The U.S. Department of Labor (DOL) recently completed a sweeping overhaul of its regulation defining who is an investment advice fiduciary (the Fiduciary Rule) under the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (the Code). The Fiduciary Rule—together with the new Best Interest Contract Prohibited Transaction Class Exemption (the BIC Exemption) greatly expand the types of communications that constitute fiduciary advice and subject many more financial service professionals to a heightened fiduciary standard of care. The new rules are arguably the most significant change to the retirement industry in the last 40 years, and they will profoundly change the way financial services are provided.
This article provides a general overview of current law and the changes made by the Fiduciary Rule and the BIC Exemption. It then summarizes some of the most important effects the new rules will have on retirement plan service providers and plan sponsors.
ERISA provides a person is a fiduciary if he or she provides investment advice for a fee. The Fiduciary Rule completely rewrites a four-decade old rule defining what constitutes “investment advice.” Specifically, it provides a person will be deemed to have provided investment advice if he or she makes “recommendations” regarding certain investments and/or investment strategy. DOL defines the term “recommendation” very broadly as a “communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.” To fall within the definition of investment advice, a person must also meet one of the following conditions:
- he or she represents or acknowledges that he or she is acting as a fiduciary within the meaning of ERISA of the Code;
- he or she renders the advice pursuant to a written or verbal agreement, arrangement, or understanding that the advice is based on the particular investment needs of the advice recipient; or
- he or she directs the advice to a specific advice recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA.
The Fiduciary Rule is intentionally broad so that many more financial services companies and their employees, agents, representatives, and independent contractors who deal with plans and IRAs will be deemed fiduciaries. Therefore, a number of activities that are not fiduciary in nature today will be “investment advice” once the Fiduciary Rule goes into effect (e.g., sales of investment products and services, many communications about rollovers, recommendations regarding participation in a transaction-based versus fee-based accounts).
The Fiduciary Rule includes a number of exceptions for activities that are not intended to be fiduciary investment advice, including the following (subject to certain additional requirements):
- the provision of investment education;
- recommendations to plans or IRAs advised by independent fiduciaries with financial expertise, including broker-dealers, registered investment advisers, banks, insurance companies, and people with at least $50 million of assets under management or control;
- making available investment platforms to plans (not IRAs) and the provision of limited information about the investments on the platform;
- recommendations by certain employees of plan sponsors; and
- recommendations made in connection with certain swap transactions.
Best Interest Contract Exemption
As noted, the Fiduciary Rule greatly expands the types of communications that are fiduciary in nature, and many service providers will, for the first time, become fiduciaries subject to the stringent requirements under ERISA and/or the Code. One of the most important consequences of fiduciary status is that these service providers will now be subject to the prohibited transaction rules under ERISA and/or the Code. Those rules generally prohibit a fiduciary from receiving a direct or indirect fee in connection with advice to a plan or IRA unless the adviser meets the conditions of a statutory or regulatory exemption.
DOL recognized that, absent exemptive relief, “new” fiduciary advisers would not be able to continue to be compensated for their services, so the agency created a new prohibited transaction class exemption to permit advisers to receive customary forms of compensation. Specifically, the BIC Exemption allows advisers, financial institutions, and affiliates to receive transaction-based compensation (e.g., commissions) and payments from third parties (e.g., gross dealer concessions; revenue sharing payments; 12b-1 fees; distribution, solicitation or referral fees; volume-based fees; fees for seminars and educational programs) for investment advice transactions, provided that certain conditions are met.
The BIC Exemption has a number of complex conditions, but the most important is that advisers and their supervising financial institutions must adopt “Impartial Conduct Standards” for dealing with their clients. The Impartial Conduct Standards include a standard of care—often referred to as the “best interest” standard—which largely mirrors the duties of prudence and loyalty under ERISA, and financial institutions must warrant that they will comply.
The best interest standard of care is intended to be enforceable by private parties even where DOL lacks its own enforcement jurisdiction. For advice provided with respect to an employee benefit plan, the standard of care is enforceable through ERISA’s remedy and enforcement scheme. However, ERISA generally does not apply to IRAs, and DOL does not have enforcement authority. In order to make the best interest standard of care enforceable, the BIC Exemption requires the financial institution backing a fiduciary adviser to contractually acknowledge fiduciary status and warrant that the adviser will abide by the best interest standard of care. The investor can then bring a claim for breach of contract in the event the adviser fails to abide by the standard of care.
Importantly, the BIC Exemption expressly prohibits contractual exculpatory language and limitations on investors’ ability to participate in class action law suits. It is very likely that the plaintiffs’ bar will play a primary role in enforcing the new rules in the IRA space. And it is possible, if not likely, that the Fiduciary Rule will result in a spate of class action litigation in the not-too-distant future.
