Category Archives: BICE

Interesting Angles on the DOL’s Fiduciary Rule #70


BICE, DOL, fiduciary, plan sponsors, prudent, recordkeeper, registered investment advisers

The Fiduciary Rule and Recordkeeper Services

This is my 70th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

Almost all of my Angles articles have been about the impact of the fiduciary rule on advisors—representatives of broker-dealers and RIAs. However, the fiduciary rule also affects recordkeepers and the services that they offer to plans and advisors. In that regard, most of the work that we are doing for recordkeepers falls into three categories:

  • Acceptance of fiduciary responsibility by recordkeepers for “financial wellness” of participants.
  • Providing investment services and support for advisors, without becoming a fiduciary.
  • Providing investment services and support for plan sponsors, without becoming a fiduciary.

The next few Angles articles will discuss these issues in detail. This article is just to introduce the topics.

Financial Wellness

Financial wellness combines a focus on benefit adequacy with basic budgeting and financial management. Typically, it covers advice on plan participation, amounts to defer, repayment of indebtedness, budgeting and management of regular expenses, basic savings, investment advice and management of participants’ accounts, roll-ins to plans, and rollovers from plans. The objective is to help employees with financial decision-making for the short, intermediate and long terms. Where the recommendations constitute fiduciary advice under ERISA and the Best Interest Contract Exemption, the recordkeepers are accepting fiduciary status.

Investment Assistance to Advisors

The fiduciary rule includes an exception for investment services provided to “independent fiduciaries with financial expertise,” or “IFFEs.” Those fiduciaries include broker-dealers, RIAs, banks and trust companies, and insurance companies. In turn, where those financial institutions are willing to serve as fiduciaries with their advisors, recordkeepers can provide investment recommendations to the advisors without becoming fiduciaries. That is because the financial institution and the advisors are considered to be independent and knowledgeable fiduciaries who can evaluate the recordkeeper recommendations on behalf of their plan, participant and IRA clients.

Investment Assistance to Plan Sponsors

While recordkeepers have great flexibility to provide investment advice to advisors (who qualify as IFFEs) without becoming fiduciaries, the same is not true for advice to plan sponsors. (The IFFE provision also applies to some larger plans.)

However, there are some exceptions of general application for providing investment information to plan sponsors. The most useable exception is for responding to requests for proposals (RFPs) and requests for information (RFIs). But, even that exception is limited. The investment list provided by the recordkeeper can only be based on the size of the employer or the size of the plan, or both. For existing plans, it could be based on the current investment line-up.

A Prediction About Future Directions

As a prediction, recordkeepers will increasingly take advantage of the IFFE carve-out. That means that they will be providing suggested investment line-ups to qualifying IFFE advisors. The advisor will then need to evaluate the line-up and decide whether to present it to the plan sponsor. If an advisor then gives that investment line-up to the plan sponsor, the law will treat it as the advisor’s fiduciary recommendation (and, therefore, not as a recommendation by the recordkeeper).

That is the only meaningful exception for individualized non-fiduciary investment recommendations by recordkeepers. The RFP/RFI exception will also help, but it provides, by definition, a generic list of investments.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #69


BICE, broker-dealers, DOL, registered investment advisers

Compensation Risks for Broker-Dealers and RIAs

This is my 69th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

While the Best Interest Contract Exemption (BICE) is greatly simplified during the transition period, there is more than meets the eye, and broker-dealers and RIAs need to consider whether their practices for compensating advisors encourage advice to retirement investors that may not be in the best interest of those investors. Certain compensation practices are more risky than others. This article discuss some of the arrangements that pose the greatest risks.

As background, transition BICE requires that broker-dealers and RIAs adhere to the Impartial Conduct Standards when making investment recommendations to plans, participants, and IRA owners . . . where there is a conflict of interest. For this purpose, a prohibited conflict of interest exists where the firm or the individual advisor receives compensation from a third party (e.g., 12b-1 fees or insurance commissions) or where the compensation is received as a result of the recommendation (e.g., commissions on securities transactions). Transition BICE first applied on June 9, 2017, and based on recent DOL activity, it appears that it will continue to be the rule until June 30, 2019.

