Category Archives: prohibited transaction

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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Interesting Angles on the DOL’s Fiduciary Rule #23


DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

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

When the definition of fiduciary advice is expanded on April 10, 2017, the investment and insurance recommendations of a much larger group of advisers will be classified as fiduciary advice and will, as a result, increase the focus on financial conflicts of interest (which ERISA and the Internal Revenue Code refer to as “prohibited transactions,” or PTs). My suspicion is that, for most ERISA retirement plans, there will not be a great impact on advisers—because, to a large degree, advisers to retirement plans already are acknowledged fiduciaries. (To be fair, though, there will be some impact . . . particularly on smaller plans, where some insurance companies and broker-dealers have, in the past, taken the position that their advisers are not fiduciaries. Nonetheless, based on my recent experience in working with broker-dealers, the adjustments are being made without a great deal of difficulty.)

On the other hand, the impact on advisers’ practices with IRAs will be significant. That is particularly true of investment and insurance services provided by broker-dealers. But, it is also true, to a lesser degree, of the services provided by RIAs. (Note: This article does not discuss recommendations to participants to take distributions and roll over to IRAs or recommendations to IRA owners to transfer their IRAs. Significant changes will be required for both RIAs and broker-dealers for those recommendations.)

One of the biggest changes—because of the fiduciary prohibited transaction rules—is that advisers will no longer be able to make recommendations that can affect the level of their compensation. An obvious example is that an adviser could not recommend a proprietary mutual fund (managed by an affiliate) without committing a prohibited transaction. That’s because a recommendation cannot increase the compensation of the adviser, his supervisory entity (e.g., a broker-dealer), or any affiliated or related party. Another example is that a financial adviser with a broker-dealer could not recommend that an IRA invest in mutual funds which pay different levels of 12b-1 fees to the broker-dealer and, indirectly, to the adviser. In effect, the adviser would be setting his own compensation (as well as the compensation of the supervisory entity). Similar issues exist for referral fees, revenue sharing, and so on. In all of those cases, the broker-dealer will need to either move to a level fee environment or to satisfy one of the prohibited transaction exemptions (most likely BICE—the Best Interest Contract Exemption).

Similar issues exist for RIAs. For example, we have seen cases where RIAs recommend proprietary products (e.g., affiliated mutual funds). That is a prohibited transaction. Another example of an RIA prohibited transaction is where the adviser recommends an allocation to fixed income and an allocation to equities, but then charges a higher fee for managing the equities. By virtue of recommending the allocations, the adviser has determined the level of its compensation . . . and, therefore, has committed a prohibited transaction.

The moral of this story is that broker-dealers and RIAs need to closely review their investment practices for qualified money. (“Qualified” money is the new terminology for money in IRAs or plans. It is an easy reference to the types of accounts that are subject to the new rules.) Since virtually all investment and insurance advice to IRAs and plans (including recommendations about distributions, withdrawals and transfers) will become fiduciary advice on April 10, 2017, two steps should be taken. First, if they don’t already exist, processes need to be put in place so that any advice satisfies the prudent person requirement. Generally speaking, that process should result in portfolio investing. Second, all payments for the advice (including indirect and non-cash compensation, whether to the adviser, the supervisory entity or any affiliates or related parties) needs to be examined. Once these rules are applicable, the compensation arrangements will need to satisfy the prohibited transaction rules in section 406(b)(1) and (3) of ERISA and the corresponding provisions in section 4975 of the Internal Revenue Code. Or, in the alternative, the condition of a prohibited transaction exemption must be satisfied.

And, all of that needs to be done by April 10, 2017.

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 #22


BICE, DOL, fiduciary, prohibited transaction

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

While the application of the new fiduciary rule and prohibited transaction exemptions to broker dealers and investment advisers is fairly obvious — if not fully understood, there has been little in the way of discussion about its application to banks. This post highlights some of those issues.

