In November 2023, the U.S. Department of Labor released its package of proposed changes to the regulation defining fiduciary advice and to the exemptions for conflicts and compensation for investment recommendations to retirement plans, participants (including rollovers), and IRAs (including transfers). On March 8, 2024, the DOL sent the final rule to the Office of Management and Budget in the White House.
Key Takeaways
- The DOL’s proposals make it clear that robo advice, both “hybrid” and “pure”, can be fiduciary advice, subject to the provisions of ERISA and the Internal Revenue Code.
- When pure robo advice (no human directly involved) or hybrid robo advice is given, if it satisfies the regulatory definition of fiduciary advice, the financial institution will be a fiduciary under ERISA (if to an ERISA plan or a participant in such a plan) and subject to ERISA’s duties of prudence and loyalty.
- If robo advice generates a fiduciary recommendation that is conflicted, the conflicted amount (e.g., commissions, management fees) will be a prohibited transaction under ERISA and the Code, which would necessitate compliance with the conditions of a prohibited transaction exemption (PTE).
- This article discusses robo advice under PTE 2020-02.
Under the current PTE 2020-02, the exemptive relief is not extended to “pure” robo-advisers. Instead, only “hybrid” robo-advisers can provide nondiscretionary fiduciary advice to retirement investors where the advice is conflicted (e.g., proprietary investments, revenue sharing, commissions). However, when the proposed amendments to the PTE become final and applicable, compensation resulting from conflicted nondiscretionary advice will be permitted if the conditions of the exemption are satisfied.
In the preamble to the proposed PTE 2020-02, the DOL explains:
The Department is proposing to remove PTE 2020–02 Section I(c)(2), which excludes investment advice generated solely by an interactive website in which computer software-based models or applications provide investment advice based on personal information each investor supplies through the website, without any personal interaction or advice with an Investment Professional (robo-advice). As explained in the preamble to PTE 2020–02, the statutory exemption in ERISA section 408(b)(14), (g), and Code section 4975(d)(17) and 4975(f)(8), includes specific conditions that are tailored to computer-generated investment advice. PTE 2020–02, by contrast, was tailored to investment advice that is provided through a human Investment Professional who is supervised by a Financial Institution.
Note: The reference to the statutory exemption is to the computer model exemption in the 2006 Pension Protection Act (PPA). In 2009, the DOL issued final rules under the PPA’s computer model provision with detailed conditions to protect participants from conflicted advice, while allowing the conflicted compensation to be retained.
Comment: While not discussed in the preamble, I believe that the DOL has become more comfortable that pure robo advice can provide important benefits (e.g., lower costs and more universally affordable advice) and that pure robo advice can be adequately regulated (e.g., with the conditions in PTE 2020-02, as amended).
The preamble discussion continues:
The Department is now proposing to amend PTE 2020–02 to allow Financial Institutions providing investment advice through computer models to rely on the exemption. The Department understands that Financial Institutions may use a combination of computer models and individual Investment Professionals to provide investment advice and may wish to have a single set of policies and procedures that can govern all recommendations, regardless of whether a Retirement Investor speaks with an Investment Professional. Including computer-generated advice in this exemption would simplify Financial Institutions’ compliance, so that a Retirement Investor could request an Investment Professional’s assistance with a particular transaction, or an Investment Professional could review the computer model’s recommendations, without separate analysis as to whether an Investment Professional has provided fiduciary investment advice.
Note: PTE 2020-02 provides relief only for nondiscretionary conflicted fiduciary advice. If the robo adviser or the firm have any discretion or control over the management of the retirement plan, participant account, or IRA, the PTE could not be used for relief from prohibited conflicts.
Comment: It appears that, if an advisor is involved, both the advisor and the firm will be fiduciaries for the advice and both will be subject to the conditions of PTE 2020-02. However, while not explicitly stated, it appears that, where the advice is pure robo, the firm will be both the advisor and the financial institution. That places a burden on the firm to prudently vet and select the robo advice systems and their output and to monitor the recommendations. For example, the requirement to have an annual retrospective review and report would apply to the recommendations of the robo advisor.
But there is no such thing as a free lunch. The preamble discussion goes on to explain:
Like any other advice arrangement, Financial Institutions relying on computer models would have to satisfy the exemption’s best interest standard and other protective conditions in order to satisfy PTE 2020–02. For example, a computer model that preferentially recommends that a Retirement Investor purchase products that generate more income to the Financial Institution would not be permitted under this exemption…. To enhance their policies and procedures, it would be reasonable for a Financial Institution to incorporate some, but not all, of the statutory exemption conditions [of the PPA 2006 exemption for computer models] when relying on PTE 2020–02, although a Financial Institution could not merely pick and choose among the conditions of both exemptions in an attempt to avoid the meaningful conflict mitigation requirements each exemption provides. In other words, a Financial Institution must determine that its policies and procedures are, in fact, prudently designed to ensure compliance with the Best Interest standard….
Comment: One of the requirements of PTE 2020-02 is that the conflicts of both the advisor and the firm be “mitigated”. (This is different than Reg BI for broker-dealers, which only requires mitigation of the incentives for the advisors.) While there is not a clear definition of how much mitigation is “enough”, it seems reasonable to believe it means that the incentive effective of the conflict should not excessively encourage recommendations that are in the best interest of the advisor or the firm, but not of the retirement investor. (I say “excessively” because any incentive compensation (e.g., commission) has some incentive effect.) In my view, the quoted language expresses a view by the DOL that (i) the conditions of PTE 2020-02 must be satisfied without regard to the conditions in the PPA computer model exemption, and (ii) while some of the conditions in the PPA computer model exemption may act as mitigation of conflicts, firms cannot cobble together some of the computer model requirements with some of the 2020-02 requirements to satisfy the PTE’s requirements. In other words, the PTE’s conditions must all be satisfied without regard to the PPA provisions and the associated rules.
Concluding Thoughts
Pure robo advice will, when the PTE is finalized, become a valuable tool for providing investment advice to retirement investors…plan fiduciaries, participants, and IRA owners. There are issues to resolve, for example, how will the disclosures be delivered on a timely basis. But systems will be developed to manage that.
My best guess about the future (at least the relatively new future) is that robo advice will first find a retirement investor home with IRA owners…particularly the young and the tech savvy. I can see, shortly thereafter, the use of robo advice for plan participants, much the way asset allocation models are used now, but more individualized.
