Category Archives: General

Interesting Angles on the DOL’s Fiduciary Rule #97


DOL, fiduciary, General, prudent, registered investment advisers, SEC

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 #94


broker-dealers, DOL, fiduciary, FINRA, General, registered investment advisers, SEC

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 #83


DOL, General, prohibited transaction, SEC

Part 2 of Undisclosed (and Disclosed) 12b-1 Fees

This is my 83rd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In last week’s post (Angles #82) I discussed the fiduciary and prohibited transaction rules that should be considered in light of the SEC’s “Share Class Selection Disclosure Initiative” (“SCSDI”). As a refresher, the SCSD Initiative is a self-correction and self-reporting program where RIAs can identify, correct and report failures to adequately disclose the receipt of 12b-1 fees in addition to their advisory fees. My article discussed the consequences under the DOL’s guidance for the receipt of 12b-1 fees—on top of advisory fees—for both non-discretionary investment advice and discretionary investment management, where the results are quite different.

This article builds on that. The topics for this article:

  • When will, or could, a recommendation of a higher-cost share class (and, therefore, a more expensive investment) satisfy the best interest standard of care (that is, the prudent person rule and the duty of loyalty)?
  • What kind of disclosure of 12b-1 fees would be adequate under the fiduciary rule?

Let’s look at each of those issues.

When will, or could, a recommendation of a higher-cost share class (and, therefore, a more expensive investment) satisfy the best interest standard of care (that is, the prudent person rule and the duty of loyalty)?

As a general principle, a fiduciary adviser should not recommend or select investments that are more expensive than reasonable and necessary. That is one of the considerations under the prudent man rule and under the duty of loyalty. On the other hand, investment advisers are entitled to receive reasonable compensation for their services.

A fiduciary adviser could recommend mutual funds that pay 12b-1 fees as long as the total compensation to the adviser and the firm does not exceed a reasonable amount and as long as the cost of the investment (e.g., expense ratio) is not unreasonably high. (This assumes that there is adequate disclosure of the 12b-1 fees.) So, for example, if an adviser recommends a mutual fund that has a 1% expense ratio, and 25 basis points is paid as 12b-1 fees, the reasonableness of the cost for the mutual fund should be the net expense ratio, or .75%. The adviser needs to determine whether that cost is appropriate and reasonable for the particular qualified account.

On the other hand, if the payment of the 12b-1 fee to the adviser’s firm—when added to the advisory fee—results in excess (or “unreasonable”) compensation for the services, the compensation would not be justifiable and it could mean that the cost (or expense ratio) of the mutual fund was unreasonably expensive (since the cost of the 12b-1 fee was not justified). The former is a prohibited transaction and the latter is a fiduciary breach.

In a nutshell, the prudent man rule and duty of loyalty require an evaluation of the cost of the investment (e.g., mutual fund). However, that analysis is connected at the hip to the reasonableness of the adviser’s compensation.

What kind of disclosure of 12b-1 fees would be adequate under the fiduciary rule?

While the Department of Labor (“DOL”) hasn’t issued any specific guidance on this subject, it has issued guidance about disclosures of compensation in other situations. For example, the DOL’s 408(b)(2) regulation requires that service providers disclose their compensation to plan fiduciaries. While 408(b)(2) applies only to compensation for plan services, it may help understand the expectations for other fee disclosures under the fiduciary rule.

Simply stated, the 408(b)(2) guidance is that the retirement plan fiduciaries must be provided with adequate information to make two determinations. Those are:

  • Whether the compensation of an adviser and the firm is reasonable relative to the services provided.
  • Whether, and to what extent, an adviser and the firm have conflicts of interest.

With that understanding, it seems reasonable to think that the expectation of the fiduciary rule is that the disclosures would enable an investor to calculate a relatively accurate estimate of the compensation paid. For example, it would be risky to say that the adviser or his firm “may” receive 12b-1 fees. The question is, would a reasonable person be able to approximate the total compensation based on that information. Another example would be where the disclosure is that the firm will, in addition to the advisory fee, receive 12b-1 fees in the range of -0-% to 1.00%. Again, the issue is whether the investor can reasonably calculate the total compensation when provided with that information.

A significant risk is that, where the disclosures are inadequate, the adviser and the firm are receiving compensation that was not approved—and that the DOL and IRS would take the position that the payment was a prohibited transaction.

These rules—and particularly, the prohibited transaction rules—are complex and, if not understood, can result in significant problems.

However, once understood—and with appropriate disclosures and agreements—compliance is not conceptually difficult.

