7/5/16 - Labor Dept.’s Fiduciary Rule Will Require Firms Providing Retirement Investment Advice to Reassess Compensation and Compliance
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7/5/16 - Labor Dept.’s Fiduciary Rule Will Require Firms Providing Retirement Investment Advice to Reassess Compensation and Compliance

The Labor Department in April issued its final fiduciary rule, which — among other things — redefines when providers of retirement investment advice assume a fiduciary responsibility and must meet attendant compliance requirements. Under the fiduciary rule’s definition, banks, broker-dealers, investment advisers, insurance companies, and other financial institutions whose personnel provide investment advice regarding the assets of covered plans — such as employee-benefit plans (under the Employee Retirement Income Security Act of 1974) and individual retirement accounts (under the Internal Revenue Code of 1986) — will be fiduciaries in a broader array of advice relationships.

These firms will first need to determine whether they are fiduciaries and, if so, whether they currently engage in certain transactions that create conflicts of interest, such as transactions generating several common forms of compensation. Firms will be required to stop engaging in such “prohibited transactions” or comply with specific requirements — designed to safeguard against conflicts of interest — to meet the terms of a prohibited-transaction exemption.

The rule created two key prohibited-transaction exemptions: the best-interest-contract exemption (“BIC exemption”) and the principal-transaction exemption (“PT exemption”). The BIC exemption permits financial institutions and their advisers to provide investment advice to retail retirement investors and receive otherwise prohibited forms of compensation, provided they meet certain conditions. The PT exemption permits financial institutions and their advisers to engage as principal in certain transactions with covered plans and receive a markup, markdown, or similar payment as a result of advice regarding the transaction, if they meet certain conditions.

Both exemptions impose on a firm and its advisers a host of requirements, including the following basic standards of impartial conduct:

  • Giving advice that is in the customer’s best interest (BIC and PT)
  • Receiving no more than reasonable compensation (BIC) or seeking to obtain the best execution reasonably available under the circumstances (PT)
  • Avoiding misleading statements (BIC and PT)

As a result of these requirements, firms relying on these exemptions will need to review their current compensation and business practices under a new “fiduciary” lens and reassess their compliance systems and policies and procedures to ensure compliance with the terms of the exemption

Is Your Firm a Fiduciary?

The rule redefines “fiduciary” by revising the related definition of “investment advice” to cover a broader array of advice relationships. Under this broadened definition, investment advice includes providing to a plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner for a fee or other compensation:

  • Investment recommendations
  • Investment-management recommendations, including recommendations with respect to rollovers, transfers, or distributions from a plan or IRA

A fee or other compensation may be direct, such as a commission paid by a plan, or indirect, such as a revenue sharing payment from a third party.

When an individual acts as an employee, agent, or registered representative on behalf of a firm engaged to provide such advice, both the individual and the firm would be fiduciaries.

Does Your Firm Engage In Prohibited Transactions?

Firms that fall within the expanded definition of fiduciary will need to review their compensation arrangements and business practices to determine whether they engage in certain transactions that create conflicts of interest. Significantly, these prohibited transactions include transactions generating several common forms of compensation, such as:

  • Commissions
  • Sales loads
  • 12b-1 fees
  • Revenue-sharing payments from investment providers or other third parties
  • Level fees in certain circumstances (e.g., where a recommendation that a participant roll money out of a plan to a fee-based account will result in an increase in the amount of fees received)

Prohibited transactions also include engaging as principal in certain purchases and sales with covered plans (“principal transactions” and “riskless principal transactions”) and receiving a markup, markdown, or similar payment as a result of advice regarding the transaction.

Firms that engage in prohibited transactions will need to discontinue engaging in such transactions by changing their compensation or business practices, or comply with specific requirements — designed to safeguard against conflicts of interest — to meet the terms of a prohibited-transaction exemption.

For a number of firms, relying on a prohibited-transaction exemption will be the only way to avoid a significant change to compensation or business practices.

How Can Your Firm Comply With the Bic and PT Exemptions?

BIC Exemption

The BIC exemption permits financial institutions (along with their advisers) that provide investment advice to retail retirement investors to receive otherwise prohibited types of compensation, provided they meet certain conditions.

A key requirement of the BIC exemption is that both the firm and its advisers must adhere to the following basic standards of impartial conduct:

  • Giving advice that is in the customer’s best interest
  • Receiving no more than reasonable compensation
  • Avoiding misleading statements

These standards of impartial conduct are stricter than those that previously applied to many firms and advisers now considered fiduciaries under the rule. Firms must prepare policies and procedures designed to ensure compliance with the impartial-conduct standards. Firms must also adhere to acknowledgement, contract, disclosure, and record-retention requirements, as explained further in the summary of key requirements below.

Requirements vary for certain business practices due to differences in their potential for conflicts of interest. Firms that limit their offerings, in whole or in part, to proprietary products or products that generate third-party payments must comply with additional requirements intended to mitigate the conflicts of interest inherent in such arrangements. On the other hand, firms that use level-fee arrangements, and banks and bank employees that receive referral fees pursuant to bank networking arrangements, are subject to streamlined requirements, because such arrangements tend not to give rise to conflicts of interest except in certain limited circumstances.

