The Expanding Legal Requirements for Rollover IRAs

Transcription

1 The Expanding Legal Requirements for Rollover IRAs By Fred Reish Partner, Drinker Biddle & Reath LLP PlanAdvisorTools.com Provided compliments of Virtus Investment Partners

2 The Expanding Legal Requirements for Rollover IRAs by Fred Reish Partner, Drinker Biddle & Reath LLP Background and Introduction More than $1 trillion will be rolled into Individual Retirement Accounts (IRAs) over the next five years 1. The implications of that cascade of money is causing growing concern among regulators. The focus of the regulators is on service providers who are involved in the rollover process, which include broker-dealers, Registered Investment Advisers (RIAs) and recordkeepers. This article discusses recent guidance on distributions from defined contribution plans and rollovers to IRAs and the impact of that guidance on advisors. For clarification, this article refers to broker-dealers as non-fiduciary advisors and their representatives as financial advisors. (We recognize that a financial advisor may become a functional fiduciary when providing individualized investment advice based on the particular needs of a plan or a participant.) In addition, this article refers to registered investment advisers (RIAs) and their representatives as fiduciary advisors (even though it s conceivable than an RIA could be providing services to a plan as a non-fiduciary). History of Guidance The first regulatory initiative was the Department of Labor (DOL) Advisory Opinion A. In a nutshell, the opinion stated that when capturing rollovers to IRAs from retirement plans, non-fiduciary advisors faced few, if any, hurdles. However, the DOL went on to say that fiduciary advisors could be considered fiduciaries for distributions if they make recommendations about distributions and rollovers. As fiduciaries, they would need to satisfy the prudent man standard in making distribution recommendations, and could potentially engage in prohibited transactions if their fees inside the IRA are higher than they were in the plan. In my opinion, for fiduciary advisors, the easiest way to avoid these complications is to educate participants and recommend distributions. The DOL s advisory opinion is the only significant guidance in this area in eight years. As a result, most people believed that broker-dealers were largely unregulated in the distribution and rollover process, while the role of RIAs was highly regulated and complex to navigate. But that changed last year; the Financial Industry Regulatory Authority (FINRA) is now taking several steps to more tightly regulate broker-dealers in this area. The guidance issued by FINRA includes: Visit or call us at for more information. 1 The Intelligent Investor, Who s Training Your Retirement Navigator?, Jason Zweig, WSJ.com (Feb. 14, 2014) 2

3 Regulatory Notice Report on Conflicts of Interest 3 Regulatory Notice Investor Alert: The IRA Rollover: 10 Tips to Making a Sound Decision 5 In addition, both FINRA and the U.S. Securities and Exchange Commission (SEC) listed rollovers to IRAs as 2014 Examination Priorities 6. In its Examination Priorities, the SEC said that it would look at the practices of both broker-dealers and RIAs in capturing rollovers to IRAs. The balance of this article focuses on FINRA s Regulatory Notice 13-45, and its guidance on suitable recommendations. However, that guidance should not be viewed as limited to broker-dealers. The Employee Retirement Income Security Act (ERISA) fiduciary standard is generally considered to be a higher standard of care than the suitability standard. One reason is that, under ERISA s fiduciary standard, an advisor must engage in a prudent process to develop recommendations and must put the interests of the participant first. In that context, an advisor cannot make fiduciary recommendations that provide additional financial benefits to the advisor (because of the prohibited transaction rules in ERISA section 406(b). As a result, it is plausible, and perhaps likely, that the new FINRA considerations will be considered relevant when making a fiduciary recommendation. Discussion of FINRA Regulatory Notice In Regulatory Notice 13-45, FINRA asserted jurisdiction by taking the position that a recommendation to take a distribution from an ERISA, participant-directed defined contribution plan (e.g., a 401(k) or ERISA 403(b) plan) is inherently a recommendation to liquidate the investments in a participant s account. As a result, FINRA views the distribution recommendation as an investment recommendation, which means that the suitability standard applies. Based on that analysis, FINRA states that the suitability rules require that financial advisors and brokerdealers consider certain factors in developing suitable recommendations about distributions. While the DOL has not taken a similar stance, in the future it could take the position that a recommendation to take a distribution is inherently a recommendation to liquidate the investments in a participant s account and, therefore, it could be a fiduciary recommendation. In that case, a fiduciary advisor would need to engage in a prudent process to develop the distribution recommendation and would need to take steps to avoid prohibited transactions. 2 FINRA Regulatory Notice 13-23, Brokerage and Individual Retirement Account Fees (July 2013). 3 FINRA Report on Conflicts of Interest, October It labels 401(k) distributions as key liquidity events and adds: The recommendations a representative makes at this stage of an investor s life have profound implications for the investor and deserve thorough scrutiny and review. (Emphasis added.) (See page 4.) 4 The Intelligent Investor, Who s Training Your Retirement Navigator?, Jason Zweig, WSJ.com (Feb. 14, 2014). 5 FINRA Regulatory Notice 13-23, Brokerage and Individual Retirement Account Fees (July 2013). 6 FINRA Report on Conflicts of Interest, October It labels 401(k) distributions as key liquidity events and adds: The recommendations a representative makes at this stage of an investor s life have profound implications for the investor and deserve thorough scrutiny and review. (Emphasis added.) (See page 4.) 3

