Category Archives: BICE

Interesting Angles on the DOL’s Fiduciary Rule #32


BICE, DOL, fiduciary, prudent

What “Level Fee Fiduciary” Means for Rollover Advice

This is my 32nd 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.

As explained in article #30 in the Angles series, in order to use the simplified, or BICE-lite, alternative for recommending that participants take distributions and roll over to IRAs with the adviser, the adviser must be a “Level Fee Fiduciary.” The Best Interest Contract Exemption (BICE) defines “Level Fee Fiduciary” as:

A Financial Institution and Adviser are ‘‘Level Fee Fiduciaries’’ if the only fee received by the Financial Institution, the Adviser and any Affiliate in connection with advisory or investment management services to the Plan or IRA assets is a Level Fee that is disclosed in advance to the Retirement Investor. A ‘‘Level Fee’’ is a fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee.

If the financial institution satisfies that definition, an adviser can use the BICE-lite, simplified process for recommending that participants rollover to IRAs. On the other hand, if the compensation does not satisfy that definition, then the adviser and the financial institution (e.g., broker-dealer) must satisfy all of the BICE conditions in order to recommend a rollover without committing a prohibited transaction.

The key words in the definition are: “only fee received.” (For the remainder of this article, I use “adviser” to collectively refer to the adviser, the financial institution, and all affiliates and related parties.) Does that mean that, if the adviser receives other forms of compensation, such as 12b-1 fees, that the adviser cannot levelize his compensation (for purposes of rollover recommendations) by offsetting the 12b-1 fees on a dollar-for-dollar basis? At least one DOL speaker has said that it does. That is, a Department of Labor employee has said that, if any additional compensation is received—even if it is offset, the Level Fee Fiduciary, or BICE-lite, approach is not available.

On the other hand, the definition does permit “compensation that is provided on the basis of a fixed percentage.” If the additional payments are offset against the advisory fee, then the only compensation received by the adviser is the stated level fee.

The preamble to the BIC exemption is worded slightly differently than the exemption:

It is important to note that the definition of Level Fee explicitly excludes receipt by the Adviser, Financial Institution or any Affiliate of commissions or other transaction-based payments. Accordingly, if either the Financial Institution or the Adviser or their Affiliates, receive any other remunerations (e.g., commissions, 12b– 1 fees or revenue sharing), beyond the Level Fee in connection with investment management or advisory services with respect to, the plan or IRA, the Financial Institution and Adviser will not be able to rely on these streamlined conditions in Section II(h).

Interestingly, the preamble, in the first sentence, suggests that no other payments can be received, but in the next sentence suggests that payments cannot be on top of (or “beyond”) the level fee (as opposed to offset against the level fee). The first sentence says that the definition “excludes receipt . . . of commissions or other transaction-based payments.” That seems clear enough (unless you want to argue that an offset effectively trumps the receipt). The next sentence refers to the receipt of “any other remunerations (e.g., commissions, 12b-1 fees, or revenue sharing), beyond the Level Fee . . .”. While not entirely clear, a reasonable interpretation is that, if the additional payments are offset against the Level Fee on a dollar-for-dollar basis, the payment of those additional amounts is not “beyond the Level Fee.” (A similar “levelizing” approach would be to pay over into the IRA any payments received from the investments.)

So, where does that leave us? For the belt-and-suspenders crowd—the very conservative advisers, the ultra-safe answer is to avoid all other payments or benefits. On the other hand, for those advisers who are willing to rely on a reasonable interpretation (or, in other words, to use a belt without suspenders), a possible approach is, in the case where additional payments are received, to offset those additional payments on a dollar-for-dollar basis (or to pay them over into the IRA). Keep in mind, though, this is a legal issue. As a result, advisers should not rely on general articles such as this one. Instead, you need to get individualized legal advice that applies to your particular circumstances and that quantifies the degree of risk, if any, that you are taking.