The Impartial Conduct Standards are: the best interest standard of care (basically ERISA’s prudent man rule and duty of loyalty); no more than reasonable compensation; and no materially misleading statements. However, the DOL has imposed one more requirement. In the notice of the extension of the transition rules (and, previously, in a set of FAQs), the DOL made clear that firms need to have policies, procedures and practices that ensure that advisors do not succumb to the allure of incentive compensation and give advice that is not in the best interest of the retirement investor in order to receive that compensation. (However, if the compensation is reasonable for the services rendered, it would be difficult, but not impossible, to argue that a violation had been committed.)

On a related matter, the DOL has said that, for advisors and their supervisory firms to receive the benefit of the DOL and IRS non-enforcement policies, the firms must make diligent and good faith efforts to comply with BICE. I worry that the failure to have policies, procedures and practices in place will cause the loss of protection under the non-enforcement policy.

Based on prior DOL statements and guidance, there are several types of compensation that appear to create greater risks. In those areas, firms are well-advised to have robust policies, procedures and supervision. Some of those are:

  • Recruitment compensation. The DOL has identified recruitment compensation practices that it believes create substantial incentive for advisors to make recommendations that are not in the best interest of retirement investors. Firms should familiarize themselves with that DOL guidance and design their programs accordingly.
  • Bonus arrangements. This is another area where firms should consider re-designing their compensation practices to avoid concerns identified by the DOL. For example, the DOL favors narrower increments to qualify for bonuses (or increased bonuses) and then favors that the bonuses for each of those narrower “steps” be correspondingly smaller so not to be an inappropriate incentive to give advice that favors the advisor over the retirement investors. Similarly, “waterfall” bonus arrangements are disfavored. (A waterfall arrangement is one where the increased bonus percent “waterfalls” back to cover all of the commissions for the year.)
  • Recommendations of plan distributions and rollovers. In the typical situation, the advisor will not earn anything if the participant doesn’t accept the recommendation, but the advisor will receive compensation (and, for a large rollover, perhaps significant compensation) if the retirement investor accepts the recommendation. The DOL has issued detailed guidance about what information it expects broker-dealers and RIAs to collect and examine before making recommendations to participants to take distributions and make rollovers. A firm’s policies and procedures–including supervision–should literally reflect (or even re-state) those requirements. This is not an area to take risk.

Those are just some examples . . . but now that the full exemptions are being delayed until 2019, broker-dealers and RIAs should revisit the DOL’s guidance and focus on developing compliant practices, particularly in the high risk areas.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #67


BICE, DOL, fiduciary, prudent, SEC

Fiduciary Rule: From the DOL to the SEC

This is my 67th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions, and related developments in the securities laws.

It now seems certain that the DOL will extend the applicability date of the final exemptions to July 1, 2019, or thereabouts. In any event, it will be a long extension. As a practical matter, that means that the transition rules under the Best Interest Contract Exemption (BICE) and Prohibited Transaction Exemption 84-24 will be extended until June 30, 2019 . . . in other words, the transition rules will continue until the applicability of revised final exemptions.

The extended time will be used for the DOL and the Securities and Exchange Commission (SEC) to cooperate in the development of new fiduciary rules by the SEC (and perhaps changes to the DOL’s fiduciary regulation) and for revised exemptions to be issued by the DOL for BICE and 84-24.

However, that coordination will probably not produce rules as favorable as some expect nor as unfavorable as others anticipate. Let me explain that comment.

The DOL’s new fiduciary regulation—which became fully applicable on June 9 of this year—defines the recommendations that cause an advisor and his or her supervisory entity to be fiduciaries. For example, if an advisor recommends an investment, an investment manager, an investment strategy or policy, a withdrawal from an IRA or a distribution and rollover from a plan, that is already fiduciary advice.

