Is Your Compensation Reasonable Under DOL Rules? Take the 3-Prong TEST!

By Kim O'Brien InsuranceNewsNet

Commentary

Reasonable compensation is a vague and undefined standard, but the DOL has held ERISA plan fiduciaries to this standard for many years, which gives precedence to its application.

A recent court case awarded the plaintiffs (who were employees of the plan) $7.5 million on an excessive fee claim. At issue is 17 mutual funds that were chosen as investment options for the Southern California Edison Company 401(k) plan in March 1999.

For each of those funds, the Edison plan fiduciaries initially selected the retail shares instead of the institutional shares, or failed to switch to institutional share classes once one became available. Here the plaintiffs contend that the fiduciary defendants breached their duty of prudence by not switching the retail shares of the 17 funds at issue to institutional shares.

What this means for IRA rollovers under the DOL Fiduciary Rule and adherence to the Impartial Conduct Standards is that “Reasonable Compensation” will be under heightened and severe scrutiny. At Americans for Annuity Protection (AAP), we believe reasonableness of compensation will be measured using three tests.

TEST ONE: The Marketplace

Reasonable compensation has traditionally been interpreted and applied by the DOL as a standard that is tested against market-based benchmarks, which typically means what is “usual and customary” in the marketplace.

Compliance with this standard will be determined based on whether your compensation is in line with amounts being received by others in the market making recommendations of similar products, as well as the services, rights, and benefits you and your firm provide to your clients.

INTERPRETATION: If the compensation you receive is within the average paid for similar product types (FIAs versus FAs) and product classes (10-year versus 7-year), it is likely to be considered by most standards and precedents as reasonable.

The reasonable compensation standard does not dictate or prescribe any specific amount of compensation you and your firm can receive, which is where AAP sees the biggest liability under the Rule.

You can bet lawyers will be targeting the most significant outliers (compensation that is far out of line with the market). The reasonableness of your compensation will depend on the facts and circumstances at the time of the recommendation.

Typically, compensation that pays less than 1 percent annually for each year of surrender is within most market-based benchmarks for similar products (fixed indexed and fixed rate with similar surrender periods). Also, less than 1 percent is likely to be reasonable compared to investment management and 401(k) fees.

You should review the compensation you are paid on the products you are authorized to recommend and identify products whose compensation is outside what is average for the market of similar product types and surrender periods.

Recommendations of these products will be subject to higher scrutiny and require detailed justification and documentation that they were the product that best met your client’s objectives, needs, time horizon and risk tolerance compared to other similar products available to you.

In addition, recommendations outside the average or higher than street (what others receive) will require neutral factors (discussed below).

TEST 2: Differentials in Compensation

Reasonable compensation is not the only compensation consideration of impartial conduct standards. If compensation differs among products of the same type and surrender period and you make a recommendation with a higher compensation, that differential must be justified by “neutral factors.”

Or, if you are receiving compensation higher than others who sell that product, the “above street” differential must be justified by “neutral factors.”

Neutral factors can include:

1. The additional services you provide;
2. The time it took you to thoroughly assess and analyze product options against customer preferences;
3. Product benefits like company strength and rating;
4. Product features that best address your customer’s needs; and,
5. Your unique experience, skills and knowledge.

Providing more than one product for consideration and documenting how you and your client arrived at the final product(s) selection will be critical to defending a best-interest recommendation and justifying differential compensation.

TEST THREE: Conflicts of Interest Disclosure

The writing agent making the recommendation and receiving compensation must disclose his/her total compensation for that sale. If some compensation is paid to the writing agent and additional compensation to the firm and the writing agent has financial interest in the firm, AAP believes you are best protected to disclose that relationship and financial interest.

For example: If you get 7 percent and your firm gets 2 percent, we believe the disclosure specifies that the Advisor receives 7 percent and separately discloses that the firm receives additional compensation to cover the firm’s distribution, training and administration costs. Find a disclosure with a strong and compliant disclaimer.

A compliant disclosure will:

1. Identify the product name, type and surrender period.
2. The company issuing the recommended product.
3. A description of the total compensation received for the sale in dollars or percentages.
4. Other general compensation information and/or conflicts of interest.
5. A statement about the Advisor’s relationship with the issuing company.
6. Client signature and Advisor warranty that Disclosure was provided.

But remember, disclosure alone is not enough. A transaction that is found to be “prohibited” because the impartial conduct could not be demonstrated with strong documentation and client engagement/approval, at best will result in return of premium and commission payback.

At worst, it could mean the sale is nullified and deemed prohibited, causing the IRS to apply an excise tax on the amount of the prohibited transaction of up to 100 percent of the premium.

Make sure that along with your disclosure you:

1. Document the process of client assessment and product solution analysis
2. Record the client’s agreement with assessment and the recommendation
3. Validate reasonability of compensation and justify any differential
4. Retain all records in a cyber-secure system

Agents who use a system that allows them to document, record and retain, will be best positioned to meet and, if necessary, defend that they complied with Impartial Conduct Standards under the Rule.

Readers interested in learning more and identifying compliant disclosure documents and documentation systems can contact AAP through our website at www.aapnow.com, or email Kim O’Brien.

Kim O’Brien is a 35-year veteran of the insurance industry specializing in guaranteed annuities and life insurance. She is the current CEO of Americans for Annuity Protection and Founder of AssessBEST, Inc., a sales and compliance software system. Visit www.AAPnow.com or www.AssessBEST.com for more information.

This article is provided for educational and informative purposes only and not for the purpose of providing legal advice. Readers should consult with their own legal and compliance counsels to obtain guidance and direction with respect to any issue or question. Contact Kim at [email protected].