Service Provider
Compensation
Steve Saxon, Andrée St. Martin, Roberta Ufford
Provider Compensation
 … an issue for Plan
sponsors and
providers
 … pension plans,
DC plans, welfare
plans
2
Provider Compensation
 ERISA regulates pension and welfare plans.
– pension plans - DB plans, DC plans (e.g., 401(k))
– welfare plans - health, disability, life
– insured and self-insured
 ERISA has highly technical rules regulating the conduct
of fiduciaries (e.g., employers, investment managers and
advisers, and other fiduciary service providers), including
prohibitions on fiduciary conflicts of interest.
 It also has technical “prohibited transaction” rules that
regulate, among other things, the provision of services to
plans.
3
Provider Compensation

Plan sponsor/fiduciary has a fiduciary duty to
prudently select and compensate plan providers.
 A plan “service provider” is any person rendering
services to a plan.
 A service provider may or may not be a fiduciary;
and, is only a fiduciary “to the extent” of its
fiduciary acts.
 Under traditional analysis, a non-fiduciary service
provider (a “mere” service provider) does not owe a
direct duty to the plan.
4
Provider Compensation –
Two Forms
 Paid by the plan, e.g., typical fees for plan
administration and investment management,
securities transaction costs.
 Some fees are invoiced; some costs are reflected
in investment return (e.g., unitized funds may
"hide" expenses).
 Provider compensation from third parties, e.g.,
commissions, soft dollars, 12b-1 and other fees from
mutual funds, pharmacy rebates, "non-cash"
compensation.

Some third party payments are not “compensation” for
plan services.
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May a Provider Legally Accept
Payments from a Third Party?
 Key Consideration: Is the payment is made “in
connection” with a "fiduciary" act on the part of the
Provider?
 Other Possible Considerations:
 If Provider is not acting as a "fiduciary" in causing
the payment, is the Provider a plan fiduciary for any
other reason?
 Is Provider's total compensation "reasonable"?
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Service Provider Compensation:
Mutual Fund Fees
Plan
Investments (plan pays management
and other fees)
Plan
Service
Fees
Service Provider
Mutual
Fund
Commissions/Other Fees
• e.g., 12b-1 fees
• paid by fund or agent
(trustee, broker
or recordkeeper)
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Fiduciary Provider May Not Receive
Payments Absent Exemption
 If a payment is in connection with a Provider’s fiduciary
act, Provider cannot accept it (or must offset it against
fees plan might otherwise pay).
 E.g., 401(k) plan recordkeeper/investment provider
with fiduciary authority to select plan investment
options generally must rebate or offset fees received
from mutual funds,
 DOL Adv. Ops. 1997-15A (May 22, 1997) and 200510A (May 11, 2005).
 Certain exemptions allow Providers to retain
commissions/management fees, e.g., PTE 75-1, 774, 84-24.
8
Provider May Receive Payments Not
Connected with Fiduciary Act
 A Provider may accept payments from third parties, IF
the payment is not caused by a fiduciary act.
 E.g., plan recordkeeper/investment provider who
merely offers a "platform" of investments from which
plan sponsors choose, is not a fiduciary and may
retain frees from mutual funds.


See DOL Adv. Ops. 2003-09A (Aug. 25, 2005) and
1997-16A (May 22, 1997)
These opinions recognize that offering a typical
401(k) investment platform doesn’t make a
recordkeeper a fiduciary.
 Haddock may suggest a different result.
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Does Haddock Threaten Traditional
Analysis?
Haddock v. Nationwide Financial Services, Inc.

Civ. Action No. 3.01cv1552 (SRU) (D. Conn, February 24,
2006)
 Lawsuit by 401(k) plan sponsors filed in 2001 relates to
Nationwide’s receipt of fees from unaffiliated investment
companies (“funds”) offered as investment options under
variable annuity contracts.
 Under a typical service arrangement, each plan sponsor
chose a group of funds for its plan from those Nationwide
made available under its annuity contract.
 Nationwide selected available funds based in part on
revenue sharing paid by funds.
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Does Haddock Threaten Traditional
Analysis?
Haddock v. Nationwide Financial Services, Inc. (con’t)
 Denying Nationwide’s motion for summary judgment,
court held –