Since that’s a regulation, the DOL can amend it. However, I doubt that any of those recommendations will be removed from the category of fiduciary advice. On the other hand, an amended regulation could expand the circumstances in which selling is allowed without becoming fiduciary advice (perhaps with enhanced disclosures of non-fiduciary status) and could require a more personalized recommendation, e.g., a recommendation that is individualized to a plan, participant or IRA owner. However, I doubt that the changes will substantially alter the current landscape.

The second fiduciary issue is the standard of care—the dual duties of prudence and loyalty. For advice to plans and participants, those duties are statutory. They cannot be changed by regulation. And, they cannot be changed by the SEC. Only Congress can amend the law (and this Congress seems to have a difficult time doing anything).

However, the statutory prudent man rule and duty of loyalty only apply to advice to ERISA plans and their participants. For IRAs, those duties (which are referred to as the “best interest standard of care”) are imposed by the exemptions, for example, BICE. (As an aside, that means that advisors and their firms only need to comply with the best interest standard of care for IRAs if they are committing prohibited transactions by, e.g., receiving variable compensation or third party compensation. So, for example, a level fee advisor to an IRA would not be committing a prohibited transaction and, therefore, would not need to comply with the conditions of an exemption, e.g., the best interest standard of care.) However, the DOL can amend exemptions. So, BICE and 84-24 could be changed to a standard other than the best interest standard of care. Having said that, though, there may not be significant changes. If you look at the best interest standard, it requires that the advisor and his or her firm act prudently and loyally. It’s possible that the SEC could adopt the ERISA rule as the standard for retail advice for broker-dealers and RIAs. In any event, it’s difficult to imagine a new SEC standard that is much different than prudence and loyalty.

With regard to disclosures for exemptions, it’s possible—perhaps even likely—that the DOL will follow the SEC’s lead. Before the DOL does that, though, it must make an independent finding that the SEC’s disclosures are adequately protective of the interests of plans, participants and IRA owners. In that regard, the DOL needs to consider the effectiveness of the disclosures, as well as the facts to be disclosed. Nonetheless, I believe that the SEC will be leader on disclosures and the DOL will make every effort to use the SEC disclosures as conditions of the prohibited transaction exemptions. That will be more than is required under the transition exemptions, but it will probably be significantly less than is required under the current versions of the final exemptions.

We are working with clients to develop their strategies and comments for the SEC. I expect to have additional insights as those develop.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #65


BICE, DOL, fiduciary, prohibited transaction, prudent

Unexpected Consequences of Fiduciary Rule

This is my 65th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The fiduciary and best interest standards of care, as well as the prohibited transaction rules, will impact advisors in some unexpected ways. That is particularly true of investment advice to IRAs. Here is an example.

When plan or IRA assets are held by a custodian, an advisor often has the ability to recommend either transaction-fee (TF) mutual funds or no-transaction fee (NTF) mutual funds. The recommendation of either TF or NTF funds is a fiduciary act for plan assets, and it will be a best interest act for IRA assets—if the advisor or his or her firm receives any payments beyond a stated advisory fee that is level. (In effect, the payments from the custodian “unlevelize” the advisory fee.)

For both the prudence and best interest standards of care (which are virtually identical), an advisor must consider whether it is prudent to recommend a TF fund or an NTF fund. The issue is that NTF funds typically have a higher expense ratio, while TF funds charge an initial transaction cost but usually have a lower expense ratio. As a general statement, NTF funds would be appropriate for short-term holdings, while TF funds would be more cost-effective for longer term holdings.

To further compound matters, there are also prohibited transaction issues. Some custodians pay money to advisors if the advisors select NTF funds (because, I assume, the custodians make more money on NTF funds). The Department of Labor would consider those payments to be prohibited transactions, since they result from an advisor’s recommendation and since they generate payments above and beyond the advisor’s stated level fee.

