On November 3, 2023, the US Department of Labor (DOL) issued proposed fiduciary rules for investment advice to private sector retirement plans, participants in those plans, and IRA owners. The DOL refers to those clients as “retirement investors” and this bulletin will do the same.
The proposals will change the definition of fiduciary retirement advice to capture virtually all recommendations to retirement investors, significantly expanding the circumstances in which investment advisers will be fiduciaries under the Employee Retirement Income Security Act (ERISA), and the Internal Revenue Code. In addition, when fiduciary investment advisers make conflicted recommendations, for example, rollover recommendations, the advisers will, if the proposals are finalized as is, need to comply with the conditions in expanded prohibited transaction exemptions.
This package of proposals includes four sets of rules, including the new definition of fiduciary advice, an exemption for financial conflicts of investment advisers (and others in the securities world), an exemption for independent insurance agents, and amendments to other exemptions for conflicted nondiscretionary investment recommendations.
This bulletin focuses on the first two: the new proposed definition of fiduciary investment advice and the proposed amendments to the exemption for investment advisers conflicts (Prohibited Transaction Exemption (PTE) 2020-02).
Before discussing those, though, it’s important to point out that these are proposals. The November 3 publication date started a 60-day period in which comments can be filed with the DOL to be considered in writing the final regulation and exemptions.
After the 60-day period, the DOL will review the comments and draft the final rules. When that’s done, the DOL will send the final regulation and exemptions to the Office of Management and Budget (OMB) in the White House. Once the OMB review is completed, the final rules will be published in the Federal Register and will be effective 60 days later. In other words, this is just the beginning of the process.
Even so, it is important to follow the development of the rules and consider their possible impact on the practices of investment advisers.
The Proposed Definition of Fiduciary Advice
The proposed regulation includes three definitions of fiduciary advice.
- Discretionary management of the investments in plans, participants’ accounts and IRAs – that definition is already in the current regulation and is not a change.
The next two, however, are significant changes. They define a person as a fiduciary investment adviser if:
- “The person making the recommendation represents or acknowledges that they are acting as a fiduciary when making investment recommendations.”
Comment: The new proposal states, in essence, “if you say that you are a fiduciary, then you will be a fiduciary adviser for purposes of ERISA and the Internal Revenue Code.” This will likely cause investment advisers to become fiduciaries for the advice they give, since it is common to acknowledge fiduciary status in advisory agreements and disclosure materials and brochures.
- “The person either directly or indirectly (e.g., through or together with any affiliate) makes investment recommendations to investors on a regular basis as part of their business and the recommendation is provided under circumstances indicating that the recommendation is based on the particular needs or individual circumstances of the retirement investor and may be relied upon by the retirement investor as a basis for investment decisions that are in the retirement investor’s best interest.”
Comment: Stated conversationally, an investment adviser will be a fiduciary if the adviser (1) is in the business of making investment recommendations, which, is the case; and (2) a third party observing the communications with the adviser and the retirement investor would conclude that (a) the recommendation is individualized to the investor’s needs and circumstances, and (b) the recommendation could reasonably be relied upon by the retirement investor in making an investment decision that is in the investor’s best interest. Since investment advisers are generally required under SEC guidance to develop an understanding of the investor’s needs and circumstances, the fiduciary definition for nondiscretionary investment advice would ordinarily be satisfied.
Under current rules, the definition of nondiscretionary fiduciary advice is a 5-part test that includes a requirement that investment advice be given to the retirement investor on a “regular basis.” With the proposed removal of the "regular basis” requirement, one-time advice will be fiduciary advice. That will include, for example: recommendations to rollover money from a retirement plan to an IRA, recommendations to transfer an IRA from another firm, point-in-time advice where ongoing advice is not contemplated; one-time consulting arrangements if recommendations about investment strategies or policies are part of the project.
To compound matters, the definition of investment advice is not limited to specific investments. Instead, it is broadly defined. Here is what the proposed regulation says:
The phrase ‘‘recommendation of any securities transaction or other investment transaction or any investment strategy involving securities or other investment property’’ means recommendations:
(i) As to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, as to investment strategy, or as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
(ii) As to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., account types such as brokerage versus advisory) or voting of proxies appurtenant to securities; and
(iii) As to rolling over, transferring, or distributing assets from a plan or IRA, including recommendations as to whether to engage in the transaction, the amount, the form, and the destination of such a rollover, transfer, or distribution.
Comment: In other words, the proposed definition of investment recommendations is not limited to recommendations of specific securities; instead, it also includes recommendations about investment strategies, investment policies, and asset allocation; recommendations of discretionary and nondiscretionary investment advisers; and recommendations to rollover benefits from a retirement plan or to transfer an IRA, as well as how to invest in the IRA when provided before or concurrent with the rollover or transfer recommendation. Investment advisers should be cognizant of this broad definition of investment recommendations and of the inclusion of IRA transfers in the definition of rollover recommendations. While not clear, this expansive definition of an investment recommendation may represent current DOL thinking.
