The DOL “Fiduciary Rule,” FAQ 15: Factors to Evaluate for a Rollover Recommendation

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, 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 for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

In April, the DOL issued FAQs that explain the fiduciary interpretation and the conditions of the exemption.

This article discusses FAQ 15, a DOL question and answer about the factors that must be considered to satisfy the best interest standard of care for rollover recommendations:

Q15. What factors should financial institutions and investment professionals consider and document in their disclosure of the reasons that a rollover recommendation is in a retirement investor’s best interest?

Financial institutions and investment professionals must consider and document their prudent analysis of why a rollover recommendation is in a retirement investor’s best interest. For recommendations to roll over assets from an employee benefit plan to an IRA, the relevant factors include but are not limited to:

• the alternatives to a rollover, including leaving the money in the investor’s employer’s plan, if permitted;
• 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.

When considering the alternatives to a rollover, the financial institution and investment professional generally should not focus solely on the retirement investor’s existing investment allocation, without any consideration of other investment options in the plan. For rollovers from another IRA or from a commission-based account to a fee-based arrangement, a prudent recommendation would include consideration and documentation of the services under the new arrangement. As relevant, the analysis should include consideration of factors such as the long-term impact of any increased costs; why the rollover is appropriate notwithstanding any additional costs; and the impact of economically significant investment features such as surrender schedules and index annuity cap and participation rates.

To satisfy the documentation requirement for rollovers from an employee benefit plan to an IRA, investment professionals and financial institutions should make diligent and prudent efforts to obtain information about the existing employee benefit plan and the participant’s interests in it. In general, such information should be readily available as a result of Department regulations mandating disclosure of plan-related information to the plan’s participants (see 29 CFR 2550.404a-5). If the retirement investor won’t provide the information, even after a full explanation of its significance, and the information is not otherwise readily available, the financial institution and investment professional should make a reasonable estimation of expenses, asset values, risk, and returns based on publicly available information. The financial institution and investment professional should document and explain the assumptions used and their limitations. In such cases, the financial institution and investment professional could rely on alternative data sources, such as the most recent Form 5500 or reliable benchmarks on typical fees and expenses for the type and size of plan at issue.

In order to adequately cover this FAQ, it will take several articles. But for starts, let’s focus on the information that a financial institution and investment professional need to make a compliant information. To restate the bullet points at the beginning of the DOL’s answer, that information includes:

• the four alternatives generally available to a plan participant:  leave the money invested in the plan; roll over to an IRA; take a taxable distribution; or transfer the money to the plan of a new employer. The DOL says that all four must be considered. But, for our purposes, let’s assume that the participant is retiring and that a taxable distribution doesn’t make sense. The remaining options are to leave the money in the plan or to rollover to an IRA. That requires an analysis of which option is in the participant’s best interest in light of the participant’s investment profile and the other factors in the FAQ (discussed below).
• the costs in the plan and the IRA, including the administrative fees, the investment costs and the service costs (g., advisory fees). In terms of potential claims, this could be the most important factor. For example, if the rollover IRA (that is, the investment expenses, transaction charges, and administrative fees) cost one percent more per year in the IRA as compared to the plan costs, the financial institution and investment professional would need to demonstrate added value through additional services, investments or features that offset the cost differential. The key is that the added value be based on that particular participant and not a generic or hypothetical participant. As a word of warning, when the examinations begin a year or two from now, expect the first question to be: “How do you justify the added costs of the IRA in making the rollover recommendation?”  In other words, what value is being provided to that investor, based on his or her particular needs, that offsets the increased costs?  The answer should be the same as the “specific reasons” given to the participant in writing at the time of the recommendation.
• whether the employer pays for the plan’s administrative expenses. This information is not easy to obtain. In that case (and while there isn’t any guidance on this), it may be that financial institutions will need to assume that the employer pays for the plan’s administrative expenses absent information to the contrary.
• the different levels of services and investments available in the plan and the IRA. This is where additional services and investments could favor a rollover recommendation. But a key is to reasonably evaluate whether those additional services and investments provide enough value to the particular participant to justify the rollover recommendation. I have seen some cases where rollover forms list additional (or a large number of) investments as a justification for a rollover recommendation. I am concerned that, standing alone, that is not a justification; but it could be a justification if the additional investment opportunities had significant value to the particular retirement investor. Keep in mind that, when the examinations start, the DOL or IRS will be looking at how the rollover money was actually invested and will compare that to the plan investments. In most cases, that comparison will show a material difference in expenses. But that is not dispositive if the investments and other services for the IRA provided significant added value to the investor. As a word of warning, though, for purposes of the comparative cost analysis of the plan and the IRA, the costs of the actual IRA investments should be at least approximately the same as to how the IRA was actually invested after the rollover. Otherwise, it brings into question whether the best interest was properly done.

Another concern is that the reasons that are used to justify a rollover must tie into the investor profile. For example, where a rollover into an annuity was recommended ostensibly based on the needs of a retirement investor, the investor profile should support that conclusion. Stated slightly differently, thought should be given to what information should be collected about retirement investors so that the profiles are better able to be coordinated with the recommendations made to those retirement investors–and particularly to those who are retiring.

Concluding thoughts

There are five steps to a compliant rollover process (which will be detailed in a subsequent article). Two of those are the critical steps of (i) gathering information about the participant’s needs and objectives and (ii) performing the best interest analysis of that information to determine which outcome is best for that participant. A key part of that will be evaluating the costs in the plan and in a contemplated IRA in order to do the comparative analysis of the investments and services that would best suit the participant’s investor profile. The outcome of a best interest process is dependent on the quality of the data obtained about the plan, the IRA and 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.