The Department of Labor’s “Fiduciary Rule,” PTE 2020-02:  The FAQs

This series focuses on the DOL’s new fiduciary “rule”, which was effective on February 16. This, and the next several, articles look at the Frequently Asked Questions (FAQs) issued by the DOL to explain the fiduciary definition and the exemption for conflicts of interest.

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 retirement plans, participants and IRA owners (“retirement investors”).

In addition, the DOL announced, in the preamble to the PTE, an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will be fiduciaries for their recommendations to retirement investors and, therefore, will need the protections afforded by the exemption. The relief provided by the exemption is conditional, that is, the “conditions” in the exemption must be satisfied in order to obtain relief from the prohibited transaction rules in ERISA and the Internal Revenue Code. For the period from February 16 until December 20, a DOL and IRS non-enforcement policy based on the Impartial Conduct Standards will be available.

In April, the DOL issued FAQs that explain its reasons for issuing the guidance. The FAQs also go into detail about the fiduciary definition and the conditions of the exemption.

Fiduciary Issues and Answers

This article discusses FAQ 6, which outlines the 1975 regulation defining fiduciary advice:

Q6. How does ERISA define fiduciary investment advice?

Under ERISA’s statutory text, a firm or investment professional provides fiduciary investment advice to the extent she “renders investment advice for a fee or other compensation, direct or indirect, with respect to any money or other property of such plan, or has any authority or responsibility to do so.”

In 1975, the Department issued a regulation that adopted a five-part test for determining when recommendations count as investment advice. Under this 1975 regulation, the person making the recommendation must:

1. Render advice to the plan, plan fiduciary, or IRA owner as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property,
2. On a regular basis,
3. Pursuant to a mutual agreement, arrangement, or understanding with the plan, plan fiduciary, or IRA owner, that
4. The advice will serve as a primary basis for investment decisions with respect to plan or IRA assets, and that
5. The advice will be individualized based on the particular needs of the plan or IRA.

All parts of the 1975 test must be satisfied for a firm or investment professional to be an investment advice fiduciary when making a recommendation.

The 5-Part Test and Rollover Recommendations

Historically, the DOL’s position was that a rollover recommendation didn’t satisfy the 5-part test because the recommendation was not given on a “regular basis” (the second part of the test). In fact, the DOL said that a rollover recommendation was a one-time event….just the opposite of advice on a regular basis. However, the DOL’s new interpretation couples the rollover recommendation with other investment or insurance advice given to the owner of the rollover IRA, and there it is….recommendations being given on a regular basis. To be fair, a one-time recommendation about how to invest the IRA is not enough to satisfy the regular basis part. But, in the real world, in many, if not most, cases, there are ongoing recommendations to buy, sell, hold, reallocate, etc., to the rollover IRA. As a result, it seems that most rollover recommendations will now be fiduciary advice, meaning that the investment professional (that is, the advisor or agent) is a fiduciary and must satisfy ERISA’s prudent man rule and duty of loyalty. To fulfill that duty, the DOL says that an investment professional must have information about the plan’s investments, expenses, and services (among other information).

In addition, there is almost always a conflict of interest, for example, the compensation earned from the rollover IRA. That conflict is a prohibited transaction under ERISA and the Internal Revenue Code. That means that the advisor and the agent need the protection of an exemption. There are two that may be available. The first is Prohibited Transaction Exemption (PTE) 2020-02 for all investments and insurance and PTE 84-24 which just applies to insurance products. Those exemptions are discussed in other articles in this series.

The 5-Part Test and IRAs

The fiduciary test also applies to advice to IRAs (in addition to advice to plans and participants). However, it applies to IRAs in a different way.

If an advisor satisfies the 5-part test when making recommendations to IRAs, the advisor will be a fiduciary, but only for prohibited transaction purposes. Said differently, ERISA’s prudent man standard for advice to plans and participants doesn’t apply to advice to IRAs. Instead, investment advice to IRA is subject to standards of care under other laws and regulations. Two examples would be the best interest standard in Reg BI for broker-dealers and the best interest standard for investment advisers in the SEC’s Interpretation for Investment Advisers.

But that’s only part of the story. If recommendations to IRAs involve conflicts of interest (e.g., proprietary products, commissions, 12b-1 fees), and the advice satisfies the 5-part test, the compensation from the IRA and its investments constitutes a prohibited transaction. That means that an exemption is needed, and that’s where PTE 2020-02 comes into play. One of the conditions of the PTE is that the advisor and the “financial institution” (e.g., broker-dealer or RIA firm) must satisfy a best interest standard of care. (The best interest standard is a combination of the prudent man rule and the duty of loyalty.)  The failure to satisfy that standard means that one of the exemption’s conditions was not satisfied and therefor the earnings from the IRA are prohibited.

The exemption also requires that the financial institution have policies and procedures to ensure compliance with the best interest standard.

When you combine the best interest standard with the requirement for policies and procedures-and a requirement for an annual written report on compliance, it is likely that the DOL’s PTE will have a significant impact on advice to IRAs, particularly for broker-dealers.

Concluding Thoughts

The DOL, though a number of “interpretations” of the 5 parts of the fiduciary definition, will undoubtedly impact the processes used for recommending rollovers. That much seems certain.

However, there has been less discussion of the potential impact on advice to IRAs.
For “pure” level fee investment advisers, there may be little, if any, impact. (“Pure” means that the investment adviser and affiliates are not receiving any compensation, cash or non-cash, related to their services to IRAs.)  However, for financial institutions such as broker-dealers, whose compensation is transactional or paid by third parties, the impact could be substantial. Even there, though, the burden is somewhat lighter for broker-dealers who have developed robust processes to comply with Reg BI’s best interest standard. But one is not the other. PTE 2020-02 imposes compliance burdens on top of Reg BI. It would be a mistake to think that the PTE parallels Reg BI.

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.