U.S. Department of Labor Fiduciary Rule
The Department of Labor (DOL) issued its final ”fiduciary” rule which will have wide ranging and significant impacts to broker-dealer and investment advisory business practices. In short, this rule subjects broker-dealers and investment advisers who provide advice and recommendations to clients as it relates to their retirement investment and retirement asset management to the ERISA fiduciary standards and investor remedies. The rule is commonly referred to as the “Conflicts of Interest” rule. This document is a summary of the rule and its major provisions. For complete details please refer to the final rule publications. Links to the publications are included at the end of this document.
New Definition of Who Is a Fiduciary
Under the new rule, a “fiduciary” is a person who offers investment “advice” or a “recommendation” specific to an individual’s retirement assets for a fee or other compensation, direct or indirect. This includes a recommendation to a plan, plan fiduciary, plan participant or beneficiary, an IRA or IRA owner. Advice covered by the rule can be of many forms: a recommendation to acquire, hold, dispose of, or exchange and advice as the manner in which assets should be invested after a roll over, transfer or distribution from a retirement plan or IRA. The advice is directed to a specific retail retirement client regarding a specific investment decision.
A fiduciary is a person who represents or acknowledges it is acting as a fiduciary under this Rule or the IRS code. A fiduciary is also one who provides written or unwritten understanding that advice or recommendation is based on the particular needs of a specific client. In other words, to offer general informational advice about building retirement assets is not considered a fiduciary relationship.
A significant impact of this new rule is that an adviser, who becomes a fiduciary in order to avoid conflicts of interest and associated penalties, will now have to conduct business under an available exemption in order to receive compensation – known as the Best Interest Contract Exemption or BICE.
For an IRA account, a contract is required between the investor and the fiduciary’s institution that outlines and warrants several conditions of the relationship between the institution and the investor. A contract is not required for an ERISA-covered plan.
What is Advice or Recommendation? What is Not?
The final rule includes a definition of what constitutes a “recommendation” which then kicks in the fiduciary status of a person based on the relationship with the retirement investor.
Examples of advice or recommendations covered as a fiduciary include:
- Advice related to the investment of retirement assets
- Acquiring, holding, disposing of or exchanging securities
- Investment of retirement assets after rolled over, transfer or distribution from a retirement plan or IRA
- Advice related to the management of retirement assets
- Investment strategies, portfolio composition
- Proxy voting
- Selection of other persons to provide advice
- Selection of the type of retirement account (commission or fee based)
- Transfers and roll overs from a plan to an IRA that may not even include an actual recommendation to invest or take action
- A recommendation that, based on its content, context and presentation, is perceived by the recipient as a recommendation to take action or refrain from action
- Recommendations developed to address a specific retail retirement investor(s) about a specific investment
- Providing a list of securities to an investor deemed as an appropriate investment vehicle even if no specific security is identified or recommended
- No distinction is made between recommendations made by a person or a computer
The rule provides detailed description of services, actions and information that do not meet the definition of a “recommendation:” 1) Platform Providers and Related Activities, 2) Investment Education, 3) Transactions with Independent Fiduciaries with Financial Expertise, 4) Swap Transactions, 5) Employees of Plan Sponsors, Plan or Plan Fiduciaries. Each of these exclusions is discussed below.
- Platform Providers and Related Activities
Marketing to a plan fiduciary, or its participants, a platform to select or monitor retirement assets as long as the communication is without regard to the specific needs of the plan, or its participants, and the plan fiduciary is independent of the person marketing the platform is not considered a “recommendation.” The adviser who offers such marketing must disclose to the plan fiduciary in writing that the marketing is not the offer of advice as a fiduciary. Plan fiduciaries under this exemption are restricted to those who are not plan participants, IRA owners or beneficiaries.