POST-SCRIPT: One oddity about the stricter interpretation (that is, that any payments cause the “forfeit” of BICE lite) is that, if full BICE compliance is required, there is no conflict of interest to disclose, since the DOL has separately said that the offset method works to eliminate conflicts of interest (i.e., prohibited transactions).

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 #31


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

“Un-levelizing” Level Fee Fiduciaries

This is my 31st 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.

In the last article I posted, I discussed the three meanings of “Level Fee Fiduciary.” This article discusses the kinds of payments or benefits that will “un-levelize” a Level Fee Fiduciary.

As a starting point, the definition of compensation, for these purposes, includes any money or things of monetary value. So, it covers both cash and non-cash amounts. However, as the DOL explains, it must be directly or indirectly connected to a recommendation:

The term ‘‘fee or other compensation, direct or indirect’’ means . . . any explicit fee or compensation for the advice received by the person (or by an affiliate) from any source, and any other fee or compensation received from any source in connection with or as a result of the purchase or sale of a security or the provision of investment advice services, . . . A fee or compensation is paid ‘‘in connection with or as a result of’’ such transaction or service if the fee or compensation would not have been paid but for the transaction or service or if eligibility for or the amount of the fee or compensation is based in whole or in part on the transaction or service. [Emphasis added.]

In other words, if an adviser ordinarily charges a level fee (for example, 1% per year) for non-discretionary investment advice or discretionary investment management for plans, participants or IRAs, and receives any additional benefits or payments attributable to those services, the additional payments will un-levelize the adviser’s compensation and result in a prohibited transaction. (However, as explained in the last article, if the payments or benefits are offset dollar-for-dollar, the adviser will re-levelize his or her compensation.)

Some forms of additional compensation are obvious. For example, that includes commissions, 12b-1 fees, revenue sharing, trailing commissions, and so on. Others, though, are more subtle and, therefore, easier to overlook. Those could include trips, gifts, awards, reimbursements, marketing support, conference registrations, and so on. The DOL pointed to some of those payments in its definition of third party payments in the Best Interest Contract Exemption (BICE):

‘‘Third-Party Payments’’ include sales charges when not paid directly by the Plan, participant or beneficiary account, or IRA; gross dealer concessions; revenue sharing payments; 12b–1 fees; distribution, solicitation or referral fees; volume-based fees; fees for seminars and educational programs; and any other compensation, consideration or financial benefit provided to the Financial Institution or an Affiliate or Related Entity by a third party as a result of a transaction involving a Plan, participant or beneficiary account, or IRA. [Emphasis added.]

In the fiduciary regulation, the DOL gave additional examples of compensation as:

. . . including, though not limited to, commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to brokerage firms in return for shelf space, recruitment compensation paid in connection with transfers of accounts to a registered representative’s new broker-dealer firm, gifts and gratuities, and expense reimbursements.” [Emphasis added.]

While advisers to retirement plans have, by and large, been aware of these rules, my experience is that advisers who focus primarily on wealth management, including advice to IRAs, are not familiar with the rules.

To paraphrase Hill Street Blues (for those of you old enough to remember that show) . . . Be careful out there.

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 #30


BICE, DOL, fiduciary, prohibited transaction

Three Kinds of Level Fee Fiduciaries . . . and What’s A “Level Fee?”

This is my 30th 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.

The DOL’s use of the phrase “Level Fee Fiduciary” is creating a lot of confusion about the application of the new fiduciary regulation and the Best Interest Contract Exemption (BICE). This article, and the next one, will try to dispel some of that confusion.

The label “Level Fee Fiduciary” has been used for many years for one meaning, but BICE has used it for a different purpose and, depending on your reading, a different definition.

