Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

This is my 76th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The regulation defining fiduciary advice for plans, participants and IRAs applied on June 9, 2017. As a result, we now have some experience with the fiduciary regulation and the transition prohibited transaction exemptions. Based on that experience, there are some significant misunderstandings about how the rules work. This article discusses one of those.

If a broker-dealer or RIA firm receives prohibited (or “conflicted”) compensation from an IRA, the compensation may be permissible under the Best Interest Contract Exemption (BICE). During the transition period (until July 1, 2019), BICE only requires that fiduciary advisors (such as broker-dealers and RIAs, and their representatives) adhere to the Impartial Conduct Standards. There are three Impartial Conduct Standards. Those are:

  • The best interest standard of care (which is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty).
  • The compensation of the financial institution and the individual advisor is no more than a reasonable amount for the services rendered.
  • Neither the financial institution nor the advisor makes any materially misleading mis-statements.

There are two other considerations, though. The first is that BICE is an exemption to the prohibited transaction rules and, therefore, the burden of proof is on the financial institution (e.g., the RIA firm or broker-dealer). As a result, compliance with those three Impartial Conduct Standards should be documented in a retrievable form. The second is that the Department of Labor has said that financial institutions need to have policies, procedures and practices that ensure that their advisors are adhering to the Impartial Conduct Standards.

All in all, though, it is possible to comply with those requirements. Stated another way, the most burdensome requirements in BICE were delayed until July 1, 2019—and will likely be revised before those rules apply.

However, there is a caveat. That is, BICE only applies to non-discretionary investment advice. In other words, if the financial institution or its advisors have the responsibility or authority to make the decisions, or if they actually make the investment or transaction decisions, and there is a financial conflict of interest (that is, a prohibited transaction), BICE does not provide relief. To make matters even worse, there are very few exemptions for prohibited transactions resulting from discretionary decisions. Based on conversations with RIAs over the last few months, I have learned that many of them are not aware that, where they have financial conflicts (for example, 12b-1 fees or payments from custodians) for discretionary investment management for IRAs, there is usually not an exemption and the compensation is prohibited.

In other words, where advisors have discretion, the “cleanest” approach is “pure” level fee advice. Any payments or financial benefits from third parties (e.g., custodians, mutual funds, insurance companies) are prohibited. The DOL’s definition of “discretion” is very broad, for example, if the advisor selects the share class, and the investor does not approve that share class in advance, the advisor (and therefore the financial institution) has exercised discretion.

With that in mind, my advice is that RIAs and broker-dealers should consult with their ERISA attorneys to make sure that they understand these rules and are in compliance.