Fiduciary Rule Implications
As you know, the Department of Labor (DOL) re-proposed its fiduciary regulation. If that is finalized as currently written, most advisers will be fiduciaries with respect to individual retirement accounts (IRAs) as well as tax-qualified and 403(b) plans governed by the Employee Retirement Income Security Act (ERISA). The purpose of this article is to consider how the DOL intends to affect adviser behavior in the retirement marketplace through a new exemption called the “best interest contract exemption,” or “BIC,” proposed along with the new regulation.
The BIC represents a significant shift in the DOL’s philosophy regarding class exemptions. Traditionally, those have allowed fiduciaries—provided they meet the necessary conditions—to receive compensation under circumstances otherwise contrary to the Internal Revenue Code (IRC)’s and ERISA’s prohibited-use, self-dealing, conflict-of-interest and anti-kickback provisions. However, exemptions typically focus on a particular kind of product or service and type of compensation arrangement. On the other hand, the BIC is intended to apply rather broadly to a number of products, services and compensation arrangements that result in payment to a fiduciary that would otherwise be prohibited—i.e., compensation that varies based on investment recommendations or that is paid to the adviser by third parties in connection with such advice—so long as certain contractual, reporting and recordkeeping requirements are met. Also, unlike prior exemptions, the BIC aims to protect a specific class of investors.
The BIC is directed at the provision of advice—not discretionary management services—to certain retail investors the DOL deems to be in need of additional protections. These include participants or beneficiaries in participant-directed plans; the beneficial owners of IRAs; and sponsors, or similar fiduciaries, of non-participant-directed defined contribution (DC) and defined benefit (DB) plans covering fewer than 100 participants. Therefore, by default, the BIC does not apply to advice given to other investors such as sponsors, or similar fiduciaries, of participant-directed plans. The DOL’s basis for excluding those and other plans is that the related fiduciaries are sophisticated and do not need the BIC’s protections.
The exclusion of the sponsor, or similar fiduciary, of any participant-directed plan—especially one covering fewer than 100 participants—from the BIC is a curious decision. It is difficult to understand why the DOL believes the BIC should not apply to such a plan, given the department’s stated policy behind the rule. Consequently, the adviser to such a plan must look to other exemptions, which the proposal has substantially modified. For example, the adviser would not be able to receive 12b-1 fees, revenue sharing and other payments under these other, modified exemptions, yet might be able to if he relies on the BIC.
If the BIC becomes available, the DOL claims, advisers may be able to receive the same compensation, including commissions, 12b-1 fees, revenue sharing, etc., they typically do today—compensation that may otherwise be prohibited under the new fiduciary definition. To qualify, they would need to meet significant contractual, compensation reporting and recordkeeping requirements. Among other things, the contract must provide that the adviser will adhere to “impartial conduct standards” including a “best interests” standard, which mirrors ERISA’s fiduciary duties of prudence and loyalty. In effect, the department proposes to use the BIC to impose a fiduciary standard of conduct on the management of IRAs, which heretofore were not subject to ERISA’s fiduciary standards. Additionally, by calling for the contract to be entered into before the advice is given, the DOL seems to be saying that the sales process, when involving retirement investors, is subject to fiduciary requirements, while, in other situations, it may be nonfiduciary in nature.
Further, each adviser’s associated financial institution must commit to adopt written policies and procedures reasonably designed to mitigate the impact of material conflicts of interest and ensure that the adviser adheres to the “best interests” and other conduct standards. These procedures will demand the ongoing evaluation of compensation practices to determine if they induce advisers to fail to act in the best interests of retail investors.
Advisers should consider whether compliance with the BIC is agreeable, or even possible, and whether the adoption of other compensation arrangements—e.g., flat dollar, assets under management (AUM), fee levelization, etc.—is a better alternative to the BIC.
David C. Kaleda is a principal in the Fiduciary Responsibility practice group at the Groom Law Group in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers (B/Ds), insurers, banks and service providers. He served on the DOL’s ERISA Advisory Council from 2012 through 2014.