On October 25, 2011, the Department of Labor (DOL) published in the Federal Register a final rule addressing the statutory “eligible investment advice arrangement” exemption in ERISA §§ 408(b)(14) and (g) and the parallel provisions in Code §§ 4975(d)(17) and (f)(8) (collectively, the “Statutory Exemption”). Absent such an exemption, ERISA § 406 and Code § 4975 would prohibit fiduciaries that are affiliated with other financial institutions such as broker-dealers, insurance companies or investment companies from providing investment advice to participants and beneficiaries of self-directed individual account plans (IAPs) and individual retirement accounts (IRAs) concerning investments that would result in the payment of additional fees to the fiduciaries or their affiliates.
The final rule implements the Statutory Exemption. It replaces an earlier “final rule” that was published on January 21, 2009, the day after the Presidential Inauguration. The earlier rule included an administrative class exemption that would have provided supplemental relief for the same transactions covered by the Statutory Exemption, provided that certain conditions were satisfied. Specifically, the administrative class exemption would have limited the level-fee requirement to compensation received by the employee, agent or registered representative providing advice on the fiduciary adviser’s behalf, making the requirement inapplicable to the fiduciary adviser’s (i.e., the company’s) own compensation. It also would have expanded the relief for computer model arrangements to permit individualized investment advice after the furnishing of computer model recommendations (“off model” advice) or, in situations where computer modeling is not feasible, after the furnishing of certain investment education material.
Acting under a general directive from the new administration, the DOL extended the earlier rule’s effective date several times to “review legal and policy issues” relating to the rule. The DOL ultimately withdrew the earlier rule on November 20, 2009, citing concerns of a number of commenters regarding the administrative class exemption and “the adequacy of [its] conditions to mitigate the potential for investment adviser self-dealing.”
The DOL then published a new proposed rule on March 2, 2010. The new proposed rule did not include an administrative class exemption, but was otherwise “nearly identical” to the earlier final rule. Given the similarities of the new proposed rule to the earlier final and proposed rules, the DOL indicated in the preamble to the new proposed rule that its prior explanations in the publication of the earlier final and proposed rules “should be read as applicable to the regulations being proposed in this notice.” The final rule published on October 25, 2011, is the product of that new proposed rule. The final rule is effective on December 24, 2011, and is applicable to covered transactions occurring on or after that date. This memorandum will summarize briefly the key provisions of the final rule.
Because the DOL cut back significantly on the relief afforded by the earlier final regulation, the Statutory Exemption is not likely to be very useful to those who actually need it – the thousands of investment fiduciaries who have affiliates. Entities without affiliates have no use for the Statutory Exemption, since those entities can (and already do) rely on ERISA § 408(b)(2) for their advisory fees. The “$64,000 Question” is whether an exemption that was intended only for entities with affiliates will provide any relief whatsoever to those entities. Unfortunately, the answer to that question appears to be that the Statutory Exemption will provide those entities little, if any, relief.
As we explain in greater detail below, the fee-leveling approach required by the regulation specifies that the compensation of both the individual adviser and his employer entity must be entirely level. The result is that, unless a financial institution has a separate advisory affiliate that receives no insurance commissions, brokerage commissions, or 12b-1 or service fees from mutual funds, the financial institution cannot use the fee-leveling alternative. As an initial matter, the DOL’s regulatory impact analysis fails to consider the cost to financial institutions of having to create such separate advisory affiliates. And even if a financial institution were to go through the expense and effort of setting up such an advisory affiliate, few if any individual advisers who have clients other than plans and IRAs would be willing to move to that company, since they would be seriously affecting their compensation with respect to all of their other clients.
The computer modeling alternative permitted by the Statutory Exemption is a poor substitute for the millions of IRA owners and IAP participants who invest in stocks and bonds through brokerage windows, since there is currently no viable computer model that takes into account individual securities. The DOL recognized as much by allowing computer models to exclude brokerage windows. To further complicate matters, the final rule departs from all prior formulations of the modeling approach by requiring that any model take into account employer securities, whereas under both the proposed rule and the earlier proposed and final rules, employer securities (as well as lifestyle funds, target-date funds and annuities) could be excluded. It seems highly doubtful that plan sponsors who offer employer securities as an investment option will be willing to cover the cost of a computer model that invariably advises a dramatic reduction in employer securities holdings and any other single stock position, which is presumably what any such model would do. The DOL does not consider this likely outcome in the preamble, nor does its regulatory impact analysis consider the implications of this provision.
