When the Department of Labor crafted its investment advice rule, everyone knew the types of questionable sales practices it had in mind.
But its biggest impact might come on simple rollovers, the kind of transactions that had not been considered fiduciary advice in the past. Several legal analysts are warning advisors to be careful about these transactions in 2022.
“Many may be surprised to learn that this ruling impacts all wealth managers who recommend rollovers, even if the advisors had no advisory relationship with a plan itself,” wrote Kim Shaw Elliott, a partner with The Wagner Law Group, in a client alert.
“This is a major departure from past practice, since historically advice to roll assets out of a Title I Plan, even when combined with a recommendation as to how the distribution should be invested, did not constitute investment advice,” she noted.
The rule was authored during the Trump administration, but the Biden administration allowed the investment advice rule to take effect Feb. 16.
It replaces the Obama administration fiduciary rule, which imposed substantial regulations on commission-based sales of annuities. A federal appeals court sided with industry plaintiffs and tossed out the rule in 2018.
The investment advice rule has two main parts: new Prohibited Transaction Exemption 2020-02, allowing advisors to provide conflicted advice for commissions, and a reinstatement of the "five-part test" from 1975, to determine what constitutes investment advice.
It came with a compliance date of Dec. 20, but the DOL is giving advisors a six-week pause, until Jan. 31, 2022.
The penalties for running afoul of the new advice rules are significant, Shaw Elliott noted.
“Advisors who engage in prohibited transactions can be punished severely, including a whopping excise tax of up to 100% of the amount involved, compounded over time,” she wrote.
“The IRS might disqualify the IRA, resulting in the entire value of the IRA being included in the income of the IRA owner in the year of the breach.”
So how did we get here? Let’s back up and review the law.
Long-standing Employee Retirement Income Security Act law forbids an investment advisor from receiving additional compensation as a result of a recommendation to a plan or plan participant unless an exemption is available, Shaw Elliott explained. Under the new interpretation, the rollover advice itself likely is conflicted.
“This is true even if the adviser goes from receiving no compensation when the recommendation is made to any compensation in the future from the IRA,” she wrote. “The advice is considered fiduciary investment advice because it is necessarily a recommendation to liquidate or transfer the plan’s property interest in the affected assets and the participant’s property interest in plan investments.”
More transactions than what are traditionally thought to be rollovers are considered. The investment advice rule prohibiting transaction exemption defines a rollover to cover five different transactions:
» ERISA-covered plan to an IRA.
» ERISA-covered plan to another ERISA-covered plan.
» IRA to an ERISA-covered plan.
» IRA to another IRA to the extent permissible under the Code (including an individual retirement account, Health Spending Account, Archer Medical Savings Account, Coverdell Education Savings Account), to the extent permissible under the code.
» Different account type, such as converting from a brokerage account to an advisory relationship or from a commission-based account to a fee-based account.
The new rule does not mean that IRAs have now become ERISA plans, Shaw Elliott emphasized. The new guidance confirms that the DOL has authority to conclude what is “investment advice” for either type of retirement program so that it can properly evaluate whether a prohibited transaction has occurred. The IRS, however, remains the sole enforcer of the tax rules that affect IRAs.
What To Do
Relief is available for conflicts of interest under 2020-02, Shaw Elliott noted. That relief will allow for the receipt of third-party compensation such as 12b-1 fees, revenue sharing and sub-TA fees as well as commissions, bonuses and other forms of unlevel compensation.
Four criteria must be met:
1. Any recommendation must meet the Impartial Conduct Standards, meaning that it must be in the best interest of the client, that all compensation the advisor receives as a result of the recommendation is reasonable and that the advisor makes no materially misleading statements.
2. Extensive disclosures must be made in writing to the client, including a written acknowledgement that the advisor acts as a fiduciary, specific descriptions of the services to be provided and a description of any major conflicts of interest.
3. All rollover recommendations must be specially documented and presented to the client before the transaction. The recommendation must describe the alternatives to the rollover and compare the investment options, fees and expenses, both in the current plan or arrangement and in the recommended IRA or other arrangement. The disclosure must explain why the advisor’s recommendation is in the best interest of the client and whether the employer pays for any of the administrative expenses. It should also compare the different services available in the current arrangement to what is recommended.
4. The advisor must maintain effective policies and procedures to comply with the above and to mitigate any conflicts of interest.
Prudent advisors will prepare to fully cover themselves while meeting the requirements of the investment advice rule exemption 2020-02, Shaw Elliott wrote. This includes:
1. Review all current disclosures, including Form ADV-2a, Form ADV-2b, Form CRS, 408(b)(2) reports and other documents to be certain that the proper disclosures, including of all conflicts of interest, are made.
2. Reassess all sources of compensation so that they may be disclosed. Check your own accounting records for payments you receive, 408(b)(2) disclosures, selling agreements and other documentation.
3. Prepare a new rollover form for each rollover type that specifically compares the current arrangement to the proposed arrangement regarding services, fees and expenses as well as the investments, plus lays out what the proposed arrangement is and why it is in the best interest of the client.
4. Revise compliance manuals to provide an effective program to meet the Impartial Conduct Standards, describe services and compensation, and acknowledge fiduciary status.
5. Test, track and maintain records of how effective your compliance program is. Include what kinds of mistakes are made, who made them and what corrective action was taken.
6. Report annually the results of your compliance program to a senior executive officer appointed for this purpose who must certify that you have an effective program designed to maintain compliance with the Investment Advice PTE. Keep those records for six years. The DOL will likely request this report upon any audit.
7. All advisors should examine their investment advisory arrangements with care. The PTE provides protection for a broad range of conflicts, including conflicts arising from variable compensation, third-party compensation, proprietary products and principal trading. Be aware that these conflicts apply to both discretionary and nondiscretionary investment services, but the relief of the PTE is available only to nondiscretionary advice. Discretionary management is expressly excluded. Accordingly, advisors should take care to see that any conflicted discretionary management arrangements satisfy other exemptions or DOL guidance, or they will be left without any relief from prohibited transaction penalties.
8. Train, train, train those at all levels of the firm to understand and appreciate the importance of these rules.