Nationwide was a plan fiduciary because it retained
discretion to add/delete fund options.
Nationwide may have been a fiduciary in choosing funds
for its platform.
Revenue sharing payments from funds could constitute
“plan assets.”
Even if revenue sharing payments are not “plan assets,”
Nationwide’s receipt of revenue sharing could have
involved prohibited transactions.
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Service Provider Compensation:
Pharmacy Rebates
Plan
Service
Fees
Drug Co.
Drug Rebates
PBM/TPA
12
DOL Settlement Suggests Different
Standard for Welfare Plans?
 DOL’s complaint against PCN alleges  PBM is a fiduciary
 PBM agreed to share drug rebates, but improperly
retained part of plan’s portion
 Pharmacy Manager settles with DOL (5/06)
 PCN paid $721,000 to plans and penalties to DOL
 In future, PCN must disclose retained rebates and
account for them.
 Case suggests that a service provider may retain a
payment received in connection with a fiduciary decision

This is not the approach taken on mutual fund fees.
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Duties Where Provider is Allowed to
Receive Third Party Payments

When a Provider receives a third party payment in
connection with plan services –

DOL’s longstanding view: the plan
sponsor/fiduciary must "take the payment into
account" in determining whether the plan’s
payment to the provider is “reasonable
compensation.”


See, e.g., DOL Adv. Ops. 97-15A and 97-16A.
If services to plan and third party "overlap," plan
might reasonably request to pay less for services.

If payments are for separate services by a provider to
a third party, plan fees ought not to be reduced.
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Plan Sponsor’s Duty to Take Third
Party Payments into Account
 A fiduciary (typically, employer/sponsor) must “prudently”
select the plan’s service providers. The fiduciary —

must “engage in an objective process designed to
elicit information necessary to assess the
qualifications of the provider, the quality of services
offered, and the reasonableness of the fees charged
in light of the services provided. . . such process
should be designed to avoid self-dealing, conflicts of
interest or other improper influence.” - Field Assistance
Bulletin 2002-3 (Nov. 5, 2002).
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No Corresponding ERISA Disclosure
Duty for a Non-Fiduciary Provider
 Currently, a non-fiduciary Provider has no affirmative
ERISA duty to disclose its payments from third parties.

DOL has "encouraged" disclosure in guidance on mutual
fund fees and "float."
 More recently, increased regulatory attention to
disclosure by Providers that are not ERISA fiduciaries.


New York State Attorney General investigations of
insurance industry practices, including commissions and
other payments
SEC investigations and enforcement (e.g., shelf space
actions and pension consultant examinations)
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DOL is Developing a Provider
“Incentive” to Disclose, if Not a Duty
 Because a Provider is a “party in interest,” its provision
of services to the plan requires an exemption.

As a party in interest, Provider would be liable for excise
tax (pension) or section 502(i) penalties (welfare) if the
services are not exempt.
 Current 408(b)(2) regulations require —



