The Department of Labor is amending a longstanding Employee Retirement Income Security Act (ERISA) regulation that defines fiduciary “investment advice.” Barring postponement by the new administration, the new rule will generally become effective on April 10, 2017, and will dramatically affect financial advisors and other service providers who provide assistance to ERISA plan sponsors, plan participants, and IRA customers with their investment decisions.
Expanding the Definition of “Investment Advice”
The rule, 29 C.F.R. § 2510.3-21, greatly expands the range of activities that constitute fiduciary investment advice under ERISA. Today, fiduciary duties attach to investment advice if the advice provider and the advice recipient have a mutual understanding that the advice “will serve as a primary basis for investment decisions.” The new rule eliminates this concept of “reliance” and instead treats as fiduciary investment advice any “communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.” In addition, the new rule covers not only recommendations to buy and sell, but also recommendations about whether to hold a security or other property, take a distribution or rollover, manage assets or select an investment manager, and use a brokerage or fee-based advisory account.
These changes are important for two reasons. First, fiduciaries are subject to a “best interest of the investor” standard of care. A fiduciary must therefore make recommendations with the care, skill, diligence and prudence that a person experienced in such matters would use taking into account the investment objectives, risk tolerance, financial circumstances and needs of the investor. A fiduciary must also make recommendations without regard to the financial interests of the advice provider. Because the new rule’s broad definition of a “recommendation” potentially encompasses routine sales activity, it creates a major disruption for traditional commission-based advisors such as broker-dealers and insurance agents.
Second, fiduciaries are subject to ERISA’s prohibited-transaction rules, which apply to both employee benefit plans and IRAs. This means that a fiduciary may not provide investment advice if it would cause the fiduciary’s compensation to vary, unless a prohibited transaction exemption applies. In other words, an advisor who receives commissions—as well as any other provider compensated through a plan’s investments who might provide advice under the new definition, such as plan recordkeepers or third-party administrators—must either comply with an exemption or avoid providing fiduciary advice in the first place. Even an advisor who charges a flat fee must be careful when marketing its own advice services to a prospective customer, because its compensation will vary based on whether or not the customer hires it.
Dealing with the New Definition
The rule provides a few tools to navigate these new waters. The most prominent of these is a new, broad-based prohibited transaction exemption called the “Best Interest Contract,” or “BIC,” exemption. The BIC exemption is available for fiduciary advice to IRA customers, plan participants, and plan fiduciaries who hold, manage or control less than $50 million in plan and non-plan assets. The BIC exemption’s conditions are extensive, but it principally requires that the advice be provided pursuant to an enforceable obligation to act in the retirement investor’s best interest, either under ERISA or under a private contract with an IRA owner. Streamlined requirements apply where the advisor’s and its affiliates’ compensation is a fixed percentage of the advised assets or a set fee that does not vary with the investments recommended.
The rule also identifies a number of circumstances that, despite the rule’s otherwise broad scope, will not be considered fiduciary advice. For example, the rule outlines specific types of investment education that are not considered advice. Other carve-outs exist for marketing investment platforms, making general communications to the public, certain communications among employees of an employer sponsoring a plan, and recommendations to plan fiduciaries who hold, manage or control at least $50 million in plan and non-plan assets and who are capable of independently evaluating investment risks and recommendations. All of these carve-outs are subject to certain conditions and, in many cases, subject to certain disclosures to the recipient.
Consequences to Investors, Plan Sponsors and the Industry
Although the rule is intended to benefit retirement investors, it is likely to prove disruptive to the retirement industry. For example, the rule will now subject account rollover recommendations to a fiduciary standard, so many expect rollovers to IRAs to decline and the proportion of assets remaining in 401(k) and other employer plans to increase.
The rule will also likely increase the use of low-cost investments that have minimal or no 12b-1 fees or revenue-sharing associated with them. Thus, an increasing proportion of retirement assets will likely be invested in collective investment trusts, index funds, and low- or no-revenue-sharing share classes of mutual funds. By the same token, high-cost and high-revenue-sharing investments, as well as proprietary investments of an advice provider, will likely receive a smaller share of retirement assets. Other products such as variable annuities may also diminish in popularity as the rule subjects them to increased requirements under the BIC exemption.
Pricing for advice services to retirement customers will also likely shift from variable or commission-based arrangements to fixed-fee-based arrangements. This is because variable compensation would trigger the need to comply with the BIC or another prohibited-transaction exemption, or will limit the advice provider to communications that fit within a carve-out under the rule. Registered investment advisors, who generally employ fixed-fee arrangements today, will likely be less affected than broker-dealers and other commission-based service providers. Similarly, fee-based managed account products, including so-called “robo-advisors,” should see a boost in sales.
Plan sponsors will also need to consider how the new advice landscape may affect them. Many plan sponsors will need to determine whether and how to prudently select and monitor an advice provider both for recommendations on the plan lineup and for recommendations to plan participants. Sponsors may also need to evaluate the current plan lineups in light of the new rule and potentially change compensation arrangements with service providers. IRA owners may be faced with similar issues.
Ralph C. Derbyshire is Senior Vice President and Deputy General Counsel for FMR LLC, the parent company of Fidelity Investments. Fidelity Investments is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing, and other financial products and services to more than 20 million individuals, institutions, and financial intermediaries. From 2012 – 2014, he served as the investment management industry representative to the Department of Labor’s ERISA Advisory Council.
James Barr Haines is a Vice President and Associate General Counsel at Fidelity Investments, supporting Fidelity’s workplace plan administration business. Jay is also co-chair of the Boston Bar Association’s ERISA Sub-Committee.