Category Archives: DOL

Hearing on Retirement Income by the ERISA Advisory Council

I recently testified before the Department of Labor’s ERISA Advisory Council on the subject of lifetime income. More specifically, it was about lifetime income products and services for retirees provided through defined contribution plans. Here are my opening comments:

Thank you for this opportunity to testify.

I am Fred Reish, a partner in the law firm of Drinker, Biddle and Reath. However, this testimony is not on behalf of the firm, but instead represents the views of my partner, Bruce Ashton, and myself.

As a starting point, it is helpful to have a foundation for development of recommendations. For example, I suggest:

  • The conversation about defined contribution plans needs to increasingly and emphatically include retirement income.
  • Plan sponsors and participants need good quality, reasonably priced retirement income products and services.
  • Plan sponsors need clear, objective and implementable guidance on how to do that.
  • Participants need information, education and advice on how to best use those products and services.
  • Both plan sponsors and participants will benefit from the use of knowledgeable fiduciary retirement income consultants.
  • Any guidance should be agnostic as to retirement income products and services. Participants may need a combination of products and services to properly address their needs.

Here are more detailed thoughts that could inform decisions for going forward:

1.       The safe harbor regulation for annuities in defined contribution plans does not work and will not work. Plan sponsors, by and large, are not in a position to determine if those criteria are satisfied.

2.       If a new safe harbor regulation is developed, it needs to be objective and obvious, in the nature of a checklist of items to obtain, but not to be reviewed at the level of an insurance expert.

3.       Insurance consultants are expensive and they are few-and-far-between. But, if used as independent fiduciaries at a platform level, similar to 3(21) and 3(38) fiduciary investment advisers on 401(k) recordkeeping platforms, the cost can be borne by insurance companies or spread over thousands of plans and millions of participants.

4.       Plan sponsors are more likely to provide services to participants if they can do so in a context of providing information and education, and plan sponsors are more likely to use products and services approved by fiduciary advisors and consultants.

5.       In that vein, plan sponsors are more likely to embrace concepts if the service providers are legally responsible. As a result, plan sponsors should be able to rely on their providers (for example, recordkeepers) for that purpose, so long as they do not have a reason to doubt the competency of the providers. In the real world–and especially for small- and mid-sized plans, that is what is already happening–and the rules should parallel the real world in this case.

6.       Participants need help making decisions about retirement income products and services. They are not, by and large, educated or experienced in the analytical processes for determining which products or services to select for 20 or 30 years into the future or the amounts to be allocated among such products and services. This is analogous to the fiduciary services that participants receive for investing their accounts, for example, target date funds and managed accounts.

7.       It may not be realistic to expect participants to make lifelong decisions in the period of days immediately before they take retirement distributions. If retirement income products or services are accumulated during participation in a plan, they are more likely to be used in retirement. That is true of insured products and securities products and services.

8.       Target date funds are popular with both plan sponsors and participants. They are likely to be a popular way to provide non-guaranteed retirement investment income or to accumulate guaranteed retirement income products. As a result, guidance should be issued to make clear that is permissible. Defaults work and should be considered, particularly where a participant’s account has been invested in a manner that incorporates retirement income services and products during the accumulation phase. The Department should recognize the power of its guidance–even soft guidance, for example, look at the favorable impact Interpretive Bulletin 96-1 had on investment education.

9.       It is not possible to develop perfect answers to these complex problems. However, we should not let the perfect be the enemy of the good. Good answers will do the job.

10.     Products and services will be developed in the future that are not even imagined today. Any guidance should be flexible to allow future developments.

With those thoughts in mind, I recommend the following:

1.       The Department of Labor should discuss 401(k) and other defined contribution plan vehicles for retirement income. Words matter. Retirement income projections are not just projections—they are perspective. I cannot think of a better way to change the perspective and, thereby, change the conversation.

2.       The Department should affirmatively state that insurance and annuity products are, in concept, prudent for defined contribution plans and should simplify its annuity safe harbor regulation. We support the legislative proposals on this matter, but suggest that additional objective safeguards be added. In addition, clarify the QDIA safe harbor to include annuities in each of the three QDIA options, that is, target date funds, balanced funds and managed accounts.

