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 (all of whom are referred to as “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.

The fiduciary regulations under ERISA and the Internal Revenue Code have two definitions of fiduciary advice. The first is the obvious—where the investment professional and financial institution have discretion over the investments in retirement accounts. In effect, that is a one-part test—“discretion.” In addition, there is a 5-part test for non-discretionary fiduciary advice. The DOL did not amend the regulation to modify any of the “parts,” but instead reinterpreted some of the parts, and particularly the “regular basis” part, to significantly increase the number of investment professionals and financial institutions who are fiduciaries.

This article focuses on the requirement in PTE 2020-02 that financial institutions and investment professionals provide participants with the “specific reasons” why a rollover recommendation is in the best interest of the participant.

The requirement to provide participants, in writing, with the specific reasons why a rollover recommendation is in their best interest is deferred by the DOL’s enforcement policy until July 1, 2022. At that point, this condition of the PTE must be satisfied:

Prior to engaging in a rollover recommended pursuant to the exemption, the Financial Institution provides the documentation of specific reasons for the rollover recommendation, required by Section II(c)(3), to the Retirement Investor.

The cross-reference is to the policies and procedures provisions of the PTE, which says:

The Financial Institution documents the specific reasons that any recommendation to roll over assets…is in the Best Interest of the Retirement Investor.

While the DOL didn’t provide any examples of reasons that would or would not be compliant, the SEC has. In my opinion, it is likely that the DOL will follow the SEC’s lead on this point.

In my last article, Best Interest #87, I pointed out that the fact that an IRA offered more investment options than a participant’s plan was not, in and of itself, a reason that would justify a rollover recommendation. But, if the investment professional determined that some of the investments offered by the IRA, but that were not available in the plan, would improve the outcomes for the participant, then the additional investment options could be part of the justification of a rollover recommendation. In effect, an investment professional needs to be able to say, in a credible way, that the additional investments would benefit the retirement investor “because………”. Keep in mind that the SEC or DOL come into the picture a year or more after the rollover recommendation was made and after the written specific reasons were given to the retirement investor, and will be able to see if the additional investments were actually used to improve the outcomes for the retirement investor.

The SEC has also given a second example of a “reason” that will not , standing alone, be a justification for a rollover recommendation. In the Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors, the SEC staff asked and answered:

5. If a retail investor expresses a preference for a particular type of account, would making an account recommendation on the basis of that preference satisfy the standards?

No. Although the retail investor’s preference should be considered, you would not satisfy the standards based on the retail investor’s preference alone. For example, a retail investor may express a preference for a brokerage account during an initial conversation, but may not fully understand what the differences between brokerage and advisory accounts actually are in terms of costs and available products and services. As stated above, when making an account recommendation to a retail investor, you must have a reasonable basis to believe that the recommendation is in the retail investor’s best interest based on, among other things, a reasonable understanding of the retail investor’s investment profile and the account characteristics. Where a retail investor expresses a preference for a particular type of account, the staff believes that factor should be considered. You would not, however, be relieved of the obligation to consider reasonably available alternatives and recommend an account you reasonably believe is in the retail investor’s best interest.

Comment: From the SEC’s perspective, a rollover recommendation is an account recommendation. In effect, it is a recommendation to sell the investments in the participant’s 401(k) account and to move the proceeds to an IRA “account.” Then, while the SEC acknowledges that an investment professional  should consider a participant’s (that is, a retail investor’s) stated preferences, the obligation on the investment professional is to consider the reasonably available alternatives (for example, to leave the money in the plan) and to recommend the account type that is in the best interest of the participant.

In addition, the investment professional and the firm (the “financial institution”) should consider retaining the materials reviewed and the reasons for the recommendation. In that regard, the SEC staff said:

Broker-dealers and investment advisers are subject to recordkeeping rules that may affect their decisions or obligations to document the basis for account recommendations. Additionally, in the staff’s view, it may be difficult for a firm to assess periodically the adequacy and effectiveness of its policies and procedures or to demonstrate compliance with its obligations to retail investors without documenting the basis for certain recommendations. Reg BI’s Compliance Obligation requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. Similarly, the Advisers Act compliance rule requires investment advisers registered or required to be registered under the Advisers Act to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act, which include preventing breaches of the IA fiduciary standard in violation of section 206 of the Advisers Act.

While the DOL’s PTE 2020-02 requires documentation, the SEC only points out that investment advisers and broker-dealers may need to retain documentation of their analysis and recommendation. However, the failure to retain that information may come back to haunt those firms if the SEC asks for proof of compliance and the documentation cannot be provided.

Concluding Thoughts

Financial Institutions, such as broker-dealers and investment advisers, need to carefully consider their written “specific reasons” for rollover recommendations. Those reasons must be provided to participants and IRA owners beginning July 1 when plan-to-IRA rollovers and IRA-to-IRA transfers are recommended.

As this article and the preceding one indicate, “more investments” and investor preferences, standing alone, are not considered by the SEC to be enough to justify rollover recommendations. I suspect that the DOL’s views are in alignment with the SEC’s.

To be safe, broker-dealers and investment advisers should require analysis of the needs and circumstances of the particular participant/IRA owner and how that particular investor can be helped with his or her retirement investing. Generic reasons may not work.

Also, financial institutions should consider whether their supervisory processes should evaluate how the rollover investor was actually invested in light of the specific reasons given to the investor.

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.