However, not all is lost. Under the Best Interest Contract Exemption (BICE), where an advisor receives additional compensation that is prohibited under these rules, the additional compensation is permissible, if the conditions of the exemption are met. One of the BICE conditions is that the total compensation cannot be more than a reasonable amount. Note that, for plan purposes, the additional compensation would need to be disclosed in the advisor’s 408(b)(2) disclosures. In addition, and for both plan and IRA assets, it is possible, perhaps even likely, that an assertion could be made that undisclosed compensation is impermissible (since, arguably, the advisor is setting its own compensation as a result of the nondisclosure). As a result, an advisor should disclose, at the beginning of the fiduciary relationship, all of the compensation which the advisor will or may receive.

However, there are two other conditions for BICE. The first is that the advisor cannot make any materially misleading statements about the transactions or the compensation. The second is that the advisor must adhere to the best interest standard of care. That standard of care includes deciding whether the prudent recommendation is to use TF or NTF funds. If those conditions are not satisfied, the additional compensation is impermissible, at least from the perspective of the Department of Labor.

To make matters even more complex, the Best Interest Contract Exemption only protects compensation resulting from non-discretionary advice. So, for example, if the advisor is the one who decides to use NTF funds, that decision amounts to discretion. In that case, BICE would not be available to permit the prohibited payments from the custodian.

Now that the final fiduciary rule applies (as of June 9, 2017), advisors need to review all of their sources of compensation directly or indirectly from “qualified” assets (that is, plans, participants or IRAs). The changes are more far-reaching than most people think.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #64


BICE, DOL, fiduciary, General, prudent

What Does the Best Interest Standard of Care Require?

This is my 64th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The best interest standard of care is found, among other places, in the Best Interest Contract Exemption (BICE). The standard is a combination of ERISA’s prudent man rule and duty of loyalty. In fact, in the prudence portion of the definition, the only change is that the words “prudent man” are changed to “prudent person.” But, that begs the question, what does the prudent person rule require?

Generally speaking, it requires the following:

  • A prudent process by a hypothetical knowledgeable person who obtains and evaluates the information needed to make a careful and skillful decision.
  • With regard to investments, it requires that fiduciary advisors adhere to generally accepted investment theories. DOL guidance is clear that, in interpreting the best interest standard of care, fiduciaries are to look to ERISA’s history. And, ERISA’s history confirms that generally accepted investment theories are to be used. Again, though, what does that mean? Among other things, it means that IRA owners and plan participants should be advised to invest in a portfolio with asset allocation based on their needs, objectives and circumstances. The DOL explained in the preamble to its participant investment advice regulation (§2550.408g-1) that:

“After careful consideration of all the comments on the issue, the Department does not believe it has a sufficient basis for determining appropriate changes to the generally accepted investment theory standard. While several commenters described theories and practices they believe to be generally accepted, there did not appear to be any consensus among them, with the exception of modern portfolio theory,22 which the Department believes is already reflected in the rule’s reference to investment theories that take into account the historic returns of different asset classes over defined periods of time.

22This is consistent with a survey of literature on generally accepted investment theories prepared for the Department. See Deloitte Financial Advisory Services LLP, Generally Accepted Investment Theories (July 11, 2007) (unpublished, on file with the Department of Labor).”

  • It is hard to imagine that broader concepts of diversification would not also be considered to be generally accepted investment theories. For example, even though portfolios may be diversified among asset classes, there is an argument that the investments in each asset class should also be diversified. While this is an issue for investment experts, and not for lawyers, it seems fairly obvious that diversification by asset class and within asset classes would be, at the least, good risk management. Keep in mind that IRAs are retirement vehicles. As a result, IRAs should be invested in a manner consistent with retirement investing, which suggests, among other things, the avoidance of large losses. That is particularly true for older IRA investors.

However, in the final analysis, the retirement investor gets to decide how his money will be invested. While advisors may be obligated to recommend investment strategies that are consistent with generally accepted investment theories, a retirement investor can override those recommendations and direct that the account be invested differently. In that case, a fiduciary advisor is well-advised to obtain written directions from the retirement investor about how the investor wants the account to be invested. Armed with that direction the fiduciary advisor’s duty is to provide advice within the limits imposed by the retirement investor.

The application of fiduciary, or best interest, concepts to individual retirement investors will be new for many advisors. As a result, advisors, and their supervisory entities, should focus on the fiduciary requirements for a prudent process and for the application of general accepted investment theories.

