The Department of Labor’s “Fiduciary Rule,” PTE 2020-02 (Part 12): The Requirement that Investment Advisers and Broker-Dealers to Receive No More Than Reasonable Compensation
On February 16, 2021, the DOL’s prohibited transaction exemption (PTE) 2020-02 became effective. The PTE is titled “Improving Investment Advice for Workers & Retirees.” It 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 retirement plans, participants and IRA owners (“retirement investors”).
In the preamble to the PTE, the DOL announced an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will be fiduciaries and therefore will need the protections afforded by the exemption. In addition, they will need prudent, or best practice, processes to satisfy the fiduciary and best interest standards of care.
In order to obtain the benefit of the exemption, financial institutions and investment professionals will need to satisfy the “conditions” in the exemption. For the period from the effective date (February 16) until December 20 of this year, a DOL and IRS non-enforcement policy for prohibited transactions will be available in lieu of the exemption. That is, neither the IRS nor the DOL will enforce the rules against transactions with plans, participants or IRA owners that result from nondiscretionary fiduciary advice and that are prohibited in the Code or ERISA, so long as the Impartial Conduct Standards are satisfied. See Best Interest #41 for a discussion of the Impartial Conduct Standards.
This article builds on my earlier posts about the DOL’s rule, Parts 1-11.
This article is about the requirement in the PTE and in the Impartial Conduct Standards that financial institutions and investment professionals receive no more than reasonable compensation.
Before discussing the definition of reasonable compensation, there are a couple of foundational concepts to understand. First, if the compensation is excessive, the protection in the exemption is lost. As a result, all of the compensation earned by the financial institution from the affected account(s) will need to be restored to the retirement investor (i.e., the plan, participant or IRA owner). Second, while I refer to compensation of the financial institution, the actual definition is much broader. It is: “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);…”
Note, though, that once the conditions of the full exemption must be satisfied—on December 21, 2021, the compensation requirement also includes a best execution standard. That is, while all of the conditions of the exemption apply now (and first applied on February 16, many financial institutions are relying on the DOL’s nonenforcement policy which extends until December 20, 2021. As a result many, if not most, financial institutions do not intend to comply with all of the conditions in the exemption until December 21. However, the reasonable compensation limit applies currently since it is part of compliance with both the nonenforcement policy and the exemption.
With regard to the definition of “reasonable compensation,” the DOL explains in the preamble to PTE 2020-02: “The reasonable compensation standard requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the Investment Professional and Financial Institution are delivering to the Retirement Investor.”
In other words, the starting point for determining the reasonableness of compensation paid to the financial institution (e.g., broker-dealer or investment adviser) is to determine what the market pays for a particular service. However, that is not the end of the analysis. The preamble continues:
“Several factors inform whether compensation is reasonable, including the nature of the service(s) provided, the market price of the service(s) and/or the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.”
“The Department did not intend to suggest that reasonableness will be assessed solely against the existing market practices. The reasonable compensation standard will not be met if the fees bear little relationship to the value of the services actually rendered.”
But, what does this mean in the real world?
The last quoted, and bolded, sentence may be the most telling. “Reasonableness” is in the eye of the beholder—or, more accurately, it is in the eyes of a knowledgeable and objective “beholder”. Relatively minor differences in compensation for the same services won’t be a problem. And where there is a standard (and transparent) charge (or compensation) for a particular type of transaction or service, there shouldn’t be any problems. For example, the commissions and 12b-1 fees for the A shares of equity mutual funds may be identical or, at least, similar. Assuming that mutual funds were in the best interest of the investor, the compensation resulting from recommendations of those mutual funds would likely be reasonable. But, there is still the issue of whether the “best interest” share class was recommended.
However, where there are material differences in compensation for the same (or similar) services or products, the higher compensation recommendations are likely to be questioned. For example, in one case a court found that investment fees below the 75th percentile would be reasonable—but that means that, for compensation in excess of the 75th percentile, the compensation might be challenged and the recipient would be put in the position of needing to prove that its fees were reasonable (because, e.g., the services differed in quality or quantity). Keep in mind that the burden of proof is on the financial institution that claims the protection of an exemption.
I should also note that, while there is an explicit requirement that compensation be reasonable, another condition of the exemption—the best interest standard of care—requires that costs be considered in developing a recommendation to a retirement investor. Since, in the financial services world, cost and compensation are often connected at the hip, broker-dealers and investment advisers should be especially attentive to issues of compensation and costs.
Finally, it is not enough to ensure that compensation is reasonable. The exemption requires policies and procedures that are designed to accomplish that result:
“…the exemption will not be satisfied if the Financial Institution does not establish, maintain, and enforce written policies and procedures prudently designed to ensure that the Financial Institution and its Investment Professionals comply with the reasonable compensation standard in connection with covered fiduciary advice and transactions.”
While much of PTE 2020-02 is similar to the DOL’s Reg BI, and therefore broker-dealers will be able to take advantage of their Reg BI compliance practices, policies and procedures, this issue—reasonable compensation—is not an element of Reg BI (but, of course, the consideration of cost is). As a result, broker-dealers will need to develop practices, as well as policies and procedures, to comply with the PTE requirement about reasonable compensation.
Compliance with the PTE’s conditions will be an even bigger job for investment advisers, since they will not have developed policies, procedures and practices to comply with Reg BI, for example, the mitigation requirements. But, in the case of reasonable compensation, investment advisers will be in the same position as broker-dealers . . . starting from scratch.
While December 21 may seem to be in the distant future, the months will go by quickly. Now is the time to start working on compliance with the new PTE.
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.
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The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.