Registered investment advisers, including dual registrant broker-dealers (collectively “advisers”) who provide discretionary investment management services to individual retirement accounts (IRAs), are fiduciaries under the Internal Revenue Code (the “Code”). While the Code does not have a fiduciary standard of care, it does have a duty of loyalty in the sense that most conflicts of interest are prohibited.
The Code prohibits an investment adviser fiduciary to an IRA from using its authority as a fiduciary to receive additional compensation. This means that an adviser with the authority to make asset allocation decisions in an IRA cannot charge a different fee for different investment categories (e.g., equities vs. fixed income) unless a prohibited transaction exemption is available. Alternatively, there are other compensation structures that can be considered.
Advisers who manage IRAs may have discretionary authority to determine the asset allocation among equities and fixed income assets based on the investor’s investment objectives, financial needs and circumstances. The fee charged for this service may be a level fee based on the value of all assets – equity and fixed income; in that case, there would not be a conflict that it was a prohibited transaction. But, let’s suppose the adviser wants to charge one fee for advising on the portion of the investor’s IRA portfolio that is allocated to equities, and a lower fee for the portion allocated to fixed income investments, and the adviser has the discretion to decide how much is allocated to equities and how much is allocated to fixed income. As explained later in this article, the allocation to the higher fees (that is, to equities) is an exercise of discretion that is a conflict and a prohibited transaction because it increases the adviser’s compensation.
Fiduciary Status under the Code
Under the Code, an adviser who exercises authority or control over management of IRA assets is a fiduciary. Incidentally, there is a similar definition of fiduciary under the Employee Retirement Income Security Act (ERISA), but stand-alone IRAs are not subject to ERISA. Similar to ERISA, though, the Code prohibits transactions involving self-dealing.
The Self-Dealing Rule
Under the Code, an adviser cannot use her fiduciary authority – i.e., the authority to make allocation decisions – to cause herself to receive additional compensation. The rule applies to an adviser who charges a higher level fee for equities, as compared to fixed income, because the adviser’s use of her fiduciary authority to allocate more to equities results in additional compensation to her.
Compensation Structure Solutions
This raises the question of whether there is a prohibited transaction exemption available to address this compensation structure when the adviser has discretion over the asset allocation decisions. Unfortunately, there is not. (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees) (the “PTE”) is not available because it is limited to variable compensation resulting from non-discretionary fiduciary investment advice to IRAs.
Therefore, one approach is to change the service structure so that the asset allocation decision is non-discretionary, i.e., the investor has the final decision-making authority over the asset allocation and needs to consent before a change is implemented. If the asset allocation is non-discretionary, then the adviser can rely on PTE 2020-02, if the conditions of the exemption are satisfied.
An alternative solution is for the adviser to charge a blended fee that is level across the IRA portfolio. For example, an adviser might charge 100 basis points for advising on an equity-only portfolio, but 80 basis points on a fixed income-only portfolio. For a 50/50 asset allocation, the adviser could charge, as an example, 90 basis points for that portfolio.
Another alternative is for the adviser to establish several asset allocation strategies and develop an established fee that reflects the general considerations of each asset allocation. As an example, an adviser might charge 100 basis points on the 80% equities/20% fixed income portfolio, 95 basis points on the 60% equities/40% fixed income portfolio, 90 basis points on the 50% equities/50% fixed income portfolio, 85 basis points on the 40% equities/60% fixed income portfolio, and 80 basis points on the 20% equities/80% fixed income portfolio. The retirement investor can then decide which portfolio strategy to use for his IRA. This structure will not result in a prohibited transaction as long as the level fee is reasonable and is charged across the whole portfolio on an ongoing basis.
Conclusion
With the heightened attention on rollovers and compliance with PTE 2020-02, it is likely that regulators will also focus their attention on the services and fees charged to IRAs. Broker-dealers should review current practices and compensation structures for IRAs to ensure that the prohibited transaction rules of the Code are satisfied.
