On Aug. 21, 2008, the U.S. Department of Labor (“DOL”) announced the publication of proposed regulations implementing the prohibited transaction exemption for investment advice to participants in participant-directed individual account plans under section 408(b)(14) and (g) of the Employee Retirement Income Security Act of 1974 (“ERISA”), and the parallel provisions of section 4975 of the Internal Revenue Code of 1986 (the “Code”). The proposed regulations provide guidance on the exemption’s requirements for fee leveling and computer model arrangements, and include a non-mandatory model form that advisers may use to satisfy the fee disclosure requirement.

DOL simultaneously published a proposed class exemption, which is designed to supplement the statutory exemption as a means of increasing the availability of professional investment advice. It would provide relief for investment advice to individuals following asset allocation recommendations generated by a computer model, or in the case of IRAs where modeling is not feasible, certain investment education material on asset allocation.

Background

Over the years, DOL has identified categories of “investment education” that can be provided to plan participants responsible for the investment of their plan accounts without making the provider an ERISA fiduciary, and also has described structures for providing investment advice to participants that avoid conflicts of interest that could violate ERISA’s prohibited transaction rules. Nevertheless, many have felt that there were still too many barriers preventing participants from receiving the advice they need to be able to effectively manage their retirement savings.

In response, as part of the Pension Protection Act of 2006 (the “PPA”), Congress enacted a statutory investment advice prohibited-transaction exemption, which allows greater flexibility for participants in 401(k) plans and IRAs to obtain investment advice. Specifically, subject to the requirements of section 408(g), section 408(b)(14) of ERISA provides that certain investment advice-related transactions will be exempt from the prohibitions of section 406 of ERISA, which prohibits various types of transactions between a plan and persons who are parties in interest with respect to the plan, as well as fiduciary self-dealing and conflicts of interest. Section 408(g) in turn requires that the investment advice be provided to participants by a fiduciary adviser, and that the advice arrangement meet either a “level fee” requirement or a “computer model” requirement.

Under the level fee structure, the fiduciary adviser’s fees or other compensation must not be affected by the investments selected by the participant as a result of the advice. Under the computer model arrangement, the advice must arise solely from the use of a computer model that meets a series of requirements, including that it be based on objective criteria and independently certified as meeting the conditions of the exemption. Either structure must be independently approved and subject to annual independent review to assure compliance with the exemption.1

DOL had to take regulatory action for the computer model portion of the exemption to be available because the model’s certification process, which must be in place before a model can be used, is to be defined by DOL. Also, the computer model approach was not available to IRAs pending a DOL study on whether the approach was feasible for IRAs. There was an issue for IRAs because the statutory exemption requires a computer model to take “into account all investment options under the plan.” Since IRAs generally do not have limits on available investments, Congress was concerned whether a computer model for IRAs could take into account the full range of investments available to the IRAs. As a result, DOL was to determine whether a computer model investment advice program was feasible for IRAs by, among other things, taking into account “the full range of investments … in determining the options for the investment portfolio of the account beneficiary.” If it could not make the required findings, it was to grant an administrative exemption based on the new statutory exemption. DOL also was required to submit a report to Congress of its conclusions as to the feasibility of computer models for IRAs.

In December 2006, DOL solicited public comments to assist it in developing regulations under section 408(b)(14) and (g), and in making its determination with respect to the utilization of computer models for IRAs. DOL received a number of comments in response, including varying views on the “full range of investments” issue.

On Aug. 21, 2008, DOL submitted its report to Congress on the feasibility of computer model programs for IRAs. In its report, DOL concluded that the computer model approach under the exemption is feasible for IRAs, by reading the “full range of investments” language to mean that the computer model should take into account “all of the generally recognized asset classes that are necessary for an account beneficiary to construct a diversified investment portfolio.” Thus, DOL determined that the statutory exemption did not require a computer model to take into account the “full universe” of every investment legally available to IRAs.