Additionally, marketing activities to assist plan fiduciaries in the selection and ongoing review of investment alternative are not “recommendations” under the rule. Specifically the marketing must identify investment alternatives that meet the plan objectives as identified by the plan fiduciary. A response to a request for information or a proposal with a generic or sample set of investment options that is based on the size of the plan is not a “recommendation.” However, the response to the request must disclose whether the person who identifies the investment alternatives has a financial interest in any of the alternatives and if so, the precise nature of such interest.
- Investment Education
The rule does not significantly change current provisions related to general investment education with one exception – specific investment options and distribution options. Four types of education information are addressed in the rule: 1) plan investment education, 2) general financial, investment and retirement information, 3) asset allocation models and 4) interactives investment materials. These four types of educational information are not deemed to be recommendations.
- The description of the investment objectives of plan investment options, mutual funds, risk and return characteristics, historical returns, fees, and other such general information
- The discussion of general financial concepts such as diversification, risk, return, inflation, risk tolerance and other generic financial topics
- Providing hypothetical asset allocations based on generally accepted investment theories without a specific investment recommendation with reference to a specific product
- Making available questionnaires, worksheets, software or similar material to provide tools to retirement investors to estimate future retirement needs as long as it remains generic without reference to specific products
What is Advice or Recommendation? What is Not? Continued
- Transactions with Independent Plan Fiduciaries with Financial Expertise
The final rule provides that a person is not deemed a fiduciary when rendering advice to an independent person who is a fiduciary of a plan or IRA with respect to an arm’s length sale, purchase, loan, exchange or other property under the following conditions if the adviser believes they are dealing with a fiduciary of the plan or IRA and is:
- A bank defined in the ’40 Act or similar institution regulated and supervised and subject to periodic examination by a State or Federal Agency
- An insurance carrier qualified under one or more states
- An investment adviser registered under the ’40 Act or under State laws
- A broker-dealer registered under the ’34 Act
- Any other person acting as an independent fiduciary that hold, or has under management or control total assets of at least $50 million
- Swap and Security-Based Swap Transactions
Persons acting as swap dealers, etc. do not become investment advice fiduciaries as a result of communication and activities conducted during the course of a transaction regulated under Dodd Frank or the ’34 Act or applicable CFTC and SEC regulations under four conditions.
- The person cannot act as adviser to the plan.
- The plan must have an independent plan fiduciary.
- No fee or compensation is received as a result of the transaction by the person.
- The independent plan fiduciary provides written representation that he or she understands that the person is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity in connection with the transaction.
- Employees of Plan Sponsors, Plans or Plan Fiduciaries
Generally employees of plan sponsors do not become fiduciaries by providing advice to plan fiduciaries or another employee of the plan sponsor. Employee are not fiduciaries if they provide advice to plan participants if the employee’s job responsibilities does not involve providing investment advice, is not registered or licensed under federal or state securities laws and the advice does not require the individual to be registered as a result of the offer of such advice. In any event, no compensation is permitted beyond the employee’s normal compensation.
Effects of Being a Fiduciary
Consequences of being an adviser in a fiduciary role are many. First being subject to ERISA and its conflicts of interest concerns, and the restrictions and requirements of the prohibited transaction rules. Second is the new required contract and its consequences to subject an institution or adviser to legal action in cases of violations of the rules. Without drawing upon the Best Interest Contract Exemption, an adviser or institution is prohibited from receiving compensations from third parties, commissions or other compensation related to the recommended transaction.
Best Interest Contract Exemption
As noted above under ERISA, financial advisers and financial institutions are prohibited from receiving payments from third-parties, and taking action on conflicts of interest to affect or increase their own compensation in connection with a transaction involving an ERISA plan or IRA. The common types of compensation current in the industry such as brokerage or insurance commissions, 12b-1 fees and revenue sharing payments fall within the prohibitions when received by fiduciaries as a result of transactions that involve advice to the plan, its participants, beneficiaries and IRA accounts.
