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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Investment Advice to Plans Under the DOL’s Fiduciary Rules


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

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

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

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

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

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

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

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

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More Thoughts on Distributions and Rollovers


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

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

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

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

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

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

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

 

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Distribution and Rollover Education


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

There are two issues.

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

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

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

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

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The Year of the Fiduciary Rule


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

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

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

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

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

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

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

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

 

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What Was Hot in the Second Quarter of 2015


DOL, fiduciary, prohibited transaction

In April, I wrote that the “hot” issues on my desk for the first quarter were: the prospect of the DOL’s fiduciary proposal; allocation of revenue sharing in 401(k) plans; and capturing of rollovers from retirement plans.

Those continued to be the top issues in the second quarter. In fact, two of the issues “merged” in the sense that the hottest issue in the fiduciary proposal is distributions from retirement plans and the capturing of rollovers.

With that in mind, here is a brief description of the hot issues in the second quarter:

  • By the end of June, most people were at least generally familiar with the fiduciary “package,” including the proposal to expand the definition of fiduciary advice and the two prohibited transaction exemptions that apply to the “sales” process. With the July 21 deadline for comments rapidly approaching, the work shifted from education to the preparation of comment letters. Generally stated, that work fell into three categories:
    • Requests for clarifying and limiting the definition of fiduciary advice. For example, the proposal says that a recommendation specifically directed to a person could be fiduciary advice. In theory, that could be a general mailing to thousands of people, but with each letter having a specific addressee. I can’t imagine that the DOL intends for it to be that broad. So, that will likely be limited or, at least, clarified so that only includes specific, rather than general, recommendations. There will likely be some changes to the fiduciary definition, but the final version will probably be much the same as the proposal. So, expect most sales practices to fall under the fiduciary advice definition.
    • Comments to clarify Prohibited Transaction Class Exemption 84-24. These comments are primarily for clarification of some of the conditions. This exemption applies to insurance products that are sold to plans and IRAs (other than individual variable annuities that are sold to IRAs, which are under the Best Interest Contract Exemption, BICE, see below). While the DOL will probably modify and clarify 84-24, it is unlikely that major changes will be made to this exemption.
    • Comments requesting material changes to the Best Interest Contract Exemption. This proposed exemption applies to all other sales and recommendations. The DOL is likely to make significant concessions in its re-write and finalization of this exemption, particularly regarding financial disclosures.

Note that, though, for large plans, there is a sales “carve-out” from the fiduciary rule. However, for small plans, there is not. In other words, for small plans, sales would generally be considered to be fiduciary advice.

Also BICE only applies to certain transparent and/or highly regulated investments, such as mutual funds, bank deposits and insurance contracts. In other words, sales of other investments, such as private equity funds and hedge funds do not have an exemption and, thus, can only be recommended where compensation to the adviser, the adviser’s financial institution, and all affiliated entities is level. That virtually eliminates recommendations of proprietary products of those types.

  • With regard to revenue sharing, the current issue is whether or not it should be “levelized” or “equalized.” Simply stated, the issue is whether the revenue sharing (such as 12b-1 fees and subtransfer agency fees) that is generated by a particular mutual fund should be allocated back to the participants who own that mutual fund. The fundamental question is whether it is fair, or even prudent, for some participants to be invested in high expense funds that pay revenue sharing, while others are lower expense fund that do not pay revenue sharing . . . and the cost of the plan is either entirely or largely borne by the revenue sharing. In other words, is it equitable for a subset of participants to be charged for all or substantially all of the cost of operating a plan . . . through the revenue sharing that their investments generate . . . and through the additional expense that supports those payments? Some providers and plan sponsors have decided that it is not.

Those are the key issues that were on my desk in the second quarter. In the Fall, we will look at the hot issues for the third quarter.

 

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Impact of the DOL’s Fiduciary Proposal on Participant Investment Advice


DOL, fiduciary, prohibited transaction

This client alert, written by Fred Reish, Bruce Ashton, Brad Campbell, Joan Neri, and Josh Waldbeser, from the Drinker Biddle Employee Benefits and Executive Compensation Group, summarizes our conclusions about the impact on participant investment “recommendations” of the Department of Labor (DOL) proposal to expand the definition of fiduciary investment advice.  We also discuss the proposed “Best Interest Contract” Exemption (BICE) permitting financial institutions to receive variable and indirect compensation based on advisor recommendations.

