Almost a year after being proposed and after public hearings and thousands of comment letters, the U.S. Department of Labor (“DOL”) has finalized its regulation redefining and broadening the meaning of fiduciary investment advice rendered to retirement plans and IRAs. The regulatory package also includes new and revised class exemptions necessitated by the scope of the revised fiduciary definition. The DOL considers these changes necessary to make the fiduciary concept relevant to changes in the retirement plan marketplace over the last 40 years. While retaining the overall structure of the proposal, the final package includes changes addressing a number of concerns raised by commenters.
The final regulation is widely viewed as the most comprehensive revision of rules affecting the retirement industry since the enactment of ERISA and will affect substantially all advisers, even if they do not have plan clients, because of the regulation’s reach to IRA assets. Advisers who have nothing to do with plan assets, but who have high net worth clients with IRA money, will be profoundly impacted by this change. The new rule will also impose significant compliance costs on broker-dealers and insurance agencies that may need to qualify under the rule’s so-called BIC exemption. These are only a few of the reasons many people are referring to the finalized regulation as a game changer.
The following discussion will highlight the primary features of the final rule, including its sweeping expansion of the fiduciary concept and the detailed requirements of the numerous exemptions and exclusions that will need to be complied with in order to continue providing investment advice to retirement client.
I. FINAL DEFINITION OF THE TERM FIDUCIARY
Expanded Fiduciary Definition. Like the proposal, the final regulation significantly enlarges the definition of fiduciary advice. The finalized definition of fiduciary investment advice covers recommendations relating to the holding, acquisition and sale of securities or other property and, as under the proposal, recommendations to take rollovers from a plan, as well as investment recommendations for rollover assets. For now, the final regulation eliminates the proposal’s inclusion of financial valuations, appraisals and fairness opinions as covered fiduciary recommendations, but the DOL has indicated it is developing an amendment that will cover ESOP appraisals.
The final regulation also follows the proposal by covering recommendations relating to the investment management of plan or IRA assets, including rollover assets, so that recommending an investment manager would have fiduciary implications. The final rule clarifies that investment management recommendations can also include communications relating to investment policies or strategies, portfolio composition and the selection of investment account arrangements, such as the choice of a brokerage or advisory account.
In response to commentators, the final rule provides that advice as to the purchase of health, disability, term life insurance and similar life insurance policies without an investment component will not constitute fiduciary investment advice. However, the preamble to the final regulation makes a point of noting that if an adviser effectively has discretionary control over the decision to purchase such insurance, the adviser could potentially come under the management or administration branches of the functional fiduciary definition, even if the adviser was not deemed to have provided investment advice.
Additional Conditions for Fiduciary Advice. Under the old definition of fiduciary advice, there needed to be a mutual understanding between the parties that the advice would serve as a primary basis for plan investment decisions. The proposal eliminated these requirements, and the final version of the definition maintains this position, by providing that there only needs to be an understanding that a recommendation is based on the particular investment needs of the retirement investor receiving it or directed to a specific recipient regarding the advisability of a particular investment or management decision with respect to plan or IRA assets. The point of this language, as revised under the final rule, is to distinguish specific investment representations to an individual from recommendations to the general public. The final rule contains a new provision to make clear that such general communications are not fiduciary advice.
Under the final rule, the threshold question in determining if fiduciary advice has been rendered is whether a “recommendation” has occurred. Following the FINRA definition of the term, the final rule clarifies that a “recommendation” means a communication that, based on its content, context and presentation, would be reasonably viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action. The DOL views a number of the proposed rule’s so-called carve-outs from the fiduciary advice definition as being outside the scope of a recommendation. Accordingly, the carve-outs for platform providers and investment education are now treated as exceptions to the definition of a recommendation, so that complying with the terms of one of these exceptions will avoid fiduciary status.
The old fiduciary advice rule consists of a five-part test, one component of which is that investment advice recommendations be furnished on a regular basis. As under its proposed version, the final regulation eliminates this requirement, so that a one-time recommendation directed to a plan or IRA (e.g., one-time advice on a large, complex plan investment or a rollover recommendation to an IRA owner) may be treated as fiduciary advice. Nevertheless, the preamble to the final rule indicates that, in certain circumstances, the BIC exemption contract, discussed below, may be permitted to clarify that the adviser’s services will be limited to one-time advice so that the adviser will not have any ongoing monitoring responsibilities with respect to a recommended investment after its acquisition. This may be limited, however, to investments that can be prudently recommended in the first place without provision for a monitoring mechanism.
