Under ERISA Sections 3(38) and 405(d), if a plan appoints an “investment manager,” as that term is defined, the plan’s primary fiduciaries are relieved of responsibilities for the investment results -- so long as the investment manager is prudently selected and monitored. Section 3(38) provides that “[t]he term ‘investment manager’ means any fiduciary ... who has the power to manage, acquire or dispose of any asset of a plan; who is registered as an investment [advisor] ... is a bank ... or is an insurance company ... and has acknowledged in writing that he is a fiduciary with respect to the plan.”
The issues discussed in this article are applicable to both investment advisors and investment managers. For ease of reading, we will use the phrases “investment advisor” and “investment advisory services” throughout to refer to either or both investment advice and investment management.
RESTRICTIONS ON INVESTMENT ADVICE MAY VIOLATE THE NONDISCRIMINATION RULES
Some investment providers impose significant charges or require minimum account balances that may violate the nondiscrimination requirements of Section 401(a)(4) of the Internal Revenue Code (Code). For example, a mutual fund company might require a minimum account balance of $10,000 for a participant to use its investment advice service. As a result of the minimum account balance, it is likely that the availability of these providers’ services will be proportionately skewed towards the HCE population. This, of course, raises the concern that a plan using this service would discriminate in favor of HCEs—in violation of Code Section 401(a)(4). An analogous nondiscrimination violation would exist where a plan imposes a minimum account balance to use the stock brokerage service offered by the plan. That is, the effect of the plan-imposed minimum must be tested for compliance with the nondiscrimination requirements.
WHAT DO THE NONDISCRIMINATION RULES REQUIRE?
Qualified plans must make benefits, rights and features (BRFs) available in a nondiscriminatory manner.5 The definition of BRF includes all optional forms of benefits, ancillary benefits and other rights and features available to any employee under the plan.”6 The term other rights and features generally means “any right or feature applicable to employees under the plan.”7 There is an exception for rights or features that “cannot reasonably be expected to be of meaningful value to an employee (e.g., administrative details).8
The opportunity to receive investment advice is not specifically listed as a right or feature. However, the Treasury regulations do include, in the definition of rights or features, the analogous right to direct investments and the right to a particular form of investment. The regulations also state that the list is not exclusive.9 Further, the right to use an investment advisor does not appear to fit within the “no meaningful value” exception, as evidenced by what participants are charged for investment advice services. As a result, there seems to be little question that investment advice services would be an other right or feature, subject to the qualification requirements for nondiscrimination.
As such, if a plan offers investment advice, access to that service must be both currently and effectively available to employees. Treas. Reg. §1.401(a)(4)-4 provides a safe harbor for the current availability requirement-—satisfying the ratio percentage test (i.e., the percentage of NHCEs to whom the BRF is available equals or exceeds 70% of the HCEs to whom the BRF is available). However, there is no safe harbor for the effective availability requirement.
HOW DOES A PLAN SATISFY THE EFFECTIVE AVAILABILITY REQUIREMENT?
A determination as to whether the effective availability requirement has been met (i.e., the right does not substantially favor HCEs) is based on the “relevant facts and circumstance.”10 While the regulation does not provide any further detail as to which facts and circumstances will be considered relevant, the regulation includes examples that offer some guidance. In two of the examples, the IRS found that the BRFs did not satisfy the effective availability requirement where the only employees who were likely to receive any benefit were HCEs.11 One of these examples involved a two-week retirement window about which non-highly compensated employees (NHCEs) were not notified. The other example provided for such narrow eligibility (i.e., terminating employment between July 1, 1999, and January 1, 2000, due to a specific type of disability) that it did not reasonably cover anyone but a particular HCE. In another example, all of the HCEs, but only a few NHCEs, were eligible for the BRF.12 Although these examples stated that the ratio percentage test was satisfied, the IRS found that the BRFs were not effectively available as only HCEs would be likely to receive the benefits.
Some investment advisors require minimum account balances or impose significant fees in order to receive the advice. An argument can be made that the use of such an advisor by an HCE will not violate the nondiscrimination rules if a particular requirement is externally imposed (i.e., the plan permits the use of investment advisors generally and, as a result, each participant may select his own advisor, but an HCE participant selects an advisor with a high minimum.) For example, under this argument, even if the advisor’s restriction on its face is discriminatory, there is no violation of Code Section 401(a)(4) because the plan itself does not impose the restriction.
