DOL Rules that Target Fiduciary Conflict of Interests May Impact Employee Plan Sponsors and Fiduciaries

“Middle class economics means that Americans should be able to retire with dignity after a lifetime of hard work. But loopholes in the retirement advice rules have allowed some brokers and other advisers to recommend products that put their own profits ahead of their clients’ best interests, hurting millions of American workers and their families.

A system where firms can benefit from backdoor payments and hidden fees often buried in fine print if they talk responsible Americans into buying bad retirement investments -- with high costs and low returns -- instead of recommending quality investments isn’t fair.”

Department of Labor — Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year. www.dol.gov/protectyoursavings/FactSheetCOI.pdf.

Requiring investment advisers to retirement-based programs and their participants to act in the best interests of the programs and their participants is at the heart of the Department of Labor’s new fiduciary conflict of interest regulations. The Department’s interest in blocking self-interested advice to plan participants is not new. The Department first proposed rules addressing these concerns in 2010. The 2010 rules were widely criticized as being overly broad, prompting the Department to propose modified rules in 2015 and to alter the rules yet again earlier this year.

The Department’s most recent effort reflects a sincere effort to solve real problems. Read literally, though, the rules continue to over reach. While the rules discourage abusive activities by avaricious salespeople, they also preclude some appropriate practices and may drive honest advisers out of the market.

The new rule may have a significant impact on investment advisers who work with retirement plans, participants in those plans and the owners of IRAs (individual retirement accounts). But the reach of the rule is not limited to investment advisers, plan participants and IRA owners. The rule also may affect plan sponsors and other plan fiduciaries.

General Standard

As compared to the existing rules, which were issued in 1975, the new rules substantially expand the reach of the fiduciary standards prescribed by the Employee Retirement Income Security Act of 1974 (ERISA). Essentially, an individual or entity will be considered to be providing “investment advice” and, as a result, a “fiduciary” subject to ERISA’s fiduciary standards if it --

  • provides an investment related “recommendation,” and
  • receives direct or indirect compensation for doing so, and
  • it represents that it is acting as a fiduciary, or
  • it renders the advice pursuant to an agreement, arrangement or understanding that the advice is based on the particular investment needs of the recipient, or
  • it directs the advice to a specific person or persons regarding the advisability of a particular investment or management decision.

What is a “recommendation?”

One of the key factors in determining fiduciary status is whether a “recommendation” was made. According to the regulations, an objective standard is used to determine whether a “recommendation” has been made. But this “objective” standard seems to be viewed from the perspective of the recipient. The regulations provide that “recommendation” means “a communication that, based on its content, context, and presentation would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.”

This standard or test seems reasonable in the abstract, but its application might lead to odd results. For example, does the accountant who provides auditing services to a plan become a fiduciary by suggesting that its client consider engaging investment adviser A, B or C to provide advice regarding the client’s 401(k) plan? One would hope not, but the result may turn on the language the accountant used in making this suggestion.

What “recommendations” lead to fiduciary status?

The “recommendation” must relate to investment related issues in order to trigger fiduciary status. The regulations specifically provide that the following types of recommendations are sufficiently investment related to trigger fiduciary status:

  • A recommendation regarding acquiring, holding, disposing of or exchanging securities or other investment property;
  • A recommendation regarding how securities or other investment properties should be invested after those securities are rolled over, transferred or distributed from a plan to an IRA;
  • A recommendation regarding the management of securities or other investment property, including a recommendation on investment policies or strategies or portfolio composition;
  • A recommendation regarding the selection of others to provide investment advice or investment management services;
  • A recommendation regarding selection of investment account arrangements; or
  • A recommendation regarding rollovers, transfers or distributions from a retirement plan or IRA.

Are there any exceptions?

Yes. The regulations also provide that certain types of services will not lead to fiduciary status.

For example, marketing of a platform of investment alternatives without regard to the individualized needs of a plan is not considered to be the type of “recommendation” that will make one a fiduciary as long as certain requirements are met --

  • The plan fiduciary to whom the platform is made available must be independent of the person who is marketing the platform; and
  • The marketer must disclose in writing to the plan fiduciary that it is not undertaking to provide impartial advice or to give any advice in a fiduciary capacity.

