What Advisors Need to Know About the New Fiduciary Rule

By Jeffrey Levine, Director of Retirement Education
Follow Me on Twitter: @theslottreport

Section 4975 of the Tax Code, Tax on Prohibited Transactions, outlines various transactions that may not be engaged in with respect to certain tax-favored accounts, including IRAs, qualified plans and even health savings accounts (HSAs). Specifically, section 4975(c)(1)(E) prevents a fiduciary from dealing with the income or assets of a plan or IRA in his own interest or his own account. Similarly, 4975(c)(1)(F) prohibits a fiduciary from receiving any consideration for his own account from any party dealing with the plan or IRA in connection with a transaction involving assets of the plan or IRA. Together, these two sections place stringent compensation restrictions on anyone deemed to be a fiduciary.

Prior to the Department of Labor’s new Fiduciary Rule, however, many financial professionals were not considered fiduciaries with respect to the accounts that they served. Thus, 4975(c)(1)(E) and 4975(c)(1)(F), which both specifically reference fiduciaries, failed to apply in many instances. As a result, certain revenue-generating transactions that would be impermissible if an advisor was classified as a fiduciary were often acceptable under the “old” rules. With the introduction of the new Fiduciary Rule, however, that changes. Now, far more financial professionals will be considered fiduciaries with respect to clients’ IRAs, making far more revenue-generating transactions prohibited transactions… unless, of course, there was some magic-like way that advisors could engage in prohibited transactions without incurring any penalties.

Well, believe it or not, there is! Under section 4975(c)(2) of the Tax Code, the Secretary of the Treasury (read “IRS”) is given the power to grant exemptions from prohibited transactions defined under the Tax Code that mirror those defined under ERISA. However, in order to streamline and unify the exemptions for both the Tax Code and ERISA, the authority to grant exemptions for both was given to the Secretary of Labor (read “the Department of Labor”).

For years, the Department of Labor (DOL) issued exemptions that were extraordinarily narrow in scope and very much transaction-based. In a complete reversal, however, on the same day as it unveiled its new Fiduciary Rule, the DOL also unveiled a 300+ page document that introduced a new, broad, principal-based prohibited transaction exemption, known as the Best Interest Contract Exemption.

The Best Interest Contract Exemption
In general, the Best Interest Contract Exemption, or BICE for short, was created to continue to allow financial professionals to receive compensation that would otherwise be considered a prohibited transaction under the new Fiduciary Rule, provided that they meet certain guidelines. Without a doubt, the most important such guideline is that in order to qualify for the exemption, an advisor must commit to acting as a fiduciary and to act in the best interest of his or her clients.

As noted above, in the past, the DOL has generally created exemptions for prohibited transactions with a very narrow focus. In contrast, the BICE was intentionally created to be extremely broad and covers just about all the current standard compensation models and industry practices. Provided advisors “adhere to basic fiduciary standards aimed at ensuring their advice is in the best interest of their customers and take certain steps to minimize the impact of conflicts of interest” they may receive various types of compensation that could otherwise be considered a prohibited transaction.

Acknowledgement of Fiduciary Status Under the Best Interest Contract Exemption
One of the most critical elements of the BICE is that in order to qualify for the exemption, financial institutions must acknowledge their fiduciary status, as well as that of their advisors, in writing. Furthermore, and perhaps of even greater importance is that the fact that the BICE is not available if a financial institution includes a contractual provision that prohibits a client from seeking compensatory remedies or diminishing their rights to pursue class action litigation in court. Thus, although the BICE may, itself, be buried in account-opening documentation and essentially “hidden” from investors in a mountain of paperwork, the above requirements essentially guarantee that none of that paperwork will include legalese that reduces a client’s ability to seek to recover damages from advice that was not in their best interest. And while investors, themselves, may not ever be aware of this (even though they should), you can be sure that those that represent such investors will, and there’s a good chance they are licking their lips right about now.

