Apr 7, 2016
In 1975 when DOL last issued regulations defining who is a fiduciary advisor
, most retirement plans were defined benefit pension plans or profit sharing plans. Investment decisions were made by the employer or financial experts hired by the employer. There were few if any participant-directed plans and individual retirement accounts were in their infancy.
One of the purposes of the 1975 regulation was to distinguish between fiduciary “advice” and investment product sales. The distinction was important because ERISA prohibits a fiduciary from exercising its authority to pay itself additional compensation. A fiduciary advisor receiving product commissions based on its recommendations would violate ERISA’s fiduciary standard of care, and would be required to surrender his compensation and pay substantial penalties to the Internal Revenue Service. If the breach was intentional, the advisor could be fined and ordered not to provide fiduciary services to any retirement plan.
Accordingly, the 1975 regulations defined fiduciary advice based on a five-factor test that included an “ongoing” advice relationship and an oral or written “understanding” that the advice would be the primary basis for the plan’s investment decisions. This definition included most fee-based advisors operating under an advisory agreement, but excluded most broker activities if the broker could show that there was no mutual understanding and no “ongoing” advice relationship. Brokers and investment providers could accomplish this by disclaiming an ongoing advice relationship or fiduciary status in communications or broker account agreements with the plan.
Since 1975 retirement plans have shifted from employer-directed to participant-directed accounts. As of mid-2015 IRAs held the greatest share of retirement assets at $7.6 trillion and participant-directed 401(k)s were second at $4.7 trillion. These massive sums are invested by individuals with relatively little investment experience. Because commissioned brokers and fee-based advisors offer similar services, it is not easy for individual investors to tell whether their financial advisor is a fiduciary or is selling a product that may or may not be in the participant’s best interest.
In light of current realities, the new regulations strike a different balance between the plan and participant’s interest in obtaining objective advice and the financial advisor’s ability to continue receiving third-party compensation without exposure to ERISA’s forfeiture rules and penalties. In addition, the regulations seek to encourage continued use of educational information and investment tools to assist participants without exposing the sponsor or advisor to liability for the participant’s investment decisions.
Sponsor and Participant Protections
For “retail” investors,1
the rules provide that any recommendation by an advisor to buy, sell or hold a security or other investment, or with respect to the management of an investment or account, is fiduciary advice if the advisor receives compensation in connection with the advice. Under this objective test, the retail plan investor is assured---without having to inquire--that the advisor is acting as a fiduciary and is taking personal responsibility for his or her advice.
A fiduciary advisor also helps reduce the sponsor’s fiduciary risk. The ERISA requirement that the advisor follow a prudent process will help the plan sponsor demonstrate its own compliance with ERISA. Having a co-fiduciary allows the sponsor to shift some or all of the fiduciary liability for the advice given and insulates the sponsor from advice given to the participants by the advisor.
Plan Information, General Education
The sponsor does not become a fiduciary advisor to participants for any general information it gives (directly or through the plan’s recordkeeper) about the advantages of participating in the plan, including the advantages of regular contributions, tax deferral on contributions and compounded returns, investment principles such as dollar-cost averaging over time, historic differences in rates of return between different asset classes, effects of fees and expenses on rates of return, effects of inflation, estimating future retirement income needs, determining investment time horizons, assessing risk tolerance, retirement-related risks (e.g., longevity risks, market/interest rates, inflation, health care and other expenses) and general methods and strategies for managing assets in retirement.
Information about the plan’s features, including how and when payments may be taken from the plan and including the ability to roll over a distribution to an IRA or other retirement plan, is not investment or management advice. (However, the sponsor retains fiduciary responsibility under prior DOL guidance for the content of the communications it provides to participants.)
Investment information about specific investment options given by the sponsor to a participant generally is not investment advice. Because plan sponsors do not receive compensation in exchange for the investment information they provide, they are not advice fiduciaries to the participants. This helpful guidance protects a sponsor even in cases where it seems a recommendation is made such as offering participants a limited investment menu or model allocation portfolios with specific investments. The regulation notes that any incidental financial benefit to the sponsor associated with sponsoring the plan (such as revenue sharing derived from the investment that offsets plan expenses) is not considered compensation in exchange for any recommendation. (Note that the same caveat about the content of fiduciary communications applies here as well.)
