best practices: compliance with retirement issues

Best Practices:Compliance With Retirement Issues

Marcia S. Wagner, Esq.

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1. Recent Updates to ERISA

2. IRC 4975 and IRA Beneficiaries

3. Annuities, TDFs & Stable Value Funds

4. Sales Practice Issues

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Priority Objectives from WashingtonOutlook on U.S. Private Retirement System◦ Retirement security remains a major priority.◦ Pushing for reform through Congress and DOL.

Improving the DC Savings System ◦ Obama Administration’s proposals target 401(k)

plans, advisors and other providers.

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Recent Updates to ERISA

- Participant Investment Advice

Prop. Reg’s for ERISA Section 408(g)

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How Can Inv. Advice Be Conflicted?Advisor to 401(k) plan receives 12b-1 fees

from funds as compensation for services.Plan sponsor asks advisor to give fiduciary

“investment advice” to participants.◦ Prohibited conflict arises if advisor’s level of

compensation can vary based on advice provided. (e.g., equity funds pay higher 12b-1 fees to advisor,

creating incentive to steer participants to them)

ERISA’s prohibited transaction rules. ◦ Conflicted advice is prohibited (even if in good faith).◦ PPA of 2006 added ERISA 408(b)(14) exemption.

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Pension Protection Act of 2006PPA statutory exemption for providing

participant-level fiduciary advice.◦ Fiduciary Adviser must be RIA, bank, insurer or

broker-dealer.◦ Eligible Investment Advice Arrangement must have (1) level fees that cannot vary as a result of advice, or (2) advice from computer model certified by expert.

Other conditions for exemption.◦ Authorization from separate plan fiduciary.◦ Annual review by independent auditor.◦ Advance notice to participants with disclosures for fees

and material affiliations of parties (i.e., conflicts).

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Rulemaking Under ERISA 408(g)“Rollercoaster” rulemaking for 408(g) reg’s◦ Proposed in Aug. ’08 and finalized in Jan. ’09. ◦ Rules included (1) interpretive regulations, and

(2) class exemption broadening relief for conflicts.◦ Withdrawn in Nov. ’09 over conflict concerns.

New 408(g) reg’s proposed on Feb. 26, 2010.◦ Does not include controversial class exemption.◦ Similar to interpretive portion of original rules.

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Eligible Inv. Adv. Arrang. - Level FeeNew proposal is consistent with FAB 2007-1.

(a) Individual advisor must have level compensation.(b) Advisory firm must have level compensation.(c) Firm’s affiliates may receive variable compensation.

Example◦ Advisory firm charges asset-based fee offset by 12b-1

fees from plan’s funds (i.e., firm gets level fee).◦ Individual advisor receives level compensation from

advisory firm for services to plan.◦ Advisory firm’s affiliate is plan’s bond fund manager,

earning more if participants invest in bond fund.◦ “Level fee” condition for Eligible Inv. Advice Arrang.

does not apply to affiliates.

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Eligible Inv. Adv. Arrang. - Comp. ModelAdvice must be from computer model.◦ Must consider historical risks/returns of asset classes.◦ Must consider fees/expenses of investment options.◦ Must consider participant’s personal info.◦ Investment expert must certify computer model.

Computer model advice can not be followed by individualized investment advice.

Does DOL proposal favor index funds?◦ Model must consider historical returns of asset

classes (not individual funds) and fees/expenses.◦ Proposed rules suggest that model should favor

cheapest menu option in each asset class.

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Recent Updates to ERISA - Fee Disclosures from Providers Interim Final Reg’s Under ERISA Section 408(b)(2)

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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” interim final reg’s this year.

Rationale for interim 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 fee info

sponsors should be requesting.

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Covered Providers and DisclosuresCovered Service Providers ◦Fiduciaries (including ERISA fiduciary or RIA).◦Providers of recordkeeping and brokerage services.◦Providers of accounting, actuarial, legal and other

professional services if they receive indirect fees.

Required to disclose compensation in writing.◦Must provided before entering into contract.◦Formal contract and conflicts disclosure not required.◦ Indirect compensation requires more detailed

disclosure.◦Service-by-service disclosure of fees is generally not

required.

