Revenue-Sharing Payments

Art by Tim BowerADVISER QUESTION: I am a fiduciary investment adviser to Employee Retirement Income Security Act [ERISA] plans and receive an advisory fee for my services. I also own a company that provides recordkeeping services to ERISA plans. May I recommend mutual fund investments to those plans that pay revenue sharing to my recordkeeper company?


ANSWER: It depends. The receipt of the revenue-sharing payments can result in a prohibited transaction (PT). However, if you offset those payments against your recordkeeping fees, that averts the PT.

Under the PT restrictions in ERISA and the Internal Revenue Code (IRC), you may not use your fiduciary authority to cause yourself or your affiliate to receive additional compensation or to receive compensation from a third party in connection with transactions involving plan assets. This is sometimes referred to as the “self-dealing rule.” In your case, you would be using your fiduciary authority as an investment adviser to cause your affiliated recordkeeper to receive compensation from a plan investment—the revenue-sharing payments from the mutual funds.

However, you can avoid this PT if you offset the revenue-sharing payments against your recordkeeping fees. In other words, your recordkeeping company would need to agree to provide its plan services for a stated fee—which could be a dollar amount or a percent of assets—and also agree to offset the revenue-sharing payments against the stated fee. By doing so, neither you nor your recordkeeping company would receive additional compensation as a result of the investment recommendations. This offset method was approved by the Department of Labor (DOL) in an advisory opinion issued to Frost Bank (Advisory Opinion 97-15A).

An alternative would be to agree to pay the revenue-sharing amounts over to the plan—for example, into an expense recapture account. However, this “pay-over” method is less commonly used.

A similar issue exists where a fiduciary adviser recommends a group annuity contract to a plan—and the insurance company makes a payment to a third-party administrator (TPA) that is affiliated with the adviser. That payment is a PT unless the Frost offset or “pay-over” method can be used.

The DOL’s position on these issues was confirmed in a complaint filed against an investment adviser who owned a TPA firm. To quote from the DOL’s January 2015 press release: “An investigation by the U.S. Department of Labor’s Employee Benefits Security Administration [EBSA] found that, from at least 2006 through 2011, [Defendant] caused himself [or his companies] to be paid certain commissions and fees, the amounts of which were not properly disclosed to or specifically authorized by the plans or independent fiduciaries. [Defendant] also failed to use all fees received by him to offset fees that the plans otherwise would have had to pay and used his fiduciary authority as investment adviser to cause the plans to remain invested in a higher fee fund class when the same fund portfolio was available in a lower fee class. By these actions, [Defendant] breached his fiduciary responsibilities under ERISA and caused the plans to suffer financial losses for which he was liable.

“Resolution: The department is asking the court to: require the defendants to correct the prohibited transactions; restore to the plans all losses, plus interest; disgorge any and all plan assets obtained; disgorge any and all enrichment resulting from the breaches; permanently enjoin the defendants from future ERISA violations; and permanently prohibit the defendants from serving as fiduciaries or service providers to any ERISA-covered employee pension or benefit plan.”

Note that the self-dealing rule applies only if the adviser is a fiduciary. If the adviser is not a fiduciary under today’s rules, then the payments are allowable under the self-dealing rule. However, to avoid a PT, the total compensation—both direct and indirect—of the nonfiduciary adviser’s affiliated recordkeeper or TPA must not be more than a reasonable amount for the services. If the DOL’s proposed expansion of the fiduciary definition is finalized, almost all retirement sales practices will be considered fiduciary advice. As a result, these arrangements—even where an adviser is not a fiduciary under today’s rules—would become PTs.

Forewarned is forearmed. To avoid the PTs described above, advisers will need to comply with exemptions or remedies, such as the Frost offset method. Also, in our experience, some advisers are unaware that these PTs also apply to individual retirement accounts (IRAs), even under current laws. With the increasing focus on IRAs, advisers should review their practices for compliance with the PT restrictions.

Fred Reish is chair of the Financial Services ERISA practice at the law firm Dirnker, Biddle & Reath. A nationally recognized expert in employee benefits law, Reish has written four books and many articles on the Employee Retirement Income Security Act (ERISA), Internal Revenue Service (IRS) and Department of Labor (DOL) audits, as well as pension plan disputes. Joan Neri, who has been associated with the firm since 1988, is counsel on the Employee Benefits and Executive Compensation Practice Group. Her practice focuses on all aspects of employee benefits counseling.