Broker-dealers and their registered representatives (advisors) providing services to private sector tax-qualified and ERISA-governed retirement plans, participants in those plans and IRA owners (collectively, Retirement Investors) are subject to a number of compensation rules.

ERISA’s fiduciary responsibility rules mandate that ERISA plans pay no more than reasonable compensation to service providers (including advisors).

In addition, the prohibited transaction rules that apply to Retirement Investors set limitations on compensation. For example, if a service provider receives compensation in excess of a reasonable amount, the excess is a prohibited transaction for both the plan fiduciary and the service provider. It is also a prohibited transaction if an advisor receives compensation that varies based upon the recommendation made (i.e., variable compensation) or third-party compensation as a result of the recommendation, unless a prohibited transaction exemption applies. Lastly, some prohibited transaction exemptions – like Prohibited Transaction Exemption (PTE) 2020-02 – have other limitations on compensation. This post focuses on the compensation limitations in the DOL’s proposed amendments to PTE 2020-02.

PTE 2020-02 allows advisors to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to Retirement Investors. The proposed amendments to PTE 2020-02 include a number of compensation-related requirements detailed below.

Reasonable Compensation

The current PTE 2020-02 requires adherence to “impartial conduct standards” consisting of a best-interest standard and a requirement that neither the advisor nor the firm receive more than reasonable compensation for the services provided to Retirement Investors. This requirement remains unchanged under the proposed amendments. In the Preamble to the current PTE, the DOL explains that the determination of reasonable compensation is a market-based standard “measured by the market value of the particular services, rights and benefits” the firm and the advisor deliver to the Retirement Investor. In other words, to evaluate reasonableness, advisors should consider whether the compensation reflects the value of services provided to the Retirement Investor as determined by the competitive marketplace.

Mitigation of Conflicts of Interest

Another condition for relief under PTE 2020-02 is the 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.

We discussed this requirement in detail in our blog post entitled Compliance with PTE 2020-02:  Mitigating Conflicts of Interest, including the importance of evaluating compensation practices to ensure they don’t create or reinforce conflicts of interest. This requirement remains unchanged in the proposal; however, the proposed amendments add the following additional language:

Financial Institutions may not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, or other similar actions or incentives that are intended, or that a reasonable person would conclude are likely, to result in recommendations that are not in Retirement Investors’ Best Interest. [emphasis added]

The Preamble to the proposed amendments explains that under this requirement firms should not “offer incentive vacations, or even paid trips to educational conferences, if the desirability of the destination is based on sales volume and satisfaction of sales quotas.” This language is difficult to interpret. For example, the reference to “desirability of the destination” suggests that destinations need to be assessed based on desirability – an inherently subjective standard.

Third-Party Payments

The proposed amendments to PTE 2020-02 provide a definition of third-party payments.

“Third-Party Payments” include sales charges when not paid directly to the Financial Institution by the Plan, from a participant or beneficiary’s account, or from an IRA; gross dealer concessions; revenue sharing payments; 12–1 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 an Affiliate or Related Entity by a third party as a result of a transaction involving a Plan, participant or beneficiary account, or IRA.

As explained above, third-party payments are considered prohibited compensation for which PTE relief is needed. This definition clarifies the types of compensation that require compliance with PTE 2020-02.

Compensation Disclosure under the Proposed Amendments

The proposed amendments to PTE 2020-02 require that the Retirement Investor receive a pre-transaction disclosure about the right to receive information regarding costs, fees and compensation.  Specifically, the Retirement Investor must receive –

A written statement that the Retirement Investor has the right to obtain specific information regarding costs, fees, and compensation, described in dollar amounts, percentages, formulas, or other means reasonably designed to present full and fair disclosure that is materially accurate in scope, magnitude, and nature, with sufficient detail to permit the Retirement Investor to make an informed judgment about the costs of the transaction and about the significance and severity of the Conflicts of Interest, and that describes how the Retirement Investor can get the information, free of charge….[Emphasis added]

If this proposal is finalized, firms will want to develop a document that responds to requests by Retirement Investors about costs, fees and compensation. The DOL indicates that this information can be set forth on a website.

Conclusion

Although these requirements are just proposals, we expect that they will be finalized in substantially the same form later this year. In the meantime, firms should review their current compensation practices and assess whether and to what extent they will need to be revised when these rules are finalized.