The U.S. Department of Labor (“DOL”) on October 25, 2011 issued a final rule implement-ing the ERISA statutory exemption from the prohibited transaction rules for providers of investment advice to benefit plan participants and individual retirement accounts, enacted under the Pension Protection Act of 2006 (“PPA”).1 The final rule provides certain notable clarifications and modifications of the proposed regulations issued on February 26, 2010.
The PPA provides a statutory exemption from ERISA’s prohibited transaction rules to a fiduciary adviser who offers investment advice under an “eligible investment advice arrange-ment” that either (i) provides for fees to be received by the adviser that do not vary depending on the investment options selected or (ii) uses a qualified computer model invest-ment advice program. An “eligible investment advice arrangement” must meet certain additional requirements to qualify for the exemption, including: (1) a plan fiduciary2 independent of the adviser must expressly authorize the arrangement; (2) an independent auditor must conduct an annual compliance audit and issue a written report to the authoriz-ing fiduciary; (3) the adviser must provide certain disclosures to the participant or beneficiary; and (4) the sale, acquisition or holding of a security or other property must occur solely at the direction of the recipient of the advice.
The final rule substantially tracks the statutory exemption requirements set forth in Section 408(g) of ERISA and Section 4975(f)(8) of the Code. The final rule largely retains the substan-tive provisions of the 2010 proposed regula-tions. The DOL reaffirms that neither the PPA nor these final Regulations invalidate or otherwise affect prior guidance given by DOL on the provision of investment advice.
Fee Leveling Requirement
The final rule for this alternative provides that no fiduciary adviser providing investment advice may receive from any party (including an affiliate of the fiduciary adviser), directly or indirectly, any fee or other compensation that varies depending on the basis of a participant’s or beneficiary’s selection of a particular investment option. As such, the final rule clarifies, in response to comments, that the fee leveling requirement only proscribes the receipt of fees or compensation that vary based on investment selections and that the requirement covers the receipt of any such payment that could have the effect of creating an incentive for a fiduciary adviser to favor certain investments, without regard to the payor’s intent.
The final rule also clarifies that the fee leveling requirement applies broadly to proscribe the receipt of every form of remuneration, including commissions, salary, bonuses, awards, promo-tions, or other things of value such as trips, gifts and other non-cash things of value that vary depending on a participant’s selection of a particular investment option. The DOL refused to provide an exception for particular compensation arrangements or bonuses, but noted that a compensation arrangement based on the overall profitability of an organization may satisfy the fee leveling requirement if the investment advice and investment option components are excluded from, or constitute a negligible portion of, the calculation of the organization’s profitability.
Furthermore, consistent with the 2010 proposed regulation and the DOL Field Advice Bulletin 2007-1, the DOL confirms that the fee leveling requirement applies to any fees and compensation received by the fiduciary adviser entity, as well as any employee, agent or registered representative of the fiduciary adviser, but does not extend to payments received by affiliates of the fiduciary adviser unless the affiliate also is a provider of investment advice.
Computer Model Design and Operation
The final rule provides that a computer model must be designed and operated to appropriately weight the factors used in estimating future returns of investment options. This provision replaces the 2010 proposed requirement that a computer model be designed and operated to avoid investment recommendations that inappropriately distinguish among investment options within a single asset class on the basis of a factor that cannot be expected to persist in the future, such as historical performance. The DOL has thereby clarified that a computer model may take into account historical performance of an investment option among multiple factors.
The rule retains the general requirement that a computer model be designed and operated to apply generally accepted investment theories that take into account, without limitation, the historic risks and returns of different asset classes over defined periods of time.
In addition, the final rule removes employer securities and asset allocation funds from the list of investment options that may be excluded from consideration by the model and still satisfy the statutory requirement that a computer model consider all investment options available under the plan or IRA in making recommendations. Thus, the final rule requires that a computer model take into account qualifying employer securities and asset allocation funds whenever they are designated as available investment alternatives by the plan or IRA. This change reflects the DOL’s belief that it is feasible to design a computer model capable of addressing these investment options. The final rule, however, permits the computer model to exclude consideration of in-plan annuity options. The final rule also permits the model to exclude investment options that a participant or beneficiary requests to be excluded from consideration.
