Compliance Corner: ERISA Fiduciary Duties (Part 2)

Article  |  Originally published as an external client alert

In December, we published the first part of this series on ERISA’s fiduciary duty rules and considerations. In the first part, we explained how to determine whether an entity or individual involved in the administration of an employer-sponsored retirement, health, or other welfare plan constitutes a fiduciary with respect to that plan. We then provided a high-level overview of the fiduciary duties that ERISA imposes on those entities and individuals. For this second part of our fiduciary series, we will discuss ERISA’s prohibited transaction rules, the permissible and impermissible uses of plan assets, and other compliance issues that may arise in connection with the management of plan assets.

Background / Recap

ERISA imposes strict standards of conduct (i.e., fiduciary duties) on entities and individuals who fall within the definition of a fiduciary with respect to an employee benefit plan. The fiduciary duty rules generally apply to retirement plans, health plans, and other welfare plans alike, provided those plans are subject to ERISA. Accordingly, unless an employer’s health and welfare plans fall outside of the scope of ERISA (for example, because they are exempt under the voluntary plan or payroll practice safe harbors, or because the employer is a church or state/local governmental entity), then ERISA’s fiduciary duty rules will broadly apply to any entity or individual deemed to be a fiduciary with respect to those plans.

Some entities or individuals will be “automatic” fiduciaries with respect to an ERISA plan by virtue of their designated roles. For example, every ERISA plan is required to have a “plan administrator” and at least one “named fiduciary,” and whoever serves in these roles are automatic fiduciaries. Often, however, the named fiduciary and plan administrator will be the same person or entity, and the employer will be the one serving in both of these roles by default. Other entities or individuals may be fiduciaries by virtue of the plan functions they perform. Under ERISA § 3(21), generally, an entity or individual is a fiduciary with respect to a plan to the extent he/she/it performs plan functions that involve discretionary authority or control over plan administration or plan assets, or rendering investment advice for compensation.

For those entities and individuals who are deemed to be fiduciaries with respect to an ERISA plan, ERISA imposes the following fiduciary duties:

  1. The duty to act solely in the interests of plan participants and beneficiaries (aka, the “Duty of Loyalty”), and to use plan assets for the exclusive purpose of providing plan benefits, or for defraying the reasonable expenses of plan administration (aka, the “Exclusive Benefit Rule”);
  2. The duty to act with the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims (aka, the “Prudent Expert Rule”);
  3. The duty to diversify the investments of the plan; and
  4. The duty to administer the plan in accordance with the plan documents.

For anyone who is a fiduciary with respect to an ERISA health or welfare plan, one of the key considerations when reviewing the design and administration of your plan is whether, or when, various plan-related funds become “plan assets” for ERISA purposes, and what that designation means with respect to the receipt, transfer, and use of those funds.

When are Funds Considered to be Plan Assets?

Generally, “plan assets” include any property, interest, or right owned by an ERISA-covered plan. This can include insurance policies and/or funds held by the plan for the purpose of providing benefits or paying reasonable plan administrative expenses. An employer’s general assets usually are not considered to be plan assets. Accordingly, a plan that pays benefits solely from the employer’s general assets is treated as “unfunded” for ERISA purposes (we discuss the significance of “unfunded” vs. “funded” plan status in the next section of this article).

However, if funds are segregated from an employer’s general assets and placed in a separate trust or account that is maintained exclusively for the purpose of paying plan benefits and/or reasonable plan administrative expenses, then that alone may be enough to cause those funds to be plan assets (and, thus, for the plan to be treated as a “funded” plan). The determination as to whether a separate account, in and of itself, is enough to create plan assets, and, thus, a “funded” plan, is a complicated one. For employers that utilize separate accounts in the plan’s name (or a third party’s name) and/or that are held out as being used solely for plan purposes, it is recommended that you discuss this practice with your benefits consultants or legal counsel to see whether this may create compliance issues.

Participant contributions, whether paid directly to a plan or indirectly through wage withholding by the employer, are plan assets by definition under the DOL regulations. Participant contributions become plan assets as of the earliest date on which such contributions “can reasonably be segregated from the employer’s general assets” and no later than 90 days from the date on which such amounts would have been payable to the participant in cash. Pursuant to these rules, with respect to each payroll, employee contributions withheld become plan assets, at the latest 90 days thereafter, even if the employee contributions are never actually segregated from the employer’s general assets. Additionally, amounts attributable to participant contributions are also plan assets. These would include, for example, forfeitures under a health FSA, and may also include refunds, rebates, demutualization payments, and similar insurer payments made in connection with an insured plan (if participant contributions were used to pay the premiums on the insurance policies).

Why is it Important to Know When Funds are Plan Assets?

It is important to know when funds are plan assets because a number of significant ERISA requirements are affected by the existence of plan assets and the treatment and handling of those plan assets. For example, self-insured (aka, self-funded) plans may be considered  to be “funded” or “unfunded” for ERISA purposes depending on whether they have plan assets. Funded plans are subject to ERISA’s trust requirement (i.e., plan assets be held in a formal trust administered by one or more trustees), fidelity bond requirement (i.e., every fiduciary with respect to the plan and every person who handles plan funds must be bonded), and numerous Form 5500 requirements, including the Schedule H financial reporting and independent qualified public accountant’s opinion (IQPA) requirements.

