The DOL's New Fiduciary Rules for Retirement Investment Advice

After years of debate and speculation, the U.S. Department of Labor (DOL) issued its final package of rules to regulate individuals and entities that provide investment advice to retirement plans and IRA investors. The DOL’s final “fiduciary” regulation and related administrative exemptions aim to curb investment advice practices that, in the DOL’s view, fail to serve the best interests of retirement investors. Common current practices may be permissible, but are subject to new conditions that may require changes for certain investment advice providers.

Investment Advisers as “Fiduciaries”

Key to the DOL’s final rule is a new regulation that determines when an investment adviser is a “fiduciary” under the Employee Retirement Income Security Act (ERISA) and the prohibited transaction excise tax rules under the Internal Revenue Code (Code). Effective April 10, 2017, the regulation replaces the current five-part test for fiduciary status with a substantially broader definition. The new definition generally covers any person who provides a “recommendation” to a retirement plan investor for a fee.

The new “fiduciary” definition has two essential components. First, to be a “fiduciary,” a person must make a recommendation for a fee or other compensation, whether direct or indirect, as to either:

• The advisability of acquiring, holding, disposing of, or exchanging, plan or IRA assets, or a recommendation as to how plan or IRA assets should be invested after the plan or IRA assets are rolled over, transferred or distributed from the plan or IRA; or

• The management of plan or IRA assets, including, among other things, recommendations on investment policies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., brokerage versus advisory); or recommendations with respect to rollovers, transfers, or distributions from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer, or distribution should be made.

Second, with respect to the recommendation, the person must either:

• Acknowledge its fiduciary status;

• Have an agreement, written or verbal, that the advice is based on the particular investment needs of the advice recipient; or

• Direct the advice to a specific advice recipient.

In applying the new fiduciary definition, a critical threshold question is whether a communication is a “recommendation.” Borrowing from FINRA’s definition, the final regulation defines “recommendation” as “a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.” The DOL also borrowed from select SEC and FINRA interpretations about recommendations regarding the degree of individually tailored communications, lists of securities, aggregating communications, and disregarding whether the source is a person or a computer.

The final rule clarifies that a “recommendation” will include the recommendation of other persons who provide advice or investment management services, but it will not include the marketing of oneself or one’s services. This clarification is intended to allow responses to requests for proposals and general sales pitch materials.

No “magic words” are needed to acknowledge fiduciary status, and the DOL cautioned affiliates about trying to use a “bait and switch” tactic between related entities that may or may not be fiduciaries. However, the preamble includes an example clarifying that a trustee that acknowledges fiduciary status for a purpose other than investment advice would not be considered acknowledging fiduciary status for an affiliate with respect to an affiliate’s investment-related communications.

Exceptions to Fiduciary Status

Starting from the broad “fiduciary” definition, the final regulations exclude certain activities from being either “recommendations” or “investment advice.” 

Education

Investment education is not considered a recommendation, and therefore does not subject the education provider to fiduciary status. The scope of permitted investment education is mainly based on DOL Interpretive Bulletin 96-6. One key change from the 2015 proposed regulation is that asset allocation models and interactive investment materials may identify specific investment options available under ERISA plans (but not IRAs), subject to certain conditions, without being considered a recommendation.

General Communications

Suze Orman can rest easy – the DOL does not consider her general communications, or the communications of columnists or on-air personalities, to be a recommendation, and therefore they are not subject to a fiduciary standard. In addition, the final rule clarifies that general communications, like newsletters, are not recommendations.

Platform Provider and Selection and Monitoring Assistance

Providing an ERISA plan with an investment platform, defined by the market, and related selection and monitoring of investments, are deemed to not be recommendations. Platform providers may also include a proposed list of investments in an RFP response without making a fiduciary recommendation.

Advice to an Independent Fiduciary

The previous “seller’s carve-out” of the 2015 proposed regulations has morphed into an exception for advice provided to an independent fiduciary of a plan or IRA if that independent fiduciary is either a licensed or regulated provider of financial services or is responsible for the management of at least $50 million in assets if certain conditions are met. The DOL intended to capture true arm’s length transactions in which the independent fiduciary is not relying on the other party to provide impartial advice. The $50 million threshold is based on FINRA’s institutional account concept and allows all plan and non-plan assets under management to be included in meeting the threshold.

