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.

Under these standards, a rollover recommendation will ordinarily be nondiscretionary fiduciary advice and result in a financial conflict of interest that is a prohibited transaction under both ERISA and the Internal Revenue Code. But, since the recommendation is nondiscretionary, PTE 2020-02 can provide relief, but only if all of its conditions are met.

In addition, the SEC position is that a rollover recommendation by a broker-dealer or investment adviser is subject to the best interest standard in Reg BI and the Investment Adviser Interpretation.

Both the SEC and the DOL say that cost is a material consideration in the analysis of whether a rollover is in the best interest of a participant (a “retirement investor”). For example, in the preamble to PTE 2020-02, the DOL stated: “… the Department agrees that the cost of an investment product will be a factor in every recommendation …”.

In another part of the preamble, the DOL said:

“With respect to recommendations to roll assets out of an Title I Plan and into an IRA, the factors that a Financial Institution and Investment Professional should consider and document include the following: The Retirement Investor’s alternatives to a rollover, including leaving the money in his or her current employer’s Plan, if permitted, and selecting different investment options; the fees and expenses associated with both the Plan and the IRA; whether the employer pays for some or all of the Plan’s administrative expenses; and the different levels of services and investments available under the Plan and the IRA.”

The SEC Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors, also addresses consideration of costs in the rollover analysis. It does so in series of Q and As about account-type selection. (Keep in mind that a rollover recommendation is an “account-type” recommendation since it is a recommendation to liquidate the 401(k) account and invest in an IRA “account’). With regard to costs, the Staff said:

3. Consideration of Costs in Account Recommendations

   1. Are costs always a relevant factor to consider when making account recommendations?Yes, you must always consider cost as a factor when making an account recommendation. While Reg BI and the IA fiduciary standard do not always obligate you to recommend the least expensive type of account, both require you to have a reasonable basis to believe that the account recommendation is in the retail investor’s best interest and does not place your or your firm’s interests ahead of the retail investor’s interest. As discussed further below, if you recommend a higher cost account, you must have a reasonable basis to believe the account recommendation is nonetheless in the retail investor’s best interest based on other factors and in light of the particular situation and needs of the retail investor. The Commission has pursued enforcement actions against investment advisers for recommending higher-cost products to clients when similar, lower-cost products were available.
   2. What are examples of costs that I should consider when recommending an account?In the staff’s view, you should consider the total potential costs when evaluating whether an account is in a retail investor’s best interest, including indirect costs that could be borne by the retail investor. Examples of costs can include account fees (e.g., asset-based, engagement, hourly), commissions and transaction costs (e.g., markups and markdowns), tax considerations, as well as indirect costs, such as those associated with payment for order flow and cash sweep programs. When applicable, cost of an account also includes fees associated with the investment products that are available through the account, such as the internal expenses of funds, including management fees, distribution and servicing fees, and the costs of investing in funds, including front-end and back-end fees. The effect of certain costs, such as distribution and servicing fees and transaction costs related to purchasing fund shares, may depend on the investor’s anticipated investment horizon. In these cases, you should consider the potential impact of those costs on the investor’s account based on an understanding of that horizon.

Considering the focus on costs by the two regulators, financial institutions, such as broker-dealers and investment advisers, and their investment professionals will need to obtain cost information about the plan and its investments and services, and compare those to the costs of the services and investments in the potential rollover IRA. Then, as the SEC staff explains in the quote above, “…if you recommend a higher cost account, you must have a reasonable basis to believe the account recommendation is nonetheless in the retail investor’s best interest based on other factors and in light of the particular situation and needs of the retail investor.”  Based on the language in the preamble to PTE 2020-02, the DOL would take the same position.

Where does that leave financial institutions and their investment professionals?

It’s likely that, if a rollover recommendation is reviewed by the SEC or DOL, one of the first questions will be: “How do you justify the higher costs in the rollover IRA?”

At that point in time, the regulator will have access to the written specific reasons (why the rollover was in the best interest of the participant) that were given to the participant at the time of the rollover recommendation. In addition, the regulator will be able to see how the rollover IRA was invested and what services were provided in connection with the rollover IRA and will be able to compare them with the specific reasons that were given to the retirement investor. A problem could arise, for example, if the specific reason was that the IRA had access to a larger pool of investments, but the rollover IRA was invested in mutual funds or ETFs that are similar to investments available in the plan’s lineup.

While that discussion is in the context of a DOL investigation and an SEC examination, the same concepts will apply where the review is being done by an attorney for the retirement investor.

Concluding Thoughts

As a result, broker-dealers and investment advisers should consider documenting plan costs and the comparison to the IRA costs. In addition, it would be good risk management to have internal processes to ensure that the rollover IRA is invested in a manner consistent with the written specific reasons given to the participant.

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.