3.       The Department should issue guidance that the concepts in the SunAmerica Advisory Opinion and the Pension Protection Act advice exemptions apply to retirement income products and services–at both the plan sponsor level and the participant level, so that plan sponsors can receive advice on the prudence of retirement income insurance companies and guarantees, and so that participants can receive advice on how to use those guaranteed products and investment products and services. It should be clear that the independent fiduciary is the responsible fiduciary, and not the plan sponsor. For example, DOL Field Assistance Bulletin 2007-01 applies a similar approach to participant investment advice.

4.       The Department should issue guidance that platforms of retirement income products and services are analogous to brokerage windows, and therefore the platform, but not the products and services, needs to be vetted by plan sponsors as fiduciaries.

5.       The Department should issue new guidance focusing on retirement income similar to Interpretive Bulletin 96-1 to the effect that education can be provided about retirement income products and services in the plan, and it would not be considered fiduciary advice.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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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Moving from Angles to Bests

Now that I have completed 100 articles about interesting Angles on birth –and death–of the DOL’s Fiduciary Rule, and the birth of an SEC best interest standard for broker-dealers and RIAs, I am going to start on a new series. The new series, rather than being titled “Angles,” will be called “The Bests.”

So, from now on, my articles—maybe the next 100—will focus on two “bests”—the SEC’s best interest standard and best practices for advisors and plan sponsors.

I figure that the SEC’s best interest rules will be developed and implemented over the next year or two, giving me a wealth of materials for new articles. But, I don’t want to be limited to that. I think that it’s important to talk about best practices for retirement plans and retiree investing and withdrawing, with a focus on helping participants to and through retirement—accumulation and decumulation.

With this introduction of the new series, the articles will begin after the Labor Day break.

Enjoy the dog days of summer . . . family vacations, baseball games and barbeques!

Fred Reish

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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 #100

Investment Advisers and the SEC’s Interpretation of Their Duties: Part II

This is my 100th article about interesting observations—or “angles”—concerning the Department of Labor’s Fiduciary Rule and the SEC’s “best interest” proposals.

Part I of this post discussed the application of the SEC’s best interest standard to recommendations to participants to take distributions and rollover to IRAs. It also discussed the apparent requirement for a thoughtful and professional process to develop the recommendation. However, it reserved for this post, Part II, the factors to be considered in that process.

The RIA Interpretation lists a number of factors to consider in the best interest process. However, most of them apply to investment recommendations, rather than advice about distributions. But a few are helpful. For example, the costs of investments and services and consideration of the investor profile are relevant factors.

Under Reg BI, though, the SEC is a little more helpful. For example, Reg BI says that an advisor should engage in a careful, skillful, diligent and prudent process. Reg BI also refers to FINRA Regulatory Notice 13-45 in several places. That Regulatory Notice requires that the information about the important factors (see below) be gathered and considered in light of the investor profile. While the Regulatory Notice says that the rollover recommendation must be suitable in light of these factors, the RIA Interpretation and Reg BI add that the recommendation must be in the “best interest” of the participant and that the interests of advisors and their firms cannot supersede those of the participant.

Although vacated by the 5th Circuit, the DOL’s Best interest Contract Exemption (BICE) described a prudent process, using language similar to the SEC’s proposed Reg BI . . . care, skill, prudence and diligence. In addition, the DOL’s BICE also said that information needed to be gathered about the relevant factors and those factors should be evaluated in light of the needs and circumstances of the participant. In other words, the SEC’s proposals and the DOL’s vacated rule are remarkably similar on rollover recommendations.

In sum, I think that it’s fair to say that, in order for the SEC’s best interest standard to be satisfied, an advisor (of a broker-dealer or an RIA) must engage in a process where the advisor gathers, and carefully and professionally considers, the relevant information. That process would need to satisfy the best interest and loyalty standards.

