Interesting Angles on the DOL’s Fiduciary Rule #80


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

Is the New Fiduciary Rule Enforceable During the Transition Period? (Myth #5)

This is my 80th 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.

This is another in my series of articles about myths concerning the Fiduciary Rule. This article deals with the “myth” that the fiduciary rule will not be enforced during the transition period. As the word “myth” suggests, that’s not correct.

As background, the Department of Labor said that it will not, under appropriate circumstances, enforce the requirements of the fiduciary regulation and prohibited transaction exemptions (and, particularly, the Best Interest Contract Exemption [BICE]):

Accordingly, during the phased implementation period from June 9, 2017 to July 1, 2019, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the Fiduciary Rule and applicable provisions of the PTEs [Prohibited Transaction Exemptions] or treat those fiduciaries as being in violation of the Fiduciary Rule and PTEs.”

The IRS has agreed to abide by that non-enforcement policy.

At first blush, that could be interpreted to be a free pass for compliance until the transition period ends on July 1, 2019. However, it would be a mistake to read it that way. The DOL went on to say:

At the same time, however, the Department emphasizes, as it has in the past, that firms and advisers should work “diligently and good faith to comply” with their fiduciary obligation during the Transition Period. The “basic fiduciary norms and standards of fair dealings” are still required of fiduciaries during the Transition Period (citations omitted).

As a result, we know that there is a “line in the sand” and crossing that line could result in DOL enforcement. However, we don’t know quite where the line is. Elsewhere, though, the DOL has said that it expects financial institutions (for example, broker-dealers and RIA firms) to develop policies, procedures and practices which are designed to ensure that advisors do not succumb to conflicts of interest and do not make recommendations that are not in the best interest of retirement investors. As a result, it would be poor risk management for broker-dealers and RIAs to provide investment advice to plans, participants and IRAs (“retirement investors”) without having adopted appropriate policies, procedures and practices . . . and then supervising compliance with those policies, procedures and practices. Stated slightly differently, there is a risk that the failure to take those steps could result in the DOL finding that a broker-dealer or RIA had not worked “diligently and in good faith” to comply with the fiduciary rule and the PTEs.

So, the first lesson is that the non-enforcement policy does not give a free pass during the transition period. Instead, there are expectations about good faith efforts to comply with the Impartial Conduct Standards and about the adoption and application of policies, procedures and practices to mitigate the effects of conflicts of interest and incentive compensation.

A second enforcement risk is that private claims by investors can be made under the fiduciary rule and the prohibited transaction exemptions. It is clear that, for advice to plans and participants (which would include, for example, recommendations of rollovers), there is a private right of action under ERISA. In other words, for advice to plans and participants, ERISA’s remedial provisions apply even during the transition period. As a result, while DOL and IRS enforcement may be limited, private claims can be filed on behalf of fiduciaries and participants.

The issue is somewhat more complex for claims of fiduciary breaches and failures to satisfy the PT exemptions for IRAs. However, it is likely that claimant’s attorneys will be asserting fiduciary claims with creative theories. For example, if an advisor with a broker-dealer engages in a prohibited transaction (that is, receives compensation from a third party, such as a mutual fund, or otherwise makes recommendations that affect the level of his or her compensation), the broker-dealer and advisor would need the benefit of a prohibited transaction exemption—probably BICE. That creates a Hobson’s choice. If the broker-dealer defends itself by saying that it was not claiming the benefit of the BIC exemption (and, therefore, was not bound by the Impartial Conduct Standards, including the best interest standard of care), that defense is effectively an admission of the commission of a prohibited transaction. On the other hand, if the broker-dealer responds by claiming the benefit of the exemption, the broker-dealer is agreeing that it is bound by the Impartial Conduct Standards. While neither of those may be explicit claims available to claimants, those choices can put financial institutions and their advisors in difficult positions.

Finally, there may be claims by state regulators. For example, the State of Massachusetts recently filed a claim against a broker-dealer on the basis that it violated its policies and procedures concerning sales contests. Those policies and procedures were developed as a result of the DOL’s Fiduciary Rule and prohibited transaction exemptions. In other words, the claim was not that the broker-dealer violated the Impartial Conduct Standards, but instead it violated its own policies and procedures, which were developed in order to comply with the those Standards. (By the way, individual investors and their attorneys could also assert claims on that basis.)