DOL also noted in its report that it had become aware of investment advice arrangements that, while not covered by the statutory exemption, may be beneficial to participants and beneficiaries of individual account plans and IRAs. DOL therefore proposed a separate class exemption for such arrangements, discussed in Part B below.

A. The Proposed Regulation

The statutory exemption provides relief from the prohibitions of section 406 of ERISA for certain transactions in connection with the provision of investment advice to a participant or beneficiary if the investment advice is provided by a “fiduciary advisor” under an “eligible investment advice arrangement.” The transactions covered are (i) the provision of the advice with respect to a security or other property available as an investment under the plan; (ii) the acquisition, holding or sale of the security or other property pursuant to the advice; and (iii) the direct or indirect receipt of compensation by the fiduciary adviser or an affiliate in connection with the preceding transactions.

A “fiduciary adviser” is any person who is a fiduciary to the plan as a result of providing investment advice, and who is either a registered investment adviser, bank trust department, insurance company qualified to do business under the laws of a state, or registered broker-dealer or their affiliates, employees or registered representatives. Also included in the definition of “fiduciary adviser” is any person who develops the computer model, or markets the computer model or investment advice program. DOL was charged with issuing rules that would permit a single advice program developer or marketer to elect to be treated as the sole fiduciary adviser to the plan in connection with developing or marketing the particular program. In accordance with that mandate, DOL has proposed a separate regulation, which provides that any such election must (i) be in writing; (ii) contain specific information, including the identity of the arrangement and the person offering the arrangement, with respect to which the election is to be effective; (iii) be provided to the plan fiduciary who has authorized use of the arrangement; and (iv) be retained in accordance with the exemption’s general record retention requirements.

An “eligible investment advice arrangement” is an arrangement that meets either the requirements for feeleveling or for computer modeling, or both.

1. Fee-Leveling

For investment advice arrangements that use a fee-leveling structure, any investment advice must be based on generally accepted investment theories that take into account the historic returns of different asset classes over defined periods of time. The advice must also take into account information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences. A fiduciary advisor could also take into account additional considerations or information that a participant or beneficiary may provide.

To safeguard against improper incentives to recommend particular investment products, the proposal would prohibit fees and compensation received directly or indirectly – including salary, bonuses, awards, promotions, or other things of value – by a person who provides investment advice on behalf of a fiduciary adviser from varying based on the selection of investment options. Commissions or compensation received by the fiduciary adviser itself for investments made as a result of the advice provided also could not vary based on investment selections.

Consistent with its prior views, DOL interpreted the fee-leveling requirements to apply only to fiduciary advisers, and not to the affiliates of fiduciary advisers.

2. Computer Models

A computer model must be designed and operated to (i) apply generally accepted investment theories that take into account the historic returns of different asset classes over defined periods of time (although not precluding a model from applying generally accepted investment theories that take additional considerations into account); (ii) utilize information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences (along with any additional considerations that a particular computer model may take into account); and (iii) utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the plan.

In addition, a computer model must be designed and operated to avoid investment recommendations that (i) inappropriately favor investment options offered by the fiduciary adviser – or a person with a “material affiliation” or “material contractual relationship” with the fiduciary adviser – over other investment options available under the plan; or (ii) inappropriately favor investment options that may generate greater income for the fiduciary adviser or a person with a “material affiliation” or “material contractual relationship” with the fiduciary adviser, for example, by favoring a higher-cost investment alternative over an otherwise identical investment alternative with a lower cost.

A computer model would not fail to meet the above requirements simply because the only investment options offered under the plan are options offered by the fiduciary adviser, or a person with a material affiliation or contractual relationship with the fiduciary adviser. However, a computer model could not be designed and operated to inappropriately favor investment options that generate the most income for such persons.

