Compliance with PTE 2020-02: Mitigating Conflicts of Interest

Key Takeaways

  • PTE 2020-02 requires that financial institutions—such as broker-dealers—mitigate conflicts of interest “to the extent that a reasonable person reviewing the policies and procedures and incentives as a whole would conclude that they do not create an incentive for the firm or the investment professional to place their interests ahead of the interest of the retirement investor.
  • The DOL has issued FAQs that provide examples of mitigation techniques to reduce compliance risks in connection with compensation structures.
  • While there are a variety of mitigation techniques that can be used for different types of conflicts, the following two elements need to be part of mitigating every type of conflict: (1) an appropriate best interest process for developing the recommendation; and (2) supervision of the proper implementation of that process.


The DOL’s prohibited transaction exemption (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees), allows broker-dealers and their registered representatives (advisors) to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to private sector tax-qualified and ERISA-governed retirement plans, participants in those plans, and IRA owners. (The PTE refers to those 3 classes of investors as “retirement investors.”) In addition, in the preamble to the PTE, the DOL announced an expanded definition of fiduciary advice, meaning that many more broker-dealers and their advisors are fiduciaries for their recommendations to retirement investors – including rollover recommendations – and therefore, will need the protection provided by the exemption.

Specifically, one of the conditions for relief under PTE 2020-02 is mitigation of conflicts of interest, described as follows:

Financial Institutions’ policies and procedures mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests ahead of the interest of the Retirement Investor.

For this purpose, a “Conflict of Interest” is described as an interest that might incline a firm or its registered representative – “consciously or unconsciously – to make a recommendation that is not in the best interest of the Retirement Investor.”

The DOL indicates that there are a variety of mitigation techniques that can be used for different types of conflicts, but in each instance the following elements should be part of that mitigation procedure: (1) an appropriate best interest process for developing the recommendation, and (2) supervision of the proper implementation of that process. Further, the DOL emphasizes the importance of evaluating compensation practices to ensure they don’t create or reinforce conflicts of interest:

Financial institutions should carefully assess their compensation practices for potential conflicts of interest and work to avoid structures that undermine investment professionals’ incentives to comply with the best interest standard. To be prudent and loyal, fiduciaries should design compensation structures that minimize the dangers associated with conflicts of interest, as opposed to designing structures that create or reinforce conflicts of interest that run contrary to the interests of the investor.

As examples of compensation structures that could result in potential conflicts, the DOL in its Frequently Asked Questions (FAQs) discusses commission-based compensation and payout grids in FAQs 16-17.

Commission-Based Compensation and Mitigation Techniques

In FAQ-17, the DOL points out that commission-based compensation that varies based on the investment product recommended can result in conflicts of interest:

Financial institutions should carefully review the amounts used as the basis for calculating investment professionals’ compensation to avoid simply passing along firm-level conflicts to their investment professionals. If, for example, investment professionals are paid a fixed percentage of the commission generated for the financial institution, this may transmit firm-level conflicts to the investment professional, who is effectively rewarded for preferentially recommending those investments that generate the greatest compensation for the firm. The overarching goal should be to avoid incentive structures that encourage investment professionals to make recommendations inconsistent with the Impartial Conduct Standards. Accordingly, firms should work to align the interests of their investment professionals and retirement investors, and to root out misaligned incentives to the extent possible.

In effect, the DOL is saying that, if one investment pays more to the firm (for example, 8%), and another pays less to the firm (e.g., 4%), and if the firm passes through a set percent of the commission to the advisor (e.g., 80%), the firm has an arrangement that passes through its incentive to make more money to the advisor. The question, then, is, how can the conflict be mitigated? One obvious answer is to level the advisor’s compensation regardless of which investment is recommended. While that should effectively mitigate the conflict, it may not be a practical “solution.”

Another approach would be to use “neutral standards” for determining the compensation of the advisor. For example, let’s suppose it took twice as much time to explain the investment product and the advisor needed additional education and experience to sell the product that was in the best interest of the retirement investor. Those circumstances would likely justify a commission of twice as much as the other alternatives that could have been recommended, but that were not in the best interest of the retirement investor.

Yet another approach that could, at the least, be part of mitigating the conflict is to have a well-defined, demonstrably reasonable best interest process for recommending one of the alternatives over the others. To the extent that a retirement investor’s profile reveals a need for a specific product (e.g., guaranteed retirement income), and the product and allocation of the investor’s financial resources to the product is in the best interest of the investor, a higher compensating recommendation could be justified.

Payout Grids and Mitigation Techniques

From the DOL’s perspective, payout grids also create conflicts of interest. FAQ-17 discusses specific approaches to mitigate the incentive effect of payout grids.