Effect on Certain Adviser Referrals. An unanswered question under the proposed regulation was whether certain incidental communications could amount to fiduciary investment advice. For example, some commentators thought a literal reading of the proposal could result in a third party administrator, call center or other service provider becoming an inadvertent fiduciary if it responded to a question from a retirement plan client about available investment advisers or managers, even though the respondent’s fee was not related to or contingent on the response. One of ERISA’s statutory requirements is that fiduciary status applies to a service provider only if it receives compensation in connection with its referral or recommendation.
The finalized regulation deals with incidental advice by redefining the requisite fee so there would be fiduciary advice when an amount is explicitly received for particular advice, if a fee is paid that would not have been paid but for the advice, or if eligibility for or the amount of the fee is based in whole or in part on the advice. Accordingly, if a plan service provider can show that a referral or recommendation with respect to investment advisory services was purely an extra for which no fee was received, the recommendation should be non-fiduciary in nature. On the other hand, if the recommendation is deemed to be a part of its regular services, for which it earns a fee, the helpful service provider could potentially be viewed as a fiduciary adviser.
II. EXCEPTIONS FROM FIDUCIARY DEFINITION
Platform Provider Exception. The final rule retains an exception enabling third party administrators and recordkeepers marketing or offering an investment platform to retirement investors to maintain their non-fiduciary status. This relief is conditioned on the provision of written disclosure that, in making the platform available, the provider is not purporting to give impartial investment advice or to render advice in a fiduciary capacity. To qualify under this exception, the platform provider’s assistance in selecting and monitoring investments on the platform would need to be performed without regard to the individualized needs of the particular plan or its participants. However, the preamble to the final rule allows some level of customization (referred to as “segmentation”) so that winnowed bundles of investment options may be offered to different general types of plans differentiated by objective criteria (e.g., small, medium and large plans). Nevertheless, the preamble warns that, if a platform provider communicates that a particular platform is “appropriate” for a given plan, the communication will likely constitute a fiduciary recommendation.
Other communications and activities related to providing an investment platform that are considered exempt recommendations under the final rule include identifying investment alternatives meeting objective criteria specified by a plan fiduciary, such as investment funds of a certain size or with expense ratios below a particular threshold. A provider can also respond to requests for identification of investment alternatives with a particular type of asset or credit quality. The exception for these activities is conditioned on the provider’s written disclosure of any financial interest it may have in the alternative investments and the precise nature of this interest. In addition, the provider would be permitted to furnish, on an exempt basis, objective financial data for investment alternatives, as well as independent benchmarks.
The final regulation also permits responding to an RFP or similar plan solicitation by identifying a limited sample set of investment alternatives based on the size of the employer plan or the current investment alternatives designated under the plan, provided the response is in writing and discloses the provider’s financial interest in these investments, if any.
The platform provider exception will not apply to communications made to plan participants or IRAs. The rationale for the DOL’s decision in this regard is that these communications are typically not subject to review by an independent plan fiduciary interacting with the platform provider.
Bundled Investment Services. The preamble to the final regulation also addresses the status of related services frequently bundled with investment platforms, such as elective managed account programs, qualified default investment alternatives, investment adviser/ manager options, and non-affiliated RIA services. The preamble to the final rule states the DOL’s belief that investment recommendations within the meaning of the fiduciary rule would not include “much” of the information a platform provider would convey to plan clients in explaining these features. However, the regulation offers no practical guidance with respect to identifying the type of information that might have fiduciary implications. The preamble indicates the final regulation did not make any changes reflecting comments on this matter.
Investment Education Exception. The final regulation contains a liberalized version of the proposed regulation’s carve-out for investment education. Consistent with DOL Interpretive Bulletin 96-1, there are four categories of investment-related guidance that service providers may render to retirement investors without triggering fiduciary status: (i) plan information, (ii) general financial, investment and retirement information, (iii) asset allocation models, and (iv) interactive investment materials. Unlike the interpretive bulletin, the proposed and final regulations cover information furnished to plan sponsors, plan fiduciaries and IRA owners, as well as participants and beneficiaries.
The proposed rule prohibited educational materials from referring to specific investment alternatives, based on the fear that this could encourage conflicts of interest. However, the final rule lifts this restriction with respect to plans, but not IRAs. Thus, plan investment alternatives can be used in asset allocation models if: (i) the investment’s inclusion on the investment platform is subject to oversight by a plan fiduciary independent from the person who developed or markets the investment alternative or the model, (ii) the model identifies all other investments available under the plan having similar risk and return characteristics to the investment referred to in the model, and (iii) the model is accompanied by a statement indicating that these other investments have similar characteristics to those included in the model and identifying where information on them can be obtained. Similar restrictions apply where plan investment alternatives are referred to in interactive investment materials.
