- Where an investment adviser charges different fees for managing fixed income in a portfolio than for managing equities, and has discretion to determine the allocation between the two in an IRA, the investment adviser has control over its fees, which appears to violate a prohibited transaction provision in the Internal Revenue Code.
- The inadvertent violation can be corrected, going forward, by using a blended rate where both allocations are charged the same fee. In other words, there would just be an account fee and not a fee that varied by allocations that are within the control of the investment adviser.
- There are other potential solutions, including transitioning the allocations to nondiscretionary advice.
Both the Internal Revenue Code (Code) and the Employee Retirement Income Security Act of 1974 (ERISA) include prohibited transaction provisions that literally prohibit certain transactions (unless exempted by statute or by a prohibited transaction exemption). ERISA-governed qualified retirement plans are subject to both ERISA and Code prohibitions. However, standalone IRAs are only subject to the Code prohibitions. In that regard, Code sections 4975(c)(1)(E) and (F) provide:
(c) Prohibited transaction
(1) General rule
For purposes of this section, the term “prohibited transaction” means any direct or indirect—
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
In plain English, subparagraph (E) means that a fiduciary adviser cannot manage an IRA’s investments in a way that benefits the adviser beyond the negotiated advisory fee. For example, a fiduciary adviser could negotiate a fee of 1% (or 100 basis points) for managing an equity portfolio and 70 basis points for managing a fixed income portfolio without a problem (so long as the amounts are reasonable for the services rendered). But, when the fiduciary adviser can move money from one portfolio (or part of a portfolio) to another, and the fees are increased by that movement of money, the adviser has dealt with the assets of the “plan” (which includes IRAs) for his own interest. It is even conceivable that the IRS could take the position that, if the fiduciary adviser has discretion to allocate all of the portfolio to fixed income investments, any allocation to equities (with the higher fees) would be a prohibited transaction.
As an extreme example, if the adviser in this hypothetical scenario managed one-half of a portfolio in equities (for a fee of 100 basis points) and one-half in fixed income (for 70 basis points), but then, with unilateral discretion moved the fixed income allocation to equities—thereby increasing the adviser’s fees on those assets to 100 basis points, it appears that the fiduciary adviser would have used its discretion for its own interest or account, which is a prohibited transaction.
Before going further, I should point out that ERISA defines a fiduciary adviser to include any adviser that manages IRA or plan assets with discretion—in a sense, a one-part test, which is, does the adviser have discretion. To quote the regulation (§ 2510.3-21(c)(1)), a person is a fiduciary if:
Such person either directly or indirectly (e.g., through or together with any affiliate) –
(A) Has discretionary authority or control, whether or not pursuant to agreement, arrangement or understanding, with respect to purchasing or selling securities or other property for the plan;…”
To avoid confusion that could result from the use of the word “plan” in the quoted language, that term includes IRAs for purposes of the prohibited transaction rules. (See Code section 4975(e)(1).)
Going back to the example, if the fiduciary adviser had instead used a blended fee of, e.g., 85 basis points, the adviser could have discretion to reallocate the investments between equities and fixed income without running afoul of this prohibited transaction rule—because those changes did not and could not increase the adviser’s fees.
An alternative solution would be to change the allocation to nondiscretionary—that is, changes to the allocations could only be done only with client consent, and then to rely on, and comply with, Prohibited Transaction Exemption 2020-02. For firms that are already complying with that PTE (for example, to recommend rollovers), that is a workable approach that would allow the adviser to retain the different fee levels for fixed income and equities (and possibly for additional asset classes) while complying with the rules.
Both of these solutions require thought and documentation. As a result, they should only be implemented in consultation with an attorney who is knowledgeable about these issues and rules.
While this article focuses on allocations among asset classes where the adviser charges different fees, the prohibited transaction rules apply to any use of the income or assets for the benefit of a fiduciary adviser. That would include, for example, the inclusion of proprietary investments (e.g., mutual funds) in managed accounts. The issues for that type of arrangement are even more complex. For example, there is an exemption that permits the receipt the higher of the two fees (that is, the account fee or the fund fee), but that approach has not an attractive option in most cases. The use of a nondiscretionary approach under PTE 2020-02 offers opportunities to firms that are willing the comply with the conditions of the exemption.
At the beginning of the article, I also quoted subparagraph (F) of the Code’s prohibited transactions. It is a slightly different prohibition. For example, it could apply to payments from custodians and 12b-1 fees (or other payments) from mutual funds or their affiliates. But that is for another article in the future.
It is clear that regulatory and enforcement attention is turning to rollover IRAs—witness PTE 2020-02. I think that the regulators’ attention will also extend to IRAs more generally. As a result, now is the time to review practices related to advice to IRAs and to ensure that the practices of investment advisers (and other investment professionals) are complying with ERISA and the Internal Revenue Code, and particularly with the prohibited transaction rules. This article will help identify some of the practices that could be problematic.