Forewarned is forearmed.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #63


BICE, DOL, fiduciary, prohibited transaction, prudent

Policies and Procedures: The Fourth BICE Requirement

This is my 63rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

On August 31, the Department of Labor (DOL) issued its proposal to extend the transition period for three prohibited transaction exemptions until July 1, 2019. Those exemptions are the Best Interest Contract Exemption (BICE), the 84-24 exemption (for sale of annuities and insurance products), and the Principal Transactions Exemption. In all likelihood, the DOL will finalize that extension within the next 60 days.

The practical effect will be to both delay the applicability date of the final exemptions until July 1, 2019 and to extend the transition versions of those exemptions until June 30, 2019.

However, the DOL is not proposing to extend the applicability date of the fiduciary rule. The full fiduciary regulation applied earlier this year–on June 9, 2017. In other words, advisors to “qualified” accounts (i.e., plans, participant accounts and IRAs) already are fiduciaries. And, where the advisor or the advisor’s supervisory entity (for example, a broker-dealer) receives payments from third parties (such as insurance commissions or 12b-1 fees), or where the advice increases their compensation, those payments will be prohibited transactions. As a result, those advisors and entities will need the protection of a prohibited transaction exemption.

BICE is the exemption that will be used for most transactions. In order to comply with BICE, the supervisory entity and the advisor must satisfy the three Impartial Conduct Standards: the best interest standard of care; no more than reasonable compensation; and no materially misleading statements.

It is commonly believed that BICE requires satisfaction of only those three conditions. However, that is not the case. There is a fourth, and less well-known, requirement. As stated in the DOL’s August 31 guidance:

“During the Transition Period, the Department expects financial institutions to adopt such policies and procedures as they reasonably conclude are necessary to ensure that advisers comply with the impartial conduct standards. During that period, however, the Department does not require firms and advisers to give their customers a warranty regarding their adoption of specific best interest policies and procedures, nor does it insist that they adhere to all of the specific provisions of Section IV of the BIC Exemption as a condition of compliance. Instead, financial institutions retain flexibility to choose precisely how to safeguard compliance with the impartial conduct standards, whether by tamping down conflicts of interest associated with adviser compensation, increased monitoring and surveillance of investment recommendations, or other approaches or combinations of approaches.” (Emphasis added.)

As a result, supervisory entities, such as broker-dealers and RIAs, need to ensure that their practices, policies and procedures, and supervision are adequate to protect retirement investors from the conflicts arising from advisor compensation that could incent an advisor to make recommendations that are not in the best interest of a retirement investor. While the conflict can arise in any situation involving commissions or similar transactional payments, there are other, less obvious, areas where the conflict can be significant and where, therefore, the policies and practices may need to be strengthened. For example, when an advisor recommends that a participant take a distribution and roll it over to an IRA, that recommendation typically results in higher compensation for the advisor. And, where the rollover amount is large, the additional compensation can be significant. As a result, financial institutions, such as broker-dealers and RIAs, need to have compliant processes in place to ensure that inappropriate rollover recommendations are not made. In addition, those recommendations need to be supervised to ensure compliance with the best interest standards. This is an area where a conservative approach is good risk management.

The same concept applies to other types of recommendations where significant increases in compensation to advisors could result, as well as to bonus and recruiting arrangements. Any arrangement that materially increases advisor compensation should be closely vetted. That vetting should occur at three levels. The first is the design of the compensation system; the second is the development of policies and procedures to oversee that fiduciary recommendations are in the best interest of retirement investors; and the third is the supervision of those policies and procedures. Now is the time to review practices, policies and supervision in light of the DOL’s expectations.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #57


408(b)(2), BICE, broker-dealers, DOL, fiduciary, General

DOL FAQs on 408(b)(2) Fiduciary Disclosures

This is my 57th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor has issued a new set of “Conflict of Interest FAQs (408(b)(2) Disclosure Transition Period, Recommendations to Increase Contributions and Plan Participation).”