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Disclosure of Compensation Format and manner of disclosure◦Dollar amount, formula, percentage of plan assets, per

capita charge, or any other reasonable method.◦Whether fees will be billed or deducted and any other

manner of receipt must be disclosed.

Compensation shared among related parties◦Must disclose if payment flows to related party on

transactional basis (e.g., commissions, 12b-1 fees).

Special Rules for Platform Providers ◦Must provide fee information for investment options.◦Requirement can be met by pass-through of prospectus.

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Timing of Disclosures UnderInterim 408(b)(2) Regulations

Timing requirements for disclosures. ◦Disclosure must be made reasonably in advance of

entering into, extending or renewing services.◦Changes no later than 60 days after provider

becomes aware of change.

Erroneous information ◦Will not result in violation if provider acted with good

faith, reasonable diligence.◦Errors and omissions must be disclosed within 30

days after coming to light.

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Prohibited Transactions and Interim 408(b)(2) Regulations

If provider fails to make disclosure, plan’s payment of fees is a prohibited transaction.◦Disclosure failures can be cured.◦Plan must make written request for information, and

provider must respond within 90 days.◦Refusal or inability to comply with request requires

plan fiduciary to notify DOL.

No conflicts of interest for fiduciaries.◦408(b)(2) disclosure does not cure self-dealing.

Outlook◦Effective date delayed from Jul. 16, 2011 to

Jan. 1, 2012, but further changes may be on horizon.

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Practice Tips for 408(b)(2) Compliance

Must provide disclosures by Jan. 1, 2012.◦ Identify all ERISA accounts.◦ Identify indirect compensation and transaction-based

compensation paid to subcontractors and affiliates.◦Develop “template” notices.◦Special considerations for RIAs and dual registrants.◦Establish process for disclosing info changes.

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Overview of Prohibited Transactions “PT” rules are key protection for plans.◦Section 406 of Title I of ERISA◦Section 4975 of IRC (Title II of ERISA)

ERISA plans are subject to Titles I and II.◦Penalty for PT under Title I is civil liability.◦Excise tax for PT under Title II: - First tier excise tax of 15% per year

- Second tier excise tax of 100%◦For example, if IRS discovers uncorrected PT after 3

years, excise tax is 145% (15% + 15% + 15% + 100%).

IRAs are subject to Title II only.

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Application of PT Rules to IRAs PT occurs if disqualified person enters into

transaction with IRA.Disqualified person includes:◦ IRA owner, fiduciary or other provider◦Affiliates (e.g., family, 50% subsidiary, 10% owner)

Penalty for PT may vary:◦ IRA disqualification◦ IRA disqualification and excise taxes◦Excise taxes only◦Taxation as deemed distribution

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PTs Involving IRA Owner Special rules apply if IRA owner engages in PT.◦ IRA disqualified as of 1st day of year - IRC 408(e)(2).◦ IRA assets become taxable upon disqualification.◦10% penalty tax under IRC 72(t) may apply.

Do excise taxes apply under IRC 4975?◦ IRC 4975(c)(3) says “No,” but IRS says “Yes”.◦Excise taxes relief does not apply if IRA owner retains

investment control.◦Typically, if IRA owner engages in PT, disqualification

occurs and excise taxes also apply.

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Examples of IRA Owner Engaging in PTLoan to IRA ownerTransactions with IRA ownerFiduciary “self dealing” by IRA ownerEarning fees from personal IRA

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More Examples Break points for fees on IRA /Non-IRA assets◦PTE 97-11 relief for brokerage services◦PTE 93-33 relief for “free checking” from banks◦No other relief (e.g., investment management fees).

“Checkbook LLC” IRA◦ IRA transfers assets to new LLC.◦ IRA owns 100% of LLC, and LLC “owns” assets. ◦ IRA owner can access assets as LLC manager

(e.g., buy property without IRA custodian’s approval)◦But LLC assets are deemed IRA assets under DOL’s

“look through” rule.◦Same PT rules apply to IRA owner.

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Other Prohibited Transactions If disqualified person (other than IRA owner)

engages in PT, excise taxes only apply.IRA disqualification upon investment in life

insurance contract.If IRA invests in collectibles (e.g., antiques)...◦Prohibited investment is taxable as a distribution -

IRC 408(m).If IRA owner pledges IRA assets as collateral

for a loan…◦Pledged assets taxable as deemed IRA distribution.◦NOTE: Pledge of non-IRA assets as security for any

IRA debt is a PT (DOL Adv. Op. 2009-03A).

