The Department of Labor’s Proposed Prohibited Transaction Exemption and Its Impact on Recommendations to Plans, Participants and IRAs (Part 3): Investment Adviser Considerations

On December 18, 2020, the DOL issued its final prohibited transaction exemption (PTE) that will allow conflicted compensation resulting from nondiscretionary fiduciary investment advice. The PTE is titled “Improving Investment Advice for Workers & Retirees.”  The citation is Prohibited Transaction Exemption 2020-02. The exemption is effective February 16, 2021.

The exemption and the associated expansion of the definition of fiduciary advice will have the greatest impact on recommendations by investment advisers and broker-dealers (1) to retirement plan participants about rollovers, and (2) to IRA owners about how to invest in their IRAs. This article focuses on the impact on investment advisers who recommend rollovers.

As background, an exemption is an exception to the prohibited transaction rules, but the exception is only available if its conditions are satisfied . . . and there are conditions. My Best Interest #37 post explains the conditions in the proposed PTE, and the provisions of the final PTE are substantially similar.

As finalized, the exemption permits conflicted fiduciary advice to ERISA retirement plans, participants and IRAs resulting from nondiscretionary recommendations. (Prohibited transactions resulting from discretionary investment management are not exempted.) While level fees ordinarily do not constitute prohibited transactions (i.e., financial conflicts of interest) some advice by investment advisers does involve conflicts of interest, e.g., recommendations to IRA owners that result in revenue sharing payments to the advisory firm from custodians. Also, a rollover recommendation can involve a conflict of interest even where the adviser charges a level fee. This because the RIA firm and the adviser usually receive more compensation if a participant accepts the recommendation and rolls the money in his account into an IRA with the adviser.

However, the prohibited transaction rules do not apply to all recommendations. Instead, they only apply to fiduciary recommendations, and fiduciary status is determined by the DOL’s 5-part test. That test is “functional” in the sense that, if the recommendations or advice satisfy the 5-part definition, the firm and the adviser are fiduciaries. In the past, investment advisers who did not act as fiduciaries to a plan were able to take the position that their rollover recommendations to participants in such a plan were not fiduciary advice because a recommendation to a participant to roll over to an IRA was a one-time recommendation–and therefore did not satisfy the regular basis prong of the 5-part test. However, the new DOL “interpretation” changes that.

But, first, as background, here’s the 5-part test as explained by the DOL in the exemption. The adviser (or firm) must receive compensation associated with their services and …

. . . a financial institution or investment professional . . . must—(1) … make recommendations as to the advisability of investing in, purchasing, or selling securities or other property (2) on a regular basis (3) pursuant to a mutual agreement, arrangement, or understanding with the Plan, Plan fiduciary or IRA owner, that (4) the advice will serve as a primary basis for investment decisions with respect to Plan or IRA assets, and that (5) the advice will be individualized based on the particular needs of the Plan or IRA.

In the preamble to the PTE, the DOL explained that it had changed its mind about what “regular basis” means and now has a more expansionary view. It gives two examples. The first is that, if an adviser has a relationship where the adviser regularly gives financial advice about tax-qualified accounts (e.g., plans or IRAs) to an investor, and subsequently makes a rollover recommendation to the investor, the DOL tacks the individual advice to the rollover recommendation and finds that advice is being given on a regular basis. In the past, the DOL would not have considered the earlier investment recommendations in its analysis of whether advice was being given on a regular basis.

The second example is an adviser who makes a rollover recommendation to a participant in contemplation that the participant will roll over the money to an IRA with the adviser, and the adviser will make recommendations about how to invest the IRA (and thereafter about whether to buy or sell investments in the IRA). That would also be advice that is given on a “regular basis” and thus satisfy that prong of the fiduciary definition. In effect, most rollover recommendations will now be treated as fiduciary advice and the processes described by the DOL for those recommendations would need to be followed (for example, information about the plan and IRA that need to be considered, and the needs and circumstances of the participant).

As a word of warning, the 5-part test is functional and, as a result, fiduciary status is based on what is contemplated or actually happens and not necessarily on what the paperwork says. In fact, the DOL has said that, while any agreements or disclosures between the advisory firm and the investor are facts to be considered, they are not, in and of themselves, determinative of whether a fiduciary relationship has been established (for example, a provision that says that recommendations will not be made on a regular basis will not control if, in fact, they are made regularly).

Since most rollover recommendations will now be fiduciary advice, advisers will need to develop and adhere to a prudent process for making those recommendations. In addition, and as explained earlier, fiduciary rollover recommendations by investment advisers ordinarily result in prohibited transactions. The DOL’s PTE 2021-02 is designed to provide relief from those prohibited transactions, but only if the conditions of the exemption are satisfied. (See Best Interest #37 for a discussion of the conditions in the proposal; the final is substantially the same.)

The exemption doesn’t become effective until February 16, and the new Biden administration took office on January 20. It is a common practice for new administrations to, on the inauguration day, delay and study all guidance from the old administration that has not yet become final. And, in this case, the Biden administration did just that. As a result, it is highly unlikely that the PTE will be effective on February 16, if ever.

That creates a situation where the expanded DOL interpretation of the definition of fiduciary advice for rollovers is probably here to stay, but the exemption for conflicted recommendations to rollover IRAs will not be effective, at least for the foreseeable future. Fortunately, the DOL has extended its non-enforcement policy on nondiscretionary fiduciary advice to December 20, 2021. That policy will protect against IRS and DOL enforcement, but only if the Impartial Conduct Standards are satisfied. But that is an article for another day.