“This rulemaking would amend the regulatory definition of the term fiduciary set forth at 29 CFR 2510.3-21(c) to more appropriately define when persons who render investment advice for a fee to employee benefit plans and IRAs are fiduciaries within the meaning of section 3(21) of ERISA and section 4975(e)(3) of the Internal Revenue Code. The amendment would take into account practices of investment advisers, and the expectations of plan officials and participants, and IRA owners who receive investment advice, as well as developments in the investment marketplace, including in the ways advisers are compensated that can subject advisers to harmful conflicts of interest. In conjunction with this rulemaking, EBSA also will evaluate available prohibited transaction class exemptions and propose amendments or new exemptions to ensure consistent protection of employee benefit plan and IRA investors.”

Before getting into the anticipated changes in the new proposals, here is background information for context.

 

Background

The new regulatory proposal is already being referred to as “Fiduciary 4.0.” The 1.0 rule was the original 1970s regulation defining fiduciary advice. The vacated Obama-era regulation and exemptions are called Fiduciary 2.0. The Trump-era Prohibited Transaction Exemption (PTE) 2020-02, and its expanded definition of fiduciary advice is known as 3.0. 

Under all of the existing fiduciary rules and almost certainly under the anticipated proposal, discretionary investment management is fiduciary advice. There is no exception to that. 

The proposed fiduciary definition will cause more financial professionals to be fiduciaries. 

Fiduciary 1.0 gave us the 5-part test for fiduciary status for non-discretionary recommendations. Fiduciary 2.0 would have dramatically expanded that definition, but of course, when it was vacated, that expanded definition went away and the old 5-part test was re-instated. In Fiduciary 3.0 (that is, PTE 2020-02), the DOL didn’t re-write the 1.0 rule; instead, it re-interpreted it, giving more expansive readings to some of the parts of the 5-part test. The effect was, in some ways, the same as a re-writing, in the sense that it “captured” many more financial professionals, and their firms, within the fiduciary definition. That’s particularly true of rollover recommendations and investment advice to IRAs.

The expanded 5-part test, and in all likelihood, the upcoming proposal, apply to recommendations to ERISA retirement plans, participants in those plans (including rollover recommendations), and individual retirement accounts and individual retirement annuities. The three of those are collectively referred to as “retirement accounts” and “retirement investors.” It is recommendations to those accounts and investors that will be covered by the new proposals.

The focus of rules 2.0 and 3.0 have been primarily on conflicts of interest. The role of the fiduciary definition in that context is that a fiduciary is prohibited from making recommendations that result in the receipt of money or anything of monetary value to the financial professional, his or her firm, or an affiliate. Those conflicts of interest are prohibited under ERISA and the Internal Revenue Code. Without an exception, the compensation from transactions recommended by a fiduciary would be strictly prohibited. But those exceptions, called exemptions, are not for free. They come with strings attached. The “strings” are called conditions and they can, and likely will be, demanding.

 

The Proposed Fiduciary 4.0

In the language quoted earlier about the DOL’s agenda, the DOL said:

“This rulemaking would amend the regulatory definition of the term fiduciary set forth at 29 CFR 2510.3-21(c) to more appropriately define when persons who render investment advice for a fee to employee benefit plans and IRAs are fiduciaries within the meaning of section 3(21) of ERISA and section 4975(e)(3) of the Internal Revenue Code. The amendment would take into account practices of investment advisers, and the expectations of plan officials and participants, and IRA owners who receive investment advice, as well as developments in the investment marketplace….”

It shouldn’t be a surprise that “more appropriately define” means that the proposed fiduciary definition will cause more financial professionals to be fiduciaries. For example, the proposal could say that, when a financial professional holds himself or herself out as being in a relationship of trust and confidence with a retirement investor, it will result in a fiduciary relationship. Think about that. If a financial professional gives a retirement investor a Form CRS that says that the financial professional will act in the best interest of the retirement investor, would a reasonable retirement investor conclude that he or she was in a relationship of trust and confidence?

Alternatively, the DOL could be working on reducing the 5-part test to a one-part test, such as expanding the fiduciary definition to include any investment advice to a retirement investor, even on a one-time basis, as fiduciary advice. In that case, for example, any recommendation of an investment, an annuity, or an investment service, would be fiduciary advice.

Either way, or any other way, the DOL is almost certain to materially expand the definition of who is a fiduciary.

If finalized in that way, it will have two major consequences. First, almost any recommendations to ERISA retirement plans or their participants will be fiduciary advice, subject to the prudent man standard of care and duty of loyalty. That’s significant, since breaches of ERISA’s fiduciary standards can be enforced by private rights of action. Second, it will significantly increase the number of conflicted recommendations that are prohibited transactions and that therefore will require the use of a prohibited transaction exemption. Because of that, the DOL will be issuing new exemption proposals. As the DOL said on its agenda: “In conjunction with this rulemaking, EBSA also will evaluate available prohibited transaction class exemptions and propose amendments or new exemptions to ensure consistent protection of employee benefit plan and IRA investors.”

The proposed exemptions will have new conditions that must be satisfied. I expect that they will be similar to the conditions in PTE 2020-02, for example, a best interest standard of care (a fiduciary process and a duty of loyalty), no more than reasonable compensation, declaration of fiduciary status, descriptions of conflicts, mitigation of conflicts, and perhaps an annual summary of compliance.

The changes will primarily impact rollovers, sales of annuities, and recommendations to IRAs. 

Concluding Thoughts

I anticipate that the changes will primarily impact rollovers, sales of annuities, and recommendations to IRAs.

I doubt that it will have much effect on advice to ERISA retirement plans, because that world largely moved to level fee investment advice. In the case of a level fee, there is not a fiduciary violation for providing either nondiscretionary advice or discretionary management. Financial professionals can negotiate their fees at arm’s-length and then provide their advisory services without conflicts.

However, rollover recommendations almost always involve a conflict. Even if a financial professional advises a plan, the professional will charge more (e.g., basis points) for advice to a rollover IRA than what is being charged to the plan.

Any transaction-based compensation, though, necessarily involves a conflict that would be prohibited if the anticipated fiduciary definition is broad enough to capture all recommendations to retirement investors. And that is a real possibility. As a result, any rollover recommendation to a participant, any recommendation of an individual retirement annuity, and a commission-based recommendation to an IRA investor, could result in a prohibited transaction. In that case, an exemption would be needed and its conditions would have to be satisfied. It’s reasonable to expect those conditions to be similar to what is in PTE 2020-02 (as described above).

While the timing of the new proposals isn’t clear, a reasonable expectation would be that they would be released in the April to June time frame. Allowing for time to write the final rules in light of comments from the private sector, it’s possible that these rules could be effective by the end of this year.