By Fred Reish - Partner, Drinker Biddle & Reath LLP
The Department of Labor’s highly controversial fiduciary proposal is likely to become a final rule— but with some significant changes that will impact investment advice to plans and Individual Retirement Accounts (IRAs). This article discusses likely changes to the proposal and how the rules will affect advisers.
Before discussing the changes, however, let’s look at the timing. The Department of Labor (DOL) issued the proposal in April; private sector comments were filed between then and July; several days of hearings were held in August; and additional comments were filed in September. The DOL is now considering the input from the comments and hearings, and will probably issue its final guidance
in May or June of 2016. But, the DOL has said that it will not require compliance until eight months after issuance, which puts us in the first quarter of 2017. Even with the eight-month delay, it will be difficult to meet the requirements because the changes are that substantial. As a result, advisers should pay attention to the rules as they develop—and should be thinking about how they couldimpact their practices.
To understand the DOL’s proposed changes, it’s necessary to divide them into two categories:
• The regulation that will define when investment recommendations cause an adviser to be a fiduciary; and
• The prohibited transactions that apply to advisers when they make investment recommendations that:
a. cause themselves (or affiliates, for example, their broker-dealer) to receive payments from third parties (for example, mutual funds or insurance companies), or
b. affect the amount of their compensation (e.g., recommending mutual funds that pay 12b-1 fees) or the compensation of affiliated firms (e.g., recommending mutual funds managed by an affiliate).
To avoid the prohibition, advisers will need to satisfy one of the exemptions, or exceptions, that are part of the DOL’s fiduciary package.
The Fiduciary Proposal
Now, let’s turn to the fiduciary rule. Under the proposal, an investment recommendation would be fiduciary advice if it 1) was individualized for the recipient or 2) it was specifically directed toward the recipient. Many commenters argued that the “specifically directed” language was so broad that it could include marketing—for example, a mass mailing—just because it was mailed to an individual’s name and address. The DOL seems to be sympathetic to those concerns and the final rule will likely narrow the definition. In any event, it will take more than marketing for an adviser to become a fiduciary.
The original proposal defines a recommendation to include a “suggestion” that the investor engage in, or refrain from a particular course of action. Some commenters asserted that a “suggestion” wasn’t enough to be a recommendation. The DOL seemed receptive to narrowing that part of the definition as well. However, the DOL still intends to have a broad definition of fiduciary and advice. As a result, most common investment and insurance sales practices will become fiduciary advice under the new rules.
When an adviser becomes a fiduciary, the requirements are two-fold and listed in the DOL guidance as the “Best Interest” standard:
• The investment advice must be prudent, i.e., the adviser engage in a prudent process to develop the recommendation—the prudent man rule; and
• The adviser must put the interests of the investor (e.g., the plan, participants or IRA owners) ahead of his own—the duty of loyalty
In addition, the fiduciary rule and the exemptions all require that the expenses and compensation be within reason when comparing the services being rendered to the market costs for similar investments and services.
Fiduciary status has a few exceptions, two of which apply to the sales and advice process: the seller’s carve-out and the participant education carve-out.
The seller’s carve-out will permit non-fiduciary sales to plans where certain conditions are satisfied; the most important condition being that the adviser says that he is selling and not advising. However, the proposal limited this carve-out to sales to “large” plans (defined as a plan that has at least 100 participants). Commenters urged the DOL to extend that exception to small plans, but Department officials seemingly met their pleas with resistance. As a result, it is probable that sales to small plans and IRAs will still be considered fiduciary advice.
The proposed participant education carve-out permits advisers and providers to give investment education to participants—similar to what is now done under Interpretive Bulletin 96-1—but with one critical change: investment education can no longer specify the investments in an asset allocation. In other words, if the education indicated specific mutual funds in an asset allocation, that would be considered fiduciary investment advice. Many commenters—including both those who favored and objected to the overall fiduciary proposal—feared the change would be harmful to participants, because, in order to implement the education, participants would need to do more research and more than likely, would not put in that additional effort. Those commenters also pointed out there wasn’t a history of abuse in the use of asset allocation models and that, in any event, plan fiduciaries had already prudently selected those investments for the plan. As a result, the DOL is likely to permit the use of specific investments in asset allocation education for plans (but not for IRAs, where the investments had not been previously selected by fiduciaries).
