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.

While much has been written about the impact of the PTE on rollover recommendations to retirement plan participants, there has been much less coverage of recommendations to IRA owners. Even there, most of the discussion has been about recommendations to transfer IRAs from another firm to the investment professional’s firm. However, there are other recommendations to IRA owners that are covered by the PTE. This article discusses both the consequences of a recommendation to transfer an IRA from another firm and the consequences of investment advice to an IRA that involves a conflict of interest.

With regard to conflicts of interest resulting from non-discretionary investment advice to IRAs, they come in many forms. The conflicts could include, for example, recommendations that result in or involve: (i) commissions; (ii) revenue sharing with the firm from, e.g., custodians or investments; (iii) trailing payments (e.g., 12b-1 fees or trailing payments related to annuities); (iv) payout grids;  (v) proprietary investments, or (vi) payments from third parties partially or entirely attributable to the investment recommendation.

With regard to recommendations to transfer an IRA from another firm, the conflict of interest is the compensation earned from the IRA after it is transferred.

While this article conversationally refers to “conflicts of interest,” under the Internal Revenue Code and ERISA they are “prohibited transactions.” Where a prohibited transaction results from a fiduciary recommendation, it is literally “prohibited.” However, there can be relief in the form of exemptions. In this case, it is Prohibited Transaction Exemption (PTE) 2020-02. The relief is “conditional” in the sense that it is only available if the conditions of the exemption are satisfied. Here are the conditions of PTE 2020-02 that apply to conflicted advice to IRAs:

• The Impartial Conduct Standards, which include:
  • The best interest standard of care, which is a combination of the prudent man standard (the fiduciary standard of care) and the duty of loyalty;
  • No more than reasonable compensation for the services provided and best execution of the transaction;
  • No materially misleading statements.
• Written disclosures provided to IRA owners:
  • Fiduciary acknowledgement under ERISA and the Code;
  • Services;
  • Conflicts of interest;
  • If a recommendation is made to transfer (or “rollover”) the IRA, the “specific reasons” why the transfer is in the best interest of the IRA owner.
• Policies and procedures designed to:
  • Ensure compliance with the Impartial Conduct Standards;
  • Mitigate conflicts of the investment professional and the financial institution;
  • Require disclosures of the specific reasons why the transfer recommendation is in the best interest of the IRA owner.
• Annual retrospective review. After the end of a year, the financial institution must review an adequate number of covered recommendations to reasonably determine if the requirements of the PTE are being satisfied or, if not, to decide what changes are needed to ensure compliance in the future. Any failures should be corrected and reported. The review must be reduced to a written report and signed by a senior executive officer. The process must be completed within six months after the end of the year.

Generally, the “conditions” must be satisfied for all conflicted recommendations to IRA owners. However, two of the conditions apply only to recommendations to ”rollover” recommendations. PTE 2020-02 defines “rollover” to include IRA-to-IRA transfers and changes of account types in IRAs. For rollover recommendations the PTE requires that the IRA owners be provided, in writing, with the specific reasons why the recommendation is in the best interest of the IRA owner. In addition, the financial institution must have policies and procedures concerning the delivery of the specific reasons for rollover recommendations.

Other covered recommendations to IRA owners do not include the specific reasons requirement. However, the remaining conditions apply to those “conflicted” recommendations.

IRA-to-IRA Transfer Recommendations

The best interest process for recommending an IRA-to-IRA transfer is similar to the process for recommending plan-to-IRA rollovers. These are the steps:

• Obtain the relevant information about the IRA owner. The DOL describes that as the retirement investor’s financial circumstances, risk tolerance, investment objectives, and needs. Keep in mind that this is in the context of retirement assets.
• Obtain information about the current IRA’s investments, services, and expenses. This can be done though a copy of the IRA statement from the current provider and through an interview of the IRA owner.
• Consider the investments, services, and expenses in the IRA of the investment professional’s firm.
• Do a comparative analysis of the current IRA information and the potential new IRA information, in light of the relevant information about the IRA owner and develop a recommendation in the best interest of the IRA owner. The DOL has indicated that, for IRA-to-IRA transfer recommendations, the services to be provided to the retirement investor will be significant considerations.
• Provide the IRA owner with a written statement of the specific reasons why the transfer recommendation is in the best interest of the IRA owner.

Then, the firm needs to retain information necessary for the annual retrospective review and to be able to prove compliance with the conditions in the PTE for six years.

Investment Recommendations to IRA Investors

Ongoing investment recommendations to an IRA owner will also need to be based on the relevant information about the retirement investor and in the context of achieving the investment objectives of the IRA owner. Under both SEC and DOL guidance, costs are to be significant factors in evaluating the investments to be offered. Firms can expect to be questioned about recommendations of more expensive investments when similar lower cost investments were available. Costs are not the only factor, but they will always be a factor. In addition, the PTE is only available where compensation is reasonable.

One approach to justifying both costs and compensation is to have a defined and value-added model for serving IRAs. That could include, for example, services that provide value above and beyond the investment advice. Some investment professionals’ service models include financial planning, retirement planning, assistance with withdrawals at a sustainable rate, assistance with required minimum required distributions, periodic reviews of objectives and financial condition, and so on. In other words, the level of compensation (which is one of the costs) can also be based on the services provided to the IRA owner, and particularly on the services related to achieving financial security in retirement.

As a cautionary note, while the DOL’s definition of fiduciary advice for rollovers only applies after the February 16, 2020 effective date of the PTE (and was extended to February 1, 2022 if good faith efforts were made to prudently recommend IRA rollovers/transfers), the PTE’s relief will be needed for conflicted recommendations to all IRAs, even if they were at the broker-dealer or investment adviser before the implementation dates of the new fiduciary interpretation and the PTE. As a result, where the advice to IRAs satisfies the redefined 5-part test, all of the PTE’s conditions should be satisfied in connection with any recommendations.

Concluding Thoughts

A recommendation to transfer an IRA—where the investment professional will be providing ongoing financial services—is a fiduciary recommendation. Since the investment professional and his or her firm will make money if the recommendation is accepted (that is, the fees or commissions from the IRA), the compensation is a conflict of interest that is prohibited under ERISA and the Code. PTE 2020-02 provides relief, but only if its conditions are satisfied.

Similarly, if the ongoing investment recommendations to any IRA owner result in conflicts (for example, transactional compensation or third party payments), that “compensation” is a prohibited transaction. Again, PTE 2020-02 provides relief from the prohibition, but only if its conditions are satisfied.

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.