Under final regulations from the Department of Labor (DOL), certain types of advice provided to retirement plans, plan fiduciaries, participants, beneficiaries and individual retirement accounts (IRAs) or IRA owners in exchange for direct or indirect compensation constitute “investment advice” subject to ERISA’s fiduciary standards. The rules were proposed in 2010 and again in 2015.1
The DOL lists the following types of communications as “investment advice” potentially subject to the rule:
- A recommendation to acquire, hold, dispose of or exchange securities or other investment property, or advice on how to invest securities or other property after a plan or IRA distribution
- A recommendation for managing securities or other investment property, including recommendations on investment policies or strategies; portfolio composition; selection of investment advisors or managers; selection of investment account arrangements (e.g., brokerage versus advisory); and the amount, form and destination for a rollover or other distribution
A recommendation is a communication that — based on content, context and presentation — would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from an action. According to the DOL, determining whether a recommendation has occurred is an objective rather than subjective inquiry. The more individually tailored a communication is to its recipient, the more likely it is to be viewed as a recommendation. For example, providing a list of securities deemed appropriate for an investor would be a recommendation. It makes no difference whether the communication is initiated by a person or computer software.
Under the new definition of investment advice, more advisors who make recommendations to plans, participants or beneficiaries for managing investments and the timing of distributions will be considered investment advice fiduciaries subject to ERISA. More recommendations could give rise to a prohibited transaction, potentially subjecting the plan sponsor to the associated 15% penalty tax. To minimize disruption to the retirement industry, the DOL finalized some relief through the new “best interest contract” (BIC) exemption. Those who provide investment advice to plans, plan sponsors, fiduciaries, plan participants, beneficiaries, and IRAs and IRA owners must either avoid payments that create conflicts of interest or comply with the terms of an approved exemption.
The final rule is silent on whether appraisals, fairness opinions and statements of value are investment advice as the DOL plans to address these in a separate regulatory initiative.
While the final regulations are generally applicable as of April 10, 2017, there is a longer transition period (to January 1, 2018) for the BIC exemption and the prohibited transaction exemption for principal transactions.
What makes advice fiduciary investment advice?
The final regulation describes the types of relationships that must exist for investment advice to give rise to fiduciary responsibilities. To be considered fiduciary investment advice, the recommendation must be made either directly or indirectly (e.g., through an affiliate) by someone who meets at least one of three conditions:
- Represents or acknowledges that he or she is acting as a fiduciary
- Renders the advice under a written or verbal agreement, arrangement or understanding that the advice is based on the recipient’s investment needs
- Advises a specific recipient on the advisability of making investment or management decisions on securities or other investment property of the plan or IRA
What activities, communications or materials are not considered investment advice?
The DOL excluded some services, communications and materials from the rule, including marketing by platform providers, assistance in selecting and monitoring platform providers, general communications, plan information and investment education. The DOL also identified activities that involve investment advice but do not make the involved party a fiduciary, unless he or she acknowledges acting as a fiduciary under ERISA or the tax code.
According to the DOL, a fiduciary designation does not apply to the normal activity of marketing oneself or an affiliate as a potential fiduciary, without making an investment recommendation covered by the final rule. However, a communication that results in a rollover or investment recommendation would be subject to the rule.
A platform provider offers access to a selection of investment funds. Marketing (or making available) a platform of investment alternatives (including qualified default investment alternatives) for plan participants to a plan fiduciary who is independent of the platform provider is not a recommendation if the provider informs the plan fiduciary (in writing) that the advice is not impartial or given in a fiduciary capacity. Platform providers marketing directly to plan participants, beneficiaries or their relatives may not rely on this provision.
Selection and monitoring assistance
Providing assistance to plan fiduciaries who select and monitor investments offered through platforms or similar mechanisms is not making recommendations, provided the service is limited to identifying investments that meet objective criteria specified by the fiduciary, such as required expense ratios, fund size, asset type or credit quality.
Furnishing or making available general communications that a reasonable person would not view as an investment recommendation — such as newsletters, talk show commentary or conference presentations — is not giving investment advice.
Providing or offering certain educational materials is not considered investment advice. The final regulation classifies investment education into four categories: (1) plan information; (2) general financial, investment and retirement information; (3) asset allocation models; and (4) interactive investment materials.
Plan information. Comparative information about forms of distribution is not a recommendation as long as it is not individualized. Information about the benefits of participating or contributing more; the effect of preretirement withdrawals on retirement income; and general descriptions of the plan’s investment options, fees and expenses are not recommendations. However, information related to the appropriateness of an individual benefit distribution option for the plan or IRA, or a particular participant, beneficiary or IRA owner would constitute investment advice.
