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.

The DOL’s expanded definition of fiduciary advice captures rollover recommendations where the investment professional provides investment advice to the participant about the participant’s retirement account on a regular basis either before or after a rollover recommendation. For example, if the investment professional advises a participant about investments already in an IRA and subsequently recommends that the retirement investor roll money in a retirement plan to an IRA with the investment professional, that would satisfy the “regular basis” requirement under the DOL’s interpretation. Similarly, if an investment professional recommends that a participant roll over to an IRA and the investment professional will provide ongoing investment advice to the rollover IRA, that would, in the eyes of the DOL, also satisfy the “regular basis” prong of the regulatory 5-part test.

If a rollover recommendation is made in a manner that satisfies the fiduciary definition, the recommendation would have to be in the “best interest” of the participant.  But, what does the best interest standard require?  PTE 2020-02 provides this definition:

Best interest “advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, and does not place the financial or other interests of the Investment Professional, Financial Institution or any Affiliate, Related Entity, or other party ahead of the interests of the Retirement Investor, or subordinate the Retirement Investor’s interests to their own;…” [Emphasis added.]

This article focuses on the information that must be obtained about the participant—the “retirement investor”—as a part of a compliant best interest process. As the quoted language says, an investment professional must base the recommendation “on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor.”

So, we know that information must be obtained. Unfortunately, the DOL doesn’t go into any detail concerning its expectations of the specific information needed for those categories. Fortunately, though, the SEC staff has recently issued fairly detailed guidance on the information needed to recommend an “account type”—and a rollover recommendation is considered to be an account-type recommendation.

In its Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors, the SEC staff asks and answers a number of questions, including the following:

2. Factors to consider before making an account recommendation

   Both Reg BI and the IA fiduciary standard require you to have a reasonable basis for an account recommendation, based on a reasonable understanding of the retail investor’s investment profile and the account characteristics.

   1. What are examples of investor characteristics I should consider to have a reasonable basis to believe the recommendation is in the retail investor’s best interest?

      As part of establishing a reasonable understanding of the retail investor’s investment profile, the staff believes that you should consider, without limitation, the retail investor’s:

      • financial situation (including current income) and needs;
      • investments;
      • assets and debts;
      • marital status;
      • tax status;
      • age;
      • investment time horizon;
      • liquidity needs;
      • risk tolerance;
      • investment experience;
      • investment objectives and financial goals; and
      • any other information the retail investor may disclose to you in connection with an account recommendation.

The staff also believes that you should consider, without limitation, the retail investor’s:

• anticipated investment strategy (g., buy and hold versus more frequent trading);
• level of financial sophistication;
• preference for making their own investment decisions or relying on advice from a financial professional; and
• the need or desire for account monitoring or ongoing account management.

You must, in any case, obtain and evaluate enough information about the retail investor to have a reasonable basis to believe the account recommendation is in the best interest of that retail investor and that your recommendation is not based on materially inaccurate or incomplete information.  [Emphasis added and bullet points inserted]

The Staff Bulletin goes on to describe additional information about the plan and IRA investments, services and costs that must be collected in the specific context of a plan participant rollover recommendation:

4. Retirement Account Rollover Recommendations.

   1. Are there additional factors that I should consider when making a rollover recommendation in order to have a reasonable basis to believe the recommendation is in the retail investor’s best interest?

Yes. When making a rollover recommendation to a retail investor, you must have a reasonable basis to believe both that the rollover itself and that the account being recommended are in the retail investor’s best interest. In addition to the factors discussed above, the staff believes that there are specific factors potentially relevant to rollovers that you should generally consider when making a rollover recommendation to a retail investor. These factors include, without limitation, costs; level of services available; features of the existing account, including costs; available investment options; ability to take penalty-free withdrawals; application of required minimum distributions; protection from creditors and legal judgments; and holdings of employer stock.

As with account recommendations more generally, relevant factors should be considered in light of, among other things, the retail investor’s investment profile to develop a reasonable belief that the retirement account or rollover recommendation is in the retail investor’s best interest. In the staff’s view, when making a rollover recommendation, 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 the recommendation.

Question and answer 2.a. make clear that the SEC staff’s position is that investment professionals need to collect detailed information about an investor in order to be able to develop a meaningful profile in order to recommend a particular account type, including a rollover recommendation (from a 401(k) “account-type” to an individual retirement “account-type”).  Then Question and answer 4.a. explains that the relevant factors about the plan and the potential rollover IRA (e.g., investments, services and costs) must be considered in light of the investment profile (that is, in light of the specific investor’s circumstances that are specified in the Staff Bulletin).  In other words, compliance with the best interest standard requires an understanding of the circumstances of the retirement investor. The factors about the plan and the potential IRA need to be evaluated in light of those circumstances (as established by the information gathered for the investor’s profile).

While a best interest determination is a matter of judgment and there will some room for determining the “best” recommendation for an investor/participant, the failure to obtain and consider adequate information about the investor can be a red flag for the regulators (and probably for claimants’ attorneys).

Concluding Thoughts

The starting point for a best interest recommendation, including rollover recommendations, is a good understanding of the needs and circumstances of the participant/retirement investor.  This article discusses the expectations of the SEC staff for developing an adequate investor profile for an account-type recommendation (which includes rollover recommendations).  To make good decisions, good information is needed.

While this guidance is from the SEC staff, I believe that the DOL would agree with the position of the SEC staff.

Forewarned if forewarned.  This guidance should be taken to heart.

In addition, financial institutions and investment professionals should seriously consider retaining the information gather and evaluated, as suggested by the SEC staff:  In the staff’s view, when making a rollover recommendation, 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 the recommendation.

While the SEC staff urges that documentation be retained, the DOL’s requirements in PTE 2020-02 are more demanding.  The PTE requires that participants be provided, in writing, with the “specific reasons” why a rollover recommendation is in their best interest.

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.