The computer model must take into account all “designated investment options” available under the plan, without giving inappropriate weight to any particular investment option. The term “designated investment options” includes any investment option designated by the plan into which the participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts. It would not include brokerage windows, self-directed brokerage accounts, or other arrangements where a participant and beneficiary could select an investment beyond those designated by the plan. The computer model would not be required to take into account an investment option that invests primarily in qualifying employer securities, provided that any such limitation is disclosed to participants, beneficiaries and fiduciaries.

Prior to utilization of the computer model, the fiduciary adviser would be required to obtain a written certification from an “eligible investment expert” that the computer model meets the above requirements. If the computer model is later modified in a manner that may affect its ability to meet these requirements, the fiduciary adviser would be required to obtain a new certification. The certification would be required to be in writing and contain the following:

  • An identification of the methodology(ies) applied in determining whether the computer model meets the requirements described above
  • An explanation of how the applied methodology(ies) demonstrate that the computer model met these requirements
  • A description of any limitations that were imposed on the “eligible investment expert’s” selection or application of methodologies for determining whether the computer model meets these requirements
  • A representation that the methodology(ies) were applied by a person or persons with the educational background, technical training or experience necessary to analyze and determine whether the computer model meets the requirements described above, and a statement certifying that the “eligible investment expert” has determined that the computer model meets these requirements

DOL noted that it is not requiring the use of any particular methodology in determining compliance with the statutory criteria because, as computer models continue to develop, flexibility in developing new methodologies for examining these models may be needed.

An “eligible investment expert” would be defined as a person who, through employees or otherwise, has the appropriate technical training or experience and proficiency to analyze, determine and certify, in a manner consistent with the certification standards, whether a computer model meets the above requirements. The term “eligible investment expert” would not include any person that has any “material affiliation” or “material contractual relationship” with (i) the fiduciary adviser, (ii) a person who has a “material affiliation” or “material contractual relationship” with the fiduciary adviser, or (iii) any employee, agent, or registered representative of the foregoing. The proposal does not contain any specific credentials that would define the appropriate expertise and experience for an eligible investment expert. Thus, it is the fiduciary adviser who is responsible for determining eligible investment expert status, which determination, DOL noted, would be a fiduciary act that must be done prudently in accordance with section 404(a)(1) of ERISA.

A person who has a “material affiliation” with another person would be (i) any “affiliate” of such other person; (ii) any person directly or indirectly owning, controlling or holding 5 percent of more of the “interests” of such other person; or (iii) any person, 5 percent or more of whose “interests” are directly or indirectly owned, controlled, or held by such other person. The proposal further defines “interest” as (i) the combined voting power of all classes of stock entitled to vote, or the total value of the shares of all classes of stock if the entity is a corporation; (ii) the capital interest or the profits interest of the entity if the entity is a partnership; or (iii) the beneficial interest of the entity if the entity is a trust or unincorporated enterprise.

A “material contractual relationship” arises if payments made by one person to the other person pursuant to written contracts or agreements between them exceed 10 percent of the gross revenue, on an annual basis, of the other person. DOL has invited comments on whether this percentage should be higher or lower.

Finally, the proposal defines an “affiliate” as (i) any person directly or indirectly owning, controlling, or holding with power to vote, 5 percent or more of the outstanding voting securities of such other person; (ii) any person, 5 percent or more of whose outstanding voting securities are directly or indirectly controlling, controlled by, or under common control with, such other person; and (iii) any officer, director, partner, copartner, or employee of such other person. This definition is largely based on the definition of “affiliated person” in section 2(a)(3) of the Investment Company Act of 1940, other than elements of that definition that DOL viewed as focused on persons who exercise control over investment company management.