In order to allow continued advice to the retail investors under conditions designed to safeguard the interest of the investors over and above the financial adviser or institution, DOL approved an exemption known as the Best Interest Contract Exemption or BICE. BICE permits advisers and their institutions to receive various forms of compensation that would, in the absence of an exemption, not be permitted under ERISA or the IRS Code. Advisers who rely on the exemption must adhere to an “Impartial Conduct Standard” when the make investment recommendations. All conditions noted in the exemption must be met.
Major Provisions of the BICE:
- A financial institution and its advisers is required to acknowledge their fiduciary status in writing to the client.
- The financial institutions and advisers must adhere to the enforceable standard of fiduciary conduct and fair dealing with retail clients with respect to their advice or recommendation which requires them to:
- Give advice that is in the best interest of the client that is based on investment objectives, risk tolerance, financial situations and the needs of the retirement investor without regard to the financial or other interest of the advisers or institutions;
- Charge no more than reasonable compensation;
- Make no misleading statements related to the transaction.
- Implement policies and procedures reasonably designed to mitigate harmful impacts of conflicts of interest, disclose basic information of their conflicts to retail clients and the cost of the advice
- IRAs and non-ERISA plans prompt a requirement to detail the Impartial Conduct Standard Standard in an enforceable contract with the retail retirement investors.
- ERISA plans are not required to engage in a contract with the institution but they are obligated to adhere to the same standards of fiduciary conduct.
- Level fee fiduciaries along with their affiliates that receive only a non-variable fee in connection with advisory or management services are not required to enter into a contract with retirement clients, but are required to provide a written statement of their fiduciary status, adhere to the standards and document in writing the reason or basis of a recommendation.
- Refrain from giving or using incentives for advisers to act contrary to the customer’s best interest
- Disclose to clients the costs of its services, fees and compensation practices.
Advisers who offer advice to retail retirement investors under a conflicted compensation structure must protect their customer from the dangers posed by conflicts of interest.
To foster compliance with the broad investor protective standards in the rule, BICE focuses on the enforceability of its terms when institutions and advisers breach their obligations and cause losses to retail retirement investors. Under the contractual arrangement, the investors have access to a remedy to redress the injury. ERISA already enforces their rights to proper fiduciary conduct, but the institution must acknowledge it and its advisers status to the investor. A copy of the contract must be stored and made accessible by the investor on the institution’s website.
Further, an institution and adviser may not rely on the exemption if they include contractual provisions disclaiming liability for compensatory remedies or waiving or qualifying a retirement investor’s right to pursue a class action or other representative action in court. The exemption does permit institutions to
Best Interest Contract Exemption, Continued
include provision that waive the investor’s right to punitive damages or rescission as contract remedies to the extent permitted by applicable law
Although BICE provides relief for all categories of fiduciary recommendations including advice on rollovers, distributions, services and investment recommendations related to any asset, the operational or procedural impacts differ when the clients is an existing IRA client with a contract for services, an existing IRA client without a contract for services, a client who participates in an ERISA plan or a Level Fee Clients.
Level fee is generally less complicated, as reliance on the BICE exemption is not necessary as neither the financial intuition nor the adviser is exercising discretion in a manner that varies fee income or compensation. However, the potential for a conflict of interest does exist when an adviser recommends actions related to a roll over into a fee based account that generate ongoing though level fees. Therefore, usually the only time in which advisers to a level fee account investor would rely on the exemption is in connection with roll over recommendations.
Under this scenario, the financial institution must give the retail retirement client a written statement of its and its advisers’ fiduciary status and the financial institution and the adviser must comply with the Impartial Conduct Standard. If the recommendation is to roll over from an ERISA plan to an IRA, the financial intuition must document, in great detail, the reasons why the recommendation is in the best interest of the client. The same holds true if the recommendation is to roll over from another IRA or a switch to a commission-based account to a level fee arrangement.