But, what are the relevant factors? The leading guidance on that question is found in FINRA Regulatory Notice 13-45 and the DOL’s vacated BICE (including a FAQ issued by the DOL). Boiled down to the essence, those materials say that advisors must consider, at the least, the investments, services and expenses in the plan; the investments, services and expenses for the proposed rollover IRA; and information about the participant (for example, financial objectives, needs, and risk tolerance). It would also be permissible to consider other factors, such as participant preferences, outside assets, other family investments, and so on.

While BICE has been vacated, it likely reflects the DOL’s current thinking about a prudent process and, as a result, could be applied by the DOL to situations where fiduciary advisors make recommendations of distributions and rollovers. (See DOL Advisory Opinion 2005-23A.) Also, since the DOL has the most experience with plan distributions, FINRA and the SEC may defer to the DOL’s thinking in this area. And, while the FINRA Regulatory Notice only covers recommendations by broker-dealers and their advisors, I doubt that the standard for RIAs would be lower than the standard for broker-dealers.

As a result, investment advisers should develop processes for gathering and considering information about the investments (and fees, costs and services) available to the participant in the plan, and compare them to similar information for a proposed IRA, in light of the investment profile of the participant.

And, keep in mind, as I mentioned in Part I of this article, the SEC’s Interpretation RIA reflects current SEC thinking. This is not something to be put off for the future.

NOTE: This article discusses rollover recommendations to participants in participant directed plans. The issues for “pooled” plans are different. In particular, the analysis for defined benefit plans can be more complex.

NOTE: While the DOL’s vacated Fiduciary Rule would have applied to private sector, ERISA-governed retirement plans, the SEC’s guidance applies to participants in all plans, including government plans.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.wpengine.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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 #99

Investment Advisers and the SEC’s Interpretation of Their Duties: Part I

This is my 99th article about interesting observations concerning the Department of Labor’s (DOL) Fiduciary Rule and the SEC’s “best interest” proposals.

The SEC labeled its interpretation of the standard of care for RIAs (the “RIA Interpretation”) as a proposal. However, in that proposal, the SEC explained that the RIA Interpretation was based on the SEC’s current understanding of the duties of investment advisers. More specifically, the SEC described the RIA Interpretation as reaffirming and clarifying the RIA fiduciary rule: “. . . we believe it would be appropriate and beneficial to address in one release and reaffirm—and in some cases clarify—certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

As a result, investment advisers should treat the RIA Interpretation as governing guidance and should make sure that they are complying with the duties explained in the RIA Interpretation.

This article discusses some of those duties and compares them to the DOL’s vacated fiduciary rule and the SEC’s proposed Regulation Best Interest (“Reg BI”) for broker-dealers.

The RIA Interpretation says that all advice to all clients is fiduciary advice and, therefore, subject to the RIA duty of care and duty of loyalty. (There are several duties of care, but this article focuses on the best interest standard of care. There is also a duty of loyalty, which, for example, covers the disclosure requirements for RIAs.) To juxtapose the RIA duties with Reg BI, broker-dealers also have a best interest standard of care, but only for recommendations to “retail customers” about securities or strategies involving securities. Other recommendations by broker-dealers are not covered by the best interest standard.

With regard to the DOL, when the 5th Circuit Court of Appeals vacated the Fiduciary Rule, the old fiduciary regulation was revived. That regulation imposes a 5-part test for fiduciary status. (Note that the 5-part test only applies to non-discretionary investment advice. Whenever an advisor has discretion over assets in a plan, a participant’s accounts or an IRA, the advisor is automatically a fiduciary under a separate part of the regulation. And the DOL’s definition of discretion is very broad.) One of the 5 “parts” is that the advice must be given on a “regular basis,” meaning that a one-time recommendation would not cause a person to be a fiduciary. As a practical matter, the 5-part test is usually satisfied by the services typically offered by investment advisers to plans, participants’ accounts and IRAs. In addition, it is a functional test. As a result, where representatives of broker-dealers regularly make recommendations to those qualified accounts (and satisfy the other 4 parts), representatives and broker-dealers will be fiduciaries, even if they do not think they are.

To understand how those rules operate, let’s look at several scenarios involving recommendations of plan distributions and rollovers.

