The Department of Labor has finalized a new rule that requires retirement investment advisers to meet a fiduciary standard and eliminate conflicts of interests with their clients.
Although several notable concessions worked their way into the final rule, expect continued controversy as advisers struggle with what are potentially complex and costly compliance obligations, as well as the Securities and Exchange Commission issuing its own, separate rule in the coming months.
The text of the final rule, published in the Federal Register on April 8, further defines who is a “fiduciary” under the Employee Retirement Income Security Act when investment advice is offered to plan participants and beneficiaries.
The goal was to modernize ERISA, which was enacted in 1974 before the existence of 401(k) plans. Rule proposals to address purported conflicts of interest with investment advice were issued in 2010 and 2015.
“There has been a dramatic shift from employer-sponsored defined benefit plans to self-directed IRAs and 401(k)s,” a statement issued by the Obama Administration said. “These changes have increased the need for good retirement advice, yet until today the ERISA rules governing retirement investment advice had not been meaningfully updated.”
Firms and advisers will be required to make “prudent investment recommendations” without regard to their own interests or those of related parties; charge only reasonable compensation; and make no misrepresentations to customers regarding recommended investments.
The threshold for establishing fiduciary investment advice is whether a “recommendation” occurred, with a suggested course of action. The more individually tailored the communication is, the more likely it will be viewed as a recommendation.
The final rule includes specific examples of communications that would not be covered investment advice. Education about retirement savings and general financial and investment information, for example, will not constitute advice regardless of who provides it, the frequency, or format.
Also not covered are general communications that “a reasonable person would not view as an investment recommendation,” including general circulation newsletters; commentary on publicly broadcast talk shows; remarks in speeches and at conferences; widely distributed research or news reports; and general marketing materials.
Employees working in a company's payroll, accounting, human resources, and financial departments are not deemed to be fiduciaries as long as there is no compensation related to benefit plan recommendations that goes beyond their normal pay.
To allow advisers to continue receiving commission-based compensation on a case-by-case basis, the Labor Department is authorized to issue Best Interest Contract Exemptions (BICE) and Prohibited Transaction Exemptions (PTE).
“We were asked to adjust the mechanics of the contract. Companies said that they would have to put a contract in front of potential customers the minute they walked in the door, or the minute they got on the phone, so we addressed that.”
Secretary of Labor Thomas Perez
The BICE provision permits firms to continue current compensation and fee practices, as long as they maintain policies and procedures designed to mitigate conflicts of interest. Disclosure requirements include descriptions of material conflicts of interest and compensation received from third parties in connection with recommended investments. A regularly updated webpage must provide information about the institution's business model, material conflicts of interest, and compensation and incentive arrangements with advisers.
A PTE permits investment advice fiduciaries to sell or purchase certain recommended debt securities and other investments out of their own inventories to or from plans and IRAs.
The rule states that investors will not be able to rely upon the new rule’s enforcement mechanisms just because they did not like how an investment turned out. “Advisers can usually prove they have acted in their clients’ best interest by documenting their use of a reasonable process and adherence to professional standards in deciding to make the recommendation … and by documenting their compliance with the financial institution’s policies and procedures required by the BCIE,” it says.
The Labor Department is finalizing an amendment that provides relief for insurance agents and brokers and insurance companies to receive compensation for recommending fixed rate annuity contracts to plans and IRAs.
A notable concession in the final rule is that it moves beyond the eight-month implementation fast track originally proposed. The “most onerous provisions of the regulation”—preparation of policies and procedures, new disclosures, and new contract provisions—will become effective on Jan. 1, 2018, says Erin Sweeney, of counsel at law firm Miller & Chevalier. “In addition, the DoL eliminated some of the most contentious disclosure requirements from the proposal, including eliminating the requirement to develop investment projections and distribute an annual disclosure to investors.”
Other changes made from the proposal include exempting plans covered by ERISA from the requirement that a fiduciary investment adviser or financial institution enter into a written contract with an investor prior to making a “recommendation.”
“We were asked to adjust the mechanics of the contract,” Secretary of Labor Thomas Perez said during a conference call. “Companies said that they would have to put a contract in front of potential customers the minute they walked in the door, or the minute they got on the phone, so we addressed that.”
“Although IRAs and non-ERISA plans remain subject to the written contract requirement, the final regulation clarifies that the contract provisions can be incorporated into account opening documents,” Sweeney says. “Existing clients need not execute a new written contract. Instead, advice providers can notify current clients of the amendments and, if the client does not object to the modifications, the new provisions will become part of the existing agreement between the advice provider and the investor.” The Labor Department also incorporated a grandfathering rule for existing arrangements.