Historically, Level Fee Fiduciary referred to a fiduciary adviser whose compensation was level or, at least, levelized. What’s the different between level and levelized? “Level” refers to an adviser who has a stated fee, for example, 1% per year, and does not receive any other payments. “Levelized” refers to a fiduciary adviser who has a stated fee (e.g., 1%), but who receives payments from third parties as a result of the recommendations — and then levelizes those payments by offsetting them dollar-for-dollar against the 1% fee. In both of those cases, the advisers receive no more, nor any less, than the 1%. Based on two DOL advisory opinions, the offset method works to, in effect, create a level fee. (An alternative method of levelizing is to pay the third party amounts into the plan or IRA; to be safe, that should be mandated in the agreement with the retirement investor.)

The advisers are not committing a prohibited transaction in either of these cases. As a result, the advisers do not need an exemption, or exception, from a prohibited transaction.

BICE then used “Level Fee Fiduciary” in a different setting. In BICE — a prohibited transaction exemption, the rule only applies to three scenarios. Those are: (1) a recommendation to take a distribution from a plan and roll over to an IRA with the adviser; (2) a recommendation to transfer an IRA to the adviser; and (3) a recommendation to switch “qualified money” from a commission-based account to a fee-based account. Each of those three recommendations will result in a prohibited transaction if the adviser receives more compensation if the retirement investor accepts the recommendation. Needless to say, an adviser will almost always make more money (with the possible exception of the case where the adviser is charging the same fee in the IRA as the adviser charged for services to the plan).

For the BICE provisions on these three scenarios (which is sometimes referred to as BICE-lite), the definition of “Level Fee Fiduciary” is:

“A Financial Institution and Adviser are ‘Level Fee Fiduciaries’ if the only fee received by the Financial Institution, the Adviser and any Affiliate in connection with advisory or investment management services to the Plan or IRA assets is a Level Fee that is disclosed in advance to the Retirement Investor. A ‘Level Fee’ is a fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee.”

In and of itself, that definition could either mean (1) that no other payments can be received by the adviser, or (2) that the adviser could receive other payments so long as they were not on top of, or in addition to, the stated fee (that is, it would be permissible if the additional payments were offset dollar-for-dollar, such that they did not increase the fee). Unfortunately, at least one senior DOL official has said that the Department intended for the language to mean that no additional payments could be received regardless of whether they were offset or not. Keep in mind, though, that the statement of individual DOL employees are not considered to be legal authority.

The third use of the concept of Level Fee Fiduciary is in the Pension Protection Act “level fee” exemption. That involves an entirely different situation. In that case, if the conditions of the exemption are satisfied, an organization can commit a prohibited transaction, so long as the advice is provided by a separate unit that receives only level fee compensation for providing the advice. For example, that separate unit could recommend proprietary funds to IRAs and participants, without violating the law.

So, those are the three scenarios in which an adviser could be labeled as a Level Fee Fiduciary. But, the definitions, the requirements for compliance and the compensation considerations are different for each of the scenarios.

Hopefully, that clarifies the meaning. In my next post, I will talk about the forms of compensation that would cause an adviser’s level fee to become “un-levelized.”

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 #29


BICE, DOL, fiduciary, prohibited transaction, prudent

Capturing Rollovers: What Information is Needed?

This is my 29th 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.

The Department of Labor’s fiduciary regulation provides that a recommendation to take a distribution from a plan, and to roll the money over to an IRA, is a fiduciary act. As a result, the recommendation must be prudent and cannot result in a prohibited transaction. However, a prohibited transaction almost automatically occurs, since an adviser typically makes higher fees in the IRA than from the plan (even where the adviser is providing services to the plan). As a result, an exemption is needed, even if the recommendation is otherwise prudent. Fortunately, the Level Fee Fiduciary provision of the Best Interest Contract Exemption (BICE) provides the framework for qualifying for an exemption.

In addition to the fiduciary regulation and BICE, other rules regulate the recommendation of distributions. For example, in Regulatory Notice 13-45, FINRA stated that a recommendation to take a distribution from a plan must be “suitable.” (In effect, FINRA was saying that a recommendation to take a distribution from a plan is tantamount to a recommendation to a participant to liquidate the participant’s investments in the plan; therefore, it is a securities recommendation.) FINRA then provides a number of considerations for advisers to evaluate in making a suitable recommendation. Those factors and considerations are remarkably similar to the considerations in a prudent process under ERISA.