Under the DOL’s 5-part test, an advisor who recommends a distribution and rollover would not ordinarily be a fiduciary. However, there is an exception. Where the advisor is a fiduciary to a plan, and makes a recommendation to a participant in that plan to take a distribution and roll over to an IRA with the advisor, the DOL will consider the advisor (either a broker-dealer or RIA) to be a fiduciary for that purpose. See DOL Advisory Opinion 2005-23A.

The DOL’s position applies to all types of ERISA-governed plans, including 401(k)s, 403(b)s, cash balance plans, profit sharing plans and pension plans. (While most private sector plans are covered by ERISA, government plans are not. In addition, some private sector plans are not, for example, one-person plans and most church plans.)

With regard to RIAs, the SEC said, in its RIA Interpretation, that recommendations of plan distributions and rollovers would be fiduciary advice, subject to the best interest standard of care. Since the SEC RIA Interpretation applies to all recommendations to all clients, an investment adviser would be held to the best interest standard of care for distribution and rollover recommendations to all plans (even if not ERISA covered), including 401(k)s, 403(b)s, cash balance plans, pension plans and profit sharing plans.

Under the proposed Reg BI, a broker-dealer’s rollover recommendation to a participant in a participant-directed plan would also be subject to the best interest standard of care. That is because the recommendation to take a distribution necessarily includes a recommendation to liquidate the investments inside the participant’s account. In other words, it is a securities recommendation. However, it appears to me that a recommendation to take a distribution from a cash balance or pension plan would not involve a securities recommendation and, therefore, would not be subject to the best interest standard. Similarly, a recommendation to take a distribution from a “pooled” defined contribution plan, such as a profit sharing plan, may not involve a securities recommendation, since the participant does not have any authority to determine which investments are sold to finance the distribution.

In both cases—RIAs and broker-dealers, the recommendation about how to invest the money in the rollover IRA would be covered by the SEC’s best interest standard. (However, while RIAs would have an ongoing duty to monitor the account, broker-dealers do not. The duty to monitor could be modified by the agreement. For example, RIAs can contract to not monitor, while broker-dealers can agree to monitor.)

Now that we know which rollover recommendations are subject to the best interest standard, there are two remaining questions. The first is, what is the best interest standard? The second is, what does the best interest standard require for distribution recommendations?

Those two questions will be answered in Part II of this Angles.

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 #98

Regulation Best Interest: Consideration of Cost and Compensation

This is my 98th article about interesting observations concerning the Department of Labor’s fiduciary rule and the SEC’s “best interest” proposals.

The SEC’s Regulation Best Interest (Reg BI) proposes a number of major changes to the governance of broker-dealers. For example, it imposes a best interest standard of care on recommendations of securities transactions and it requires that material conflicts of interest involving financial incentives be eliminated or, alternatively, disclosed and mitigated. Based on the SEC’s examples of mitigation, it appears “real” mitigation is expected and not just existing practices with more disclosure.

There are other significant changes. For example, there is an increased focus on the costs and compensation related to recommended securities transactions and investment strategies. The SEC’s discussion explains that:

“[O]ur proposed interpretation of the Care Obligation would make the cost of the security or strategy, and any associated financial incentives, more important factors (of the many factors that should be considered) in understanding and analyzing whether to recommend a security or an investment strategy.” [Emphasis added.]

The SEC’s position is that both the costs of recommended securities or strategies and the associated compensation (that is, the financial incentives) will be more important factors than they have been in the past.

The SEC goes on to explain its position on costs:

“We preliminarily believe that, in order to meet its Care Obligation, when a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost of the security or strategy is justified (and thus nevertheless in the retail customer’s best interest) based on other factors (e.g., the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), in light of the retail customer’s investment profile.” [Emphasis added.]

In addition, the SEC explained its position on compensation:

“When a broker-dealer recommends a more remunerative security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker- dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile.”

The two quotes (which are together in a single paragraph in Reg BI) may appear to conflict with each other. However, they are consistent and coherent if they are interpreted as follows: a broker-dealer will need to justify recommending a higher-cost investment (over another reasonably available, but lower-cost alternative). However, if there are two similar investments (including costs), but one pays the broker-dealer (and the financial advisor), more than the other, and it is better for the investor, then it could be recommended under the best interest standard. The inverse of that, though, is that the higher cost (and higher compensating) alternative cannot be recommended unless there are different characteristics and features that justify the cost.

