The DOL s Fiduciary Rule: Where It s Going

Transcription

1 SM PlanAdvisorTools.com The DOL s Fiduciary Rule: Where It s Going By Fred Reish - Partner, Drinker Biddle & Reath LLP

2 SM The DOL s Fiduciary Rule: Where It s Going by Fred Reish Partner, Drinker Biddle & Reath LLP The Department of Labor s highly controversial fiduciary proposal is likely to become a final rule but with some significant changes that will impact investment advice to plans and Individual Retirement Accounts (IRAs). This article discusses likely changes to the proposal and how the rules will affect advisers. Before discussing the changes, however, let s look at the timing. The Department of Labor (DOL) issued the proposal in April; private sector comments were filed between then and July; several days of hearings were held in August; and additional comments were filed in September. The DOL is now considering the input from the comments and hearings, and will probably issue its final guidance in May or June of But, the DOL has said that it will not require compliance until eight months after issuance, which puts us in the first quarter of Even with the eight-month delay, it will be difficult to meet the requirements because the changes are that substantial. As a result, advisers should pay attention to the rules as they develop and should be thinking about how they could impact their practices. To understand the DOL s proposed changes, it s necessary to divide them into two categories: The regulation that will define when investment recommendations cause an adviser to be a fiduciary; and The prohibited transactions that apply to advisers when they make investment recommendations that: a. cause themselves (or affiliates, for example, their broker-dealer) to receive payments from third parties (for example, mutual funds or insurance companies), or b. affect the amount of their compensation (e.g., recommending mutual funds that pay 12b-1 fees) or the compensation of affiliated firms (e.g., recommending mutual funds managed by an affiliate). To avoid the prohibition, advisers will need to satisfy one of the exemptions, or exceptions, that are part of the DOL s fiduciary package. 2

3 The Fiduciary Proposal Now, let s turn to the fiduciary rule. Under the proposal, an investment recommendation would be fiduciary advice if it 1) was individualized for the recipient or 2) it was specifically directed toward the recipient. Many commenters argued that the specifically directed language was so broad that it could include marketing for example, a mass mailing just because it was mailed to an individual s name and address. The DOL seems to be sympathetic to those concerns and the final rule will likely narrow the definition. In any event, it will take more than marketing for an adviser to become a fiduciary. The original proposal defines a recommendation to include a suggestion that the investor engage in, or refrain from a particular course of action. Some commenters asserted that a suggestion wasn t enough to be a recommendation. The DOL seemed receptive to narrowing that part of the definition as well. However, the DOL still intends to have a broad definition of fiduciary and advice. As a result, most common investment and insurance sales practices will become fiduciary advice under the new rules. When an adviser becomes a fiduciary, the requirements are two-fold and listed in the DOL guidance as the Best Interest standard: The investment advice must be prudent, i.e., the adviser engage in a prudent process to develop the recommendation the prudent man rule; and The adviser must put the interests of the investor (e.g., the plan, participants or IRA owners) ahead of his own the duty of loyalty In addition, the fiduciary rule and the exemptions all require that the expenses and compensation be within reason when comparing the services being rendered to the market costs for similar investments and services. Fiduciary Carve-Outs Fiduciary status has a few exceptions, two of which apply to the sales and advice process: the seller s carve-out and the participant education carve-out. The seller s carve-out will permit non-fiduciary sales to plans where certain conditions are satisfied; the most important condition being that the adviser says that he is selling and not advising. However, the proposal limited this carve-out to sales to large plans (defined as a plan that has at least 100 participants). Commenters urged the DOL to extend that exception to small plans, but Department officials seemingly met their pleas with resistance. As a result, it is probable that sales to small plans and IRAs will still be considered fiduciary advice. 3

