Category Archives: registered investment advisers

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 #1


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

While you have probably read articles that summarize the DOL’s final fiduciary rule and exemptions—and perhaps even articles that discuss specific aspects of the rules, there are a number of interesting observations “hidden” in the preambles to the regulation and exemptions.

In many cases, those comments are so focused on limited issues or complex that they are beyond the scope of the initial articles, speeches and webcasts. As a result, I will be writing several articles about those “nuggets.” This is the first of those articles.

In the preamble to the Best Interest Contract Exemption (BICE), the DOL noted that a fiduciary adviser and his or her financial institution (e.g., RIA firm or broker-dealer) could contractually limit the duty to monitor. But then the DOL went on to say:

“Further, when determining the extent of the monitoring to be provided, as disclosed in the contract pursuant to Section II(e) of the exemption, such Financial Institutions should carefully consider whether certain investments can be prudently recommended to the individual Retirement Investor, in the first place, without a mechanism in place for the ongoing monitoring of the investment. This is particularly a concern with respect to investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor’s interests. Without an accompanying agreement to monitor certain recommended investments, or at least a recommendation that the Retirement Investor arrange for ongoing monitoring, the Adviser may be unable to satisfy the exemption’s Best Interest obligation with respect to such investments. Similarly, the added cost of monitoring such investments should be considered by the Adviser and Financial Institution in determining whether the recommended investments are in the Retirement Investor’s Best Interest.”

In other words, if an adviser isn’t going to have a duty to monitor the investments, don’t recommend investments that retirement investors lack the capacity to properly monitor.

It’s not clear where that line will ultimately be drawn – for example, does it refer to the particular investor or the average investor? As a result, some caution is warranted.

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Investment Advice to Plans Under the DOL’s Fiduciary Rules


broker-dealers, DOL, registered investment advisers

As I work with broker-dealers and RIA firms, certain patterns are developing in their efforts to satisfy the requirements of the DOL’s fiduciary rule and the exemptions.

This article looks at some of those “solutions” and comments on the areas where there is some agreement . . . or at least a majority opinion.

The DOL’s rule will, when finalized, regulate investment advice to plans and participants, investment advice to IRAs, and recommendations about distributions from plans and IRAs.

In this post, I look at the decision being made about advice to plans.

Interestingly, it appears that the changes will impact plans much less than IRAs and rollovers. The plan solutions fall into two categories. The first is that RIAs and broker-dealers will provide level-fee investment advice to plans. In some of those cases, a broker-dealer may need to act under its RIA registration. The level fee will be accomplished, by and large, either through expense recapture accounts or by payment from plan assets.

Note that, for purposes of this article, the words “level fee” actually refer to a “levelized” fee. For example, the broker-dealer or RIA could charge a flat fee (in terms of basis points or dollars) to the plan and be paid by the plan. Or, the broker-dealer or RIA could receive additional payments (for example, insurance commissions or 12b-1 fees) and either offset those against the flat fee or pay those amounts over into the plan. Both of those have the effect of “levelizing” compensation. But, it’s not enough to just do it. There needs to be an agreement to offset or pay over.

A second common solution is that advisers will be required to work with providers who have third-party 3(21) nondiscretionary and/or 3(38) discretionary investment advisers on their platforms. For example, representatives of a broker-dealer would be required to recommend that plan sponsors use the platform’s third-party fiduciary adviser to select and monitor the plan investments. In that way, an adviser and the broker-dealer will not be fiduciaries for purposes of selecting the investments. Note, though, that under the fiduciary rule, a recommendation of a fiduciary adviser (e.g., the 3(21) or 3(38) platform adviser) is, in its own right, fiduciary advice.

That’s a quick update for now. As this article suggests, these circumstances and decisions are evolving. So, keep tuned.

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The Year of the Fiduciary Rule


broker-dealers, DOL, fiduciary, registered investment advisers

2016 promises to be the year of the fiduciary . . . the fiduciary rule, that is.

It now seems certain that we will have a final fiduciary rule in effect by the end of 2016.

What will that mean? It will re-write the rules for investment advice and sales to retirement plans and IRAs. The impact will vary, depending upon whether the person making the recommendation is an RIA, a broker-dealer, or an insurance agent or broker.

