Executive Summary: On April 6, 2016, the U. S. Department of Labor (DOL) released a long-awaited final rule expanding the definition of "fiduciary" under ERISA as well as the duties of investment advisors who qualify as fiduciaries thereunder. In addition, the DOL issued two related prohibited transaction exemptions that have the effect of minimizing the compliance burden imposed on investment advisors who now, under the final rule, qualify as fiduciaries, by (1) permitting firms to receive certain common types of compensation if they contractually commit to putting their clients' best interests first, and (2) permitting certain principal transactions between those fiduciary-advisors and their customers.
Regulations prescribing the circumstances under which a firm or individual is deemed an ERISA fiduciary as a result of providing investment advice to its client were issued by the DOL nearly 40 years ago. Due to significant changes in the investment and retirement landscape, those rules have become dated and ineffective. One of the more significant effects of the dated fiduciary regulations was the loophole that allowed many financial professionals, consultants, brokers, insurance agents, and other advisors to escape the title of fiduciary when giving investment advice to ERISA plans and their participants. This permitted some financial advisors to recommend investments in financial products that were beneficial to the advisor (e.g., due to preferential compensation structures), but were misaligned with their client's interests and needs. This conflict of interest – i.e., the tug-of-war between the advisor's personal interests and the best interests of the client – while strictly prohibited for ERISA fiduciaries, was common practice for the "loophole" financial advisors.
The practical effect of the changes made by the final rule is that more advisors will be considered "fiduciaries," and will no longer be able to recommend that retirement assets be invested in overpriced or fee-heavy products that do little more than earn the advisor a commission.
Who is a fiduciary?
Under the final rule, any individual or entity receiving compensation for making retirement-related investment recommendations that are individualized or specifically directed to a plan, plan fiduciary, plan sponsor, plan participant, plan beneficiary, or to an IRA or IRA owner is an ERISA fiduciary.
Specifically, fiduciary responsibility will now arise when a recommendation, either directly or indirectly, is made by an individual or entity who:
- represents or acknowledges that they are acting as a fiduciary within the meaning of ERISA or the Internal Revenue Code;
- renders advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular investment needs of the advice recipient; or
- directs advice to a specific recipient or recipients regarding the advisability of a particular investment or a management decision with respect to securities or other investment property of a plan or IRA.
Effect of Fiduciary Standard
Once deemed an ERISA fiduciary, individuals or entities providing investment advice to plans, plan fiduciaries, plan sponsors, plan participants/beneficiaries, and IRA owners must, among other things:
- provide impartial advice that is in their client's best interests;
- charge no more than reasonable compensation; and
- not accept any payments creating conflicts of interest unless they qualify for a prohibited transaction exemption intended to assure that the customer's interests are protected.
The new rule can potentially impose fiduciary liability upon nearly every type of advisor on which a plan, plan sponsor, or participant would normally rely for advice. The expansion of the definition of fiduciary will significantly affect many of the day-to-day operations of plans, plan sponsors, and participants. Not unsympathetic to the administrative burdens this places on plan operations, the final rule excludes certain types of activities and communications by financial advisors to facilitate everyday plan operations.
For instance, investment education that provides general information about plan investment options, or information about plan enrollment procedures, will not constitute fiduciary advice, as long as no specific investment recommendations are made. This is not a "bright-line" test, however, and the concern is that potential fiduciary liability may very well have a chilling effect on advisors' willingness to communicate with investors. Accordingly, many advisors have already expressed concern that even making rollover versus distribution recommendations will constitute fiduciary investment advice.
The final rule provides additional exclusions from fiduciary liability for record-keepers and third-party administrators that make investment "platforms" available to plan fiduciaries. The platform providers do not thereby also become fiduciaries, so long as (i) the platform does not take into account individualized needs of the plan or the participants, and (ii) the provider represents in writing that it is not a fiduciary and is not providing impartial investment advice.
Prohibited Transaction Exemptions
In an effort to ease the transition from non-fiduciary to fiduciary investment advisor, the DOL has also issued new prohibited transaction class exemptions. The "Best Interest Contract Exemption" ("BIC exemption" or "BICE") permits fiduciary investment advisors to continue (certain) current compensation and fee practices, as long as they commit to providing investment advice that is in the best interests of their customers and satisfy additional conditions, set by the DOL, that are intended to mitigate conflicts of interest. The "Principal Transaction Exemption" increases existing exempted relief to enable a fiduciary investment advisor to sell to (or purchase from) its plan or IRA clients certain types of investment securities – primarily debt securities. The exemption is contingent on satisfying conditions similar to those of the BICE.
The DOL is also amending existing Prohibited Transaction Exemption 84-24, which permits insurance companies, and their agents and brokers, to receive compensation for recommending certain fixed-annuity products to plans and IRAs without having to satisfy all of the conditions that apply under the BICE. (Other, more complex products, such as variable annuities, would have to qualify under the BICE.)
What should employers do now?
Plan sponsors will need to review the relationships that they have with their financial advisors as well as the structure of their retirement plans to ensure compliance with the new rule. A plan sponsor's first and most important step to ensuring compliance with the new rule is to determine whether its financial advisors are fiduciaries of the plan. Contracts should be reviewed to see if they are appropriate to the circumstances, given the requirements of the new rule. Finally, plan sponsors should review the fee arrangements with their financial advisors to determine if changes need to be made in order to remain in compliance.
Compliance with the Fiduciary Rule will be required starting in April 2017 (12 months from publication). Likewise, the new and revised prohibited transaction exemptions may be relied upon at that time. However, full compliance with the conditions of the Best Interest Contract Exemption and the Principal Transaction Exemption will not be required until January 1, 2018; from the April 2017 effective date until January 1, 2018, fewer conditions will apply.