Fiduciary status for advice to private sector retirement plans and to participants in those plans implicates a high standard of care – ERISA’s prudent person rule and duty of loyalty. However, that does not carry over to advice to IRAs. Instead, the standard of care for investment advice to IRAs is the fiduciary duty defined by the SEC – the twin duties of care and loyalty. But, the DOL’s definition of fiduciary status is still relevant for advice to IRAs because fiduciary conflicts of interest are prohibited under the Internal Revenue Code. As a result, investment advisers providing services will need to comply with PTE 2020-02 when their advice involves a financial conflict of interest.
Focusing on conflicts, fiduciary conflicts of interest are prohibited under both ERISA and the Code – literally prohibited. As a result, where fiduciary advisers receive compensation as a result of their advice or receive third-party payments due to their advice, those payments cannot be retained unless there is an available prohibited transaction exemption and the conditions in the exemption are satisfied.
The exemption available for conflicted nondiscretionary advice by investment advisers is PTE 2020-02, which the DOL is also proposing to amend.
Prohibited Transaction Exemption 2020-02
This exemption covers conflicts of interest resulting from nondiscretionary investment advice. That would include, for example, the advisory fees from a retirement plan rollover or an IRA transfer; revenue sharing from investments, custodians, or other service providers; and proprietary investment products. PTE 2020-02 has been in place for several years and most registered investment adviser firms have compliant practices and policies. However, the DOL’s proposals will make some changes.
For context, the current version of the PTE has four categories of requirements: The Impartial Conduct Standards (including the best interest standard of care); Disclosures of fiduciary status, services and conflicts, and why a rollover is in the best interest of a retirement investor; Policies and Procedures for compliance with the Impartial Conduct Standards; and an annual Retrospective Review of compliance with the conditions in the PTE.
The requirements in the first category – the Impartial Conduct Standards – will not be changed. Those requirements are compliant with the best interest standard of care (which is, in its essence, ERISA’s prudent person rule and duty of loyalty); a limit on compensation to reasonable amounts relative to the services provided; satisfaction of the best execution rules; and not making materially misleading statements relative to the recommended actions. The proposal adds a clarification that the failure to disclose material information will be considered to be misleading.
All of the Disclosure requirements in the current PTE are retained, and some new requirements are added. In addition to the current requirement that fiduciary status must be acknowledged in writing, the proposal requires that retirement investors be given a description of the best interest standard of care. Fortunately, the DOL provides sample language for that. The services and conflicts disclosures will need to include information about whether the recommendations will result in any third-party payments to the investment adviser or the firm.
In the preamble to the exemption, though, the DOL made a significant comment about the fiduciary acknowledgement. It says that, contrary to the DOL’s intentions, some financial services firms were saying that they “may” be fiduciaries or that they were fiduciaries “to the extent” they satisfied the 5-part test. The DOL disagreed with that approach, saying that retirement investors were entitled to know if they were working with a fiduciary and that, therefore, an affirmative acknowledgement of fiduciary status was required. Investment advisers should review their fiduciary acknowledgements to determine if their status is affirmatively disclosed (and not conditionally disclosed).
A new disclosure requirement is proposed to help retirement investors understand the scope and degree of any conflicts. That is, the retirement investor must be given a statement that, upon request, specific information will be provided about any costs, fees, and compensation related to the recommendation.
With regard to rollover recommendations, the proposal increases the current requirements. Specifically, the proposal requires that:
“Before engaging in a rollover, or making a recommendation to a plan participant as to the post-rollover investment of assets currently held in a plan, the financial institution and investment professional must consider and document the basis for their conclusions as to whether a rollover is in the retirement investor’s best interest, and must provide that documentation to the retirement investor.”
PTE 2020-02 currently requires that participants and IRA owners be given, in writing, the “specific reasons” why a rollover or transfer is in their best interest, but the proposed provision appears to contemplate that they will be given the underlying documentation as well.
In addition, the retirement investor must be given a description of certain factors considered by the investment adviser in that process, for example, “the fees and expenses associated with the plan and the recommended investment or account.” The DOL has provided sample language for that disclosure.
With regard to the adoption and enforcement of Policies and Procedures, the rules remain much the same. However, the DOL has added detail to the requirement that the Policies and Procedures mitigate conflicts of interest. That detail is:
“Financial institutions may not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, or other similar actions or incentives that are intended, or that a reasonable person would conclude are likely, to result in recommendations that are not in retirement investors’ best interest.”
While these types of incentives are more common for broker-dealers than RIAs, the addition of that language highlights the concerns of the DOL about incentive compensation that could cause a fiduciary adviser to make a recommendation that is not in the best interest of a retirement investor.
Finally, the requirement for an annual Retrospective Review for compliance with the conditions in the PTE remains much the same.
The proposals are just that – proposals. They are not rules or requirements.
However, these changes – perhaps modified to a degree – will likely become final in the middle of 2024. As a result, now is the time to begin considering the DOL’s concerns, how they plan to address them, and what changes investment advisers may need to make.
For more information: Contact your J.P. Morgan Client Advisor