In a prior Angles article, I talked about how the fiduciary rule applies to referrals of advisers and how the prohibited transaction rules impact solicitors’ fees (see Angles No. 12). There is a similar issue for banks. For example, it appears to be a fairly common practice for employees at bank branches to recommend that customers set up IRAs and put the money into certificates of deposit, and for the bank employees to receive bonuses for the IRAs investments in the CDs (or, alternatively, to receive credits towards bonuses based on a variety of factors, including the IRA investments). Based on the wording of the new fiduciary rule, if a bank employee recommends that an IRA invest in a certificate of deposit, and is compensated directly or indirectly for that recommendation, it is a fiduciary act for compensation. (The bonus, or bonus credit, is the compensation.) Since the bank employee is being paid compensation that is not stated and level, the payment is a prohibited transaction. That means that an exemption is needed. (There are differing opinions within the banking community about whether a bank deposit exemption is available. The specific issue is whether the bank deposit exemption covers the payment to the employee.)

To complicate matters, what if the bank customer is retiring and asks about rolling over his 401(k) account? If the bank employee recommends a rollover, that would be fiduciary advice under ERISA. As such, the bank and its employee would need to develop the recommendation through a prudent process, considering at the least the investments, services and expenses in the plan and the proposed IRA. In addition, the recommendation could be a prohibited transaction, and an exemption would be needed.

The story doesn’t end there. Similar referral and compensation arrangements also exist for referrals to a bank’s trust department, affiliated investment adviser and affiliated broker-dealer. While the Best Interest Contract Exemption is generally available for compensation for these types of referrals, it may be difficult for banks to comply, since the cost and effort of BICE compliance can be significant, but the amounts paid under these referral arrangements are, at least for each individual referral, relatively small.

As we continue working with clients on compliance issues for the new rules, it is becoming increasingly clear that there are a significant number of unanticipated consequences.

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 #18


BICE, DOL, fiduciary, prohibited transaction, prudent

As advisers who work with ERISA-governed retirement plans already know, an adviser’s compensation cannot be more than a reasonable amount. Because of the new fiduciary advice regulation, and the associated prohibited transaction exemptions (84-24 and the Best Interest Contract Exemption (BICE)), that requirement is being imposed on investment and insurance recommendations to IRAs. Interestingly, under the Internal Revenue Code (section 4975(d)(2)), it is already a prohibited transaction for an adviser to earn more than reasonable compensation from an IRA. However, because of lack of enforcement by the IRS, that requirement is often overlooked. As evidence of the fact that it is overlooked, think about the lack of benchmarking or similar services to help advisers determine if their compensation from an IRA is reasonable. But, that is about to change.

To appreciate the “reasonable compensation” requirement, a person needs to understand that the amount that is reasonable is determined based on the services that are provided. In its guidance, the DOL explains how reasonableness is to be determined:

“The reasonableness of the fees depends on the particular facts and circumstances at the time of the recommendation. Several factors inform whether compensation is reasonable including, inter alia, the market pricing of service(s) provided and the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.”

However, there is a difference between “market” compensation and “customary” compensation. That difference is primarily whether the market is transparent and competitive:

“Ultimately, the “reasonable compensation” standard is a market based standard. As noted above, the standard incorporates the familiar ERISA section 408(b)(2) and Code section 4975(d)(2) standards. The Department is unwilling to condone all “customary” compensation arrangements and declines to adopt a standard that turns on whether the agreement is “customary.” For example, it may in some instances be “customary” to charge customers fees that are not transparent or that bear little relationship to the value of the services actually rendered, but that does not make the charges reasonable.”

As a hypothetical example . . . if an adviser provides a wide range of services, that might justify compensation of 1% per year of the assets under management. On the other hand, if an adviser provides a more limited range of services, that might be worth one-half of 1% per year (that is, 50 basis points). As a more specific example, BICE requires that advisers state whether or not they will be monitoring the investments on behalf of the IRA owner or plan. Obviously, all other things being equal, an adviser that provides fiduciary monitoring services is entitled to more money than one that does not.

With that understanding, the key question is, how will an adviser determine whether its compensation is reasonable? Most likely, it will be done in the same way that is in the 401(k) world. In other words, the value of services will be determined by the competitive marketplace. Since competitive market data is not generally available for IRAs, RIA firms and broker-dealers will need to work with service providers who have that information. In the 401(k) world, those are called benchmarking services.

