Using Unitized Managed Accounts in 401(k) Plans

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Why is TD Ameritrade Institutional making this information available to you? At TD Ameritrade Institutional we are committed to helping advisors be successful. We continually look for ways to bring thought leadership and best practices ideas to you in order to support your business growth and success. We know how hard you work, and that sometimes it can be difficult to navigate some of the complexities in your business. That s why we have asked retirement industry experts that you recognize as thought-leaders to provide information on topics that impact your practice. Although the information included in this document isn t tailored to the circumstances of a particular advisor, we hope you find it educational, informative and that it will help you identify opportunities in your business. Who is providing this information? This information was created by Fred Reish and Bruce Ashton of the law firm Drinker Biddle & Reath LLP to be provided to independent registered investment advisors who custody assets with TD Ameritrade Institutional. Drinker Biddle & Reath is a 620-attorney firm with 12 offices nationwide. Mr. Reish is a member of the firm s Employee Benefits & Executive Compensation practice group, Chair of the Financial Services ERISA Team and Chair of the Retirement Income Team. His practice focuses on fiduciary issues, prohibited transactions, tax-qualification and retirement income. Mr. Ashton is also a partner in the Employee Benefits & Executive Compensation practice group and the Financial Services ERISA Team. His practice focuses on fiduciary issues, prohibited transactions and retirement income, and in addition, agency audits and investigations and ESOPs. TD Ameritrade Institutional is not affiliated with Drinker Biddle & Reath. While TD Ameritrade Institutional is pleased to make this information available to you, neither TD Ameritrade Institutional nor any of its affiliates is responsible for this content. How should you use this information? Drinker Biddle & Reath intends for this information to provide a general overview about the topics covered and to help answer some general questions about Unitized Managed Accounts in 401(k) plans. Because neither Drinker Biddle & Reath nor TD Ameritrade Institutional is providing this information as legal advice tailored to your specific circumstance, this information is not intended to be relied upon as such. You are urged to consult with attorneys or compliance experts that understand your particular circumstances before utilizing any of the ideas or information presented here in your practice. TD Ameritrade Institutional 2

Introduction Advisors want to help 401(k) participants with investing, but they often have concerns about how to do it and still comply with applicable ERISA legal requirements. These concerns may be heightened in light of the April 2017 applicability date of the Department of Labor s ( DOL ) new fiduciary advice regulatory package. In this article, we address issues that advisors are raising about the creation of portfolios to help participants with investing. (For this discussion, we assume that the portfolios are set up as unitized managed accounts or UMAs. In this article, depending on the context, we use the term UMA to refer to a portfolio managed by an advisor that constitutes an investment vehicle and is treated as a plan designated investment alternative, or as a managed account service for managing participant accounts using a plan s core investment menu.) We have used a question and answer format in an effort to provide practical, implementable information that advisors can use in their practices. Background Before getting into the specific questions, we should review the requirements of the Employee Retirement Income Security Act ( ERISA ). We assume advisors are familiar with the basics, but just to recap: the law says that anyone who renders investment advice for compensation is a fiduciary. Fiduciaries are required to fulfill specific duties, to act prudently and to avoid conflicts of interest (what ERISA calls prohibited transactions). The duties include the obligation to act in the interest of plan participants for the exclusive purpose of providing benefits. Acting prudently means engaging in a prudent process gathering relevant information, assessing the information and making an informed, reasoned decision based on that information 1. The prohibited transaction rules say that a fiduciary cannot use his authority to cause himself, any affiliate or any other person in which he has an interest that may influence the advice he gives to make more money. A fiduciary also cannot engage in transactions that are adverse to the interests of the plan or participants and cannot receive compensation from third parties in connection with transactions involving plan assets. If an advisor serves as a fiduciary, engaging in a prohibited transaction would mean that the advisor would have to correct the transaction which would generally mean forgoing his compensation and would be subject to excise tax penalties. The DOL s new conflict of interest regulation provides an expansive definition of fiduciary investment advice. It includes any recommendation to a plan, participant or IRA owner regarding the investment or management of retirement assets, as well as recommendations regarding distributions and rollovers. Recommendation is also broadly defined to include a communication directed to a specific person that could be taken as a suggestion that the investor take or refrain from taking certain action. The regulatory package includes a couple of new prohibited transaction exemptions and modifications of some existing ones. The primary exemptions that advisors are concerned with are the best interest contract exemption or BICE and 84-24, which deals with the sale of fixed annuities and insurance contracts to plans or IRAs. Both BICE and 84-24 require that advisors act in the best interest of their clients. This means observing the ERISA prudence requirement, basing their recommendations on the needs of the client and acting without regard to their own or their firm s financial interests. There are other detailed requirements, but this one is central to the exemptions. With that background, let s look at the advisor questions. By Fred Reish and Bruce Ashton 3