For example, for RIAs, the greatest impact will be on investment advisers who recommend retirement plan distributions and rollovers and those who receive additional fees (for example, 12b-1 fees) from their IRA investors. On the other hand, advisers of broker-dealers will need to make significant changes in disclosures and compensation practices across the board (that is, for recommendations to plans and IRAs, and recommendations about distributions and rollovers).

Interestingly, the impact on retirement plan sales and advice may be less than is commonly expected. However, the impact on advice and sales to IRAs will be nothing short of revolutionary. Similarly, the “capturing” of IRA rollovers, through recommendations to participants to take distributions, will be dramatically affected.

We will be writing articles about all of that after the final rules are issued. That is likely to occur in the April/May/June timeframe.

One more comment: Much of the attention has been focused on the prohibited transaction exemptions, and particularly the Best Interest Contract Exemption (BICE). However, in my opinion, there has not been enough attention given to the fiduciary standard of care. For example, if an insurance agent recommends an annuity contract, both the financial stability of the insurance company and the provisions of the annuity contract need to be evaluated and a prudence determination must be made. I haven’t seen much said about that. Similarly, the recommendation of mutual funds to IRAs would need to take into account issues such as the quality of the investment management, the prudence of the amount allocated to that asset class or investment category, the reasonableness of the expense ratios, and so on. I think that, once these consequences are fully appreciated, the nature of investment and insurance advice given to IRAs will be materially changed.

That’s it for now. There will be much more in the future.

 

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The Essence of the Fiduciary Proposal . . . for Advisors


DOL, fiduciary, registered investment advisers

By now, you’ve probably read about some of the details of the Department of Labor’s fiduciary proposal. This article isn’t about the details; it’s about the essence. What’s the big picture?

First, the proposal significantly expands the definition of fiduciary advice. As a result, almost every person who makes an investment recommendation to a plan, a participant or an IRA owner will be considered a fiduciary.

For “pure” level-fee advisors (which are typically RIAs), there won’t be any change for their services to plans, participants or IRAs . . . with one exception. The exception is “capturing” rollovers.

For any advisor—broker-dealer, RIA, insurance broker—who makes a recommendation to a participant to take a distribution and roll over, and who will be paid more in the IRA than from the plan, it will be a prohibited transaction. In other words, the recommendation of a rollover will be considered fiduciary advice under the new proposal.

However, there is an exemption—the Best Interest Contract Exemption (BICE)—that allows for recommendations concerning rollovers, if they are in the best interest of the participant and if the advisor satisfies a number of contractual and disclosure requirements. However, it will be difficult to satisfy those requirements.

As a result, it is likely that most advisors will decide to provide “education” about distribution alternatives and about the most important considerations for participant in making those decisions. Education is treated differently than a recommendation. If a participant is provided unbiased and relatively complete education about his options, it will not be considered a recommendation. As a result, a participant can make a decision to roll over into an IRA and, after the roll over, the advisor can help with the IRA investments. In this context, “education” needs to be unbiased and complete in material regards. For risk management, it should be documented.

For non-level fee advisors, for participants, IRAs and certain plans, BICE is available — but compliance is complex and difficult. (An advisor is not a level-fee advisor if his compensation could vary depending on the recommendations that are made, or if his supervisory entity –for example, the broker-dealer or an affiliate—makes more money because of the recommendation, e.g., a management fee for an affiliated mutual fund manager.) For non-level fee advisors, the BIC exemption only provides relief for investment recommendations to participants, IRAs and small pooled plans (e.g., profit sharing plans). However, BICE does not provide relief for recommendations to participant-directed plans (e.g., 401(k) plans). For those plans, advisors must be level fee (or get relief from a different exemption).

One of the BICE requirements is that the advisor’s compensation (with limited exceptions) needs to be level. As a part of that, there cannot be any bonuses, incentives, etc., for the advisor to encourage the sale of proprietary products, investments that pay revenue sharing to the broker-dealer, and so on.

However, if BICE is satisfied, the compensation of the supervisory entity and its affiliates is not required to be level.

Another requirement is that there be a contract with the investor (for example, the IRA owner) where the advisor and the broker-dealer agree to adhere to the new “best interest” standard of care. (That standard is remarkably similar to the fiduciary standard under ERISA.)