In addition to the FINRA guidance, the DOL issued an advisory opinion (2005-23A) that concluded that a fiduciary to a plan (for example, a fiduciary adviser) who makes recommendations to participants to take distributions and roll over to IRAs is a fiduciary for the purpose of these recommendations. As with the new regulation, that implicates the fiduciary standard of care and the prohibited transaction rules.

With that in mind, the general rule for the prudence of recommending a rollover (as opposed to the prohibited transaction issues) is that a fiduciary adviser engage in a prudent process. But, that begs the question . . . what does an adviser need to do? More specifically, a prudent process produces an “informed” and “reasoned” recommendation. A recommendation is “informed” if the adviser has gathered and evaluated the information that a knowledgeable person would consider to be relevant to the issue. A reasoned decision is one that bears a reasonable relationship to the information that was evaluated.

What are the relevant factors for evaluating whether a participant should take a distribution? In other words, what information does an adviser need to gather and review?

In BICE, the DOL identifies three specific types of relevant information about the retirement plan. (Note that there may be relevant factors in addition to these three, but the DOL is saying that a recommendation to take a distribution would, at the least, need to consider these.) Those factors are: the investments in the plan; the services provided by the plan; and the expenses in the plan. Examples of other relevant matters are whether the plan permits periodic distributions without charge, and whether the participant is invested in company stock in the plan (particularly if the participant has a low basis in the company stock compared to its current value). Those factors, and other relevant matters about the plan, need to be evaluated. Of course, that means that information needs to be obtained.

Where the adviser already provides services to a plan, it should be relatively easy to gather the information. However, if the adviser does not work with the plan, the adviser will need to make a diligent effort to gather that information. (The Department of Labor says in Question 14 of the FAQs that the adviser “must make diligent and prudent efforts to obtain information on the existing plan.” Question 14 goes on to say: “In general, such information should be readily available as a result of DOL regulations mandating plan disclosure of salient information to the plan’s participants (see 29 CFR 2550.404a-5).)”

In other words, the adviser should ask the participant for a copy of the plan’s 404a-5 disclosures (which are also known as participant disclosures and/or the Investment Comparative Chart). That should be readily available to a participant, since those materials are provided to participants when initially eligible and, again, each year thereafter. In addition, an adviser could ask a participant for his most recent quarterly statement, which should reflect any expenses being charged against the participant’s account, as well as how the participant is invested and the account balance. Those statements should also be readily available since, for participant-directed plans, they are provided quarterly.

In addition a participant would have access to materials through the participant’s page on the plan’s website.

In other words, the information is readily available. (Note that the FAQs provide alternative methods of obtaining the information, but only after the adviser has engaged in “diligent and prudent efforts to obtain information,” but has not been able to do so.)

In addition to the information about investments and expenses, an adviser also needs to obtain information about plan services. In many cases, that could be done through interviewing the participant. For example, does the plan have a brokerage account option? Does the plan provide non-discretionary investment advice services or discretionary investment management services? Once that information has been gathered, an adviser should compare it to comparable information about the proposed IRA. While the gathering of information, in and of itself, can take some work, the analysis is the critical step. The information is just the foundation from which to make the analysis.

The key to the analysis and the development of a prudent recommendation is to focus on the best interest of the participant. Also, keep in mind that BICE requires that the adviser document why the recommendation is in the best interest of the investor.

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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The Presidential Election: Now What?


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

One of the consequences of the presidential election is that the future of the fiduciary rule (and the exemptions) is uncertain. What does that mean to advisers . . . regardless of whether they are representatives of RIAs or broker-dealers, or for that matter, if they are independent insurance agents?