What does this mean? It means that the fiduciary “waters” are treacherous. It means that advisors and their financial institutions should re-double their efforts to provide documented advice that is in the best interest of retirement investors. The easiest way to avoid difficulties is to comply with the new rules.

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

Share

Interesting Angles on the DOL’s Fiduciary Rule #79


BICE, broker-dealers, DOL, fiduciary, FINRA, prudent, registered investment advisers, SEC

The Fiduciary Rule: Mistaken Beliefs (#4)

This is my 79th 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.

This post continues my series on myths about the fiduciary rule and prohibited transaction exemptions. This article focuses on the issue of “reasonable compensation” for RIAs, broker-dealers and their advisors for their services to retirement plans and IRAs (“qualified accounts”), and what, if any, changes will be made to that requirement. The myth is that the SEC will draft rules that eliminate the reasonable compensation rule. That is incorrect. The reasonable compensation limitation on advisors and their supervisory entities is here to stay.

This article explains why the reasonable compensation limits are here to stay and what advisors and their supervisory entities need to do to comply with those rules.

The fiduciary regulation is currently in effect. It first applied on June 9, 2017. And, it applied in full force. That is, while there are transition versions of the prohibited transaction exemptions, the fiduciary regulation was not modified to be a transition version.

The effect of the fiduciary regulation is to broadly expand the definition of who is a fiduciary. Because of the regulation, virtually anyone who makes an investment or insurance recommendation to a plan, a participant, or an IRA owner, is a fiduciary.

The conflict of interest exceptions (called “exemptions”), on the other hand, only partially applied on June 9th. The most important exemption—the Best Interest Contract Exemption, or BICE—requires only that advisors and their supervisory entities adhere to the Impartial Conduct Standards. Those standards are:

  • The best interest standard of care, which is, in its essence, the prudent person rule and the duty of loyalty.
  • No materially misleading statements.
  • No more than reasonable compensation for the individual advisor and the entity.

However, even if the reasonable compensation condition in BICE is removed from the exemption, that will not mean that advisers and their supervisory entities can ignore that limit. And, even if the SEC or FINRA do not impose a reasonable compensation limitation, that will not change the rule. Why is that?

The reasonable compensation limit is found in both the Internal Revenue Code and ERISA. In other words, it is a statutory requirement. Neither the DOL, the SEC nor FINRA can issue a rule that overrides a statute.

But, what if the definition of fiduciary is changed and an advisor is no longer a fiduciary? That doesn’t matter either. The reasonable compensation limitation in the Code and ERISA applies to all service providers, regardless of whether they are fiduciaries.

With that background, the essential question is, how do advisors and their financial institutions determine the reasonableness of their fees? Before I answer that question, though, I want to explain two threshold issues. The first is the definition of compensation and the second is the definition of reasonableness.

ERISA and the Code use “compensation” to cover all payments, monetary and non-monetary, that are compensatory. A compensatory payment is one which is partially or entirely, directly or indirectly, attributable to an investment or insurance recommendation. The DOL uses a “but for” test to determine if a payment is compensation, that is, would the broker-dealer or RIA firm have received the payment “but for” the investment recommendations. If the payment is partially or entirely, directly or indirectly, attributable to investment recommendations, it is compensatory.

With regard to “reasonableness,” the DOL explains that the reasonableness of compensation is determined by the services provided by the advisor. In effect, the marketplace defines “reasonable” because, in most cases, the ordinary and customary compensation for the services associated with particular transactions is reasonable.

More specifically, the DOL explained in its preamble to BICE:

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.

Now, let’s turn to the steps that advisors and their supervisory entities should take to determine whether the compensation for a particular type of investment transaction is reasonable. Financial institutions and advisors need to obtain information about the marketplace pricing for various types of transactions. For example, what is the range of customary compensation for individual variable annuities? What is customary for referrals to third party asset managers? What is customary for mutual funds? And so on.

While it may be possible for financial institutions to collect that information on their own (and to update it periodically . . . perhaps annually), the more practical and cost-effective answer is to work with a benchmarking service that obtains and updates that information. Of course, advisors and financial institutions should investigate the experience and quality of the benchmarking service, and the integrity and timeliness of its data.

Keep in mind that the reasonable compensation limits are in the prohibited transaction rules. As a result, the burden of proof is on the financial institution, and not on the retirement investor. In other words, it’s important to have market data and to develop compensation policies that are consistent with the data. Since it is likely that the levels of reasonable compensation will change over time, that information should be updated at reasonable intervals.

