On April 6, 2016, the Department of Labor (“DOL”) published its final version of the Fiduciary Rule. Although the rule did not match the length of the landmark novel, War and Peace, it came close at 1,028 pages. Depending upon the translation, War and Peace ranges from l,156 to 1,455 pages. The final rule reflects the DOL’s thoughtful consideration of thousands of comments regarding the proposed rule.
In this publication, RIA Compliance Group, LLC, will attempt to summarize key changes brought about by the new rule and the impact it will have on Registered Investment Advisers (“RIAs”), financial institutions, registered representatives, and insurance agents.
Time is on your side
The final version of the Fiduciary Rule extended the initial implementation period from eight months to one year from its publication date in the Federal Register. Thanks to the phased implementation approach, firms will have until January 1, 2018 to comply with the Best Interest Contract Exemption (“BICE”) and to implement the detailed policies and procedures that are required.
Definition of Fiduciary Advice
The Fiduciary Rule applies to persons providing advice to retirement investors. Those persons must be providing recommendations dealing with the purchasing, holding, disposing or exchanging of securities or property. In many cases, the recipients of that investment advice are considering a rollover of a retirement plan distribution into an IRA.
The DOL’s definition of fiduciary advice does not encompass parties engaged in order-taking where there are no recommendations involved. The definition also excludes education provided to plans, plan participants, and IRA owners. Therefore, plan sponsors may continue to offer general financial, investment, or retirement information without triggering fiduciary obligations. The educational activities must not reference specific investment products.
In addition, the definition does not include situations where an adviser is offering products to large plan fiduciaries with more than one hundred participants. The large plan fiduciary must acknowledge in writing that the adviser is not acting as a fiduciary, and additional disclosures are required.
In general, the definition of fiduciary advice also excludes communications involving:
- Platform providers such as third-party administrators and record-keepers;
- Actions and communications with ERISA-covered employee benefit plans pertaining to swap or security-based swap transactions; and
- Employees of plan sponsors and their affiliates, employee benefit plans, and employee groups.
Fiduciary advice does not include those communications where an adviser is courting prospective clients, the so-called “hire me” conversations. Advisers are not operating as fiduciaries when they encourage a prospect to hire them. Otherwise, an adviser would need to have every prospect sign a Best Interest Contract before initiating a discussion.
Best Interest Contract Exemption (“BICE”)
The BICE is a new prohibited transaction exemption, which is intended to align the interests of the customer with those of the fiduciary adviser. Whereas the proposed Fiduciary Rule specified which investments were permitted, the final rule did not impose asset class restrictions.
The BICE requires the adviser to:
- Act in the best interest of the client;
- Adopt policies and procedures to prevent conflicts of interest; and
- Disclose any conflicts of interest that might impact their judgment.
The Final Rule does not prevent advisers from receiving commissions, 12b-1 fees, and revenue sharing payments. Nevertheless, there must be full compliance with the conditions set forth in the exemption.
The BICE requires that the firm and the adviser acknowledge their fiduciary status and that they comply with basic standards of impartial conduct such as:
- Offering prudent advice focused on the customer’s best interest;
- Refraining from misleading statements; and
- Ensuring that compensation is reasonable.
Policies and procedures must be designed and implemented in an effort to mitigate the harmful results brought about by conflicts of interest. Conflicts of interest, as well as the cost of the advice, must be fully disclosed. The final rule reduced the number of disclosures and eliminated the one-year, five-year, and ten-year projections of fees and returns requirement.
The BICE contractually obligates the firm and the adviser to give advice in the client’s best interest. It stipulates that the firm has adopted policies and procedures designed to mitigate conflicts of interest and to disclose hidden fees.
Advisers do not need to have existing customers sign a Best Interest Contract. Those customers are grandfathered unless the adviser makes a new recommendation that would trigger a new commission. Existing customers can be notified of any changes using traditional mailing methods or e-mail.
The BICE enables customers to take legal action against fiduciary advisers if the advice given is not in their best interest. Furthermore, although the Best Interest Contract may require advice recipients to go to arbitration, they retain the right to pursue a class action lawsuit against a financial institution that is not honoring its fiduciary obligations.
Principal Transaction Exemption
In addition to the BICE, the final version of the Fiduciary Rule contains a Principal Transaction Exemption. Fiduciary advisers may recommend and sell investments from their inventory. To utilize the exemption, fiduciary advisers must abide by impartial conduct standards including taking action in the customer’s best interest. They must avoid misleading statements and seek best execution.
Impact on RIAs
There had been concern that the Fiduciary Rule might adversely affect RIAs that charge a level fee to provide advice to clients regarding IRA rollovers from 401(k)s and other employer-sponsored retirement accounts. Level-fee fiduciaries receive the same compensation regardless of the client’s choice of investments. They are not compensated based on commissions or transaction fees. Although firms need not have clients execute a Best Interest Contract, they still need to retain documentation to prove the rollover is in the client’s best interest.
An RIA whose compensation does not vary based on the investments utilized must still conduct a detailed analysis of whether a rollover is in the client’s best interest. This analysis should analyze whether the client has better options available, such as remaining in his/her 401(k) retirement plan. The adviser should compare the services, fees, and investment alternatives associated with each scenario. The DOL did not mandate any particular format or method for creating and retaining documentation. Firms should consider developing a checklist for proving that they compared all of the pertinent factors and acted in the client’s best interest.
Impact on brokers and persons selling insurance
As a result of the new rule, registered representatives who are paid commissions and other compensation will need to have their clients sign Best Interest Contracts before they recommend rolling over funds.
As noted above, the final rule eliminated the list of approved investment products for retirement accounts. Therefore, a fiduciary adviser may recommend a wide variety of investments, provided there is justification for doing so. This opens the door for registered representatives to sell investments such as non-traded REITs, which were not on the approved list in the proposed rule. In addition, the Fiduciary Rule does not bar the use of proprietary products.
The BICE requirement will also apply to insurance agents who are paid commissions and other compensation that varies with the investments suggested. The Department of Labor is finalizing an amendment to PTE 84-24, an existing exemption which provides relief for insurance agents and brokers, as well as insurance companies. Prior to the new rule, variable and fixed-indexed annuities qualified for this exemption. Now neither product qualifies for the exemption. It had been expected that fixed-indexed annuities would remain entitled to the favorable exemption as was the case under the proposed rule. Variable and fixed indexed annuities may be recommended if there is compliance with the BICE. On the bright side, the revised PTE 84-24 facilitates access by plans and IRAs to fixed rate annuity contracts.
The best or worst may be yet to come
Although the Fiduciary Rule has finally come to pass, it will still be challenged in the courtroom and in Congress. Furthermore, the SEC may adopt its own fiduciary rule. In addition, valuation and appraisal requirements were not addressed in the new rule, and those issues will be covered in separate rulemaking. Please be assured that RIA Compliance Group, LLC, will continue to keep clients informed about new developments related to the Fiduciary Rule.
Compliance may not be the only impact that the Fiduciary Rule has on RIAs. It will be harder for fee-only advisers to differentiate themselves from brokers offering advice on rollovers from 401(k)s and other employer-sponsored retirement plans.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Boca Raton, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 5301 North Federal Highway, Suite 380, Boca Raton, FL 33487 – Tel: 561-600-0564 – firstname.lastname@example.org.