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 #78


broker-dealers, DOL, fiduciary, General, prohibited transaction, registered investment advisers

The Fiduciary Rule: Mistaken Beliefs (#3)

This is my 78th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The fiduciary regulation has been in effect since June of last year — a period of over six months. As you might expect, we are seeing mistakes and misunderstandings about activities that can result in fiduciary status for advisors. This article covers one of those.

The myth for this Angles is that broker-dealers and RIAs, and their advisors, must only recommend the lowest cost investments, for example, mutual funds with the lowest expense ratios. That is not correct.

In fact, the DOL has explained that:

“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” [81 Fed. Reg. 21002, at page 21030 (April 8, 2016)]

As indicated in that quote, and as explained elsewhere by the Department of Labor and several courts, an advisor’s fiduciary responsibility is to recommend investments with reasonable expenses . . . or, in a more specific context, to recommend mutual funds with expense ratios within the range of reasonableness for the particular plan and the type of fund.

For advisors with broker-dealers, the expense ratio of mutual funds typically includes a cost component and a compensation component (that is, compensation for the advisor). Assume, for example, that the expense ratio of a mutual fund is 100 basis points and that it includes a 12b-1 fee of 25 basis points. Viewed in terms of cost and compensation, the true cost of the mutual fund is 75 basis points and the cost of the advisor’s compensation is 25 basis points. In order to perform a proper analysis of cost of the investment, that distinction must be made.

Once the “true cost” is determined, that should be used as the expense ratio of the mutual fund for purpose of the fiduciary analysis of whether the cost of the investment is reasonable. (Note that, the reasonableness of the cost of an investment is a fiduciary issue measured by the best interest standard of care; however, the reasonableness of the compensation of the firm and the advisor is a prohibited transaction issue.)

A second step in the fiduciary analysis of cost is the determination of whether or not the appropriate share class is being recommended (including, for example, whether waivers are available). Generally speaking, the lowest cost available share class should be recommended. However, keep in mind that I am referring to the lowest “net cost” share class. In other words, the advisor’s compensation (for example, the 12b-1 fee) should be deducted to determine the true cost and then should be compared to the net cost of the other share classes of the same mutual fund.

Once an investment’s cost has been appropriately determined, and the appropriate share class has been determined, that information should be compared to similar data for other mutual funds in the same investment category. Again, though, the requirement is not that the lowest-cost investment be recommended. Instead, it is that the cost be reasonable relative to the value provided. On a practical level, that means that there is a range of reasonableness for a given type of investment. The risk is in recommending an investment that is clearly more expensive than what is typically charged for that type of investment.

Since a broker-dealer, RIA and advisor are fiduciaries for this purpose, the process used for the selection of investments and the determination of the reasonableness of cost should produce documentation that can be retained and retrieved. In other words, firms and advisors should be in a position to prove that they engaged in a prudent process.

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 #77


BICE, DOL, fiduciary, General, prudent

The Fiduciary Rule: Mistaken Beliefs (#2)

This is my 77th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The DOL’s fiduciary regulation and the transition Best Interest Contract Exemption (BICE) first applied on June 9, 2017. In other words, the recommendations made by broker-dealers and RIAs, and their representatives, have been governed by those rules for more than six months. While the requirements of the fiduciary standard of care and transition BICE are fairly straightforward—at least for advisors who understand the fiduciary concept, I am hearing about misunderstandings of those requirements. Angles #75 was my first post about mistaken beliefs; this article continues that theme by examining whether the best interest standard mandates the selection of the “best investment.”

To focus on BICE, when an advisor gives conflicted advice to IRAs, plans or participants, the advisor must adhere to the Impartial Conduct Standards. In that case the advisor must:

  • Adhere to the best interest standard of care.
  • Receive no more than reasonable compensation.
  • Make no materially misleading statements.

The best interest standard of care is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty. More literally, BICE defines the best interest standard as:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. (Emphasis added by me.)

While the full meaning of that language may not be obvious on its face, there is a substantial amount of guidance, through court cases and DOL opinions, about its meaning. It means, first and foremost, that an advisor must engage in a prudent process to develop a recommendation. And, the process must be done carefully and skillfully at the level of a person who is knowledgeable about the particular issues (for example, asset allocation, selection of investments, insurance products, etc.).

However, some people are saying that the best interest standard means that an advisor must recommend the best possible investment. That is incorrect. In fact, the DOL has specifically stated that, even if it were possible to select the best possible investment, that is not the requirement.

Instead, the requirement is that advisors act prudently when selecting investments . . . and prudence is defined by the quality of the process used by the advisor. So, for example, where an advisor uses reputable software to evaluate the investments and to develop an appropriate asset allocation, the use of that software would be part of a prudent process and would document that the advisor was complying with the rules.