The answer is that nobody knows. However, this article outlines the most likely alternatives. Those are:

  1. The rule will be killed by regulation or legislation.
  2. The rule will be implemented “as is.”
  3. The rule and the exemptions will be modified.

Only the second alternative (the “as is” option) could realistically be implemented by the current deadline of April 10. But, that’s the alternative that is, in my opinion, the least likely to happen. While it is low probability, it is high risk in the sense that broker-dealers and RIAs must be in compliance by April 10 if it happens. As a result, broker-dealers, RIA firms and IMOs need to continue working on complying with the new rules until they hear otherwise.

For either of the other two alternatives to play out in a thoughtful way, the applicability date of the rule will need to be delayed. That would be the first step of the process. If I had to guess, the delay would be until either December 31, 2017 or April 10, 2018.

Assuming there is a delay, I think that it would be a close call as to whether the rule would be killed or re-written. My gut feeling is that the fiduciary rule will be retained, but modified.

I say that for a few reasons. First, the fiduciary rule wasn’t the source of the greatest objections to the DOL’s guidance. Instead, that was the Best Interest Contract Exemption (BICE). Secondly, there is an argument that a rule that requires that retirement money be invested in the best interest of the investor is not, in and of itself, objectionable. In fact, many people may like that approach. Third, because of the ongoing retirement of baby boomers, many of whom are unsophisticated investors, and the rollover of their money to IRAs, there may be a perceived need to protect retirees.

On the other hand, the contrary arguments are that (1) the current system is working well and doesn’t need to be changed (and that therefore additional regulation would increase costs, without a corresponding benefit); and (2) the regulation of securities transactions should be in the hands of the Securities and Exchange Commission (SEC), and not the DOL. (One weakness with that latter argument is that insurance products, such as fixed rate annuities and fixed indexed annuities, are also sold to plans and IRAs, and the SEC doesn’t have the jurisdiction to regulate those products.)

If the SEC were to take the leadership in defining the fiduciary duty of care, there would be a uniform fiduciary definition that would apply to plans, IRAs and “non-qualified” accounts. While the conflict of interest rules for fiduciary advice to non-qualified accounts could be handled largely through disclosure, that is not the case for retirement plans and IRAs, because of the prohibited transaction rules in ERISA and the Internal Revenue Code.

To contemplate a worst case scenario, the SEC could develop a uniform fiduciary standard of care, but fiduciary advice and recommendations that involve conflicts of interest will still be prohibited by ERISA and the Internal Revenue Code. In that case, the Best Interest Contract Exemption would be revoked, and there would not be any generally available exemption for commissions, 12b-1 fees, etc. Obviously, that won’t work. As a result, BICE can’t just be withdrawn. It needs to be improved. (Of course, Congress could pass a bill that would create an exemption based on disclosures alone, but that would take time. Also, the regulatory process, with input from comments and meetings between the private sector and the regulators, is better at producing detailed guidance.)

So, while the outcome is not predictable, my “best guess” is that we will end up with a rule similar to the DOL’s fiduciary standard of care and that there will be modified exemptions that are based more on disclosures and less on prohibitions.

Stay tuned.

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 #28


BICE, DOL, fiduciary, prudent

What About Rollovers that Aren’t Recommended?

This is my twenty-eighth 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.

Under the DOL’s fiduciary regulation, the recommendation of a plan distribution and IRA rollover will be fiduciary advice, subject to the best interest standard of care and the prohibited transaction rules. But, what if a participant takes a distribution and rolls over into an IRA with an adviser . . . without a recommendation by the adviser?

As background, there are three ways that a participant can make a decision to take a distribution and roll over into an IRA. The first is “unsolicited.” In other words, the participant made the decision without any input from an adviser or recordkeeper. The second is “educated.” Distribution education involves providing a participant with information about the participant’s alternatives and the important considerations for selecting among the alternatives. The information must be unbiased and substantially complete. It cannot provide guidance to a participant to make a particular decision. The third way is “recommendation.” In the case of a recommendation, the adviser must engage in a prudent process to evaluate the relevant factors and to reach a reasoned recommendation in the best interest of the participant.