The better benchmarking services will consider both the range of services and the compensation of the adviser. As explained above, the calculation of reasonable compensation is based on the services provided, but not just on the size of the account. In that regard, there will need to be a range of benchmarking alternatives, for example, discretionary investment advice for individual securities; discretionary investment advice for mutual funds; non-discretionary advice for both of those scenarios; recommendations for the purchase of individual annuities, including evaluations that take into account the different types of annuities (e.g., fixed rates annuities, fixed indexed annuities, and variable annuities); referrals to discretionary investment managers; and so on. The benchmarking will need to consider services and compensation in the first year and in subsequent years (for example, will the adviser be monitoring the investments).

While the services do not exist today, it is likely that they will in the relatively near future, say, in the next six to 12 months.

Forewarned is forearmed. Advisers need to be attentive to these issues, now that they are front and center.

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 #12


DOL, fiduciary, prohibited transaction

This is my twelfth article about interesting observations “hidden” in the fiduciary regulation and the exemptions.

The DOL has long taken the position that the recommendation of a discretionary investment manager is a fiduciary act. (At least one court has adopted that position – in a case involving investments with Madoff.)

While I am not aware of any guidance or litigation about potential prohibited transactions because of payments to persons who recommend investment managers (e.g., solicitor’s fees), from a legal perspective, if the person making the referral is a fiduciary and that person receives a fee, it may be a prohibited transaction under ERISA and the Internal Revenue Code.

To further complicate matters, when the new fiduciary rule becomes applicable on April 10, 2017, the definition of “fiduciary” will cover someone who makes referrals to both discretionary investment managers and non-discretionary investment advisers for plans, participants and IRAs. More specifically, the fiduciary definition includes:

“A recommendation as to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services . . .” [Emphasis added.]

In other words, a person who recommends a fiduciary adviser (which could include financial advisers, insurance agents and investment advisers under the new definition) will be a fiduciary for that purpose, if a fee is paid for the referral; and the payment of that fee could be (or, perhaps, probably will be) a prohibited transaction.

This is a significant change. Advisers who pay fees for referrals should consider its impact.

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Interesting Angles on the DOL’s Fiduciary Rule #10


DOL, fiduciary, General, prohibited transaction

This is my tenth article about interesting observations “hidden” in the fiduciary regulation and the exemptions.

When the new fiduciary advice regulation is applicable on April 10, 2017, a recommendation to a participant to take a distribution and rollover to an IRA will be a fiduciary act. It doesn’t matter if the adviser has a pre-existing relationship with the plan or the participant, or not.

Some RIA firms and broker-dealers focused on a similar issue when FINRA issued its Regulatory Notice 13-45 in late 2013. As that notice explained, distribution recommendations are investment recommendations (and thus, in the case of FINRA, are subject to the suitability standard), but distribution education is not an investment recommendation. To avoid the additional compliance work (and possibly prohibited transactions), many RIA firms and broker-dealers adopted a distributions education approach using 13-45 as the model. While the DOL agrees that distribution education is not a fiduciary recommendation, it does not agree that 13-45 is a safe harbor:

“In response to the comments suggesting that the Department adopt FINRA Notice 13-45 as a safe harbor for communications on benefits distributions, the FINRA notice did not purport to define a line between education and advice. The final rule [i.e., the fiduciary advice regulation] seeks to ensure that all investment advice to retirement investors adheres to fiduciary norms, particularly including advice as critically important as recommendations on how to manage a lifetime of savings held in a retirement plan and on whether to roll over plan accounts. Following FINRA and SEC guidance on best practices is a good way for advisers to look at for the interests of their customers, but it does not give them a pass from ERISA fiduciary status.”

As a word to the wise, RIAs and broker-dealers should revisit their 13-45 distribution education materials, and revise them to be consistent with the DOL’s approach.

 

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Interesting Angles on the DOL’s Fiduciary Rule #6


DOL, fiduciary, General, prohibited transaction, prudent

This is my sixth article about interesting observations “hidden” in the preambles to the fiduciary regulation and the exemptions.

In some cases, the concerns about the scope of the fiduciary rule are overblown. For example, there have been some statements that advice about minimum required distributions for IRAs would be fiduciary advice. That is not the case.

In the preamble to the fiduciary regulation, the DOL explained:

“With respect to the tax code provisions regarding required minimum distributions, the Department agrees with commenters that merely advising a participant or IRA owner that certain distributions are required by tax law would not constitute investment advice. Whether such “tax” advice is accompanied by a recommendation that constitutes “investment advice” would depend on the particular facts and circumstances involved.”

