The Department of Labor’s “Fiduciary Rule,” PTE 2020-02: The FAQs

Background

The DOL’s prohibited transaction exemption (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees), allows investment advisers, broker-dealers, banks, and insurance companies (“financial institu­tions”), and their representatives (“investment professionals”), to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to ERISA retirement plans, participants (including rollover recommendations), and IRA owners (“retirement investors”). In addition, in the preamble to the PTE the DOL announced an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals are fiduciaries for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

Specifically, one of the conditions for relief under PTE 2020-02 is mitigation of conflicts of interest. The PTE describes that requirement as:

Financial Institutions’ policies and procedures mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests ahead of the interest of the Retirement Investor.

In FAQ 17 about the PTE, the DOL specifically addressed the issue of payout grids, their incentive effect and possible mitigation steps. FAQ 17 begins with the question:

Q17. Are there special considerations for financial institutions that use payout grids in implementing the exemption’s required policies and procedures?

My last post, Best Interest #77, discussed the general concepts. This article goes into the more detailed parts of the DOL’s “answer”. That part of the FAQ discussed three specific issues. I repeat the answers here and then comment on what they mean.

• Grids with one or several modest or gradual increases are less likely to create impermissible incentives than grids characterized by large increases. Firms should be very careful about structures that disproportionately increase compensation at specified thresholds. These structures can undermine the best interest standard and create incentives for investment professionals to make recommendations based on their own financial interest, rather than the retirement investor’s interest in sound advice.

Comment:  The DOL’s position is simple….keep the bands in the grid narrow and the increases in compensation modest for reaching a new band. The thinking is that narrower bands with more moderate increases will be less likely to incent an investment professional to make a recommendation (e.g., a rollover recommendation) that moves the professional into the higher band. That is consistent with the SEC’s approach. Of course, it’s one thing to say narrow bands and modest increases, but it is more difficult to determine where those lines are actually drawn when preparing a grid. One approach would be to have a “committee” approach….with representatives from distribution, compliance and legal looking at the degree of the incentive and agreeing that the bands and amounts were unlikely to unduly incent investment professionals to prioritize themselves over the retirement investors. As a word of advice, if it doesn’t pass the “smell test”, it probably won’t pass the DOL’s test.

• As the investment professional reaches a threshold on the grid, any resulting increase in compensation rate should generally be prospective – the new rate should apply only to new investments made once the threshold is reached. If the consequence of reaching a threshold is not only a higher compensation rate for new transactions, but also retroactive application of an increased rate of pay for past investments, the grid is likely to create acute conflicts of interest. Retroactivity magnifies the investment professional’s conflict of interest with respect to investment recommendations and increases the incentive to make the sales necessary to cross the threshold regardless of the investor’s interest. The danger is particularly great when the sales necessary to cross the threshold would generate compensation for the investment professional that are disproportionate to the compensation the professional would normally receive for recommendations that are not at the threshold.

Comment:  The use of a retroactive, or waterfall, approach is, in effect, an “invitation” to the DOL to closely scrutinize the grid and its effects. This approach was also part of the Obama-era Best Interest Contract Exemption. In other words, the DOL is serious about the use of grids that retroactively increase compensation splits and the potential adverse impact of those grids on best interest recommendations.

• As discussed in Q16, financial institutions employing escalating grids should establish a system to monitor and supervise investment professional recommendations, both at or near compensation thresholds and at a greater distance. Financial institutions should ensure that the thresholds do not create undue sales incentives. Aggressive thresholds can create incentives to make investment recommendations that are contrary to the retirement investor’s interest.

Comment: From the DOL’s perspective, grids create conflicts of interest. Under PTE 2020-02, the conflicts of both firms and investment professionals must be mitigated to avoid overly incenting those professionals to make recommendations that are in the best interest of the professionals and not of the retirement investors. There are a variety of mitigation techniques that can be used for different types of conflicts, but it seems like there are at least two approaches that will need to be part of mitigating every type of conflict. Those are:  (i) an appropriate best interest process for developing the recommendation, and (ii) supervision of the proper implementation of that process. Since each band of a grid increases an investment professional’s compensation, the recommendation of an investment, rollover, annuity, etc., that moves a professional to the next band is a conflict above and beyond the direct compensation received for that recommended transaction. As a result, the transactions that move professionals into a higher band warrant additional—perhaps heightened—supervision. Even though it probably doesn’t need to be said, the greater the compensation increase associated with a higher band, the greater the likely incentive effect and, accordingly, the increased importance of close supervision of adherence to a best interest process.

Concluding Thoughts

While grids create unique issues, the key is to minimize the incentive effect of moving from one band to a higher one. The can be accomplished, as the DOL points out, by limiting the sizes of the bands, limiting the increase in compensation when moving to a higher band, and by increasing only prospective compensation.

Beyond that, the key is to have solid best interest processes for investment professionals to develop their recommendations, e.g., for developing a rollover recommendation. Then, firms need to supervise the process for developing those recommendations to ensure that the processes are followed and that the recommendations reflect reasonable outcomes based on the information gathered and evaluated.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.