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

 

 

Share

FINRA 2018 Annual Regulatory and Examination Priorities Letter Makes No Mention of a Fiduciary Duty for Brokers


FINRA

FINRA released its 2018 Annual Regulatory and Examination Priorities Letter (Priorities Letter) on January 8, 2018. While FINRA advises that it can change its priorities in response to circumstances, the purpose of the Priorities Letter is to permit broker-dealers to plan their compliance, supervisory and risk management programs and to prepare for FINRA examinations. Therefore, this Priorities Letter is significant both in what it says and in what it has chosen not to say including failing to discuss FINRA’s views regarding a “fiduciary standard.”

My colleagues, Sandy Grannum, Jim Lundy, Jamie Helman, and I wrote a post about this issue for the Broker-Dealer Regulation & Litigation Insights blog. Read more here.

Share

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.

 

Share

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.

Share

Interesting Angles on the DOL’s Fiduciary Rule #76


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

This is my 76th 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 regulation defining fiduciary advice for plans, participants and IRAs applied on June 9, 2017. As a result, we now have some experience with the fiduciary regulation and the transition prohibited transaction exemptions. Based on that experience, there are some significant misunderstandings about how the rules work. This article discusses one of those.

If a broker-dealer or RIA firm receives prohibited (or “conflicted”) compensation from an IRA, the compensation may be permissible under the Best Interest Contract Exemption (BICE). During the transition period (until July 1, 2019), BICE only requires that fiduciary advisors (such as broker-dealers and RIAs, and their representatives) adhere to the Impartial Conduct Standards. There are three Impartial Conduct Standards. Those are:

  • The best interest standard of care (which is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty).
  • The compensation of the financial institution and the individual advisor is no more than a reasonable amount for the services rendered.
  • Neither the financial institution nor the advisor makes any materially misleading mis-statements.

There are two other considerations, though. The first is that BICE is an exemption to the prohibited transaction rules and, therefore, the burden of proof is on the financial institution (e.g., the RIA firm or broker-dealer). As a result, compliance with those three Impartial Conduct Standards should be documented in a retrievable form. The second is that the Department of Labor has said that financial institutions need to have policies, procedures and practices that ensure that their advisors are adhering to the Impartial Conduct Standards.

All in all, though, it is possible to comply with those requirements. Stated another way, the most burdensome requirements in BICE were delayed until July 1, 2019—and will likely be revised before those rules apply.

However, there is a caveat. That is, BICE only applies to non-discretionary investment advice. In other words, if the financial institution or its advisors have the responsibility or authority to make the decisions, or if they actually make the investment or transaction decisions, and there is a financial conflict of interest (that is, a prohibited transaction), BICE does not provide relief. To make matters even worse, there are very few exemptions for prohibited transactions resulting from discretionary decisions. Based on conversations with RIAs over the last few months, I have learned that many of them are not aware that, where they have financial conflicts (for example, 12b-1 fees or payments from custodians) for discretionary investment management for IRAs, there is usually not an exemption and the compensation is prohibited.

In other words, where advisors have discretion, the “cleanest” approach is “pure” level fee advice. Any payments or financial benefits from third parties (e.g., custodians, mutual funds, insurance companies) are prohibited. The DOL’s definition of “discretion” is very broad, for example, if the advisor selects the share class, and the investor does not approve that share class in advance, the advisor (and therefore the financial institution) has exercised discretion.

With that in mind, my advice is that RIAs and broker-dealers should consult with their ERISA attorneys to make sure that they understand these rules and are in compliance.

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

 

 

Share

Interesting Angles on the DOL’s Fiduciary Rule #75


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

The Fiduciary Rule: Mistaken Beliefs

This is my 75th 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.

In the past, there was a common belief among advisors that fiduciary status could be avoided by presenting a list of investments to plan sponsors. For example, an advisor might provide a list of three alternatives in each investment category (e.g., three alternatives for a large cap blend fund, three alternatives for a small cap fund, and so on). The belief was that, since the list did not “recommend” any particular investments, it could not be a fiduciary recommendation.

While that may (or may not) have been correct before June 9, it is not correct today. The presentation of a selective list will result in fiduciary status, implicating the prudent man rule, the duty of loyalty, and the fiduciary prohibited transactions.