Recipients of Fiduciary Recommendations
The fiduciary definition will apply to:
• Investment recommendations to plans.
• Investment recommendations to participants.
• Investment recommendations to IRA owners.
• Distribution recommendations to participants and IRA owners
While the first two recipients are consistent with current rules, the second two are major changes that will impact almost all advisers—even if they don’t work with retirement plans.
Prohibited Transactions and Exemptions
Where an adviser serves as a “pure” level fee adviser, fiduciary advice does not result in a prohibited transaction (with one exception, described below, for recommendations about distributions). A “pure” level fee is either 1) compensation that is a set fee (either a percent or a dollar amount) over all advised assets, or 2) compensation of the adviser, or an affiliate, that is not increased by the recommendations (e.g., a management fee for an affiliated mutual fund). For example, if an adviser charges 25 basis points (bps) to a 401(k) plan for advice about selection and monitoring of the plan’s mutual funds, that would be level fee. And, if neither the adviser nor any affiliates received any payments above and beyond that fee, that would be a pure level fee. In those cases, fiduciary investment advice to a plan, a participant or an IRA owner would not cause a prohibited transaction. Therefore, the adviser would not need a prohibited transaction exemption, which is, in effect, official permission to violate the prohibited transaction rules—if the conditions of the exemption are satisfied. Typically, those conditions are disclosure-based.
Now that we’ve covered prohibited transactions, let’s look at the proposed exemptions. There are two exemptions that cover common compensation arrangements in sales and recommendations to plans, participants and IRA owners:
• The Prohibited Transaction Exemption (PTE) 84-24 covers the sale of insurance products. The DOL is proposing to modify this existing exemption to add new conditions and to move the sales of variable annuity products to IRAs to the new BIC exemption.
• The Best Interest Contract Exemption, commonly called BICE or the BIC exemption, will cover the sales of most common investment products to plans and IRAs. PTE 84-24 has been in effect since 1984 and a number of insurance companies and broker-dealers have required their agents and advisers to use it when they sell insurance products to plans. However, with the proposed change to the definition of fiduciary, almost all sales of insurance products to plans and IRAs will be considered fiduciary advice. As a result, the exemption will be in common use. The good news is that, based on the experience of the insurance companies and broker-dealers who have been using the PTE, it appears the required disclosures have not been significant barriers to those sales. Even with the DOL’s proposed changes, that should still be the case.
While that applies to all insurance sales to plans and sales of traditional fixed annuities and fixed indexed annuities to IRAs, the DOL is proposing to treat individual variable annuity contracts as primarily being securities. As a result, the DOL proposal took recommendations of variable annuities to IRA owners out of PTE 84-24 and moved them to BICE, which has more stringent requirements.
Many industry commenters argued that the move was not appropriate because it would be confusing to retirees to have different types of disclosures for different annuity products. However, the DOL does not seem persuaded by that reasoning, and it is likely that sales of variable annuity contracts to IRAs will fall under BICE.
While the use of PTE 84-24 for recommendations of insurance products appears to be workable (with increased disclosures), the same cannot be said of the requirements of BICE. As proposed, that exemption will impose requirements that will be expensive to implement and could take years to develop. Those points were made clear to the DOL and it looks like they will be making significant changes to this exemption.
Before discussing some of the detailed provisions, though, it would be good to explain the structure of the exemption. The concept is that, with the right “controls,” the DOL could permit transactions where financial institutions (e.g., broker-dealers, insurance companies, mutual fund managers) could receive compensation for their services, even if those services and products were recommended by a fiduciary adviser who was supervised by, or affiliated with, said financial institution. But, the problem is, of course, what are the “right controls”? A partial list of proposed conditions includes:
• A tri-party contract between the adviser, the financial institution and the investor, signed before any advice is given. Hence, the name Best Interest Contract Exemption.
• Financial disclosures initially, and annually, in dollar amounts about costs and compensation.
• Warranties and policies about conflicts of interest.
