1. Best Practices: Compliance With Retirement Issues Marcia S. Wagner, Esq.

2. 2 1. Recent Updates to ERISA 2. IRC 4975 and IRA Beneficiaries 3. Annuities, TDFs & Stable Value Funds 4. Sales Practice Issues

3. 3 Priority Objectives from Washington Outlook 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.

4. 4 Recent Updates to ERISA - Participant Investment Advice Prop. Reg’s for ERISA Section 408(g)

5. 5 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.

6. 6 Pension Protection Act of 2006 PPA 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).

7. 7 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 ◦ Withdrawn in Nov.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.

8. 8 Eligible Inv. Adv. Arrang. - Level Fee New 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.

9. 9 Eligible Inv. Adv. Arrang. - Comp. Model Advice 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.

10. 10 Recent Updates to ERISA - Fee Disclosures from Providers Interim Final Reg’s Under ERISA Section 408(b)(2)

11. 11 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.

12. 12 Retirement Security Initiative Improving 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.

13. 13 Covered Providers and Disclosures Covered 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.

14. 14 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.

15. 15 Timing of Disclosures Under Interim 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.

16. 16 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.

17. 17 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.

18. 18 1. Recent Updates to ERISA 2. IRC 4975 and IRA Beneficiaries 3. Annuities, TDFs & Stable Value Funds 4. Sales Practice Issues

19. 19 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.

20. 20 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

21. 21 PTs Involving IRA Owner Special rules apply if IRA owner engages in PT. ◦ IRA disqualified as of 1 st 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.

22. 22 Examples of IRA Owner Engaging in PT Loan to IRA owner Transactions with IRA owner Fiduciary “self dealing” by IRA owner Earning fees from personal IRA

23. 23 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.

24. 24 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).

25. 25 Practice Tips for IRA Providers Consider 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.

26. 26 1. Recent Updates to ERISA 2. IRC 4975 and IRA Beneficiaries 3. Annuities, TDFs & Stable Value Funds 4. Sales Practice Issues

27. 27 DC Plan Annuitization Obama 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.

28. 28 Approaches to DC Plan Annuitization Annuitization 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.

29. 29 Approaches to DC Plan Annuitization Annuitization 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.

30. 30 Target Date Funds Popular 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.

31. 31 Recent Developments for TDFs DOL 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.

32. 32 DOL’s Proposed Changes to QDIA Reg’s Background 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).

33. 33 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.

34. 34 Conflicts of Interest in TDFs Conflicts 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.

35. 35 Congressional Proposal for TDFs Senator 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.

36. 36 Stable Value Funds Dodd-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.

37. 37 1. Recent Updates to ERISA 2. IRC 4975 and IRA Beneficiaries 3. Annuities, TDFs & Stable Value Funds 4. Sales Practice Issues

38. 38 SEC, FINRA and NASAA Initiatives SEC 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.

39. 39 Certifications and Prof. Designations NASAA 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.”

40. 40 Suitability in Fixed Annuity Transactions NAIC 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.

41. 41 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.

42. 42 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.

43. 43 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.

44. 44 Indexed Annuities May 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.

45. 45 Best Practices: Compliance With Retirement Issues Marcia S. Wagner, Esq. 99 Summer Street, 13 th Floor Boston, MA 02110 Tel: (617) 357-5200 Fax: (617) 357-5250 Website: www.erisa-lawyers.com marcia@wagnerlawgroup.com A0055266