1 Can a financial advisor charge a fee for advisory services to the plan and also charge a separate fee for managing a portfolio created for participant investing? Yes, if properly structured. Under the ERISA prohibited transaction rules, a fiduciary cannot use his authority to cause himself, affiliates or certain others to receive additional compensation. So where a financial advisor is a fiduciary to a plan, the receipt of the additional fee for managing a UMA would be a prohibited transaction issue if (a) the advisor has discretion over the selection of plan assets and exercises that discretion to include the UMAs he or an affiliate manages, or (b) the advisor recommends the inclusion of the UMAs in the plan lineup even if the advisor does not have discretion. The simplest way to avoid the problem is for the advisor not to charge a separate fee for managing the UMA portfolios. He could still receive his fee for managing or advising on the selection of plan investment options. He could also receive the UMA management fee if he offsets that fee against the plan-level fee. There are a couple of ways in which the advisor might be able to collect both fees, however. First, there is the hire me exception. That is, if the package originally selected by the plan sponsor includes both the plan-level services and the UMA management services of the advisor, each with its own fully disclosed fee, there would be no prohibited transaction. In general, sales activities are not considered fiduciary actions until the advisor is actually hired so long as during the sales process, the advisor does not make a recommendation. A recommendation by an advisor even one who is not already a fiduciary to the plan to include the UMAs in the plan would be considered fiduciary investment advice and would give rise to the prohibited transaction. But in the absence of a recommendation, an advisor selling a package is not exercising fiduciary authority to recommend an additional service, but is being hired to provide all services at the same time. In this situation, the advisor could receive both fees. But it is important to recognize that the plan sponsor must still monitor the advisor s performance of both functions. A second way is if the advisor, who is already serving as a fiduciary, does not make a recommendation. If, instead, the advisor only provides information to the plan sponsor that the UMA portfolios and his management service are available and the plan sponsor makes the decision to offer the portfolios in the plan, the advisor has not exercised fiduciary authority to cause himself to receive additional compensation and has not engaged in a prohibited transaction. Advisors will need to tread carefully here, however. The line between providing information and making a recommendation can be blurry, especially in light of the new definition of recommendation in the DOL regulation. If the plan sponsor could reasonably conclude that the advisor is suggesting that the plan include the advisor s UMAs and his management services, this would constitute fiduciary advice and give rise to a prohibited transaction if the advisor receives both fees. 1 By Fred Reish and Bruce Ashton 4

2 Is it ok to guide participants into the UMAs? Yes, if there is no fee paid to the advisor. No, if the advisor makes a recommendation and receives a fee. 2 If an advisor makes a recommendation as defined in the new advice regulation and receives additional compensation for this recommendation, the answer is clearly no. If the advisor does not receive any additional compensation for the recommendation, the concern is lessened. The recommendation would still need to be prudent and in the interest of the participant, but there would be no prohibited transaction because the advisor is not receiving an additional benefit. The other approach relies on an exception for education under the advice regulation. The exception is similar to the guidance under Interpretive Bulletin 96-1 2 : advisors can provide plan information, general financial and retirement information, general information about asset allocation models and interactive investment materials. But the advisor could not provide information about the UMAs themselves, because that would not fall within the education exception. If an advisor provides no more than the information permitted under the education exception and refrains from the temptation to answer a participant s plea for advice ( what should I do? what would you do if you were in my situation? ), the advisor will not be making a fiduciary recommendation. And if the advisor is otherwise able to receive additional compensation for managing the UMAs (e.g., see circumstances described in Q&A 1 of this article), it would be able to do so under this education exception. By Fred Reish and Bruce Ashton 5

3 Can a UMA be a QDIA? Yes, so long as the UMA meets various requirements. To understand this answer, we should first review the requirements for an investment to be considered a qualified default investment alternative (or QDIA) under the ERISA regulation 3. The regulation provides that the default investment must be an investment product or model portfolio that meets the following criteria: The product or portfolio applies generally accepted investment theories; Is diversified so as to minimize the risk of large losses and is designed to provide long-term appreciation and capital preservation through a mix of equities and fixed income investments; and Has a target level of risk appropriate for participants of the plan as a whole (a balanced fund) or is based on a participant s age, target retirement date or life expectancy and changes the asset allocation to become more conservative with increasing age (a target date fund or TDF). Alternatively, a QDIA can be an investment management service in which a fiduciary allocates the assets of a participant s account with the same diversification and long-term goals as the other alternatives. Like a target date fund, a participant s account would need to be managed based on a participant s age, target retirement date or life expectancy; but unlike the other alternatives, the account manager must restrict the investments to the plan s designated investment alternatives ( DIAs, or funds on the plan s core menu). Since balanced funds and TDFs are separate funds or portfolios, they are not subject to this restriction and may include investments other than the plan s DIAs. In all cases, the UMAs would need to be managed by a 3(38) investment manager (that is, an RIA with discretion that acknowledges in writing its fiduciary status), or by the plan trustee or plan sponsor. 3 Continued on next page By Fred Reish and Bruce Ashton 6