4 The proposed participant education carve-out permits advisers and providers to give investment education to participants similar to what is now done under Interpretive Bulletin 96-1 but with one critical change: investment education can no longer specify the investments in an asset allocation. In other words, if the education indicated specific mutual funds in an asset allocation, that would be considered fiduciary investment advice. Many commenters including both those who favored and objected to the overall fiduciary proposal feared the change would be harmful to participants, because, in order to implement the education, participants would need to do more research and more than likely, would not put in that additional effort. Those commenters also pointed out there wasn t a history of abuse in the use of asset allocation models and that, in any event, plan fiduciaries had already prudently selected those investments for the plan. As a result, the DOL is likely to permit the use of specific investments in asset allocation education for plans (but not for IRAs, where the investments had not been previously selected by fiduciaries). Recipients of Fiduciary Recommendations The fiduciary definition will apply to: Investment recommendations to plans. Investment recommendations to participants. Investment recommendations to IRA owners. Distribution recommendations to participants and IRA owners While the first two recipients are consistent with current rules, the second two are major changes that will impact almost all advisers even if they don t work with retirement plans. Prohibited Transactions and Exemptions Where an adviser serves as a pure level fee adviser, fiduciary advice does not result in a prohibited transaction (with one exception, described below, for recommendations about distributions). A pure level fee is either 1) compensation that is a set fee (either a percent or a dollar amount) over all advised assets, or 2) compensation of the adviser, or an affiliate, that is not increased by the recommendations (e.g., a management fee for an affiliated mutual fund). For example, if an adviser charges 25 basis points (bps) to a 401(k) plan for advice about selection and monitoring of the plan s mutual funds, that would be level fee. And, if neither the adviser nor any affiliates received any payments above and beyond that fee, that would be a pure level fee. 4

5 In those cases, fiduciary investment advice to a plan, a participant or an IRA owner would not cause a prohibited transaction. Therefore, the adviser would not need a prohibited transaction exemption, which is, in effect, official permission to violate the prohibited transaction rules if the conditions of the exemption are satisfied. Typically, those conditions are disclosure-based. Now that we ve covered prohibited transactions, let s look at the proposed exemptions. There are two exemptions that cover common compensation arrangements in sales and recommendations to plans, participants and IRA owners: The Prohibited Transaction Exemption (PTE) covers the sale of insurance products. The DOL is proposing to modify this existing exemption to add new conditions and to move the sales of variable annuity products to IRAs to the new BIC exemption. The Best Interest Contract Exemption, commonly called BICE or the BIC exemption, will cover the sales of most common investment products to plans and IRAs. PTE has been in effect since 1984 and a number of insurance companies and broker-dealers have required their agents and advisers to use it when they sell insurance products to plans. However, with the proposed change to the definition of fiduciary, almost all sales of insurance products to plans and IRAs will be considered fiduciary advice. As a result, the exemption will be in common use. The good news is that, based on the experience of the insurance companies and broker-dealers who have been using the PTE, it appears the required disclosures have not been significant barriers to those sales. Even with the DOL s proposed changes, that should still be the case. While that applies to all insurance sales to plans and sales of traditional fixed annuities and fixed indexed annuities to IRAs, the DOL is proposing to treat individual variable annuity contracts as primarily being securities. As a result, the DOL proposal took recommendations of variable annuities to IRA owners out of PTE and moved them to BICE, which has more stringent requirements. Many industry commenters argued that the move was not appropriate because it would be confusing to retirees to have different types of disclosures for different annuity products. However, the DOL does not seem persuaded by that reasoning, and it is likely that sales of variable annuity contracts to IRAs will fall under BICE. While the use of PTE for recommendations of insurance products appears to be workable (with increased disclosures), the same cannot be said of the requirements of BICE. As proposed, that exemption will impose requirements that will be expensive to implement and could take years to develop. Those points were made clear to the DOL and it looks like they will be making significant changes to this exemption. 5