Effects of the Fiduciary Rule
Advisers and their supervising institutions will need to implement substantial new compliance protocols to come into compliance with the Fiduciary Rule. That will likely require a considerable technology and operations build out over the next year. The financial service industry will bear the brunt of the compliance challenges associated with the new rule, and each affected industry will face unique challenges. In particular, the new rules will have the following effects on various industries:
- Broker-Dealers. Because broker-dealers routinely interact directly with customers in the retail space, the impact of the Fiduciary Rule will be particularly severe. Currently, broker-dealers are required to abide by a “suitability” standard of care under the securities laws when they make investment recommendations. However, broker-dealers generally take the position that they do not provide fiduciary investment advice under either ERISA or the securities laws. Under the new Fiduciary Rule, many broker-dealer sales interactions, for the first time, will be deemed fiduciary advice subject to the more rigorous best interest standard of care, particularly when broker-dealers make recommendations regarding rollovers. Consequently, many broker-dealers will need to develop entirely new policies and procedures to ensure that they are complying with the best interest standard of care under the BIC Exemption, and financial institutions will need to find ways to effectively supervise their large retail salesforces.
- Insurers. The Fiduciary Rule will have a significant impact on the sale and distribution of many insurance products. Like broker-dealers, many insurers currently take the position that they do not provide fiduciary investment advice in connection with the sale of their products. However, many of those sales activities will be fiduciary advice under the Fiduciary Rule. Insurers will be required to comply with the BIC Exemption for the sale of both variable and fixed indexed annuities, which means, among other things, developing procedures to document the value and benefit of guaranteed and proprietary products. Insurers will also need to reconsider the compensation structures for their salesforces, particularly in light of the fact that many types of incentive compensation widely used in the industry today are not permissible under the BIC Exemption. An added challenge is that many insurers currently rely on Independent Marketing Organizations (and other state-regulated distributors) to distribute their products, but those organizations do not qualify for relief under the BIC Exemption.
- Record Keepers. Record keepers generally do not provide fiduciary investment advice during the sales process or when communicating with plan participants through their call centers. However, the Fiduciary Rule greatly expands the types of communications that are considered fiduciary in nature, so record keepers that wish to continue to be non-fiduciary service providers may need to revise their procedures for interacting with plan participants and other clients. For example, they will need to carefully review their call center operations, including their scripts, and provide additional training to their call center representatives. They may also need to amend many of their sales agreements to provide for new disclosures and/or representations.
- Investment Managers. Although investment managers customarily acknowledge fiduciary status in connection with the provision of discretionary investment management services to benefit plan investor clients after they are hired, the potential extension of fiduciary status to statements made in connection with the marketing of such services will prompt investment managers to carefully scrutinize their existing marketing practices. Investment managers will need to consider how their existing practices fit within the new regulatory framework, and whether they need to alter those practices to comply with the Fiduciary Rule. For example, subscription agreements, investment management agreements and offering and marketing materials will need to be reviewed and revised. In addition, sales personnel and placement agents who market to benefit plan investors, particularly those who are not represented by independent fiduciaries, will need to ensure that their communications to such investors satisfy one or more of the other exceptions outlined above. Investment managers will also need to carefully assess their potential exposure and their ability to navigate through the conditions of the various exceptions.
The Fiduciary Rule will have less of direct impact on plan sponsors. Today, most plan sponsors provide participants with investment education but not fiduciary investment advice in reliance on long-standing DOL guidance. The Fiduciary Rule generally codifies and expands that existing guidance. The Fiduciary Rule also contains a number of helpful clarifications, including confirmation that employees of a plan sponsor (e.g., human resource employees) who communicate information about the plan and distribution options to participants are generally not considered investment advice fiduciaries.
Nevertheless, plan sponsors will need to evaluate and monitor their policies on investment education and the way in which those providing investment education to plan participants are compensated. Plan sponsors will also need to revisit their vendor relationships and ascertain whether the vendor is providing the service in a fiduciary capacity or not. Certain vendors may now be considered ERISA fiduciaries (e.g., recommendations on investment policies or strategies, as well as regarding portfolio composition, are now considered fiduciary activity). In this regard, plan sponsors should expect a number of disclosures from plan vendors regarding the nature of the relationship with the plan. Additionally, plan sponsors may wish to reach out to their record keepers to discuss any anticipated changes in their service offerings (e.g., whether participants will still be able to call the record keeper’s call center to discuss rollovers).
Effective Date and Next Steps
The Fiduciary Rule is the most impactful change to the retirement industry in four decades, and the industry has a relatively short period in which to come into compliance. The Fiduciary Rule and BIC Exemption are generally effective on April 17, 2017 (with some provision delayed until January 1, 2018). It will take many months to identify issues, triage, develop compliance strategies, and operationalize the new rules, so it is critical that financial institutions and plan sponsors begin to take immediate steps to review their operations.