W. Scott Simon
Last month in this column, we explained that the Conflict of Interest Rule (Rule) promulgated by the U.S. Department of Labor on April 8, 2016, pertains to only one “kind” of the three kinds of fiduciaries described in section 3(21) of the Employee Retirement Income Security Act of 1974 (ERISA), which can be thought of as “Fiduciary Central.” That one kind of fiduciary–an ERISA section 3(21)(A)(ii) fiduciary– is a non-discretionary advice-giver.
All three elements described in section 3(21)(A)(ii)–1) a fiduciary 2) that renders (non-discretionary) investment advice 3) for compensation–must be present in order for the Rule to apply to an advisor communicating with a plan participant or an IRA owner.
Element 1: Fiduciary
The Rule broadens the class of entities–which it defines as “Financial Institutions”–that will bear the “fiduciary” moniker come April 10. These include registered investment advisors, broker/dealers, banks, and insurance companies. This definition also includes any employees, contractors, agents, representatives, affiliates, or related entities of a given Financial Institution.
Element 2: Investment Advice
The Rule also broadens the definition of “investment advice.” More precisely, “retirement investment advice” that’s rendered to 1) participants in ERISA plans such as 401(k) plans, profit-sharing plans, money purchase pension plans, and defined benefit plans, as well as 2) owners of IRAs and participants in non-ERISA plans. Note that the Rule does not pertain to investment advice rendered to those investing in taxable accounts and non-retirement accounts. That retail environment remains within the purview of the SEC.
Determining whether an advisor has rendered “retirement investment advice” in a given situation requires posing a threshold question: Has the advisor made a “recommendation” as defined by the Rule? If there’s no recommendation, then there’s no investment advice, and since, as noted, investment advice is one of the three elements of ERISA section 3(21)(A)(ii), an advisor’s communication will not make it a fiduciary subject to the Rule.
So how does the Rule define a “recommendation”?
A “recommendation” is a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion (some have termed this a “call to action”) that a recipient of the investment advice should engage in, or refrain from taking, a particular course of action. (A “recipient of investment advice” is defined as a plan, plan fiduciary or plan participant or beneficiary, IRA or IRA owner.)
The following four kinds of communication are each defined by the Rule as a “recommendation”:
- The advisability of acquiring, holding, disposing of, or exchanging investment property;
- How investment property should be invested after the property is rolled over, transferred, or distributed from a plan or IRA;
- The management of investment property, including recommendations on investment policies, strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, or types of investment account arrangements (e.g., brokerage account vs. advisory account); or
- Whether, in what amount, in what form, or to what destination a rollover, transfer, or distribution from a plan or IRA should be
Note that the test of whether a particular communication rises to the level of a “recommendation” is whether a reasonable person–not the recipient of the advice–will view the communication as being a recommendation.
The more individually tailored the communication is to the specific recipient of the advice, the more likely it will be judged to be a recommendation.
A series of actions may comprise a recommendation in the aggregate; it’s possible, though, that if viewed individually, they would not.
It doesn’t matter if a communication is initiated by a human being or a computer software program such as a robo-advisor.
An advisor’s “hire me” communication in a marketing scenario will not be deemed a recommendation; that’s true, though, if an advisor describes only its services and fees. If the advisor adds to that description by, for example, suggesting to an IRA owner that a particular product, investment, or platform should be used, then that leaves the realm of a “hire me” communication and enters that of a recommendation.
An advisor’s suggestion to select other persons to provide advice is a recommendation.
When an advisor provides a Rule-defined recommendation, it rises to the level of “investment advice” but only when the advisor delivers it in one of the three following contexts:
- By representing or acknowledging that it’s acting as a fiduciary under ERISA or the Internal Revenue Code in rendering investment advice; or
- By rendering investment advice with a written (or unwritten) understanding that it’s based on particular investment needs of a specific advice recipient(s); or
- By directing investment advice to a specific advice recipient(s) about the advisability of a particular investment decision or recommendation.
Element 3: Compensation
We’re still not out of the woods yet. In fact, no fiduciary investment advice will be deemed to be rendered if no fee or other compensation is given in exchange for it. So it’s important to see how the Rule broadens the definition of “fee or other compensation”:
- Any explicit fee or compensation for the advice received by a person (or an affiliate) from any source; or
- Any fee or compensation received from any source in connection with, or as a result of, the recommended purchase or sale of a security or the provision of investment advice
Examples of fees or compensation include–but are not limited to–commissions, loads, finder’s fees, revenue-sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to brokerage firms in return for shelf space, recruitment compensation paid in connection with transfers of accounts to a registered representative’s new broker-dealer firm, gifts and gratuities, and expense reimbursements.
A fee or compensation is paid “in connection with, or as a result of” investment advice if the fee or compensation would not have been paid but for the recommended transaction or advisory service, or if eligibility for, or the amount of, the fee or compensation is based in whole or in part on the transaction or service.
An Analytical Framework to Determine If an Advisor Is Subject to the Rule
In order for an advisor to become subject to the Rule in a given situation, as noted, it must be a fiduciary providing investment advice for compensation (ERISA section 3(21)(A)(ii)). Here’s an analytical framework that can be used to go about determining that:
Is any one of four different kinds of communication deemed a “recommendation?” If not, an advisor is not subject to the Rule.
If so, is the recommendation delivered by the advisor in one of three different contexts? If not, an advisor is not subject to the Rule.
If so, is the recommendation deemed “investment advice?” If not, an advisor is not subject to the Rule.
If so, is the investment advice rendered in exchange for “a fee or other compensation?” If not, an advisor is not subject to the Rule.
If so, “fiduciary” status is conferred on the advisor.
Wait, not so fast. If the recommendation is a safe harbor exception/exclusion designated in the Rule, it’s not considered investment advice. And if there’s no investment advice, one of the three elements of ERISA section 3(21)(A)(ii) is lacking. In that case, the Rule will not apply to an advisor.
In next month’s column, we’ll have a look at some of these safe harbor exceptions/exclusions.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.