ERISA’s Prohibited Transaction rules really are not well understood by much of the retirement plan market, yet they have a broad insidious affect anyone who is in the business. Simply put, no one can get paid from a plan’s assets, and no one’s compensation can be connected in any way to a plan’s assets, unless there is a specific prohibited transaction exemption which permits it.
There are thousands of exemptions, if you count the “individually” granted exemptions which the DOL is empowered to issue. The ones which have the most significant impact are the class exemptions, of which there really are two types: those issued by the DOL, and those provided by the statute. Of these, the most pervasive is probably the “408(b)(2)” service provider exemption, and even that is often misunderstood. Under that rule, no service provider can receive compensation in connection with services provided to a plan unless that compensation is “reasonable” as defined by the regulation issued under 408(b)(2).
Those 408(b)(2) regulations are, to my mind, among the most effective regs ever published by the DOL. They are relatively short, precisely written, yet written in such a way to cover that wide range of products and services which are available to plans.
408(b)(2), however, is often confused with its regulatory sibling, 404(a)-5,** which is not a prohibited transaction rule: 404(a)-5 is merely a rule which requires that participants regularly receive certain investment disclosures. Though failure to provide those disclosures are a fiduciary breach, there are no specific statutory penalties for failing to meet the 404(a)(5) rules. Failing 408(b)(2), on the other hand, results in a prohibited transaction which may require the return of compensation received and the assessment of a tax (or the potential of a penalty, for 403(b) plans….).
A common misunderstanding between 408(b)(2) and 404(a)(5) is the nature of the requirements: 408(b)(2) requires the service provider’s contract with the plan’s fiduciary contain certain, specific terms. It does NOT require that those fees be disclosed to participants, nor does it require annual disclosure. It is simply a business matter between the fiduciary and the service provider. The only time a follow-up “disclosure” is ever required is if there is a material change in the contract’s terms (including the service fee), and then that disclosure is only required to be made to the plan fiduciary (though there are certain parts of 408(b)(2) which rely upon parts of 404(a)(5)). Back in 2012 when the rule was first put into place, we all had to make a “transition” 408(b)(2) disclosure to all fiduciaries, but that was merely a one-time requirement. Unfortunately, the jargon related to that transition rule still hangs around. 408(b)(2) is, at its heart, a rule which requires specific, enduring contract terms. It is not a disclosure rule.
Where it really gets confusing is that if that service provider’s fee is charged against a participant’s account, that charge is then required to be disclosed to plan participants. But this requirement comes from 404(a)-5, not 408(b)(2), which is a very meaningful distinction: failure to disclose a fee charged against a participant’s account under 404(a)-5 may be a fiduciary breach, but it does not otherwise cause a potentially expensive failure in the prohibited transaction exemption under 408(b)(2).
The prohibited transaction rules really act as a governor on how plans operate, but they are almost hidden, in many ways, because most of the rules are not found in the plan document rules themselves. They do, however, have a deep impact on how things are run.
**Note:For brevity purposes, my reference to “404(a)-5” is really a reference to DOL Reg 2550.404(a)-5, and not to a section of ERISA itself. My reference to 408(b)(2), on the other hand, is a reference to ERISA Section 408(b)(2).