Examples of external restrictions are impositions placed on participants from sources other than a plan or its fiduciaries, whereas internal restrictions are impositions placed on participants by the plan document or a fiduciary through the operation of the plan. External restrictions could include minimum dollar amounts imposed by the investment provider (e.g., for a stock brokerage account), a minimum amount for a particular investment or a minimum balance to use a particular investment advisor. For example, the requirement of a $100,000 minimum investment by a hedge fund would be an external restriction. Some ERISA attorneys believe that the availability of investments with externally imposed restrictions would not cause a plan to violate the nondiscrimination rules.13 Although the IRS has not provided any definitive guidance on this matter, some IRS officials have taken the position that the IRS does not agree with this conclusion.14
If a plan selects an investment advisor for participants that requires a minimum balance of $10,000, it may not be considered external restriction. As a practical matter, it may be considered a plan-imposed or internal restriction, if that is the only investment advisor available to the participants. For example, suppose the plan is a typical plan in which many NHCE’s account balances do not exceed $10,000. A recent EBRI study indicated that 45% of 401(k) participants have account balances of less than $l0.000—-and presumably these accounts are primarily held by NHCEs.15 If all of the HCEs have account balances of at least $10,000, but only 45% of NHCEs have account balances of at least $10,000, the plan would not pass the safe harbor (i.e., the ratio percentage test) for effective availability. As a result, the plan would need to demonstrate, based on facts and circumstances, that the right to use the investment advisor was both effectively and currently available to NHCEs. As indicated above, the examples provided in Treas. Reg. §1.401(a)(4)-4(c)(2) stated that the BRFs used in the examples were not currently available, even though the plan passed the ratio percentage test with respect to these BRFs. Thus, it appears as though the plan would have considerable difficulty proving that the right to use the investment advisor was both effectively and currently available to NHCEs.
UNREASONABLE FEES MAY CAUSE THE PLAN TO VIOLATE THE NONDISCRIMINATION RULES
Similarly, if a plan charges an unreasonable fee for the advice, it may violate the Code’s nondiscrimination requirements. For example, a nondiscrimination issue could arise if the plan required a fee of 25 basis points for investment advice with a minimum of $2,500 per year. If this amount was a plan-imposed limit, then the fee would likely be so high that it precluded most NHCEs from being able to use the service. As a result, the advice service would probably not satisfy the Code’s nondiscrimination rules regarding current and effective availability.
AVOIDING POTENTIAL DISCRIMINATION PROBLEMS
An argument can be made that the selection by the plan of an investment advisor that requires a minimum account balance or imposes a significant fee does not violate the nondiscrimination requirements. Those who subscribe to this argument take the position that participants are not required to use the investment advisor designated by the plan; instead, they may select their own investment advisor without even notifying the plan.
However, where the plan sponsor designates an investment advisor who imposes minimum account balances or significant fees and does not expressly allow the use of other investment advisors by participants with smaller balances or advisors with lower fees, it may, as a practical matter, effectively impose the minimum requirements of the selected investment advisor as plan restrictions. Although any participant can hire his or her own investment advisor, that would require him or her to pay the investment advisor out of his or her own pocket and to take the investment advisor’s advice and implement it personally.
Assuming there is a discrimination issue, we see three ways to avoid the problem:
- Allow participants to use any outside investment advisor. So long as the plan allows participants to use any outside investment advisor, the plan will not violate the nondiscrimination rules, even if a particular advisor is not available in a nondiscriminatory manner. Thus, any limitation imposed by an outside advisor—-such as a $10,000 account balance requirement imposed by the investment advisor-—would be an external, not an internal, restriction. The plan should not provide any particular advisor with any preferential treatment in terms of connectivity or communication.
- Monitor demographics. If an investment advisor is currently and effectively available to NHCEs in a nondiscriminatory manner, then the investment advisor does not have to be available to every NHCE. But, the plan would need to satisfy the Code’s discrimination testing requirements. However, this option is probably not available for most plans (because of the high proportion of non-HCEs with small account balances).16 And, as a practical matter, few plans would want to take on this additional testing burden or the risk of failure.
- Choose an investment advisor that does not require a minimum balance. If a plan offers the services of an investment advisor that is available to all participants (i.e., not conditioned on a minimum balance or a high minimum fee), the nondiscrimination rules will be automatically satisfied.
We believe that most plans are satisfying the nondiscrimination requirement by selecting investment advisors that impose a relatively small charge (so that all participants can afford it) or, alternatively, the plan sponsor or the investment provider is covering the cost so that it is nominally free to the participants.
