The DOL’s expanded definition of fiduciary advice is explained in the preamble to PTE 2020-02.
When conflicted fiduciary advice is given to retirement investors, that is, retirement plans, participants (including rollovers), and IRA owners (including transfers of IRAs), it results in prohibited transactions under the Internal Revenue Code and ERISA. The prohibited transaction is the compensation earned as a result of the fiduciary recommendation, e.g., the fees or commissions from a rollover IRA.
The PTE provides relief for the prohibitions resulting from conflicted non-discretionary recommendations. However, the relief is conditional, that is, it is only available if all of the PTE’s conditions are satisfied.
The compliance deadline was February 1, 2021 for most of the PTE’s conditions and July 1 for the one remaining condition–the requirement to provide retirement investors in writing with the “specific reasons” why a rollover recommendation is in their best interest.
As a result, the documentation and processes for compliance with PTE 2020-02’s conditions should now be completed. So, this is a good time to consider the liability issues and the opportunities created by the PTE.
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.
Since a significantly increased number of recommendations to retirement investors will be fiduciary recommendations under the expanded fiduciary interpretation, and since many, if not most, of those recommendations will involve conflicts of interest, financial institutions and investment professionals will need to satisfy the “conditions” (or requirements) in the PTE. The 4 categories of those conditions are: (1) the Impartial Conduct Standards (including the best interest standard of care); (2) disclosures (including the “specific reasons”), (3) policies and procedures (include mitigation of conflicts), and (4) the annual retrospective review and report.
With the exception of the annual retrospective review and report, the first 3 requirements should be in place and being implemented for covered recommendations. (See Best Interest #93 for a discussion of the correction of failures to comply with those requirements.)
As a result, this Best Interest #100, which is the last in this series, is a good place to look at the areas of significant potential liability and some planning opportunities related to the PTE.
When considering the possibility of liability, I think the clear cut “winner” is noncompliant recommendations of plan-to-IRA rollovers. First, and obviously, there is often a lot of money involved. When a retirement investor suffers material losses after making a rollover, and particularly an older investor, the financial and emotional impacts are substantial. Those are fuel for the litigation fire. Second, the DOL guidance describes a specific 5-step process, which if not followed, would probably result in a fiduciary failure. Those steps are: (1) obtain relevant information about the retirement investor’s needs, financial circumstances, investment objectives and risk tolerance; (2) obtain information about the retirement plan’s investments, services, and expenses; (3) consider information about the available IRA’s investments, services and expenses; (4) evaluate the plan information and the IRA information in light of the participant’s profile, and formulate a recommendation that is in the best interest of the participant/retirement investor; and (5) provide the participant/retirement investor in writing with the specific reasons why a rollover is in the investor’s best interest.
The third reason for the heightened litigation/arbitration potential is the requirement for written “best interest” specific reasons. While the specific reasons are delivered concurrently with the recommendation, they will be reviewed years later by plaintiffs’ or claimants’ attorneys (or by the regulators). If, with the advantage of hindsight, those specific reasons didn’t make sense or weren’t implemented, the reasons will likely be used as evidence against the financial institution and the investment professional.
As a result, considerable care should be used in (1) determining which specific reasons are compliant, (2) supervising the reasons provided to ensure that they reflect the investor’s profile and needs, and (3) supervising the implementation of the “solutions” suggested by the specific reasons. As an example of that latter point, if the specific reasons include the availability of a large number of investments in an IRA, then the expectation would likely be that some of the large number of investments that are materially different than the retirement plan’s investments would be recommended to the investor. Or, if a specific reason is that certain needed services are needed by the retirement investor, and those services can be provided in connection with a rollover IRA, then supervision should ensure that those services are actually provided.
Beyond the plan-to-IRA rollover scenario, another significant “threat” is that the best interest standard of care, as defined by the DOL, will become the standard of care applied by courts and arbitration panels. While the SEC best interest standards for investment advisers and for broker-dealers aren’t actionable as claims in private lawsuits, the convergence of the regulators on the concept of a best interest standard of care and a duty of loyalty may ultimately be seen as the community standard of care, much the way that negligence is now. Stated differently, the failure to meet the expectations for investment professionals to act in the best interest of investors may become the definition of negligence. That process could take years, but it is possible.
In addition, the requirement in PTE 2020-02 that the conflicts of financial institutions and investment professionals be mitigated is an issue that may produce compliance failures. First, it is a principles-based standard, meaning that its application will evolve over time. What works today may not work five years from now…which is the nature of principles-based standards. Just think of how ERISA’s fiduciary standard has evolved over time. Twenty years ago, there wasn’t any litigation on share class selection; today it may be the #1 issue in ERISA fiduciary breach litigation. Is that regulation by enforcement, or is it the nature of principles-based rules? I think it’s the latter.
While PTE 2020-02 creates threats, it also provides opportunities.
For example, there are opportunities to use proprietary mutual funds and CITs, and to collect both an advisory fee for the account and a management fee for the fund, which is not permissible under current rules. The catch is that the PTE only provides relief from prohibited transactions where the advice is non-discretionary. Since investment advisers commonly manage IRAs with discretion, the relief would not be available at first blush. However, if the investment advisory agreement for the IRA is amended so that the proprietary investment is recommended on a non-discretionary basis (and to eliminate any other discretion related to the proprietary investment), the arrangement can be converted to be non-discretionary–and the PTE will be available. The balance of the IRA can continue to be managed with discretion. A number of firms have taken advantage of this opportunity.
If the terms of an investment advisory agreement with an ERISA-governed retirement plan could be read to include recommendations to provide investment advice or investment management services to participants in the plan, there is a risk that, if a firm recommends itself as a participant-level adviser, the resulting fees would be prohibited transactions. However, under PTE 2020-02 a firm can, acting as a fiduciary, recommend itself to provide additional services. In order to avail itself of the protections of the PTE, the recommendation must be non-discretionary; however, the services that are recommended could be discretionary, e.g., management of participant accounts.
More generally, now that the work on the 2020-02 compliance issues is completed, financial institutions can consider how the PTE can be used to provide additional services and products and receive the compensation associated with those products and services.
PTE 2020-02 presents both threats and opportunities. The greatest threat is for plan-to-IRA rollover recommendations that do not satisfy the conditions of the PTE. That is due to, for example, ERISA’s private of action for fiduciary breach, the large amounts involved in some rollovers, and the requirement that participants be given the specific reasons why a rollover recommendation is in their best interest.
However, the PTE also create opportunities to recommend proprietary investments to plans and IRAs and to recommend additional services such as investment management services for participants.
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