IRA clients without an existing contract must enter into an enforceable contract. Contracts must comply with the contract inclusions and exclusions listed above. The contract must be signed prior to or at the same time as execution of the first recommended transactions. Alternatively the contract is permitted to be included in industry standard account opening agreements. Electronic signatures are allowed. The institution must comply with recordkeeping requirements and notify the DOL of its intent to use the BICE exemption.
To address clients with an existing contract or agreement, the DOL included a “negative consent” provision in the rule that allows the financial institution to deliver an amended proposed contact which complies with all the contract inclusions and exclusions prior to the effective date of January 1, 2018. The contract is considered effective if the retail investor does not terminate or cancel the amended contract within 30 days. Although the negative consent eliminates the need to obtain a client’s signature, it does not eliminate the other requirements of the BICE exemption related to the offer of investment advice.
If the client is a participant of a plan subject to Title I of ERISA, no contract is required. However, the institution must comply with the Impartial Conduct Standards, provide the required disclosures discussed above, notify the DOL of its intent to use the exemption and comply with the recordkeeping requirements. A distinct requirement for plan clients is that the financial institution and adviser is not permitted, in any contract or communication, to disclaim or limit the liability of the advisers or institution if the disclaimer is prohibited under ERISA. Contracts or agreements may not include waivers or other communication that limit the right of the client to bring a class action or other legal action or require arbitration or mediation of claims in a venue that is distant or limits the rights of the investor to assert its claim.
What is the Impartial Conduct Standard
Throughout the BICE, the DOL references the “Impartial Conduct Standard” as a compliance requirement. The Impartial Conduct Standard is the conditions of the exemption for the provision of advice provided to all retirement investors. What this means is that the financial institution and adviser makes a recommendation or offers advice only on the basis of the best interest of the client rather than in interest of the institution or adviser. The compensation that the institution or adviser receives in relation to the recommendation is not in excess of what is considered reasonable under ERISA and the IRS code. Finally, the institution or adviser is prohibited from making any misleading statements with regard to the recommendation, fees and compensation and conflicts of interest.
The DOL addresses situations with inherent conflicts of interest when an institution or advisers makes a recommendation of a proprietary product or an investment that generates third party payments. An institution or adviser is permitted to rely on the exemption provided that the recommendation is prudent, the fees are reasonable and the conflicts of interest are disclosed and the conflicts are managed through stringent policies and procedures that focus on the customer’s best interest rather than that of the institution or adviser.
Policies & Procedures Requirement
Under the exemption financial institutions must adopt, document in writing and enforce compliance with anti-conflict of interest policies and procedures. This provision requires institutions to take specific steps to identify and document any material conflict of interest and the steps taken ensure its adviser comply with the Impartial Conduct Standard. The policies and procedures must address the elimination of compensation practices and incentives intended or expected to persuade the adviser to make recommendation not in the best interest of the investor.
In response to requests from the industry, the DOL adopted an exemption condition to require a financial institution to designate a specific person to address material conflict of Interest and monitor advisers’ compliance with the Impartial Conduct Standard.
As part of the adoption of policies and procedures designed to enforce compliance with the Impartial Conduct Standard, institutions need to pay particular attention to the policies addressing institutional and adviser compensation. The rule allows for differential compensation based on neutral factors, subject to the institution’s policies and incentive practices that are designed to always put the client’s interest first. The final rule illustrates several examples of policies institutions may adopt. However, it is assumed that the institution will make it a practice to monitor and make corrections to its policies and procedures.
Generally, these types of compensation are allowable:
- Independent Computer Model Generated Compensation
- Level Fee Compensation
- Asset-Based Compensation
- Level Commission-Based Compensation with Stringent Supervisory Structure
- Differential compensation for different categories of investment products based on neutral factors and subject to policies and procedures that safeguard against conflict
- Differential compensation rewarding advisers for their compliance with the Impartial Conduct Standard
These types of compensation are not allowed:
- Pay based solely on the amount of third-party payments
- Higher pay due to increased third party payments
- Pay based on quotas, appraisals, performance or personnel actions, bonuses, contracts, special awards differential compensation or other actions or incentives intended or reasonable expect to cause advisers to make recommendation not the best interest of the investor
Prohibited Trade Exemptions
The final rule created or amended several Prohibited Trade Exemptions (PTEs).