services are “necessary and appropriate,”
the arrangement is “reasonable,” and
no more than “reasonable compensation” is paid.
 See 29 CFR § 2550.408b-2.
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Developing a Provider “Incentive” to
Disclose: § 408(b)(2) Regs
 DOL likely to make disclosure a condition of exemption.
 Likely to require disclosure of information sufficient to
permit plan fiduciary to consider whether –
 the plan pays reasonable fees for services,
 the service provider's total compensation
(including third party fees) is “reasonable,” and
 any conflicts of interest affect the service
provider's advice.
“This amendment will ensure plan fiduciaries are provided or have
access to information necessary to determine whether an
arrangement is reasonable…this regulation is needed to eliminate
the current uncertainty…”
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Developing a Provider “Incentive” to
Disclose: § 408(b)(2) Regs
 Possible Disclosure Model - FAB 2002-03 addresses
disclosure of “float” income by service providers. To
avoid potential prohibited transactions, service providers
should disclose —
 circumstances where float is earned,
 when “float” period may begin and end, and
 rate earned on float.
 Unclear whether DOL will issue model or “safe
harbor” format for service provider disclosure under
408(b)(2).
 See Proposed Schedule C for “hints.”
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Schedule C - Reporting of Service
Provider Compensation
 Schedule C, filed by plan administrator, requires reporting
on service provider compensation paid by the plan.
 For years, Schedule C Instructions have required
reporting of “indirect” compensation, including “finder’s
fees” and other fees and commissions received in
connection with plan transactions.
 But, typically not reported …
 2004 ERISA Advisory Council Report - Service
provider compensation paid indirectly by mutual fund
revenue sharing typically not reported.
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Schedule C - Reporting of Service
Provider Compensation
 DOL proposed changes to Schedule C (Service Provider
Compensation).
 Schedule C changes expected to “clarify” reporting
requirements and ensure plan officials obtain information
necessary to review reasonableness of compensation,
taking into account “revenue sharing or other financial
relationships” and potential conflicts of interest that might
affect services.
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Schedule C - Reporting of Service
Provider Compensation
 Proposed Schedule C changes would —
 Establish an elaborate scheme for reporting “indirect
compensation” received by most service providers.
 “Indirect compensation” would include all
amounts paid in connection with plan services, or
the recipient’s position with the plan.
 Require some third party payments to be reported
on an unallocated basis.
 Require “float” to be reported in dollars.
22
Compensation Principles Applied:
Class Actions vs. Plan Sponsors
 New class actions allege plan fiduciaries imprudently
allowed plan providers to receive “revenue-sharing”
payments. Plaintiffs allege plan fiduciaries —
 caused plans to enter service arrangements under
which the plan and participants paid “unreasonable
fees” and “hidden and excessive fees,”
 did not understand/recognize revenue sharing
arrangements, and
 did not disclose to participants in “proper detail and
clarity” the transactions, fees and expenses.
 E.g., Loomis v. Exelon Corp., Case No. 1:06-cv-04900
(filed Sept. 11, 2006, N.D. Ill.).
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Service Provider Compensation:
Disclosure to Plan Participants
 DOL is considering changes to regulations for
participant-directed plans under section 404(c).
 DOL says that rulemaking is needed – “to ensure
that the plan participants…are provided the
information they need, including information
about fees and expenses, to make informed
investment decisions . . .”
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Service Provider Compensation:
Disclosure to Plan Participants
 DOL review of 5500 filings of participant
directed plans revealed that only 50% identify
themselves as "404(c) plans"



Currently, DOL is thinking about applying the same
disclosure requirements to all participant directed
individual account plans, whether or not the plan is a
404(c) plan (requires finding a disclosure duty).
New guidance likely to include both automatic and
on-request disclosure requirements.
DOL exploring possible role for electronic
information in new disclosure regime.
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Service Provider Compensation:
Disclosure to Plan Participants
 Possible changes based on 2004 ERISA Advisory
Council Recommendations

Deliver a “profile prospectus” (or equivalent) for each
plan investment option.

Require investment education for participants.

Include investment expense information on annual
statements provided to participants.

DOL should provide a sample model participant
disclosure format.
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Compensation Principles Applied: Spitzer
Settlement with 403(b) Provider
Retirement Product Disclosure - Settlement Agreement
 In a settlement with the New York State Attorney General,
a 403(b) provider agreed to pay restitution and implement
a standard format for retirement product disclosure.
 Settlement relates to 403(b) Retirement Program
endorsed by NY State Teacher's Union. The 403(b)
provider and Union did not disclose to teachers
expense reimbursements paid by provider to Union.
 Provider’s 403(b) Program competed with 403(b)
products offered to teachers by other providers.

Orders available at www.oag.state.ny.us/press/2006/0ct/oct10a_06.html
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Compensation Principles Applied: Spitzer
Settlement with 403(b) Provider
NY Attorney General Settlement Agreement
 "One-Page Disclosure" to 403(b) Participants



States "all-in" investment cost, as a percentage of
account balance.
Chart shows affect of fees on investor account balances
over time.
Discloses that fund companies may pay 403(b) provider
to be included as investment options, and that 403(b)
provider and funds are seeking to make a profit.
 Does not require disclosure of rates or amounts
paid by funds, individual fund fees, or contract
charges.
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Service Provider Compensation:
Suggestions for Plan Sponsors?
 Review Plan fee arrangements.
Identify Providers’ direct/indirect compensation
 Consider benchmarking?
 Review fiduciary process for legal sufficiency
 Adequate due diligence?
 Documentation?
 Review governance/fiduciary structure.
 Review disclosure to participants about how plan fees
are paid, especially asset-based charges that support
plan administrative costs.

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Service Provider Compensation:
Suggestions for Service Providers?
 Plan Providers, including 401k and Managed Care

Review disclosure to plan sponsors of
direct/indirect compensation.



Consider "plain language" disclosure of third party
revenue (not necessarily including rates of fees).
Review contractual authority to make changes in
"401(k) fund platform" and other fee arrangements.
Consider cost and issues relating to proposed
Schedule C reporting and comment to DOL.
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