In April of this year, the Department of Labor issued a suite of rules (i) expanding the class of persons and entities who are fiduciaries for purposes of ERISA and the Internal Revenue Code; (ii) providing two new prohibited transaction exemptions (or PTEs); and (iii) amending a handful of existing PTEs to conform to the new regulatory regime. (For a list of, and links to, the suite of final rules, please see our post of April 11, 2016.) The fiduciary definition, exemptions and amendments, and their respective preambles, occupy in total almost 1,000 pages of the Federal Register. Collectively, these items enact a sea-change in the regulation of investment advice provided to ERISA-covered retirement plans and Individual Retirement Accounts (IRAs). When the Department promulgated these rules, it promised to provide subsequent guidance—including Frequently Asked Questions (FAQs)—in response to questions that would inevitably arise.

Speaking at a trade association meeting in Boston at the end of October, a senior Department of Labor official reported that the Department was hard at work on its first set of FAQs. He said that the FAQs would reinforce some of the rule’s basic concepts that questioners seemed to struggle with and add some gloss to particular aspects of the rule that the Department felt needed additional attention. His predictions proved accurate. In this post we provide a sampling of some of the highlights of the recently issued FAQs. We have chosen three topics that fall under the heading of “basic concepts,” and three topics that elucidate particular aspects of these rules. There is, of course, a measure of editorial discretion at work in our selection to topics. Other practitioners might choose differently based on their particular needs and interests. For anyone who works with or needs to comply with these rules, we recommend reading the FAQs in their entirety.

Clarification of Basic Concepts

  • Q&A 3—Fiduciary status and its attendant consequences

Because of the narrow definition of “fiduciary” that has been in place since 1975, a preponderance of retail financial advisors—or at least those who are licensed as registered representatives of broker-dealers (e.g., FINRA series 7) or hold state insurance licenses, as opposed to those who are licensed as Registered Investment Advisors (i.e., FINRA series 65)—did not consider themselves to be fiduciaries. The final fiduciary rule changes this. We thought that the preambles to the final fiduciary rule and the Best Interest Contract (BIC) exemption explained the rationale for the rule and the need for one or more exemptions. The Department, however, felt the need to revisit the issue in FAQ 3:

Under ERISA and the Code, parties providing fiduciary investment advice to plan sponsors, plan participants and beneficiaries, and IRA owners, are not permitted to receive payments creating conflicts of interest unless they comply with a prohibited transaction exemption. Thus, if an adviser or financial institution receives compensation that creates such a conflict of interest (e.g., transaction-based payments such as commissions, or third party payments such as 12b-1 fees or revenue sharing) the transaction generally must meet the terms of an exemption.

This can be put in even simpler terms: any time an advisor has the ability to vary the time or the amount of his or her compensation in the exercise of his or her discretion (e.g., by being paid on commission) in connection with his or her advice/recommendation to a retirement plan, retirement plan participant, or IRA holder, the receipt of such compensation results in a prohibited transaction that requires an exemption (statutory, class or individual) to proceed.

  • Q&As 6 and 7—Advisors with discretionary authority

Where a retail broker with no connection to his or her customer’s retirement plan advises the customer to roll over an account balance from the plan to an IRA from which the broker will be paid commissions, the workings of the fiduciary rule and the BIC exemption are clear: the broker is a fiduciary with respect (and subsequent) to the rollover; the receipt of commissions is a prohibited transaction; and the BIC exemption furnishes a possible exemption. But what if the broker is also the advisor to the retirement plan? The BIC exemption is not available where advisers have or exercise any discretionary authority or discretionary control with respect to the recommended transaction. In contrast, relief is available “even if the adviser serves as a discretionary fiduciary with respect to the plan” so long as the adviser does not have or exercise his or her discretion to cause the rollover. Put another way, so long as the advisor is not making the actual rollover decision, the BIC exemption remains available.

The same holds true in the case of recommendations to roll over assets to an IRA to be managed on a going-forward basis by a discretionary investment manager. The BIC exemption provides relief for investment advice to roll over a plan account into an IRA, even if the adviser or financial institution will subsequently serve as a discretionary investment manager with respect to the IRA, so long as the adviser does not have or exercise any discretionary authority or discretionary control with respect to the decision to roll over assets of the plan to an IRA.