This article discusses the DOL’s relief from the 408(b)(2) requirement that a “change” notice be given for advisers who became fiduciaries to ERISA-governed retirement plans because of the June 9th expansion of the definition of fiduciary advice.

Before getting into the details of the relief, let’s look at what the DOL’s FAQs did not do. If an adviser (or his or her supervisory entity) was a fiduciary, functional or acknowledged, before June 9th, but did not give a 408(b)(2) notice of fiduciary status, that is not covered. In other words, it is a violation that is not remedied by the Department of Labor’s guidance. If the adviser’s prior 408(b)(2) disclosures, or agreement, stated that the adviser (and his or her supervisory entity) is not a fiduciary, then relief is not provided and a disclosure must be given.

So, what does that leave?

The DOL’s relief applies where an adviser became a fiduciary solely because of the change of definition. But, the relief from disclosing the new fiduciary status only applies if “the covered service provider furnishes an accurate and complete description of the services that will be performed under the contract or arrangement with the plan, including the services that would make the covered service provider an investment fiduciary under the currently applicable Fiduciary Rule.”

In other words, the covered service provider (for example, a broker-dealer) must provide an accurate and complete description of its fiduciary services. For example, those services could be recommendations about the selection and monitoring of the investments in a 401(k) plan. My experience is that, few—if any—broker-dealers made that representation in their previous 408(b)(2) disclosures (since it would have resulted in fiduciary status under the old rules). As a result, it is likely that advisers, and their supervisory entities, will need, at the least, to give more detailed descriptions of their services in order to take advantage of the 408(b)(2) relief. Needless to say, that should be done as soon as possible. (Technically, the DOL FAQs say that these disclosures should be made “as soon as practicable after June 9, 2017, even if more than 60 days after June 9, 2017.”)

Even if those conditions are satisfied and, therefore, the relief is available, the requirement for the 408(b)(2) fiduciary notice is only delayed until the applicability date of the final exemptions (that is, the Best Interest Contract Exemption (BICE) and the Principal Transactions Exemption). If the fiduciary definition remains the same, or substantially similar, the pre-June 9th 408(b)(2) disclosures will need to be updated at that time to declare fiduciary status. However, there is at least an outside chance that the regulation will be modified to define some sales practices as non-fiduciary. Obviously, if that change is made, there would not be a need to disclose fiduciary status for those non-fiduciary sales practices.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #55


BICE, broker-dealers, DOL, fiduciary, registered investment advisers

The DOL’s RFI and the Recommendation of Annuities

This is my 55th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor’s Request for Information (RFI) on the fiduciary rule and exemptions does a good job of focusing on the key issues for advisers and their financial institutions (e.g., broker-dealers and RIA firms). That is, the questions in the RFI cover most of the issues that prove to be compliance problems for our clients, in the sense that the requirements were difficult to satisfy or expensive to implement.

In addition, the RFI also highlights an issue for independent insurance agents, which is that, in the exemptions scheduled to apply on January 1, 2018, the sale of fixed indexed annuities to qualified accounts (e.g., plans and IRAs) is transferred from Prohibited Transaction Exemption 84-24 to the Best Interest Contract Exemption (BICE). That creates a difficult situation, because independent insurance agents will not be able to sell fixed indexed annuities under BICE, because BICE requires that a financial institution supervise the sale. I believe the DOL thought that insurance companies would serve as the supervisory entities (and, in a manner of speaking, as co-fiduciaries) for independent insurance agents who were appointed as agents for the insurance companies. However, insurance companies were not willing to do that. As a result, independent insurance agents will effectively be precluded from selling fixed indexed annuities. (Note that a number of insurance intermediaries have applied to the DOL for “financial institution” status under BICE. However, the DOL has not issued final guidance for the applicants.)

Fortunately for those agents, the 84-24 exemption was amended for the transition period to put fixed indexed annuities, along with variable annuities and fixed rate annuities, under the exemptive relief of 84-24. However, the final 84-24 exemption continues to say that fixed indexed annuities are not included in 84-24, but instead must be sold under BICE.

