Almost a year ago the Department of Labor (DOL) adopted Prohibited Transaction Exemption 2020-02 (“PTE 2020-02”). PTE 2020-20 allows investment advisors and broker-dealers to receive otherwise prohibited compensation, including commissions, 12b-1 fees, revenue sharing, and mark-ups and mark-downs in certain principal transactions. On the surface, this seems like good news. But the DOL significantly changed its interpretation of the “five-part fiduciary test” in the exemption’s preamble and now holds that a rollover recommendation can be ERISA investment advice if the advice is ongoing.
This means that advisors giving advice to clients about whether to roll over 401k assets into an IRA will be engaging in a prohibited transaction under ERISA. PTE 2020-02 further extends the prohibited transaction rules to advising clients on moving from one IRA to another.
By way of background, the prohibited transaction rules (in ERISA and the Internal Revenue Code (“the Code”)) prohibit an investment fiduciary from receiving additional compensation as a result of its advice, unless an exemption is available. Under Section 406(b) of ERISA and Internal Revenue Code 4975, a fiduciary is prohibited from:
- Using ERISA plan assets for his or her interest for his or her own accounts
- Representing an adverse party in a transaction involving an ERISA plan
- Receiving consideration for a personal account from any party dealing with a plan transaction involving plan assets.
Exemptions are essential since penalties for violating ERISA’s and the Code’s prohibited transaction rules are severe and can include an excise tax of up to 100 percent of the amount involved, compounded over time. The IRS can also disqualify the IRA, with the result of the IRA’s value being considered income of the IRA owner in the year of the breach.
For investment advisors to rely on the PTE 2020-02, they must have policies and procedures to implement Impartial Conduct Standards, which require fiduciaries to ERISA and IRA plans to:
- Provide prudent investment advice
- Charge only reasonable compensation, and
- Avoid misleading statements.
For financial institutions and their employees, agents, and representatives (“Investment Professionals”) serving retirement investors, this means more disclosure and documentation to satisfy the DOL’s expectations.
The exemption went into effect on February 16, 2021, but the DOL and the IRS recently agreed to extend their non-enforcement policy until January 31, 2022.
More specifically, the DOL will begin requiring financial firms to comply with the Impartial Conduct Standards by February 1, 2022. The documentation and disclosure requirements for rollovers, such as the written policies and procedures, annual review, and written disclosure, will not be enforced for rollovers until June 30, 2022.
Let’s address a few basic questions first.
Who Needs the Exemption?
Financial Institutions and Investment Professionals who recommend rollovers to retirement plan participants, including:
- from an ERISA plan to another ERISA plan or to an IRA,
- from an IRA to another IRA, or
- from one type of account to another, such as a commission-based account to a fee-based account.
When does an advisor cross the line from providing education (non-fiduciary act) to providing a recommendation (fiduciary act) about rollovers? The DOL provided a roadmap for determining when an advisor is not an investment advisor fiduciary under ERISA in Interpretive Bulletin 96-1. This bulletin identifies four categories of educational materials that advisors can provide to plan participants and beneficiaries without providing fiduciary investment advice, including (1) plan information (information about plan terms and benefits, alternatives offered), (2) general financial and investment information (e.g., risk and return, diversification, asset classes, etc.), (3) asset allocation model (pie charts, graphs, showing hypothetical portfolios with different time horizons and risk profiles), and (4) interactive investment materials.
An advisor provides ERISA fiduciary advice when it discusses specific investment products or advisors with the client prior to the rollover, and the client and the advisor have a mutual understanding that the advisor will be providing investment advice on a regular basis after the rollover.
Why is the Exemption Needed?
PTE 2020-02 has a significant impact. It expands the definition of investment advice under ERISA to include a recommendation to a plan participant to roll over his or her assets from the plan to an IRA.
This is HUGE because ERISA fiduciaries are prohibited from engaging in transactions where they receive increased compensation because of their advice. Simply put, an advisor cannot receive compensation for advising a plan participant to roll over his or her 401(k) assets into an IRA managed by that advisor, since that advice is considered ERISA investment advice (more on that later). Receiving an advisory fee for making a recommendation to transfer the assets to an IRA managed by the advisor would be a prohibited transaction.