Swaps

Due to the protections provided by the Dodd-Frank Act’s business conduct standards, the final regulations exempt swap dealers and swap participants acting as a counterparty in a swap or security-based swap transaction with an ERISA plan represented by a fiduciary independent of the counterparty.

Employees

Employees of a plan sponsor who make recommendations to a plan fiduciary, without receiving additional compensation, are not considered investment advice fiduciaries.

The only exceptions described above that are available with respect to IRAs are general communications, investment education without identifying specific investments, and possibly the independent fiduciary exception. The independent fiduciary, swap, and employee exceptions do not apply to a fiduciary if fiduciary status has been acknowledged.  

Scope of Plans and IRAs

The definition of fiduciary and investment advice is focused on retirement plans and IRAs. Advice with respect to health, disability, and term life insurance policies are explicitly excluded from the scope of the regulation. The advice applies whether it is at a plan level or at the participant level. Plans include any ERISA plan and any plan under Code Section 4975(e)(1)(A), which includes: IRAs (including SIMPLE IRAs and SEP IRAs), Archer medical savings accounts (MSAs), health savings accounts (HSAs), Coverdell education savings accounts, and Keogh or HR-10 plans for self-employed individuals.

Administrative Exemptions in the Final Regulatory Package

As a result of the expanded definition of an investment advice fiduciary under the final regulations, many of these newly-minted investment advice fiduciaries who receive variable compensation (e.g., commissions) resulting from their investment advice might otherwise be engaging in a self-dealing prohibited transaction. The DOL’s final regulatory package establishes a number of prohibited transaction exemptions (PTEs) that are designed to permit investment advice fiduciaries to engage in transactions that ERISA and the Code would otherwise prohibit, including the receipt of third-party payments and compensation that varies based on the investment advice provided. Without a prohibited transaction exemption, common forms of compensation (even if in the best interest of the retirement investor) would trigger the Code’s excise tax (generally equal to 15% of the amount involved) and, for ERISA plan transactions, expose the investment advice fiduciary to liability under ERISA’s civil enforcement provisions.

The remainder of this article provides a detailed overview of the final package’s primary PTE, the Best Interest Contract Exemption, and a brief summary of the final package’s other PTEs for specific types of transactions.

Best Interest Contract Exemption

The final Best Interest Contract Exemption (BIC Exemption) is the exemption of general applicability for investment advice fiduciaries in the retail investment marketplace. Using a “standards-based” approach, the BIC Exemption generally requires individuals who provide fiduciary investment advice (advisers) and the investment advisers, banks, insurance companies and registered broker-dealers that employ or otherwise retain them (financial institutions) to adhere to an enforceable fiduciary standard of conduct and take certain steps to mitigate conflicts of interest. The final BIC Exemption retains the core requirements of the proposed exemption announced in 2015, but it has been substantially revised to ease implementation and improve the exemption’s workability.

Scope of BIC Exemption

The DOL intends that the BIC Exemption will cover variable compensation and third party payments for fiduciary investment advice provided to retail “retirement investors,” regardless of plan-type. “Retirement investors” do not include plan or IRA fiduciaries who fall within the exemption for advice provided to fiduciaries with financial expertise (namely, fiduciaries who are licensed or regulated financial service providers or responsible for the managing at least $50 million in assets), but it does include fiduciaries of small participant-directed plans, who were excluded from the 2015 proposal.

The BIC Exemption will be available for investment recommendations concerning all investment types, rather than for the limited list of assets set out in the 2015 proposal. The exemption is likewise available for all types of fiduciary investment advice, including recommendations to take a distribution, roll over assets from a plan or IRA, or utilize services such as managed accounts and advice programs.

The exemption will not apply to advice provided with respect to the adviser’s or financial institution’s in-house retirement plans, or where the adviser exercises discretionary authority or control with respect to the recommended transaction. The exemption also does not cover “robo advice” providers receiving non-level compensation or principal transactions other than “riskless” principal transactions.