So, basic advice about tax requirements and consequences is not fiduciary advice. However, if the adviser recommends which investments the IRA owner should sell to fund the distribution, that is fiduciary investment advice which must be:

  • prudent and in the best interest of the IRA owner, and
  • free from financial conflicts of interest (or in compliance with a prohibited transaction exemption).
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An Overview of the Fiduciary Rule


BICE, DOL, fiduciary, General, prohibited transaction

The DOL’s fiduciary rule has been published in the Federal Register. Based on our review of the regulation and conversations with our clients, here are some overview thoughts about the regulation and the two “distribution” exemptions (84-24 and BICE).

The Fiduciary Definition

The rule is much as expected. The definition of fiduciary advice continues to be very broad, capturing almost all common sales practices for investments and insurance products. It includes investment recommendations to plans, participants and IRA owners, as well as recommendations about distributions from plans and transfers and withdrawals of IRAs. All of those will be fiduciary activities.

As a result, those recommendations will be subject to the fiduciary standard when made to plans or participants, and subject to the Best Interest standard of care when made to IRA owners (if the adviser needs the prohibited transaction relief provided in BICE or 84-24).

Much of the conversation has been about the requirements of the exemptions. Because of that, we are concerned that the impact of the fiduciary and Best Interest standards of care has not been adequately considered. In our opinion, those standards of care will be more impactful than generally thought.

In both cases (that is, the prudent man rule and the Best Interest standard), the adviser’s recommendations will be measured by what a hypothetical prudent and knowledgeable investor would do. In other words, it is the standard of a hypothetical knowledgeable person, and not the standard of the actual adviser or the investor.

What were the most notable changes in the final regulation from the proposal?

  • The “applicability” date for the regulation was deferred until April 10, 2017. Most people thought that compliance would be required on January 1, 2017, so that gives the financial services sector an additional three months to comply with most of the requirements. (See the additional extension of time for certain BICE requirements below.)
  • Advisers will continue to be able to provide participant education for retirement plans, using asset allocation models (AAMs) that include specific designated investment alternatives. (“Designated investment alternatives” are those investments that are selected by the plan fiduciaries for participant direction in 401(k) or 403(b) plans. As a result, they must be prudently selected and monitored by the plan fiduciaries.)However, populated asset allocation models are not permitted as a part of investment education for IRA owners. In that case, AAMs that include the names of investments would be fiduciary investment advice.
  • Platform providers (that is, recordkeepers) will be allowed to provide additional assistance, within limits, to respond to requests for proposals and similar inquiries from plan sponsors.

When an adviser becomes a fiduciary, the adviser’s conduct is also governed by the fiduciary prohibited transaction rules in ERISA and the Internal Revenue Code. Generally speaking, those rules prohibit advisers (or their affiliates) from receiving payments from third parties (such as 12b-1 fees or insurance commissions) and from making investment recommendations that affect the levels of their compensation. Those transactions are literally prohibited. However, the DOL has issued prohibited transaction exemptions which, if their requirements are satisfied, would allow the receipt of those types of payments. There are two exemptions that could apply to fiduciary advisers to mid-sized plans, participants, and IRAs. Those are 84-24 and BICE, which are discussed below.

Prohibited Transaction Exemption (PTE) 84-24

The current version of 84-24 covers the sale of all insurance products by fiduciary advisers. The proposed amendment to the exemption would have continued to cover those sales to plans and IRAs, but would have transferred the sale of individual variable annuity contracts from the 84-24 exemption to BICE. That was a significant change, because 84-24 is generally viewed as less burdensome than BICE. As a result, many in the insurance industry urged the Department of Labor to return individual variable annuities to 84-24 when the final rules were issued.

But, that didn’t happen. In fact, sales of other types of insurance were moved from 84-24 to BICE.

