Beyster Institute

ESOP and 401(k) Coordination Tips in a Post-Disclosure World

By Thomas Roback, Jr.

Thomas Roback
Thomas Roback, Jr., managing director,
Blue Ridge ESOP Associates

After several postponements, 401(k) fee disclosure was mandated by the Department of Labor (DOL) before July 1st of 2012. So what kind of impact have we seen in the ESOP world? Has it been successful in helping plan sponsors and participants understand the costs of their 401(k) plans?

408(b)(2) overview

ERISA Section 408(b)(2) exempts professionals from prohibited transaction requirements if they have "reasonable" service agreements with plan sponsors, and/or parties of interest. The regulations apply to fiduciaries, Third Party Administrators (TPA) such as Blue Ridge ESOP Associates, and brokers receiving payments from the plan, and any professional who will receive "indirect" compensation.

ERISA 408(b)(2) impacts a number of 401(k) plans and KSOPs for which TPAs provide third party administration services. This includes all plans for which the firm receives any form of indirect compensation (revenue sharing) from the plan. That includes 401(k) plans and KSOPs that receive daily recordkeeping services through various 401(k) recordkeeping platforms. Most ESOP TPAs are not a "covered service providers" (CSPs) with respect to any standalone ESOP for which they provide services. The definition of "covered service provider" is explained below.

The 408(b)(2) disclosure rules apply to CSPs and there are three categories. A CSP is one who enters into a contract or arrangement with a plan and who expects to receive at least $1,000 in compensation. That includes compensation received by the CSP, an affiliate or subcontractor.

Category A:
A fiduciary service provider or registered investment advisor providing services directly to the plan.

A fiduciary providing services to an investment contract, product or entity that holds plan assets in which the covered plan has an equity interest.

Investment advice provided directly to the covered plan by a registered investment advisor under either the Investment Advisors Act of 1940 or state law.

Category B:
Recordkeepers or brokers providing services to participant-directed plans if one or more investment alternative is made available through an arrangement connected to the recordkeeper or broker.

Category C:
Services for indirect compensation. This includes accounting, appraisal, banking, legal, investment brokerage or TPA services if the service provider reasonably expects to receive indirect compensation.

With respect to the typical standalone ESOP, most TPAs are not in Category A because they are not acting as a custodian or a trustee in a fiduciary capacity. Category B would not apply to most ESOP TPAs because ESOPs are generally not participant-directed plans, and even if participant direction is offered, we are not operating in a situation if investment alternatives are made available in conjunction with our recordkeeping services. Category B is intended to cover recordkeepers and brokers who offer a platform of investment alternatives to participant-directed account plans. Category C should not apply either because ESOP TPAs are not typically receiving indirect compensation for services provided to any standalone ESOP. However, if they are receiving indirect compensation from the 401(k) portion of a KSOP, the TPA is a CSP and as such, will have to provide 408(b)(2) required disclosures.

In short, for ESOP providers, the regulations will require that there be a specific written agreement outlining the scope of work, direct and indirect compensation, termination compensation, and manner of receipt. Investment entities, brokers, and their fiduciaries that hold plan assets (such as the investments from an ESOP non-stock account) must provide information on fees and expenses related to the investments.

Unfortunately, we haven’t seen much evidence that all of this effort has been useful yet. It’s still relatively early, but most plan sponsors have barely glanced at these fee disclosures. Many plan sponsors don’t have the time, expertise or energy to analyze these new disclosures. That’s a shame because the DOL estimated a three-year cost of compliance at more than 1.6 million hours or almost $135 million. Not a drop in the bucket in this era of budget deficits.

ESOP and 401(k) coordination tips
ESOP companies should look for providers that have a consultative and holistic approach in this new world of disclosure. When you provide more than one qualified plan to your employees, plan administration should be done in harmony. The delivery of compliance services should be seamless. The process should involve one validated census for compliance testing, including the tests that apply to your separate plans and those that apply to your retirement plans on a combined basis. If tests fail, your provider should explain why and look for ways to improve test results. A good provider will not just deliver reports, but also explain them and offer objective recommendations. It also could be useful to authorize your TPA to share these recommendations with your financial advisor and/or accountant.

It also might be useful to work with a provider that can work off of several different daily recordkeeping platforms, including those that offer open architecture and access to thousands of mutual funds and hundreds of fund families. Your TPA should coordinate the delivery of all services and ensure that participant vesting and other records are kept up-to-date and ensure that all loans and distributions are processed properly. The flexibility in working with many recordkeeping platforms lets them offer the right solution for the customer with no proprietary fund constraints for participants. Your TPA should be independent, have no asset-based charges and all fees should be fully disclosed.

A dedicated team of ESOP and 401(k) specialists provides a coordinated approach to the delivery of services for both plans:

  • Plan sponsor sends census, ownership and officer data, etc. to one service team.
  • Service team coordinates census scrub, contribution calculations, determination of deduction limits and delivery of reports for plan sponsor.
  • Service team provides coordinated determination of highly compensated and key employees and summary of nondiscrimination testing.
  • Combined plan testing (top heavy and annual additions) is completed through a coordinated effort; excess annual additions corrections are completed through a coordinated effort, eliminating the need for the plan sponsor to serve as intermediary in providing 401(k) data to the ESOP administrator for combined testing.
  • TPA provides the plan sponsor with a dedicated single point of contact for all 401(k) plan recordkeeping, administration and other questions, eliminating the runaround that comes from dealing with multiple vendors or different service personnel. Unfortunately, some daily recordkeepers give plan sponsors the runaround, with telephone transfers from the “relationship manager” to the “distribution unit” to the “compliance unit,” and beyond. You do not want to get lost in the shuffle.
  • Plan auditors deal with one service team with respect to audit requests.

Your service team should deliver a proactive and consultative approach to plan administration and compliance services, with a focus on timeliness and technological innovation. Your professionals should have significant breadth of experience in providing ESOP and 401(k) administration and compliance services. Your TPA working with their 401(k) alliance partners, can provide an arrangement in which the daily recordkeeper handles what it does best processing transactions, updating accounts daily, providing web access, participant 401(k) call centers – while testing and compliance services are handled by a TPA service team that specializes in those services. Daily recordkeepers are best at daily transaction processing; they will bundle in testing and compliance services as an accommodation. Often, the people in their compliance unit who are running the nondiscrimination tests do not know the client or their business and may not be readily available to explain test results such as a failed ADP test and may not be available to discuss possible courses of action to ensure that future tests pass – i.e., automatic enrollment, safe harbor formulas, etc. In addition, the compliance unit may not have a census scrubber routine and the compliance testing unit’s software and systems may be disassociated from the daily recordkeeping system. Furthermore, certain daily recordkeepers put the burden on the employer to identify “highly compensated” employees for testing purposes rather than using pension software that assists in the identification of HCEs.

Of the plan sponsors who have taken the time to benchmark fees and service depth, most seem to just be going through the motions. Many have no intention of making a switch. However, benchmarking activity has picked up and when done well it is very useful to plan sponsors. It is important to get complete data and transparency. Reputable providers offer a thorough analysis including, advisor fees, recordkeeper cost, TPA cost, money manager cost, participation, cost per participant and in basis points. Variables include: asset size, number of participants, plan complexity, participant demographics, and plan design. Results should include the mean, median and mode. Generally, analyzing the average weighted cost based on the actual allocation of fund choices is more useful than just looking at the average expense ratio.

Let’s keep in mind there is no requirement that a plan sponsor select the lowest cost provider, but there is no question they need to understand what services they receive and the reasonableness of costs involved. While RFPs are time-consuming for providers, if you don’t benchmark yourself, a competitor will.