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

This series focuses on the DOL’s new fiduciary “rule”. 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 (including rollover recommendations), 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 are fiduciaries for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

Specifically, one of the conditions for relief under PTE 2020-02 is mitigation of conflicts of interest. The PTE describes that requirement as:

Financial Institutions’ policies and procedures mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests ahead of the interest of the Retirement Investor.

In FAQ 17 about the PTE, the DOL specifically addressed the issue of payout grids, their incentive effect and possible mitigation steps. FAQ 17 begins with the question:

Q17. Are there special considerations for financial institutions that use payout grids in implementing the exemption’s required policies and procedures?

The first part of the answer is:

Financial institutions should carefully review the amounts used as the basis for calculating investment professionals’ compensation to avoid simply passing along firm–level conflicts to their investment professionals. If, for example, investment professionals are paid a fixed percentage of the commission generated for the financial institution, this may transmit firm-level conflicts to the investment professional, who is effectively rewarded for preferentially recommending those investments that generate the greatest compensation for the firm. The overarching goal should be to avoid incentive structures that encourage investment professionals to make recommendations inconsistent with the Impartial Conduct Standards. Accordingly, firms should work to align the interests of their investment professionals and retirement investors, and to root out misaligned incentives to the extent possible.

Comment:  In effect, the DOL is saying that, if one investment pays more to the firm (for example, 8%), and another pays less to the firm (e.g., 4%), and if the firm passes through a set percent of the commission to the investment professional (e.g., 80%), the firm has an arrangement that passes through its incentive to make more money to the financial professional. The question, then, is, how can the conflict be mitigated? One obvious answer it to levelize the investment professional’s compensation regardless of which investment is recommended. While that should effectively mitigate the conflict, it may not be a practical “solution.”

Another approach would be to use “neutral standards” for determining the compensation of the investment professional. For example, if it took twice as much time to explain an investment and if the investment professional needed additional education and experience to sell a product that was in the best interest of the retirement investor, that could probably justify a commission of twice as much as the other alternatives that could have been recommended, but that were not in the best interest of the retirement investor.

Yet another approach that could, at the least, be part of mitigating the conflict is to have a well-defined, demonstrably reasonable best interest process for recommending one of the alternatives over the others. To the extent that a retirement investor’s profile reveals a need for a specific product (e.g., guaranteed retirement income), and the product and allocation of the investor’s financial resources to the particular product were in the best interest of the investor, a higher compensating recommendation could be justified.

Both the SEC and the DOL are allowing flexibility for financial institutions to design their mitigation practices, but that doesn’t mean that a practice that is on paper, but that isn’t effective, will satisfy the requirement. After all, there is a requirement for an annual retrospective review. In that regard, PTE 2020-02 requires that:

The Financial Institution conducts a retrospective review, at least annually, that is reasonably designed to assist the Financial Institution in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.

Since the mitigation requirement is part of the policies and procedures requirements, the review specifically applies to the mitigation practices of financial institutions.

The DOL concludes its answer with this:

Financial institutions should carefully assess their compensation practices for potential conflicts of interest and work to avoid structures that undermine investment professionals’ incentives to comply with the best interest standard. To be prudent and loyal, fiduciaries should design compensation structures that minimize the dangers associated with conflicts of interest, as opposed to designing structures that create or reinforce conflicts of interest that run contrary to the interests of the investor.

Comment:  While the earlier discussion in this article primarily covered “practices,” for example, best interest processes and supervision, the DOL’s conclusion focuses on compensation structures. For example, is the range of compensation paid to investment professionals so wide that the higher compensating investments create incentives that are so great that they cannot be mitigated by any means? In that case, the first step in mitigation would be elimination of compensation differences or, at least, reducing the differences to the point that the financial institution’s mitigation practices were effective.

Between that beginning and ending, the DOL discusses specific approaches to mitigate the incentive effect of payout grids. Those approaches will be the subject of my next post.

Concluding Thoughts

Mitigation is a principles-based requirement. It can’t be reduced to a formula or a black-and-white definition. As a result, financial institutions should consider conservative approaches, beginning with the best interest process and supervision, and then considering whether compensation ranges should be narrowed and, perhaps, in some cases should be levelized.

It’s possible, perhaps even likely, that PTE 2020-02 is a real change of perspective on mitigation—as opposed to just an enhancement. If so, it will be more demanding than financial institutions have been used to, and that possibility should be considered in developing mitigation “solutions”.

Otherwise, when the DOL investigates compliance with PTE 2020-02, some financial institutions may feel that they are the victims of “regulation by enforcement”.

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.