3. Additional Requirements Applicable to Fee-Leveling and Computer Model Arrangements

a. Authorization by a Plan Fiduciary

Section 408(g)(4) of ERISA provides that the investment advice arrangement must be expressly authorized by a plan fiduciary (or, in the case of an IRA, the IRA beneficiary). The authorizing person cannot, however, be the person offering the arrangement, any person providing designated investment options under the plan, or any affiliate of either. The proposal clarifies that an IRA beneficiary will not be treated as an affiliate of a person offering an investment advice arrangement solely by reason of being an employee, thereby enabling employees of a fiduciary adviser to take advantage of the exemption.

b. Annual Audit

Section 408(g)(6) of ERISA requires that the fiduciary adviser engage an independent auditor at least annually for the purpose of documenting compliance with the exemption’s requirements. The independent auditor must have appropriate technical training or experience and proficiency, and must so represent to the fiduciary adviser. For these purposes, the proposal provides that an auditor is considered independent if it does not have a “material affiliation” or “material contractual relationship,” as defined above, with the person offering the investment advice arrangement to the plan or any designated investment options under the plan.

In preparing the written audit report, the independent auditor would be directed to review sufficient relevant information to formulate an opinion as to whether the investment advice arrangement, and the advice provided pursuant to such arrangement, was in compliance with the regulation. The auditor would not be precluded from using information obtained via sampling. Therefore, the proposal generally permits the auditor to determine the appropriate scope of its review and the extent to which it can rely on representative samples for determining compliance.

The proposal would require that the written audit report be furnished to the fiduciary adviser and, except with respect to an arrangement with an IRA, to each fiduciary who authorized the use of the investment advice arrangement, within 60 days following completion of the audit. In the case of an IRA, the fiduciary adviser would be required, within 30 days of receiving the audit from the auditor, to provide the report to the IRA beneficiary or to make the report available on its website. If the report were made available on the fiduciary adviser’s website, the beneficiaries must be provided information concerning the purpose of the report, and how and where to locate the report applicable to their account.

In addition, in the case of an IRA, if the written audit report identifies noncompliance with the requirements of the regulation, the fiduciary adviser would be required to submit the report to DOL within 30 days following receipt of the report from the auditor. DOL noted that submission of this report will enable it to monitor compliance with the statutory exemption in those instances where there is no authorizing ERISA plan fiduciary to carry out that function.

c. Disclosure to Advice Recipients

Consistent with the statutory disclosure requirements under ERISA section 408(g), the proposal would require that the fiduciary adviser provide to participants and beneficiaries, prior to the initial provision of investment advice as to any security or other property offered as an investment option, a notification describing, in either written or electronic format:

  • The role of any party that has a “material affiliation” or “material contractual relationship” with the fiduciary adviser in the development of the investment program, and in the selection of investment options available under the plan (to the extent that this information is not otherwise provided)
  • All fees and other compensation relating to the advice that the fiduciary adviser or any affiliate is to receive (including compensation provided by third parties) in connection with the provision of the advice or in connection with the sale, acquisition, or holding of the security or other property
  • Any “material affiliation” or “material contractual relationship” of the fiduciary adviser or its affiliates in the security or other property

In addition, the notification to participants and beneficiaries would also be required to 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, including, as to computer model arrangements, any limitations on the ability of the model to take into account an investment primarily in qualifying employer securities
  • That the adviser is acting as a fiduciary of the plan in connection with the provision of the advice
  • That a recipient of the advice may separately arrange for the provision of advice by another adviser that would have no “material affiliation” with, and receive no fees or other compensation in connection with, the security or other property.

The notice furnished to participants and beneficiaries must be written in a clear and conspicuous manner, and in a manner calculated to be understood by the average plan participant. It must be sufficiently accurate and comprehensive so as to reasonably apprise the participants and beneficiaries of the information required to be provided in the notification.

For purposes of satisfying the fee and compensation disclosure requirements, the proposal contains an optional model disclosure form. The form would permit the disclosure of a range of fees and compensation received from both affiliated and nonaffiliated funds, provided that specific information is available from a specified source, which may be a website address.