THE PROHIBITED TRANSACTION ISSUE
ER1SA’s prohibited transaction rules prohibit a fiduciary from providing conflicted investment advice, that is, advice that results in additional compensation to the fiduciary. Since, as explained earlier in this article, investment advisors are ERISA fiduciaries, they are subject to the restrictions of the prohibited transaction rules found in ERISA Sections 406(b)(1) and 406(b)(3), which prohibit an investment advisor from dealing with plan assets for its own interest or account and from using its authority to cause the plan to pay it an additional fee. A corresponding DOL regulation states “a fiduciary may not use the authority, control or responsibility which makes such a person a fiduciary to cause a plan to pay its additional fee to such fiduciary.”17
These prohibited transaction issues typically arise when an investment advisor is giving advice on investments that can affect its own income. For example, some mutual fund companies and their affiliates (“mutual fund providers”) receive income from investment advisory fees from the mutual funds they manage. Additionally, some insurance companies, banks and trust companies (collectively “alliance providers”) may receive revenue sharing from their multi-fund family offerings. Mutual fund and alliance providers may give advice on their investments without violating the prohibited transaction rules under certain circumstances. Their options are described below.
Offsetting Revenue Sharing, Amounts By Fees. The DOL determined in an advisory opinion, known as the “Frost Opinion” (http://www.reish.com/pa/benefits/op97-15atext.cfm), that a fiduciary did not engage in a prohibited transaction where it offset the amount of compensation it received from third parties against the fees it charged a plan.18 Although Frost gave investment advice on funds for which it received revenue sharing, it offset its fees by amounts it received from revenue sharing. To the extent any revenue sharing amounts exceeded the fees charged by Frost, the plan was entitled to the excess amount.
Thus, for the revenues received from the investments, the provider could rely on the Frost Opinion if it offset its fees by the amounts it received from revenue sharing (and, for funds it managed, by its investment management fees). To do so, it would need to enter into an agreement to that effect with an independent plan fiduciary. (Arguably, such an explicit written agreement might not be required if the conditions of the Frost Opinion were being observed in practice, but we believe the safer course-—and one more consistent with a strict reading of the opinion-—would be to formalize the arrangement.)
Leveling the Revenue Sharing Received on the Investment Options. While ERISA prohibits mutual fund and alliance providers from giving advice on investments that can affect their own incomes, it does not prohibit them from giving advice where their income is not affected. Thus, if an investment advisor will receive the same amount of revenue regardless of which investment it recommends, the investment advice will not cause it to engage in a prohibited transaction. In order to ensure that they will receive the same amount of revenue for each investment, mutual fund and alliance providers should only provide advice on funds that provide the same level of revenue sharing. For example, some investment providers give advice on their proprietary product (for which each fund generates the same level of revenue sharing), but will not provide advice on the retail funds they offer.
Using an Independent Investment Advisor. The DOL determined in an advisory opinion, known as the “SunAmerica Opinion” (http://www.reish.com/ pa/benefits/2001-09a.pdf), that a fiduciary did not engage in a prohibited transaction where it arranged for an independent advisor to give investment advice to participants in plans for which it provided investments.19 The DOL states “Whether a party is ‘independent’ for purposes of the subject analysis will generally involve a determination as to whether there exists a financial interest (e.g., compensation, fees, etc.), ownership interest or other relationship, agreement or understanding that would limit the ability of the party to carry out its responsibility beyond the control, direction or influence of the fiduciary.”20 In the SunAmerica Opinion, the following facts were provided as evidence that the investment advisor was independent: (1) the fees received by the investment advisor from SunAmerica did not exceed 5% of its annual gross income; (2) the fees paid were not affected by the investments made by participants based on the investment advice given; (3) neither the choice of the investment advisor, nor any decision to continue or terminate the relationship would be based on the fee income to SunAmerica; (4) there were no other relationships between SunAmerica and the investment advisor; and (5) SunAmerica was obligated to use the investment methodology and output developed by the independent investment advisor—that is, neither SunAmerica, nor its affiliates, were able to change or affect the output of the computer programs. Mutual fund and alliance providers may utilize an independent investment advisor, in accordance with the SunAmerica Opinion, in order to avoid these types of prohibited transactions.