The exemption also covers recommendations of a financial institution’s proprietary investment products or investment products that generate payments from third parties. For example, without the exemption, broker-dealers can be prohibited from advising on 401(k) rollovers if they receive additional compensation such as 12b-1 fees, trailing commissions, sales loads, mark-ups and mark-downs, and revenue sharing payments from mutual funds or third parties. Similarly, without the exemption, the advisor would be prohibited from receiving revenue-sharing payments from a custodian.
How Far Does the Exemption Extend: Discretionary Versus Non-Discretionary Advice?
As discussed above, the preamble to this exemption extends the prohibited transaction rules to investment advisors that advise IRA accounts. But the exemption only covers rollover advice and non-discretionary investment advice arrangements. In this context, non-discretionary advice arrangements describe situations where the investment advisor only executes transactions after receiving approval from the client. Discretionary investment advice arrangements are those where the client’s advisor trades in the account without prior approval. If an investment advisor has discretion, the exemption does not apply.
This discretionary versus non-discretionary distinction can be confusing. In the preamble to PTE 2020-02, the DOL explained that “the potential for conflicts in a discretionary arrangement is heightened because most, if not all, of the investment transactions will occur without interaction with the Retirement Investor.” Simply put, the DOL is concerned that advisors with discretion have the power and incentive to use those assets for their own gain. Non-discretionary advisors, however, must get the client’s permission before executing investment decisions, so fewer protections are needed.
Let’s unpack what this means. As a result of PTE 2020-02, the act of recommending a rollover to a retirement investor is now considered investment advice, assuming the arrangement is ongoing. And as previously explained, receiving an advisory fee for this advice would be considered a prohibited transaction under both ERISA and the Internal Revenue Code (the “Code”). So both discretionary and non-discretionary advisers to retirement investors recommending rollovers must rely on the exemption to receive payment for their services. In most situations, the rollover transaction itself is non-discretionary, since the client must agree before it can occur.
Are All Rollover Recommendations Considered ERISA Fiduciary Advice?
No. At the core of this exemption is the DOL’s discussion of how to determine whether you are providing investment advice as an ERISA fiduciary. In prior guidance, the DOL held that an advisor who is not otherwise a plan fiduciary and who recommends that a participant withdraw funds from the plan and invest the funds in an IRA would not be engaging in a prohibited transaction, even if the advisor will earn management or other investment fees related to the IRA.
PTE 2020-02 changes this position. The DOL now holds that advice on whether to take a distribution from a retirement plan and roll it over to an IRA (or to roll over from one plan to another plan, or from one IRA to another IRA) may be ERISA investment advice if the advice is either part of an ongoing relationship or the start of an ongoing relationship. For example, if an advisor provides advice with respect to the IRA after the rollover, this advice will satisfy the “regular basis” requirement.
What Does the Exemption Require?
The key conditions of the exemption require financial institutions and investment professionals to:
- Acknowledge that they are fiduciaries under ERISA;
- Disclose, in writing, to the client the scope of the relationship and all material conflicts of interest (similar to Regulation Best Interest’s requirement for broker-dealers);
- Comply with the Impartial Conduct Standards
- Exercise reasonable diligence, care, skill, and prudence in making a recommendation, meaning that the firm and its representatives have a reasonable basis to believe that the recommendation being made is in the best interest of the client, based on that client’s investment profile and the potential risks and rewards associated with the recommendation;
- Receive only reasonable compensation (as compared to the marketplace) and seek best execution of the transaction;
- Ensure that statements made to retirement investors about the recommended transaction are not materially misleading;
- Provide written disclosures to retirement investors of the reasons the rollover recommendation is in their best interest;
- Conduct an annual compliance review of the firm’s compliance with the conditions of PTE 2020-02 and document the results in a written report to a “Senior Executive Officer” of the financial institution; and
- Maintain written documentation of the specific reasons that any recommendation to rollover assets from an ERISA plan to an IRA, from one IRA to another IRA, or from one type account to another (such as a commission-based account to a fee-based account) is in the best interest of the retirement investor.
Tips to Comply with PTE 2020-02
- Acknowledge Fiduciary Status.
Advisors are required to provide a written acknowledgment of their status as fiduciaries under ERISA, which can be done by including required language in the investment management agreement and Form ADV Part 2A.
