Category Archives: General

Interesting Angles on the DOL’s Fiduciary Rule #39


DOL, fiduciary, General

FINRA Regulatory Notice 13-45: Guidance on Distributions and Rollovers

This is my 39th 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.

Even though the DOL fiduciary rule is being delayed, other regulators have indicated their interests in protecting participants from inappropriate recommendations to take plan distributions and roll over to IRAs.

FINRA, which oversees broker-dealers, addressed rollover recommendations to participants in Regulatory Notice 13-45. In describing the purpose of the notice, FINRA said:

“FINRA is issuing this Notice to remind firms of their responsibilities when (1) recommending a rollover or transfer of assets in an employer-sponsored retirement plan to an Individual Retirement Account (IRA) or (2) marketing IRAs and associated services.”

FINRA noted that:

“A broker-dealer’s recommendation that an investor roll over retirement plan assets to an IRA typically involves securities recommendations subject to FINRA rules. . . . Any recommendation to sell, purchase or hold securities must be suitable for the customer and the information that investors receive must be fair, balanced and not misleading.”

FINRA went on to say that:

“A recommendation concerning the type of retirement account in which a customer should hold his retirement investments typically involves a recommended securities transaction, and thus is subject to Rule 2111. For example, a firm may recommend that an investor sell his plan assets and roll over the cash proceeds into an IRA. Recommendations to sell securities in the plan or to purchase securities for a newly opened IRA are subject to Rule 2111.”

In essence, FINRA concludes that a recommendation to take a rollover includes a recommendation to liquidate* the investments in a participant’s 401(k) account. . . and that the liquidation recommendation is a “recommended securities transaction” and “thus is subject to Rule 2111.” The guidance then goes on to say:

“If Rule 2111 is triggered, a registered representative must have a reasonable basis to believe that the recommendation is suitable for the customer, based on information about the options obtained through reasonable diligence, and taking into account factors such as tax implications, legal ramifications, and differences in services, fees and expenses between the retirement savings alternatives.” (Emphasis added.)

Earlier in the Notice FINRA also describes the need for an adviser to compare investments, services and expenses in the plan and the recommended IRA before making a recommendation.

That is strikingly similar to the Best Interest Contract Exemption (BICE) requirement that fiduciary advisers must do a comparative analysis of the investments, services and expenses in the Plan and the proposed IRA before recommending a rollover.

The regulators appear to be harmonizing around the type of analysis and investigation required to make a suitable or prudent recommendation.

*In a footnote, FINRA observes that it is possible that a plan could permit distributions in kind, rather than requiring liquidation of the plan’s designated investment alternatives. As a practical matter, I have not worked with any 401(k) plans that distribute in kind. I assume that my experience is typical and that few, if any, 401(k) plans permit distributions of their mutual fund shares.

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 #19


DOL, fiduciary, General, prudent

This is my nineteenth article about interesting observations about the fiduciary regulation and the exemptions.

In an earlier post (Angles #16), I described how advisers could use the “hire me” approach to explain their services and fees without becoming a fiduciary for that purpose. Generally stated, under that approach, an adviser could explain his services and fees, but could not discuss specific products or platforms. In other words, if the adviser “suggested” specific products or platforms, the adviser would become a fiduciary even under “hire me.” The DOL explained that result in the preamble to the fiduciary regulation:

“An adviser can recommend that a retirement investor enter into an advisory relationship with the adviser without acting as a fiduciary. But when the adviser recommends, for example, that the investor pull money out of a plan or invest in a particular fund, that advice is given in a fiduciary capacity even if part of a presentation in which the adviser is also recommending that the person enter into an advisory relationship. The adviser also could not recommend that a plan participant roll money out of a plan into investments that generate a fee for the adviser, but leave the participant in a worse position than if he had left the money in the plan. Thus, when a recommendation to ‘‘hire me’’ effectively includes a recommendation on how to invest or manage plan or IRA assets (e.g., whether to roll assets into an IRA or plan or how to invest assets if rolled over), that recommendation would need to be evaluated separately under the provisions in the final rule”

I mention this because I have recently seen some confusion about the extent and scope of “hire me.” As you might expect, it is because people want to extend “hire me” to all kinds of scenarios, and thereby limit their fiduciary status and legal exposure. For example, I was recently asked if an adviser could tell an IRA owner that the adviser would charge 1% per year to help select, manage, and monitor individual variable annuities. That might work if the IRA owner initially told the adviser that he wanted to hire someone to search for individual variable annuities. However, if the “suggestion” that an individual variable annuity would be appropriate comes from the adviser, that would likely result in fiduciary status for identifying the particular type of investment to be made (and, therefore, cause the loss of the non-fiduciary “hire me” approach).

So, as a word of warning, if you intend to use “hire me” to market your services, keep in mind that it is to describe your services and fees, but without a suggestion that any particular product, investment or platform, be used by the IRA owner.