The SEC’s best interest will require that a broker-dealer be diligent, careful, skillful, and prudent—which suggests a process—and that the process result in an investment that is in the best interest of the investor, with a greater emphasis on cost and compensation.

For those of you who work with retirement plans, you will recognize that the process, and the factors to be considered, are similar to ERISA’s prudent process requirement.

The proposals under Reg BI are significant and will, if finalized, require changes in the operations, including supervision, of broker-dealers.

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 #97

Regulation Best Interest Recommendations by Broker-Dealers: Part 3

This is my 97th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last two articles—Part 1 and Part 2 on this topic, I discussed the fact that proposed Reg BI and its best interest standard of care for broker-dealers did not apply to all of the recommendations made by broker-dealers. The proposed best interest standard for broker-dealers will apply only to securities transactions recommended to “retail customers.” (Reg BI defines a “retail customer” as “a person, or the legal representative of such person, who . . . uses the recommendation primarily for personal, family, or household purposes.”) I compared that to the SEC’s Interpretation for RIAs, which applies to all advice to all clients. This article gives examples of how the proposals will differ when applied to common scenarios.

Based on the discussions in the Reg BI package, and on my conversations with securities lawyers, the definition of “retail customers” appears to refer to individuals, participants’ accounts in retirement plans, IRAs, custodianships, guardianships, and personal trusts. That’s not meant to be an exhaustive list, but it is meant to point out that it doesn’t appear to apply to business accounts or retirement plans. Frankly, I’m surprised that it doesn’t apply, at the very least, to small businesses and small plans.

Let me explain. Assume that Jim and Joan Smith, a married couple, have been working for a large company, Acme Corporation. However, they decide to leave Acme and to start up “Jim and Joan’s Bakery.” Fortunately, the bakery is successful and their cash flow is strong enough to start a retirement plan for the two of them, who are the only workers at the bakery. Knowing that the company will grow, their advisor (who works for a broker-dealer) recommends that they set up a 401(k) plan and recommends the investments. Those recommendations would not be covered by the Reg BI best interest standard of care.

At the same time, though, the advisor recommends that Jim and Joan take distributions from the Acme 401(k) plan and roll that money into IRAs. Both the rollover recommendation and the recommended IRA investments would be covered by the best interest standard.

Jim and Joan were also participants in the Acme pension plan. The advisor recommends that the pension benefits be withdrawn and rolled to IRAs. It appears that the withdrawal recommendation would not be subject to the best interest standard (because it does not require that Jim and Joan buy, sell or hold any securities), but the recommendations about investing in the rollover IRA would be.

The advisor helps Jim and Joan invest their accounts inside their new 401(k) plan. That would be covered by the best interest standard of care.

As the business becomes more successful, Jim and Joan set up personal accounts with the broker-dealer. Recommendations on those personal accounts would be subject to the best interest standard. But, if they had an account for their business, those recommendations would not be.

The business continues to grow and the advisor recommends that Jim and Joan set up a cash balance plan and assists them in the asset allocation and selection of investments for the plan. That would not be subject to the best interest standard of care.

With the continued success of the business, Joan and Jim decide to have children and the advisor helps them set up 529 accounts for the children’s education. The 529 investments would be subject to the best interest standard.

Confused? You should be. All of the advice in this article was to Jim and Joan. And, Jim and Joan have the same sophistication for evaluating each of the recommendations. Yet, because of the definition of “retail customer,” the duties owed by the advisor and the broker-dealer under the proposed Reg BI bounce around. Ask yourself . . . will the average investor understand which rules apply to which situation? I don’t think so. The burden shouldn’t be on the investor to understand these technical rules. Instead, the rules should be consistent and understandable.

Needless to say, this is my opinion. It doesn’t mean it is right; but it does mean that I’ve thought about it.