Before getting into that, though, let’s look at the most important requirements of 84-24. Those are:

  • The adviser must acknowledge in writing that he is a fiduciary and must agree to adhere to the best interest standard of care. (As a practical matter, the best interest standard of care is a combination of ERISA’s prudent man rule and ERISA’s duty of loyalty. In other words, those concepts are being extended from ERISA to IRAs.)Think about the consequences of that. For example, the recommendation of a particular insurance company must be prudent and the recommendation of the particular insurance contract must also be prudent.
  • The adviser’s compensation must be no more than reasonable and the adviser cannot receive any additional financial incentives, for example, trips, awards, or bonuses.
  • The adviser’s statements cannot be materially misleading. The failure to describe a material conflict of interest is deemed to be misleading.
  • The adviser must disclose his compensation.
  • The 84-24 exemption also limits the commissions that can be paid to advisers to “reasonable” amounts. As a result, we believe that advisers who recommend or sell insurance and annuity contracts should obtain benchmarking information about similar sales and the commissions that are reasonable under those circumstances.
  • Before the sale is made, those disclosures must be delivered to the plan fiduciary or IRA owner in writing, and the fiduciary or IRA owner must acknowledge the disclosures and approve of the transaction in writing.

What are the most important changes in the final 84-24 exemption?

  • The types of insurance products covered by 84-24 were further limited. That is because group variable annuity contracts and fixed indexed annuities were transferred from 84-24 to BICE. As a result, 84-24 now covers only fixed rate annuities and insurance policies.
  • The compensation payable to advisers was expended from just commissions to include accruals of health benefits and retirement benefits, but other payments and benefits are prohibited.
  • The applicability date will be April 10, 2017. Many people thought that it would be January 1, 2017, so that allows another three months to develop compliant procedures and practices.

Best Interest Contract Exemption (BICE)

The most significant changes were made to the Best Interest Contract Exemption. The changes were so great that it is not possible to describe them in this short article. So, we will just mention a few. (But, we will be doing a separate article on BICE in the coming weeks.)

BICE provides an exemption for prohibited transactions resulting from recommendations of any investment or insurance products to plans or IRAs. (In that sense, it provides an alternative exemption for the insurance products within the scope of 84-24.)

Generally speaking, it requires a contract or similar writing that is signed by a financial institution and that is given to the investor. (The financial institution is the bank, insurance company, broker-dealer or RIA, who oversees the adviser.) The financial institution contractually agrees that it and the adviser will serve as fiduciaries and will adhere to the best interest standard of care. The financial institutional also must agree to disclose material conflicts of interest and represent that none of its statements are misleading. In addition, a host of other disclosures must be made.

What are the most noteworthy changes in the final BICE?

  • The final version of BICE requires a contract that is signed by the financial institution and an IRA owner. However, for plans, the financial institution can deliver a written disclosure, but it is not required that the plan fiduciaries sign a contract with the financial institution.
  • The contract and disclosures do not have to be delivered or signed at the time of the first conversation. Instead, that requirement can now be satisfied at point of sale.
  • The proposal had demanding disclosure requirements at point of sale and annually thereafter. Those disclosures were liberalized and can now be made with information that is more general, but which has to be clearly and conspicuously provided to the plans or IRA owners. The investor has the right to obtain detailed information on request.
  • The proposal had a website requirement that was difficult, and perhaps impossible, to satisfy. The final has a less burdensome website disclosure requirement.
  • The final version of BICE has simplified compliance procedures for level fee advisers who are (i) capturing distributions and rollovers from plans, (ii) recommending withdrawals or transfers of IRAs, or (iii) recommending transfers from commission-based accounts to fee-based accounts.
  • As finalized, BICE has provided greater relief for investment accounts that are already in existence at the time of the applicability date of the new rules. For example, an adviser can now make a hold recommendation without becoming subject to the prohibited transaction rules.
  • The applicability date has largely been deferred to January 1, 2018. However, some of the requirements become applicable on April 10, 2017. Those include, for example, the best interest standard of care and reasonable compensation limitation.
  • BICE requires that the compensation paid to the adviser, the financial institution, and affiliates be no more than reasonable. We believe that financial institutions (such as broker-dealers and insurance companies) will need to develop or obtain benchmarking information in order to evaluate the reasonableness of the compensation of their advisers. In due course, we suspect that benchmarking services will develop for sales to IRAs, much as they have already developed for advice to plans.
  • While the proposal excluded some assets (e.g., illiquid investments) from its relief, the final BICE is available for all types of investments.