Prohibited Trade Exemption 84-24 generally allowed the receipt of commission by an adviser or institutions, when plans and IRA’s purchased insurance contacts, annuity contract and mutual funds.
PTE84-24 continues to cover activities related to traditional fixed annuities. Activities related to variable and fixed indexed annuities are not subject to the BICE exemption.
In certain cases and under specific conditions, principal transactions in certain assets (fixed income products) are permitted under a new Prohibited Trade Exemption:
- Broker-dealers, investment advisers who are fiduciaries and avail themselves of the exemption
- Both principal and riskless principal transactions are permitted for principal traded assets
- Principal traded assets include debt securities, Certificates of Deposit and Unit Investment Trust registered under the ’40 Act
- Debt security is defined to include debt securities issued by U.S. companies, U.S. Treasury securities, certain agency debt and asset backed securities
- Financial institutions must comply with FINRA’s best execution rule and provide confirmations under SEC Rule 10b-10
- Financial institutions must provide annual list of principal transactions effected for the retirement investor
- Fiduciary status must be acknowledged and adherence to the Impartial Conduct Standards
- Institutions must adopt policies and procedures designed to prevent violation of the Standards
- Institutions must adopt compensation policies that refrain from giving or using incentives to advisers that are contrary to the best interest of the retirement investor
PTE75-1 Part 5 is amended to permit the receipt of compensation related to the extension of credit to avoid a failed securities transaction as long as the fiduciary is not the cause of the failed transaction. The compensation must be fair, and is subject to disclosure and recordkeeping requirements.
This is not a comprehensive discussion of Exemptions. Please see the Release for additional details.
Effective Date(s), Applicable Date, Transition Period, Compliance Date
The official effective date of the new definition of “fiduciary” is June 7, 2016. The actual application of the definition of “fiduciary” and with certain exceptions, the prohibited transaction exemptions (PTE) are applicable on April 10, 2017. Responding to implementation concerns of the industry, the DOL provided a “transition period” during which a reduced number of the exemptions are applicable. The transition period runs from April 10, 2017 to January 1, 2018. The entire rule set is fully effective and institutions and advisers must be fully compliant on January 1, 2018.
Department of Labor Employee Benefits Security Administration 29 CFR Parts 2509, 2510, and 2550 Definition of the Term “Fiduciary’: Conflict of Interest Rule – Retirement Investment Advice (pp. 20946 – 21002)
Department of Labor Employee Benefits Security Administration 29 CFR Part 2550 Class Exemption for Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs (pp. 21089 – 21139)
Department of Labor Employee Benefits Security Administration 29 CFR Part 2550 Amendments to Prohibited Transaction Exemption (PTE) 75-1, Part V, Exemptions from Prohibitions Respecting Certain Classes of Transactions Involving Employee Benefit Plans and Certain Broker-Dealers, Reporting Dealers and Banks (pp. 21139 – 21147)
Department of Labor Employee Benefits Security Administration 29 CFT Part 2660 Amendment to and Partial Revocation of Prohibited Transaction Exemption (PTE) 84-24 for Certain Transactions Involving Insurance Agent and Brokers, Pension Consultants, Insurance Companies and Investment Company Principal Underwriters (pp. 21147-21181)
Department of Labor Employee Benefits Security Administration 29 CFR Part 2550 Amendments to and Partial Revocation of Prohibited Transaction Exemption Involving Employee Benefit Plans and Broker-Dealers; Amendments to and Partial Revocation of PTE 75-1, Exemption from Prohibitions Respecting Certain Classes of Transaction Involving Employee Benefit Plans and Certain Broker-Dealers, Reporting Dealers and Banks (pp. 21181 – 21208)