Because of those issues, the Department of Labor asked, in Question 17 of the RFI:

If the Department provided an exemption for insurance intermediaries to serve as Financial Institutions under the BIC Exemption, would this facilitate advice regarding all types of annuities? Would it facilitate advice to expand the scope of PTE 84–24 to cover all types of annuities after the end of the transition period on January 1, 2018? What are the relative advantages and disadvantages of these two exemption approaches (i.e., expanding the definition of Financial Institution or expanding the types of annuities covered under PTE 84–24)? To what extent would the ongoing availability of PTE 84–24 for specified annuity products, such as fixed indexed annuities, give these products a competitive advantage vis-a`-vis other products covered only by the BIC Exemption, such as mutual fund shares?

In effect, the DOL is asking questions about two alternatives. The first is whether “insurance intermediaries,” such as IMOs, should be allowed to serve as “financial institutions,” which would allow independent insurance agents to use the Best Interest Contract Exemption. Based on our representation of a number of IMOs and BGAs, many of those types of organizations would be willing to serve in the financial institution role, if that was available. If properly done, that solution would work.

The second question is whether to continue to include fixed indexed annuities, along with fixed rate and variable annuities, under the 84-24 exemption. In that case, independent insurance agents would not need a financial institution to supervise their activities. At the present time, the 84-24 rules are more restrictive on compensation and require greater disclosure of compensation than BICE. So, while that alternative is less burdensome in terms of the need for a financial institution, it is more demanding in terms of compensation disclosures.

It is likely that one or both of those solutions will be permitted when the rules are revised by the current leadership at the DOL. While the financial institution alternative is more burdensome and involves greater regulation, it could be favored by the DOL because of the financial institutions’ supervision of the independent insurance agents. On the other hand, if the DOL favors less regulation and burden, the 84-24 exemption will be expanded to include all forms of annuities. Only time will tell.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #54


BICE, DOL, fiduciary, prudent

The DOL’s RFI and Possible Changes to BICE

This is my 54th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor issued a Request for Information (RFI) about the fiduciary regulation and the prohibited transition exemptions. The questions in the RFI indicate the issues of greatest interest to the DOL and, in some cases, are suggestive of possible outcomes. This article looks at two issues concerning BICE–the Best Interest Contract Exemption.

The first question is about a possible extension of the transition rules, now scheduled to expire on December 31 of this year. The DOL asks:

“Would a delay in the January 1, 2018, applicability date of the provisions in the BIC Exemption, Principal Transactions Exemption and amendments to PTE 84-24 reduce burdens on financial services providers and benefit retirement investors by allowing for more efficient implementation responsive to recent market developments? Would such a delay carry any risk? Would a delay otherwise be advantageous to advisers or investors? What costs and benefits would be associated with such a delay?”

While it is always risky to make predictions, I think that the transition period will be extended, perhaps through the end of 2018.

As background, “transition” BICE requires only that the “financial institution”—e.g., the broker dealer or RIA firm—and the adviser “adhere to” the Impartial Conduct Standards (ICS). The ICS has three conditions: the best interest standard of care, no more than reasonable compensation, and no materially misleading statements. It is a conduct-based standard, and there aren’t requirements for written agreements or disclosure statements.

I believe that the DOL will find that those protections are adequate for the intervening period, as financial institutions transition to the new fiduciary regime, and that delaying compliance with additional requirements for contracts, disclosures, etc., will not negatively impact qualified investors in a material way.

Another set of BICE questions deals with the written contract and warranty requirements in the version of the exemption scheduled to apply on January 1 of 2018 (but likely to be delayed). The two requests for information are:

“5. What is the likely impact on Advisers’ and firms’ compliance incentives if the Department eliminated or substantially altered the contract requirement for IRAs? What should be changed? Does compliance with the Impartial Conduct Standards need to be otherwise incentivized in the absence of the contract requirement and, if so, how?

6. What is the likely impact on Advisers’ and firms’ compliance incentives if the Department eliminated or substantially altered the warranty requirements? What should be changed? Does compliance with the Impartial Conduct Standards need to be otherwise incentivized in the absence of the warranty requirement and, if so, how?”