The DOL proposed some model language in the preamble to PTE 2020-02 “as an example of language that will satisfy the disclosure requirement”:
When we provide investment advice to you regarding your retirement plan account or individual retirement account, we are fiduciaries within the meaning of Title I of the Employee Retirement Income Security Act and/or the Internal Revenue Code, as applicable, which are laws governing retirement accounts. The way we make money creates some conflicts with your interests, so we operate under a special rule that requires us to act in your best interest and not put our interests ahead of yours.
The DOL also recommended including these additional bullet points:
Under this special rule’s provisions, we must:
- Meet a professional standard of care when making investment recommendations (give prudent advice);
- Never put our financial interests ahead of yours when making recommendations (give loyal advice);
- Avoid misleading statements about conflicts of interest, fees, and investments;
- Follow policies and procedures designed to ensure that we give advice that is in your best interest;
- Charge no more than is reasonable for our services; and
- Give you basic information about conflicts of interest.
Recommendation: Firms that want to rely on the PTE 2020-02 should consider incorporating the DOL’s proposed language into their investment management agreements. The additional bullet points are not required by the exemption and may be omitted. Firms that act as ERISA 3(38) fiduciaries under ERISA are also required to acknowledge that they are acting as a fiduciary with respect to plan assets.
- Provide written disclosure to the client about the scope of the relationship and all material conflicts.
The DOL said that firms can rely on other regulatory disclosures to satisfy this requirement, including disclosures required on Form ADV and Form CRS. Since Form CRS does not allow much leeway to include additional disclosures, firms should consider using Form ADV Part 2A or a separate disclosure document, such as the disclosures provided under Section 408(b) of ERISA.
Recommendation: To the extent not already addressed, advisors should consider discussing these topics in the Form ADV Part 2A or a separate disclosure document. Some firms may consider amending the ERISA Section 408(b)(2) disclosures they provide to ERISA plans to meet PTE 2020-02’s disclosure requirements. Consider addressing the following topics (if applicable):
- The limitations on the advice and products being offered. If the advisor only offers proprietary products or products offered by its affiliates, clients should understand why and what this If an advisory firm recommends that clients invest in a mutual fund that the firm manages, this should be disclosed, along with an explanation as to how conflicts are mitigated and why the investment is in the best interest of the client.
- Special incentives. Firms should either specifically prohibit any incentives or rewards that might encourage employees to NOT act in the best interest of the clients or have processes to mitigate the incentive by ensuring that investments are selected based on the client’s needs and objectives. For example, a mitigating factor could be that the firm’s compensation policy is based on neutral factors tied to the differences in the services delivered to clients and not the amount of payment received in connection with a specific investment
As a reminder, advisors should include “full and fair” disclosures in their Form ADV Part 2A addressing these topics:
- Payments made and received by the firm and its affiliates, including referral fees, revenue sharing, 12b-1 payments, shareholder servicing fees, and recordkeeping fees;
- Clients who may also have vendor or business relationships with the firm and whether they receive favorable treatment because of those
- Affiliated service providers, such as broker-dealers, custodians, consultants, or administrators, the extent to which the advisor uses these service providers, and how the firm mitigates conflicts of
- Benefits the firm receives from service providers, such as providing access to educational seminars related to current products and industry issues. This disclosure should also include the firm’s participation in sales events, conferences, and programs held by mutual fund
- Outside business activities of executives and
Advisors providing investment advice to ERISA plans are already required to provide disclosures regarding their services and the fees and expenses charged under ERISA Section 408(b)(2). This section allows ERISA plans to make reasonable arrangements with a “party in interest” for office space, legal, accounting, and other services necessary for the establishment or operation of a plan, including investment advice, as long as no more than reasonable compensation is paid for the services. Section 408(b)(2) requires that the service provider provide extensive disclosure about their services and their compensation.
- Comply with the Impartial Conduct Standards
The Impartial Conduct Standards require that a fiduciary meet the following conditions relevant to ERISA plans and IRAs:
- Provide prudent investment advice;
- Charge only reasonable compensation; and
- Avoid misleading statements.
Prudent Advice: Firms and their representatives must exercise reasonable diligence, care, skill, and prudence in making a recommendation, meaning that the firm and its representatives should have a reasonable basis to believe that the recommendation being made is in the best interest of the client, based on that client’s investment profile and the potential risks and rewards associated with the recommendation.