BIC Exemption Requirements

The final BIC Exemption places the burden of compliance squarely on the financial institution. As an essential requirement, the financial institution must acknowledge in writing that both it and its adviser will act as fiduciaries with respect to investment recommendations.  In some circumstances, the financial institution might not otherwise be considered a fiduciary because the adviser providing fiduciary investment advice acts independently from the financial institution (for example, where an adviser recommending an annuity product is an independent insurance agent). Nevertheless, the DOL indicated that a financial institution must accept fiduciary responsibility for the recommendations of the adviser as a condition of the exemption, because the financial institution’s role in supervising individual advisers is a key safeguard of the exemption.

Contract Requirements

Consistent with the financial institution’s acknowledgement of fiduciary status, the final BIC Exemption saddles the financial institution with the legal liability for ensuring compliance with the exemption’s requirements. ERISA plan investors, including ERISA plan participants, beneficiaries and fiduciaries, may pursue legal action against the financial institution by using statutory enforcement provisions of ERISA § 502. There is no pre-existing, federal statutory enforcement mechanism for IRA and non-ERISA plan investors, apart from the Code’s excise tax on prohibited transactions. To fill that gap, with respect to IRA and non-ERISA plan transactions only, the final BIC Exemption requires the execution of a “Best Interest Contract” that warrants compliance with the exemption’s substantive requirements, which must be enforceable by the retirement investor against the financial institution.

The BIC Exemption protects retirement investors’ right to pursue contractual remedies (or statutory remedies, for ERISA plan investors) by disallowing class action waivers and contractual limitations on the adviser’s or financial institution’s liability. However, the retirement investor may agree to reasonable binding arbitration for individual claims and may waive its right to seek punitive damages or rescission of recommended transactions.

The final BIC Exemption relaxes some of the 2015 proposal’s requirements related to the form and execution of the Best Interest Contract. Under the final exemption, the Best Interest Contract is a two-party agreement between the retirement investor and the financial institution, rather than a three-party agreement including the adviser. The Best Interest Contract does not need to be executed before any recommendation is made; instead, the contract’s execution may wait until the time the recommended transaction is executed, provided that it covers prior advice. The Best Interest Contract may be a master contract covering multiple recommendations; it may be incorporated into an account opening document or similar document; and it may be signed either by hand or electronically. However executed, the financial institution must maintain an electronic copy of the contract on a website accessible by the retirement investor.

Conditional relief is available for circumstances in which a retirement investor acts on fiduciary advice notwithstanding the absence of a Best Interest Contract, such as where the retirement investor does not open an account after receiving a recommendation. In addition, the exemption provides significant transitional relief by removing the need to obtain signatures from existing customers who make additional purchases after the BIC Exemption becomes effective. Under a “negative consent” procedure, a financial institution may obtain the assent of customers with existing contractual arrangements as of January 1, 2018, by sending a contract amendment, as long as the customer does not terminate the contract within 30 days.

Impartial Conduct Standards and Anti-Conflict Policies and Procedures

The final BIC Exemption regulates the behavior of financial institutions and their advisers by requiring the financial institution to affirmatively state that it and its advisers will adhere to “Impartial Conduct Standards” and warrant compliance with certain anti-conflict policies and procedure requirements. For IRA and non-ERISA plan retirement investors, the exemption’s substantive standards must be incorporated into the Best Interest Contract, meaning that their violation is an enforceable breach of contract. Financial institutions transacting with ERISA plan retirement investors must also comply with the exemption’s substantive standards to avoid civil liability for a non-exempt prohibited transaction under ERISA.

The Impartial Conduct Standards require the financial institution and its advisers to act in the “Best Interest” of the retirement investor by providing advice that “reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the retirement investor, without regard to the financial or other interests of the adviser, financial institution or any Affiliate, Related Entity, or other party.”  The financial institution and adviser must also charge no more than “reasonable compensation” for their services and refrain from making materially misleading statements about the recommended transactions, fees and compensation, material conflicts of interest, or other matters relevant to the investment decision.  