PT Exemption

The PT exemption permits financial institutions and their advisers to engage in principal transactions or riskless principal transactions with covered plans, participant or beneficiary accounts, or IRAs and receive a markup, markdown, or similar payment as a result of advice regarding the transaction, provided they meet certain conditions. These conditions largely mirror those of the BIC exemption, with some notable differences. First, under the PT exemption, the impartial-conduct standards differ: Instead of requiring that the firm and adviser receive no more than reasonable compensation, they require that the firm and adviser seek to obtain the best execution reasonably available under the circumstances. Second, the PT exemption includes different disclosure requirements and additional general conditions.

Key Requirements

BOTH EXEMPTIONS

 
1. Acknowledge fiduciary status (firm)
2. Adhere to impartial-conduct standards (firm and advisers)
3. Have policies and procedures designed to ensure that advisers adhere to impartial-conduct standards (must address specific requirements regarding conflicts of interest and sales incentives) (firm)
4. Provide certain disclosures (e.g., to retirement investor concerning fees, compensation, and material conflicts of interest) (firm)
5. Retain records demonstrating compliance with the exemption (firm)
6. With respect to IRAs and other plans not covered under ERISA, enter a written enforceable contract with the client requiring adherence to the exemption’s standards (firm)

BIC EXEMPTION

  • Required disclosures under (4) include notice to Labor Department of intention to rely on exemption
  • Level-fee fiduciaries need only comply with (1) and (2) and document the reasons why recommendations to do the following are in the best interest of the retirement investor:
    • Roll over to an IRA from an ERISA plan or another IRA
    • Switch from a commission-based account to a level-fee arrangement
  • Banks and bank employees that receive referral fees pursuant to bank networking arrangements need only comply with (2)
  • Firms that limit recommendations in whole or part to proprietary products or products that generate third-party payments must meet additional requirements to comply with (2)
 

PT EXEMPTION

  • Impartial-conduct standards require that the firm and advisers seek to obtain the best execution reasonably available under the circumstances
  • Different disclosure requirements
  • Additional general conditions:
    • Purchase of a debt security by a covered plan, participant or beneficiary account, or IRA gives rise to additional requirements, including an assessment of the credit and liquidity risk of the debt security
    • The transaction may not be part of an agreement, arrangement, or understanding designed to evade ERISA or the Internal Revenue Code or otherwise impact the value of the asset
    • Purchase or sale must be for cash
  • Policies and procedures must address how the firm will conduct the required assessment of credit and liquidity risk of debt securities
 

Implementation

In general, the requirements of the fiduciary rule, including the impartial-conduct standards, will become applicable on April 10, 2017. Full compliance with the BIC and PT exemptions is not required until Jan. 1, 2018. From April 10, 2017, to Jan. 1, 2018, the BIC and PT exemptions are available, provided:

  • The firm and its advisers comply with the applicable impartial-conduct standards
  • The firm designates a person or persons responsible for addressing material conflicts of interest and adherence to the impartial-conduct standards
  • The firm meets certain disclosure and record-retention requirements
  1. Assess their compensation arrangements and business practices to detect any prohibited transactions
  2. Decide which practices they will discontinue and which they will revise to qualify for an exemption
  3. Discontinue activities that do not qualify for an exemption
  4. Be in the process of executing a plan to achieve compliance with exemptions on which they intend to rely

How Promontory Can Help

Promontory has extensive knowledge of the investment-advisory business, along with deep firsthand experience advising firms on regulatory expectations regarding fiduciary standards and the implementation of new regulations. We can help your firm comply with the fiduciary rule through services including:

  • Conducting a business-impact assessment of the fiduciary rule to identify aspects of current practices that do not align with the requirements of the rule
  • Refining policies and procedures to align with the fiduciary rule
  • Helping develop necessary board and management governance and reporting
  • Helping develop appropriate controls and associated monitoring and testing programs to ensure compliance with the fiduciary rule is maintained and subject to appropriate risk practices
  • Identifying areas where firms can draw on existing Regulation 9 compliance efforts to ease compliance with the fiduciary rule
  • Designing a road map for complying with the fiduciary rule within the implementation period
  • Assessing existing personnel in key areas to determine whether they possess the skills necessary to execute the road map

Contact Us

For more information, please call or email your usual Promontory contact or:

Julie Williams
Managing Director and Director of the Domestic Advisory Practice
juwilliams@promontory.com
+1 202 384 1087

Michael Dawson
Managing Director
mdawson@promontory.com
+1 202 384 1080

Conway Dodge
Managing Director
cdodge@promontory.com
+1 202 370 0461

Michele Meyer
Director
mmeyer@promontory.com
+1 202 603 3709

Michael Sullivan
Managing Director
msullivan@promontory.com
+1 202 370 0507