To meet this standard, financial advisory firms should consider performing two levels of due diligence. First, at a firm level, documented due diligence should demonstrate that investment products offered to retirement investors meet the standard of prudence. Second, the firm and the financial professional must decide and document that the product is appropriate for each particular investor at that time.
- Document the due diligence performed on investment products being offered to clients. Has a comparison been done to determine whether products being offered meet the client’s investment goals, have a decent performance record, and fees being charged are reasonable compared to the market? Has the firm considered the risks and conflicts associated with the products, and does it have procedures in place to monitor risks and police any associated conflicts of interest? Documenting that the firm has done its homework is critical.
- Evaluate the types of products and services the firm offers to determine whether they are appropriate for specific types of clients. Consider developing guidelines for financial advisors, including a recommended list. Recommendations of products should be based on pre-determined guidelines, not on incentives.
- Provide training to advisors so they understand what information they need from clients to open accounts and develop an investment plan. The training should address where the documentation should be maintained.
- Supervise advisors to retirement investors to make sure that the recommendations are appropriate. Ensure that a supervisor is responsible for reviewing and signing off on any new accounts and changes to investment strategies for existing accounts.
Reasonable Fees: As previously discussed, firms have a duty to charge only reasonable compensation, so it’s important to have written documentation to show that their fees are in line with the market. In the final release, the DOL noted that firms should consider certain factors when determining whether the fees are reasonable, including “the nature of the service(s) provided, the market price of the service(s) and/or the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.”
- Develop a process for determining whether compensation is reasonable by reviewing Form ADVs of your competitors and surveys of financial advisors and document your conclusions.
No misleading statements: Given the emphasis by regulators like the SEC and FINRA on marketing and advertising, most financial service firms already have processes in place for reviewing client communications. The process should require a review of all communications to retirement investors, including advertisements, websites, advisory contracts, disclosure documents, and day-to-day communications.
- Develop standardized templates to be used and require periodic reviews and updates
- Review communications for consistency. The firm’s Form ADV, website, disclosures provided to potential clients, and advisory contracts should all include consistent information.
- Train IARs on how to discuss rollovers to meet this standard
- Provide written disclosures to retirement investors of the reasons the rollover recommendation is in their best interest.
Advisors making a rollover recommendation will need to document the reasons why the rollover is in the retirement investor’s best interest. In a series of FAQs, the DOL explains what factors firms and their investment professionals should consider and document in their disclosure of why a rollover might be in an investor’s best interest. For a rollover from a 401K plan to an IRA, the factors include:
- The retirement investor’s alternatives to a rollover, “including leaving the money in the investor’s employer’s plan, if permitted;”
- A comparison of the fees and expenses associated with both the plan and the IRA;
- Determining whether the employer pays for some or all of the plan’s administrative expenses;
- A comparison of the levels of service and investments available under each option.
Similarly, for IRA-to-IRA rollover recommendations, the DOL provided this advice:
For rollovers from another IRA or from a commission-based account to a fee-based arrangement, a prudent recommendation would include consideration and documentation of the services under the new arrangement. As relevant, the analysis should include consideration of factors such as the long-term impact of any increased costs; why the rollover is appropriate notwithstanding any additional costs; and the impact of economically significant investment features such as surrender schedules and index annuity cap and participation rates.
Gathering the data for comparison is probably the most challenging requirement of this exemption. Clients may not have this information or know where to access it. The DOL expects investment professionals to make “diligent and prudent efforts” to obtain information about the client’s existing 401(k) plan or IRA, as applicable.
For 401K plans, advisors can ask clients for a copy of the 404a-5 disclosure statement, Advisors can also ask clients to access the plan website to get information about investments in the plan, the client’s asset allocation, plan fees and expenses, and services offered by the plan.
If the information is not available or the client is unwilling to provide it, the DOL says “the financial institution and investment professional should make a reasonable estimation of expenses, asset values, risk, and returns based on publicly available information.”
- Gather information about the client’s current financial situation and investment goals, as well as information about the client’s current 401(k) plan to prepare a comparison of fees and expenses, services, and investments options of the plan to the IRA solution the firm recommends (or from IRA to IRA). Many firms already gather this information as part of the account opening process.
- Educate the client on options regarding the assets in the 401(k) plan, and the advantages and disadvantages of a 401K to an IRA, or from IRA to IRA, as applicable.