Seller’s Carve-Out. The final rule liberalizes the counterparty exception from the definition of fiduciary advice under which a person acting as a counterparty in an arm’s-length transaction (e.g., a purchase, sale or loan between the plan and the counterparty) may provide advice without being deemed to be an investment advice fiduciary if certain conditions are met. Under the proposal, the plan sponsor or another plan fiduciary independent of the counterparty would have been required to provide a written representation that the plan had at least 100 participants, that it had sufficient expertise to evaluate the transaction, and that it would not rely on the counterparty to act as a fiduciary. This written representation was not required if the plan fiduciary had at least $100 million of assets under management.
For non-institutional advisers, the final rule eliminates the qualifying condition of 100 participants and reduces the $100 million threshold for applicability of the seller’s exception to $50 million. The $50 million threshold is based on the FINRA definition of an institutional account and indicates the exemption’s underlying rationale that a financially sophisticated plan fiduciary can correctly evaluate sales communications made by a counterparty without the need to classify it as fiduciary advice. Consistent with this reasoning, the final rule extends the counterparty exception to regulated banks, insurance companies, registered investment advisers and registered broker-dealers with no minimum size requirement.
Since the essence of this exemption is the existence of a non-advisory relationship, the counterparty may not receive a fee from the plan, plan sponsor, a plan participant or an IRA owner. Therefore, unlike many of the exceptions to the fiduciary rule, the seller’s exception does not sanction commissions or variable compensation. A counterparty could, however, charge a fee for rendering non-fiduciary services unrelated to a sale covered by the seller’s exception.
Exception for Advice from Employees of Plan Sponsor. As under the proposed rule, advice from an employee to the plan sponsor will not be fiduciary advice, provided the employee does not get paid additional compensation for such advice, and certain other conditions are met. A corresponding exception from the fiduciary rule with similar conditions applies to advice from a human resources employee to plan participants.
Swap Counterparties. Another carryover from the proposed rule relates to advice from a swap dealer to an ERISA plan. This advice will not be fiduciary advice if the plan client provides a written representation that it understands the swap dealer is not providing impartial advice as a fiduciary and certain other conditions are met.
Clarification for Self-Marketing. An adviser may market and tout the services of itself or an affiliate without being viewed as a fiduciary adviser when making “hire me” recommendations. But if any investment recommendations are included with the “hire me” recommendation (e.g., whether to roll assets into an IRA or how to invest assets if rolled over), they will be viewed separately as fiduciary advice.
III. BEST INTEREST CONTRACT EXEMPTION
Best Interest Contract (“BIC”) Exemption – General. As a practical necessity, the broad scope of the new fiduciary definition requires exemptive relief to avoid subjecting all plan advisers to undue restrictions on traditional business models and compensation arrangements. The BIC exemption is the primary vehicle for such relief with respect to retail retirement clients. Qualifying under the terms of this exemption, which at a minimum requires acknowledging fiduciary status, allows an adviser classified as a fiduciary to earn all types of variable compensation in connection with advice provided to plan and IRA clients.
The BIC exemption, however, does not cover variable compensation that arises as a result of discretionary advice. Nevertheless, the DOL has clarified that the exemption can still provide relief for advisers who are in the business of providing discretionary advice, as long as the discretionary advice itself does not generate variable compensation. For example, a fiduciary adviser may make a recommendation for a participant to roll over his or her plan account to an IRA, where the fiduciary adviser would then provide investment management services for the rollover IRA for a fee. As long as the fiduciary adviser does not have discretion over the rollover decision, the BIC exemption (specifically, the “Level Fee Fiduciary” rule, as discussed below), would be available to provide relief for the rollover advice. As illustrated in this example, relief under the BIC exemption is available, even though the adviser is in the business of providing discretionary investment advice.
Under the proposed fiduciary rule, the relief provided by the BIC exemption was restricted to certain listed investments. The finalized BIC exemption will cover transactions involving all types of securities and property (including, but not limited to, non-traded REITs, options, security futures and private equity).
The following retirement investor clients are covered under the BIC exemption:
- any IRA client;
- any participant in an ERISA or other tax-qualified retirement plan; or
- any “retail” plan client with assets of less than $50 million (including but not limited to DC plans with participant-directed investments).
Written Contract Requirement under BIC Exemption. The core requirement for the BIC exemption under the proposed rule was a written contract between a fiduciary adviser and a retirement client that needed to be executed before advice could be rendered. The contract had to provide that the advice would be in the best interest of the retirement investor and consistent with ERISA’s prudent man standard of care. The agreement also had to provide that the adviser was limited to reasonable compensation and warrant the adviser would make certain disclosures, avoid misleading statements and adopt compliance policies mitigating conflicts of interest.