These additional requirements can be particularly onerous, and for that reason, most employers attempt to maintain unfunded plan status with respect to their self-funded ERISA plans by having benefits paid solely from the company’s general assets. Although plans that accept participant contributions technically have plan assets, pursuant to EBSA Technical Release 92-01, the DOL will not enforce the trust requirement for plans that would be considered funded solely because of participant contributions made through a cafeteria plan. Furthermore, pursuant to DOL regulations, the same exception effectively applies with respect to ERISA’s fidelity bond and Form 5500, Schedule H and IQPA requirements. Note, however, that this non-enforcement relief is unavailable if the employer segregates participant contributions from the employer’s general assets or transmits plan assets to an intermediary account outside of the employer’s general assets to pay benefits.

Another reason why it is important to know when funds are plan assets is because of the Exclusive Benefit Rule, which states that plan fiduciaries must use plan assets exclusively for the purposes of providing plan benefits or defraying reasonable plan administrative expenses. Thus, for any funds that constitute plan assets, plan fiduciaries must carefully monitor how those funds are being used, and when making decisions as to whether an expense is payable from plan assets, the plan fiduciary must act prudently and solely in the interests of participants and beneficiaries and in accordance with the terms of the plan’s governing documents (i.e., in accordance with the Duty of Loyalty and Prudent Expert Rule).

Reasonable expenses of administering a plan include direct expenses properly and actually incurred in the performance of a fiduciary’s duties to the plan. The analysis of whether an expense is reasonable is a fiduciary determination made at the time the expense arises based on all relevant facts and circumstances. For the most part, if an expense is incurred at arm’s-length and in good faith, the reasonableness requirement may not be a major concern. However, close scrutiny should be given to situations where plan assets are being used to pay for services provided by a “party in interest” (i.e., a person or entity directly or indirectly related to the plan) or to reimburse the employer for expenses it incurs in administering the plan.

Only expenses related to non-settlor (i.e., administrative) functions are payable from plan assets. As a general rule, all plan design decisions relating to the establishment, amendment, or termination of a plan are considered to be settlor functions. Of course, from a practical standpoint, whether something is a settlor or non-settlor function can be a fine distinction in many cases. For example, if a plan sponsor incurs legal fees to amend its plan to add a new coverage feature, those legal fees would be expenses related to a settlor function, which are not eligible for payment from plan assets. However, if the plan sponsor incurs legal fees to amend its plan to comply with legal changes, those would be non-settlor (administrative) expenses eligible for payment from plan assets (since the amendment is merely for compliance purposes). Overhead expenses generally should not be paid or reimbursed from plan assets. For employees whose time is not devoted entirely to plan administration, DOL guidance suggests that an employee’s compensation expenses will not be reimbursable at all unless the employee spends at least 80% of his or her time on plan administrative functions.

Prohibited Transaction Rules

ERISA prohibits certain listed transactions, unless a statutory or regulatory exemption applies to permit the transaction. There are two categories of prohibited transactions: (1) transactions between plans and “parties in interest” (“PII”) and (2) transactions involving fiduciary self-dealing. The prohibitions apply whether a transaction is fair or beneficial to the plan and regardless of whether the plan suffers a loss.

Specifically, ERISA § 406(a)(1) prohibits a fiduciary from causing a plan to engage in a transaction if the fiduciary knows or should know that the transaction constitutes a direct or indirect-

  • Sale, exchange, or leasing of any property between the plan and a PII;
  • Lending of money between the plan and a PII;
  • Furnishing of goods, services, or facilities between the plan and a PII;
  • Transfer to, or use by or for the benefit of, a PII of any plan assets; or
  • Acquisition, on behalf of a plan, of any employer security or real property in violation of ERISA § 407(a).

ERISA § 406(b) prohibits a fiduciary from-

  • Dealing with plan assets in the fiduciary’s own interest or for the fiduciary’s own account;
  • Acting in any transaction involving the plan on behalf of a party whose interests are adverse to those of the plan or its participants or beneficiaries; and
  • Receiving any consideration (e., a kickback) from any party in connection with a transaction involving plan assets.

There are a number of statutory and administrative exemptions that allow common transactions necessary to the conduct of plan business to fall outside of the scope of the prohibited transaction rules. Most notably, for example, even though the furnishing of goods and services between a plan and PII is prohibited under ERISA § 406(a)(1), an exemption is provided by ERISA § 408(b)(2) for reasonable arrangements with PIIs for services necessary for the operation of a plan if no more than reasonable compensation is paid.

On the other hand, there are also several prohibited transaction pitfalls in the health and welfare plan context. These are transactions that will, in most cases, be deemed to be non-exempt prohibited transactions and will subject responsible plan fiduciaries to potential liability under ERISA for having engaged in such transactions. For example, an employer’s retention of prescription drug, medical loss ratio, or other medical rebates when the coverage was paid for, in whole or in part, with plan assets would be a prohibited transaction. Additionally and more broadly, an employer’s retention or reversion of plan assets for its own account without having properly substantiated that the amounts qualify as reimbursements for reasonable plan administrative expenses would be a prohibited transaction.

Lastly, plan fiduciaries (including employers that are fiduciaries with respect to the plans they sponsor) must be careful not to engage in transactions on a plan’s behalf where the service provider on the other side of the transaction either is the fiduciary or is another party in which the fiduciary as an interest (thus, creating a conflict of interest). Being involved in the decision to retain such a service provider is a prohibited transaction for the affected fiduciary for which there is no exemption. This can occur, for example, where a plan fiduciary makes the decision to choose itself or its affiliate to provide services to the plan in exchange for a fee.

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