The U.S. Department of Labor has 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.

This article focuses on PTE 2020-02 and the relief it provides to broker-dealers, investment advisers, banks and trust companies, and insurance companies that sell through employees and statutory employees.

The DOL addresses the issue of limited, or as the DOL says, “restricted” menus of products available for recommendations in the preamble to PTE 2020-02:

Financial Institutions that offer a restricted menu of proprietary products or products that generate Third-Party Payments can establish, maintain, and enforce written policies and procedures that satisfy these requirements. For example, the Department would view a Financial Institution that authorizes a limited universe of investment recommendations as satisfying the policies and procedures requirement if it prudently does the following:

• Documents in writing its limitations on the universe of recommended investments, the Conflicts of Interest associated with any contract, agreement, or arrangement providing for its receipt of Third-Party Payments or associated with the sale or promotion of proprietary products.
• Documents any services it will provide to Retirement Investors in exchange for Third-Party Payments, as well as any services or consideration it will furnish to any other party, including the payor, in exchange for the Third-Party Payments.
• Reasonably concludes that the limitations on the universe of recommended investments and Conflicts of Interest will not cause the Financial Institution or its Investment Professionals to receive compensation in excess of reasonable compensation for Retirement Investors as set forth in Section II(a)(2).
• Reasonably concludes that these limitations and Conflicts of Interest will not cause the Financial Institution or its Investment Professionals to recommend imprudent investments; and documents in writing the bases for its conclusions.
  • Informs the Retirement Investor clearly and prominently in writing that the Financial Institution limits the types of products that it and its Investment Professionals recommend to proprietary products and/or products that generate Third-Party Payments.
• In this regard, the notice should not simply state that the Financial Institution or Investment Professional ‘‘may’’ limit investment recommendations based on whether the investments are proprietary products or generate Third-Party Payments, without specific disclosure of the extent to which recommendations are, in fact, limited on that basis.

Clearly explains its fees, compensation, and associated Conflicts of Interest to the Retirement Investor in plain English.

Ensures that all recommendations are based on the Investment Professional’s considerations of factors or interests such as investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor.

At the time of the recommendation, the amount of compensation and other consideration reasonably anticipated to be paid, directly or indirectly, to the Investment Professional, Financial Institution, or their Affiliates or Related Entities for their services in connection with the recommended transaction is not in excess of reasonable compensation within the meaning of ERISA section 408(b)(2) and Code section 4975(d)(2).

The Investment Professional’s recommendation reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor; and the Investment Professional’s recommendation is not based on the financial or other interests of the Investment Professional or on the Investment Professional’s consideration of any factors or interests other than the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor. The Department intends this as an example of one way a Financial Institution could satisfy the policies and procedures requirement, but not the only way.

The Department requests comment on whether additional guidance is needed regarding a Financial Institution or Investment Professional’s recommendations of proprietary products to a Retirement Investor, and, if so, the type of guidance that would be most useful.

For this article, I want to look at the two paragraphs that I bolded. Both involve a best interest process. The first is:

Reasonably concludes that these limitations and Conflicts of Interest will not cause the Financial Institution or its Investment Professionals to recommend imprudent investments; and documents in writing the bases for its conclusions.

In other words, the advisor or agent (the “investment professional”) and the financial institution must assess whether, in light of the investment profile of the retirement investor, a best interest recommendation can be made from the limited menu. I believe that there are actually two best interest decisions—the first is account type and the second is about the investment options within the account type. For example, a brokerage account is an account type and a managed account is a different account type. If the investment profile is such that a managed account type is the prudent option, then the first issue is whether the limited menu includes managed accounts. The second would be whether the limited menu includes investment managers that can prudently be recommended to the particular investment manager, e.g., good quality, reasonable costs, management style consistent with the needs of the investor.

That is a hypothetical example that may or may not reflect common scenarios, but my point is that, at least arguably, there are two steps to the limited menu analysis.

If a determination is made that the limitations will not cause an imprudent recommendation, the bases for that conclusion must be reduced to writing.

Then, the financial professional will need to engage in a best interest process which the DOL describes as:

The Investment Professional’s recommendation reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor; and the Investment Professional’s recommendation is not based on the financial or other interests of the Investment Professional or on the Investment Professional’s consideration of any factors or interests other than the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor.

The first part of that definition is, in essence, ERISA’s prudent man rule. It defines a process where a fiduciary would obtain the information relevant to a particular recommendation (e.g., the investor profile, quality and costs of investments and strategies), and then evaluate that information at the level of “a prudent person acting in a like capacity and familiar with such matters.”  As an aside, the reference to “a prudent person…familiar with such matters” is why the prudent man rule is sometimes called the prudent expert rule. It says that fiduciaries are to be measured by a standard of a hypothetical knowledgeable person.

The second part of the quote is the duty of loyalty. The fiduciary advisor/agent cannot base the recommendation “on the financial or other interests of the Investment Professional.”  That is likely to come up most often when a more expensive option that pays more to the advisor/agent is recommended and an equivalent option is available to the retirement investor at a lower cost.

Concluding Thoughts

The bottom line on the DOL’s thinking about limited menus is that recommendations can be made from those menus where the best interest of the investor can be served. While a number of factors can be involved, two key factors are cost and quality. Of course, it all starts with the profile of a retirement investor. If the menu doesn’t offer superior options of what is right for the retirement investor, the DOL would likely say that the recommendation was a breach of the fiduciary and best interest standards. And where the best interest standard in PTEs 2020-02 and 84-24 aren’t satisfied, the exemption is not  available and any compensation is prohibited.