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 ERISA 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.

Discussion

In PTE 2020-02, the DOL defined “rollover” recommendation as:

…any recommendation to roll over assets from a Plan to another Plan or an IRA…, from an IRA…to a Plan, from an IRA to another IRA, or from one type of account to another (e.g., from a commission-based account to a fee-based account)….

The PTE requires that, for all “rollover” recommendations, the Financial Institution must provide the participant or IRA owner, in writing, with the “specific reasons” why the rollover is in the investor’s best interest. (As a practical matter, a recommendation to change the account type in a retirement account will most likely involve an IRA.)  Here’s how that was explained in the preamble:

The Financial Institution also must provide documentation of the specific reasons that any recommendation to roll over assets from one Plan or IRA to another Plan or IRA, or from one type of account to another, is in the Retirement Investor’s best interest.

That documentation requirement obviously applies to a recommendation to transfer the retirement investor’s IRA from a commission-based account to a fee-based account (because that is the example in the PTE). In that case, the IRA investor must be given the written “specific” reasons why the recommended account change is in the best interest of the IRA investor. (Note that the DOL announced in Field Assistance Bulletin 2021-02 that it would not enforce the “specific reasons” disclosure requirement until July 1, 2022.)

A reasonable interpretation of the example would be that the reverse—from fee-based to commission-based—would also be covered by PTE 2020-02 and the written specific reasons must be provided to the IRA investor for that type of recommendation. However, the definition isn’t limited to those two… it says “from one type of account to another”. That raises the question of, what other types of account changes are covered?

Unfortunately, that question is not answered in the exemption or the preamble to the PTE. So, where does that leave us? It leaves us in unchartered legal waters. The only detailed discussion of account types (that I am aware of) is in footnote 174 of Regulation Best Interest (Reg BI). In that footnote, the SEC said:

In addition to brokerage versus investment advisory accounts, there are also many options or account types within brokerage accounts. For example, brokerage accounts can include: Education accounts (e.g., 529 Plans and tax-free Coverdell accounts); retirement accounts (e.g., IRA, Roth IRA, or SEP–IRA accounts); and specialty accounts (e.g., cash or margin accounts, and accounts with access to Forex or options trading). Different brokerage accounts can also offer different levels of services, such as access to online trading, or can offer different products, for example, in higher dollar amount accounts (e.g., access to products with break-points).

Could the DOL possibly be considering all of these to be account types, subject to 2020-02 recommendation rules? Perhaps, but perhaps not.

While we can’t know if the DOL intends to apply the SEC’s definition, in gray cases, the safer approach may be a conservative one.

For example, investment advisers should consider whether nondiscretionary and discretionary accounts are different “account types”. Where an investment adviser is already complying with the conditions in PTE 2020-02, the additional requirement would be to give the IRA investor a written explanation of why the recommended change is in the IRA investor’s best interest. For investment advisers who do not contemplate using PTE 2020-02 because they intend to avoid prohibited transactions (that is, financial conflicts) in retirement accounts, recommendations of changes of account types will need to be avoided (but perhaps an educational approach could be used).

For broker-dealers, similar issues arise. For example, a recommendation of a third party asset manager may be a recommendation of an account type different than a brokerage account. What about a recommendation that part of an IRA be invested in a variable annuity, coupled with a recommendation that the funds to purchase the annuity come from liquidation of mutual funds in an IRA? Is that a change of account types?

If viewed from the perspective of a regulator, the first step in the analysis could be to ask if the compensation of the broker-dealer or RIA firm, and their investment professionals, changed as a result of the recommendation. To the extent that there was a material change in compensation, a regulator might be inclined to consider that to be a change in account type.

Reg BI and PTE 2020-02 both require that recommendations of changes in account type be in the best interest of the investor. But 2020-02 adds requirements for a fiduciary acknowledgement and disclosure of the specific reasons why the recommendation is in the best interest of the retirement investor (as well as other conditions).

Concluding thoughts

The DOL definition of “rollover” includes recommendations of changes of account types in retirement accounts. That definition, and the associated compliance requirements, are easy to overlook, but dangerous if overlooked. To complicate matters, “account type” is not defined. The only “definition” is an example of a change from commission-based to fee-based accounts. But the definition could reasonably be broader than that. As a result, the safer approach is to consider all of the account types for retirement money and to have compliant processes (under 2020-02) for those recommendations.

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.