The US Department of Labor (“DOL”) is proposing to allow conflicted fiduciary investment advice to retirement plans, participants, and IRAs (who are collectively referred to as “Retirement Investors”). This article discusses the proposal and its likely impact on broker-dealers and investment advisers.
As background, ERISA and the Internal Revenue Code (“Code”) prohibit fiduciary advice to plans and participants where the financial professional can earn additional compensation if the recommendation is accepted by the plan fiduciaries or the participants. The Code also prohibits that type of conflicted advice to IRAs, as well as to plans and participants. The prohibitions are absolute, but exceptions can be made through “prohibited transaction exemptions.” For historical reasons, the DOL has the authority to issue exemptions for both ERISA and the Code.
The proposal, if finalized, will exempt conflicted fiduciary advice (that is, nondiscretionary recommendations) that result in variable compensation for financial professionals (and their supervisory entities, e.g., broker-dealers or RIA firms), if its conditions are met. There are several sets of conditions; the one that will most directly affect financial professionals is that the financial professional and the supervisory entity must comply with the Impartial Conduct Standards. Those standards are:
- The investment advice must be in the best interest of the Retirement Investor. The best interest standard is a combination of ERISA’s prudent man rule and duty of loyalty. This standard is virtually the same as the standard of care in the SEC’s Regulation Best Interest (“Reg BI”) for broker-dealers and is very close to the SEC’s standard of care for investment advisers. As a result, it is fair to say that the duties of care for financial professionals are being harmonized.
- The compensation received by the financial professional and the supervisory entity cannot exceed a reasonable amount relative to the services rendered. In addition, the requirement in the securities laws for “best execution” must be satisfied.
The limitation to reasonable compensation is unique to ERISA and the Code. While financial professionals to plans will be familiar with this requirement, financial professionals to IRAs (and their supervisory entitles) will need to pay closer attention to the levels of compensation. That is because, if the conditions of an exemption are not satisfied, the consequence is loss of the revenue associated with the advice. From a practical perspective, there will probably be benchmarking services that help with the determination of the reasonableness of compensation—which is a market-driven concept. An issue for IRAs (both individual retirement accounts and individual retirement annuities) is that there are so many categories of investments and of related services. One possible result is that compensation for different types of investments and annuities could become more uniform.
- Statements by the financial professional and the supervisory entity about the recommended transaction and other relevant matters cannot be materially misleading. This requirement is consistent with other laws and therefore does not create new administrative burdens.
In addition to the Impartial Conduct Standards, there are requirements for:
- Disclosures. Retirement Investors must be given a written acknowledgement of fiduciary status and written descriptions of the services to be provided and the material conflicts of interest. These do not need to be unique disclosures. For example, Form CRS, Form ADV, and other securities disclosures can be used. However, the acknowledgement of fiduciary status under the Code and ERISA will be new.
- Policies and Procedures. The supervisory entities will need to develop and enforce written policies and procedures to promote compliance with the exemption’s requirements. A unique requirement in this part of the exemption is that supervisory entities will need to document the specific reasons why any of the following recommendations are in the best interest of a particular Retirement Investor: to roll over from a plan to another plan or an IRA; to roll over from an IRA to a plan; to roll over from an IRA to another IRA; or to change from one type of account to another (e.g., from a commission-based account to a fee-based account).
To compound matters, the DOL is taking the position that, if a financial professional is already giving financial advice to an individual about investing in securities (e.g., personal assets), a subsequent recommendation to roll over to an IRA with the financial professional would be advice that is given on a “regular basis ”, thus satisfying one prong of the 5-part fiduciary definition (and making it much easier to assert that the financial professional is a fiduciary). Similarly, if a financial professional recommends a rollover contemplating that the money will go into an IRA where the financial professional will provide ongoing financial advice, then the arrangement satisfies the “regular basis” prong of the fiduciary definition. That is a change from the DOL’s prior position and will result in a significant expansion of fiduciary status for financial professionals and their supervisory entities.
- Retrospective Review. The supervisory entity (e.g., broker-dealer or RIA firm) must, at least annually, conduct a retrospective review of the advice subject to the exemption for the purpose of detecting and preventing violations of the Impartial Conduct Standards and the policies and procedures requirement. The review must be formalized in a written report. The CEO of the entity must then sign off on that report.
While it is possible that broker-dealers will allow their registered representatives to provide conflicted fiduciary advice to plans and participants under this exemption, it seems like the retirement world has, for the most part, moved to level-fee investment advice. However, the exemption could have a significant impact in two areas: rollover recommendations and advice to IRAs.
The DOL has taken an expansive—and controversial—position in saying that a continuous financial relationship with a participant’s individual investments could support fiduciary status for the rollover recommendation. Nonetheless, that is the DOL’s position and broker-dealers and investment advisers should take note. That means that they will either need to prohibit those recommendations and only permit rollover “education” or, alternatively develop compliant rollover programs, which consider the investments, costs, and services in the plan and the rollover IRA. After gathering and evaluating that information, financial professionals will need to make recommendations that are in the best interest of the participants (for example, either to leave the money in the plan or roll it over into an IRA).
With regard to advice to IRAs, my experience is that it’s common for financial professionals of both broker-dealers and RIAs to provide financial recommendations on an ongoing (or “regular”) basis and to satisfy the 5-part test for fiduciary status. In that case, the supervisory entities will likely take advantage of the exemption, including implementing complaint policies and procedures, and performing the retrospective annual analysis. That will also require those firms to develop processes for determining reasonable compensation for each category of investments that they offer.
The conflicts for broker-dealers are easy to identify because of the transaction-based nature of the compensation. That would include, for example, commissions, front-end loads for mutual funds, 12b-1 fees, and revenue sharing.
The conflicts that could impact both broker-dealers and investment advisers include rollover recommendations and recommendations to transfer IRAs from another firm.
In my experience, a conflict for some RIAs is the receipt of revenue sharing paid by custodians. Of course, any payments from third parties to RIAs resulting from investment recommendations could be prohibited conflicts under current rules. However, they would be allowed under the proposed exemption, if the conditions are satisfied.
All in all, the proposal goes a long way-but not all the way-in harmonizing the guidance issued last year by the SEC for broker-dealers and investment advisers. However, it does create new compliance burdens, and financial professionals need to understand those compliance issues.
Keep in mind that this is just a proposal. However, there is a good chance that it could be finalized by the end of this year.
To learn more, please contact your Hartford Funds representative.