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 (all of whom are referred to as “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.

The fiduciary regulations under ERISA and the Internal Revenue Code have two definitions of fiduciary advice. The first is the obvious—where the investment professional and financial institution have discretion over the investments in retirement accounts. In effect, that is a one-part test—“discretion.” In addition, there is a 5-part test for non-discretionary fiduciary advice. The DOL did not amend the regulation to modify any of the “parts,” but instead reinterpreted some of the parts, and particularly the “regular basis” part, to significantly increase the number of investment professionals and financial institutions who are fiduciaries.

This article focuses on the requirement in PTE 2020-02 that financial institutions and investment professionals provide participants with the “specific reasons” why a rollover recommendation is in the best interest of the participant.

The requirement to provide participants, in writing, with the specific reasons why a rollover recommendation is in their best interest is deferred by the DOL’s enforcement policy until July 1, 2022. At that point, this condition of the PTE must be satisfied:

Prior to engaging in a rollover recommended pursuant to the exemption, the Financial Institution provides the documentation of specific reasons for the rollover recommendation, required by Section II(c)(3), to the Retirement Investor.

The cross-reference is to the policies and procedures provisions of the PTE, which says:

The Financial Institution documents the specific reasons that any recommendation to roll over assets…is in the Best Interest of the Retirement Investor.

While the DOL didn’t provide any examples of reasons that would or would not be compliant, the SEC has. In my opinion, it is likely that the DOL will follow the SEC’s lead on this point.

The SEC’s guidance is in the Adopting Release for Regulation Best Interest (Reg BI) for broker-dealers. Even though the guidance is in a broker-dealer regulation, it almost certainly also applies to investment advisers. As the SEC explained in its recent Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors:

The following is a staff bulletin styled as questions and answers reiterating the standards of conduct for broker-dealers and investment advisers when they are making account recommendations to retail investors. Both Regulation Best Interest (“Reg BI”) for broker-dealers and the fiduciary standard for investment advisers under the Investment Advisers Act (the “IA fiduciary standard”) are drawn from key fiduciary principles that include an obligation to act in the retail investor’s best interest and not to place their own interests ahead of the investor’s interest. Although the specific application of Reg BI and the IA fiduciary standard may differ in some respects and be triggered at different times, in the staff’s view, they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.

Back to Reg BI’s Adopting Release where the SEC said:

[B]roker-dealers should consider a variety of additional factors specifically salient to IRAs and workplace retirement plans, in order to compare the retail customer’s existing [retirement plan] account to the IRA offered by the broker-dealer. These factors should generally include, among other relevant factors: Fees and expenses; level of service available; available investment options; ability to take penalty-free withdrawals; application of required minimum distributions; protection from creditors and legal judgments; holdings of employer stock; and any special features of the existing account.

Comment: That makes sense. After all, a rollover recommendation requires a comparison of the investments, services and expenses of the plan and the IRA. And the additional enumerated factors and features seem material to an analysis of which account type (that is, the plan account or the IRA “account”) is in the best interest of a participant. But then the SEC goes on to say:

With respect to available investment options, we caution broker-dealers not to rely on, for example, an IRA having ‘‘more investment options’’ as the basis for recommending a rollover. Rather, as with other factors, broker-dealers should consider available investment options in an IRA, among other relevant factors, in light of the retail customer’s current situation and needs in order to develop a reasonable basis to believe that the rollover is in the retail customer’s best interest. [Emphasis added.]

Comment: In other words, the mere existence of “more investment options” is, standing alone, not a meaningful factor. Instead, the issue is whether having more investment options provides value to the particular investor. In order to make that determination, financial institutions and investment professionals should have an idea of how the participant will be invested in the IRA. For example, if the rollover money is invested in a portfolio of mutual funds, that raises the obvious question of whether the availability of “more investment options” provided enough value to the participant to offset the likely higher cost of being in the IRA, as opposed to leaving the money in the plan. It’s important to consider that regulators come in after the fact and will be able to see if the rollover IRA took advantage of the availability of “more investment options.”

Concluding Thoughts

The requirement to provide participants with the “specific reasons” why a rollover recommendation is in their best interest is challenging. Since those reasons must be provided to the participant in writing, they can be easily examined in the future—by the regulators or by attorneys for the participants. By the time the regulators or attorneys review the written specific reasons, it will be at least a year or two after the IRA investment recommendations were made and they will know how the rollover IRA was invested. As a result, they will be able to see if the investments recommended for the rollover IRA were in alignment with the specific reasons given for the rollover recommendation.

In supervising rollover recommendations, financial institutions should consider reviewing the investments recommended for rollover IRAs to determine if the investment professionals properly implemented the specific reasons.

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.