To quote from the new fiduciary regulation:

“Providing a selective list of securities to a particular advice recipient as appropriate for that investor would be a recommendation as to the advisability of acquiring securities even if no recommendation is made with respect to any one security.”

While the practice of presenting selective lists was, at least in my experience, primarily for participant-directed plans, e.g., 401(k) plans, under the new definition, the presentation of selective lists of investments would also be fiduciary advice to individual retirement accounts and individual retirement annuities.

The “moral of the story” is that advisors and their supervisory entities (for example, broker-dealers and RIAs) need to realize that when they provide these types of lists, they will be making fiduciary recommendations. For recommendations to retirement plans, that means that the advisor must engage in a prudent process to evaluate the investments based on factors such as the expenses of the investments, the quality of investment management, the reasonableness of the compensation paid to the advisor from the investments (e.g., 12b-1 fees), and so on. From a risk management perspective, that process should be documented and retained in a retrievable form.

For recommendations to IRAs, if the advice is given by a “pure” level fee fiduciary, the advisor is not committing a prohibited transaction (that is, doesn’t have a financial conflict of interest), and the best interest standard of care does not apply to the advisor. A “pure” level fee advisor would typically be an RIA that charges a level advisory fee, does not receive any payments from the investments, and does not recommend any proprietary products.

However, where an advisor to an IRA receives payments from the investments or where the advisor can affect the level of his compensation based on the investments that are recommended, that would be a financial conflict of interest, which is a prohibited transaction under the Internal Revenue Code.

As a result, if an advisor presents a selective list of investments to the IRA owner, those would be viewed as fiduciary recommendations and any payments from the investments (such as 12b-1 fees) would be prohibited transactions. To avoid a violation, the advisor and the financial institution would need to satisfy the requirements of transition BICE. The most significant of those requirements is the best interest standard of care, which is a combination of ERISA’s prudent man rule and duty of loyalty. That standard of care is somewhat more demanding than the suitability and know-your-customer standards. Advisors and financial institutions need to understand these rules, so that they do not inadvertently fail to comply with them. Also, the burden of proof of compliance is on the financial institution; as a result, the best interest process should be documented.

The second “moral of the story” is that advisors should be familiar with the new rules, so that they don’t inadvertently fall into a compliance trap.

Forewarned and forearmed.

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

 

 

Share

Interesting Angles on the DOL’s Fiduciary Rule #74


BICE, DOL, fiduciary, recordkeeper

One More Fiduciary Issue for Recordkeepers

This is my 74th 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 my last four posts, Angles 70 through 73, I discussed issues and opportunities for recordkeepers under the new fiduciary rule and the transition Best Interest Contract Exemption. This post covers a carve-out to the fiduciary definition that probably will not work—or, at least, won’t work effectively—for recordkeepers.

That carve-out to the fiduciary definition is one that allows recordkeepers to provide lists of the investments available on their platforms that satisfy certain criteria specified by the plan sponsor, for example, performance, expense ratios, volatility, etc. Specifically, that provision says that a recordkeeper does not become a fiduciary by:

Identifying investment alternatives that meet objective criteria specified by the plan fiduciary (e.g., stated parameters concerning expense ratios, size of fund, type of asset, or credit quality), provided that the person identifying the investment alternatives discloses in writing whether the person has a financial interest in any of the identified investment alternatives, and if so the precise nature of such interest; . . .”.

At first blush, that raises a practical question of whether plan sponsors who aren’t working with advisors have the ability to select appropriate criteria. Fortunately, the DOL permits recordkeepers to provide information to plan sponsors about generally accepted criteria. So, that hurdle can be cleared.

Similarly, in a FAQ, the DOL permits recordkeepers to use the criteria in an investment policy statement and provide the plan sponsor with the list that those criteria produce, without the recordkeeper becoming a fiduciary for that purpose.

In that regard, the FAQ states:

The recordkeeper would not be treated as making a recommendation for purposes of the Rule if it provided a list of all of the investment alternatives available on the platform that meet the requirements of the plan’s investment policy statement.

The recordkeeper must apply the criteria to all of the investments that are available on its platform and then report the results. As you might imagine, that could, depending on the criteria selected by the plan sponsor, be a list of just a few funds or a list of hundreds of funds.