4 However, FINRA goes on to say that, if the financial advisor provides education to participants, but not recommendations, the suitability standard would not apply. I believe that, while the DOL guidance is not clear on this point, a similar analysis would apply to fiduciary advisors to plans. In other words, one way to minimize the risk of running afoul of both the DOL and FINRA is to provide unbiased education to participants about their distribution alternatives, including written materials about the advantages and disadvantages of leaving their money in the plan, transferring the money to the plan of a successor employer, taking a taxable distribution and/or rolling over into an IRA. While that may seem relatively straightforward, it is more complex than it appears. For example, if a participant s account includes appreciated company stock, it may make sense to take a taxable distribution of the stock or to leave it in the current plan. Or if the investments in the plan are much less expensive (for example, institutional share classes) than can be obtained in an IRA, the participant needs to be told about that consideration. The list of considerations is too long for this article, but a good document or brochure should be developed to provide unbiased educational content to participants, covering the most important considerations. While education on distribution alternatives will solve the problem for some advisors, others will want to make recommendations or will want to respond to requests for recommendations. Let s look at the impact of the FINRA guidance on those advisors. Regulatory Notice lists seven factors that may be relevant when developing a suitable recommendation about whether to take a distribution, roll over into an IRA, leave the money in the current plan or transfer the money to a successor employer plan. Those factors are: 1. Investment options: An IRA may enable an investor to select from a broader range of investments than a plan. While that is true in many cases, it would not apply where the participant s 401(k) plan offered a brokerage account option. 2. Fees and expenses: Both plans and IRAs typically involve investment-related expenses and plan or account fees. While an IRA may have retail pricing for investments, a 401(k) plan may have cost advantages, including the fact that mutual funds in a 401(k) plan generally waive front-end loads. Also, a plan may offer share classes (or collective trusts) with lower expense ratios than retail mutual fund shares. 3. Services: A participant may wish to consider the different levels of service available under the alternatives. For example, a plan may offer investment management or investment advice and education. On the other hand, an IRA may offer personalized advice from a financial advisor or investment adviser. In many cases, the ability to receive one-on-one personalized advice and perhaps comprehensive financial planning could be the determining factor for a participant who is weighing these factors. 4. Penalty-free withdrawals: FINRA guidance points out that a participant may be able to take penaltyfree withdrawals from a plan if the employee leaves employment between ages 55 and 59½. However, that may not be possible until age 59½ for an IRA. Also, a participant may be able to take loans from a plan, but cannot from an IRA. 5. Protection from creditors and legal judgments: Generally speaking, plan assets have unlimited protection from creditors under federal law, while rollover IRAs are protected under ERISA only in bankruptcy proceedings. However, state laws may provide additional protection from creditors. 4