That said, the Best Interest Contract Exemption does give financial institutions some protection as well. For one, although the institution cannot limit a client’s ability to seek compensatory remedies, they can limit an investor’s ability to seek punitive (“punishment”) damages. According to the DOL, as long as an investor has a non-forfeitable right to be “made whole,” institutions should be sufficiently motivated to ensure compliance with the Best Interest Contract Exemption’s provisions. In another “win” for financial institutions, the BICE also grants institutions the ability to require clients to agree to arbitration for individual claims.

Impartial Conduct Standards Under the Best Interest Contract Exemption
Under the terms of the BICE, advisors must also adhere to “Impartial Conduct Standards.” There are several key aspects of these standards, including a requirement that advisors only give advice which is in the best interest of a retirement investor. It would certainly seem hard to argue against that! On a related note, advisors must also avoid making misleading statements about investments, compensation or conflicts of interest.

Another aspect of the Impartial Conduct Standards is that it requires compensation be no more than reasonable. Unfortunately, the BICE does not specifically define what “reasonable compensation” is, which leaves at least one very important subject open to interpretation.

Interestingly, this aspect of the BICE may spur more advisors to further their education by seeking advanced certifications, degrees, licenses and or associations with education-based groups and organizations. For example, a person could, and in most cases, should be expected to pay more for advice coming from a CPA and/or CFP® who regularly participates in advanced study groups and/or is an active member of education-based organizations when compared with another advisor who holds no similar designations and does not invest time and/or money in his or her education. Of course, these are far from the only factors that will determine whether compensation is reasonable but there should be little doubt that advisors with a higher level of knowledge and who offer premium advice should be able to charge a relative premium for their services.

The reasonableness of compensation may also be tied to the type of investment a client utilizes within their planning. For instance, in response to some inquiries from insurance carriers during the 2015 comment period on the proposed rule, the DOL makes it clear in the BICE that, “In the case of a charge for an annuity or insurance contract that covers both the provision of services and the purchase of the guarantees and financial benefits provided under the contract, it is appropriate to consider the value of the guarantees and benefits in assessing the reasonableness of the arrangement, as well as the value of the services.”

Numerous other requirements must also be met to ensure compliance with the BICE, including:

• Firms must fairly disclose fees, compensation and material conflicts of interest associated with their recommendations
• Firms can’t incentivize their advisors to act contrary to their clients’ interests (it’s a sad state that such a requirement is necessary)
• Firms must implement policies and procedures to prevent violations of the Impartial Conduct Standards

Who is Subject to the New Fiduciary Rule?
Once the new Fiduciary Rule is in effect, many advisors who, previously, were not subject to fiduciary standards, will find themselves subject to these higher requirements. In order to determine to what extent you will be impacted by the rule, you can ask yourself the following three questions:

1. Are you making a “recommendation?” A recommendation includes advice relating to the advisability of acquiring, holding, disposing of, or exchanging investments, as well as advice related to rollovers (discussed in greater depth below).

2. Will you receive any fee or other compensation, whether directly or indirectly?

3. Is your advice being given to a “Retirement Investor?” According to the Fiduciary Rule, “Retirement Investors include plan participants and beneficiaries, IRA owners, and ‘retail’ fiduciaries of plans or IRAs (generally persons who hold or manage less than $50 million in assets, and are not banks, insurance carriers, registered investment advisers or broker dealers), including small plan sponsors.”

If the answer to ALL three of the above questions is “yes,” then unless you are specifically exempt from fiduciary status, you will be subject to the new rules.

Rollovers ARE Advice – A Key Change for Advisors
Perhaps the most significant change for advisors under the new rules, outside of their newfound (in many cases, at least) “fiduciary” status, is that the fiduciary requirements extend beyond just investment recommendations. In addition to recommendations made to clients to buy, hold, sell, exchange or manage an investment – which would obviously fall under the new Fiduciary Rule – recommendations related to the rollover process, itself, are also covered under the rule. In other words, if an advisor suggests to a client that they rollover their 401(k) into an IRA and purchase “X” investment, there are two recommendations there which would be subject to fiduciary standards. The recommendation to purchase investment X would have to meet those standards but, so would the actual recommendation to complete a rollover in the first place.