The exemption requires the model to be certified. The final rule expressly excludes a person who develops the computer model utilized by the fiduciary adviser from an “eligible investment expert” who may certify the model.
The exemption requires that any sale, acquisition or holding of a security occur solely at the direction of the recipient of the advice. The DOL was asked whether certain “rebalancing” arrangements were consistent with this requirement.
The DOL notes in the preamble to the final rule that a fiduciary adviser may periodically rebalance a participant’s portfolio and maintain a particular asset allocation structure with the participant’s advance authorization if the participant is informed of and approves, at the time of the advance authorization, the specific circumstances under which a rebalancing will take place and the particular investments that will be utilized for rebalancing. According to the DOL, a preauthorized rebalancing that does not involve the exercise of discretion by the fiduciary adviser complies with the statutory requirement that any sale, acquisition or holding of a security or other property occur solely at the direction of the recipient of the advice.
The DOL further states that, where the particular investments that might be utilized for rebalancing are not known, a fiduciary adviser may be given the discretion to select investments without violating the “solely at the direction” requirement if the participant is afforded an advance notice of the intended investments and a reasonable opportunity, generally at least 30 days, to object to the investments. In contrast, the final rule does not allow a fiduciary adviser to change, without the participant’s affirmative direction, a particular asset allocation structure to a different structure to implement a “re-allocation” or “reoptimization.” In sum, under the exemption, a fiduciary adviser may not reallocate assets to achieve a different asset allocation structure without the participant’s affirmative authorization, but may rebalance invest-ments to maintain a particular asset allocation struc-ture so long as the participant is provided a sufficient notice period to raise an objection.
Other Notable Provisions
The final rule retains the requirement, for both types of advisory arrangements, that a fiduciary adviser request information relating to the participant, including age, time horizon, risk tolerance, current investments in designated investment options, other assets and sources of income, and investment preferences.
The statutory exemption requires an annual compliance audit. The final rule requires a fiduciary adviser to provide the authorizing fiduciary with written notifica-tion that (i) the fiduciary adviser intends to comply with the statutory exemption and the regulations; (ii) the fiduciary adviser’s investment advice arrangement will be audited annually by an independent auditor for compliance; and (iii) the auditor will furnish the authorizing fiduciary with a copy of the auditor’s findings within 60 days of its completion of the audit. In connection with this mandatory disclosure, the DOL expects the authorizing fiduciary to take reasonable steps including making inquiries with the auditor if the report is not furnished in a timely manner. The DOL confirms that the required disclosures to fiduciaries may be combined with other disclosures required under securities or other laws, and that use of the model disclosure form is not mandatory.
The DOL declined to address the prohibited transaction implications of making recommendations to plan participants to roll-over plan benefits into an IRA. Instead, the DOL reiterated its prior position that merely advising a plan participant to take an otherwise permissible plan distribution does not constitute an investment advice subject to the ERISA fiduciary rules, even when that advice is combined with a recommenda-tion as to how the distribution should be invested.3 The DOL is considering this issue as part of its review of the definition of “fiduciary” with respect to persons providing investment advice.4
The final rule generally tracks the statutory require-ments for the prohibited transaction exemption under the PPA and largely adopts the 2010 proposed regula-tions with certain important clarifications and modifica-tions. Notably, the final rule clarifies the scope of the fee leveling requirement, the design and operation of a qualified computer model and the meaning of the solely-at-the direction requirement in the context of rebalancing and reallocation.
The effective date of the final rule is 60 days after October 25, 2011, the date of publication in the Federal Register. Advisory firms providing investment advice to plan participants and IRAs, as well as plan sponsors and fiduciaries, should review their investment advice arrangements to determine whether they need to take any action to comply with the final rule.