POSTSCRIPT: All of the recommendations in this article, when made by an investment adviser (RIA), are covered by the best interest standard. That’s straightforward, consistent and understandable.

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 #96

Regulation Best Interest Recommendations by Broker-Dealers: Part 2

This is my 96th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last post, I compared the proposed best interest standard of care for broker-dealers—the SEC’s Regulation Best Interest (“Reg BI”), and the SEC’s proposed Interpretation Regarding Standard of Conduct for Investment Advisers (“RIA Interpretation”). In that article, I focused on the types of recommendations that implicated the best interest standard of care. For broker-dealers, the best interest standard only applied to recommendations of securities transactions and securities strategies. However, for RIAs the best interest standard applies to all advice and recommendations.

This article focuses on the advice recipients, that is, which investors will be protected by the best interest standard of care if the advice is given by a broker-dealer or, alternatively, if the advice is given by an RIA. Part 3 of this series gives examples of how the proposals apply to investors.

Focusing on the recipients of the advice, Reg BI’s standard of care would only protect “retail customers”:

“A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making recommendations of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, . . . .” [Emphasis added.]

Reg BI defines “retail customer” as:

“A person or the legal representative of such person, who . . .[u]ses the recommendation primarily for personal, family, or household purposes.”

Based on my reading of the SEC proposal, and on my conversations with securities lawyers, a “retail customer” includes individual investors, family and personal trusts, IRA owners, and plan participants. However, it does not include businesses, retirement plans, and tax-exempt organizations. Unfortunately, the SEC did not explain why they excluded some of those investors, who may be relatively unsophisticated. For example, if a small business owner has a 401(k) plan, advice about the business owner’s personal account would be protected by the best interest standard of care; advice about the investments in the plan would not be; advice to the owner about investing his participant account would be; and advice about investing the corporate account would not be.

It seems difficult to imagine that the small business owner—who has the same level of sophistication regardless of which account he or she is investing—would understand that the protections under the securities laws varied depending on which “hat” the business owner was wearing. This will, undoubtedly, lead to confusion.

On the other hand, in its RIA Interpretation, the SEC explains: “An investment adviser has a fiduciary duty to all of its clients, whether or not the client is a retail investor,” and “This obligation to provide advice that is suitable and in the best interest applies not just to potential investments, but to all the investment advice provides to clients . . . .”

In other words, the best interest duties of investment advisers are much broader than the proposed rule for broker-dealers. Looking at the example above, an investment adviser has a best interest duty to the small business owner when recommending investments for the business; investments for a retirement plan; personal investments; and investments in a participant account in the retirement plan. In addition to the material differences in the range of recommendations and recipients, an investment adviser also has a duty to monitor the investment recommendations (unless there is a contractual agreement that the adviser will not). However, a broker-dealer’s best interest obligation ends when a recommendation is made; that is, there isn’t an obligation to monitor.

This article is not intended to favor either RIAs or broker-dealers, but instead is to explain the SEC’s proposals. Each reader of this column can decide whether the benefits and burdens of the proposals favor one business model or the other. Also, I should point out that Reg BI is just a proposal. On the other hand, while the RIA Interpretation is labeled as a proposal, it is a compilation, or interpretation, of the SEC’s position on the rules regulating investment advisers.

In my next post, Part 3, I will expand on the examples in this article.

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 #94

SEC Proposed Reg BI and Recommendations of Rollovers (Part 3)

This is my 94th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

Part 1 of this series discussed the provisions in the SEC’s proposed Regulation Best Interest that would impose a best interest standard of care for rollover recommendations by broker-dealers and their registered representatives. (More specifically, the standard applies if the rollover recommendation involves securities transactions—which would ordinarily be the case for participant-directed plans.) Part 2 described some of the considerations for developing a best interest recommendation process.

This article—Part 3—describes the proposed requirement to “mitigate” the conflict of interest inherent in a rollover recommendation.

Since a broker-dealer and its representative would not, in most cases, receive any compensation if a participant does not roll over, there is, to use the SEC’s language, a material conflict of interest involving financial incentives. In that regard, Reg BI says that a broker-dealer must disclose and mitigate or, alternatively, eliminate the financial incentive conflict of interest. (This article refers to broker-dealers, but that includes the registered representative, or advisor.)

