W. Scott Simon
This month’s column will complete my analysis and discussion of the Conflict of Interest Rule (Rule) which was issued by the U.S. Department of Labor (DOL) on April 8, 2016.
It now looks as though the Rule’s applicability date of April 10 for implementation will “slip” to some later date [Ed. Note: the implementation has now been delayed by 60 days]. As noted in last month’s column, it’s likely that the Rule will remain in limbo for some period of time after which it will be left as is, modified in some way, or outright extinguished. Whatever the ultimate fate of the Rule, though, I think it’s important to finish this comprehensive examination of the Rule as it was set forth on April 8, 2016.
Transition Rules
There are certain transition rules for the various Best Interest Contracts (BIC), including a temporary relief period that excuses full compliance from April 10, 2017, to Jan. 1, 2018. These rules are designed to help financial institutions that will find it difficult to comply with a Full-Blown BIC/Disclosure BIC/BIC Lite by the deadline. (Only a Full-Blown BIC requires a formal written contract while the other BIC versions merely require assorted disclosures, representations and the like–although these are important and can be extensive.)
Certain BIC requirements, such as compliance policies and some disclosures, are waived for this transition period. Financial institutions must still (1) comply with the Impartial Conduct Standards, (2) acknowledge fiduciary status in writing, and (3) make certain other disclosures such as conflicts of interest. As of Jan. 1, 2018, though, all the BIC rules will go into full effect based on the original schedule.
IRA Rollovers
When providing services to a retirement plan, an advisor often develops relationships with the plan sponsor and plan participants. Some participants may turn to the advisor and seek advice, such as whether they should roll their assets out of the plan and/or what assets to roll over into the plan. Some advisors have exploited the trust they’ve created with participants by selling them high-cost investments n such situations. This may create a conflict of interest when an advisor’s fees charged for, say, rollover assets are higher than its fees charged for plan assets.
The Rule repeals DOL Advisory Opinion 2005-23A, the DOL’s former guidance on IRA rollovers. Instead, the Rule treats any rollover advice with respect to a plan or an IRA as fiduciary investment advice. Three kinds of rollover advice automatically are prohibited transactions (which can be circumvented through use of the Best Interest Contract Exemption (BICE)): (1) recommendations to a plan participant to take a distribution and roll it over into an IRA; (2) recommendations to an IRA owner to transfer its IRA to the advisor; and (3) recommendations to a participant or IRA owner to move from a transaction-based account to a fee-based account.
Impact on Fee-Based Advisors
The Rule will affect substantially all advisors because of its reach to IRA assets. This includes fee-based advisors offering IRA rollover advice. RIAs that are level fee fiduciaries might need to go the BIC Lite route in order to provide conflict-free IRA rollover advice since, as noted, compensation associated with an IRA is likely to be greater than compensation derived from a plan. The BIC Lite may also be relied on by an advisor when it offers rollover advice to investors with whom it has no pre-existing relationship– so-called “off the street” investors.
Impact on Commissioned-Based Advisors
The Rule, as noted, will affect substantially all advisors because of its reach to IRA assets. This too will include commissioned-based advisors offering IRA rollover advice.
Variable compensation between product categories such as mutual funds and variable annuities is permitted, but it must be based on “neutral factors” tied to services such as the time, effort or expertise needed to sell an investment product. This kind of thinking is misplaced, I think. After all, one of the rules of thumb–at least in institutional sales–is that the more complex or riskier (and/or sexy?) an investment product or service, the higher the fee to be secured for selling it successfully. However, selling, say, a lousy investment product and generating a high fee as a result shouldn’t be blessed by the Rule just because it has a long sales cycle.
I think that the converse is often true as well: just because, say, low cost, broadly and deeply diversified investment products (usually) have relatively short sales cycles doesn’t mean that the investment and management fees generated as a result by those selling them should necessarily–as they often are–be low as the Rule seems to imply. In my view, such products offer plan participants (and, as ERISA reminds us, their beneficiaries–which implies inclusion of a wholly different generation(s) that, in certain cases, may benefit from a portfolio prudently invested and managed ab initio) as well as IRA owners much more efficient and effective portfolios long term.
Some responses from commissioned-based advisors to the Rule might include (1) migration to a fee- based service model, (2) levelization of commissions, and (3) structuring revenue-sharing as flat dollar payments.
Amended PTE 84-24 and Annuities
Because commission-earning advisors will be fiduciaries under the Rule, an exemption from prohibited transaction rules is necessary for insurance companies and insurance agents as well as brokers to be able to receive commissions when selling annuities to plans and IRAs.
The Rule provides two exemptions: (1) the BICE which allows commissions on all annuity types including fixed annuities, fixed indexed annuities and variable annuities, and (2) a Prohibited Transaction Exemption(PTE) 84-24 which allows commissions on fixed annuities only.
Securing the protection of PTE 84-24 requires: (1) disclosure of conflicts, (2) disclosure of commissions must be done annually for ongoing deposits and must segregate compensation paid to a financial institution and the advisor, (3) commissions must ordinarily be expressed as a flat dollar figure but, if not possible, as a percentage, and (4) the investor must provide written authorization for the purchase of the annuity involved and acknowledge receipt of any disclosures.
It’s worth noting that PTE 84-24 will be easier to comply with than the BICE. For example, no written contract or compliance policies are necessary. On the other hand, while there may be fewer compliance conditions than the BICE, PTE 84-24 doesn’t allow commissions on sales of fixed index annuities or variable annuities, unlike the BICE which does. Nor does PTE 84-24 provide any relief for revenue- sharing.
The Grandfathering Provision of the BICE
The BICE grandfathering provision is applicable to contracts existing before April 10, 2017. The purpose of this is to allow advisors to receive variable compensation such as commissions, 12b-1 fees and revenue-sharing for any post-April 10, 2017, recommendations (1) on assets sold before April 10, 2017, or (2) on assets sold pursuant to a purchase program established before April 10, 2017.
On or after April 10, 2017, compensation cannot be paid for any new investment recommendations. A grandfathered recommendation cannot have violated prohibited transaction rules when it was initially executed. Any compensation received must be reasonable.
Enforcing the Rule
The DOL is unable legally to enforce the Rule against advisors to IRAs so the Rule allows retirement investors to enforce it through breach of contract actions–either on their own or through class actions.
The IRS is not likely to enforce the Rule against advisors to IRAs given its long history of not imposing excise taxes on those engaging in prohibited transactions.
The Rule, however, allows attorneys through class action lawsuits on behalf of plans and IRAs–mass numbers of investors–to enforce its provisions. They must prove that an investment is defective, marketed incorrectly, or shows systemic violations of the Rule.
The Rule may also be enforced through arbitrations–one investor at a time–involving IRAs. Most investors alleging loss of IRA assets will likely opt for FINRA arbitration and plead that the investments were somehow “unsuitable.” Some commentators point out that many FINRA arbitrators seem to see themselves as fact-finders, not judges; that is, they make decisions based on a cut-and-dried rules- based suitability mentality, not a flexible principles-based fiduciary mentality.
Whatever the ultimate fate of the Rule–even if outright abolished–it would appear that the trend in the marketplace is moving (albeit too slowly for many perhaps) toward level fee compensation and away from variable compensation. The marketplace will eventually accept that variable compensation must be jettisoned because it is impossible to serve two masters and still give investors a fair shake.
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.