The final rule relaxes many of the requirements necessary to qualify for the BIC exemption. For example, with respect to ERISA plans, it eliminates the contract requirement, the source of much anxiety and potential paperwork, although advisers wishing to qualify for the exemption must still provide written acknowledgement of their fiduciary status no later than the time the recommended transaction is executed. Operationally, advice to an ERISA plan must meet the “Best Interest” standard, the recommended transaction must not cause amounts to be earned in excess of reasonable compensation and the adviser must avoid statements that are materially misleading. Further, the adviser will have to adopt the same compliance policies and procedures regarding conflicts that would have been required if BIC conditions applied in full. The policies must be designed to prevent violations of the impartial conduct standard. Where the written contract requirement does not apply, as would be the case with ERISA plans, there will be no new private right of action for breach of contract, although, in accordance with current law, an investment advice fiduciary would still be subject to lawsuits for breaches of fiduciary duty.
The written contract requirement remains in place for IRAs and non-ERISA plans. IRA clients will now have written BIC contractual provisions that they can enforce. Similar to the FINRA rule and as provided under the proposed rule, they will have a right to participate in class actions. Mandatory arbitration is still permitted, but the final rule clarifies that arbitration provisions with an unreasonable forum are not. Also, the BIC contract can require the client to waive the right to punitive damages and rescission awards if permitted under applicable law. As under the proposed rule, however, the contract may not disclaim or limit liability for an adviser’s violation of its terms.
For advice to non-ERISA plans and IRA owners that would be subject to the contract requirement, the timing of the contract can be synchronized with the paperwork opening the account, although the contract must cover any advice rendered before its execution. The contract may be signed electronically. Existing clients can agree to the new contractual provisions by negative consent. Moreover, the final rule reduces the contract requirement to a bilateral agreement between a retirement investor and the advisory firm, thereby eliminating the requirement that personnel actually rendering the advice be parties to the contract.
These specialized requirements for the BIC contract, as further described below, illustrate that the BIC exemption has splintered into several different exemptions applicable to various types of fiduciaries, each with its own rules.
Elements of the BIC Contract. Where a full-blown BIC contract is required to be in writing for IRAs and non-ERISA plans, the following provisions must be included in its terms:
- Acknowledgement of Fiduciary Status.
- Impartial Conduct Standard. The contract must state that: the firm and its advisers will provide investment advice that is in the “Best Interest” (as defined below) of the retirement investor, the recommended transaction will not result in unreasonable compensation for the firm or advisers, and statements relevant to the transaction (e.g., concerning compensation or conflicts of interest) will not be materially misleading.
- Warranties Relating to Compliance Policies.
- The firm’s policies are reasonably designed to ensure its advisers will meet the Impartial Conduct Standards.
- All conflicts are identified and documented in the formulation of the policies.
- The policies are designed to prevent violations of the Impartial Conduct Standards.
- responsible person or persons (“BIC Officer”) will be designated for monitoring compliance and addressing conflicts of interest.
- Individual advisers may earn differential compensation only if the policies are reasonably designed to avoid a misalignment of client’s interests with adviser’s interests.
- The DOL has indicated that differential compensation is only permitted to the extent it reflects “neutral factors” relating to differences in services, such as the time or expertise needed to sell particular categories of investments (such as variable annuities). An individual adviser may not receive a higher payout from a particular investment, simply because the product generates higher commission-based compensation for the firm.
- New Client Disclosures. The following disclosures must appear in the BIC contract itself or in a separate single written disclosure statement provided to the retirement investor along with the contract.
- A description of the Best Interest standard of care owed by the individual adviser and firm. This new fiduciary standard, which appears to blend ERISA’s prudent man standard of care and the duty of loyalty, requires an adviser to provide investment advice that reflects “the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser… .”
- Information regarding services to be provided.
- An explanation of how the client will pay for services (e.g., direct or third party payments, commissions or fees, etc.).
- Disclosure of all conflicts.
- General information on fees and charges, including third party payments from investments must be disclosed.
- Information with respect to the client’s right to obtain a description of compliance policies within 30 days (or prior to the transaction if an upfront request is made).
- Information that the client has a right to obtain specific compensation information (dollar amount or formula) for any recommended transaction within 30 days (or prior to the transaction if an upfront request is made).
- Disclosure that model BIC contracts and compliance policies are posted on a website and provision of a link.
- Disclosure of any proprietary products or investments generating third-party payments, and the extent to which recommendations are limited to such products or investments.
