What the new DOL definition of an investment advice fiduciary means for retirement plan advisers

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1 DOL Fiduciary Rule White paper What the new DOL definition of an investment advice fiduciary means for retirement plan advisers Christine Cushman, JD, LLM, CLU Summary I. The new definition of investment advice fiduciary II. III. IV. Making a recommendation Activities that are not recommendations Other ERISA fiduciaries V. ERISA fiduciary duties VI. rohibited VII. Exemptions to prohibited VIII. What the rule means for advisors IX. Reasonable compensation X. To be or not to be a fiduciary XI. Top 10 things to remember To ensure that participants benefits within employer-sponsored retirement plans were afforded certain levels of protection, Congress enacted the Employee Retirement Income Security Act ( ERISA ) in art of the protection provided in ERISA derives from the duties (and liability for breaching those duties) imposed on individuals and entities that are defined by ERISA as fiduciaries. Historically, the Department of Labor ( DOL ) has had the responsibility for defining who is and who is not a fiduciary for purposes of both ERISA and the Internal Revenue Code ( IRC ) with regard to the prohibited transaction rules. I. The new definition of investment advice fiduciary ERISA s definition of investment advice fiduciary includes any person who renders investment advice for compensation (direct or indirect) with respect to any assets of a plan or has any authority or responsibility to do so. 1 On April 6, 2016, the DOL issued final regulations with respect to this definition. In addition to updating the long-standing five-part test for determining when someone is an investment advice fiduciary, the new regulation expands the definition to include advice in the context of individual retirement accounts ( IRAs ) and distributions and rollovers. The new definition will affect both group and individual retirement plans directly and indirectly.

2 The final regulations provide that a person is an investment advice fiduciary if he or she receives direct or indirect compensation for a recommendation as to: > the advisability of acquiring, holding, or disposing of securities or other investment property (together Securities or Security ) or how such property should be invested after it is rolled over, transferred, or distributed from the plan or IRA; or > the management of Securities including or with respect to rollovers, distributions, or transfers from a plan or IRA; or whether, in what amount, in what form, and to what destination such a rollover, transfer or distribution should be made. The new definition also requires that: > the person represents or acknowledges that he or she is acting as a fiduciary; > the advice is rendered pursuant to a written or verbal agreement or understanding that the advice is based on the particular investment needs of the advice recipient; and > the recommendation is directed to a specific advice recipient regarding the advisability of a particular investment or management decision with respect to Securities or other investment property of the plan or IRA. II. Making a recommendation Advisers must first make a recommendation to be considered an investment advice fiduciary. A recommendation for purposes of the definition is: A communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action. Whether a recommendation has been made is an objective inquiry. The more individually tailored the communication is to a specific recipient the more likely the communication will be viewed as a recommendation. For example, if an adviser provides his client a select list of Securities that may be appropriate for investment, he has probably made a recommendation with respect to the advisability of acquiring Securities even if the adviser does not recommend any one Security. A series of actions that may not constitute a recommendation when viewed individually may amount to a recommendation when considered in the aggregate. For example, suppose an adviser is educating someone about variable annuities, generally describing the product s lifetime income and possible features such as living benefits, death benefits etc. The client then asks if the adviser has such an annuity that provides all of those benefits. It is possible that the conversation as a whole might be considered a suggestion to purchase the annuity. Finally, a recommendation may be initiated by a person or a computer software program (i.e. a robo-adviser). III. Activities that are not recommendations The final regulations include several activities that would not be considered a recommendation and thus not subject to a fiduciary standard. Such activities include: 2