Protection from fiduciary advice liability is also extended to employees of the sponsor who provide information or recommendation to the sponsor, as long as they are not receiving compensation in connection with the advice beyond their normal salaries.
Sponsors should note that the regulations do not change their basic fiduciary duties. Sponsors remain responsible for the investment decisions they make including the adoption of any investment alternative or default investment option. Sponsors always retain fiduciary liability for selecting and monitoring the performance of the plan’s financial advisor and any non-fiduciary service providers.
Advisor’s Fiduciary Activities and Compensation
The objective “advice” definition should also assist the advisor in determining when he or she becomes a fiduciary to a plan sponsor or participant. The “recommendation” test is derived from rules and regulations adopted by the Financial Industry Regulatory Authority (“FINRA”). As a rule of thumb, if the advisor’s communications with the plan or the participant are of the type that normally would be a “recommendation” under FINRA guidance, it is likely the communications also constitute advice under ERISA.
The general exclusion from the “advice” definition for general educational information that applies to sponsors also is available to the advisor. Advisors may provide investment information about a specific investment and the information by itself will not be a “recommendation” unless the advisor suggests that recipient buy, sell or hold the investment. However in this regard, the regulations suggest that the context of the communications between the advisor and sponsor or participant increases the risk that specific investment information may cross over into “tailored” advice to the recipient and result in a “recommendation.” The regulations provide guidance for advisors that wish to stay on the “education” side of the discussion.
Asset Allocation Models
Asset allocation model portfolios that assign a specific investment to the model allocation continue to be treated as non-fiduciary “education” provided certain conditions are met. These include: (1) the alternatives in the model must be designated investment alternatives under an employee benefit plan; (2) the alternative is subject to fiduciary oversight by plan sponsor; (3) the asset allocation models identify all the other designated investment alternatives available under the plan that have similar risk and return characteristics, if any; and (4) the asset allocation models are accompanied by a statement that identifies where information on those investment alternatives may be obtained, including the participant disclosure statement under DOL regulation 2550.404a-5.
The regulations do not extend the same model allocation treatment to IRAs because there is no independent party to approve the menu or the allocations. In the one-on-one context of an IRA engagement, the combination of funds selected by the advisor that are allocated into a model is indistinguishable from recommending a strategic allocation to the account holder.
General marketing activities are not advice. RFP responses that contain sample menus are not advice if the advisor notifies the requesting party in writing that the advisor is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity. Further, the RFP response containing the sample lineup must disclose whether the advisor has a financial interest in any of the alternatives, and if so, the precise nature of such interest.
Without acting as a fiduciary, firms and advisors can provide a variety of questionnaires, worksheets, software, and similar materials that enable workers to estimate future retirement needs and to assess the impact of different investment allocations on retirement income, as long as the advisor meets conditions similar to those described for asset allocation models. These interactive materials can even consider the impact of specific investments, as long as the specific investments are identified by the investor, rather than the advisor.
Advisors who provide rollover counseling services are likely to be fiduciaries to the participant. Recommendations to take a distribution and roll it into an IRA are considered account “management” advice. The context of these discussions including the potential fee to the advisor will make it difficult for the advisor to claim that it is only providing education.
Referrals of one or more financial advisors to a plan fiduciary for consideration in hiring the advisor generally will not constitute advice unless the referring party receives a referral fee. This situation arises commonly when an advisor who does not normally advise ERISA plans or IRA accounts makes a referral to an ERISA plan advisor. The referring party automatically becomes a fiduciary and would need to satisfy the fee disclosure requirements under ERISA section 408(b)(2) in order to receive the fee.2
If the referring advisor receives a share of broker commissions, he or she would appear to have the same compliance obligations as the direct advisor including satisfaction of the “best interest contract” exemption discussed below.