  • Q&A 34—Compliance

If there were the proverbial water cooler around which benefits practitioners and their clients might gather, the question of how, exactly, might the fiduciary rule be enforced would be among the most popular topics of conversation. The Department, hearing the buzz apparently, decided to weigh in. The question is: “How will the Department approach implementation of the new rule and exemptions during the period when financial institutions and advisers are coming into compliance?” Here is what they said:

The Department has been and will continue working together with fiduciaries, financial institutions, recordkeepers, insurance companies, advisers, and other stakeholders to help them come into compliance with the new rule and related prohibited transaction exemptions. . . . Although the Department has broad authority to investigate or audit employee benefit plans and plan fiduciaries, compliance assistance is a high priority for the Department. The Department’s general approach to implementation will be marked by an emphasis on assisting (rather than citing violations and imposing penalties on) plans, plan fiduciaries, financial institutions and others who are working diligently and in good faith to understand and come into compliance with the new rule and exemptions. (Emphasis added).

Conspicuously absent from this Q&A is any mention of IRAs. While the Department has interpretive authority over how the ERISA prohibited transaction rules apply to IRAs, the IRS has enforcement authority. Violations of the prohibited transaction rules are subject to excise taxes under the Code and civil penalties under ERISA. In general, when an IRA is involved in a prohibited transaction, the IRA loses its tax-exempt status and the IRA holder (or beneficiary) is treated for tax purposes as having received a taxable distribution. The distribution is taxed as ordinary income and subject to a 10% early distribution penalty unless an exception applies (e.g., over the age of 59½, disabled, etc.).

In addition, any “disqualified person” who takes part in a prohibited transaction is subject to a 15% penalty based on the amount involved (here, the IRA account balance) in the prohibited transaction. Disqualified persons include the IRA holder as well as advice fiduciaries, who are all jointly and severally liable for the entire amount of the penalty. IRS Form 5330 must be filed in connection with a prohibited transaction, and there are penalties for failing to file. It may well be that the Department of Labor envisions that the fiduciary rule will be enforced by self-reporting on Form 5330.

Additional (Sub) Regulatory Gloss

  • Q&As 5, 13 – 19—Level fees

The concept of fee leveling is first raised in Q&A 5, which simply notes that the Department uses the term “full BIC Exemption” to describe the relief that is subject to the exemption’s full conditions, as distinguished from the relief provided for “level fee fiduciaries” that is subject to more streamlined conditions.

The BIC Exemption offers streamlined relief for level fee fiduciaries to receive compensation as a result of their provision of investment advice to retirement investors. While level fee fiduciaries do not generally “have the sorts of conflicts of interest that give rise to prohibited transactions or require reliance on an exemption,” the Department emphasizes that there is a clear and substantial conflict of interest when an adviser recommends that a participant roll money out of a plan into a fee-based account that will generate ongoing fees for the adviser that he would not otherwise receive, even if those fees do not vary with the assets recommended or invested. The same holds true in the case of advice to switch from a commission-based account to an account that charges a fixed percentage of assets under management on an ongoing basis. The streamlined, level fee provisions of the BIC Exemption provide relief in these instances.

The Department made clear that an adviser/financial institution may not rely on the level fee provisions in the BIC exemption if they receive third party payments (e.g., 12b-1 fees or revenue sharing payments) in connection with the assets recommended. FAQ 18 set out the Department’s view of the contours and outside limits of what constitutes a level fee:

For purposes of the exemption, a “level fee” is a fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee. Third party payments such as 12b-1 fees and revenue sharing payments, even if they provide the same amount or percentage for each investment offered, are transaction-based fees and vary on the basis of a particular investment because they are paid only for the particular investments that are included in the arrangement. (Emphasis added).

This answer should not surprise, since it accurately reflects the text of the final BIC exemption. It does, however, highlight a difficulty that financial institutions might encounter in designing level fee arrangements.

  • Q&As 9 and 12—the Grid, awards, incentives and recruitment

Through the medium of the full BIC exemption, the Department’s fiduciary and related rules preserve many existing compensation practices common in the retail brokerage and insurance spaces. In return, the new and amended PTE exemptions impose a series of consumer protections (a/k/a “impartial conduct standards”), a core tenet of which requires that financial institutions cannot:

use or rely upon quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives that are intended or would reasonably be expected to cause Advisers to make recommendations that are not in the Best Interest of the Retirement Investor.