Unfortunately, if the recordkeeper further winnows the list of investments produced by the application of the generally accepted criteria or the IPS criteria, the recordkeeper could become an investment fiduciary. In that regard, the DOL has said:

However, if the recordkeeper exercises discretion in narrowing the response to a selective list of investment alternatives, in the Department’s view, the communication could constitute an investment recommendation for purposes of the Rule if a reasonable person would view the communication as a recommendation that the fiduciary choose investments from the selective menu screened by the recordkeeper.

My view is that this carve-out may not be particularly helpful . . . because recordkeepers cannot provide selective lists without running the risk of becoming fiduciaries. As a result, recordkeepers that do not want to be fiduciaries are likely to provide investment line-ups to advisors through wholesalers (see Angles #72) and through responses to RFPs and RFIs as described in Angles #73.

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

 

Share

Interesting Angles on the DOL’s Fiduciary Rule #73


DOL, plan sponsors, prudent, recordkeeper

Recordkeeper Investment Support for Plan Sponsors

This is my 73rd 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 Angles article #70, I discussed three areas where the fiduciary rule is impacting recordkeepers. Those are: acceptance of fiduciary status; non-fiduciary investment services for advisors; and non-fiduciary investment services for plan sponsors. Angles articles #71 and #72 discussed the first two points. This article discusses the third.

In the past, recordkeepers often provided sample line-ups to start-up plans and to existing plans that were transferring to their recordkeeping platform. However, under the new fiduciary definition, a selective list of investments is considered to be fiduciary investment advice, which means that the recordkeeper would need to make prudent recommendations and would be subject to ERISA’s prohibited transaction rules (e.g., for any proprietary investments and revenue sharing). Fortunately, there is an exception in the fiduciary regulation; unfortunately, though, the scope of the exception is limited. Let me explain.

The DOL’s fiduciary regulation—which applied on June 9, 2017—expands the definition of fiduciary advice. However, it also includes “carve-outs,” or exceptions, from the fiduciary definition. One of those exceptions is that fiduciary advice does not include a line-up of investments that is provided:

“ . . . In response to a request for information, request for proposal, or similar solicitation by or on behalf of the plan, identifying a limited or sample set of investment alternatives based on only the size of the employer or plan, the current investment alternatives designated under the plan, or both, provided that the response is in writing and discloses whether the person identifying the limited or sample set of investment alternatives has a financial interest in any of the alternatives, and if so the precise nature of such interest; . . .”

As a result, a recordkeeper can provide a plan sponsor with a sample list of investments (for example, for a 401(k) plan) without becoming an investment advisor fiduciary. However, the investment line-up can only be based on the size of the employer or the size of the plan, the plan’s current investment alternatives (if it is an existing plan), or both. In other words, the line-up cannot be customized for the particular plan (by, e.g., taking into account other factions). If it is customized, that would be fiduciary investment advice.

In addition, the sample line-up must be:

  • In response to a request for information, request for proposal, or similar solicitation by or on behalf of the plan.
  • In a written form which discloses whether the recordkeeper has a financial interest in any of the investments in the line-up and, if so, the precise nature of the interests must be described. That would include any proprietary investments and any investments that pay revenue sharing to the recordkeeper.

The sample list is limited to line-ups that would generally be proposed for plans or employers of a particular size (or be based on the line-up of an existing plan) and, therefore, would be of limited value to many plans, this RFP/RFI exception will likely provide some value to small, start-up plans which are serviced by advisors with little or no 401(k) experience and to plans that do not have advisors.

However, where plans do have advisors (even if they have limited experience with plans), the better approach would probably be the wholesalers exception, which was discussed in a prior post, Angles article #72.

Interestingly, if a recordkeeper goes beyond the limits of the RFP/RFI exception (for example, customizes the investment line-up), the recordkeeper will be a fiduciary to the plan, which implicates both the fiduciary standard of care and the prohibited transaction rules. Since recordkeepers commonly receive revenue sharing from a plan’s investments and, therefore, engage in prohibited transactions, they would need to comply with the transition rules for the Best Interest Contract Exemption. Those rules are: adherence to the best interest standard of care; receipt of no more than reasonable compensation; and not making materially misleading statements. For the duration of the transition period (until July 1, 2019), those requirements do not appear to be insurmountable. As a result, some recordkeepers may decide to provide fiduciary investment advice to plan sponsors, rather than use the RFP/RFI carve-out. To this point in time, though, I haven’t seen a movement in that direction.