Conclusion

The final rules will require structural changes for some financial services companies. For example, we believe that broker-dealers will be affected the most. Insurance companies will also need to make changes. At the other end of the spectrum, most RIAs will only need to make changes to adjust to the new rules regarding recommendations of distributions and rollovers from plans and withdrawals and transfers of IRAs.

Recordkeepers fall in between those two groups. Recordkeepers who have insurance companies or mutual fund manager affiliates will be impacted more than independent recordkeepers.

While not directly affected by the new rules, mutual fund management firms need to understand their impact, for example, the needs of broker-dealers in this new environment. Some broker-dealers may decide to shift many of their accounts to level fee advisory accounts. In that case, they may not be able to receive 12b-1 fees or other payments. Instead, they will likely want share classes that are specifically designed for advisory accounts. Those share classes could resemble a retail version of institutional shares.

At this point, though, it is impossible to know all of the repercussions. Stay tuned.

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More Thoughts on Distributions and Rollovers


DOL, fiduciary, prohibited transaction

After my last post, I was asked another question about distributions and rollovers under the DOL’s proposed fiduciary regulation. Here’s the question and my answer:

Question: One thing I have heard is that all IRA Rollovers will fall under the DOL ERISA fiduciary standards with this rule.  Have you heard that?  Or, would all IRA Rollovers be covered under the new fiduciary definition, but not necessarily be ERISA covered?

Answer:  That’s generally correct, but it’s more complicated than that.

For ERISA tax-qualified plans, under the new rules a recommendation to take a distribution from a plan will be fiduciary advice subject to the prudent man rule and a duty of loyalty to the participant. And, the process must comply with the fiduciary prohibited transaction rules. That means that a fiduciary adviser can’t earn more from the rollover IRA than the adviser was earning from the participant’s account in the plan (unless the adviser satisfies a prohibited transaction exemption).

However, a recommendation to a participant to take a distribution from a government plan would not be subject to these requirements, since government plans are not governed by ERISA.

On the other hand, a recommendation to an IRA owner to transfer or withdraw money from an IRA is subject to rules similar to those for ERISA plans. That’s because a recommendation to withdraw or transfer IRA money is fiduciary advice under the Internal Revenue Code, and if the adviser benefits financially from that recommendation, the adviser must satisfy one of the exemptions. The relevant exemptions impose the Best Interest standard of care (which is a combination of ERISA’s prudent man rule and duty of loyalty).

These are major changes. Almost all advisers will need to change their practices to adapt to the new rules.

 

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Distribution and Rollover Education


DOL, plan sponsors, prohibited transaction, prudent

A reporter recently asked me to explain why people are saying that, under the DOL’s fiduciary proposal, an adviser should not recommend that a participant take a distribution and roll over to an IRA, but instead should provide distribution education. Here’s my answer:

There are two issues.

The first is that the recommendation to take a distribution must be in the best interest of the participant. That is, it must be a prudent recommendation and it must be done with a duty of loyalty to the participant.  In order to make a prudent recommendation, the adviser needs to investigate the relevant factors that a knowledgeable person would want to know to make that decision.  Some of those factors are:  the investment expenses in the plan as opposed to those in an IRA; the costs for advice in the plan versus those in an IRA; the range of investment options in the plan versus those in an IRA, and whether a larger range of investments is advantageous to the participant; the flexibility and costs of withdrawals from the plan as compared to an IRA.  That requires quite a bit of investigation and analysis, but does not prohibit a recommendation.

The second is that, if the adviser makes more in the IRA than in the plan, it is a prohibited transaction. For example, if the adviser doesn’t make anything from the plan (that is, he isn’t the adviser for the plan), but will receive 1% per year for advising the IRA, it is clearly in the best interest of the adviser to recommend a rollover, but is it right for the participant?  The DOL says that is a conflict, and financial conflicts are prohibited unless there is an exemption.  But, there isn’t an exemption specifically on point.  And, while people think that the Best Interest Contract Exemption (BICE) is intended to apply, it isn’t clear what BICE requires in this situation.  So, until the final BIC exemption is issued, it isn’t clear how advisers will be able to avoid prohibited transactions if they make distribution recommendations.

However, if an adviser provides non-biased and good quality distribution education, that’s not considered a recommendation. As a result, the prohibited transaction rules don’t apply.

Note: These rules will also apply to recommendations to withdraw or transfer money from IRAs. It is not just a plan issue.

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