Pending Legislation to Remove Prohibited Transaction Provisions. There is currently legislation that would remove this prohibited transaction issue-—known as the Boehner bill. The Boehner bill would create a prohibited transaction exemption for investment advice on their own products by registered investment advisors, banks, insurance companies or registered broker/dealers if certain disclosure requirements are met. These disclosure requirements are satisfied if, near the time the advice is initially provided, the participant is given notice of: (1) all fees and/or commissions to be paid to the investment advisor; (2) the relationship between the investment advisor and the investments offered; (3) any limitation on the scope of the advice; (4) the types of service offered by the investment advisor; (5) that the investment advisor is a fiduciary; and (6) that participants can hire their own independent investment advisors at their own cost. Disclosures required by applicable securities laws would also have to be made. Additionally, any fees and commissions paid to the advisor would have to be reasonable and any sale of investments by the investment advisor would have to be at fair market value. The House of Representatives passed the bill on April 11, 2002, and it is currently being considered by the Senate. The DOL has expressed support for the bill.
Prohibited Transaction Class Exemption. The DOL issued a prohibited transaction class exemption. PTCE 77-4 (www.reish.corn/pa/benefits/ptcc77-4.cfm) that provides relief from ERISA Section 406(b)(l) if certain requirements are met. The class exemption provides that an investment advisor for participants, who is also an investment advisor to a mutual fund, may make recommendations to the plan about funds, including the fund it advises, so long as:
- No commission is paid in connection with the plan’s purchase of the mutual funds (which eliminates broker-sold investments);
- No redemption fee is paid upon sale of the mutual funds, unless it is only paid to the fund and the investment advisor does not share in the fee;
- An independent fiduciary (e.g., the plan committee) approves the selection of the investment advisor and approves its compensation; and
- The investment advisor offsets the advisory fee it receives from the mutual fund against the fees it charges the plan participants for investment advice services.
However, PTCE 77-4 does not apply to any alliance funds of an investment advisor, since the class exemption is limited to the situation of an investment advisor acting as a fiduciary for the selection of mutual funds for which it also serves as the fund advisor.
CONCLUSION
There has been considerable debate over the last several years about the permissibility and advisability of “conflicted investment advice”—that is, investment advice offered by a mutual fund investment advisor on its own products. No one seriously questions the need for participant investment advice, but the proper way to deliver it-—and by whom-—has been an ongoing concern. Included in this debate is the issue of cost. In order to provide advice, some advisors impose significant charges or require minimum account balances. As a result, the nondiscrimination requirements may be violated. However, by properly structuring investment advice, mutual fund and alliance providers may offer investment advice without violating the nondiscrimination and prohibited transaction rules.
ENDNOTES
1 Research Report: How Well Are Employees Saving and Investing in 401(k) Plans, 2002 Hewitt Universe Benchmarks, Hewitt Associates LLC, p. 54. 2 401(k) Plan Participants: Characteristics, Contributions and Account Activity, Investment Company Institute: similar results were reported from surveys by Fidelity Investments and Mutual or Omaha Companies.
3 401(k) Participant Preferences Study, Mutual of Omaha Companies; nearly identical results were reported in a survey by John Hancock.
4 Press Release, American Express 401(k) Participant Survey Reveals the Growing Effects of the Down Market, December 2002 (summarizing results from the American Express Retirement sent Services’ 2002 Participant Satisfaction Survey).
5 Treas. Reg. §1.401(a)(4)-4(a).
6 Treas. Reg. §1.401(a)(4)-4(a).
7 Treas. Reg. §1.401(a)(4)-4(e)(3)(i).
8 Treas. Reg. §1.401(a)(4)-4(e)(3)(ii)(C).
9 Treas. Reg. §1.401(a)(4)-4(e)(3)(iii).
10 Treas. Reg. §l.401(a)(4)-4(c)(1).
11 Treas. Reg. §1.401(a)(4)-4(c)(2), Examples 2 and 3.
12 Treas. Reg. §1.401(a)(4)-4(c)(2), Example 1.
13 See, American Bar Association. Section of Taxation Letter to Commissioner Rossotti, IRS dated, January 27, 1999.
14 American Bar Association, Section of Taxation, Committee on Employee Benefits, Questions and Answers from May 9, 2003, meeting with IRS, Q&A 9.
15 EBRIs (Employee Benefits Research Institute) 2002 Retirement Confidence Survey.
16 See text above at note 15.
17 DOL Reg. §2550.408b-2(e)(1).
18 Advisory Opinion 97-15A.
19 Advisory Opinion 2001-09A.
20 Advisory Opinion 2001-09A, Footnote 11
© 2004
This article was reprinted, with permission, from The ASPA Journal, Vol. 34, No. 2, March-April 2004. © 2004 ASPA. All rights reserved.
Learn more about R&R related practice areas:
Employee Benefits