Per the final Fiduciary Rule, “recommendations with respect to rollovers, distribution, or transfers from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer or distribution should be made” will be subject to fiduciary standards.

This additional requirement places a new burden on advisors, but certainly not one that is unfair. Advisors of all types will now have to increase their knowledge of the benefits and drawbacks of various rollover options. Even a hypothetical infallible investment guru, who never makes even a single investment mistake, will need to make sure that he/she is properly evaluating the merits of a rollover in order to avoid potential regulatory issues.

Unfortunately, acting as a fiduciary and evaluating which rollover option is in a client’s best interest is no easy task. For starters, when a client retires or otherwise has access to plan funds, they may have as many as six potential “rollover” options. They are:

• Leave the funds in their existing employer plan
• Move the funds to a new/alternate employer plan
• Roll the funds over to an IRA
• Convert the funds to a Roth IRA
• Complete an in-plan Roth conversion (a.k.a. in-plan Roth rollover)
• Take a lump-sum distribution

You can download this free white paper on the 6 options available for a distribution from a company retirement plan.

Further complicating matters is the fact that there is no one-size-fits all template that can be used to determine which option is best for a client. Each client – and in fact, each client’s retirement plan – must be evaluated individually, based on its own merit. And there is no shortage of variables to consider either. For instance, in recommending a rollover (or a “don’t rollover”) or distribution, an advisor should, among other factors, consider impacts relating to:

• Fees
• Available investments
• Services provided
• The 10% early distribution penalty
• Creditor protection
• Simplicity/convenience
• Required minimum distributions
• Estate planning

Who and What is Not Subject to the New Fiduciary Rule
While the new Fiduciary Rule is extremely broad and will subject many advisors to fiduciary standards on a wide range of recommendations, there will still be many situations where advisors will not be subject to such standards.

For instance, as noted above, the Fiduciary Rule only applies to Retirement Investors. Thus, if an advisor is working with a client with regard to a non-retirement account (other than Health Savings Accounts, Medical Savings Accounts and Coverdell Savings Accounts – which are subject to the same prohibited transaction rules as IRAs under the Tax Code), they will not be subject to the Fiduciary Rule. Note however, that, depending upon an advisor’s business model, they may still be subject to fiduciary status for other purposes (i.e., under the Investment Advisers Act of 1940).

This will, in many cases, create some odd dichotomies. For instance, the same advisor may use the same investment with the same client, but in two separate accounts; one an IRA and the other a non-qualified account. In many situations, the investment recommendation made with respect to an IRA would be subject to fiduciary standards, whereas the same recommendation could be subject to the less onerous suitability standard. Bizarrely enough, it’s conceivable that, at some point in the future, we could see arbitration proceedings where an advisor gets the stamp of approval for use of an investment within one account, while at the same time finding themselves subject to damages and/or other penalties for using the same investment in a different account.

The Fiduciary Rule will also fail to apply in circumstances where communication is not deemed to be a recommendation. Such circumstances include the following:

• Generic “hire me”-esque messages
• General information communicated to wide audiences, such as newsletters, talk shows and speeches.
• Interactive investment materials, such as worksheets
• Certain generic asset allocation models
• General information about a plan’s options

Note the extensive use words like “generic” and “general” in the items above. It’s important for advisors to understand that the more specific the information they provide, the greater the likelihood that the communication may be considered a recommendation, thus falling subject to the Fiduciary Rule.

Final Thoughts
By many accounts, including our own, the final Fiduciary Rule strikes a well-selected balance between protecting investors’ retirement savings and making sure that compliance costs and administration aren’t overly burdensome. That said, most advisors will have to make at least some subtle, but meaningful changes in response to the Department of Labor’s rule. Those that adapt the quickest, and invest in their education and in their businesses, are poised to reap the greatest rewards as throngs of Baby Boomers continue to retire each day. Those that don’t might want to think about just retiring, themselves.