In addition, there are stringent financial disclosures before the sale, before each new transaction, and after the end of each year. For example, after the end of each year, the investor must be given the dollar amount of all expenses resulting from the investment recommendations (for example, in the IRA) and the dollar amount paid to the advisor and the supervisory entity in the preceding year.

My belief is that very few, if any, RIAs or broker-dealers currently have the systems in place to be able to do that kind of reporting . . . and that it would be very expensive to create the systems.

There are other requirements that make compliance with BICE even harder, but this gives you the basic idea.

At this point, there is about another 60 days left in the comment period. After that, there will be hearings. If the regulation does become final, which is a distinct possibility, it will probably be in the first or second quarter of next year, with an “applicability” date of late 2016 or early 2017.

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Aging Boomers and Rollovers to IRAs


DOL, fiduciary, plan sponsors, recordkeeper, registered investment advisers, service providers

As baby boomers approach retirement in a defined contribution world, the regulators are focusing on distributions and rollovers to IRAs. The SEC, FINRA, DOL and GAO have all spoken on the subject. Their conclusion appears to be that plan fiduciaries, advisors and recordkeepers need to reconsider their current practices and, in some cases, change their practices.

Why? The reason is relatively straightforward. As large numbers of 401(k) and 403(b) participants approach retirement, regulators are becoming increasingly aware that they will be moving from a plan environment where they are “bubble wrapped” by plan fiduciaries . . . and have the benefit of being able to select from investments that have been vetted by the fiduciaries and that are, as a result, good quality and relatively low-cost investments. Based on current practices, most of those participants will rollover into IRAs with investments and advisors that are using retail pricing.

In addition, participants will go from a fiduciary environment that is protected from conflicts of interest into a retail environment that allows conflicts of interest. (Note that there is a difference between a conflict of interest and “succumbing” to a conflict of interest. In my experience, most—but not all—advisors provide good advice at reasonable costs.)

The regulators are asking, “Does it make sense for participants to leave the protected environment of retirement plans and go into the retail environment of IRAs?”

To create a worse-case scenario, imagine a 401(k) participant who is defaulted into a target date fund and stayed there during his working career. In effect, the participant has never selected an investment, and it is possible that the participant never learned anything about mutual funds. At retirement, that participant is encouraged to rollover his money into a retail market.

So, where does that leave us? For plan sponsors, I think that it means that they should consider allowing participants to stay in the plan, even after retirement, and should provide flexible distribution alternatives through their recordkeeper. For advisors and recordkeepers, I think that it means that they need to create meaningful educational materials and help participants make the right decisions, depending on the participants’ needs and preferences.

This is just the beginning of this story. There is too much at stake for it to end here. For example, it is estimated that over two trillion dollars will become eligible for distribution between January 1, 2014 and December 31, 2018.

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Providing Compliant Services


broker-dealers, DOL, registered investment advisers

The increasing regulation of 401(k) distributions and rollovers to IRAs continues to be a subject of great interest to my clients . . . and a considerable amount of work for me. One of the benefits of concentrated work in that area has been an enhanced appreciation of the difficulty of broker-dealers, provider call centers, and RIAs in providing compliant services . . . from a practical perspective.

For example, viewed academically, it is possible to put together a compliant rollover program under FINRA’s guidance in Regulatory Notice 13-45. At the least, that would involve written materials and discussions about the seven factors listed in the guidance. The written materials would be provided to participants to both educate them and to support compliance and supervision. The conversations would be structured to provide a reasonable basis for developing a suitable recommendation, based on the individual needs and circumstances of the participant.

On a practical level, it is feasible for a financial adviser or an investment adviser to engage in that process . . . for a participant with a large account balance. However, that is only a small part of the real world of 401(k) participants. Many of the conversations are with participants with small account balances and, for a provider’s call center, are of limited duration. As a result, the compliance procedures and “scripts” for participants with small account balances are often more difficult to develop than for the individualized treatment that can be financially justified for wealthier participants.

Nonetheless, the regulators—FINRA, the SEC and the DOL—now expect broker-dealers and RIAs to have compliant procedures for “capturing” IRA rollovers. Based on my experience, this is not an easy job. I recommend that, at the least, your procedures incorporate unbiased and relatively thorough educational materials that are given to all participants who are eligible for distributions and a process that solicits the most important information about the needs and circumstances of the participants. Without that kind of approach (or something similar to it), it will be difficult to formulate a suitable or prudent distribution and rollover recommendation.

