On October 25, 2011, the United States Department of Labor (DOL) issued (for the second, and hopefully, the last time) final regulations regarding the provision of investment advice to participants and beneficiaries in participant-directed individual account plans and individual retirement plans (the Final Regulations), which provide relief for investment advice arrangements that meet the qualifications of either (i) a “fee-leveling arrangement” where the compensation of the adviser does not depend on the investment decisions of the participant or beneficiary, or (ii) a computer modeling program that is certified to be objective. Rules relating to each type of arrangement are addressed in detail below.
The Final Regulations implement the statutory exemption for investment advice under the Pension Protection Act of 2006 (PPA), which was intended to allow investment advice providers “to offer their services to [plan] participants and beneficiaries [who are] responsible for investment of assets in their individual accounts and, accordingly, for the adequacy of their retirement savings.” The prohibited transaction rules of the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (the “Code”), generally preclude fiduciary investment advisers from being compensated by those investment funds that the advisers recommend to participants and beneficiaries, a common method of compensation in the current mutual fund environment. These rules protect participants and beneficiaries from investment advice from conflicted individuals. On the other hand, these rules also significantly narrow the pool of potential investment advisers, particularly in the context of the current consolidated financial services industry, by eliminating this common source of payment in the mutual fund industry.
The statutory exemption, which falls under section 408(b)(14) of ERISA and section 4975(d)(17) of the Code, provides a limited exemption to the foregoing rules and is intended thereby to facilitate plan sponsors to offer plan participants and beneficiaries investment advice under circumstances in which the DOL believes there are sufficient safeguards to ensure that the advice offered is competent and not impermissibly conflicted.
The DOL followed a long and circuitous route on the way to the Final Regulations. On February 2, 2007, the DOL issued Field Assistance Bulletin 2007-01 to address certain issues presented by the then-new statutory exemption. The DOL issued, extended the effective date of, and then withdrew final regulations in 2009. On March 2, 2010, the DOL issued a new proposed version of the investment advice regulations (the “Proposed Investment Advice Regulations”), which attempted to mollify critics of the prior regulations who argued that those regulations provided more support to financial advisers than to participants and beneficiaries.
The Final Regulations generally endorse the approach and terms of the Proposed Investment Advice Regulations but with some minor changes and clarifications. The Final Regulations become effective on December 27, 2011 and will apply to transactions that occur on or after that date.
Finally, the Final Regulations clarify that they do not supersede or supplant any other guidance issued by the DOL regarding the provision of investment advice and when the provision of investment advice may constitute a prohibited transaction under ERISA or the Code.
Overview of the Final Regulations
If the requirements of ERISA section 408(g) are satisfied, the investment advice-related transactions added under ERISA section 408(b)(14) will be statutorily exempted from the prohibited transactions rules under ERISA section 406. The investment advice-related transactions described in section 408(b)(14) include:
- the provision of investment advice to the participant or beneficiary with respect to a security or other property available as an investment under the plan;
- the acquisition, holding or sale of a security or other property available as an investment under the plan pursuant to the investment advice; and
- the direct or indirect receipt of compensation by a fiduciary adviser or an affiliate (or any employee, agent, or registered representative of the fiduciary adviser or affiliate) in connection with the provision of investment advice or the acquisition, holding or sale of a security or other property available as an investment under the plan pursuant to the investment advice.
Section 2550.408g-1 of the Final Regulations describes the general requirements that must be satisfied in order for the investment advice-related transactions described in ERISA section 408(b)(14) to be exempt from the prohibitions of section 406. Under the Final Regulations, the requirements of ERISA section 408(g), are met only if the investment advice is provided by a fiduciary adviser under an “eligible investment advice arrangement.” There are two main types of “eligible investment advice arrangements” under ERISA section 408(g) and both types of arrangements are intended to mitigate the potential for conflicted advice or advice which may benefit the fiduciary adviser in other ways. Additionally, a fiduciary adviser may develop an “eligible investment advice arrangement” that satisfies the requirements applicable to both types of arrangements. The general types of “eligible investment advice arrangements” are fee-leveling arrangements and arrangements that use computer models.
Eligible Investment Advice Arrangements
Both types of “eligible investment advice arrangements” must be based upon generally accepted investment theories that take into account the historic risks and returns of different asset classes over defined periods of time and possibly other additional considerations. The investment advice issued under both types of arrangements must take into account investment management and other fees and expenses attendant to the recommended investments. The fiduciary adviser or computer model, likewise, must request and, to the extent provided, utilize in its advice participant or beneficiary specific information relating to age, time horizons (e.g., life expectancy or retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income, and investment preferences of the participant or beneficiary.