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Practice Tips for IRA ProvidersConsider adopting appropriate policies to

avoid potential PT issues.◦Restrictions on loans from IRA to owner (and any

other party).◦No principal transactions between IRA and owner.◦ Limits on transactions between IRA and owner’s

affiliates, including business/company.◦Restrictions on FAs earning fees from personal IRAs.◦Review breakpoints and fee discounting practices.◦Review “checkbook LLC” or any similar products.◦Restrictions on life insurance and collectibles.◦Procedures for reporting/escalating potential PT

issues.

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DC Plan AnnuitizationObama Administration believes lifetime

income options facilitate retirement security.◦ Initiative to reduce barriers to 401(k) annuitization.

DOL / IRS / Treasury issued a joint release with requests for information on Feb 2, 2010.

Agencies hold joint hearing in Sept. 2010.◦ Fostering “education” to help participants make

informed retirement income decisions.◦ Disclosure of account balances as monthly income

streams.◦ Modifying fiduciary safe harbor for selection of issuer

or product.

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Approaches to DC Plan AnnuitizationAnnuitization outside of DC Plan ◦ IRA annuity portal◦ Plan sponsor is not IRA fiduciary if employer involvement is

limited in accordance with DOL reg’s.

DOL requirements for fiduciary safe harbor◦ No IRA contributions from employer.◦ Participation is voluntary.◦ No endorsement of IRA program from employer.◦ Employer receives no compensation from IRA provider.

TIP: Ensure advisors do not encourage employers to assume role which triggers fiduciary liability.

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Approaches to DC Plan AnnuitizationAnnuitization inside of DC plan◦ Immediate annuities as plan distribution option, or deferred

annuities for plan investment/distribution.◦ DOL safe harbor protects against fiduciary liability.◦ Safe harbor requires research of annuity providers, and

consultation with experts (if necessary).

• DOL requirements for fiduciary safe harbor◦ Objective, thorough search of providers.◦ Consider provider’s ability to make future payments.◦ Consider cost (including fees) relative to benefits.◦ Consult with experts, if necessary.

TIP: Ensure advisors do not assume fiduciary role.

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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.

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Recent Developments for TDFsDOL and SEC at Senate Special Committee on

Aging hearing on TDFs (Oct. 28, 2009).◦ Investor Bulletin jointly released by DOL and SEC.◦ DOL’s fiduciary checklist on TDFs is pending.

SEC proposal for TDFs (Jun. 16, 2010).◦ If name has target date, “tag line” disclosure needed.◦ Advertising must include glide path information.

On Nov. 30, 2010, DOL proposes rules on TDF disclosures for participants, amending:◦ QDIA reg’s issued under PPA of 2006◦ Participant-level fee disclosure reg’s that were

finalized on Oct. 14, 2010 but are not yet effective.

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DOL’s Proposed Changes to QDIA Reg’sBackground on QDIA Reg’s◦ Participant deemed to be directing investment to

default choice if QDIA requirements are met.◦ Default investment must be a QDIA, and QDIA notices

must be provided to participants.

DOL proposes change to QDIA notice for TDFs.◦ Explanation and illustration of TDF’s glide path.◦ Relevance of target date (e.g., 2030) in TDF name.◦ Disclaimer that TDF may lose money after retirement.

DOL also proposes general changes to QDIA notice (even if not a TDF).

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DOL’s Proposed Changes to Participant-Level Fee Disclosure Reg’s

Background ◦ New rules will require disclosure of plan-related fees

and annual comparative chart for plan’s investments.

DOL proposes change to annual comparative chart for TDFs (even if not a QDIA).◦ Must include appendix with additional TDF info. ◦ Same info as required for QDIA notice.

Informal follow-up guidance from DOL◦ TIP: Develop “fiduciary friendly” materials that can be

readily passed through to participants.

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

in affiliated underlying funds.◦ Conflicts are permitted because fund managers are

carved out from ERISA’s fiduciary requirements.Are fund managers ever subject to ERISA? ◦ Firm requested clarification on scope of carve-out.◦ In Adv. Op. 2009-04A (Avatar Associates), DOL

declined to rule that the TDF managers are fiduciaries.

