W. Scott Simon
Since 2010, the U.S. Department of Labor (DOL) has sought to fashion a fiduciary rule that will mitigate conflicts of interest arising from advisors’ receipt of variable compensation–commissions, 12b-1 fees, revenue-sharing, etc.–when rendering investment advice to retirement investors. The result, on April 8, 2016, was issuance by the DOL of (among other items) its long-awaited Rule titled: “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule–Retirement Investment Advice.”
1974 to Now
When the Employee Retirement Income Security Act (ERISA) was enacted in 1974, defined benefit plans were about the only kind of retirement plan around. The fiduciaries of DB plans sponsored by companies made all the decisions and bore all the risks of investing for the plans. Individual Retirement Accounts (IRA) were nonexistent since they had just been created by ERISA. IRAs were intended to provide individuals not covered by a retirement plan at work with a tax-advantaged savings program. In addition, they were meant to complement work-related plans by allowing rollover of assets at retirement or when employees changed jobs.
In 2016, the retirement landscape is obviously much more complex. Now, 401(k) and other defined contribution plans as well as IRAs dominate the retirement marketplace. Now, investors themselves–not others such as fiduciaries of DB plans–must make the decisions and bear the risks of investing for their retirement. Now, there are countless more and increasingly complex investment products such as target date funds (TDFs), exchange-traded funds (ETFs), hedge funds, private-equity funds, real estate investment trusts (REITs), and insurance products such as fixed indexed annuities. Now, in addition to traditional IRAs, there are Roth IRAs, SEP-IRAs, SARSEP IRAs, and SIMPLE IRAs.
Many of these investment products are marketed directly to plan participants and IRA owners by non- fiduciaries that enjoy a vast asymmetric information advantage within a caveat emptor environment. The result is that many plan participants and IRA owners today have little ability to assess the value of investment advice or potential conflicts of interest intelligently and are therefore at the mercy of these non-fiduciaries.
The Reason for the Rule: IRAs
The primary reason for issuance of the Rule doesn’t involve qualified retirement plans. Although litigation over the last decade has shown that hidden–and therefore high–costs exist even in multibillion-dollar 401(k) plans sponsored by giant corporations (e.g., Braden v. Wal-Mart), the $4.7 trillion held in 401(k) plans is relatively better regulated and incurs relatively lower costs than the $7.4 trillion held in IRAs. (Many likely would say that 401(k) plans hold far more in assets than IRAs do, but in fact, IRAs hold more than 50% greater assets than 401(k) plans.)
The real reason for issuance of the Rule is to mitigate what the DOL regards as the bad effects resulting from the practices of some advisors providing conflicted investment advice and products to unsuspecting IRA owners. The HR director at a plan for which our RIA was the investment manager pursuant to ERISA section 3(38) referred to those engaged in such practices as “circling sharks” waiting for plan participants to retire so they could place them in high-priced investment products.
He told us that our firm had rendered great assistance to many plan participants in helping them accumulate tidy sums. That’s why, he said, it would especially be a shame if the nest eggs of those participants choosing to leave the low-fee environment of the plan were needlessly squandered by the sharks’ high fees. As a result, he asked our firm to provide a rollover IRA option for his company’s retirees to protect them from this calamity.
Because our RIA was a fiduciary to the plan, we didn’t feel comfortable offering rollover IRA services given the legally gray area of DOL Advisory Opinion 2005-23A. That opinion holds that any rollover advice given by a plan fiduciary might trigger a prohibited transaction for which there is no applicable exemption. But such advice given by an advisor that’s not a plan fiduciary won’t trigger a prohibited transaction. The upshot, then, is that while an advisor that’s a plan fiduciary likely couldn’t provide rollover services, the plan’s, say, record-keeper that’s not a plan fiduciary could swoop in and provide rollover services–even though, according to the HR director, those services are usually much more costly and suboptimal to boot.
Some Advisors Are Unhappy With the DOL
Some advisors are unhappy that the DOL would “move into” their IRA-rollover business through issuance of the Rule. While understandable, the DOL is on firm legal footing in its seeming invasion of the IRA marketplace. Here’s why:
Under ERISA, IRAs are not employer-sponsored “plans,” and so any B/Ds or RIAs that provide services to IRAs are not subject to ERISA’s fiduciary duties or prohibited transaction rules. However, IRAs are “plans” for purposes of the prohibited transaction rules in the Internal Revenue Code (IRC), which includes a definition of “fiduciary” that closely tracks that found in ERISA. (See IRC section 4975.)
So even though IRAs and other non-ERISA plans are not subject to ERISA, an Executive Order issued in 1978 by President Jimmy Carter transferred from the IRS to the DOL rule-making authority over the fiduciary status and prohibited transaction provisions of IRC section 4975 that correspond to those in ERISA. (See Reorg. Plan No. 4 of 1978, § 102(a) (43 FR 47713, October 17, 1978 and confirmed by statute in P.L. 98-532 (1984).) It is this authority, granted nearly 40 years ago, that allows the DOL to bring IRAs under its purview through the Rule.
The kicker, then, is that while the DOL has no power to enforce any penalties against those advisors who engage in prohibited transactions when rendering investment advice to IRA owners, the IRS does have that power. And it could exercise it by imposing excise taxes on advisors who engage in a prohibited transaction by, for example, earning more than “reasonable” compensation from an IRA owner. (See IRC section 4975(d)(2).)
But the IRS has chosen not to enforce any such penalties against offending advisors. Through such non- enforcement, the IRS has, by default, allowed advisors rendering advice to IRA owners to be governed by the suitability standard instead of the fiduciary standard. The issuance of the Rule now subjects such advisors to the more stringent fiduciary standard, and some of them are none too happy about that.
Class Action Lawsuits
So although the DOL has the power to regulate IRAs, it cannot legally enforce any penalties against offending advisors. And while the IRS has such powers of enforcement, it has chosen not to exercise them against such advisors. The DOL’s solution to this conundrum is to allow IRA owners to sue–on their own or by joining a class action–offending advisors for breach of fiduciary duty (by alleging violation of the Best Interest fiduciary standard)–just as participants in ERISA plans are able to do already.
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.