Under a fee-leveling arrangement, the fiduciary adviser’s compensation, direct or indirect, cannot vary depending on the selection of a particular investment option by the participant or beneficiary. This provision is intended to eliminate the potential for a fiduciary adviser to be incentivized to recommend one investment over another.
However, the level fee requirement does not extend to an affiliate of a fiduciary adviser. Accordingly, the compensation of one or more affiliates of a fiduciary adviser can vary depending on the participant’s or beneficiary’s selection of a particular investment option pursuant to the investment advice of the fiduciary adviser and, provided the investment advice complies with the Final Regulations, the direct or indirect receipt of compensation by the affiliates of the fiduciary adviser in connection with the provision of investment advice or the acquisition, holding or sale of a security or other property available as an investment under the plan pursuant to the investment advice will be exempt under ERISA section 408(b)(14)(iii).
In other words, so long as fiduciary adviser X receives level fees regardless of the investments a participant or beneficiary selects, fund managers related to X and other affiliates of X can receive increased compensation resulting from fiduciary adviser X’s advice. Thus, the fee-leveling requirement seems to strike somewhat of a balance between minimizing potentially conflicted advice and operating within the context of the current 401(k) plan environment, given the consolidation of the financial services industry.
Under a certified computer model, investment advice must be generated through a computer model that uses objective criteria to recommend an asset allocation based on the investment options available under the plan and appropriately weighs the factors utilized in estimating the future returns of the investment options.
The computer model must be designed and operated to take into account all designated investment options available under the plan without giving inappropriate weight to any investment option. Designated investment options do not include brokerage windows or similar arrangements.
Despite the all-inclusive language, the computer model need not make any recommendations regarding investing in (i) an in-plan annuity option if the participant or beneficiary is, simultaneously with the computer generated advice, given a description of how the in-plan annuity option operates; or (ii) any designated investment option the participant or beneficiary requests to be excluded. However, the computer model must take into account designated investment options consisting of qualifying employer securities and asset allocation funds (such as lifecycle or target-date funds), which were excluded from mandatory consideration under the Proposed Investment Advice Regulations.
The computer model must be designed and operated to avoid investment recommendations that inappropriately favor investment options (i) offered by the fiduciary adviser (or a person with a material affiliation or material contractual relations with the fiduciary adviser); or (ii) that may generate greater income for the fiduciary adviser (or a person with a material affiliation or material contractual relations with the fiduciary adviser). A material contractual relationship exists between persons if payments made by one of the persons exceed the gross revenue on an annual basis of the other person.
The computer model must be certified in advance of its use for compliance with the foregoing asset allocation computer modeling provisions by an “eligible investment expert” who satisfies certain technical expertise and is sufficiently independent from the fiduciary adviser and the person who created the computer model and the certification must set forth certain required elements. A fiduciary adviser’s selection of an eligible investment expert is a fiduciary act governed by ERISA section 404(a)(1). Thus, a fiduciary adviser must act prudently in its selection of an eligible investment expert. However, the eligible investment expert so selected will not be considered a plan fiduciary under ERISA. Also, since the expert is not expected to handle any plan assets during the certification process, the expert is not required to be bonded under ERISA section 412.
While ERISA section 408(g)(11)(A) and the Final Regulations provide that every person involved in the development of a computer model or the marketing of an investment advice program is a fiduciary adviser and a fiduciary of the plan which utilizes such investment advice program, they also mitigate the breadth of this rule by permitting arrangements where one person involved in the developing or marketing of the model or program can elect to be treated as the sole fiduciary adviser with respect to the computer model or investment advice program. 
Other Requirements Applicable to Both Types of Arrangements
In addition to the requirements discussed above, each fiduciary adviser must ensure that the selected arrangement complies with the following requirements:
Authorization by a Plan Fiduciary :
- A plan fiduciary must expressly authorize the eligible investment advice arrangement being used in the plan.
- The authorizing plan fiduciary generally cannot be (i) the person offering the arrangement; (ii) any person providing designated investment options under the plan; or (iii) any affiliate of either. However, a fiduciary adviser or affiliate which maintains a plan can authorize the provisions of investment advice by the fiduciary adviser under its plan so long as the fiduciary adviser offers the same arrangement to participants and beneficiaries of unaffiliated plans in the ordinary course of its business.
The Final Regulations make it clear that a plan sponsor is not treated as a person providing a designated investment option under the plan merely because the plan sponsor’s securities is one of the designated investment options offered under the plan.