- Provision of contact information for the firm’s representative who can address concerns relating to services.
- If applicable, an explanation of how regulatory information may be available on FINRA’s BrokerCheck or IARD.
- A description of if (and how often) the client’s investment will be monitored for recommended changes.
Certain contractual provisions, however, may not be included in the BIC contract. These include:
- Limits on the liability of the individual adviser or firm for contractual violations.
- Limitation of the client’s right to participate in class action lawsuits.
- Mandatory arbitration clauses with an unreasonable venue.
However, as previously discussed, waivers of the right to receive punitive damages or rescission awards are permitted.
BIC Exemption – ERISA Plans. As noted above, there is no need to enter a written BIC contract if a plan client is subject to ERISA. However, a statement of Fiduciary Status and a single written document with certain disclosures must be provided to the client before or when a recommended transaction is executed. The required Fiduciary Status document must state that the individual adviser and the firm will be acting as fiduciaries with respect to the advice. The client disclosures mirror the New Client Disclosures described above that would otherwise be incorporated in the BIC contract.
Operationally, the firm and adviser must comply with the Impartial Conduct Standard of the BIC contract. In addition, the firm will need to prepare an internal document reflecting the same compliance policies and procedures regarding the Impartial Conduct Standard and conflicts of interest that would have been required if the BIC conditions applied in full. Any contract that the parties do enter into cannot contain the contractual provisions that are prohibited from being included in the BIC contract, such as limits on liability or the right to participate in class actions.
BIC Exemption – Simplified Requirements for Level-Fee Fiduciaries. Another softening of the BIC conditions applies to advisers whose compensation is a level fee (i.e., a fixed percentage of assets under management or a set fee that does not vary). As under the relaxed requirements for ERISA plans, this group will also be entitled to rely on the BIC exemption without entering a contract if the advisory firm furnishes a written statement no later than execution of the transaction that the firm and the individual adviser will be acting as a fiduciary with respect to the advice. The firm and the adviser must also comply in practice with the Impartial Conduct Standard, described above. Finally, in the context of a rollover transaction from a plan to an IRA, the adviser will need to document specific reasons why the rollover recommendation was considered to be in the Best Interest of the client. This should include a description of the client’s alternatives, as well as differences in fees, services and available investments. Where the recommended transaction is a rollover from one IRA to another or a switch from a commission-based account to a level-fee arrangement, the reasons for the change must be documented with consideration of the services that will be provided for the fee.
In connection with rollover advice, it should be noted that all rollover recommendations will be viewed as fiduciary advice, even if they do not include investment recommendations. Further, level-fee fiduciaries offering rollover advice will need to comply with the BIC exemption even if there has been no pre-existing relationship with the plan. They will also need to comply with the BIC exemption if they are already providing plan-level services for a fee, to the extent that they will earn a higher fee rate on rollover IRA assets. However, it appears that qualifying for the exemption will not be necessary when the rate of rollover IRA-related compensation is no greater than the adviser’s existing rate of plan-related compensation, since there is no financial gain to the adviser as a result of the rollover.
Transaction Disclosures. For BIC exemption purposes, plan and IRA clients must receive the following disclosures before or when each recommended transaction is executed:
- A description the Best Interest standard of care owed by the individual adviser and firm;
- A description of all conflicts of interest;
- Information regarding the client’s right to obtain a description of compliance policies within 30 days (or prior to the transaction if an upfront request is made);
- Information regarding the client’s right to obtain specific compensation information (dollar amount or formula) for any recommended transaction within 30 days (or prior to the transaction if an upfront request is made); and
- Disclosure that model BIC contracts and compliance policies are posted on a website and the availability of a link.
While these disclosures are required for each investment recommendation, they do not need to be renewed for subsequent recommendations for the same investment product made within one year unless there are material changes. In addition, they do not need to be provided if the adviser is a level-fee fiduciary or with respect to certain advice made under a bank networking arrangement.
Web Disclosures. Advisory firms seeking to qualify under the BIC exemption must also post the following information on the firm’s public website, updating it on a quarterly basis:
- A description of the firm’s business model and its associated conflicts;
- A schedule of typical fees and charges;
- Model BIC contracts (for non-ERISA plans and IRAs) or model BIC exemption disclosures (for ERISA plans), which must be reviewed on a quarterly basis and updated within 30 days;
- A description of firm compliance policies;
- A list of all product sponsors that make third party payments, and an explanation of such arrangements;
- Disclosure of compensation and incentive arrangements for individual advisers, and provision of a “full and fair description” of payout grids (without referring to a specific adviser’s payout); and
- Upon request, provision of a copy of the firm’s compliance policies.
