The most significant change over the past quarter century in the structure of the retirement arrangements of most U.S. employers has been the dramatic shift away from defined benefit pension plans toward profit-sharing plans and especially 401(k) plans. Layered on top of that trend has been the widespread proliferation of self-directed 401(k) plans in which each participant is allowed to exercise control over the assets in his or her account. These changes relieved employers of both the risk of investment loss on retirement plan assets and the fiduciary duty of monitoring the individual investment of such assets. While favorable for employers, self-directed plans impose risks on plan participants who often now bear the investment risk and the necessity of managing the investment of their retirement assets.
Fiduciary Risks and the New Safe Harbor
In the current environment, participants want and need access to expert advice to assist them in managing the investment of their accounts. Many employers, hoping to empower their employees to make smart investment decisions and thereby maximize the retirement benefits provided by the employers’ contributions, want to facilitate providing such advice to plan participants. Unfortunately, in Interpretive Bulletin 96-1, the Department of Labor (DOL) ruled that, in order for employers and others to avoid risking becoming fiduciaries of their participants’ self-directed account assets, they must not stray beyond providing information regarding the plan, general financial and investment information, broad-based asset allocation models, and interactive investment questionnaires.
In the recently enacted Pension Protection Act of 2006 (the Act), Congress has now established rules for how more detailed and individualized investment advice may be provided to plan participants without employers and others risking reassuming a fiduciary role in their self-directed plans. Under a new safe harbor, the plan sponsor and other fiduciaries who select and oversee the “fiduciary adviser” will not be treated as failing to meet their fiduciary duties solely due to the provision of investment advice by the fiduciary adviser under an “eligible investment advice arrangement” that complies with the Act. The safe harbor does not remove the requirement of prudent selection and periodic review of the fiduciary adviser, but the plan fiduciaries have no duty to monitor the specific investment advice given by the fiduciary adviser.
Eligible Investment Advice Arrangements
An eligible investment advice arrangement is one that provides, among other conditions, either that any fees (including any commissions or compensation) received by the fiduciary adviser for investment advice or relating to an investment transaction involving plan assets not vary depending on the basis of any investment option selected or be based on a computer model to provide investment advice. That is, the fiduciary adviser will essentially not be paid any more or less depending on the specific investments chosen by the participant. The arrangement must be expressly authorized by a plan fiduciary other than the person offering the investment advice program, any person providing investment options under the plan, or any affiliates of such persons. Fiduciary advisers include registered investment advisers, banks and similar financial institutions (if advice is provided through a trust department), insurance companies, registered brokers or dealers, or affiliates or certain qualified employees of the foregoing entities.
Before the investment advice is provided, the fiduciary adviser must comply with certain participant notice requirements. In addition, the fiduciary adviser is required to maintain accurate records about the information provided to participants, provide such information at no charge to the participant at least once annually and upon request, and provide at no charge accurate information concerning any material change in the information. Furthermore, an annual audit is required by an independent auditor for compliance with applicable requirements, and the auditor must issue a written report of the audit results to the fiduciary (usually the employer acting as the plan administrator) that authorized the arrangement.
Computer Model Programs
A computer model program can be an “eligible investment advice arrangement” if certain requirements are met. The program must apply generally accepted investment theories, use relevant participant information (such as age, life expectancy, risk tolerance, and other investment sources), use objective criteria for asset allocation portfolios comprised of plan investment options, not be biased in favor of investments offered by the fiduciary adviser or related persons, and take into account all investment options under the plan. In addition, an eligible investment expert must certify that the model meets these requirements. The DOL will issue regulations regarding certification and who qualifies as an expert, but the expert must essentially not be related to the investment adviser. If changes are made to the model, the certification must be renewed. The participant may request investment advice beyond the model but only if the request was not solicited by any person carrying out the arrangement. The Act also contains an exclusion for the use of computer models for IRAs, but the DOL is required to complete a study by December 31, 2007, and either determine that such a model is feasible or grant a class exemption for IRAs.
New Prohibited Transaction Exemption
The Internal Revenue Code (the Code) and the Employee Retirement Income Security Act (ERISA) generally prohibit certain transactions between fiduciaries of retirement plans and plan participants that could directly or indirectly benefit the fiduciaries. The Act creates a new exemption under the Code and ERISA for transactions between fiduciary advisers and plan participants who direct the investment of plan assets in their individual accounts under an “eligible investment advice arrangement.” The exemption also applies to IRAs, HSAs, Archer MSAs, and Coverdell education savings accounts.
The Act will make it possible for retirement plans to permit investment advisers, as fiduciaries, to offer investment advice to their participants without running afoul of the prohibited transaction rules. More specifically, if certain requirements are met, an exemption is now provided for the following: providing investment advice; an investment transaction pursuant to such advice; and the direct or indirect receipt of fees or other compensation in connection with the provision of the advice or an investment transaction pursuant to the advice.
The fiduciary adviser must provide disclosures with respect to any transaction in accordance with applicable securities laws. The sale, acquisition, or holding of a security or other property must also occur solely at the direction of the recipient of the advice. Compensation received by the fiduciary adviser must in all cases be reasonable, and the terms of transactions must be at least as favorable to the plan as an arm’s length transaction would be. These new requirements reinforce the need for the plan administrator to understand and carefully evaluate the fee arrangements with fiduciary advisers.
The provisions of the Act relating to investment advice will be effective after December 31, 2006. Before next year, plan administrators may need to evaluate arrangements with their investment advisers. If a plan permits an eligible investment advice arrangement, express approval of the arrangement in advance will be required. Plan sponsors will want to consider the time and expense involved in obtaining an annual written audit report of the arrangement. If a computer model will be provided, plan administrators will need to make sure the specific requirements for such models will be met.