The FINRA guidance, and the SEC and FINRA 2014 Examination Priorities List, are posted under the “external resources” page on my blog at http://fredreish.wpengine.com/external-resources-2/.

 

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Advisory Opinion 2013-03A


408(b)(2), DOL, fiduciary, prudent, recordkeeper, registered investment advisers

In Advisory Opinion 2013-03A, the Department of Labor said: “This letter also does not address any fiduciary issues that may arise from the allocation of revenue sharing among plan expenses or individual participant accounts . . .”

In effect, the DOL was saying that it has not issued any guidance—and is not prepared to issue guidance—concerning the allocation of revenue sharing. That is a reminder that there isn’t any explicit guidance on how to allocate revenue sharing. As a result, fiduciaries need to engage in a prudent process to make that decision.

In most cases, revenue sharing is used to pay the cost of recordkeeping. In effect, it is arguable that, when the recordkeeper keeps the money, it is a pro rata allocation among the participants’ accounts. That is because the most common way of allocating expenses (for example, recordkeeping or RIA charges) among participants’ accounts is the pro rata method. So, when a recordkeeper keeps the revenue sharing, participants benefit on a pro rata basis. (“Pro rata” means that amounts are allocated among the participant’s account balances in proportion to the value of the account balances.)

A consequence of the 408(b)(2) disclosures and the DOL’s guidance on revenue sharing is that fiduciaries need to pay more attention to revenue sharing. For example, do fiduciaries want the recordkeepers to keep the revenue sharing or do they want to allocate the revenue sharing to participants (along with the charges for recordkeeping)? Should part of the cost of recordkeeping be allocated to participants who are invested in individual brokerage accounts or who hold company stock . . . or should the participants who invest in mutual funds bear the full cost of the recordkeeping for the plan? Those are fiduciary decisions. In the past, most plan fiduciaries have simply accepted the method used by the recordkeeper. However, even then, that was a fiduciary decision. It’s just that the fiduciaries didn’t, in many cases, know that they were making it. Going forward, there undoubtedly will be greater accountability for these fiduciary “decisions”. . . since fiduciaries have been provided with information about revenue sharing as a part of the 408(b)(2) disclosures. Forewarned is forearmed.

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Capturing Rollovers: A Changing Environment


DOL, fiduciary, prohibited transaction, registered investment advisers

Recent developments suggest that FINRA, the SEC and the DOL are working together…or, perhaps, have independently reached the same conclusions.

In the past few months, FINRA has discussed rollover IRAs in five publications. The most important of those being Regulatory Notice 13-45, which creates a fiduciary-like process for recommendations about distributions and IRA rollovers. (By the way, I believe FINRA’s Investor Alert on rollovers is helpful and should be given to prospective rollover customers.) Then, to put an exclamation point on that guidance, both FINRA and the SEC listed rollovers to IRAs as one of its 2014 Examination Priorities for broker-dealers.

Finally, it is commonly expected that the DOL will issue its proposed regulation on the definition later this year…and that the proposal will expand its prior guidance on “capturing” rollovers. Fiduciary status alone increases the scope of the DOL’s jurisdiction and implicates it’s prior guidance (see Advisory Opinion 2005-23A). As a result, a broader definition of fiduciary advice will subject more advisers and providers to that guidance. In addition, it is possible that the Department will try to label any recommendation to take distribution as fiduciary advice (by saying, e.g., that a recommendation to take a distribution is inherently also a recommendation to liquidate a participant’s 401(k) investments – similar to what FINRA has done).

To make this even more “interesting,” we are seeing SEC examinations of RIAs where the SEC is finding ERISA prohibited transactions and asserting compliance violations by RIAs. The question is, will that theme carry over into IRA rollovers?

These changes impact broker-dealers, RIAs and their representatives. Less obviously, they also impact the rollover services of recordkeepers.

Bottom line… the rules are changing. Much more attention must be given to practices and disclosures in the distribution and rollover process.

For those of you who are interested in following me on Twitter, I can be found @fredreish, or copy and paste this URL into your browser: https://twitter.com/fredreish

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