• Control of the adviser’s compensation to mitigate conflicts of interest. Because of examples given by the DOL, many viewed this condition as requiring level compensation for advisers. While the DOL said that was not the purpose, it was difficult to see how commissions, bonuses, recognition awards, etc., could be managed so that they did not appear to incent the sales of certain products over others.
Industry representatives, and some supporters of the fiduciary proposal, commented that these conditions were too difficult and expensive to satisfy. Based on DOL questions and comments, it appears there will be significant changes to BICE. For example, it appears the contract will not need to be signed until after investments and services have been discussed, explained and recommended, so long as the contract relates back to the initial conversations. The DOL also seems to understand that it is too expensive to develop the systems to calculate and report dollar amount disclosures. Some commenters have suggested disclosures similar to the retirement plan disclosures under 408(b)(2) and the participant disclosures under 404a-5. While that is familiar territory for retirement plan advisers, it will be a significant change for IRA advisers.
The most difficult issue, though, is advisers’ compensation. The DOL seems committed to requiring that an adviser’s compensation be structured to “mitigate” any incentive to favor one type of investment over another. While that may seem plausible in theory, it is difficult to envision how that would work in the real world. As a result, unless the DOL’s final BIC exemption provides much greater flexibility for adviser compensation, some advisers and their supervisory entities (e.g., brokerdealers) may opt for leveling the adviser’s compensation as a percent of all assets or as a fixed dollar amount. While that is already happening in the 401(k) world—at least to a degree—it would be revolutionary in the IRA world (for other than pure level fee Registered Investment Advisors.
The last exemption issue is the “capturing” of rollovers. Under the fiduciary proposal, a recommendation to take a distribution from a plan or an IRA is a fiduciary act—and thus the recommendation must follow the prudent man rule and the duty of loyalty. Also, if the adviser will make more money in the IRA than from the plan (e.g., 25 bps in the plan and 100 bps in the IRA), the DOL would consider that to be a prohibited transaction. It appears that BICE applies to those prohibited transactions, but it is not clear—or, better put, BICE does not have a specific set of conditions for those recommendations and the other requirements of BICE don’t make sense in that context. As a result, it’s difficult to see a clear path for compliance for distribution recommendations until the final BICE is issued. But, all is not lost. The fiduciary proposal is clear that distribution education is not fiduciary advice. As a result, some advisers, broker-dealers and RIA firms have decided they will help participants understand their distribution options and the considerations for choosing among those options. The options are: leaving the money in the current plan, transferring to the plan of a new employer, taking a taxable distribution or rolling over into an IRA. While there are a number of issues for a participant to consider in making an informed decision, some of the most important include:
• Are the investments offered by the plan adequate for the participant’s needs, or would a broader range of investments better serve the participant?
• Are the services offered by the plan for investments and planning adequate for the participant or are more needed or appropriate?
• Is the cost of the investments and services in the plan lower than in the IRA and, if so, is the additional cost of the IRA justified by added value?
• Is the distribution flexibility in the plan adequate or is the flexibility of an IRA needed or desirable?
There is no doubt these changes will be highly disruptive. However, many advisers are already acting in the best interest of investors, with reasonable fees and well-thought-out investment strategies. The fiduciary definition, standing alone, should not have a significant impact on them. The same can’t be said about the prohibited transaction rules and exemptions though, especially regarding BICE. On a positive note, however, it appears the DOL has heard and understands the industry’s comments. Even there, though, it remains to be seen whether that understanding translates into workable conditions for the exemption. The DOL has indicated it wants the new requirements to work. Based on those indicators, the final issuance will be much more reasonable than the proposal, and with some changes to common practices—and particularly with increased disclosures—advisers will be able to continue to make sound investment recommendations
By Rebecca Moore email@example.com | December 10, 2015
Data from RFP assistance provider InHub reveals why plan sponsors search for new plan advisers, what they ask for, and mistakes advisers make in the RFP process.
Creating the first draft of a request for proposals (RFP) was voted the most difficult task in the RFP process by institutional investors who recently issued investment consultant RFPs, according to data from InHub, provider of an online RFP solution and guided process for the institutional investment community.
Data from 20 recent investment consultant RFPs issued directly by investment committees of defined benefit plans, defined contribution plans and foundations/endowments, found eight in 10 RFPs resulted in a new hire. Most RFP issuers indicated a potential replacement as a probable outcome prior to the RFP starting, for several reasons.