Thus, under (and only under) the BIC exemption “quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives” are still allowed but only to the extent that they are consistent with the investor’s best interest. In the FAQs, the Department clarifies that this provision does not categorically preclude financial institutions from paying higher commission rates to advisers based on volume, e.g., by using an escalating grid under which the percentage commission paid to the adviser increases at certain thresholds.

To registered representatives and state-licensed insurance agents, the “grid”—short for “broker payout grid”—is hallowed ground. Financial institutions that “mess” with the grid (i.e., make the grid less favorable) do so at their peril. Grids provide incentives to earn more production credits or commissions as gross production increases. For example, for gross production of $100,000, the broker might be paid 20% net compensation, but from $100,000 to $250,000, the payout might go to a 25% payout. At one time, it was common for the grid to pay out retroactively as the advisor reached the next level, but this practice has fallen off in recent years, at least among the large broker dealers.

Many were concerned that the grid would not survive the fiduciary rule. Specifically, some feared that grids could have only one node or level in the post-fiduciary rule world. The FAQs clarify that this is not the case, but they also impose new requirements that constrain the way that a grid might be designed and operated. If, for example, different mutual fund complexes pay different commission rates to the firm, the Department opined that the grid cannot pay the adviser more for the higher commission funds and less for the lower commission funds (e.g., by giving the adviser a set percentage of the commission generated for the firm). Such an approach, says the Department “would incentivize the adviser to recommend investments based on their profitability to the firm, rather than their value to the investor.”

Instead, the Department approved the following approaches:

  • Firms can pay different commission amounts for different broad categories of investments based on neutral factors. Under this approach, the firm eliminates variations in commissions within reasonably designed investment categories, but variation is permitted between these categories based on neutral factors, such as the time and complexity associated with recommending investments within different product categories (e.g., one commission structure for mutual fund investments and another for annuities).
  • Firms can use grids with small increments. Thus, an appropriately structured grid would not rely on compensation thresholds that enable an adviser to disproportionately increase his or her compensation as the adviser reaches the threshold.
  • Retroactivity of payments under a grid is not permitted. As the adviser reaches a threshold on the grid, any resulting increase in the adviser’s compensation rate must be prospective. That is, the new rate should apply only to new investments made once the threshold is reached.

The FAQ further warns financial institutions employing escalating grids to pay particular attention to the conflicts of interest such grids create in establishing a system to monitor and supervise adviser recommendations, both at or near compensation thresholds and at a greater distance.

  • Q&A 23—Independent Marketing Organizations

This Q&A clarifies that independent marketing organizations (IMOs) can sell annuity contracts to retirement investors and receive compensation such as commissions and override payments. IMOs make up the largest distribution channel for fixed indexed annuities, accounting for around 60 percent of total sales, more than half of which are to plans and IRAs. While the Department, in the preamble to amended PTE 84-24, eschewed any intent to “disrupt the practice of paying commissions through a third party, such as an independent marketing organization,” that this is the case is less than clear in the text of the rule.

According to Q&A 23, “[a]n IMO can receive compensation as a result of an annuity purchase recommended by an insurance agent pursuant to either PTE 84-24 or the full BIC exemption.” (The sale of fixed indexed annuities is no longer permitted under amended PTE 84-24.)

The full BIC Exemption requires that a “financial institution” execute the best interest contract and exercise supervisory authority over advisers. But under the exemption, marketing organizations like IMOs are not treated as financial institutions that can execute the Best Interest Contract. Instead, the exemption contemplates that the insurance company (or other enumerated financial institution) will take responsibility for ensuring that the exemption’s conditions are met and that investment advice is in the best interest of the retirement investor. Under the exemption an IMO can continue to work with an insurance company and receive compensation if the insurance agent and the insurance company comply with the conditions of the exemption applicable to advisers and financial institutions, respectively.

Lastly, the Department notes that IMOs may seek to be added to the definition of financial institution with the responsibility to execute the best interest contract and ensure compliance with the exemption’s terms. According to the FAQ, the Department presently “has several such applications under consideration.”