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

 

 

Share

Interesting Angles on the DOL’s Fiduciary Rule #72


fiduciary, plan sponsors, prudent, recordkeeper

Advice to Advisors: The “Wholesaler” Exception

This is my 72nd 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 my Angles post #70, I discussed three issues for recordkeepers related to the fiduciary rule and exemptions. Angles #71 discussed the financial wellness programs developed by some recordkeepers. This article covers investment advice to advisors.

It is common knowledge that the recommendation of investments to a plan sponsor (that is, to a plan fiduciary such as a 401(k) committee) is fiduciary advice. However, it is less known that, under the new rules, investment recommendations made to fiduciary advisors is also considered fiduciary advice. And, since virtually every advisor to a plan, participant or IRA is now a fiduciary, that means that the presentation of sample investment line-ups to advisors can be fiduciary investment advice, resulting in a recordkeeper becoming a fiduciary. That is obviously problematic for the recordkeepers, but is also a problem for advisors and particularly for advisors who are not experienced in working with retirement plans.

Fortunately, though, there is at least a partial solution.

The fiduciary rules include an exception for fiduciary advice to “independent fiduciaries with financial expertise.” Simply stated, an independent fiduciary with financial expertise (or IFFE) is a broker-dealer, RIA, bank or trust company, or insurance company that is willing to serve as a fiduciary and who will, in that capacity, oversee the advisor who is providing fiduciary advice to a plan. This is sometimes refer to as the “wholesaler’s exception,” and it covers recommendations made by both recordkeepers’ wholesalers, and home office personnel.

Note that there is also an IFFE exception for advice to primary plan fiduciaries (e.g., plan committees) who oversee at least $50,000,000 in assets. However, that is a subject of another article.

The wholesaler’s exception permits recordkeepers to provide investment line-ups to fiduciary advisors, but not to plan sponsors. However, in a set of FAQs, the DOL noted that wholesaler recommendations could be made in the presence of a plan sponsor, so long as the fiduciary advisor was also at the meeting. So, the recordkeeper (and the wholesaler) can avoid fiduciary status by, for example, initially meeting with the advisor to discuss the investment line-up, and then making a presentation to the plan sponsor in the presence of the advisor (or, alternatively, having the advisor make the presentation, but with the wholesaler being able to provide comments and answer questions). It’s important to know, though, that it must be clear that the recommendations are being vetted by the fiduciary advisor so that, in a sense, the recommendations are technically fiduciary advice by the advisor and not by the recordkeeper/wholesaler. As a result, advisors should make sure that they approve of the recommendations either before they are presented or at the meeting.

In my experience, broker-dealers, RIAs, and banks and trust companies will ordinarily serve as fiduciaries for the advice given by their representatives and employees. As a result, recordkeepers and wholesalers will be able to provide investment advice to these representatives without becoming fiduciaries. However, insurance companies are generally not willing to serve as co-fiduciaries with their insurance agents, and that is particularly true of independent insurance agents and brokers. However, if the insurance agents are also registered representatives of a broker-dealer, that does not present a problem, since the broker-dealer can, from a fiduciary perspective, oversee advice about insurance products; as a result, the agents will have a financial institution to qualify as the IFFE.

As described above, where an insurance agent is only licensed to sell insurance, there will not usually be a financial institution that will serve as the IFFE. That presents a significant problem for the distribution of insurance products to plans, participants, and IRAs through independent insurance agents and brokers. While group annuity contracts can be recommended under Prohibited Transaction Exemption 84-24, and the agent or broker can receive a commission, a wholesaler cannot provide the independent agent or broker with a recommended line-up — without the wholesaler and the recordkeeper becoming fiduciaries.

If properly done, a possible solution would be for the independent insurance agent or broker to not make any recommendations about investments, but instead for the plan sponsor to utilize the services of a fiduciary on the platform, for example, a 3(21) or 3(38) platform fiduciary.

The IFFE exception will likely be embraced by the recordkeeper community. As a result, the common approach will be to provide investment line-ups to fiduciary advisors who are supervised by IFFEs. That does present an issue, though, for recordkeepers who sell directly to plan sponsors without the use of an advisor. My next article will discuss the RFP/RFI approach that can be used for that purpose.

POSTSCRIPT: This article does not discuss some of the requirements for satisfying the IFFE exception to the fiduciary definition. If an advisor or a firm intends to use that exception, it should only do so with legal guidance.

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

 

 

Share