Implications of DOL guidance◦ Plan sponsors are alone in their fiduciary obligation.◦ Must ensure TDFs (and underlying funds) are

appropriate plan investments.

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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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Stable Value FundsDodd-Frank Act enacted on Jul. 21, 2010.◦ “Swap” is broadly defined and subject to new rules.

Are stable value contracts swaps?◦ Joint study by SEC/CFTC due by Oct. 21, 2011 on

stable value funds in participant-directed DC plans.◦ If deemed to be a swap, must determine if regulatory

exemption is in public interest.◦ Any rule changes would be for new contracts only.

Any rule changes will impact industry.◦ Unclear is stable value investments held by DB plans

are viewed as swaps.

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SEC, FINRA and NASAA InitiativesSEC Seniors Summits (2006 - 2008)◦ Part of coordinated initiative to increase awareness

and enforcement of protections for senior investors.

Protecting Seniors - Sept. 2007 Report◦ Report on exam findings for “free lunch” seminars.◦ Identified helpful practices on marketing to seniors.

Protecting Seniors - Sept. 2008 Report◦ Broad report on compliance supervisory practices.◦ Addendum issued on Aug. 12, 2010.◦ Covers (1) communication, (2) training, (3) escalation,

(4) account opening, (5) suitability, (6) surveillance.

TIP: Use Report as guide for evaluating your policies.

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Certifications and Prof. DesignationsNASAA adopts Model Rule in March 2008.◦ Addresses use of senior-specific certifications.◦ Certifications require (1) educational organization,

(2) competency standards, (3) disciplinary procedures, and (4) continuing education.

◦ NAIC adopts similar model rule for insurance producers.

Dodd-Frank Act encourages states to adopt both NASAA and NAIC model rules.

FINRA Regulatory Notice 07-43

TIP: Ensure supervisory procedures comply with state laws or model rules as “best practice.”

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Suitability in Fixed Annuity TransactionsNAIC adopts Model Rule in March 2010.◦ Enhances original model rule adopted in 2003.

2010 Model Rule has new features.◦ Enhanced suitability standards (similar to FINRA).◦ Insurer remains responsible for compliance.◦ Mandatory training for producers.

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New Suitability Standard in 2010 Model Reg

Reasonable efforts to obtain suitability info◦ 2010 Model Reg expands to include 12 separate

categories (similar to FINRA).

Reasonable grounds for recommendation, must be supported with reasonable basis to believe:◦ Consumer is reasonably informed of annuity

features. ◦ Consumer would benefit from certain features.◦ Suitability of annuity as whole and certain aspects.◦ For contract exchange, suitability in consideration of

surrender charges, lock-in period, and other factors.

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Other Changes Under 2010 Model Reg

Insurer must establish supervision system.◦ Reasonably designed to ensure producers comply.◦ Training for producers.◦ Must review all recommendations.◦ Annual report for senior management.

Mandatory training for producers.◦ One-time 4 credit training course.

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Coordination between 2010 Model Reg and FINRA Rules

2010 Model Reg prevents conflict.◦ Compliance with FINRA standards is deemed

compliance under NAIC’s 2010 Model Reg.◦ Variable annuities subject to FINRA standards.◦ Voluntary compliance with FINRA standards for fixed

annuities is permitted.

TIP: Review current and pending state law, and evaluate compliance policies accordingly, especially for fixed annuities.

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Indexed AnnuitiesMay be unsuitable for senior investors.◦ Long lock-up period inappropriate for investors who

need ready access to cash.

Status unclear under securities laws.◦ Historically, indexed annuities have not been

registered under Securities Act.

SEC adopts Rule 151A in Dec. 2008.◦ Rule subjects indexed annuities to SEC jurisdiction.◦ But DC Circuit Court vacates in July 2010.

Dodd-Frank Act also exempts them (July 2010).

TIP: Review policies regarding suitability of indexed annuities for senior investors.

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Best Practices:Compliance With Retirement Issues

Marcia S. Wagner, Esq.

99 Summer Street, 13th FloorBoston, MA 02110

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

[email protected]

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best practices: compliance with retirement issues

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