In addition, in accordance with the provisions of section 408(g)(6)(B), the proposal charges the fiduciary adviser with (i) maintaining the information contained in the participant and beneficiary notice in accurate form; (ii) providing, without charge, accurate information to the recipient of the advice no less than annually; (iii) providing, without charge, accurate information to the recipient of the advice upon request of the recipient; and (iv) providing, without charge, an accurate description of any material change to the information provided at a time reasonably contemporaneous to such change.

d. Other Conditions

  • The fiduciary adviser must provide appropriate disclosure in connection with the sale, acquisition, or holding of the security or other property, in accordance with all applicable securities laws
  • The sale, acquisition, or holding must occur solely at the direction of the recipient of the advice
  • The compensation received by the fiduciary adviser and affiliates in connection with the sale, acquisition, or holding of the security or other property must be reasonable
  • The terms of the sale, acquisition or holding of the security or other property must be at least as favorable to the plan as an arm’s length transaction would be

e. Maintenance of Records

Finally, consistent with section 408(g), the proposal imposes certain record retention requirements on the fiduciary adviser. The fiduciary adviser would be required to maintain, for a period of not less than six years after the provision of investment advice, any records necessary for determining whether the applicable requirements of the proposal have been met. However, a prohibited transaction will not be considered to have occurred solely because the records are lost or destroyed prior to the end of the six-year period because of circumstances beyond the control of the fiduciary adviser.

B. Proposed Class Exemption

DOL also proposed a class exemption that would provide relief from the ERISA and Code section 4975 prohibited transaction rules for individualized investment advice following the furnishing of recommendations generated by a computer model or, in the case of IRAs where modeling is not feasible, the furnishing of certain investment education material regarding asset allocation. Unlike the statutory exemption, the proposed class exemption would apply the fee-leveling limits solely to the compensation received by the employee, agent, or registered representative providing the advice on behalf of the fiduciary adviser, as distinguished from compensation received by the fiduciary adviser itself.

The class exemption would be unavailable for any investment advice where the conditions were not satisfied. In addition, it would be unavailable, even in the case of compliant advice, during a period where there was a pattern or practice of noncompliance with any of the exemption’s conditions.

1. Computer Model Conditions

Like the statutory exemption, the proposed class exemption provides that, regardless of whether the fiduciary adviser uses a computer model arrangement or a fee leveling arrangement in connection with providing individualized investment advice, the investment advice must (i) be authorized by a plan fiduciary (or IRA beneficiary), other than the person offering the investment advice arrangement, any person providing designated investment options under the plan, or any affiliate of either; (ii) be based on certain generally accepted investment theories; and (iii) take into account information furnished by a participant or beneficiary.

The class exemption would, however, provide special rules for use of a computer modeling arrangement. Under the proposal, participants and beneficiaries must first be provided with computer-model-generated investment recommendations. The computer model must meet the requirements set forth under the statutory exemption, although it need not meet the certification requirement if it is designed and maintained by a person independent of the fiduciary adviser. The foregoing requirements for computer model investment advice would likewise apply to IRAs, unless the fiduciary adviser determined that the types or number of investment choices available to an IRA beneficiary reasonably preclude the use of a computer model meeting the requirements of section 408(g). In this event, the class exemption would require that the beneficiary be provided with certain investment education-type materials, such as graphs, pie charts, case studies, and worksheets, which reflect or produce asset allocation models taking into account the age (or time horizon) and risk profile of the beneficiary, to the extent known.

Once the computer-model-generated recommendations, or investment education/asset allocation materials in the case of certain IRA beneficiaries, have been provided, the class exemption would permit the fiduciary adviser to provide additional advice not generated by the computer model. This is in contrast to the statutory exemption, which requires that any advice follow the computer model’s recommendations. Advice furnished pursuant to the class exemption could not generate greater income for the fiduciary adviser or its affiliates than other options of the same asset class, unless the adviser prudently concludes that the recommendation is in the best interest of the participant or beneficiary, and explains to the participant/beneficiary the basis for that conclusion.