3 Available to retirement plans only: > a transaction with an independent sophisticated fiduciary (i.e. a broker dealer, registered investment adviser or an independent fiduciary with more than $50 million in assets under management) > a platform provider marketing and making available investment platforms to plans without regard to individual plan/participant needs with appropriate disclosures > selection and monitoring assistance (such as identifying options meeting the plan fiduciary s specifications in connection with developing an investment platform or responding to a plan RF on a limited basis with respect to investments available on a platform, with appropriate disclosures) Available to both retirement plans and IRAs: > investment education including plan information, general financial, investment and retirement information, asset allocation models and interactive investment materials > general communications IV. Other ERISA fiduciaries ERISA s three-part definition of fiduciary conduct encompasses five separate fiduciary positions. Three positions are mandatory for all retirement plans the named fiduciary, the trustee and the plan administrator. The other two are optional the investment advice fiduciary (often called a 3(21) investment adviser) and investment manager (often referred to as a 3(38) investment manager). The investment advice fiduciary is a co-fiduciary sharing fiduciary responsibility for plan investments with the trustee. V. ERISA fiduciary duties All fiduciary positions, including an investment advice fiduciary, are subject to affirmative duties to the plan and the plan participants under ERISA. lan fiduciaries must discharge their duties solely in the interest of plan participants: > for the exclusive purpose of providing benefits and defraying reasonable expenses of administering the plan; > with the care, skill, prudence, and diligence of a prudent person in similar circumstances; > by diversifying investments of the plan so as to minimize the risk of large losses (unless under the circumstances it is not prudent to do so); and > in accordance with the terms of the plan and related documents, to the extent such documents are consistent with the provisions of ERISA. VI. ERISA prohibited ERISA also identifies prohibited conduct in which a fiduciary cannot engage. This conduct is known as a prohibited transaction or T and penalties and excise taxes may be imposed on a fiduciary who engages in a T. There are two types of Ts the party in interest ( II ) Ts and the fiduciary Ts. arty in interest prohibited A fiduciary, service provider, employer, employee, owner of a business, and certain relatives of any of the foregoing are all parties in interest to a plan. A II T involves any of the following between a plan and a II with respect to the plan: > selling, exchanging or leasing property (for example, the sale of investment products to the plan and the related payment to the broker, consultant, or adviser of a fee or commission) > lending money or extending credit (for example, a plan loan to a participant) > furnishing goods, services or facilities (for example, any provision of services to a plan for compensation, such as plan recordkeeping, trustee, consulting, and the like is prohibited absent an exemption) 3

4 > transferring plan assets to or using them for the benefit of a II (for example, paying a fee out of plan assets to an individual serving as trustee who is already receiving compensation as an employee of the employer sponsoring the plan). Fiduciary prohibited A fiduciary T involves the following: > fiduciary self-dealing; dealing with plan assets for his/her own interest > dual loyalties; cannot represent a party in a transaction involving plan assets whose interests are adverse to those of the plan > anti-kickback; cannot receive any consideration for his/her personal account from any party dealing with the plan in a transaction involving plan assets. VII. rohibited transaction exemptions Recognizing that a plan may need to engage in certain prohibited, ERISA provides relief in some circumstances. This relief comes in the form of prohibited transaction exemptions ( TEs ). While these exemptions allow IIs and fiduciaries to engage in the prohibited transaction, they do not absolve the adviser of his or her fiduciary duty. In addition to updating and expanding the definition of an investment advice fiduciary, the final regulations added the Best Interest Contract Exemption ( BICE ) and amended several existing exemptions including TE TE TE allows an adviser to receive reasonable insurance commissions (but not other forms of variable compensation such as marketing allowances, bonuses, perks, etc.) for advice related to fixed rate annuity contracts, including as an investment alternative in a retirement plan. The exemption requires that the adviser acknowledges fiduciary status, adheres to an impartial conduct standard and issues certain required disclosures. BICE Most retirement plan advisers, however, will need to rely on BICE to receive reasonable variable compensation Variable compensation is compensation that varies based on the investment recommendations such as a commission, revenue sharing payments or other transaction based fees. BICE can be used when an investment advice fiduciary provides investment advice to 401(k) and 403(b) plans (subject to ERISA) with assets less than $50 million. BICE requires that the adviser s financial institution (i.e., a registered investment adviser, bank, insurance company or registered broker/dealer) acknowledges fiduciary status, adheres to an impartial conduct standard and issues certain required disclosures. In addition, if advice is given with respect to an IRA, BICE further requires that the adviser s financial institution enter into a contract with the advice recipient. Compliance with the new definition of investment advice fiduciary must occur by April 10, 2017, with full compliance with BICE required by January 1, VIII. What the new fiduciary rule means for advisers Financial institutions are in the process of deciding whether they want to take on fiduciary responsibility under the new regulations and whether they are willing to let their advisers do so. Based on direction and input from their firms, advisers will also have a choice to make on whether they want to be a fiduciary or whether they want to move forward doing business in a nonfiduciary capacity. The following chart highlights differences between the two 4

