Earlier this month the U.S. Department of Labor (DOL) concluded a seven-year effort to eliminate conflicted investment advice for employee benefit plans and for tax-favored individual retirement and health savings accounts (collectively, IRAs). It did so by expanding its “fiduciary” definition to include brokers and other investment advisers who previously avoided, or claimed to avoid, being fiduciaries subject to the prohibited transaction rules in the Employee Retiree Income Security Act (ERISA) and the Internal Revenue Code (Code). The package of rulings included an amended regulation, a new class prohibited transaction exemption (PTE) and revisions to several existing PTEs. Most of the changes will apply on April 10, 2017, with extensions to Jan. 1, 2018 for parts of the new PTE.

Fiduciary investment advice

ERISA and the Code impose fiduciary responsibilities and prohibitions on those who have or exercise any discretionary authority regarding plan administration or the management or disposition of plan assets. Fiduciary status also extends to anyone who renders investment advice regarding plan or IRA assets and receives direct or indirect compensation as a result. This last category is the focus of the new rules, which will require changes to most investment advisers’ relationships with plan fiduciaries, plan participants and IRA owners.

Covered advice includes not only recommendations regarding the acquisition, holding and disposition of plan or IRA assets, but also suggestions about investment policies, portfolio composition, taking (or not taking) rollovers or distributions from a plan or IRA, and the reinvestment of such proceeds. Recommending other persons to provide investment advice or management services is also covered, but offering one’s own services will not be investment advice unless the proposal incorporates other recommendations, such as an investment suggestion or advice to withdraw funds from a plan or IRA. Fortunately, the regulation identifies various services that do not constitute recommendations, including educational investment information and materials that do not recommend specific investment products. The regulation also allows asset allocation models and interactive investment tools to identify specific investment alternatives available under a plan if certain conditions are satisfied. However, there is no similar exception for IRAs.

The new rules only apply to investment advice for which one receives a fee or other compensation from any source. Advice is compensated if the adviser or an affiliate receives anything of value for the advice, itself, or as a result of the purchase or sale of a security or the provision of investment advice services. The regulation identifies a wide array of compensation forms including commissions, loads, revenue sharing payments, finder’s fees, gifts and gratuities, and expense reimbursements.

Exceptions

If a recommendation is compensated, the adviser may still avoid fiduciary status if the advice is provided to an independent fiduciary, such as a bank, insurance company, registered investment adviser, registered broker-dealer or any other fiduciary that holds, manages or controls assets totaling at least $50 million. An example of the latter would be the fiduciary investment committee for a single large plan or for smaller plans that together satisfy the threshold. To qualify for this “seller’s exception,” the adviser must clearly disclose that it does not undertake to provide impartial investment advice or to give advice in a fiduciary capacity, and it must not receive a fee or other compensation directly from the plan, plan participant, IRA or IRA owner.

The regulation applies to employee welfare benefit plans as well as retirement plans and IRAs, but most welfare plans will not be affected because “investment property” is defined to exclude health, disability and term life insurance policies or other property that does not contain any investment component. Note that the term still includes annuities purchased with plan or IRA assets and cash value life insurance policies in pension or welfare plans.

Best Interest Contract Exemption

If none of the above exceptions apply, the receipt of direct or indirect compensation for investment advice will be a prohibited transaction, and the adviser will have to return all remuneration and pay a federal excise tax—unless the adviser qualifies for a PTE. The DOL has created a new PTE and modified several others. The centerpiece is the new Best Interest Contract Exemption (BICE), which allows a fiduciary to give advice which may affect its compensation if that advice is in the best interest of the IRA owner, plan participant or plan fiduciary. Current fee practices, such as sales commissions, can be maintained if a financial institution acknowledges that it and its financial advisers are fiduciaries, and they adhere to impartial conduct standards and disclose all compensation and material conflicts of interest relating to recommendations. Any financial institution relying on the BICE must notify the Labor Department in advance and retain records to establish compliance. Finally, there must be an enforceable, written contract if the arrangement involves an IRA or a qualified retirement plan that is not subject to ERISA, e.g., a solo 401(k). The contract may require arbitration of individual claims but cannot preclude participation in class action lawsuits. The necessary elements can be incorporated in an existing contract without the customer’s signature. Negative consent will be presumed if a customer does not terminate the arrangement within 30 days after receiving the amendment.

The BICE provides special treatment for certain preexisting arrangements, but the conditions will limit its utility. For example, the exception does not extend to compensation received as a result of the investment of additional sums. Also, grandfathered status is lost if the arrangement is renewed after April 10, 2017, even if the renewal is automatic because neither party has given notice of nonrenewal. This limitation does not apply to an “evergreen” arrangement that either party may terminate at any time.

Since conflicts of interest are less likely with “level fee fiduciaries” whose compensation is based on a fixed percentage of the assets or a set fee that does not vary based on recommendations, the BICE does not require written contracts for such arrangements. A written statement of fiduciary status and compliance with best interest standards will suffice. However, if the fiduciary recommends a rollover or a change to a level fee, it must document in writing why the suggestion is in the best interest of the participant or IRA owner.

Investment advice regarding proprietary investment products may qualify under the BICE if additional requirements are satisfied. One is a clear disclosure of all limitations on the universe of investments the adviser may recommend.

Satisfying BICE conditions may be difficult for anyone advising a plan participant or IRA owner to take a rollover or taxable distribution. Acting prudently in the client’s interest will require the adviser to gather information about the existing arrangement to prepare and document an objective comparison of the relative advantages and disadvantages of the proposed change. Similarly, an existing adviser must be careful when commenting on the merits of transferring funds out of the current plan or IRA, because a recommendation not to withdraw will be treated as investment advice.

Other exemptions

The amendments to previous PTEs are intended to integrate them with the new regulation and BICE. For example, PTE 84-24 is narrowed to exempt only the sale of fixed rate annuity contracts to plans or as IRAs. As a result, the purchase of a variable or fixed index annuity contract with plan or IRA assets must satisfy the BICE conditions in order to be an exempt prohibited transaction.

Effective dates

Although the new regulation and PTE changes become effective on June 7, 2016, they will not apply until April 10, 2017, allowing additional time for investment advisers to determine how they will respond to the new rules. Some of the BICE conditions are further delayed to Jan. 1, 2018. During that transition period, the exemption generally will be available if an investment adviser upholds the best interest standard and provides simplified disclosures, including an acknowledgment of fiduciary status.

Closing comments

The burdens of complying with the new rules will be borne by the investment industry, but plan fiduciaries and IRA owners should be prepared for significant changes over the next 18 months, particularly if their investment advisers are not level fee fiduciaries.