Without much fanfare, the DOL explained the “unsolicited” alternative in Q4 of the FAQs. The question posed by the DOL was: “Is compliance with the BIC exemption required as a condition of executing a transaction, such as a rollover, at the direction of a client in the absence of an investment recommendation?”

The DOL answered: “No. In the absence of an investment recommendation, the rule does not treat individuals or firms as investment advice fiduciaries merely because they execute transactions at the customer’s direction.”

But, the DOL goes on to admonish: “If, however, the firm or adviser does make a recommendation concerning a rollover or investment transaction and receives compensation in connection with or as a result of that recommendation, it would be a fiduciary and would need to rely on an exemption.”

In other words, fiduciary status is tied to a recommendation by an adviser. Absent an adviser recommendation, a decision made by a participant is not regulated by the fiduciary and prohibited transaction rules.

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 #27


408(b)(2), BICE, DOL, registered investment advisers

The Definition of Compensation

This is my twenty-seventh article about interesting observations concerning the fiduciary rule and exemptions.

As the readers of these articles know, one impact of the new fiduciary rule is that compensation paid to Financial Institutions and advisers must be reasonable. Reasonable, in turn, is a function of a transparent and competitive marketplace. However, where the competitive market does not work (for example, where compensation is not transparent), customary compensation may not be reasonable.

But, this article is not about reasonable compensation. Instead, the question is, what is “compensation?”

The Department of Labor partially answered that question in the fiduciary regulation:

“The term ‘fee or other compensation, direct or indirect’ means . . . any explicit fee or compensation for the advice received by the person (or by an affiliate) from any source, and any other fee or compensation received from any source in connection with or as a result of the purchase or sale of a security or the provision of investment advice services, including, though not limited to, commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to brokerage firms in return for shelf space, recruitment compensation paid in connection with transfers of accounts to a registered representative’s new broker-dealer firm, gifts and gratuities, and expense reimbursements.

A fee or compensation is paid ‘in connection with or as a result of’ such transaction or service if the fee or compensation would not have been paid but for the transaction or service or if eligibility for or the amount of the fee or compensation is based in whole or in part on the transaction or service.”

Without getting into the details of that definition, suffice it to say that, if an adviser makes a recommendation and receives money (or credits toward compensation, e.g., a bonus or a grid), that would be considered to be compensation. This concept is referred to as the “but for” test. That is, “but for” the recommendation, would the adviser have received the compensation or have been entitled to greater compensation? The “but for” method is a long-standing approach used by the Department of Labor in evaluating whether a payment is compensatory.

But, what if the payment is not monetary? What if it is non-cash, for example, gifts or trips or conference sponsorships or services? In addition to the quoted language above, the question was clearly answered in the 408(b)(2) regulation. That regulation defined compensation as:

“Compensation is anything of monetary value (for example, money, gifts, awards, and trips), . . .”

In addition, the Best Interest Contract Exemption defines third party payments as including “fees for seminars and educational programs; and any other compensation, consideration or financial benefit.”

In other words, the definition of “compensation” is not limited to cash or similar payments. Instead, it includes any item of monetary value that directly or indirectly, partially or entirely, results from recommendations of investments or insurance or that is payment for advice.

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 #26


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, service providers

Reasonable Compensation for IRAs: When and How Long?

This is my twenty-sixth article about interesting observations concerning the fiduciary rule and exemptions.

This article is a little different than most of my previous posts. However, it is equally as important. To get to the point, I am writing this article about reasonable compensation for advice to IRAs because of a common misunderstanding about the requirement.

In the last month or two, I have seen a number of articles and heard several comments to the effect that it will be difficult to determine reasonable compensation for IRAs because the rule is so new. Stated a little differently, the point is that the reasonable compensation requirement for IRAs will first become effective on April 10, 2017. That is not correct.