The outcome on these issues is less clear. The DOL needs to balance the burdens of compliance with protection of retirement investors. For example, the cost, complexity and possible litigation implicit in those requirements could cause financial institutions to limit the range of investments and/or to increase their charges to investors. On the other hand, how will IRA retirement investors obtain relief if there was a breach of the best interest standard of care? While plans and participants can file claims under ERISA, retirement investors in IRAs don’t have a similar statutory right.

Those are complicated issues and there will certainly be comments by both pro-industry groups and pro-investor organizations. While I can’t predict the outcome, I believe that the DOL will try to balance those considerations, with the objective of providing retirement investors with access to a wide range of investments without increasing their costs, but at the same time providing an opportunity for enforcement of the best interest standard of care.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #53


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent

The Fiduciary Rule and Discretionary Investment Management

This is my 53rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In recent conversations I have learned that many broker-dealers and RIAs do not understand how the prohibited transaction rules and exemptions (and, particularly, the Best Interest Contract Exemption) apply differently to discretionary accounts and non-discretionary accounts. This article discusses some of those differences.

One similarity, though, is that ERISA’s prudent man rule and duty of loyalty apply for both discretionary and non-discretionary advice to retirement plans and participants.

However, ERISA does not generally govern investment advice to IRAs. As a result, absent the need for a prohibited transaction exemption, advisers to IRAs will not be governed by fiduciary/best interest standard of care. For example, where an adviser (and his or her supervisory entity) provides discretionary or non-discretionary investment advice to an IRA on a “pure” level fee basis, the adviser and the entity are subject to the fiduciary standards under the securities laws, but are not covered by the new fiduciary rule. That is because, where an adviser is providing advice for a reasonable level fee, it is not a prohibited transaction. As a result, an exemption is not needed. (By the way, a “pure” level fee is compensation that does not vary based on the advisory decisions or recommendations and that is not paid by third parties, e.g., 12b-1 fees, insurance commissions, etc. Also, the fee must be level across all related and affiliated parties.)

However, where there is a financial conflict of interest for non-discretionary or discretionary investment advice to an IRA, a prohibited transaction results. That includes, for example, where the adviser or supervisory entity (or any affiliated or related party) receives compensation in addition to the level fee. Examples of those additional, and conflicted, payments are: 12b-1 fees; insurance commissions and trails; proprietary products; asset-based revenue sharing; and payments from custodians.

Where conflicted payments are received, and a prohibited transaction occurs, the adviser and the supervisory entity will need an exemption. If the adviser provides non-discretionary investment advice, the Best Interest Contract Exemption (BICE) is available, if its conditions are satisfied. BICE requires only that the adviser and the supervisory entity comply with the Impartial Conduct Standards during the transition period (the transition period is from June 9 to December 31, 2017, but will likely be extended). The Impartial Conduct Standards are that the adviser and entity adhere to the best interest standard of care, receive no more than reasonable compensation for their services, and make no materially misleading statements. The entity–-the broker-dealer or RIA firm-–also needs to have procedures and practices to ensure that the conflicts do not result in advice that is not in the best interest of the retirement investor.

However, BICE cannot be used for prohibited transactions that result from discretionary investment management. In fact, there are only a few exemptions for discretionary investment management, and none as broad as BICE. For example, there is an exemption for the use of proprietary mutual funds.

As a result, many—and perhaps most—financial conflicts (that is, prohibited transactions) that result from discretionary investment management decisions are absolutely prohibited, because there are not exemptions for the conflicted payments.

The moral of this story is that RIA firms and broker-dealers need to distinguish between discretionary investment management and non-discretionary investment advice. For the time being, at least, most conflicts of interest for nondiscretionary advisers are permissible, if the Impartial Conduct Standards are satisfied. However, for discretionary investment management, there are few exemptions and most financial conflicts will be prohibited without any available exemptions. To the extent that the prohibited transaction rules are being inadvertently violated for managed IRAs, now is the time to correct the errors.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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