The Department of Labor (DOL) recently released its long-awaited proposed regulations describing the circumstances under which a person who provides investment advice, in connection with a retirement plan or IRA, acts as a fiduciary under ERISA and the Internal Revenue Code. If finalized, the proposed regulations will have a significant impact on how financial professionals provide investment advice to plan fiduciaries, participants, and IRA owners. This alert does not attempt to get into the details of the regulations but to highlight those aspects of the rules that will have a substantial effect on how financial advisors service ERISA retirement plans and Individual Retirement Accounts (IRA’s).
The current regulations governing fiduciary investment advice to retirement plans were issued in 1975 and have remained largely unchanged over the last 40 years. They define an investment fiduciary as one, who for a fee, renders advice to the plan as to the value of or advisability of buying, selling, investing in securities or other property, which advice is individualized and will be used as the primary basis for making the investment decision.
The new proposal is significantly broader. It applies to anyone who, for a fee, provides any of the following:
Recommendations to buy, sell, hold, or exchange securities, including recommendations to take distributions of benefits or recommendations regarding the investment of assets rolled or distributed from a plan or IRA;
Recommendations regarding the management of securities in a plan or IRA;
Appraisals and fairness opinions regarding transactions to buy, sell, or exchange assets in a plan or IRA; or
Recommendations of a person who will receive a fee to provide any of the above advice.
The new regulations would apply to any recommendation given to a plan, participant, beneficiary or IRA owner. If the advisor is a fiduciary, any party who is related to or affiliated with the advisor is also a fiduciary. The inclusion of recommendations regarding distributions or IRA rollovers is a massive change from prior law.
The DOL indicates that the word “recommendation” is broadly construed and should apply to any communication that reasonably would be viewed as a suggestion that the investor take action or refrain from taking action regarding a security or investment strategy. The proposed regulations include a handful of exceptions that generally apply to advisors in connection with large plans.
An exception for investment education is included, but, unlike prior guidance, providing a model portfolio is not considered investment education if it discloses specific investments that comprise the portfolio.
Fiduciary status is important because ERISA requires fiduciaries to act prudently and exclusively in the interests of participants and beneficiaries. This is a higher standard than the “suitability” standard which applies to investment advice outside ERISA and would, if the proposed regulations are finalized in their current form, also apply to IRA owners. Fiduciaries are also restricted by the prohibited transaction rules of the Code and/or ERISA which seek to prevent conflicts of interest. Most importantly, fiduciary compensation must be levelized, which means the compensation cannot vary based on the investment recommended.
The proposed regulations recognize that a prohibited transaction exists when an investment fiduciary receives compensation from a third party in connection with the sale of investments to a retirement plan or IRA owner. To enable fiduciaries to continue to service small plans, participants with small account balances, and IRAs – situations in which the advisor’s compensation is likely to come from 12b-1 fees or investment sales charges (loads) – the DOL issued a new series of proposed prohibited transaction exemptions.
The most important of these exemptions is the “Best Interest Contract” exemption which would permit a fiduciary to receive certain types of prohibited compensation (e.g., commissions and 12b-1 fees) if the fiduciary contractually agrees to be subject to a new “best interest” standard. This standard requires the investment fiduciary give advice that is in the customer’s best interest, avoid misleading statements, receive no more than reasonable compensation, and comply with applicable laws. The exemption requires point-of-sale and annual disclosures that are, at best onerous, and, at worst, may be impossible to satisfy.
Changes to other prohibited transaction exemptions will have a substantial impact on the sale of insurance and annuity products.
The new regulations could be finalized by the end of the year and would be effective eight months thereafter.
The DOL indicates that the word “recommendation” is broadly construed and should apply to any communication that reasonably would be viewed as a suggestion that the investor take action or refrain from taking action regarding a security or investment strategy. The proposed regulations include a handful of exceptions that generally apply to advisors in connection with large plans.