Section 4975(c)(1)(C) provides that the “furnishing of . . . services . . . between a plan and a disqualified person” is a prohibited transaction. However, section 4975(d)(2) permits, as an exception to that general prohibition, “any contract, or reasonable arrangement, made with a disqualified person for . . . services necessary for the establishment or operation of a plan, if no more than reasonable compensation is paid therefor.” (Section 4975(e)(2) defines a “disqualified” person as “a person providing services to the plan.” Then, 4975(e)(1)(B) defines a “plan” as “an individual retirement account.” And, (C) includes “an individual retirement annuity.”)

In other words, the reasonable compensation limitation is not new. It’s been with us for decades.

But, if that’s the case, why hasn’t there been more discussion and, in the bigger picture, more enforcement of the rule? There are two reasons. The first is that, by and large, the rule has been ignored. How is that possible? That’s because only the Internal Revenue Service can enforce the rule, but it hasn’t. In this case, the 15% excise tax under section 4975 would be enforced against the service provider, that is, the adviser. But, if the rule has been in effect for years without much publicity, why is there so much discussion now?

The answer is that the Department of Labor has, in conjunction with the fiduciary rule, issued two exemptions—84-24 for life insurance policies and fixed rate annuities, and the Best Interest Contract Exemption (BICE) for any and all investments that can be sold to plans and IRAs. Both of those exemptions—which are needed where prohibited compensation results from the investment or insurance recommendation—limit the adviser’s compensation for recommended investments and insurance products to be no more than a reasonable amount. In the case of BICE, for example, the Financial Institution (e.g., the broker-dealer) must agree that its compensation and the adviser’s compensation for their services will not exceed a reasonable amount. IRA and plan investors will be able to pursue breach of contract claims for excess compensation.

So, while the law limiting the compensation of advisers (and Financial Institutions) is not new, the enforcement mechanism will be.

While the new rules seem burdensome, I believe that a variety of services will be developed to assist Financial Institutions in determining reasonable compensation for different levels of services related to different types of products.

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 #25


BICE, DOL, fiduciary, prudent

Reasonable Compensation Versus Neutral Factors

This is my twenty-fifth article covering interesting observations about the fiduciary rule and exemptions.

In my last post, I wrote about the Best Interest Contract Exemption (BICE) and the requirements for “neutral factors” and “differential compensation” between “reasonably designed investment categories.” As I pointed out, the purpose of neutral factors is to determine the relationship of compensation between different categories of investments and services. In other words, neutral factors don’t establish a dollar amount of compensation, but instead they are used for determining the relative compensation between different reasonably designed investment categories. Think of it as evaluating degree of difficulty in terms of work, complexity, value, etc.

But that begs the question, if neutral factors are used to establish the ratio of compensation, how is the compensation determined?

The best way to approach that question is to look at a single reasonably designed investment category. Within an investment category, the compensation of an adviser must be both reasonable and level. Stated slightly differently, the compensation of the adviser cannot exceed a reasonable amount (based on the services rendered) and the adviser’s compensation must be level regardless of which products are recommended . . . and regardless of the payments made to the adviser’s supervisory entity (e.g., broker-dealer or any affiliate or related party). For example, if the compensation paid to the individual adviser is 1% per year for providing non-discretionary investment advice on a portfolio of mutual funds, that compensation needs to be tested for reasonableness and needs to be level regardless of which mutual funds are recommended and regardless of the payments, if any, to the adviser’s broker-dealer (or any affiliated or related party).

“Level” is fairly easy to grasp. In my example, a level fee is 1% regardless of which mutual funds are recommended. “Reasonable” is a bit more difficult. As explained in prior posts, the DOL says that reasonable compensation is based on market data—in an open, transparent and competitive market. The easiest way to obtain that information is through a benchmarking service. It is important, though, to review the reasonableness of compensation at least every two or three years. The experience of advisers in the 401(k) world is that, as the marketplace has matured, the level of reasonable compensation has become lower and lower.