Not later than 30 days following the provision of investment advice pursuant to the proposed class exemption, the individual providing the advice on behalf of the fiduciary adviser must document the basis of any investment option(s) recommended to a participant or beneficiary, including an explanation as to how such recommendation relates to the recommendations or information provided or generated pursuant to the computer model or investment education information. In addition, with respect to any investment advice that recommends investment options that may generate for the fiduciary adviser or its affiliates greater income than other options of the same asset class, the individual providing the investment advice must, not later than 30 days following the provision of such advice, document the basis for concluding that the recommendation is in the best interest of the participant or beneficiary. This documentation must be retained in accordance with the exemption’s general record retention requirement of six years.

2. Fee Leveling Arrangements

The class exemption further provides that, in lieu of using a computer model arrangement, a fiduciary adviser could use a modified version of the fee leveling arrangement described in the statutory exemption. In contrast to the statutory exemption and the proposed regulations, the class exemption would apply the fee-leveling requirement – that the fee not vary based on the investment option selected by the participant or beneficiary – only to the individual who provides the investment advice, rather than to the fiduciary adviser on whose behalf the employee, agent or registered representative is providing the advice. DOL took the view that the safeguards provided for in the proposed class exemption would be sufficient to permit the application of the fee-leveling requirement at the individual level without compromising the availability of informed, unbiased and objective investment advice.

3. Other Conditions

The proposed class exemption contains a number of additional conditions relating to the provision of investment advice that track many of the requirements of the statutory exemption, as described above under section A.3, including:

  • Disclosure of any material affiliation or material contractual relationship with any party that has a role in the development of the computer model or educational materials or the selection of available investment options
  • Disclosure of all fees and other compensation relating to the advice received by the fiduciary adviser or any affiliate
  • Ability of the advice recipient to arrange separately for the provision of advice by another adviser that has no material affiliation and receives no fees or other compensation in connection with plan investments
  • Annual independent audit to determine compliance with written policies and procedures designed to assure compliance with the exemption and the requirements of the exemption itself

C. Public Comments and Effective Date

The proposed regulations and class exemption are to become effective 60 days and 90 days, respectively, after publication of the final regulations and class exemption in the Federal Register. Comments on the feasibility of the effective dates, or other aspects of these proposals, are due by Oct. 6, 2008.

Observations

The PPA advice exemption represented a recognition by Congress that plan participants and IRA beneficiaries are increasingly responsible for managing the investments of their retirement accounts, and thus are in need of professional investment advice to assist them in this role. The resulting statutory exemption was a compromise between those who favored broad disclosure-based exemptive relief, and those who were concerned that such relief would leave participants overly vulnerable to adviser conflicts of interest. The consequence was a framework that limited relief to two specific approaches to providing advice, fee leveling and computer models.

The proposed regulations provide important guidance on fee leveling. Confirming prior DOL statements, the regulations would limit the fee-leveling requirement to the fiduciary adviser, so that fees received by the adviser’s affiliates would not prevent compliance with the exemption. The regulations also would, once finalized, permit advisers to move forward with computer model advice programs by describing the process for independent certification of a computer model, which is a prerequisite to qualifying a model under the statutory exemption.

Because the fee leveling and computer model approaches are restrictive, they may not sufficiently encourage the provision of individualized investment advice. DOL recognized the limitation and concluded that other types of advice arrangements may be beneficial. The result is a proposed class exemption that, while largely based on the statutory exemption, would allow advice arrangements beyond the limitations of the PPA. It would permit the fiduciary adviser to receive variable fees so long as the individual agent or representative of the adviser, rather than the adviser itself, is subject to fee leveling, and would permit advice beyond that provided by a computer model subject to a disclosure and heightened prudence requirement. In pursuing this approach, DOL is creating an exemption closer to (albeit subject to more conditions than) the broader disclosure-based exemption originally proposed in Congress and passed twice in the House, which has greater potential to promote individual investment advice than the PPA exemption alone.

Financial services firms that are interested in providing advice under these exemptions should review the proposed regulations and exemption to determine whether they will be able to operate under their conditions, and to identify any areas on which they may wish to submit comments during the comment period.