccurate, the entire funding regime is potentially compromised. If I invest in a company with $100 million in reported assets, and the company assets are "really" only worth $1 million, my investment may well not be all I thought it was.  A plan's funded status could be similarly misrepresented. 

One possible interesting solution would be to focus on the practicalities of the situation (thanks to Andrew Gaines for talking this through with me). As a practical matter, AIs are likely to constitute only a small percentage of a plan's total portfolio, being there to provide a potential large maximum return as to a portion of the portfolio deemed suitable by the experts for investment at higher risks. If a concern is that overreporting of asset value could somehow place a plan at risk (or, in the case of underreporting, give rise to excessive deductible plan contributions), maybe an answer could be to allow reasonable reporting based on information disseminated in accordance with market practice (e.g., historical cost or GP estimates), but only as to a portion of the plan's portfolio not to exceed certain percentages. Presumably, given the role of AIs in most portfolios, this percentage could be made fairly low without excessive market dislocation.

AIs can form a critical part of a plan's investment strategy, and in some cases probably account in part for superior overall performance. The point here is not to argue that AIs are or are not smart investments; rather the point is to argue that the question of investment choice is for the investment professional, and that it would be unfortunate if the reporting rules were to serve as an impediment to the making of an otherwise permissible investment at the direction of a responsible plan fiduciary.

Another Piece of the Extended Puzzle - Proposed DOL Regulations Reach to General Prudence Rules

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports. These issues have given rise to a four-piece puzzle, with activity regarding (i) regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.

The issue is clearly front-burner for the DOL, which is trying to proceed with a coordinated new regime that would have a real impact on the quantity and quality of information available to participants. There has already been movement in the first two arenas, with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, both of which have been controversial. Congress has proceeded, too, with the proposed Miller bill. The only theater that had remained dark was the one relating to the 404(c) rules.

Section 404(c) is the section that gives plan fiduciaries the opportunity to limit their liability in the case of plans which provide for participant-directed investments and which satisfy the regulatory Section 404(c) requirements. Thus, the DOL had broad discretion to impose such informational requirements as it saw fit under Section 404(c). Showing how much attention it is giving to the question of participant information, though, the DOL took this opportunity to expand the expected scope of its rulemaking and issue rules proposed to apply under ERISA's general prudence rules, whether or not the protection of Section 404(c) is sought. The general prudence rules, like the 404(c) rules, give the DOL a fairly free regulatory hand, as there is no clear limitation on the abilty to add regulatory color on what it means to be proceeding in accordance with general prudence-type considerations.  Thus, the new proposals would generally apply to all plans under which participants have the right to direct investments, even if the plan sponsor is willing to forego Section 404(c) relief. It is clear that that the DOL is making a concerted effort to establish a set of rules that will significantly change the nature of the information that is broadly available to participants in plans where they direct their own investments.

It remains to be seen whether the market will view the balance that has so far been struck by the DOL as being the right one. I expect the comment process regarding this particular piece of the puzzle to be extremely active in terms of submissions on all sides of the market, including participant-advocacy groups, employers, financial services organizations and administrators. One thing seems certain - the old rules, with a much more generic approach to the provision of information, seem eventually to be a thing of the past.

Now the DOL is FAQuing It - Having Fun with "Funds" on the Form 5500

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports.  These issues have generated activity in four theaters: (i) the regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.  The DOL has moved forward in the first of these two arenas with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, which have turned out to be flashpoints in the market for a firestorm of controversy affecting financial services organizations and plan sponsors alike.  Much (but not all) of the controversy has centered around the DOL's attempt to expand certain rules to a variety of types of indirect compensation and, apparently, in some cases, compensation for supposed indirect services, particularly in the context of fees surrounding "investment funds."

On July 14, the DOL issued FAQs intended to help with the administration and implementation of the new 5500 rules.  To its credit, using the efficient FAQ mechanic, the DOL is reacting quickly to a real need in the marketplace for guidance as to how these rules will work.  Putting aside the question as to whether everyone will agree with everything the DOL has done in the FAQs, it was critical that the DOL start to get on the record as to a range of seminal interpretive questions.  (And, thankfully, the FAQs were released almost a full week before the release of the The Dark Knight, so that I could read them without being distracted by what I'm anxiously hoping will be One of the Greatest Movies Ever Made.)

I'm writing here to take note of an arguably arcane but ultimately critical and interesting feature of the FAQs, relating to the nature of what is an "investment fund" for purposes of the new 5500 rules.  It did not go unnoticed by some that the new rules seemed to latch onto the concept of "investment funds" as a major underpinning of when the new indirect-type rules apply; however, the concept appeared to spring suddenly from within the authority, and didn't have a firm express basis is that which had come before.  (Yeah, it's a "lawyer point," I guess, in a group of FAQs with more direct practical implications, but, then again, I'm a lawyer.)  The issue was made more vexing by the fact that the new rules did not tap into the existing regime for look-throughs to investing plans, the so-called "plan asset" regulations (as modified by ERISA as recently amended), but rather went down this new, undefined "investment fund" road.