The proposal would significantly impact broker-dealers in assisting participants.  (We use “advisors” to mean a broker-dealer’s registered representatives and/or investment advisor representatives where the firm is dual registered.  For the impact on independent RIAs, see RIA Alert; for the impact on sales of insurance products, see Insurance Products Alert.)

Here are our conclusions, and a link to our more in-depth analysis:

  • The proposal expands the definition of fiduciary investment advice by providing that a “recommendation” to a participant would trigger fiduciary status.  A “recommendation” is a communication that would reasonably be viewed as a “suggestion” that a participant engage in or refrain from a particular course of action.  Under this standard, many common sales and investment education practices would constitute fiduciary advice.
  • Advisors could provide generalized investment education to participants without triggering fiduciary status and prohibited transaction (PT) concerns, if they avoid “recommendations.”  But this will be challenging – under the proposal, referencing available investment options would likely be a fiduciary act.
  • Broker-dealers receive 12b-1 fees and other variable/indirect compensation from investment products they sell.  Advisors who recommend investments to participants influence this compensation.  This would constitute a “fiduciary self-dealing” PT under the proposal, and exemptive relief is needed.
  • BICE would provide an exemption permitting broker-dealers to receive variable and indirect compensation based on their advisors’ non-discretionary recommendations.  However, BICE imposes disclosure and other requirements that may be practically impossible, or prohibitively expensive, to comply with.
  • Broker-dealers and advisors could instead rely on the Pension Protection Act (PPA) exemptions for non-discretionary participant advice, but this provides limited relief and compliance is challenging.
  • For participant non-discretionary investment advice and discretionary management, advisors could use a third-party computer-based asset allocation service – permitted in the DOL’s “SunAmerica” advisory opinion – since the advisor wouldn’t be influencing the broker-dealer’s compensation through its own recommendations.

This is a brief summary of our conclusions.  For the rationale for these conclusions, see our analysis here.

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The Impact of the DOL’s Fiduciary Proposal on Sales of Insurance Products


DOL, fiduciary, prohibited transaction

This client alert, written by Fred Reish, Bruce Ashton, Brad Campbell, Joan Neri, and Josh Waldbeser, from the Drinker Biddle Employee Benefits and Executive Compensation Group, states our conclusions about the impact of the Department of Labor (DOL) proposal to expand the definition of fiduciary investment advice and to modify prohibited transaction (PT) exemptions on sales of insurance products to plans, participants and IRAs.

The proposal affects insurance agents, insurance brokers and pension consultants who receive commissions for selling insurance or annuity contracts to plans and IRAs. (We refer to them collectively as “Insurance Advisors.”) The DOL’s proposal materially expands the definition of fiduciary investment advice to include common investment sales practices. As a result, we use “sales” in this Alert to refer to fiduciary recommendations of insurance products.

Here are our conclusions along with the link to our more in-depth analysis:

  • Conclusion No. 1: PT relief for the receipt of sales commissions has been available under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary” Insurance Advisors of fixed and variable insurance products to plans and IRAs, and this will continue (but with some changes).  Under the proposal, the PTE will continue to be available for sales of fixed and variable products to plans and participants, and for sales of fixed annuity products to IRAs. (By “fixed,” we mean insurance products that are not treated as securities.) However, for IRAs 84-24 relief will not be available for insurance products that are treated as securities under federal securities laws “annuity securities”).  To satisfy the conditions of the exemption, the Insurance Advisor and the insurance company would need, among other things, to comply with “Impartial Conduct Standards.”  That is, they would need to act in the best interest of the plan, participant or IRA in making recommendations.  Also, Insurance Advisors and their affiliates would not be able to receive revenue sharing, administrative and marketing fees.  
  • Conclusion No. 2: Under the expanded re-definition of fiduciary, recommending a distribution or rollover or making recommendations about the investment of property to be distributed or rolled over also constitutes fiduciary investment advice.  As a result, Insurance Advisors making these recommendations would be considered fiduciaries, would be subject to the ERISA PT rules, and would need exemptive relief to avoid the adverse consequences of a PT.
  • Conclusion No. 3: The exemption for sales of insurance products that are securities under federal securities laws, such as variable annuities, was transferred to the proposed “Best Interest Contract Exemption” or “BICE,” which has a number of new and difficult conditions.

These rules are complex and this email provides a brief summary of our conclusions.  To understand the rationale for these conclusions, see our analysis.

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


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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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