The Department of Labor’s (DOL) new proposal to expand fiduciary requirements on investment advice to advisers and brokers of individual plan participants, IRA investors and small plans could also affect plan sponsors.
The DOL proposed the new rule on April 14, 2015, and it is designed to address possible conflicts of interest in situations where investment advisers may be paid different amounts of compensation depending on what investment products they recommend.
In general, the proposed rule expands the types of advisers subject to protections under the Employee Retirement Income Security Act of 1974 (ERISA) against conflicts of interest that may result in reduced investment returns or losses. The White House’s Council of Economic Advisers claims that conflicts of interest have cost investors about 1% per year – equivalent to about $17 billion per year in losses.
Under current law, not all investment advisers and brokers are subject to the fiduciary guidelines historically associated with employer-sponsored pension plans. The purpose of the proposed rule is to expand the definition of a fiduciary to ensure that investors receive advice that is in their best interest rather than the interest of the investment adviser or broker.
Although the changes are primarily directed at advisers of individual directed accounts, plan sponsors will need to ensure that the advisers they use for rollovers and distributions adhere to the rules and monitor how the rule changes may affect how plan participants allocate their investments.
The proposal also provides Prohibited Transaction Exemptions (PTEs) from fiduciary status for (1) general investment education, (2) recommendations to large plan fiduciaries who are financial experts and (3) appraisals or valuations of the stock held by employee-stock ownership plans.
ERISA requires fiduciaries to adhere to specific guidelines to ensure they are acting in the best interest of retirement plans and participants. The legislation included a five- part test to identify who should be considered a fiduciary.
Employer-sponsored retirement plans have long been subject to disclosure requirements and guidelines for compensation arrangements that might cause conflicts of interest and recourse for breaches that apply to fiduciaries. However, these rules were developed during a time when most retirement plan decisions were made by professional pension managers and not individuals. At the time, defined benefit plans closely monitored by pension managers were common, while individual retirement accounts (IRAs) were less prevalent and Section 401(k)-type plans did not even exist.
Over the 40 years since ERISA was enacted, the shift of retirement income from defined benefit plans to participant-directed Section 401(k)-type plans and IRAs has prompted the DOL to revamp these fiduciary rules to ensure that less-sophisticated plan participants and IRA holders are protected. Due especially to open-ended options for IRA investments, many individual investors will turn to financial advisers to select investment products. Section 401(k) plan participants, faced with an often-dizzying range of investment choices, may be equally interested in investment advisory services in selecting their plan investment options.
These advisers, who are typically brokers, insurance agents, registered investment advisers or financial planners, may not meet the five-part test when providing individual advice and therefore may not be subject to the same fiduciary guidelines; thus they can suggest investment products that may not be in the best interest of the investor.
Under the proposed rule, a person who provides investment advice for a fee or other compensation (whether direct or indirect) is considered a fiduciary. A person renders investment advice by:
“providing investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an IRA owner or fiduciary, and
either (a) acknowledging the fiduciary nature of the advice or (b) acting pursuant to an agreement, arrangement or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.”
This principle-based definition broadens the current rules to ensure that all retirement savers are protected from investment advice that is subject to a conflict of interest and not in their best interest. Additionally, the proposed rule expressly treats rollover and distribution recommendations as fiduciary investment advice.
While the definitions of fiduciary status and what constitutes the rendering of investment advice are more general than the current five-part test, the DOL also issued new PTEs and amended a prior PTE to carve out certain services that clearly are not intended to create a fiduciary relationship:
- Retirement education. General information regarding the mix of retirement assets an individual should have, based on age, income and other factors, will not constitute investment advice. Advisers should avoid suggesting specific stocks, bonds or other investment vehicles that would create a fiduciary relationship.
- Sales pitches to sophisticated audiences. Depending on certain conditions, sales pitches to large plan fiduciaries with financial expertise will not be considered investment advice. Plan fiduciaries are typically aware that presenters may not be presenting investments that are within the best interest of plan participants. Sales pitches to less sophisticated audiences such as IRA investors and plan participants will not be included in this exemption.
Order-taking. Similar to the current rule, if a customer calls a broker to buy or sell a specific investment without asking for advice, the transaction will not constitute investment advice.
Best-interest contracts. Under this proposed PTE, investment advisers may continue to receive indirect compensation (such as 12b-1 fees) as long as they contractually acknowledge their fiduciary status, commit to adhere to basic standards of impartial conduct, warrant that they have adopted policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest, and disclose basic information on their conflicts of interest and on the cost of their advice.
Implications of proposed rule
Miscellaneous carve-outs. Certain swap transactions, mandatory plan reporting and communications with plan fiduciaries by the sponsor’s employees will not constitute the rendering of investment advice. Specific attention should be given to these miscellaneous items to ensure they apply to the given situation.
As mentioned earlier, the stated purpose of the proposed rule and related PTEs is to reduce investment losses from advice that is not in the best interest of beneficiaries by requiring advisers to act as fiduciaries to the individuals and small plans they advise. More specifically, the DOL states that retirement savers should see:
A definition of fiduciary and rendering of investment advice that is more applicable to today’s individually driven retirement vehicle landscape
A more level playing field that supports investment advisers who have been acting in the best interest of retirement savers despite not being considered fiduciaries
Expansion of the DOL’s role in protecting retirement savings vehicles used by the majority of Americans
An increase of retirement savings earnings as a result of reduced conflicts of interest
Next steps for plan sponsors
An increase of disclosed information regarding how advisers are compensated by the sponsors of the investment products they sell
While the rule is still in draft form, plan sponsors are encouraged to evaluate their existing fiduciary arrangement for possible unintended consequences and provide comments to the DOL.
If the proposed rule goes into effect, plan sponsors should update their current list of fiduciaries. Due to the specific language regarding rollovers and distributions, plan sponsors should ensure that any advisers they use in those situations are aware of their fiduciary relationship when interacting with individual investors.
Since most of the changes will impact individual IRA investors, plan sponsors should monitor how individuals respond to these changes since this may impact how they allocate their future investments between individual IRAs and employer-sponsored benefit plans.
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