Of course, it’s impossible to eliminate the conflict, since—if the money stays in the plan—the broker-dealer will not earn anything. But if the money is rolled over, the broker-dealer will receive compensation from the rollover IRA. As a result, the only practical choice would be to disclose and mitigate. While the SEC does not give an example of mitigation of the conflict in the context of a rollover recommendation, the SEC does cite FINRA Regulatory Notice 13-45 on several occasions. RN 13-45, in turn, requires that a broker-dealer and its representatives make a reasonable inquiry about the participant’s plan account. After all, how can a recommendation be made in a manner that is careful, skillful, diligent and prudent (the Reg BI requirements) if the broker-dealer does not have any information about the investments that it is recommending be sold? (Since participant-directed plans such as 401(k) plans typically only distribute cash, a rollover recommendation inherently incudes a recommendation to sell the investments in the participant’s account.)

RN 13-45 requires an analysis of, among other things, the investments, services and expenses in the plan. For those of you who have studied the DOL’s Best Interest Contract Exemption, you will recognize those as the three primary factors listed by the DOL for consideration in making a fiduciary rollover recommendation. In other words, proposed Reg BI (including the references to RN 13-45) and the Best Interest Contract Exemption are remarkably similar.

Where does that leave us?

Bottom line, the best “mitigation” appears to be a process that ensures that the recommendation is in the best interest of, and loyal to, the participant.

That means that broker-dealers are in essentially the same position as they were under BICE. They need to gather and evaluate appropriate information about the investments, services and expenses (among other things) in the plan; the investments, services and expenses (among other things) in the proposed IRA arrangement; and the needs, circumstances, risk tolerance, and preferences of the participant.

Broker-dealers need to develop a process for doing that, together with policies and procedures, training and supervision. That process should produce a reasonable and informed recommendation in the best interest of the investor.

Similar requirements are imposed on RIAs. That will be the subject of a future post.

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 #93

SEC Proposed Reg BI and Recommendations of Rollovers (Part 2)

This is my 93rd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

In my last post, I described the similarities between the SEC proposed Regulation Best Interest (Reg BI) and the DOL’s Fiduciary Rule (and especially the Best Interest Contract Exemption [BICE]) regarding recommendations to participants to take distributions and roll over into IRAs. The similarities include a best interest standard of care and the treatment of conflicts of interest. This article discusses the requirement of the best interest standard of care in Reg BI and compares it to the standard of care in BICE (and the requirements of FINRA Regulatory Notice 13-45). My next article—Part 3—will cover the conflict of interest issues.

In its discussion of recommendations about distributions and rollovers in proposed Reg BI, the SEC says that, where the recommendation involves a securities transaction, the best interest standard of care will apply to broker-dealers. The SEC goes on to describe the best interest standard of care as requiring care, skill, prudence and diligence and making a recommendation that is in the best interest of, loyal to, the participant.

With regard to the question of whether a recommendation to take a distribution and roll over is a securities transaction, the SEC refers to FINRA Regulatory Notice 13-45. The SEC guidance and that Regulatory Notice, in combination, point out that, in the typical recommendation to a 401(k) participant, there are two securities transactions. The first transaction is the liquidation of the investments in a participant’s account, since a distribution cannot ordinarily be made without first selling the investments in the account. (In other words, a recommendation to take a distribution usually inherently includes a recommendation to sell the investments in the participant’s account.) The second transaction is in the rollover IRA, where a new investment recommendation will be made. As a result, distribution and rollover recommendations to 401(k) and 403(b) participants will ordinarily involve two securities transactions and both will be subject to the proposed best interest standard of care.

However, the SEC does not discuss the process and analysis required to make a best interest recommendation of a distribution. As discussed above, though, the SEC makes a number of references to Regulatory Notice 13-45. That notice goes into some detail that the information needed to evaluate whether a rollover recommendation would be suitable. It seems safe to assume that, at the least, the same information would be required for a best interest recommendation.