General financial, investment and retirement information. Information and materials on retirement-related risks, and general methods and strategies for managing assets in retirement are not investment advice.
Asset allocation models. Model asset allocation portfolios, such as pie charts, graphs and case studies of hypothetical individuals are not investment advice. The models must be based on generally accepted investment theories that reflect historical returns and disclose material facts and assumptions, and be accompanied by a statement advising readers to consider their other income and investments before allocating their assets. Asset allocation models may identify a specific investment alternative if it is a designated investment alternative subject to oversight by an independent plan fiduciary, and any other designated investment alternatives with similar risk and return characteristics are also described.
Interactive investment materials. Interactive materials that allow a plan fiduciary, participant or beneficiary, or IRA owner to evaluate distribution options, products or vehicles described in the sections above are not recommendations, as long as the materials are based on generally accepted investment theories, and there is an objective correlation between the income stream generated by the materials and the information and data supplied by the participant, beneficiary or IRA owner. Under the final rule, a designated investment alternative may be included or identified in interactive investment materials under the same conditions discussed in the asset allocation model section above.
What activities or communications are not fiduciary investment advice unless acknowledged as such?
The final regulations also address three categories of activities that are not fiduciary investment advice under ERISA or the tax code unless the person represents or acknowledges acting as a fiduciary.
Seller’s exception. Advice to a plan fiduciary with financial expertise by a counterparty acting in an arm’s-length transaction (e.g., sale of an interest in a common collective trust) is not fiduciary investment advice if five conditions are met:
- The independent fiduciary is a bank, insurance carrier, investment advisor, broker-dealer or independent fiduciary that manages or controls assets of at least $50 million.
- The counterparty must reasonably believe that the independent fiduciary is capable of evaluating investment risks independently.
- The counterparty informs the independent fiduciary that the advice is not impartial or provided in a fiduciary capacity, and fully discloses any financial interests in the transaction.
- The counterparty reasonably believes that the independent fiduciary is responsible for exercising independent judgment in evaluating the transaction.
- All fees paid in connection with the transaction are for services or products other than investment advice.
All plan and non-plan assets being managed may count toward the $50 million threshold. Furthermore, the counterparty giving advice may rely on written representations from the plan or independent fiduciary that the $50 million threshold has been met, and the independent fiduciary is a fiduciary under ERISA or the tax code and is capable of evaluating investment risks.
Swap and security-based swap transactions. Advice provided to an employee benefit plan to enter into a swap or security-based swap that is regulated under the Securities Exchange Act or the Commodity Exchange Act is not fiduciary advice as long as the plan is represented by another independent ERISA fiduciary, and the swap dealer neither acts as an advisor nor receives a fee from the plan or plan fiduciary for the advice. The plan fiduciary must provide certain written representations in advance of any recommendations.
Employees. Advice provided to the plan fiduciary by the sponsor’s employees is not fiduciary investment advice, provided the employee receives no additional compensation for the advice. Additionally, an employee who inadvertently recommends an investment to another employee — such as an HR employee communicating with another employee— is not an investment advice fiduciary, as long as the advice-providing employee: (1) is not a licensed or registered investment advisor under state or federal law, (2) is not employed by the employer or an affiliate to provide investment recommendations to other employees, and (3) does not receive any additional compensation for the inadvertent advice.
How does the final rule apply to health plans, disability plans, term life plans and health savings accounts?
Advice for purchasing health, disability and term-life insurance policies is not subject to these rules as long as the policies have no investment component. However, the rule does apply to health savings accounts (HSAs), medical savings accounts (MSAs) and Coverdell education savings accounts (ESAs). As the DOL notes, these accounts receive tax preferences; HSAs may have associated investment accounts; and HSA funds may be put in IRA-approved investments, such as bank accounts, annuities and mutual funds. Furthermore, HSA trust or custodial agreements may include permissible investments, such as specific investment funds, and HSAs are subject to the prohibited transaction rules.
The DOL has publicly stated that it does not intend to extend fiduciary status to an employer who provides or contracts with a vendor who administers the HSA, but that stance is not in the final rule. Previous guidance has stated that the DOL generally does not consider HSAs to be covered under ERISA, suggesting that HSA sponsors would not be ERISA fiduciaries.
Applying the best interest contract exemption
The BIC exemption provides a way for investment advisors and financial institutions to work with participants and beneficiaries who are eligible to roll over a plan distribution to an IRA, or provide advice (versus education) on investing a defined contribution (DC) account. The exemption permits fiduciary advisors and financial institutions and their affiliates to receive variable (including additional) compensation for investment advice provided to plan participants, beneficiaries and plan fiduciaries (other than banks, insurers, registered investment advisors and broker-dealers) who hold, manage or control assets of less than $50 million.