These disclosures may use dollar amounts, formulae or reasonable ranges of value to describe the firm’s arrangements with product sponsors and individual advisers. Such disclosures must enable clients to make an informed judgment about the significance of the firm’s compensation practices and conflicts. Further, they may cross-reference and link to other public disclosures, such as the ADV brochure. The Web Disclosures are not required for level-fee fiduciaries or bank networking arrangements.
The final rule also provides relief by simplifying certain disclosures required as a condition of BIC relief, such as eliminating the need to make performance projections.
Other BIC Changes – Proprietary Products. Other provisions clarify how the BIC exemption applies to advice rendered with respect to proprietary products which otherwise might be seen as impeding the best interest of the retirement investor. Thus, if a firm limits the individual adviser’s recommendations to proprietary products or investment products that generate third party payments, the following additional requirements will apply:
- Written Statement for Client. Before or when the recommended transaction is executed, the client must receive a statement that explains how the recommendations are limited to such investment products.
- Internal Documentation. The firm must document its limitations on the universe of recommended investments, its related conflicts, and any services it will provide to product sponsors for third party payments. It must conclude that any related compensation is reasonable and any conflicts will not cause imprudent advice, and it must document the basis for its conclusions.
BIC Recordkeeping and Reporting and Compliance. The advisory firm must make a one-time filing to notify the DOL of its intention to rely on the BIC exemption. In addition, the firm must maintain all relevant records for 6 years. Such records must be made available to plan and IRA clients, but a client may not examine records of other clients. If the firm refuses a request for any records, it must provide a written notice with reasons for its refusal within 30 days. Finally, the firm must designate a BIC officer to monitor compliance with the Impartial Conduct Standards and address conflicts of interest.
IV. REVISED PTE 84-24 FOR INSURANCE AND MUTUAL FUNDS
Prohibited Transaction Exemption 84-24. PTE 84-24 has traditionally permitted fiduciary investment advisers to receive commissions and certain other forms of variable compensation in connection with the purchase and sale of insurance products and mutual fund shares by plans and IRAs. Going forward, this exemption will be revised so that the adviser’s acting in the best interest of a plan, participant or IRA will be a condition for receiving commissions on these products, similar to that which would be required under the BIC exemption, except that it will not be necessary for the adviser to enter a written agreement with the plan or IRA or adopt formal policies and procedures to mitigate conflicts of interest.
It should be noted that, with respect to insurance products, PTE 84-24 only applies to commissions; it does not permit the receipt of sales-based or asset-based revenue sharing payments, administrative fees or marketing payments from insurance companies. In the case of mutual funds, the exemption covers commissions and sales loads, but does not apply to the receipt of 12b-1 fees, revenue sharing payments, administrative fees or marketing fees.
Under its proposed revision, PTE 84-24 would not have covered variable annuities or mutual fund shares sold to IRAs, so that relief from ERISA’s prohibited transaction rules with respect to variable compensation involving these transactions would need to be sought under the more stringent BIC exemption. The final revision of PTE 84-24 also makes the exemption inapplicable to fixed index annuities which, like variable annuities, tie returns to an investment index and fail to guarantee a minimum interest rate. Thus, for transactions involving IRAs, the 84-24 exemption will only apply to fixed rate annuity contracts and life insurance policies.
The BIC exemption and PTE 84-24 differ not only with respect to the products they cover, but also as to the plans to which these products are sold. On one hand, the product range under PTE 84-24 is significantly limited compared to the BIC exemption. In contrast to the BIC exemption, however, PTE 84-24 is not restricted to transactions with plans having less than $50 million of assets that are not represented by an independent institutional fiduciary. This means that advisers operating under PTE 84-24 can potentially receive commissions on insurance, annuity products and mutual funds sold to these large plans, as well as to smaller plans.
Conditions to Qualify under PTE 84-24. As under the BIC exemption, compensation received pursuant to a transaction covered by PTE 84-24 must be reasonable, and an adviser will need to disclose material conflicts of interest that could affect the exercise of its best judgment as a fiduciary in rendering advice. In addition, the BIC exemption and PTE 84-24 share the same impartial conduct standard, and the terms of sales transactions under both exemptions must meet an arm’s-length standard. Relevant statements made by the individual adviser and firm must not be materially misleading.
