After several rounds of proposals, the Department of Labor (DOL) published final regulations in the Federal Register on April 8, 2016 that make sweeping changes to who might be a fiduciary based on the provision of investment advice to retirement plan sponsors or participants. At the same time, the DOL issued detailed new rules that must be met to stay within a "prohibited transaction" exemption that allows the vendor to be paid for investment advice. These rules, referred to in the popular press as either the "Fiduciary Regulations" or the new DOL conflict of interest rules, are effective June 7, 2016, but the DOL agrees not to apply them until April 10, 2017. Many of the material changes to migrate to a "best interest contract" standard for investment advice will be made during a transition period between April 10, 2017 and January 1, 2018.
While the rules have little direct impact on employers who sponsor retirement plans—plan sponsors were generally fiduciaries of their plans before, and will remain so under the newest guidance—the new rules may cause sweeping changes in the way the financial industry provides services to retirement plans and participants. Those industry changes may be positive or negative, depending on a plan sponsor's current service relationships and perspective.
When the Employee Retirement Income Security Act (ERISA) was adopted in 1975, the Internal Revenue Code (the "Code") was also amended and both laws included almost-identical fiduciary rules and self-dealing prohibitions with certain exemptions allowed by statute or agency action. Rather than both agencies issuing interpretive guidance and exemptions, in 1978 the two agencies entered into an agreement giving the DOL jurisdiction to issue regulations and exemptions that would be binding under both the Code and ERISA. Because of that inter-agency agreement, the DOL gained authority to issue rules that apply to both employer-sponsored retirement programs, and, with respect to the Code's prohibited transaction rules and exemptions, to Individual Retirement Accounts and annuities (IRAs) as well as to employer plans sponsored by governments and churches, which are exempt from ERISA, but must comply with the Code's rules in order to assure certain tax results.
From 1975 until June 7, 2016, the DOL defined an investment "fiduciary" under Section 3(21) of ERISA using a five-part test requiring, among other things, that fiduciary investment advice be only advice given on a "regular basis" when it is mutually understood that the advice will be the primary basis for an investment decision.
Of course, at the time this five-part standard was developed, the retirement world was a different place—there were more defined benefit plans and the few defined contribution plans that were offered generally did not allow for participant direction of investment, which is the norm today. The DOL sought to modernize the definition to take into account that the consumers of investment services are now plan participants, who are much less able to understand the conflicts of interest inherent in the fee and compensation arrangements in the industry. Only time will tell if the DOL achieved the correct balance in the new regulations.
Broader Fiduciary Definition
Now there is a new, broader, standard to determine if someone is a fiduciary. That standard can be summarized in five parts; a fiduciary relationship exists if one or more of the first three criteria are met, in addition to each of the final two being met. A fiduciary relationship exists when someone:
- recommends the purchase, sale or retention of an investment, or
- recommends someone to provide investment advice, or
- recommends whether or how to take a distribution, rollover or transfer from a plan or IRA, but only if:
- that recommendation is either based on the particular needs of a plan, participant or beneficiary, or is directed to a specific recipient, and
- the person making the recommendation (or an affiliate of that person) gets paid directly or indirectly with respect to the recommendation or the actual investment.
There no longer has to be any regular pattern of advice, nor a mutual understanding as to how it will be used, nor does the advice given have to be a primary basis for an investment decision. A single instance of advice can now be a fiduciary act. Whether a statement is a recommendation will depend on the entirety of the facts and circumstances. Based on the context, could the plan or participant or IRA owner reasonably believe the suggestion was to take or refrain from a specific course of action? The more individually-tailored a communication becomes, the higher the likelihood it will be considered a recommendation, rather than mere investment education.
This broader definition was adopted after several rounds of proposals beginning with a 2010 first draft of these regulations, and the regulations have been the subject of considerable controversy because they expand the definition in such a way that many more people will be fiduciaries under the new standard than were considered fiduciaries under the older rules. The expense involved for investment providers to comply with the new rules is expected to create some sweeping changes in the investment service industry, and may result in fewer providers giving investment advice with respect to retirement assets, at a higher cost than in the past.
