How to Avoid Fee Conflicts
Art by Alex Eben Meyer
Wealth managers provide discretionary asset management services or investment advice to plans covered by the Employee Retirement Income Security Act or to individual retirement accounts covered by the Internal Revenue Code. Increasingly, these firms are noting an interest in supplying such services not just to the plans but also, separately, to the plans’ participants regarding both their plan investments and outside investments. To do so, the firm and its representatives would have to avoid conflicts of interest that arise due to their receipt of compensation for such services.
Someone acts as a fiduciary for purposes of ERISA and the IRC if, pursuant to ERISA Section 3(21)(i) and (ii) or IRC Section 4975(e)(3)(i) and (ii), 1) the individual exercises any authority or control over the investment of a plan’s assets, or 2) renders investment advice for a fee or other compensation to the plan. The person may act also as a fiduciary in connection with a brokerage account or an advisory account.
Fiduciaries can look to ERISA Section 406(b), and parallel provisions in IRC Section 4975(c)(1)(E) and (F), to see what transactions are prohibited. Neither ERISA nor the IRC prohibit an adviser from providing fiduciary services to the plan or to participants with regard to their account balance in the plan or assets held outside of the plan in an IRA. Further, neither ERISA nor the IRC specifically prohibit a fiduciary from getting paid for providing each service. Therefore, the wealth management firm may negotiate separate arrangements whereby it provides services to the plan and the participants—including participant assets held in the plan or outside of it in IRAs—and receive compensation.
In no case, however, do ERISA’s or the IRC’s prohibited transaction provisions allow the fiduciary adviser firm to affect the amount or timing of the compensation that it or its representative receives, or that a party in which either entity has an interest—e.g., an affiliate—receives, relating to the fiduciary’s exercise of investment discretion or provision of investment advice. “Flat fee” or “level fee” arrangements will often meet the prohibited transaction requirements, but the arrangement must apply to the adviser firm, its representatives and their affiliates. Investing in or recommending investments in proprietary products or utilization of affiliated managers can give rise to prohibited transactions issues.
Also, investing in or recommending an investment option that results in the option or its manager paying a fee to the adviser firm or its affiliate raises issues. Commissions or other transaction-based compensation-arrangements, rather than being level fee, raise prohibited fee-conflict issues. While the described fee arrangements may cause prohibited transactions, they may be permissible if the adviser complies with a prohibited transaction exemption.
Department of Labor Prohibited Transaction Exemption 2020-02 provides exemptive relief and will allow many otherwise prohibited fee arrangements when a fiduciary gives advice. In the case of a discretionary account, a number of other exemptions may apply, though the adviser firm will have less flexibility as to how it and its affiliates may be paid.
Finally, advisers that provide discretionary management or investment advice services to a plan or participant(s) in the plan may wish to recommend that a participant take a distribution and roll that amount into an IRA where the manager may provide discretionary or advice services. The DOL is of the view that the adviser acts as a fiduciary when making such a recommendation. Compliance with PTE 2020-02 addresses compensation conflicts that the adviser may face in making that recommendation.
More Compliance to Consider
Wealth Managers’ Understanding of Fiduciary Requirements
In the reverse of plans’ wealth managers looking to service participants’ outside investments, the managers of individuals’ taxable accounts and individual retirements accounts increasingly have an eye on servicing their clients’ plans. Indeed, many mergers and acquisitions have been performed for this reason.
Wealth managers that act as a plan fiduciary should understand how to comply with the fiduciary duty provisions of the Employee Retirement Income Security Act, Section 404(a).
ERISA’s fiduciary duty provisions apply to fiduciaries of private-sector employer-sponsored benefit plans, though not to government-sponsored plans or nonelecting church plans. They also do not apply to IRAs. A wealth manager can be a fiduciary under ERISA with respect to a brokerage account or an advisory account.
Section 404(a) requires that the plan fiduciary 1) discharge his or her duties as a prudent expert would under similar circumstances—duty of prudence; 2) discharge those duties solely in the interest of the participants and beneficiaries—duty of loyalty; 3) diversify the plan investments to minimize the risk of large losses; and 4) act in accordance with the governing plan documents. Failure to comply can result in the fiduciary’s personal liability to the plan.
The necessary expertise to advise a plan differs from that required for a participant client or IRA-holder. The wealth manager must consider all relevant factors such as plan demographics, plan type—e.g., 401(k) vs. cash balance—and the plan’s liquidity needs.
To satisfy the duty of loyalty, the adviser must act exclusively in the interest of all of the plan’s participants and beneficiaries, not favor client participants. Disclosing conflicts is insufficient to meet the duty of loyalty.
Further, ERISA allows participants to sue plan fiduciaries for breach of fiduciary duty; it focuses on the process whereby the fiduciary gathers appropriate facts and information to make a reasoned determination within the aforementioned standards. This is called “procedural prudence.”
Reg BI Risk Alert
The Securities and Exchange Commission Division of Examinations recently issued a Risk Alert, “Observations From Broker/Dealer Examinations Related to Regulation Best Interest.” The alert demonstrates that many firms have yet to establish policies and procedures that fully comply with the regulation.
SEC staff notably found deficiencies in meeting the “disclosure care,” “conflict of interest” and “compliance” obligations as Reg BI and the alert define them. To summarize:
- Firms still heavily relied on their pre-Reg BI policies and procedures, which had not been changed at all or not enough.
- Firms failed to properly address conflicts of interest. Some merely disclosed the conflicts vs. establishing policies and procedures to mitigate them. Other firms had policies and procedures only for some of the conflicts the regulation cited. Some disclosures of conflicts were too generic.
- Policies and procedures failed to detect and promptly correct violations of Reg BI’s new obligations, which involve rollover, account and implicit-hold recommendations.
- Surveillance systems were inadequate to monitor Reg BI compliance.
- The practice of posting required Reg BI disclosures on a website or using documents such as account agreements to notify customers of where the disclosures could be found failed to meet the disclosure delivery requirements.
- The training of firm representatives on the Reg BI obligations, including the resolution of violations, was inadequate.
- The firms lacked policies and procedures to properly disclose the capacity in which representatives act when they have multiple licenses and the conflicts of interest that arise when representatives have only certain licenses.
- Reg BI for many B/Ds requires a substantial rethinking of how their firm approaches assuring that recommendations are in a customer’s best interest. Further, firms should recognize that other regulators, such as the Department of Labor, likely are taking notes on the SEC’s findings. —DK
David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C.