The DOL’s new fiduciary “rule” became effective on February 16, 2021. The rule is a combination of a new and expansive definition of fiduciary advice (and status) and an exemption from the prohibitions of ERISA and the Internal Revenue Code for financial conflicts of interest arising from nondiscretionary fiduciary advice. These changes impact all investment advisers and broker-dealers who provide services to retirement plans, participants and IRA owners.
This article summarizes the new guidance, the requirements currently in effect, and the demanding additional requirements that must be satisfied beginning on December 21, 2021. And, beginning on December 21, the full terms of Prohibited Transaction Exemption (PTE) 2020-02 will apply, including the acknowledgement of fiduciary status, the conflicts and services disclosures and, for the types of rollovers discussed below, the written statement of the “specific reasons” the rollover recommendation is in the best interest of the participant or IRA owner.
Scope of the new Rule
The DOL’s expanded fiduciary interpretation is in the preamble to PTE 2020-02. The guidance applies to advice given by financial institutions and investment professionals to ERISA retirement plans and participants (including rollover recommendations), and to IRA owners (who are referred to as “retirement investors”). “Financial institutions” includes registered investment advisers, broker-dealers, banks and trust companies, and insurance companies. “Investment professionals” refers to the representatives and agents of those financial institutions.
In the preamble to the exemption, the DOL announced an expanded definition of when financial institutions and investment professionals become ERISA and Code fiduciaries. Specifically the DOL redefined parts of the 5-part test for fiduciary status. For example, the DOL’s FAQs issued in April explained, in the context of rollovers:
Q7. When is advice to roll over assets from an employee benefit plan to an IRA considered to be a on a “regular basis”?
A single, discrete instance of advice to roll over assets from an employee benefit plan to an IRA would not meet the regular basis prong of the 1975 test. However, advice to roll over plan assets can also occur as part of an ongoing relationship or as the beginning of an intended future ongoing relationship that an individual has with an investment advice provider. When the investment advice provider has been giving advice to the individual about investing in, purchasing, or selling securities or other financial instruments through tax-advantaged retirement vehicles subject to ERISA or the Code, the advice to roll assets out of the employee benefit plan is part of an ongoing advice relationship that satisfies the regular basis prong.
Similarly, when the investment advice provider has not previously provided advice but expects to regularly make investment recommendations regarding the IRA as part of an ongoing relationship, the advice to roll assets out of an employee benefit plan into an IRA would be the start of an advice relationship that satisfies the regular basis requirement. The 1975 test extends to the entire advice relationship and does not exclude the first instance of advice, such as a recommendation to roll plan assets to an IRA, in an ongoing advice relationship.
In other words, if an investment adviser or broker-dealer recommends a rollover to a participant, and the contemplation is that the rollover will be to an IRA with the advisory firm or the broker-dealer and that investment recommendations will thereafter be made periodically to the IRA owner, the “regular basis” part of the 5-part test of fiduciary status is satisfied. (The significance of satisfying the regular basis requirement is that the other 4 parts of the test are also satisfied in the ordinary course of events, meaning that the broker-dealer or the advisory firm would be a fiduciary.) The 5-part test is a functional test and cannot be avoided by contract alone.
Different Types of Rollovers
The DOL interprets a “rollover” very broadly to include a rollover from a plan to an IRA, from an IRA to a plan, from an IRA to an IRA, or a change of account types for a plan or an IRA (e.g., from commission based to fee based). As a practical matter, the investment professionals with most financial institutions regularly recommend plan-to-IRA rollovers and IRA-to-IRA rollovers. Those recommendations are covered by the new interpretation and prohibited transaction exemption. In addition, recommendations of changes from commission-based accounts (e.g., to IRA owners) to fee-based accounts, and vice versa, will also be covered and subject to the many conditions of PTE 2020-02. This is true for both investment advisers and broker-dealers.
While that example is of a rollover recommendation, it’s important to realize that the new “rule” and the PTE apply to other advice to plans, participants and IRA owners. For example, when an investment professional makes a conflicted recommendation to a new IRA, or to an IRA that has been managed by the financial institution for many years, that recommendation will be scrutinized under these new rules.
Once a firm (and its representative) becomes a fiduciary under these tests, the next step is to determine whether the fiduciary recommendation results in a conflict of interest (or, in the language of ERISA and the Code, a “prohibited transaction”). For example, a rollover recommendation, if accepted by the participant, will usually result in a prohibited transaction because of the compensation that will be earned from the IRA.
Other prohibited transactions include third-party payments (e.g., revenue sharing, insurance commissions, solicitor fees), transaction-based payments (e.g., securities commissions, 12b-1 fees), and proprietary investments.