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 #13


DOL, fiduciary, General

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

It is not clear under current rules whether “suggesting” investment policies is a fiduciary act. In that vein, it’s also not clear if providing a sample investment policy statement (IPS) is a fiduciary act. However, that is about to change.

When the new fiduciary regulation applies—on April 10, 2017, the recommendation of investment policies, strategies or portfolio composition will be fiduciary activities. As the DOL says in the preamble to the fiduciary regulation:

Specifically, the final rule includes text that describes management of securities or other investment property, as including, among other things, recommendations on investment policies or strategies, portfolio composition, or recommendations on distributions, including rollovers, from a plan or IRA.

And, a mere suggestion to use certain investment policies can result in fiduciary status. The DOL defines a fiduciary recommendation as:

For purposes of this section, ‘‘recommendation’’ means a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.

So, what does this mean? First, if you don’t want to be a fiduciary for that purpose, the safest bet is to avoid suggestions of investment policies or providing a sample IPS. A reasonable question is . . . if you didn’t mean for your comments or the sample document to suggest the use of the policies or IPS, why did you bring it up?

On the other hand, if you are willing to be a fiduciary for this purpose, make sure that you are a fiduciary (that is, that the recommendations/IPS are prudent under the circumstances). Keep in mind that ERISA’s prudent process rule is based on generally accepted investment theories and prevailing investment industry standards. Your policy recommendations should be based on those concepts (absent an explicit instruction from the investor to the contrary).

If you have read to this point, you are probably thinking about these issues in the context of retirement plans. That’s valid, but only partially so. Beginning April 10, these rules also apply to IRAs. Do you suggest investment policies to IRA owners or supply an IPS? If so, the same concepts will apply.

Forewarned is forearmed.

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Interesting Angles on the DOL’s Fiduciary Rule #11


BICE, DOL, fiduciary, General

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

ERISA and the Internal Revenue Code limit compensation for services to plans and IRAs to “reasonable” amounts. Prohibited Transaction Exemption (PTE) 84-24 and the Best Interest Contact Exemption (BICE) also limit compensation to reasonable amounts.

While the concept of reasonable compensation is old-hat for advisers and service providers to ERISA qualified retirement plans, it has not, by and large, been used in the IRA world. As a result, some people are asking . . . what is reasonable compensation? The DOL explained the concept in a preamble:

“The obligation to pay no more than reasonable compensation to service providers is long recognized under ERISA and the Code. ERISA section 408(b)(2) and Code section 4975(d)(2) require that services arrangements involving plans and IRAs result in no more than reasonable compensation to the service provider. Accordingly, Advisers and Financial Institutions – as service providers – have long been subject to this requirement, regardless of their fiduciary status. At bottom, the standard simple requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the Adviser and Financial Institution are delivering to the Retirement Investor.

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.”

In other words, “reasonableness” is defined by free market practices . . . in a market where the costs and compensation are transparent and, therefore, where the market is truly competitive. As a result, broker-dealers, RIAs, insurance companies and banks will need to use market data to evaluate the compensation they receive for the distribution of their products and services to plans and IRAs.

Benchmarking is on its way to IRAs. Expect compensation to drop – for the more “expensive” advisers.

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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 #8


DOL, fiduciary, General, plan sponsors

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

The final regulation on fiduciary advice continues, as education, the current practice of providing participants with asset allocation models that are populated with a plan’s designated investment alternatives (DIAs).

However, the rule imposes a burden on plan sponsors to monitor those models and which DIAs are used for the models. The fiduciary focus should be on the costs and payments from investments to providers and advisers. The preamble says:

 “In this connection, it is important to emphasize that a responsible plan fiduciary would also have, as part of the ERISA obligation to monitor plan service providers, an obligation to evaluate and periodically monitor the asset allocation model and interactive materials being made available to the plan participants and beneficiaries as part of any education program.

That evaluation should include an evaluation of whether the models and materials are in fact unbiased and not designed to influence investment decisions towards particular investments that result in higher fees or compensation being paid to parties that provide investments or investment-related services to the plan.”

Who will help plan sponsors satisfy that fiduciary duty?

Most plan sponsors won’t know about this duty. Even if they become aware of the responsibility, they probably won’t know how to evaluate if the “education” models are disguised vehicles for generating management fees for proprietary products or more revenues for advisers or their financial institutions.

This looks like an opportunity for high quality advisers to provide a valuable service to plan sponsors.

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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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Fiduciary Challenges for Evaluating Plan Fees: Investment Expenses and Revenue Sharing


fiduciary, General

The allocation of revenue sharing in 401(k) plans is a fiduciary decision. We explored that issue in detail in a recent white paper. We also looked at the concept of lowest “net” expense ratios. We concluded that there were fiduciary risk management benefits to “equalizing” revenue sharing (that is, returning it to the participants whose investments generated it) and for using the lowest net expense ratio for investments (i.e., the lowest net expense ratio after offsetting revenue sharing). A copy of that white paper is here.

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