In short, the result anticipated at the outset of DOL’s regulatory impact analysis – that “quality, affordable expert investment advice will proliferate, producing significant net gains for [IAP] participants and beneficiaries and [IRA] beneficiaries” – seems tenuous at best. Since unaffiliated advisers have no need for the Statutory Exemption and are already providing advice to those who choose to use them, and advisors that are affiliated with other financial institutions are not likely to utilize it as implemented in the final rule, it is difficult to imagine that many participants will obtain investment advice as a result of this regulation.
General Scope of the Final Rule
The Statutory Exemption provides relief from the prohibitions of ERISA § 406 and Code § 4975 for three transactions:
- the provision of investment advice to Plan participants and beneficiaries by a fiduciary adviser;
- the investment transactions entered into in reliance on the advice; and
- the receipt of fees by the fiduciary adviser in connection with such investment advice or transactions.
For the Statutory Exemption to apply, the investment advice must be provided by a fiduciary adviser under an “eligible investment advice arrangement,” which is defined in ERISA § 408(g)(2) to mean an arrangement that either (a) provides that any fees received by the fiduciary adviser for investment advice or with respect to the investment of plan assets do not vary depending on the investment option selected by the participant or beneficiary (“fee-leveling”), or (b) uses a computer model under an investment advice program that meets certain requirements.
Paragraph (a)(2) of the final rule makes clear that there is no obligation on the part of plans or their sponsors to provide investment advice. Paragraph (a)(3) provides further that the rule’s requirements apply only to investment advice arrangements that involve prohibited transactions, and that the Statutory Exemption does not affect any prior guidance concerning the circumstances under which the provision of investment advice would constitute a prohibited transaction. That, of course, is consistent with Field Assistance Bulletin (“FAB”) 2007-1 (Feb. 2, 2007), which confirmed that the DOL’s prior guidance on pre-Pension Protection Act (“PPA”) methods of structuring advice programs around the prohibitions of ERISA § 406(b) remains effective.
The three main types of pre-PPA investment advice programs that can be utilized to avoid a prohibited transaction, and thus obviate the need to comply with the requirements of the final rule, are as follows:
programs structured to provide only non-fiduciary “investment education” in accordance with Interpretive Bulletin 96-1, 29 C.F.R. § 2509.96-1;
programs structured, through fee-leveling or offsets, to ensure that the adviser’s fees do not vary with the advice provided, see Adv. Op. 97-15A (May 22, 1997) and Adv. Op. 2005-10A (May 11, 2005); and
programs structured to provide financial advice through the application of methodologies developed and maintained by a third party who is independent of the fiduciary investment adviser, see Adv. Op. 2001-09A (Dec. 14, 2001).
Each of these methods of attempting to avoid a prohibited transaction has limitations. The line between investment “education” and “advice” is not always clear, and participants often want “advice” rather than just “education.” Even when information provided to participants is intended to be “education” rather than “advice,” a prohibited transaction may result if the line between the two is inadvertently crossed.
Fee-leveling programs under pre-PPA guidance are required to ensure not only that the fiduciary adviser’s fees do not vary with the advice provided, but also that the revenues received by the adviser’s affiliates do not vary with the advice provided. Few fiduciary advisers have used fee-leveling to provide broadly disseminated advice because the fee-leveling approach essentially required advisers to exclude affiliated products from their advice programs. At the time ERISA was enacted, Congress itself recognized that it would be unreasonable to require financial institutions to avoid their own products when providing services to plans. See H.R. Conf. Rep. No. 93-1280 (Aug. 12, 1974), reprinted in 1974 U.S.C.C.A.N. 5038, 5094.
Programs providing investment advice through independently developed and maintained methodologies may be challenged if the output of the methodology can somehow be changed or affected by input from the program sponsor. In other words, any recommendations provided to participants must be based solely on input of participant information into a computer program utilizing the independently developed and maintained methodologies. The effect of this restriction is to prohibit so-called “off-model” advice. Further, as noted earlier, there is currently no viable model that takes into account individual securities. As a result, models are not particularly helpful to participants who are invested in a brokerage window or IRA owners who have individual stocks and bonds in their IRAs.