Also, advisers should be aware that, when a prohibited transaction exemption—such as BICE—is being used, the burden of proof is on the person claiming the exemption, that is, the adviser. So, you need to have information in your file that supports the reasonableness of your compensation.

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 #24


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

The Meaning of Differential Compensation Based on Neutral Factors

This is my twenty-fourth article covering interesting observations about the fiduciary rule and exemptions.

The DOL’s fiduciary “package” consists of a regulation that expands the definition of advice and exemptions, or exceptions, from the prohibited transaction (PT) rules. If a recommendation by a fiduciary adviser does not constitute a PT (e.g., does not affect the adviser’s compensation, or that of an affiliate, and does not cause a payment from a third party), no exemption is needed. However, if the fiduciary recommendation causes a PT, an exemption must be used – and most often that will be BICE – the Best Interest Contract Exemption. Therein lies the rub . . . the compensation of the financial institution (e.g., the broker-dealer) and the adviser are regulated by BICE.

Under BICE, the compensation of broker-dealers can be “variable,” but must be “reasonable.” In other words, a broker-dealer can receive different payments from different product providers (e.g., mutual funds), so long as the total compensation received by the broker-dealer is reasonable relative to the services provided to the particular plan, participant or IRA owner.

The rules for compensating advisers are similar because the compensation of the adviser also must be reasonable (relative to the services that the adviser is providing to the plan, participant or IRA owner in the first year and in succeeding years). But, from that point on, the rules are different.

The starting point for understanding the other rules for adviser compensation is to determine “reasonably designed investment categories.” A reasonably designed investment category is an investment product or service that, when properly analyzed, should produce a certain level of compensation for the adviser’s services. For example, non-discretionary investment advice about mutual funds probably involves a different set of services and complexity than investment advice about individual variable annuities. In that sense, each could be called a reasonably designed investment category.

The next step is to understand that, within a particular investment category, the adviser’s compensation must be level. For example, where an adviser is providing non-discretionary advisory services concerning mutual funds, the adviser’s compensation must be level regardless of which mutual funds are recommended or how much those mutual funds pay the broker-dealer. In that way, the adviser will be “financially agnostic” as to which funds are recommended and will, at least in theory, only be interested in recommending the funds that are the best for the qualified investor (e.g., reasonable priced and of good quality). Similarly, if another investment category covers individual variable annuities, the adviser will be paid the same regardless of the particular annuity contract, insurance company, or imbedded mutual funds. That is, the adviser’s compensation will be the same across all variable annuity contracts, regardless of which one is recommended.

But, what if some categories require more work or services than other categories? For example, what if it takes more work to recommend and service an individual variable annuity than to provide non-discretionary investment advice about mutual funds? In that case, the Department of Labor says that it is permissible to pay differential compensation among reasonably designed investment categories, so long as the differences are based on neutral factors. So, for example, if the amount of work, the complexity of the product, and so on, means that the services for a variable annuity are twice as valuable, the adviser could earn twice as much for recommending an individual variable annuity and assisting with the selection of the embedded investments. On the other hand, if the services for the variable annuity were only 50% more difficult each year thereafter, then the adviser could be compensated 50% more than the annual fee that could be paid for a qualified account with mutual funds.

The key to understanding these concepts is to realize that the “neutral factors” differential compensation is not a dollar amount. Instead, it is a ratio established, for both the first and each subsequent year, between the different categories of investments. Where the relative compensation to the adviser for different reasonably designed investment categories could vary according to those ratios, compensation must still be reasonable.

So, as described in this article, an individual adviser’s compensation must be “reasonable,” “level” within an investment category, and “neutral” in differences between investment categories.

It is going to be difficult and time-consuming for the financial services community to adjust to these changes. And, the deadline is April 10 (with an extension for some purposes until January 1, 2018).

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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