One result of the final regulations and the final PTEs is the “ERISAfication” of IRAs. The Impartial Conduct Standards essentially mirror ERISA’s fiduciary standards of conduct, which do not apply under federal statutes to IRAs. However, in order to avoid the excise tax on prohibited transactions with respect to certain IRA transaction, advisers and their financial institutions who wish to rely on the BIC Exemption must agree to be subject to the same fiduciary standards as apply under ERISA.

Financial institutions are required to adopt written anti-conflict policies and procedures to ensure that advisers adhere to the Impartial Conduct Standards described above.  The policies and procedures must prohibit use of quotas, bonuses, special awards and other incentives that would reasonably be expected to cause advisers to violate the Impartial Conduct Standards.  The exemption expressly permits differential compensation based on investment decisions by retirement investors (including, but not limited to, commissions). However, the financial institution’s incentives and incentive practices must be “reasonably and prudently designed to avoid a misalignment of the interests of advisers with the interests of the retirement investors they serve as fiduciaries.”  In addition, in formulating policies and procedures, the financial institution must (i) identify and document material conflicts of interest; (ii) adopt measures to prevent material conflicts of interest from causing impartial conduct standard violations; and (iii) designate a person or persons responsible for addressing related issues.

Disclosure Requirements

The final BIC Exemption adopts a “two-tier” approach to disclosures, requiring financial institutions to provide general information in an initial contract disclosure and periodic pre-transaction disclosures, and more specific information in website disclosures or upon request.

The initial contract disclosure must be provided to the retirement investor when the advisory relationship begins and before the execution of any recommended transaction. For IRA and non-ERISA plan investors, the contract disclosure may be incorporated into the Best Interest Contract.  The contract disclosure must identify, among other specified items, the services to be provided, how the retirement investor will pay for services, and material conflicts of interest. The contract disclosure must also inform the retirement investor of its right to obtain, free of charge, the financial institutions anti-conflict policies and procedures and a specific disclosure of costs, fees and compensation.  

The pre-transaction disclosure is a brief, periodic disclosure that supplements the initial contract disclosure for advisory relationships covering multiple transactions over extended periods of time. Updated pre-transaction disclosures must be provided before the execution of recommended transactions, but no more frequently than annually after the initial contract disclosure.

The website disclosure provides more detailed information regarding, among other items, the financial institution’s business model and associated material conflicts of interest, typical account or contract fees and service charges, the financial institution’s compensation and incentive arrangements with advisers, and the financial institution’s anti-conflict policies and procedures. The financial institution must update the disclosure website on at least a quarterly basis and make it freely accessible to the public.  

The DOL states that it reworked the 2015 proposal’s disclosure requirements using a “principles-based approach” to ease concerns about logistics, costs and confidentiality risks. For example, the proposed annual disclosure has been eliminated and pre-transaction disclosures need not disclose an asset’s total cost over one-, five- and ten-year periods. With respect to the website disclosure, the final exemption provides greater flexibility on how the information may be presented, allows the website to link to other public disclosures, and does not require website disclosures to be “machine readable.”  The final exemption also provides relief for good faith errors relating to all of the exemption’s disclosure requirements.

Agency Notification and Recordkeeping

The financial institution must provide advance notification of its reliance on the BIC Exemption to the DOL and must maintain certain data accessible to the DOL and the retirement investor for six years from the transaction date. The final BIC Exemption eliminates the detailed recordkeeping requirements of the 2015 proposal; firms are only required to retain records that show they complied with the exemption.

Proprietary Products and Third Party Payments

The final BIC Exemption imposes heightened Best Interest requirements on financial institutions that restrict advisers’ investment recommendations, in whole or in part, to Proprietary Products or to investments that generate Third Party Payments. For this purpose, “Proprietary Products” include any product managed, issued or sponsored by the financial institution or any of its affiliates. “Third Party Payments” include sales charges not paid directly by the Plan, participant or beneficiary account, or IRA; gross dealer concessions; revenue sharing payments; 12b-1 fees; distribution, solicitation or referral fees; volume-based fees; fees for seminars and educational programs; and any other compensation, consideration or financial benefit provided to the financial institution or its affiliates or related entities by a third party as a result of the transaction.