Now that the administrative class exemption has been withdrawn, the final rule does little, if anything, to broaden the circumstances under which investment advice can be provided to participants and beneficiaries of IAPs and IRAs consistent with ERISA’s prohibited transaction rules. We discuss below the Statutory Exemption as implemented in the final rule.
The Statutory Exemption
Paragraph (b) of the final rule addresses the requirements of the Statutory Exemption. Like the proposed regulation, paragraph (b) of the final rule reiterates and expands upon the definition of “eligible investment advice arrangement” (“Eligible Arrangement”) under ERISA § 408(g) and Code § 4975(f)(8). An Eligible Arrangement may be one that uses fee-leveling or computer models or both.
Fee-leveling Arrangements. The final rule requires that fee-leveling arrangements meet the following conditions, among others:
- The advice must be based on generally accepted investment theories that take into account, at a minimum, the historic risks and returns of different asset classes over defined periods of time;
- The advice must take into account investment management and other fees and expenses attendant to the recommended investments;
- The advice must take into account, at a minimum, information furnished by a plan, participant or beneficiary relating to age, time horizons (e.g., life expectancy, retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income and investment preferences;
- The fiduciary adviser providing investment advice cannot receive from any party (including an affiliate of the fiduciary advisor), directly or indirectly, any fees (including any commission or other compensation) that vary depending on the investment option selected by a participant or beneficiary; and
- No employee, agent or registered representative providing investment advice on behalf of the fiduciary adviser can receive from any party (including an affiliate of the fiduciary adviser), directly or indirectly, any compensation (including salary, bonuses, awards, promotions, commissions or other things of value) that varies depending on the investment option selected by a participant or beneficiary.
As the italicized language reflects, the level-fee conditions of the final rule apply not only to any employee, agent or registered representative who provides advice on the fiduciary adviser’s behalf, but also to the fiduciary adviser itself. However, like the earlier rule, the final rule continues to provide relief for certain level-fee arrangements that would otherwise result in prohibited transactions under the DOL’s pre-PPA guidance. In particular, as stated in FAB 2007-1, these level-fee conditions do not apply to fees or other compensation received by affiliates of the fiduciary adviser (as long as the affiliates do not provide advice to the plan or IRA). As noted above, however, this “solution” works only where the financial institution employs the adviser through a separate fiduciary adviser affiliate that receives no commissions or other variable compensation. The separate adviser cannot be the same as the adviser to the affiliated mutual funds because that adviser does receive varying fees. Thus, virtually every financial institution will be required to incur the additional cost of creating a new corporate advisory entity and registering that entity under the Investment Adviser’s Act. This would be an entirely different corporate structure from that typical of broker-dealers (i.e., advisers in a different corporation than executing brokers). Because neither the broker-dealer’s nor the registered representative’s total fees from investment products or transactions can vary, the fiduciary adviser’s advisory personnel could not also be brokers. Few if any broker-dealers likely would be able to implement cost-effectively these types of arrangements.
The final rule also makes clear that the fiduciary adviser and any employee, agent or registered representative of the adviser cannot receive from any party, including the advisers’ affiliates, fees or other compensation that varies depending on the investment option selected by a participant or beneficiary. Thus, as the DOL explained in the preamble to the proposed rule, “even though an affiliate of a fiduciary adviser may receive fees that vary depending on investment options selected, any provision of financial or economic incentives by an affiliate (or any other party) to a fiduciary adviser (e.g., an employee providing advice on its behalf or an individual responsible for supervising such an employee) to favor certain investments would be impermissible.”
The DOL explained in the preamble to the final rule that the term “other things of value” would include “trips, gifts and other things that, while having a value, are not given in the form of cash.” The reference to bonuses, awards and promotions in this level-fee condition deserves particular attention. With respect to bonus programs based on a fiduciary adviser’s overall profitability, the DOL stated that “almost every form of remuneration that takes into account the investments selected by participants and beneficiaries would likely violate the fee-leveling requirement.” It acknowledged that such a program “may be permissible if the individual account plan and IRA investment advice and investment option components are excluded from, or constituted a negligible portion of, the calculation of the [fiduciary adviser’s] profitability.”