The final regulations are accompanied by a “best interest contract” exemption that permits brokers to receive commissions based on their investment recommendations as long as any potential conflicts of interest are managed with a view toward providing a recommendation in the “best interests” of the retail investor. The “best interest” standard requires the advisor to give prudent advice that is in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation.
The final regulations appear to acknowledge advisor concerns that burdensome advance contract requirements and extensive disclosures required under the proposed regulations could restrict retail investors’ access to cost-effective professional advice. The final exemption will require only a two-party contract between an IRA holder and the financial institution employing the broker and not the advisor. The agreement must acknowledge both the advisor and institution’s fiduciary liability. With the exception of punitive damage waivers, the agreement generally cannot limit liability. Contracts are not required for ERISA plans, but the financial institution is required to provide disclosures to the sponsor acknowledging fiduciary responsibility for itself and the advisor.
The regulations provide an extended transition period ending December 31, 2017. The new fiduciary advice standard applies starting on April 10, 2017. Prior to that time, brokers may continue to make recommendations and receive commissions. From April 10, 2017 through December 31, 2017, brokers will need to comply with some of the exemption requirements for most recommendations in order to continue to receive commissions, including the “best interest” standard. All requirements of the exemption including the extensive disclosure obligations imposed on financial institutions must be met starting January 1, 2018.
Non-Retail Sponsors and Fiduciaries
Brokers who advise (i) sponsors managing $50 million or more or (ii) plan fiduciaries who are professionally regulated (banks, insurance companies, ’40 Act advisors or other registered brokers) may continue to provide non-fiduciary sales advice provided certain conditions are met. The sponsor or plan fiduciary must be independent of the advisor. The advisor must fairly inform the independent sponsor or plan fiduciary that the advisor is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, in connection with the transaction and must fairly inform the independent plan fiduciary of the existence and nature of the advisor’s financial interests in the transaction. The advisor cannot receive a fee from the plan or the plan fiduciary.
Sponsors should take advantage of the one-year transition period ending April 10, 2017 to discuss the final regulation as part of the sponsor’s annual review of the advisor’s performance. If the advisor is fee-based, it is unlikely that the regulations will have a significant impact on the advisor’s compensation method. The regulation may impact the types of advice the advisor will provide in the future and whether it is provided to the sponsor or the participants.
Advisors who are brokers are not likely to have immediate answers until their financial institutions develop a compliance plan. Individual advisors may have a choice as to whether they will provide fee-based or commission-based services and may wish to discuss the advantages and disadvantages of each approach with the sponsor. During the 2016-2017 transition period, the broker may continue to provide services as they have in the past and may continue to collect commissions. By April 10, 2017, the parties should have firm plans for how advice will be provided to the sponsor and participants going forward.
Both sponsors and advisors can take some comfort in DOL representations that its initial enforcement policy will focus on assisting sponsors and advisors with compliance rather than enforcement of sanctions under ERISA. DOL is encouraging dialogue with sponsors and advisors to assist them in understanding and implementing the rules. In addition, certain minor violations of the “best interest contract” exemption requirements will not cause the advisor or institution to lose the exemption’s protection.
In addition to participants, a “retail investor” includes plan sponsors managing less than $50 million.
Referral sources (“solicitors” under the Investment Advisers Act of 1940 or “ ’40 Act”) may already be subject to the ERISA 408(b)(2) disclosure requirements as consultants receiving indirect compensation. ERISA 408(b)(2) disclosures can be made efficiently by adding them to the solicitor’s disclosure to the client required under SEC Rule 206(4)-3. Because ERISA 408(b)(2) requires fiduciaries to disclose their fiduciary status, solicitors who took the above approach may need to amend and re-deliver the SEC disclosure statement in order to identify the solicitor as a fiduciary.
Note that the views expressed above are those of Newport Group and do not constitute legal advice; readers are encouraged to consult their own legal counsel. This release is a high-level summary of a complex subject that is intended for Newport Group’s clients and intermediary partners and should not be understood as providing a comprehensive discussion of all issues or requirements under the regulations or as a guide to compliance.
Copyright © 2016 Newport Group, Inc.