Perhaps people are confusing the best interest standard with “best practice.” But, those are different things.

Having said that, there is certainly nothing wrong with an advisor doing more than is legally needed in an effort to prudently select investments.

The best interest standard—while more demanding than the suitability standard—is not as burdensome or difficult as some people believe. Instead, it requires a thoughtful and diligent process implemented by a knowledgeable advisor. Since these rules are designed to protect retirement money, that doesn’t seem like an unreasonable standard.

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 #68


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

Recommendations of Distributions: The SEC Joins the Fray

This is my 68th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In 2013, FINRA put its stake in the ground on recommendations of distributions and rollovers when it issued Regulatory Notice 13-45. The DOL has, with the development of its fiduciary regulation over the past few years—which became applicable on June 9 of this year—taken a similar, but more demanding position. However, the DOL’s guidance has more teeth than FINRA’s, because it is backed by a standard of care—the prudent man rule and duty of loyalty—and by the prohibited transaction rules in ERISA and the Internal Revenue Code. Recently, the SEC has joined the fray with the issuance of its ReTIRE initiative and its examination priorities over the past few years.

The SEC has completed the first phase of its ReTIRE initiative. This Angles article reports on the observations from the first phase and the current examination priorities.

Needless to say, recommendations and rollovers are issues of concern to the SEC and are, in fact, being examined. RIAs and broker-dealers who do not have well-developed practices and documentation for recommending rollovers and distributions may be surprised when the SEC raises those issues and faults their practices. However, my belief is that compliance with the DOL’s best interest standard of care (that is, the prudent man rule and the duty of loyalty) will satisfy the standard of care and conflicts of interest concerns of both the DOL and the SEC. As a result, broker-dealers and RIAs should focus on compliance with the DOL rules (especially in light of the SEC’s examination positions). Additionally, broker-dealers and RIAs should seriously consider affirmatively disclosing the conflicts of interest inherent in recommending distributions and rollovers.

Here is some additional information about the SEC examinations and their observations:

  • The SEC has conducted over 250 examinations under the ReTIRE initiative.
  • Specific areas of concern have been uncovered during the examinations. Those include:
  • Recommendations to investors/retirees of inappropriate share classes.
  • Misleading marketing materials regarding offerings and rollovers.
  • Lack of documentation to support the reasonableness of recommendations (including rollovers).
  • Vague or omitted disclosures related to fees, conflicts and services of affiliates.
  • Misleading touting of credentials.
  • Supervision and compliance breakdowns.

We expect that the SEC’s examinations will continue to focus on issues related to retirees and older investors, including distribution and rollover issues.

As an observation, in a recent SEC examination of a broker-dealer, the report specifically referenced practices which could violate FINRA Regulatory Notice 13-45. As a result, now is a good time for broker-dealers to review their practices, including advisor education, under 13-45, as well as the related policies, procedures and supervision.

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #64


BICE, DOL, fiduciary, General, prudent

What Does the Best Interest Standard of Care Require?

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

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

Generally speaking, it requires the following:

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

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

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

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

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

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

Forewarned is forearmed.

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

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Interesting Angles on the DOL’s Fiduciary Rule #58


408(b)(2), DOL, fiduciary, General

Recommendations to Contribute to a Plan or IRA

This is my 58th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In Angles article #56, I discussed the DOL’s position that recommendations of contributions to plans and IRAs were fiduciary advice. However, a week after that article was posted on my blog, the DOL reversed its position. The new guidance is found in the DOL’s “Conflict of Interest FAQs (408b-2 Disclosure Transition Period, Recommendations to Increase Contributions and Plan Participation).”

In the newly issued FAQs, the DOL posed the following question:

Q2. Plans and their service providers often encourage plan participants to make contributions to the plan at levels that maximize the value of employer matching contributions or to otherwise increase participants’ contributions or savings to meet objective financial retirement milestones, goals, or parameters based upon the participant’s age, time to retirement or other similar measures, without recommending any particular investment or investment strategy. Would it be fiduciary investment advice under the Fiduciary Rule to encourage additional savings or contributions to a plan or IRA in this manner?

The DOL then reversed its prior position by responding that those recommendations would not be fiduciary advice.

So, recordkeepers and advisers can unconditionally recommend contributions to plans and IRAs, right? Not so fast. A close reading of the guidance suggests otherwise. In other words, there may be traps for the unwary.