Requiring that such programs exclude revenue from IAPs and IRAs would up-end normal business practice – registered representatives are paid and promoted based on all sales, not just sales resulting from fiduciary investment advice. If broker-dealers are required to exclude all revenues from sales to IAP and IRA customers from any bonus, award or promotion decision, registered representatives may decline to give advice to such customers because their opportunities for advancement are greater with other customers.
Computer Model Arrangements. The final rule requires that a computer model arrangement be designed and operated to meet the following conditions, among others:
- The model must apply generally accepted investment theories that, at a minimum, take into account the historic risks and returns of different asset classes over defined periods of time;
- The model must take into account investment management and other fees and expenses attendant to the recommended investments;
- The model must appropriately weight the factors used in estimating future returns of investment options;
- The model must take into account, at a minimum, information furnished by a participant or beneficiary relating to age, time horizons (e.g., life expectancy, retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income, and investment preferences;
- The model must utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the plan;
- The model must avoid recommendations that inappropriately favor options (i) offered by the fiduciary adviser or a person with a material contractual relationship with the fiduciary adviser or (ii) that may generate greater income for the fiduciary adviser or a person with a material contractual relationship with the fiduciary adviser.
With the exceptions discussed below, the model must take into account all “designated investment options” available under the plan without giving inappropriate weight to any investment option.
Because the term “designated investment option” is defined to exclude brokerage windows and self-directed brokerage accounts, such features are excluded from the requirement that the model take into account all designated investment options available under the plan. The DOL also included exceptions in the final rule for (i) annuity options under which a participant or beneficiary may allocate assets toward the purchase of a stream of retirement income payments guaranteed by an insurance company, and (ii) any investment option that a participant or beneficiary requests to be excluded from consideration.
For annuity options to qualify for the exception, the participant or beneficiary must be furnished a general description of the investment and how the annuity operates. In addition, the preamble notes that, although a computer model would not be required to make recommendations to allocate investments to an annuity option, amounts that the participant has already allocated to such an annuity must be taken into account when the computer model develops recommendations for investment of the participant’s remaining assets. The DOL likewise indicated in the preamble to the previously withdrawn rule that the model must take into account investments in “legacy options” in which participants are no longer permitted to invest when giving advice concerning the investment of the participants’ remaining assets, unless a participant elects not to have such investments taken into account.
Unlike the proposed regulation, the final rule provides no exclusion from the definition of “designated investment option” for either (i) options invested primarily in employer securities, or (ii) investment funds, products or services that allocate the assets of a participant or beneficiary to achieve varying degrees of long-term appreciation and capital preservation through equity and fixed income exposures based on a defined time horizon or level of risk of the participant or beneficiary (e.g., managed accounts, target date or life-cycle funds). Computer models therefore must take such investment options into account, although a participant may specifically request to have these options excluded from consideration as described above. The preamble indicates that employer securities were added to the definition of “designated investment option” due to risks associated with “overconcentrated” investment in such securities and perceived benefits related to the provision of advice regarding employer securities. With respect to asset allocation funds, public comments noted the popularity of these funds and concerns regarding the research that participants would be required to conduct if interested in investing in asset allocation funds, even though the proposed regulation would have required the provision of a general description similar to the one applicable to annuity options under the final rule. In both cases, the preamble indicates that the DOL believes it is feasible to design computer models reflecting these capabilities. How the DOL came to that conclusion is unclear, but the inclusion of these changes in the final rule may make plan sponsors who offer employer securities as a plan investment option less likely to agree to cover the cost of investment advice arrangements utilizing a computer model to the extent that the model invariably encourages participants and beneficiaries to sell their employer securities, as it seems likely the model would do.
Like the proposed regulation, the final rule requires that a qualified, independent expert certify that a computer model (and any subsequent modification) meets the foregoing requirements prior to its utilization. As under the previously withdrawn rule, the DOL indicated in the preamble that, in performing the certification, the independent expert would not be acting as a fiduciary or “handling” plan assets such that the bonding requirements would be applicable to the expert.
General Conditions Applicable to Both Types of Arrangements.