In its Regulatory Notice, FINRA points to a number of factors to be considered, including the investments, services, and fees and expenses in the plan. A broker-dealer will need to gather information in order to evaluate those factors . . . and then compare them to the services, expenses, and investments in the proposed rollover IRA. That analysis must be done in light of the financial needs, circumstances and preferences of the participant.

While it is easy to say that plan information is needed, it is hard to find that information.

How do I know that? It is because those are the same factors that the DOL said were primary considerations for making a best interest recommendation under BICE.

The DOL, SEC and FINRA have converged to agree on the important factors that need to be considered to make a rollover recommendation. However, it’s proven to be difficult to gather information about plan investments, expenses and services. Fortunately, though, the DOL did offer guidance for situations where it was not possible to find the information. I assume that the SEC and FINRA will share the alternative approach provided by the DOL, which was described in a set of FAQs. Broadly stated, the DOL permits use of “alternative data” where a participant cannot find, or does not want to use, the primary plan data.

Also, I should point out that there continues to be an education alternative, which is that a broker-dealer can provide distribution and rollover education, rather than making recommendations. However, it’s important that the education be unbiased and relatively complete. Otherwise, it could be viewed as a disguised recommendation.

In my next post, I will discuss the conflict of interest issues where distribution and rollover recommendations are made.

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 #92

SEC Proposed Reg BI and Recommendations of Rollovers (Part 1)

This is my 92nd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

On April 18, 2018, the SEC released three proposals for comment—Regulation Best Interest (“Reg BI”) for broker-dealers, an Interpretation about the Standard of Conduct for RIAs (“RIA Interpretation”), and a CRS—Customer/Client Relationship Summary for both broker-dealers and RIAs. That was the beginning of a lengthy process, and the outcome is uncertain. However, if these rules are finalized, the impact on the securities industry and investors will be significant.

My first reaction is that Reg BI, which imposes a best interest standard of care on broker-dealers, is strikingly similar to the DOL’s Best Interest Contract Exemption (BICE). There are major differences—for example, the SEC proposal does not create a private right of action for investors, and some of the disclosure requirements are eliminated. However, once you get beyond the differences, the similarities are striking.

Let’s discuss the SEC’s Best Interest standard for broker-dealers in the context of recommendations of plan distributions and rollovers.

First, the SEC acknowledges that a rollover recommendation involves an inherent conflict of interest. In footnote 204 the SEC states: “For example, firms and their registered representatives that recommend an investor roll over plan assets to an IRA may earn commissions or other fees as a result, while a recommendation that a retail investor leave his plan assets with his old employer or roll the assets to a plan sponsored by a new employer likely results in little or no compensation for a firm or a registered representative.”

On pages 82 and 83 of the Reg BI package, the SEC explains that “Securities transactions may also include recommendations to rollover or transfer assets from one type of account to another, such as recommendations to roll over or transfer assets in an ERISA account to an IRA.”

The significance of rollovers being classified as “securities transactions” is that the proposed best interest standard of care applies to recommendations of securities transactions. That is, a recommendation to a participant to take a distribution from his or her 401(k) plan and roll over to an IRA is, in effect, a recommendation that the participant sell the mutual funds in his or her account and rollover the cash proceeds.

In fact, the rollover process involves two securities transactions. In footnote 155, the SEC explains: “A recommendation concerning the type of retirement account in which a customer should hold his retirement investments typically involves a recommended securities transaction, and thus is subject to FINRA suitability obligations. For example, a firm may recommend that an investor sell his plan assets and roll over their cash proceeds into an IRA. Recommendations to sell securities in the plan or to purchase securities for a newly-opened IRA are subject to FINRA’s suitability obligations. See FINRA Regulatory Notice 13-45.”

In addition to the existing suitability obligation, Reg BI would impose a best interest standard of care, including a duty of loyalty, such that the recommendation to sell the investments in the plan (for example, a 401(k) plan) would be subject to both suitability and best interest. The suitability and best interest standards would also apply to recommendations about the re-investment of distributed money in an IRA.

That raises a question about how a best interest recommendation of a distribution and rollover should be made. What steps should be followed? That will be the subject of my next article.

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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