The No. 1 issue motivating an RFP was a reduction in proactive service or response rate (80%). Clients stated their advisers no longer initiated new ideas and had to be reminded of what used to be regularly scheduled services. For some, their advisers were no longer accessible, the client had to follow-up multiple times on meeting action items or the followup information was incorrect and unthoughtful. Some investment committees searched for a specialist due to a general feeling that they “could do better.”
Clients also had issues with adviser expertise; conversations with advisers may become generic and the client loses confidence in the adviser. They may discover opposing philosophies about plan design or investing, or the plan may have evolved to require more of a specialist adviser.
Other reasons for conducting an RFP for a new adviser could include changes to the plan or plan sponsor or changes to the adviser firm (75%), and the desire to benchmark for proper due diligence (5%).
The most popular adviser services requested by clients were in-person committee meetings (100%), ongoing plan benchmarking and vendor analysis (100%), and investment policy statement (IPS) review and implementation (100%). This was followed by a 3(21) fiduciary investment consultant contract in writing (more than 90%).
Forty percent of clients stated in the RFP that they want the adviser to perform a formal recordkeeper RFP immediately following selection of the adviser.
Clients asked for retirement plan participant education services too; one-fourth wanted the adviser to structure and track success of education leveraged from the plan provider, and one-half wanted the adviser in-person for participant education.
InHub says seven popular questions in more recent RFPs include:
Common mistakes advisers make when responding to an RFP include:
Dec 01, 2015 | By Nick Thornton
Louis Harvey has seen his share of really well-designed 401(k) plans.
He has great faith that the best advisors can drive savings outcomes for participants.
He’s also seen the flip side, and not infrequently. Since 1976, when he founded Dalbar Inc., an independent consultancy that evaluates the quality of 401(k) plans and plan advisors, among other things, Harvey has witnessed the inception of defined-contribution plans and all of their ensuing evolutions.
In today’s 401(k) marketplace, there is mixture of what he calls high-value and low-value advisors.
The best advisors often suffer a systemic disadvantage, he said.
“The problem is that high-value advisors are equated with low-value advisors,” Harvey said. “It is absolutely essential that advisors highlight and document the value they bring for sponsors and participants.”
Though that may seem a given, too often Harvey sees advisors going beyond the call of duty, unbeknownst to their sponsor clients.
“In most business structures the differentiation of quality of service is achieved through pricing differentials, but alas, most advisor compensation is not differentiated by the value they provide,” he said.
That has made for an “illogical” market. “If I offer the services of a fully responsible co-fiduciary, my compensation doesn’t change one iota from that advisor who is selling a sponsor on starting a plan,” he said.
That may change some day. In fact, Harvey said he already sees indications that the future holds pricing advantages for the most proactive advisors. Until it does, there’s more evidence showing sponsors are becoming more attuned to the question of advisors’ value.
Newly released data from InHub, an online RFP platform that was founded in 2014 by two former plan advisors, shows that eight in 10 requests for proposals resulted in a new advisor hire.
And it is not just sponsors of large plans that are leading a prospective turnover trend. Plans with as little as $1 million in assets were part of the survey; the median plan size was $35 million.
Sponsors said a reduction in “proactive” services and response rates, as well as the need for greater plan expertise, were the reasons driving new RFPs.
When Harvey and his team set out to take the measure of an advisor for sponsor clients, they of course take into account the type of advisor in question, whether they are simply “salespeople” working under the moniker of an advisor or offer the range of fiduciary support available from 3(16), 3(21) or 3(38) advisors.
He has some advice for plan specialists selling their range of support: Keep it simple when explaining what you can do for plan sponsors.
“It is hard for a sponsor to know all that an advisor may be capable of doing if they don’t fully understand what you are,” Harvey said. “There has been a failure in the industry, an unwillingness to express the different concepts of fiduciary care in terms that employers can easily grasp and follow.”
Presuming all sponsors “speak ERISA” does a lot of advisors in, Harvey says.
Even a term like “co-fiduciary”—staple language in the advisor community—is too vague and often leaves sponsors scratching their head.