In addition, identifying investment offerings that satisfy objective criteria established by a plan fiduciary is not considered to be a covered recommendation as long as the provider discloses any financial interest it may have in the suggested alternatives. A provider also may respond to a request for proposal or information by providing a limited or sample set of investment alternatives based solely on the size of the employer or the size of the plan or the current alternatives available under the plan as long as it discloses any financial interest it may have in the suggested alternatives.

Similarly, general communications and investment education will not be considered to make the provider a fiduciary.

Why does it matter?

If the investment adviser is a fiduciary, the general fiduciary rules of ERISA come into play. For example, the investment adviser will have an obligation to comply with the prudent person standard and the exclusive benefit rule.

More importantly, as a fiduciary, an investment adviser will be subject to the conflict of interest prohibited transaction provisions of ERISA Section 406(b) and Internal Revenue Code Section 4975(c). As a result, many believe that an investment adviser/fiduciary may not receive compensation that varies depending on the advice given. The investment adviser/fiduciary also may not receive any compensation from any third party dealing with the plan or IRA.

As a fiduciary, the investment adviser also is precluded from receiving more than “reasonable” compensation in connection with the services provided to the plan or IRA. This ban on “unreasonable compensation” is at the heart of the fiduciary rule. The Department’s concerns, in essence, relate to investment advisers providing advice to plan participants that will result in the payment of unreasonable compensation to the advisers, at the expense of the participants. Under the present rules, if an adviser is not a fiduciary (as determined in accordance with the current guidance) this rule does not apply. Instead, the adviser likely has no obligation other than to meet applicable security standards, which are less exacting.

The Best Interest Contract Exception

Recognizing that the new rules might limit the advice or advisers available to plan participants, along with the new definition of “fiduciary,” the Department has proposed a prohibited transaction exemption, the Best Interest Contract Exemption (which is being referred to in the industry as “BICE”). If the requirements of BICE are met, investment advisers who are classified as fiduciaries by the new rule may nonetheless provide investment advice to plans or plan participants, including IRAs, and be reasonably compensated for their services. BICE permits these fiduciaries to receive reasonable compensation as long as they adhere to appropriate fiduciary standards and satisfy certain other requirements.

BICE permits fiduciaries to receive compensation as long as the requirements of the exemption are satisfied. Under BICE:

  • If the advice relates to an IRA, the adviser must enter into an enforceable contract with the IRA owner in which it agrees that it is acting as a fiduciary and will comply with certain standards.
  • Regardless of whether the advice is provided to a plan, an IRA or a participant, the adviser must state in writing that it is acting as a fiduciary under ERISA or the Internal Revenue Code with respect to the advice provided.
  • The adviser and its related “Financial Institution” must acknowledge that it will adhere to certain standards, including a “Best Interest” standard.
  • The Financial Institution, the adviser and their affiliates may not receive, directly or indirectly, more than reasonable compensation for their services.
  • Information provided to the retirement investor may not be materially misleading.

How do the rules impact the plan sponsors or other fiduciaries?

The new rules may not have much impact on a plan sponsor. Even before the new rules, a plan sponsor who appointed an investment adviser had a duty to monitor that adviser. At times, the appointed investment adviser may have attempted to contract around being a fiduciary under ERISA. ERISA, however, has a functional fiduciary definition, meaning that if an investment adviser engaged in a fiduciary function, such as rendering investment advice for a fee to the plan, the investment adviser was likely a fiduciary regardless of the terms of the contract. The plan sponsor’s duty to monitor and the imposition of co-fiduciary liability is unchanged under the new rules.

If the investment adviser is appointed by a plan participant (for example, if a participant designates the investment adviser who has the power to direct the investment of the participant’s account), the plan sponsor should not have any responsibility for the investment adviser’s actions unless it undertakes to conceal a breach, it knows of a breach and fails to take reasonable remedial efforts, or it enables the breach by failing to perform its own duties.

Some plan sponsors may be concerned that employees who assist in plan administration may become fiduciaries by providing advice in connection with their duties for the plan sponsor. The new rules are clear that as long as certain requirements are met neither the employee nor the employer/plan sponsor will become an investment advice fiduciary if the employee provides investment advice, assuming the employee does not receive any fee or other compensation in connection with the advice, beyond the normal compensation that the employee receives for the employee’s regular duties with the employer. Even in the absence of the new rules, plan sponsors likely may wish to make sure employees are not providing investment advice to plan participants and are only providing participants with education and information within the scope of the employee’s duties.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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