First, the recommended increase must be “objective.” For example, a non-fiduciary recommendation could be made to increase contributions to obtain the full benefit of an employer’s matching contributions. Also, a non-fiduciary recommendation for increased contributions could be “to meet objective financial retirement milestones, goals, or parameters based upon the participant’s age, time to retirement or other similar measures.” For example, a recommendation to increase contributions could be made based on calculations of the amounts needed for adequate retirement (for example, a 75% income replacement ratio in retirement). Another example is that, as a general rule of thumb, the combined employee-employer contributions should be 15% of pay in order to reasonably accumulate enough for a secure retirement.

Second, a recommendation to increase contributions is non-fiduciary advice where it is made “without recommending any particular investment or investment strategy.” So, for example, if the recommendation to increase contributions to a plan or IRA is made during a conversation that also includes a discussion of the investments, that could cause the recommendation to be fiduciary advice.

As a result, the “rules of the road” for recommending increased contributions to plans or IRAs, while avoiding fiduciary status, is to (1) make the recommendation based on an objective measurement, and (2) avoid a concurrent discussion of investments or investment strategies for the plan or IRA.

Even though there are traps in this guidance, the DOL’s position is a significant improvement.

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #57


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

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

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

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

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

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

So, what does that leave?

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #42


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

Rollovers under the DOL’s Final Rule

This is my 42nd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

On April 7, 2017 the DOL issued its final regulation on the extension of the applicability date for the fiduciary definition and the related exemptions. This article discusses the impact of those changes on fiduciary status for recommendations to plan participants to take distributions and roll over to IRAs.

In its guidance, the DOL extended the applicability date of the new fiduciary definition from April 10 to June 9, but did not otherwise modify the definition. Since the fiduciary rule defined a recommendation to take a plan distribution as fiduciary advice, any recommendation to take a distribution and rollover to an IRA on or after June 9 will be a fiduciary act. As a result, an adviser will need to engage in a prudent process to develop and make such a recommendation. (For purposes of this rule, an “adviser” includes a representative of an RIA or a broker-dealer, an insurance agent or broker, or any other person who makes such a recommendation and receives compensation, directly or indirectly, as a result. An advisory fee from the IRA or a commission from an annuity or mutual fund are examples of compensation.)

However, more is involved that just the fiduciary rule. A recommendation to rollover is also a prohibited transaction, since the adviser will typically make more money if the participant rolls over than if the participant leaves the money in that plan. Because of the prohibited transaction, the adviser will need an exemption. Under the latest changes to the rules, advisers will probably use a process called “transition BIC,” which is a reference to a transition rule under the Best Interest Contract Exemption. (This process applies only from June 9 to December 31, unless it is extended. But it is likely that, at the least, these requirements will be part of any future exemption.). Transition BIC requires only that the adviser comply with the “Impartial Conduct Standards” (ICS).

The ICS requires that advisers adhere to the best interest standard of care, receive no more than reasonable compensation, and make no materially misleading statements. For this article, let’s focus on the best interest standard. Generally stated it is a combination of the ERISA prudent man rule and duty of loyalty.

So, an adviser must satisfy both ERISA’s prudent man rule (for the recommendation) and the BIC best interest rule (for the exemption). Since the two standards of care are virtually identical, I have combined them for this discussion.

But, that begs the question of, what is a prudent and best interest process?

Specifically, it is that the adviser must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; . . .”

So, what would a prudent, knowledgeable and loyal person, who is making a recommendation about retirement investing (the “aims” of the “enterprise”), do? The first step is to gather the information needed to make an informed decision. Then that information needs to be evaluated in light of the participant’s needs and circumstances of the participant . . .with a duty of loyalty to the participant.

The only clear guidance from the DOL about what information needs to be gathered and evaluated is found in Q14 in the DOL’s Conflict of Interest FAQs (Part I-Exemptions).

The first part of the FAQ discusses the information needed if the adviser is a “Level Fee Fiduciary.” Basically, the information includes the investments, expenses and services in the plan and the proposed IRA.

But at the end of the FAQ, the DOL explains that those considerations must be evaluated even if the adviser is using regular BIC (as opposed to the Level Fee Fiduciary provision).

Accordingly, any fiduciary seeking to meet the best interest standard (in order to satisfy transition BIC) would engage in a prudent analysis of this information before recommending that an investor roll over plan assets to an IRA, regardless of whether the fiduciary was a “level fee” fiduciary or a fiduciary complying with BIC.

In other words, any adviser making a distribution and rollover recommendation on or after June 9, 2017 must have a process for gathering and evaluating information about the investments, expenses and services in the participant’s plan and in the proposed IRA, and about the participant’s needs and circumstances.

This subject is more complicated than can be covered adequately in a short article, but this is a start for understanding the new rules for distributions and rollovers.

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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