The U.S. Department of Labor has released its package of proposed changes to the regulation defining fiduciary advice and to the exemptions for conflicts and compensation for investment recommendations to retirement plans, participants (including rollovers), and IRAs.

ERISA’s fiduciary responsibility rules require that costs, for both investments and services, be no more than a reasonable amount. In other words, a prudent process will consider the costs of investments and services relative to the value of those investments or services to the retirement investor and relative to reasonably available alternatives. ERISA’s prohibited transaction rules, and the exemptions to the prohibitions, impose a similar limit on compensation when a fiduciary recommendation is conflicted, that is, the compensation cannot be more than a reasonable amount when compared to the value of services being offered. These rules apply to all ERISA-governed retirement plans and participant accounts in those plans (including rollover recommendations).

The Code has prohibited transaction provisions with similar limitations on compensation, that is, compensation cannot exceed a reasonable amount relative to the services provided. The Code limits apply to both tax-qualified retirement plans and IRAs (including individual retirement annuities). However, the Code does not have a standard of care for advice to IRAs. Instead, the applicable standard of care is imposed by other laws and regulations (for example, the fiduciary standard for investment advisers, the best interest standard for broker-dealers, and the NAIC model rule’s best interest standard for insurance agents and brokers).

My last post, The New Fiduciary Rule (15), discussed the meaning of “reasonable” for compensation and costs.

This article focuses limitations on compensation in the DOL’s proposed PTE (Prohibited Transaction Exemption) 2020-02, which applies to all conflicted recommendations by broker-dealers, investment advisers, and banks. It also applies to annuity recommendations by statutory employees and common law employees of insurance companies. Insurance companies working with independent insurance agents can, as an alternative, use PTE 84-24, which will be the topic of my next article.

The DOL’s proposed amended PTE 2020-02 has a number of compensation related requirements.

• Under the Impartial Conduct Standards, neither the advisor nor the firm can receive more than reasonable compensation for the services rendered.
   
  The compensation received, directly or indirectly, by the Financial Institution, Investment Professional, their Affiliates and Related Entities for their services does not exceed reasonable compensation within the meaning of ERISA section 408(b)(2) and Code section 4975(d)(2)….
• The advisor and the firm must give the retirement investor a disclosure document of the right to obtain additional information about costs, fees, and compensation.
   
  A written statement that the Retirement Investor has the right to obtain specific information regarding costs, fees, and compensation, described in dollar amounts, percentages, formulas, or other means reasonably designed to present full and fair disclosure that is materially accurate in scope, magnitude, and nature, with sufficient detail to permit the Retirement Investor to make an informed judgment about the costs of the transaction and about the significance and severity of the Conflicts of Interest, and that describes how the Retirement Investor can get the information, free of charge….
  [Emphasis added by me.]

   
  Comment: The preamble to the PTE provides model language for this disclosure. However, firms will need to develop their written responses if a retirement investor asks for the information. Note that the DOL says that this information can be on a website for retirement investors.

• The firm must have and enforce policies and procedures that mitigate compensation related conflicts of interest of both the firm and the advisor. (Note that Reg BI requires that broker-dealers have similar policies and procedures for advisors, but not for the firm.)
   
  The Financial Institution’s 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 interests of the Retirement Investor. Financial Institutions may not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, or other similar actions or incentives that are intended, or that a reasonable person would conclude are likely, to result in recommendations that are not in Retirement Investors’ Best Interest. [Emphasis added by me.]

   
  Comment:  In my view, “mitigation” is a sleeper. Mitigation is a principles-based concept and therefore will change over time as circumstances and expectations change. The big question is, How much mitigation is enough?

• However, the preamble has even more demanding language in its discussion of mitigation.
   
  To satisfy Section II(c), Financial Institutions may not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, or other similar actions or incentives that are intended, or that a reasonable person would conclude are likely, to encourage Investment Professionals to make recommendations that are not in Retirement Investors’ Best Interest. A Financial Institution should not offer incentive vacations, or even paid trips to educational conferences, if the desirability of the destination is based on sales volume and satisfaction of sales quotas. [The emphasis is mine.]

   
  Comment: This language is particularly difficult to apply as a practical matter. For example, how does one determine the “desirability of the destination”?  In some cases, the answer may be obvious, but in other cases it can’t be determined definitively. For example, there are many desirable destinations within the United States, but is this provision meant to mean that they should be scored by desirability—and where is the dividing line?

• The proposed PTE defines “Third-Party Payments” as follows. I include this to provide examples of the types of compensation that would be viewed as conflicted compensation for the firm and/or the advisor and therefor require compliance with the PTE.
   
  ‘‘Third-Party Payments’’ include sales charges when not paid directly to the Financial Institution by the Plan, from a participant or beneficiary’s account, or from an IRA; gross dealer concessions; revenue sharing payments; 12–1 fees; distribution, solicitation or referral fees; volume-based fees; fees for seminars and educational programs; and any other compensation, consideration, or financial benefit provided to the Financial Institution or an Affiliate or Related Entity by a third party as a result of a transaction involving a Plan, participant or beneficiary account, or IRA.
• Finally, the preamble warns firms that they cannot transfer their conflicts onto their advisors.
   
  The Financial Institution must pay close attention to any Conflicts of Interest that may exist within the Financial Institution itself. For example, it is not enough merely to pay Investment Professionals the same percentage of the Financial Institution’s compensation for a recommended investment product, as for other products, if the Financial Institution receives more compensation from recommending that product rather than other products. In such cases, the ‘‘level’’ compensation percentage effectively directly transmits the Financial Institution’s conflict of interest to the Investment Professional, as the Investment Professional’s compensation is increased in direct proportion to the profitability of the investment to the firm. Thus, Section II(c) requires the Financial Institution to look carefully at its own incentives and ensure that all recommendations are focused on the Retirement Investor’s Best Interest rather than the Financial Institution’s interests.

 

Concluding Thoughts

These requirements may be effective as early as this Summer. While it isn’t clear when they will be applicable, it could also be this Summer or a few months thereafter. Financial service firms—investment advisers, broker-dealers, banks and insurance companies—should be considering how these compensation limitations will affect their practices. If there is only a limited time for the policies to be implemented, firms would be well advised to consider the impact of the changes even before we see the final rules.

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.