  1. The Grid Bands and Thresholds

    The DOL explains that firms employing escalating grids should establish a system to monitor and supervise advisor recommendations, both at or near compensation thresholds and at a greater distance. Grids with one or several modest or gradual increases are less likely to create impermissible incentives than grids characterized by large increases. Firms should be very careful utilizing structures that disproportionately increase compensation at specified thresholds. These structures can undermine the best interest standard and create incentives for advisors to make recommendations based on their own financial interest, rather than the retirement investor’s interest.

    Since each band of a grid increases an advisor’s compensation, the recommendation of an investment, rollover, annuity, etc., that moves an advisor to the next band is a conflict above and beyond the direct compensation received for that recommended transaction. As a result, the transactions that move advisors into a higher band warrant additional—perhaps heightened—supervision. Even though it probably doesn’t need to be said, the greater the compensation increase associated with a higher band, the greater the likely incentive effect and, accordingly, the increased importance of close supervision of adherence to a best interest process.

    In sum, the DOL’s position is simple….keep the bands in the grid narrow and the increases in compensation modest for reaching a new band. The concept is that narrower bands with moderate increases will be less likely to incent an advisor to make a recommendation (e.g., a rollover recommendation) that moves the professional into the higher band. Of course, it’s one thing to say narrow bands and modest increases, but it is more difficult to determine where those lines should be drawn when preparing a grid. One way to address this is to have a “committee” approach….with representatives from distribution, compliance and legal looking at the degree of the incentive and agreeing that the bands and amounts are  unlikely to unduly incent advisors to prioritize themselves over the retirement investors. As a word of advice, if it doesn’t pass the “smell test,” it probably won’t pass the DOL’s test.

  2. Prospective Application of the Grid Increase

    The DOL also explains that once the advisor reaches a threshold on the grid, any resulting increase in compensation rate should generally be prospective – the new rate should apply only to new investments made once the threshold is reached. If the consequence of reaching a threshold is not only a higher compensation rate for new transactions, but also retroactive application of an increased rate of pay for past investments, the grid is likely to create acute conflicts of interest. Retroactivity magnifies the advisor’s conflict of interest with respect to investment recommendations and increases the incentive to make the sales necessary to cross the threshold regardless of the investor’s interest. The danger is particularly great when the sales necessary to cross the threshold will generate compensation for the advisor that is disproportionate to the compensation the advisor would normally receive for recommendations that are not at the threshold.

    The use of a retroactive, or waterfall, approach is, in effect, an “invitation” to the DOL to closely scrutinize the grid and its effects. This issue was also considered under the Obama-era Best Interest Contract Exemption. In other words, the DOL is serious about the use of grids that retroactively increase compensation splits and the potential adverse impact of those grids on best interest recommendations.

Concluding Thoughts

The DOL allows flexibility for broker-dealers to design their mitigation practices, but that doesn’t mean that a practice that is on paper, but isn’t effective, will satisfy the requirement. After all, there is a requirement for an annual retrospective review. In that regard, PTE 2020-02 requires that:

The Financial Institution conducts a retrospective review, at least annually, that is reasonably designed to assist the Financial Institution in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.

Since the mitigation requirement is part of the policies and procedures requirements, the review specifically applies to the mitigation practices of the firm. Mitigation is a principles-based requirement. It can’t be reduced to a formula or a black-and-white definition. As a result, firms should consider conservative approaches, beginning with the best interest process and supervision, and then considering whether compensation ranges should be narrowed and, perhaps, in some cases should be levelized.

PTE 2020-02 is a change of perspective on mitigation—as opposed to just an enhancement. As a result, when the DOL investigates compliance with PTE 2020-02, some firms may feel that they are the victims of “regulation by enforcement.” Where a firm’s compensation structure is such that it could be viewed as providing strong incentives to advisors to make recommendations in the advisors’ interest, the firms should ensure that their best interest processes and supervision are adequate to overcome that incentive effect.

While grids create unique issues, the key is to moderate the incentive effect of moving from one band to a higher one. This can be accomplished, as the DOL points out, by limiting the sizes of the bands, limiting the increase in compensation when moving to a higher band, and by increasing only prospective compensation.

Beyond that, the key is to have solid best interest processes for advisors to develop their recommendations, e.g., for developing a rollover recommendation. Then, firms need to supervise the process for developing those recommendations to ensure that the processes are followed and that the recommendations reflect reasonable outcomes based on the information gathered and evaluated.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

About the Author: Fred Reish

Fred Reish represents clients in fiduciary issues, prohibited transactions, tax-qualification and Department of Labor, Securities and Exchange Commission and FINRA examinations of retirement plans and IRA issues.

About the Author: Joan M. Neri

Joan Neri represents plan service providers – including broker-dealers and registered investment advisers – and employer plan sponsors and counsels them on fulfilling their obligations under ERISA and complying with the Internal Revenue Code rules governing retirement plans and accounts. Joan advises on ERISA fiduciary status and responsibilities, avoidance of prohibited transactions, the considerations associated with structuring, developing and offering investment products and services to ERISA plans and day-to-day plan operational compliance issues.

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