5 6. Required minimum distributions: Generally speaking, if an employee is still working, required minimum distributions (RMDs) from a plan are not required to start at age 70½. RMDs must start from IRAs at age 70½ (except for Roth IRAs), regardless of whether the person is working. An important note is that RMDs are required to begin at age 70½ for key employees (those with major ownership and/or decision-making roles in the business), even from a plan. 7. Employer stock: Significantly appreciated company stock may be a reason to consider taking a distribution or leaving the money in the plan because of beneficial capital gains treatment of the appreciation when distributed from a plan and sold. However, the capital gains treatment is lost if company stock is rolled over into an IRA. At the end of factors list, FINRA states, These are examples of the factors that may be relevant when analyzing available options. Other considerations also might apply to specific circumstances. In other words, FINRA is saying that there are many factors to consider when evaluating whether a distribution or rollover is appropriate for a given individual. The expectation is that financial advisors will develop suitable recommendations based on those considerations. In addition, it is reasonable to expect that fiduciary advisors will consider those factors in developing their recommendations. The Regulatory Notice goes on to list other considerations that are more typical of a suitability determination: The customer s age Other investments Financial situation and needs Tax status Investment objective Investment experience Investment time horizon Liquidity need Risk tolerance Other information the investor may disclose to the broker-dealer or registered representative in connection with the recommendation Comments have been made to FINRA about the difficulty in gathering and evaluating the information needed for a distribution recommendation. As a result, the guidance may be modified in the future. However, it is clear that more is now expected in the development of recommendations about distributions from plans and rollovers into IRAs. This conflicts with the common perception that participants will almost automatically take distributions from plans or roll over into IRAs. As a result, this may be the beginning of a trend to leave money in plans (particularly mid-sized and large plans) and take retirement income distributions from there; the greater the emphasis on fees and expenses, the more likely this will happen. 5

6 Recommendations So, where does that leave us? While the FINRA guidance may be modified, and we don t know what will be in the DOL proposal, the following steps should be considered: Provide participants with a fair and balanced written explanation of their alternatives. The Investor Alert and the factors in Regulatory Notice are starting points for those materials. Advisors who opt to make recommendations to participants about distributions, as opposed to only providing education, should use questionnaires and checklists about distribution considerations for participants. These tools document disclosures and conversations with participants about the important factors to consider in making a distribution decision. If you are an advisor to the plan, disclose any difference between your compensation for plan services and the compensation for IRA services. Disclose any differences in available investments and about administrative and investment expenses in the plan as well as in the IRA. Disclose material conflicts of interest. Have the participant acknowledge these disclosures and conversations in writing. Many, perhaps most, older participants will want personalized advisory services including the opportunity for them to ask questions, and get answers, about personal assets and retirement income. But those services are not usually offered through plans. Be sure to explain that you do provide these services. Until there is greater clarity, the best approach is a conservative one. Educating plan participants is key and while improving compliance, it will also provide a long-term benefit of building trust. Download this and other Virtus White Papers at: 6

7 Provided compliments of Intended for Investment Professional or Institutional use. This article was written by C. Frederick Reish, a partner at Drinker Biddle & Reath LLP. Reish is in the firm s Employee Benefits & Executive Compensation Practice Group and Chair of the Financial Services ERISA Team. He has specialized in employee benefits law since 1973 and works with both private and public sector entities and their plans and fiduciaries; representation of plans, employers and fiduciaries before the governing agencies (e.g., the IRS and the DOL); consulting with banks, trust companies, insurance companies and mutual fund management companies on 401(k) investment products and issues related to plan investments; and representation of broker-dealers and registered investment advisers on issues related to fiduciary status and compliance, prohibited transactions and internal procedures. Drinker Biddle & Reath LLP is unaffiliated with Virtus Investment Partners. This material is provided by Virtus Investment Partners for informational and discussion purposes only. Plan sponsors and others should consult their own counsel and designated advisor, if applicable, for specific guidance on their particular circumstances. The analysis and opinions provided may not be relied upon as investment advice and may change without notice. Statements of fact are from sources considered reliable but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the opinions provided by the authors and other sources are not necessarily those of Virtus Investment Partners. Information provided is general and educational in nature. It is not intended to be, and should not be construed as, investment, legal, estate planning, or tax advice. Virtus Investment Partners does not provide legal, estate planning, or tax advice. Laws of a specific state or laws relevant to a particular situation or pensions in general may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. All investments involve risk. Registered Representatives of a Broker-Dealer and employees of Registered Investment Advisors are subject to their Firm s policies. An investor should consider a fund s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the Virtus Funds can be found in a fund s prospectus. To obtain a prospectus, please call or visit Please read the prospectus carefully before investing. Mutual Funds distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc. All third party marks are the property of their respective owners. This paper was originally published in April Data within this paper was updated in April NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

8 Virtus Investment Partners, Inc.