Another notable change eliminated a list of approved investments. Advice providers are now permitted to provide investment advice with respect to all asset classes.
AMENDMENTS TO COI PROPOSAL
The following details some of the changes to the Department of Labor's 2015 Conflict of Interest Proposal that are found in the final rule.
What critics said about the proposal: The Department should establish a clear line between education and investment advice and avoid a result in which service providers refrain from providing essential information and education to participants and investors due to concerns about triggering fiduciary status.
The final rule: describes the types of information and activities that constitute non-fiduciary investment education-including plan information and general financial, investment, and retirement information. The Department also revised the final rule to allow asset allocation models and interactive investment materials to identify specific investment alternatives under ERISA-covered and other plans if certain conditions are met. However, in the IRA context there is no independent plan fiduciary to review and select investment options so references to specific investment alternatives are not treated as education under the education provision in the final rule.
Coverage of health and welfare arrangements
What critics said about the proposal: The proposal could be read to apply to group health, dental, and disability insurance policies. The Department should explicitly exclude these policies, which do not raise the concerns the Department appears to be addressing with respect to advice regarding investment property.
The final rule: Advice regarding “investment property” does not include health, disability, and term life insurance policies and other assets that do contain an investment component.
What critics said about the proposal: The web disclosure requirements are too burdensome for firms and could be read to require disclosure of individual adviser compensation and salaries.
The final rule:The Department has streamlined this provision and clarified that individualized information about advisers is not required.
What critics said about the proposal: The data retention requirements which called for the retention of detailed information on inflows and outflows are too burdensome.
The final rule:The Department has removed those requirements. Just as they would in other situations, firms only have to retain the records that show they complied with the law (in this case, the BICE or other exemption).
Lifetime Income Products
What critics said about the proposal: The focus on fee transparency in the proposal disadvantages lifetime income options and other insurance products, whose value – particularly the guaranteed lifetime income – may not be as easily understandable by consumers.
The final rule: The Department has included language in the BICE to make clear that advisers may recommend insurance products and revised the disclosure provisions to better reflect how insurance products are sold. In addition, the final amendment to PTE 84-24 provides a streamlined exemption for recommendations of “fixed rate annuity contracts.” which are less complex lifetime income products.
Source: Department of Labor
Paul Borden, a Partner at law firm Morrison & Foerster, detailed other notable exemptions:
BICE availability for existing clients can be based on negative consent, for example sending material to an existing client prior to effective date of rule and, if they don’t respond within 30 days, consent is assumed.
BICE disclosure requirements are streamlined, with no annual disclosure requirement.
Reactions to the final rule, as expected, differ greatly.
“The initial proposal appeared to favor low-fee and low-cost investments—typically passively managed—over all else, ‘ignoring returns, quality, and other factors that may be important to investors,’ ” says Karen Barr, president and CEO of the Investment Adviser Association. The final rule clarified that an adviser is not required to recommend the lowest fee option if another investment is better for the client.
“We also welcome the DoL’s clarifications on the timing of fiduciary status, as it appears that the final rule makes it clear that ‘hire me’ discussions that do not include investment recommendations are not fiduciary recommendations,” she said.
“As with the prior proposal, this final rule is voluminous and every word matters,” says Kenneth Bentsen, Jr., president and CEO of the Securities Industry and Financial Markets Association. “A poorly drafted rule could result in unnecessarily raising costs for investors while limiting their choice, a concern shared by many commentators and other regulators.”
There were also supporters, some of whom think the list of industry concessions may be excessive.
“Opponents of this rule have taken to calling it ‘unworkable.’ By that they simply mean that it will require them to change a business model that is inherently deceptive and exploitative,” says Jim Lardner, communications director for Americans for Financial Reform. “The rule is both workable and, very plainly, the right thing to do.”
The Labor Department estimates that the cost to comply with the final rule will be between $10 billion and $31.5 billion over 10 years, with most spending front-loaded with one-time, start-up costs.
Critics who, during the comment period, anticipated sharp increases in the cost of advice “neglected the costs currently attributable to conflicted advice” and “exaggerated the negative impacts,” the Labor Department’s economic analysis says, adding that, aside from “short-term frictions as markets adjust,” investment advice will continue to be readily available and it does not anticipate “the substantial, long-term unintended consequences predicted in the negative comments.”