6 Before discussing some of the detailed provisions, though, it would be good to explain the structure of the exemption. The concept is that, with the right controls, the DOL could permit transactions where financial institutions (e.g., broker-dealers, insurance companies, mutual fund managers) could receive compensation for their services, even if those services and products were recommended by a fiduciary adviser who was supervised by, or affiliated with, said financial institution. But, the problem is, of course, what are the right controls? A partial list of proposed conditions includes: A tri-party contract between the adviser, the financial institution and the investor, signed before any advice is given. Hence, the name Best Interest Contract Exemption. Financial disclosures initially, and annually, in dollar amounts about costs and compensation. Warranties and policies about conflicts of interest. Control of the adviser s compensation to mitigate conflicts of interest. Because of examples given by the DOL, many viewed this condition as requiring level compensation for advisers. While the DOL said that was not the purpose, it was difficult to see how commissions, bonuses, recognition awards, etc., could be managed so that they did not appear to incent the sales of certain products over others. Industry representatives, and some supporters of the fiduciary proposal, commented that these conditions were too difficult and expensive to satisfy. Based on DOL questions and comments, it appears there will be significant changes to BICE. For example, it appears the contract will not need to be signed until after investments and services have been discussed, explained and recommended, so long as the contract relates back to the initial conversations. The DOL also seems to understand that it is too expensive to develop the systems to calculate and report dollar amount disclosures. Some commenters have suggested disclosures similar to the retirement plan disclosures under 408(b)(2) and the participant disclosures under 404a-5. While that is familiar territory for retirement plan advisers, it will be a significant change for IRA advisers. The most difficult issue, though, is advisers compensation. The DOL seems committed to requiring that an adviser s compensation be structured to mitigate any incentive to favor one type of investment over another. While that may seem plausible in theory, it is difficult to envision how that would work in the real world. As a result, unless the DOL s final BIC exemption provides much greater flexibility for adviser compensation, some advisers and their supervisory entities (e.g., brokerdealers) may opt for leveling the adviser s compensation as a percent of all assets or as a fixed dollar amount. While that is already happening in the 401(k) world at least to a degree it would be revolutionary in the IRA world (for other than pure level fee Registered Investment Advisors. 6

7 The last exemption issue is the capturing of rollovers. Under the fiduciary proposal, a recommendation to take a distribution from a plan or an IRA is a fiduciary act and thus the recommendation must follow the prudent man rule and the duty of loyalty. Also, if the adviser will make more money in the IRA than from the plan (e.g., 25 bps in the plan and 100 bps in the IRA), the DOL would consider that to be a prohibited transaction. It appears that BICE applies to those prohibited transactions, but it is not clear or, better put, BICE does not have a specific set of conditions for those recommendations and the other requirements of BICE don t make sense in that context. As a result, it s difficult to see a clear path for compliance for distribution recommendations until the final BICE is issued. But, all is not lost. The fiduciary proposal is clear that distribution education is not fiduciary advice. As a result, some advisers, broker-dealers and RIA firms have decided they will help participants understand their distribution options and the considerations for choosing among those options. The options are: leaving the money in the current plan, transferring to the plan of a new employer, taking a taxable distribution or rolling over into an IRA. While there are a number of issues for a participant to consider in making an informed decision, some of the most important include: Are the investments offered by the plan adequate for the participant s needs, or would a broader range of investments better serve the participant? Are the services offered by the plan for investments and planning adequate for the participant or are more needed or appropriate? Is the cost of the investments and services in the plan lower than in the IRA and, if so, is the additional cost of the IRA justified by added value? Is the distribution flexibility in the plan adequate or is the flexibility of an IRA needed or desirable? Conclusion There is no doubt these changes will be highly disruptive. However, many advisers are already acting in the best interest of investors, with reasonable fees and well-thought-out investment strategies. The fiduciary definition, standing alone, should not have a significant impact on them. The same can t be said about the prohibited transaction rules and exemptions though, especially regarding BICE. On a positive note, however, it appears the DOL has heard and understands the industry s comments. Even there, though, it remains to be seen whether that understanding translates into workable conditions for the exemption. The DOL has indicated it wants the new requirements to work. Based on those indicators, the final issuance will be much more reasonable than the proposal, and with some changes to common practices and particularly with increased disclosures advisers will be able to continue to make sound investment recommendations to plans, participants and IRA owners. 7

8 Download this and other RidgeWorth White Papers at: 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 RidgeWorth Investments. This material is provided by RidgeWorth Investments 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 RidgeWorth. 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. RidgeWorth 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 advisers are subject to their firm s policies RidgeWorth Investments. All rights reserved. RidgeWorth Investments is the trade name for RidgeWorth Capital Management LLC, an investment adviser registered with the SEC and the adviser to the RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC, which is not affiliated with the adviser. Collective Strength. Individual Insight. is a federally registered service mark of RidgeWorth Investments. RFWP-DOL2-0915