The rules do not apply to benefit plans funded with health or disability insurance policies or term life insurance or other assets that do not have an investment component.
What is/is not "Investment Advice?"
The key to applying this broader definition of fiduciary will be knowing the difference between a "recommendation" which could be investment advice, versus mere "education."
Here are some typical services to retirement plans or participants that are either not considered recommendations or not investment advice, per the final regulation:
- Marketing or making a platform of investment vehicles available to a plan fiduciary (with disclosure in writing that the vendor is not undertaking to give impartial fiduciary advice).
- Note: this exception only applies to ERISA-covered plans, so offering a limited platform of funds to IRA holders is not exempt; giving examples of available funds to an IRA holder is also not exempt as education.
- Selection and monitoring assistance—identifying alternatives that meet specified criteria or comparisons to independent benchmarks, provided that the party who provides lists of funds that meet the established criteria discloses in writing any financial interest in any of the investment alternatives on those lists.
- This exclusion also does not apply to communications made to an IRA owner.
- General communications (not tailored for a particular recipient) like newsletters, research, price quotes, etc.
- Education on plan terms, asset allocation generally (without using plan-specific investments) or plan-specific asset allocation models based on "generally accepted investment theories."
- Note: this is a change from an earlier proposed rule; vendors can now use a plan's specific investments in these models and not be a fiduciary by virtue of offering that model, provided the model is itself developed by an independent party (i.e., Morningstar).
- This exception does not apply to the use of asset-allocation models for IRAs.
- Retirement income estimates, interactive materials like questionnaires and worksheets, can be provided without undertaking a fiduciary role, as long as the materials disclose their material assumptions.
Specific "safe harbor" exceptions:
- Seller's exception—there is no general exception for someone who simply wants to sell a product to a plan or participant (but see the BIC exemption below). The only such exception is now a "sophisticated fiduciary exception," but it is very limited in that it only applies when selling to a financial institution or a plan with more than $50 million in assets and to the person with management or control of those assets who is capable of evaluating investment risks independently. Sellers cannot be paid a direct fee by the plan or participant under this exception.
- Swaps can be exempt if the plan has an independent fiduciary who acknowledges in writing that the swap dealer is not acting as an adviser to the plan or getting paid by the plan.
- Certain communications by employees of a plan sponsor, to either the plan committee or a participant, even if it crosses the line by making a specific recommendation, as long as it is not that person's job responsibility to make such recommendations, the person is not a registered investment advisor, and the employee does not get paid separately for such advice.
- Stock or property appraisers (to be dealt with in separate guidance). Proposed rules were more narrow, exempting just independent appraisers of employer stock in ESOP transactions (but not of employer stock in 401(k)s or stock bonus plan transactions) and appraisals performed for ongoing reporting and disclosure for all plans.
Best Interest Contract Exception
At the same time new interpretive guidance was issued on who is giving "investment advice" and is therefore a fiduciary who cannot self-deal with benefit plan assets, the DOL also issued new prohibited transaction exemptions. The most important such exemption for the investment community will be the Best Interest Contract (BIC) exemption. It allows persons and entities who are fiduciaries under the broader definition, who either (i) want to be paid (directly or indirectly through an affiliate or related entity) by a third party (i.e., by receipt of revenue sharing), or (ii) want to pay or receive compensation that varies based on action taken (e.g., commissions, 12b-1 fees) for advice at the "retail" level. "Retail" means advice to (1) plan participants in defined contribution plans who direct their own investments or can make decisions with respect to taking a distribution in plans, (2) IRA owners or beneficiaries, (3) any plan fiduciary that is managing under $50 million in assets, or (4) any plan sponsor who is either not the investment decision maker or who sponsors a plan with less than $50 million in assets.
The BIC exemption requires impartial conduct—the best interest of client standard—and requires a written contract, requires that anti-conflict policies and procedures be adopted and published on the internet by each affected financial institution, and specific other disclosures be given about services, fees and compensation arrangements. More detail on each of these requirements follows.