(1) Fiduciary Authorization. Consistent with ERISA § 408(g) and Code § 4975(f)(8), the final rule requires that an independent plan fiduciary expressly authorize the arrangement. Like the proposed regulation, the final rule makes clear that, in the case of an IRA, this express authorization must be provided by the IRA beneficiary. The final rule provides further that IRA beneficiaries will not fail the independence requirement merely because they are employed by the adviser, thus enabling IRA beneficiaries to take advantage of investment advice arrangements offered by their employers.
The authorization provisions of the final rule make clear that an authorizing plan sponsor-fiduciary would not fail the independence requirement simply because the plan for which the arrangement is being authorized offers participants the opportunity to invest in qualifying employer securities. The final rule would also permit a fiduciary adviser to provide investment advice to its own employees (or employees of an affiliate), as long as the fiduciary adviser or affiliate offers the same arrangement to other, unaffiliated plans in the ordinary course of its business. However, the preamble notes that the fiduciaries of the plan sponsored by the fiduciary adviser (or an affiliate) must act prudently in selecting a fiduciary adviser and the arrangement pursuant to which advice will be provided. In addition, the fiduciaries cannot use their position to benefit themselves in violation of ERISA § 406(b), although the DOL observed that a fiduciary’s selection of itself to provide investment advice would not constitute fiduciary self-dealing of this nature if the fiduciary provides advice to the plan without the receipt of compensation or other consideration (other than reimbursement of direct expenses properly and actually incurred).
(2) Annual Audit. Like the proposed regulation, the final rule requires that the fiduciary adviser engage an independent auditor at least annually to conduct a compliance audit of the investment advice arrangement and, within 60 days after completion of the audit, issue a written report to the fiduciary adviser and each authorizing fiduciary. The final rule also adopts a special notice rule for IRAs, requiring that the fiduciary adviser, within 30 days following receipt of the report from the auditor, furnish a copy of the report to the IRA beneficiary or make the report available on its website. In the case of arrangements involving IRAs, the final rule also requires the fiduciary adviser to send to the DOL a copy of any audit report identifying instances of noncompliance. Given that the DOL has no enforcement authority over IRAs, it is unclear why it would impose such a requirement. Note that, in contrast to the proposed regulations, the final rule includes an email address for electronic submission of such audit reports.
For purposes of the independence requirement, the final rule provides that an “independent” auditor cannot have a material affiliation or material contractual relationship with the person offering the investment advice arrangement to a plan or any designated investment options under a plan. A 10% gross annual revenue test applies for purposes of determining whether an auditor has a “material contractual relationship” with a fiduciary adviser or its affiliates, which would permit an auditor to remain “independent” under certain circumstances even though the auditor has other service relationships with a fiduciary adviser or its affiliates. However, in contrast to the proposed regulations, the final rule provides that an auditor is not “independent” if he has any role in the development of the investment advice arrangement or certification of the computer model utilized under the arrangement.
As under the previously withdrawn rule, the DOL indicated that a fiduciary adviser must act prudently in selecting the independent auditor, but clarified that the auditor need not be an accountant or a lawyer and that there is not “one set of credentials, such as being a certified public accountant, auditor, or lawyer, that qualifies an individual to conduct the required audits.” As for the conduct and scope of the audit, the DOL indicated that the auditor should determine how to conduct its review, including whether to rely on representative samples in conducting the audit, and the appropriate methods to use in conducting the audit. The DOL also confirmed that the performance of the audit would not, by itself, cause the auditor to be a fiduciary under ERISA.
(3) Disclosure to Participants. The final rule requires that the fiduciary adviser provide to participants and beneficiaries without charge, prior to the initial provision of investment advice and annually thereafter, a written notification describing, among other things, fees and other compensation received, relationships among relevant parties, the fiduciary status of the adviser, the services/products being offered and product limitations and availability of other advisers. The adviser must furnish written notification of material changes to this information at a time reasonably contemporaneous with the change. The adviser also must furnish the information without charge to the recipient of the advice upon request.