Prior to a sale under PTE 84-24, certain details regarding the transaction will need to be disclosed to the client, including:
- Relationships. Whether the adviser’s ability to recommend annuity contracts is limited by any agreement with the insurer or, if they are affiliates, the nature of the limitation and relationship must be disclosed;
- Commission. The individual adviser’s commission must be expressed as a flat dollar figure to the extent feasible. Otherwise, it must be expressed as a percentage of the premiums for the first year and renewal years. The net commission for the individual adviser and the override payable to the firm (which is the remaining portion of gross dealer concession) must be separately disclosed; and
- Charges. Any charges or penalties (such as surrender charges) that may be imposed in connection with the purchase, holding or sale of the annuity contract must be disclosed.
Following these disclosures, a plan fiduciary or IRA owner must acknowledge in writing that it has received the disclosures and that it is approving the annuity sale on behalf of the plan or IRA. In the case of additional purchases through ongoing deposits under the same contract, new transaction disclosures must be provided annually. Similar disclosures and acknowledgments must be made with respect to sales of mutual fund shares, both at the time of the sales transaction and annually.
To qualify under PTE 84-24, the selling firm (e.g., the insurance company or principal underwriter of the mutual fund) must maintain all relevant records for six years. As in the case of the BIC exemption, these records must be made available to plan or IRA clients, as well as regulators at the DOL and IRS, but a client may not examine records of other clients. If the firm refuses a request for any records, it must provide a written notice with reasons for its refusal within 30 days.
V. COVERED PLANS AND EFFECTIVE DATES
Plans Subject to the Fiduciary Rule. The new fiduciary regime covers ERISA plans that are maintained by private employers as well as the tax-qualified arrangements described in Section 4975 of the Internal Revenue Code, which include sole proprietor plans, such as solo 401(k) plans, IRAs, Archer Medical Savings Accounts, HSAs and Coverdell education savings accounts. 529 plans are not subject to ERISA and they are not listed in Section 4975, so they are excluded from coverage.
Governmental plans are excluded from ERISA and the new fiduciary rule. Funded 457 plans (with plan assets) by their nature are most typically governmental plans, so they would be excluded.
403(b) accounts can be divided into three groups: (1) non-ERISA 403(b) accounts maintained by an individual, and not an employer, (2) ERISA 403(b) plans maintained by a private employer, and (3) non-ERISA 403(b) plans maintained by a governmental entity, such as a public school. The DOL has made it clear that categories (1) and (3) are not subject to ERISA or the new fiduciary rule.
Phased Effective Dates. The effective date of the new rule is 60 days after its formal publication on April 8, 2016. Although this means that the fiduciary regulation will take effect on June 7, 2016, its applicability will be delayed until April 10, 2017 which is somewhat longer than the eight months lead time the DOL originally signaled. Moreover, the need to comply with many of the conditions necessary to qualify for various exemptions under the new prohibited transaction exemption guidance will not apply until January 1, 2018.
Compliance with certain BIC requirements will be required during the transition period from April 10, 2017 through December 31, 2017. Prior to execution of a recommended transaction during this period, financial institutions will need to provide (electronically or by mail) written notice acknowledging the adviser’s fiduciary status, promising compliance with the BIC exemption’s impartial conduct standards and disclosing any material conflicts of interest. The notice will also need to disclose whether proprietary products or investments generating third party payments are being recommended and the limitations this places on the universe of investment recommendations. Further, the firm will need to designate a BIC officer to monitor compliance and comply with BIC exemption recordkeeping requirements by the start of the transition period.
After the transition period, financial institutions and advisers will be required to meet all the requirements for the BIC exemption, such as preparation of contracts, where required, and implementation of policies and procedures mitigating conflicts. For example, negative consent to the amendment of an investment advisory arrangement that qualifies as a BIC contract should be in effect by this date.
Grandfathering for Pre-Existing Transactions. An individual adviser and firm may continue to receive variable compensation with respect to investment products acquired by plan or IRA clients prior to April 10, 2017 (or a systematic purchase program established prior to such date), if the following requirements are met:
- The compensation is received under an arrangement that was entered into prior to April 10, 2017 and that has not expired or come up for renewal;
- The client’s initial acquisition of the investment product did not trigger a non-exempt prohibited transaction;
- The compensation is not related to a client’s investment of additional amounts under the previously acquired investment product (such as additional deposits under an annuity) unless the purchases are made under an arrangement established before April 10, 2017;
- The compensation is reasonable; and
- Any advice provided after April 10, 2017 (such as hold recommendations) with respect to the investment product is in accordance with the Best Interest fiduciary standard.
VI. MANAGED ACCOUNTS
Questions have arisen as to what this rule will mean for separately managed account (“SMA”) program sponsors who receive variable compensation from SMA managers they recommend (or advisers select) within a wrap program. Unfortunately, the DOL did not clarify how its new rule would apply to these retail managed account programs. Some have assumed that if a plan or IRA client pays a level fee, such as an asset-based program fee, there is no prohibited transaction issue under ERISA, but this assumption may not be correct for many programs.