Only Applies to Financial Institutions
The BIC exemption is only available to financial institutions (banks, registered investment advisors, insurance companies or registered broker dealers) and their employees, contractors and agents who satisfy applicable licensure requirements for their industry. The BIC exemption does not apply to allow employers which are themselves financial institutions (or affiliates) to be paid for investment advice for their own plan, but other PTEs may apply in those circumstances.
Written Contract Requirement
The BIC exemption also requires all advice be given pursuant to a bilateral written contract that includes:
- the best interest standard;
- warranties that the financial institution has and will comply with policies designed to mitigate material conflicts; prohibit compensation that is unreasonable in amount in relation to the services provided; and will avoid using sales quotas; performance or personnel appraisals, bonuses, contests, special awards or other actions or incentives to the extent that they would encourage advisors to make recommendation that might not be in an investor's best interests;
- whether the financial institution is undertaking to monitor an investment for continued suitability, and, if so, the frequency of the monitoring and standards for when the investor will be alerted that a change may be necessary;
- in the contract, or in a separate written disclosure given to the investor at the beginning of a relationship, a description of the fees or compensation the financial institution and affiliates will receive—no matter who is paying them—and links to additional web disclosures (more in this below);
- specific contact information for persons to call if the investor has a complaint or concern; and
- to what extent recommendations will be limited to proprietary products and/or third party products that pay the investment advisor a fee.
This written contract requirement is intended to give IRA owners and non-ERISA plans the ability to sue for breach of contract. The written contract requirement does not apply to ERISA plans, where fee disclosure in advance of providing services is already required and where there is already a right of action under federal law (ERISA) against any fiduciary of such plans, even absent a written contract.
Investment contracts (or policies and disclosures in case of ERISA plans) cannot limit liability for a breach, require arbitration in distant locations or using rules that unreasonably limit the customer's ability to make a claim, nor may a contract prohibit or impede class action lawsuits. Contracts can waive punitive damages and waive rights to rescind a transaction. Unlike in the proposed rule, the final exemption does not require the individual employee of a financial institution to be an actual party to such a contract.
General Disclosure Requirements
In addition to a written contract and disclosures when a relationship begins, the BIC exemption also requires investment vendors to give detailed transaction-based disclosures and include on a web site, which will be updated quarterly, other disclosures about the financial institution's business model, conflict and conflict mitigation policies, fee and service charge schedules, third party arrangements regarding investment products, and a description of the financial institution's compensation and incentive arrangements with advisors, including a compensation grid and description of any "move business" incentives. Note that this is not an outright prohibition on transaction-based compensation, but will make it much more difficult to maintain some current compensation practices.
Financial institutions must notify the DOL that they intend to rely on the BIC exemption and agree to maintain records for six years, sufficient to show compliance with the exemption.
The BIC exception does not apply if a transaction results in unreasonable compensation—no matter how much disclosure is made.
Level-Fee Arrangements get a Streamlined Exemption
There are some streamlined rules for "level fee" arrangements. It has been a common practice of some vendors to accept revenue sharing, and rebate it all back to a plan, and then assess a level fee in a fixed dollar amount or percentage of assets that does not vary based on the investment, or to only keep so much of the revenue sharing as is needed to cover their agreed fee. Under the streamlined exemption, the investment advisor must provide a written statement that they are a fiduciary, will comply with the impartial conduct standard and, if the transaction is a rollover or a recommendation to switch to a level fee relationship for one that was previously commission-based, the specific reasons for that recommendation. It does not appear that a vendor which offers proprietary investment funds (and so also receives investment fees inside that fund, in addition to a level fee from a plan) can comply with exception.
Even a level fee advisor can make recommendation to roll over from an ERISA plan to an IRA, but must document the reason why that recommendation meets the best interest standard.
Relief for Pre-Existing Transactions
The BIC exemption includes some grandfathering of pre-April 2017 transactions and allows continued holding of those investments without full compliance with the exemption, even if the investment provides ongoing compensation or is related to a systematic purchase program established before that date. However, the relief generally does not apply to compensation received on investments of new amounts in a previously-acquired investment vehicle.