Thus, the scope of the "investment fund" concept, and by extension the very scope of a substantial portion of the new rules, became subject to something of a cloud right from the get-go.  For example, what is an "investment fund" anyway?  How do hybrid entities, like REOCs (real estate operating companies) and VCOCs (venture capital operating companies) under the "plan asset" regulations fit in?  How does the general "operating company" concept overlay on top of the fund analysis?  These questions, and the lack of any answers (or even discussion) regarding them, resulted in a significant analytical detour right out of the interpretive gate.

Well, Q&A 7 of the new FAQs is packed with a lot of information and goes a long way towards shedding light on how the DOL views these matters.  There is the description by example of what "investment fund" means, where the DOL says in a parenthetical: "e.g., mutual funds, collective investment funds."  (It may not seem like much, but it was more than we had.)  There is the posing of the basic question of whether compensation received in connection with the management of VCOCs, REOCs and other operating companies needs to be reported, and there is the DOL's pithy and straightforward (and, to me, clearly correct and appropriate) answer, "No."  There is the clarification that, notwithstanding the foregoing, fees or commissions received by a manager or adviser in connection with an investment in an operating company could be reportable.  And, underscoring the extent to which the DOL really seems to have created a whole new quasi-"plan asset" framework in the context of the reporting rules, the DOL states: "This answer would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that [under the "plan asset" regulations] the assets of the entity would be deemed to be plan assets."

This last nuance indicates that the formalistic approach under the bedrock "plan asset" rules falls, in the reporting context, to what may be a more intuitive analysis.  As a result, essentially all that matters here is whether there is an operating company present effectively to block the look-through, not whether the entity's assets technically are "plan assets." (The need to apply the technical rules to determine whether an entity is a VCOC or REOC (or other operating company) is still present.)  It remains to be seen whether this new conceptual approach will eventually be given application for other ERISA purposes.

The foregoing is just one small aspect of an important set of FAQs, and shows, even standing alone, how interesting the development of the reaction to the fees issue has been and probably will continue to be.  In this regard, note also that, in Q&A 40, the DOL states: "In an effort to address the concerns of both service providers and plans, the Department has decided that, with respect to those employee benefit plans which are dependent on service providers for information necessary to complete the Schedule C, the plan administrator will not be required for 2009 plan year reports to list a service provider on line 4 of the Schedule C [which basically calls for the listing of uncooperative service providers] as failing to provide information necessary to complete the Schedule C if the plan administrator receives from the service provider a statement that (i) the service provider made a good faith effort to make any necessary recordkeeping and information system changes in a timely fashion, and (ii) despite such efforts, the service provider was unable to complete the changes for the 2009 plan year."  Bravo - this relief (which presumably will spawn quite a lot of "statements") is extremely welcome in light of the fact that, as shown above, on even the most basic gateway issues there is a great deal of new concepts, analyses and information to digest.   

401(k) Fee Disclosure

As 401(k) plans become the major source of retirement savings,  Congress, GAO, DOL and the SEC are all turning their attention to the issue of 401(k) fees. Last fall, Gao issued a reprt on Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees at the request of Congressman George Miller, now Chair of the House Education and Labor Committee.  Last week, the Committee held a hearing on "Hidden 401(k) Fees Undermining Retirement Security?"  If you missed the hearing, you can view it on line at the Committee's website, where the written testimony of the witnesses is also posted.

The DOL has indicated that they will be launching a number of new initiatives to increase disclosure of 401(k) fees, particularly the payment of indirect fees to service providers. The DOL has already proposed a revision of  Schedule C of the Form 5500 which would require annual disclosure of indirect fees. Recognizing that plan fiduciaries often have difficulty getting information about indirect fees, the Department is planning to propose an amendment to the statutory prohibited transaction exemption that permits service providers to be paid (ERISA section 408(b)(2)) to require service providers to provide information about indirect compensation so that plan fiduciaries can determine if their total fees are reasonable. The Department is also expected to issue a request for informtion about 401(k) disclosure of fees, both direct and indirect, to plan participants.

Meanwhile, in a speech to the ABA Business Law Section last week, Andrew Conohue, Director of the SEC's Division of Investment Management, indicated that the SEC is working with the DOL to determine how fee disclosure should be made to 401(k) plan participants. He also indicated that the Commission staff is reviewing the rule that permits mutual funds to pay 12b-1 fees.

Plan fiduciaries should be continuing to request information about indirect fees from service providers such as investment managers, investment consultants, recordkeepers and trustees to determine whether the fees paid by their 401(k) plan are reasonable. Since many fees paid by 401(k) plans are asset based, fiduciaries should review the total paid annually as plan assets grow. Also, fiduciaries should move to institutional shares of mutual funds as their investments reach the minimums for such shares. Finally, fiduciaries should benchmark the fees they are paying against industry averages.

Fiduciaries shouldn't lose sight of the fact that the key is the return participants are getting net of fees, so fees shouldn't be the only consideration. However, compared on a net basis, lower fees will often result in better performance.