- To the extent practicable, provide the client with a side-by-side comparison of fees and expenses, services, and investments options of the client’s current 401(k) plan to the IRA solution the firm recommends. Firms that already prepared documentation to comply with the DOL’s Fiduciary Rule can continue to use these forms.
- Discuss the individual needs and circumstances of the client. Consider a checklist to cover common situations, including:
- Does not wish to leave assets with former employer or employer is terminating the plan
- Dissatisfied with the limited investment options
- Dissatisfied with the performance of the investment alternatives
- Would like a lifetime income option
- Would like to consolidate assets
- Wants more direct control over the assets
- Prefers to have professional advice/management
- Would like to have more holistic planning services for other matters
- Conduct an annual compliance review of the firm’s compliance with the conditions of PTE 2020-02 and document the results in a written report to a “Senior Executive Officer” of the Financial Institution.
The goal of this review is to help firms detect and prevent violations – as well as achieving compliance with — the Impartial Conduct Standards. The methodology for conducting the review and the results much be included in a written report provided to a Senior Executive Officer, as defined below. The report should be completed within six months following the period it covers (e.g., the report covering the calendar year must be completed by June 30 of the next calendar year).
The Senior Executive Officer is also required to provide a written certification stating that:
- They have reviewed the report.
- The firm has policies and procedures “prudently designed” to achieve compliance with the exemption.
- The firm has a “prudent process to modify such policies and procedures as business, regulatory, and legislative changes and events dictate, and to test the effectiveness of such policies and procedures on a periodic basis, the timing and extent of which is reasonably designed to ensure continuing compliance with the conditions of this exemption.”
The exemption defines Senior Executive Officer as the chief executive officer, president, chief financial officer, or one of the three most senior officers of the firm.
Start preparing for this review now by incorporating testing and monitoring how the firm and its advisors are meeting the conditions of the exemption. The testing and monitoring will form the basis for your review. For example, have a compliance officer review the process for setting up new rollover accounts along with a random sample of account documentation to determine whether the policies and procedures are being followed. The compliance officer could also review a sample of reviews performed by IARs’ supervisors of account opening documents to ensure that the reviews are being done and documented. Supervisors or compliance personnel could be responsible for reviewing holdings in IRA accounts periodically to determine whether they are in line with the stated investment objectives. The firm may already have testing and monitoring in place as part of its compliance program. In that case, use those results for the PTE 2020-02 retroactive review.
- Wrapping it up with a bow: Draft policies and procedures
PTE 2020-02 requires that firms adopt and implement policies and procedures to meet three goals:
- Compliance with the Impartial Conduct Standards
- Mitigation of conflicts of interests, including any practices that could create an incentive for the firm or its investment professionals from placing their interests ahead of their clients
- Documentation of specific reasons that a recommendation to roll over assets from (a) a plan to another plan, or to an IRA, (b) to a plan, from an IRA to another IRA, or (c) from one type of account to another (e.g., from a commission-based account to a fee-based account), is in the best interest of the client.
- Review your current compliance policies and procedures to see how they can be leveraged to meet the requirements of PTE 2020-02.
- Create a working group with investment advisor representatives, supervisors, operations, and compliance personnel to draft the policies and procedures. Investment advisor representatives and operations personnel are going to bear most of the regulatory burden, so they should help develop processes that are going to work for them.
- Consider how you can use existing tools to meet the obligations. For example, client relationship management tools can be leveraged to capture discussions with clients. Transcription services can also be used to document client conversations.
- Talk to your peers or engage experts for advice on best practices. Compliance with this exemption will require changes to existing processes and the deadline is coming fast. Now is a good time to ask your peers about their practices or hire an expert to guide you through the process.
Although advisors are required to meet a fiduciary standard under SEC regulations, the DOL has stated that this may not be enough to comply with PTE 2020-02. Read the exemption in its entirety for more details, as well as the FAQs issued by the DOL.
 A party in interest is defined by ERISA to include any plan fiduciary (administrator, officer, trustee or custodian), the employer or any affiliate, any employee of such employer, any service provider to the plan (attorney, auditor, etc.) whether paid by the plan or not, or an owner of 50 percent or more of the stock of the employer, among others.
 This checklist is courtesy of Craig Watanabe, who provided recommended PTE 2020-20 Best Interest disclosure documents to NSCP members.