Rules are being challenged in court
At least five court cases have been filed, involving dozens of plaintiffs, including the U.S. Chamber of Commerce and the American Council of Life Insurers, challenging the authority of the DOL to issue these rules under various legal theories. Three of those cases were recently consolidated into one action in Texas. It is too early to tell whether these challenges might derail the regulations before financial institutions have changed their business models and disclosures in an attempt to comply.
What might these changes mean for retirement plan sponsors?
Some practices that have been common in the past may no longer be possible without violating the new rules, and some service relationships will be disrupted or some vendors will exit the business, narrowing employers' choices of retirement providers. Here are some specific things that retirement plan sponsors might expect as a result of the new regulations:
- Be on the lookout for, and read when you receive, any new disclosures from your plan vendors. If there are any surprises in the disclosures (e.g., fees you do not recall being told about earlier), you have a duty to make additional inquires.
- The DOL has long taken the position that plan sponsors have a duty to monitor their service providers. If a vendor consistently "crosses the line" and gives investment recommendations without admitting it is a fiduciary or complying with the BIC exemption, a plan sponsor could conceivably be held accountable as a co-fiduciary.
- Plan sponsors should think carefully and consult legal counsel before giving an IRA provider a list of former-employee participants who have a right to stay in a plan (with low fees), so that the vendor can encourage them to roll over to an IRA (which might have higher fees).
- If your retirement platform vendor also offers IRAs, they have a conflict. You should ask questions about what is said (and not said) when a plan participant asks about taking a distribution.
- Review any agreements with service providers now, and consider requiring the "best interest" standard be added and that the vendor represent that it has and will comply with policies designed to minimize conflicts of interest. Also look for, and eliminate, any terms that require arbitration under restrictive rules or in an unreasonable forum, discourage or prohibit class actions, or limit the adviser's liability for breach.
- Some broker-dealers and insurance companies will likely fashion a compliance program in which they admit to being fiduciaries (something they have not typically done in the past) and comply with the BIC exception. Others will probably put in programs to ensure their employees provide no more than "education" and not investment advice, which may mean cutting back on services they have historically provided.
- While the final regulations still treat the use of asset allocation worksheets as exempt investment education (even ones that help a participant reach a result of how to invest in the specific funds offered under a particular plan), the burden is on a plan sponsor to make sure the models are truly unbiased and not "designed to influence investment decisions toward particular investments that result in higher fees" (quoting DOL preamble to the regulations). Many plan sponsors will not be equipped to make this assessment without independent advice.
- If your plan is under $50 million when you seek proposals for a platform provider in the future, vendors may no longer be willing to provide a "sample" fund lineup, or might provide one that is very different than other bidders, making comparisons difficult. Employers may need to make a request which specifies the fund options to be included for proposal purposes before it can get comparable information about the administrative expenses involved, the total internal fund expenses and the amount of revenue sharing that vendor could receive to help defray administrative expenses. (Not all vendors receive same revenue sharing on the same fund.)
- Despite requests to make more exceptions for retirement vendors' call centers, the DOL declined to do so. This means many call centers will have to be less helpful than in the past— providing just information, not any real direction or recommendations.
- There might be big changes made in internal compensation systems at financial institutions, in order to comply with the required anti-conflict policies. Compensation will certainly be more transparent, and, like with the participant fee disclosures that were mandated under ERISA in 2012, may trigger more class action challenges.
- While commission-based compensation models are technically still allowed and often less expensive than fee-based advice, especially for smaller accounts, it is still not clear if financial institutions will be comfortable allowing investment advice to be given by a person who gets paid differently based on the investment recommended—the conflicts may be insurmountable. If that is the case, some IRA owners may have trouble getting any advice at all, or at reasonable cost.
- Robo-advice will grow, most likely, by complying with the BIC exemption under the level fee rules.
- Health Savings Accounts are subject to same prohibited transaction rules in the Code as IRAs and therefore subject to these rules as well, but most employers are not fiduciaries with respect to HSAs.