“Advisors must begin to recast the definition of what they do in terms of a business proposition,” Harvey said. “Their sponsor prospects are business leaders — they don’t have time to be investment or ERISA experts.”
Does a sponsor want the responsibility of choosing investments for a plan? That’s a simple question that needs to elicit a clear response, Harvey says.
“The key is clarity — I have the skills to guide your employees into better investments so you don’t have to, and I will share in those risks with you. That is unambiguous language an employer will understand, and connect with. Now you are communicating,” Harvey explained.
“On the other hand, if as an advisor I go into a meeting and say I’m a 3(21) fiduciary and I’m going to charge you 53 basis points for that — clearly a lot of employers are not prepared to begin to understand that,” he said.
Too often, advisors’ compliance departments restrict the language they can use. That’s helped perpetuate a culture of advisors that try to teach ERISA, a tactic Harvey says has proven to be an “abject failure.”
The law actually allows for much more discretion in how advisors communicate compliance issues than most are willing to use, he says.
Leading advisors are using that discretion. What else are they doing? Of the thousands of plans he has seen, the best are focused on contribution levels. Size doesn’t matter, says Harvey, as he sees many small plans succeeding on overall contribution rates.
“The best plans are designed on the realization that when left to their own devices, participants won’t save enough,” said Harvey.
Convincing business owners of that is clearly a challenge in a world where they have little incentive to sponsor a plan, as Harvey sees it.
But his experience proves it is doable. “The best advisors are continuously improving the standard of care they deliver for participants,” he said. “And they’re supporting sponsors with services that relieve them of the burdens of sponsoring a plan.”
Rule will drive RIA demand, but won’t slow rollovers to IRAs
Dec 22, 2015 | By Nick Thornton
The Department of Labor’s proposed fiduciary rule will make thousands of non-registered defined contribution plan advisors fiduciaries “over night,” say analysts at Cerulli Associates.
But if the finalized version of the complex rule resembles its proposed form, it is not expected to stem the tide of 401(k) rollovers to IRAs in the coming years, claim the analysts.
When the DOL unveiled its proposal last April, it built its case for the new rule’s necessity largely on the argument that IRA owners often receive conflicted advice, amounting to billion is losses to savers a year.
The more than $2 trillion expected to rollover from 401(k) plans in the coming years underscores the need for a uniform fiduciary standard for all advisors, argue proponents of the DOL’s proposal.
The DOL fiduciary rule survived the omnibus spending bill--there is no rider to defund the new rule, no alternative legislation...
As is, 45 percent of retirement plans specialists do not operate as a fiduciary to plans.
That will change, says Cerulli.
Fiduciary services as defined in the Employee Retirement Income Security Act “will become a pivotal offering necessary to remain relevant in the defined contribution market,” according to a new study of the DOL’s rule’s consequence on retirement provider and investor markets.
Cerulli’s data shows that 37 percent plan specialists operate as 3(21) fiduciaries, which means they advise plan sponsors but do not have full discretion over how plan assets are invested.
And 13 percent now serve as 3(38) fiduciaries, meaning they assume full discretion and responsibility for investing plan assets, leaving sponsors with the fiduciary responsibility to monitor the services provided.
Only 5 percent serve as 3(16) fiduciaries, which means they supply full plan administration services along with discretion over plan investments.
Demand for all three will clearly rise if the DOL’s rule is finalized, turning many plan advisors into fiduciaries “overnight,” and likely forcing many of those advisors with limited defined contribution business out of the market.
While complying with the rule’s new prohibited transaction exemptions will carry “monetary and personal costs” for advisors and firms, the rule is not expected to slow 401(k) rollovers, contrary to some speculation, says Cerulli.
One reason is that many large broker dealers have already begun transitioning from commission-based compensation models to fee-based models.
Broker-dealer firms of scale will continue to operate in the IRA market with “relatively little disruption,” Cerulli’s report says.
Furthermore, comprehensive drawdown strategies are not standard in 401(k) plans, leaving retiring workers with little choice but the roll assets into an IRA.
“The current inflexibility regarding withdrawals in some DC plans for retired participants is one more reason Cerulli is optimistic about future rollover activity,” said Bing Waldert, a director at Cerulli, in a statement.