For an ERISA plan, the exemption generally requires an investment advisor or the advisor’s financial institution to acknowledge fiduciary status and meet basic standards of impartial conduct. Unless compensation is level, the advisor must also warrant that it has adopted policies and procedures to mitigate any harmful impact of conflicts of interest, and disclose any conflicts of interest and the cost of the advice. All fiduciaries must retain records demonstrating compliance with the exemption. In general, required disclosures may be made electronically.
Advisors must adhere to ERISA’s “prudent expert” standard of conduct, and base investment recommendations on the investment objectives, risk tolerance, financial circumstances and needs of the participant or beneficiary, disregarding their own or anyone else’s financial interests. This portion of the impartial conduct standards is also called the “best interest” standard. The compensation received must be appropriate and be based on the reasonable compensation rules under ERISA, and advisors may not make materially misleading statements.
The DOL also streamlined compliance for level-fee fiduciaries. In addition to acknowledging fiduciary status and complying with the impartial conduct standards, a level-fee fiduciary also must consider (and document): (1) the participant’s or beneficiary’s alternatives to a rollover, including leaving the money in the employer plan if permitted, and the different fees and expenses associated with both the plan and the IRA; (2) whether the employer pays some or all of the plan’s administrative expenses; and (3) the different levels of services and investments available under each option.
Some of this information is generic to DC plans or generally available in the plan’s fee disclosures. Robo-advice providers (financial advisors that provide online portfolio management with minimal human intervention) must charge level fees to qualify for the BIC exemption. Fiduciaries who are not level-fee advisors are generally not required to perform an analysis of rollover alternatives, but are subject to extensive requirements designed to make any conflicts of interest transparent. Advisors that limit options to proprietary products must also make additional disclosures that increase transparency.
The exemption for variable compensation generally permits advisors to receive brokerage or insurance commissions. However, the rules prohibit certain incentive compensation practices, including quotas, appraisals, performance or personnel actions, bonuses, contests and special awards. Generally, any differential compensation that does not demonstrably align with the interest of the advice recipient is suspect.
The BIC exemption applies to transactions on or after April 10, 2017, but until January 1, 2018, only the best interest standard, the reasonable compensation requirement, the prohibitions on materially misleading statements, and requirements related to certain disclosures of material conflicts of interest and third-party payments apply.
Under a grandfather rule — subject to certain conditions — the prohibited transaction rules do not apply to compensation attributable to advice for (1) investments made before April 10, 2017, or (2) investments made pursuant to advice on a systematic purchase program established before that date. Compensation attributable to any advice regarding grandfathered investments after April 10, 2017, must meet the best interest standard.
To avoid prohibited transactions, insurance and financial services advisors and brokers who sell retirement investment advice and products to small plans, plan participants and IRA owners will likely have to satisfy the conditions of a prohibited transaction class exemption. Plan sponsors, plan participants and IRA owners will benefit, since the rules make conflicts of interest considerably more transparent.
Plan sponsors may wish to:
- Review contracts and arrangements with investment advice providers to ensure the advice either does not constitute a “recommendation,” or acknowledges fiduciary status and liability for the products or services offered or provided.
- Review vendors’ contracts and arrangements to determine their fiduciary status, identify any conflicts and confirm they are properly disclosing fees.
- Review DC plan investment education programs and update as necessary to provide clear guidelines to plan fiduciaries.
- Determine whether asset allocation models use specific designated investment alternatives and, if so, monitor whether such models are unbiased.
- Review general communications and confirm that they do not inadvertently provide investment advice.
- Discuss the implications of this final rule on DC plan recordkeepers, especially to the extent they provide investment education materials, such as asset allocation models and interactive investment materials.
- Ensure that plan fiduciaries are fully advised of their obligations.
- Monitor the impact of the changes on employees, particularly those nearing retirement.
- Review HSA agreements with vendors to insure that the employer remains insulated from the new DOL fiduciary/conflict of interest standards.
- Confirm that fiduciary liability insurance coverage is adequate.
- Beware of ancillary exposures. The new, broader interpretation of both advisor and advice may increase exposure for the investment industry. For example, a provider of lists and reviews of third-party investment products could be characterized as a fiduciary if the plan invests in one of the listed products, and the financial professional services policy might not cover that ancillary exposure.
- Reconsider the impact of indemnification and align it to coverage terms. The higher risk of co-defendants may present a corresponding risk of triggering indemnification rights. Ensure that insurance coverage for these risks is adequate.
- Review limits adequacy. Given the likelihood of more litigation and higher costs, sponsors might want to buy more fiduciary or professional liability insurance coverage. Be wary of peer review as a foundation of that assessment, as where exposure is increasing materially, as it is here, peer analysis may fall short.