Continued from previous page Depending on how the UMA is structured and managed, it could fall into any one of these three categories: 3 It could qualify as a target date fund if a UMA consists of a portfolio that becomes more conservative (i.e., has less equity exposure) over time. Alternatively, there could be a series of UMAs, with varying mixes of equity and fixed income investments. As participants age, they could be moved from one UMA to another, more conservative UMA, such that over time a participant s account would become more conservative as he ages. In effect, the movement of the account from UMA to UMA serves the same function as the glide path in a fund that changes its investment mix over time. Alternatively, a UMA could qualify as a balanced fund, if the portfolio has a target level of risk that considers the entire participant population and does not vary over time. Finally, a UMA could be considered a managed account, so long as there is a fiduciary who allocates a participant s account among the plan s DIAs. If a plan advisor manages the UMA, it would be within his or her discretion to structure the portfolio or participant accounts to comply with these requirements. To the extent the QDIA is a portfolio managed by another entity, however, the advisor would need to make sure that it qualifies as a QDIA and is prudently selected and monitored. (The advisor could not monitor himself in the first situation.) Whether a UMA can be a QDIA also assumes that all of the other disclosure requirements for the QDIA safe harbor regulation have been complied with by the plan. By Fred Reish and Bruce Ashton 7

4 What are the disclosure obligations for UMAs? To expand on the question, suppose an RIA creates UMA portfolios using funds on a plan s core menu. Does this simplify the participant disclosure requirements for the portfolios? Would the portfolios be considered DIAs of the plan? 4 If the portfolio is a unitized fund, then it would be considered a DIA and would be subject to the reporting requirements under the participant disclosure regulation (the 404a-5 regulation) applicable to designated alternatives. This would include performance, expense, benchmarks and other information. A way to avoid this requirement would be to create managed accounts that are not unitized and are only available as an advisory service to the participants. Even if the advisor were to use the plan s core menu of DIAs, the disclosure requirements would be more limited. Information about the core options would have to be disclosed by the plan sponsor (or plan recordkeeper), but the plan advisor would not have any responsibility to be involved in those disclosures. There would not be a need for 404a-5 DIA disclosures on the managed account service or the portfolios themselves. In that sense, managing a non-unitized portfolio consisting of a plan s core options would relieve the advisor of responsibility and exposure to liability related to the participant level disclosures. That said, the advisor would be considered a designated investment manager (or DIM), and certain disclosures about the advisor would need to be made as part of the participant disclosures. In this situation, the disclosure would consist of the fee to be charged by the DIM during the year and, on a quarterly basis, the dollar amounts paid by participants who elected to have a portion of their accounts managed by the DIM. Content provided by 1 See ERISA Sections 404(a), 406(a) and (b) and ERISA Regulation Section 404a-1. 2 Interpretive Bulletin 96-1 has been revoked by the new fiduciary advice regulation. 3 ERISA Regulation 2550.404c-5. This document was developed by Fred Reish and Bruce Ashton and provided by TD Ameritrade Institutional, and is intended solely for investment professionals. TD Ameritrade Institutional is a Division of TD Ameritrade, Inc., member, FINRA/SIPC (together with its affiliates, TD Ameritrade ). Drinker Biddle & and Reath, LLP. is a separate firm not affiliated with TD Ameritrade. The information contained in this document was not independently verified by TD Ameritrade and TD Ameritrade makes no representations about the accuracy of such information. The information provided in this document is deemed to be current as-of the date the document was published, however, the laws and regulations relating to retirement plans and retirement plan service providers, including the laws and regulations referenced in this document, are subject to interpretation as well as legislative and regulatory change. TD Ameritrade does not provide legal or tax advice. The practice guidance included in this document is not tailored to the particular circumstances of you or your firm. You must evaluate the appropriateness of the information and guidance for you or your firm and consult with appropriate professionals to address your specific circumstances. This document is intended only to provide education and to facilitate your identification of retirement practice management opportunities. You should consult your own legal and compliance advisors in pursuing any such opportunities and obtain their prior approval and authorization before utilizing the articles, checklists, or other components of this document in your practice. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company and The Toronto-Dominion Bank. 2016 TD Ameritrade IP Company, Inc. T 494214 09/30/2018 TDAI 5051 MS 09/16