Exemption for Conflicted Advice
As a result, investment advisory firms and broker-dealers will need the protection of PTE 2020-02. The good news is that there is an exemption for conflicted advice. The “bad news” is that the conditions of the exemption—and there are a number of difficult ones—must be satisfied beginning December 21. Until then, there is a temporary nonenforcement policy that is easier to satisfy, but firms need to be actively working on how they will comply with the PTE starting December 21.
DOL Nonenforcement Policy
Though the new rule was fully effective on February 16, the DOL extended (with concurrence by the IRS) an existing nonenforcement policy. That is, the DOL (and IRS) will not enforce the full conditions of the PTE until December 21 so long as the financial institution and the investment professional satisfy the Impartial Conduct Standards during the interim. While many industry groups have asked DOL to extend the nonenforcement policy beyond December 20, the DOL has not given an indication whether it will do so. It appears likely that even if there is an extension, it will be only for a short period to permit the normal, year-end disclosure process to be used to provide new PTE 2020-02 disclosures. Such an extension may provide some relief, but it is unlikely to make a material difference to firms seeking additional time to set up the procedures for satisfying the 2020-02 conditions.
Here is how the DOL explained the Impartial Conduct Standards in their April FAQs:
Q11. What are the Impartial Conduct Standards?
The Impartial Conduct Standards are consumer protection standards that ensure that financial institutions and investment professionals adhere to fiduciary norms and basic standards of fair dealing. The standards specifically require financial institutions and investment professionals to:
- Give advice that is in the “best interest” of the retirement investor. This best interest standard has two chief components: prudence and loyalty;
- Under the prudence standard, the advice must meet a professional standard of care as specified in the text of the exemption;
- Under the loyalty standard, advice providers may not place their own interests ahead of the interests of the retirement investor, or subordinate the retirement investor’s interests to their own;
- Charge no more than reasonable compensation and comply with federal securities laws regarding “best execution”; and
- Make no misleading statements about investment transactions and other relevant matters.
Of the three Impartial Conduct Standards, the best-interest standard is the most difficult to satisfy. Essentially, it is a combination of ERISA’s prudent man rule and duty of loyalty. That standard requires that the financial institution and the investment professional engage in a process that considers the appropriate information and reaches an informed decision that is in the best interest of the retirement investor. For example, in a plan-to-IRA rollover context, the financial institution would need to gather and consider:
(1) information about the investments, costs and services in the plan
(2) information about the account types, investments, services and costs in an IRA
(3) information about the needs and circumstances of the participant
The best interest standard then requires that the information be evaluated at the level of a person knowledgeable about the relevant issues (e.g., plans, IRAs, retirement investing), and the resulting recommendation would need to be in the best interest of the retirement investor.
The Full Conditions of PTE 2020-02
The nonenforcement policy expires on December 20. Beginning December 21, the full conditions of the exemption must be satisfied. Here is a list of those conditions:
- The Impartial Conduct Standards continue to apply.
- A written acknowledgement that the financial institution and investment professional are fiduciaries. (The DOL has provided sample language for this purpose, but it is not required and may not be the best choice for all financial institutions.)
- A written description of the services to be provided and the material conflicts of interest of the financial institution and the investment professional. (Presumably, a rollover recommendation results in a material conflict for example.)
- For rollover recommendations (e.g., Plan-to-IRA, IRA-to-IRA, or change of account type), the retirement investor must be given documentation of the specific reasons the rollover recommendation is in the best interest of the retirement investor.
- The financial institution must have written policies and procedures to ensure compliance with the Impartial Conduct Standards.
- The financial institution’s policies and procedures must mitigate conflicts so that they do not create an incentive for the firm or its investment professionals “to place their interests ahead of the interest of the Retirement Investor.”
- Each year, the financial institution must do a retrospective review of compliance with the requirements of the PTE. The results must be documented in a report that is reviewed and signed by a senior executive officer of the firm. Some small advisory firms have said that this condition will be one of the most burdensome to comply with.
These requirements are new, complex and burdensome. In some cases, firms may be able to avoid some of the requirements of these new rules through alternative approaches. (For example, in appropriate circumstances, it may be better for some firms to avoid providing rollover recommendations of one type or another, while providing rollover assistance in other forms.)
It will take a considerable amount of time and thought to make the decisions that are needed to develop approaches for compliance. That will be followed by development of the required written materials and training for supervisory personnel and investment professionals. There is only a limited amount of time to do that.
Note: This is a summary of lengthy and complicated documents. As a result, some significant requirements and definitions have been omitted. This is intended to provide an explanation for general discussions of the work to be done and the timing. For specific compliance efforts, more detailed information will be needed.
For a detailed summary of different aspects of the Rule, see the blog-posts addressing PTE 2020-02 at https://fredreish.com.