The prohibited transaction rules are fundamentally concerned with whether an adviser has an improper financial incentive to steer a retirement investor client to a particular investment solution. If advisers have an incentive to steer clients to a particular SMA manager, because the individual adviser or the firm can earn a higher level of net compensation, a prohibited transaction may be triggered. Of course, the DOL’s Best Interest Contract exemption will allow advisers to earn this type of variable compensation, but advisers would need to modify their managed account programs to conform with the exemption’s requirements. Many firms may not realize that if they want to continue advising their IRA and plan clients for a fee, significant changes may need to be made to their managed account programs. Fortunately, the DOL has simplified many of the conditions necessary to qualify for the BIC exemption.
If SMA manager fees or model fees are charged on top of the investment advisory program fee, the question becomes whether the program fee constitutes variable compensation. In this situation, a program sponsor might be paid 1% while the model managers may be paid separate fees that vary by manager. Assuming pricing is transparent and the adviser earns the same net compensation regardless of which SMA manager is selected, the adviser has level compensation and there is no prohibited transaction. The retirement client will pay an all-in-fee that varies with whichever SMA manager is recommended. If a more expensive SMA manager is recommended by the adviser, this gross fee will be higher for the client. However, the adviser will not have an improper financial incentive to recommend one SMA manager over another, since the adviser’s net compensation will not vary with the recommendation.
On the other hand, revenue sharing payments made to program sponsors by SMA managers could be problematic, since they are viewed as third party payments and a fiduciary adviser is not permitted to benefit financially from any third party payments received in connection with its advice, because of the conflict this entails. However, if the program sponsor complies with the requirements of the BIC exemption, it would be permitted to receive revenue sharing from SMA managers or model providers.
The new rule will effectively require retail managed account providers to change their advisory programs either by levelizing their net compensation, or operating their advisory programs in compliance with the BIC exemption. Given the broad spectrum of SMA managers with varying investment strategies, it would be virtually impossible to standardize their compensation so that every SMA manager is paid the same amount. As a result, standardization of compensation paid to or received from managers is unlikely. Even if retail managed account providers opt to rely on the BIC exemption rather than levelizing their compensation, they will be required to mitigate their financial conflicts. This, in turn, will pressure them to increase fee transparency so that the SMA manager’s fee is separately disclosed and charged on top of the program fee.
For now, the question of whether model managers that do not actively implement their strategies could become an ERISA fiduciary under the final investment advice fiduciary rule remains unanswered. In many instances, the model provider will provide its advice to the program sponsor, without even knowing the identify of any end investors. However, a model provider potentially may be viewed as a fiduciary to the extent that it is deemed to be providing advice “indirectly” to retirement clients through an adviser. The jury is still out, but if the DOL ultimately decides to adopt an expansive interpretation of the final rule, model providers could potentially be viewed as fiduciaries.
VII. CONCLUDING REMARKS
Universal Standard. The DOL’s ultimate goal is to impose a universal “Best Interest” fiduciary standard on all types of advisers to plan sponsors, participants and IRA owners. There is a certain irony to this endeavor, since if it is successful, there will be a new regime that effectively creates two classes of fiduciary advisers, those earning variable compensation and those that do not.
Affect on Plan Sponsor. Plan sponsors now must understand how their providers are affected by the new rules, lest their compensation be a prohibited transaction for which the plan sponsor could be jointly liable. Sponsors need to reach out to their vendors to inquire whether and how the plan’s fee structure and amount might be affected as well as their contractual relationship. This, in turn, may require reevaluation of the fee’s reasonableness, an always difficult task.
Regardless of whether a written BIC contract will be required, sponsors should be prepared for the likelihood that vendors will present them with new or modified documentation, as the vendors seek to qualify under one of the now finalized regulatory regime’s exceptions or exemptions or to clarify their fiduciary status. Sponsors should be aware that such changes could take the form of a negative consent requiring no affirmative action by the sponsor.
Global Effect on Providers. The compliance measures required by the expansion of those who are investment advice fiduciaries and the new and complicated system of exceptions and exemptions from fiduciary status will also have major effect on plan investment and service providers. Broker-dealers and their registered representatives will need to acknowledge their fiduciary status and qualify for an exemption if they choose to continue receiving variable compensation. Registered representatives and RIAs will be limited in their ability to capture rollovers, and the structure of managed account programs sponsored by advisory firms will also be impacted.
Stay tuned as The Wagner Law Group keeps you posted on what you need to know and please reach out to us for assistance and advice.