Cerulli’s report suggests that absence of retirement income options like annuities in 401(k) plans will also encourage retirees to rollover assets into 401(k) plans, regardless of the regulatory environment.
Only one-fifth of large 401(k) pans offer retirement income solutions, according to Cerulli.
“While interest and willingness to discuss in-plan retirement income products are growing, obstacles remain to more widespread adoption,” says Cerulli.
By Paula Aven
December 17, 2015
A very limited number of registered investment advisers work with defined contribution plans, according to a survey of plan sponsors by TD Ameritrade, only about 5%. That number makes sense if you look at the retirement plan marketplace going back seven to 10 years, says John Newman, managing director of retirement plan services for TD Ameritrade Institutional in Denver, because the small-plan market, plans with up to $10 million in assets, has been dominated by investment product providers like insurance companies, mutual fund companies and broker dealers.
“Those are entities that have large sales forces and they have a top-down distribution method where many of those proprietary product solutions are being pushed through large sales teams,” Newman says. “Independent RIAs are not part of that structure so they have not taken to the marketplace in the same numbers as non-independent advisers affiliated with investment products.”
That is slowly changing because of fee disclosure rules that came out in February 2012, with more emphasis on plan sponsors and the overall cost of retirement plans, including the cost of investments, he adds.
“Fee disclosure put fee-based RIAs on more of an equal footing – an RIA-provided solution vs. a mutual fund or insurance company relying on investment products to pay for the cost of the plan,” Newman says.
In its survey of plan sponsors, TD Ameritrade found that only 28% of plan sponsors use RIAs.
So why would plan sponsors want to work with an RIA?
The main reason is that RIAs use open investment architecture solutions from which they can create investment plan menus. These platforms don’t have ties to proprietary products. They find the best performing and best compilation of investment options for a menu or can work to make the lowest cost investment menu available.
The second reason plan sponsors may find the RIA model attractive is that plan sponsors have to live up to their ERISA fiduciary responsibilities, which can be a real challenge, especially for smaller plan sponsors.
“It makes sense to have a partner with you as a service provider that is holding themselves out as an ERISA fiduciary provider. That message resonates with advisers,” Newman says.
TD Ameritrade has found in numerous studies that plan sponsors don’t work with RIAs because they are not aware of the fiduciary RIA model that is available to them.
“One of the takeaways for advisers is to do a better job of marketing themselves to the general plan sponsor marketplace so they are more aware of what that service offering is,” he says.
Also see: “Do 401(k) plans need fixing?”
“It is an emerging trend. More plans are working with fee-based advisers who use a fiduciary model. With the way fee disclosure regulations evolved and the ERISA fiduciary regulations are expected to evolve over the next year and with the continued growth of the size of 401(k) plans in total and individual account balances, we will see that gain steam as we go forward,” he believes.
As plans move up into the $5 million to $10 million asset arena, they can save money by working on the cost of their investment menu.
“Plan sponsors view the cost of the plan as the fees they are paying to service providers and are viewing that as separate and distinct from the cost of the investment options offered to plan participants,” says Newman. “They are intertwined. Investment options are 90% of all expenses of the plan. Advisers succeed when they are able to get a plan sponsor to look at the overall cost of the plan, including the cost of investment options. They can use open architecture to drive the cost of those investment options down.”
Working with RIAs also allows plan sponsors to include exchange-traded funds within their plans, since these are more available through open architecture plans.
It has only been in the past few years that ETFs were available as part of a plan’s core investment menu, he says.
TD Ameritrade has been offering ETFs to its retirement plan clients for four years. The reason it has taken so long to adopt ETFs in the 401(k) market is that it took time for providers to figure out how to work ETFs into the operational structure of their retirement plans. There has been incredible growth in plans using ETFs in their menus, Newman says.
Also see: “Are all-ETF 401(k)s primed for a surge?”
Plan sponsors say performance reporting, participant advice and fiduciary education are the most valuable support services, according to the TD Ameritrade survey, and two-in-five say their participants want more one-on-one advice.
RIAs provide one-on-one participant advice, fiduciary support and plan sponsor education at nearly twice the rate of other types of advisers, the survey found.