Annual Audits :
- Each fiduciary adviser must engage an independent auditor (at least once a year) to conduct an audit of the fiduciary adviser's investment advice arrangement to ensure the arrangement’s compliance with the Final Regulations. The auditor may use information obtained by sampling if the auditor reasonably determines it is appropriate.
- The independent auditor must provide the fiduciary adviser (and all other fiduciaries who authorized the use of the investment advice arrangement) with a written report of the audit which sets forth the auditor’s specific findings regarding the compliance of the arrangement within 60 days after completing the audit.
- The written audit report must include the following information: (i) the name of the fiduciary adviser; (ii) the type of investment advice arrangement; and (iii) if a computer model is being used, the date of the most recent model certification and the name of the eligible investment expert who provided the certification.
- The selection of an auditor by the fiduciary adviser, like the selection of eligible investment expert, is a fiduciary act governed by ERISA section 404(a)(1).
Disclosure to Participants and Beneficiaries : The fiduciary adviser must provide (without charge) written notification to participants and beneficiaries prior to the provision of investment advice that provides certain information including:
- the role of any party that has a material affiliation or material contractual relationship with the fiduciary adviser in the development of the investment advice program and in the selection of investment options available under the plan;
- the past performance and historical rates of return of the designated investment options available under the plan, to the extent that such information is not otherwise provided;
- all fees or other compensation relating to the advice that the fiduciary adviser or any affiliate is to receive (including compensation provided by any third party) in connection with (i) the provision of the advice; (ii) the sale, acquisition, or holding of the security or other property pursuant to such advice; or (iii) any rollover or other distribution of plan assets or the investment of distributed assets in any security or other property pursuant to such advice; and
- any material affiliation or material contractual relationship of the fiduciary adviser or affiliates in the security or other property.
The disclosure to participants and beneficiaries must also explain:
- the manner, and under what circumstances, any participant or beneficiary information provided under the arrangement will be used or disclosed;
- the types of services provided by the fiduciary adviser in connection with the provision of investment advice by the fiduciary adviser;
- that the fiduciary adviser is acting as a fiduciary of the plan in connection with the provision of the advice; and
- that a recipient of the advice may separately arrange for the provision of advice by another adviser that could have no material affiliation with and receive no fees or other compensation in connection with the security or other property.
The disclosure to participants and beneficiaries must be written clearly in a manner that can be understood by the average participant. The disclosure must also be “sufficiently accurate” and be comprehensive so that participants and beneficiaries are properly informed of all of the facts required under the Final Regulations.
To meet this requirement, fiduciary advisers may use the model disclosure form attached to the Final Regulations in the form of an appendix. The Final Regulations make it clear that fiduciary advisers are not required to use the model disclosure form.
Finally, the disclosures to participants and beneficiaries may be provided using the electronic disclosure rules under 29 C.F.R § 2520.104b-1.
Disclosure to the Authorizing Fiduciary : The Final Regulations added a new requirement for the fiduciary adviser to inform the authorizing plan fiduciary in writing that the fiduciary adviser intends to comply with the conditions of the statutory exemption for investment advice under ERISA sections 408(b)(14) and (g) and the Final Regulations; that the fiduciary adviser's arrangement will be audited annually by an independent auditor for compliance with the requirements of the statutory exemption and the Final Regulations; and that the independent auditor will furnish the plan fiduciary a copy of its findings within 60 days of its completion of the audit. This requirement is intended to assist the authorizing plan fiduciary in its monitoring role vis à vis the fiduciary adviser and the provision of investment advice under the plan.
Other Conditions : The following requirements apply in addition to those listed above:
- A fiduciary adviser must provide disclosures (when applicable) in connection with the sale, acquisition, or holding of the security or other property in accordance with the applicable securities laws.
- The sale, acquisition, or holding of a security or other property occurs solely at the direction of the participant or beneficiary who received the investment advice.
- The compensation received by the fiduciary adviser and its affiliates in connection with the sale, acquisition, or holding of the security or other property is reasonable.
- The terms of the sale, acquisition, or holding of the security or other property are at least as favorable to the plan as the terms of an arm's length transaction.
Each fiduciary adviser must retain any records necessary for determining whether the applicable requirements of the Final Regulations have been satisfied for at least six years.
The relief from the prohibited transaction rules under ERISA section 406 will not apply to any transaction for which the conditions described above were not satisfied. Further, if a fiduciary adviser has engaged in a pattern or practice of noncompliance with any of the applicable conditions of the Final Regulations, the prohibited transaction relief will not apply to any transaction connected with the provision of investment advice during the period of such noncompliance.