Fees or compensation which must be disclosed under the final rule include amounts that the adviser will receive in connection with any rollover or other distribution of plan assets in connection with the provision of investment advice. In the preamble to the previously withdrawn regulations, the DOL emphasized the “potential for abuse in this area” and reiterated its view that advice concerning the taking of a distribution or investment of withdrawn amounts would constitute the exercise of discretion over management of the plan if the person is already acting in another fiduciary capacity with respect to the plan. Thus, a fiduciary may engage in self-dealing in violation of ERISA § 406(b)(1) if it exercises control over plan assets to cause a participant to take a distribution and invest the proceeds in an IRA managed by the fiduciary. The DOL further suggested that the mere disclosure of fees received in connection with such a distribution and investment would be insufficient to avoid a fiduciary self-dealing violation.
As with prior versions of the rule, the final rule includes a model disclosure form that may be used to satisfy the participant disclosure requirements, although use of the model form is not required. The DOL also confirmed in the preamble that disclosure materials required under securities and other laws may be combined with the required DOL disclosures, as long as the inclusion of other materials does not compromise the understandability and clarity of the disclosures. In response to comments requesting greater flexibility in providing electronic disclosures than what is permitted under existing DOL regulations, the DOL noted that it is currently reviewing the use of electronic media for participant disclosures and, therefore, declined to expand the final rule in this regard.
(4) Disclosure to Authorizing Fiduciary. The final rule contains a new provision which requires that the fiduciary adviser provide the authorizing fiduciary with written notification that: (a) the adviser intends to comply with the Statutory Exemption and the investment advice regulations, (b) the adviser’s investment advice arrangement will be audited annually by an independent auditor for compliance, and (c) the auditor will furnish the authorizing fiduciary with a copy of that auditor’s findings within 60 days of its completion of the audit. The preamble notes that an authorizing fiduciary would be expected to take reasonable steps if the audit report is not furnished in a timely manner, such as making appropriate inquiries with the auditor and/or the fiduciary adviser.
(5) Other Conditions. Consistent with ERISA § 408(g) and Code § 4975(f)(8), the final rule incorporates the following miscellaneous conditions for relief: (a) the fiduciary adviser must provide appropriate disclosure in accordance with all applicable securities laws; (b) the sale, acquisition, or holding of a security must occur solely at the direction of the recipient of the advice; (c) the compensation received by the fiduciary adviser and its affiliates in connection with the sale, acquisition, or holding of the security must be reasonable; and (d) the terms of the sale, acquisition, or holding must be at least as favorable to the plan as an arm’s length transaction would be.
As with the previously withdrawn regulations, the preamble confirms that a pre-authorization for a fiduciary adviser to maintain a particular asset allocation structure by periodically rebalancing investments will not violate the “solely at the direction” requirement, provided the participant is informed of and approves the specific circumstances under which a rebalancing will take place and the particular investments that will be utilized for the rebalancing. However, if the particular investments that might be selected for purposes of rebalancing are not known at the time of the authorization, the DOL indicated that the participant must be given advance notice of the investments selected and a reasonable opportunity (at least 30 days) to object. To the extent that the adviser recommends a different asset allocation structure, the preamble indicates that such “negative consent” would not satisfy the “solely at the direction” requirement, rather, an “affirmative direction” would be required.
(6) Retention of Records. Like the proposed regulation, the final rule requires the fiduciary adviser to maintain, for a period of not less than 6 years after the provision of investment advice under the arrangement, any records necessary to determine whether the applicable requirements have been met.
Definition of IRA.
For purposes of the final rule, the term “IRA” is defined to include Savings Incentive Match Plans for Employees (“SIMPLE”) IRA plans and Simplified Employee Pension (“SEP”) plans. SIMPLE IRA plans and SEP plans are IRA-based plans that are intended to offer administrative simplicity to sponsoring employers. For example, SIMPLE IRA and SEP plans are subject to minimal reporting and disclosure requirements, in contrast to other retirement plans subject to ERISA. The DOL explained that treating these plans as IRAs is intended to increase their access to fiduciary investment advice. Specifically, for purposes of the fiduciary authorization requirements, if SIMPLE IRA and SEP plans were treated as IAPs, rather than IRAs, the plan sponsor would be required to authorize the investment advice provider, even if the provider were selected by a participant. The DOL noted that many employers who sponsor these types of plans may be hesitant to assume this duty and requested input on the final rule’s operation in the context of SIMPLE IRA and SEP plans, indicating that the rules applicable to these plans may be revised in the future.
You may obtain a copy of the final rule here.