The Proprietary Product and Third Party Payments provisions reflect the DOL’s “deep and continuing concern regarding the financial institutions’ own conflicts of interest in limiting products available for investment recommendations.”  In broad terms, a financial institution that imposes Proprietary Product or Third Party Payment limitations must document, in conjunction with the anti-conflict policies and procedures, its reasonable determination that the material conflicts of interest created by its business model will not result in excess compensation or imprudent investment recommendations. Specific information regarding the use and nature of Proprietary Product and Third Party Payments limitations must also be disclosed, in significant detail, through the BIC Exemption’s disclosure regime.

The final exemption’s Proprietary Product and Third Party Payment provisions clarify some aspect of the 2015 proposed rule’s “limited range of investment” requirement, confirming that the exemption does not foreclose proprietary investment providers from receiving compensation under the exemption. It remains to be seen, however, how firms will adapt to the exemption’s requirements and insulate advisers from conflicts of interest when making recommendations from a restricted menu.

Level Fee Fiduciaries

The BIC Exemption provides streamlined exemption conditions for “Level Fee Fiduciaries,” which include financial institutions and advisers that receive only a set fee or fees and compensation based on a fixed percentage of the value of assets (rather than a commission or transaction-based fee) as a result of the adviser’s recommendation.  In these circumstances, the DOL recognizes that the retirement investor’s interest in receiving prudent investment recommendations will ordinarily be aligned with the adviser’s interest in increasing and protecting account investments.

Level Fee Fiduciaries are exempt from the contract requirement, anti-conflict policies and procedure requirements, transaction disclosures, and website disclosure requirements. However, Level Fee Fiduciaries must acknowledge their fiduciary status and abide by the exemption’s Impartial Conduct Standards. In addition, for any recommendation to roll over from an ERISA plan or IRA, the financial institution must document the specific reason why the recommendation is considered to be in the Best Interest of retirement investor.

Transitional Relief and Grandfathering Provision

Two provisions of the final BIC Exemption provide significant transitional relief.

First, the full requirements of the final BIC Exemption will not take full effect until January 1, 2018. During the transition period between April 10, 2017 (when the final rule’s definition of “investment advice” fiduciaries takes effect) and January 1, 2018, financial institutions will not be required to execute the Best Interest Contract or provide warranties or disclosures regarding anti-conflict policies and procedures.

Second, the BIC Exemption “grandfathers” certain pre-existing advisory relationships. The grandfather provision removes the need to comply with the BIC Exemption’s full requirements for compensation received as a result of investment advice on property purchased before April 10, 2017. Grandfather relief is subject to reasonable compensation and basic best interest requirements.

Other Prohibited Transaction Exemptions

The final fiduciary rule package creates or amends several other PTEs in connection with the expanded definition of investment advice fiduciary.

The new Principal Transaction Exemption will allow advisers to purchase and sell certain debt securities directly from their own inventory, or purchase investment property from the customer, subject to impartial conduct standards. As in the BIC Exemption, the final Principal Transaction Exemption provides transitional relief, requiring full compliance by January 1, 2018.

PTE 84-24, as amended, will be available for plan or IRA purchases of mutual fund shares and insurance or “fixed rate annuity contracts.”  The final PTE 84-24 differs significantly from the 2015 proposal because its will not be available for transactions in fixed indexed annuities. While PTE 84-24 will cover traditional fixed annuities, variable annuities and fixed indexed annuities must rely on the final BIC Exemption to obtain prohibited transaction relief.  

Several other existing PTEs were modified to make changes conforming to these new rules.

Moving Forward

While the final regulations and the final PTEs have generally been made more workable for financial service providers, much more work and analysis will be required during the transition period. Providers of call center services, investment education services or asset allocation models will need to review the specific conditions for those exceptions. Financial institutions that had relied on a commission or other transaction-based model will need to study what steps need to be taken to satisfy the requirements of the BIC Exemption. And some might consider shifts to a level-fee model rather than undertake the steps needed to rely on the BIC Exemption. The DOL has indicated that it intends to work with interested parties on compliance assistance activities and materials and invites stakeholders to identify areas or specific issues where they believe additional clarifying guidance is needed.