5 Can engage in nonfiduciary activities Investment education General communications Independent sophisticated fiduciary Marketing and making available investment platforms Selection & monitoring assistance IX. Reasonable compensation rior to the issues of the new DOL regulations, a service provider to a plan could only avoid committing a T if the services were necessary and no more than reasonable compensation was paid for the service. 2 This determination was made by the plan fiduciary. Concerned that plan fiduciaries were not receiving enough information to make an informed decision about whether fees paid to a service provider were reasonable, the DOL issued regulations under ERISA section 408(b)(2) that required plan service providers to provide the plan fiduciary with information about the services provided and any direct or indirect compensation that was paid for these services. Investment Advice Fiduciary Now under TE and BICE, for an investment advice fiduciary to receive variable or third party compensation, the adviser and his or her financial institution must first determine that the fees they are charging are reasonable within the meaning of section 408(b)(2). This requirement is in addition to the requirement under that section that a plan fiduciary also determine that the plan is paying no more than reasonable compensation for the service. The financial institution and the adviser should: > Look at the facts and circumstances at the time of the recommendation Nonfiduciary Financial Adviser Subject to FINRA suitability standard Subject to II Ts Subject to fiduciary Ts Subject to fiduciary duties Subject to ERISA best interest standard > Consider compensation paid to the financial institution, adviser, affiliates and related entities > Consider the value of all services and benefits provided for the charge in assessing reasonableness. 3 The DOL is clear that the standard to apply is a marketbased standard. Ask: What is the market value of the services, rights and benefits the adviser and its financial institution are delivering? Note, however, that what is customary may not be appropriate or reasonable if, for example, the fees are not transparent or bear little relationship to the value of the services offered. Though no single factor is dispositive in determining whether compensation is reasonable, factors that can impact whether compensation is reasonable include: > the complexity of the product > market pricing of services provided > scope of monitoring > market pricing of the underlying assets > whether or not the compensation is level across types of product sales The DOL has also pointed out that: > An adviser does NOT have to recommend the transaction that is the lowest cost or that generates the lowest fees > Financial institutions may seek impartial review of their fee structures to safeguard against abuse 5

6 > Fiduciaries and service providers may NOT charge more than reasonable compensation even if another fiduciary signs off on the compensation. Finally, note that reasonable compensation is just one component of an investment recommendation which is subject to an overarching best interest standard. For any particular situation, compensation may be reasonable but the investment may still not be in the client s best interest. X. To be or not to be a fiduciary With the introduction of the new DOL fiduciary rules, retirement plan advisers have decisions to make on how they want to conduct business as they work with their retirement plan clients. They can become an investment advice fiduciary providing advice to the plan (and participants) that is prudent and in the plan s best interest, charging reasonable compensation and avoiding conflicts of interest. Or they may attempt to avoid fiduciary status by providing education and selection and monitoring assistance only. Whatever decisions they make, a solid understanding of the new DOL regulations is critical to the retirement plan adviser s future success. XI. Remember The new DOL regulations are voluminous and complex. Here are ten things an adviser needs to remember about them. 1. The biggest changes to the definition of an investment advice fiduciary are the inclusion of distributions and rollovers, and the fact that more advisors to IRAs will be included in the definition. 2. Investment advice must include a recommendation. No recommendation, no advice. 3. Not all interactions with clients will be considered fiduciary actions. 4. Some advisers may choose to only provide clients with education to avoid becoming a fiduciary. 5. Advisers will be required to adhere to certain fiduciary duties and a best interest standard. 6. Fiduciary advisers will need to engage in a prudent process when they give advice. 7. There are some actions that ERISA prohibits an adviser from engaging in unless an exemption applies. 8. Whether or not advisers choose to comply with an exemption will impact how they can be paid. 9. TE can be used to receive insurance commissions on fixed rate insurance products. 10. BICE will allow advisers to receive commissions on variable products, small 401(k) plans (less than $50 million) and IRAs. 1 ERISA section 3(21)(A)(ii). 2 ERISA section 408(b)(2). A similar rule found in IRC section 4975(d)(2) applies to IRAs. 3 For example, in the case of compensation paid for an annuity that includes services and the purchase of guarantees and financial benefits, it is appropriate to consider the value of the guarantees and benefits in assessing reasonableness. 6

7 Federal income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers or registered representatives gives legal or tax advice. You should consult an attorney or competent tax professional for answers to specific tax questions as they apply to your situation. Nationwide, the Nationwide N and Eagle and Nationwide is on your side are service marks of Nationwide Mutual Insurance Company NM-3301AO (12/16) 7