The United States Department of Labor has finalized new rules defining who is an investment “fiduciary” under ERISA. These new final rules mark the latest effort (started in 2010) to update a fiduciary definition that was initially adopted in 1975.
Background
Under ERISA fiduciaries are held to the highest standard known to law; by now you have probably seen the recitation that a fiduciary must act for the “exclusive benefit” of plan participants and that a fiduciary must act with the “care, skill, prudence, and diligence” that a prudent person –who is familiar with such matters (i.e., a prudent expert) – would exercise. Moreover, fiduciaries are singled out for extra restrictions under ERISA that limit the types of transactions fiduciaries can engage in with plans. And, to top it off, fiduciaries are the targets in litigation challenging breaches under ERISA—after all, only a fiduciary can be charged with a breach of fiduciary standards.
Under the current five-part test (adopted in 1975—before the creation of 401(k) plans)–an entity providing advice is not a fiduciary unless the advice is given “on a regular basis” and must be pursuant to an agreement or understanding that the advice will serve as the primary basis for investment decisions. In other words, an advisor making a onetime recommendation that a retirement plan participant roll over their entire life savings into an inappropriate product is not an ERISA fiduciary (advice was not given on a regular basis). Similarly, an advisor can use all sorts of reassuring titles (such as “retirement advisor”)—but disclaim fiduciary status. In other words, the current standard has some significant gaps
The new rules have three main parts—a definition of fiduciary, a set of rules allowing these fiduciaries to engage in certain (otherwise prohibited) transactions, and a special set of rules governing the sale of insurance products. (There are also amendments to several other PTEs, focused on more narrow market segments—such as securities underwriting and market making. This blog will not address these other areas.)
These new rules are scheduled to become effective September 23, 2024.
The New Standard
Most significantly, a person renders “investment advice” (and, therefore is a fiduciary) if the person “makes a recommendation of any securities transaction or other investment transaction or any investment strategy involving securities or other investment property” under the following circumstances:
- The person either directly or indirectly … makes professional investment recommendations to investors on a regular basis as part of their business
- The recommendation is made under circumstances that would indicate to a reasonable investor in like circumstances that the recommendation
- is based on review of the retirement investor’s particular needs or individual circumstances,reflects the application of professional or expert judgment to the retirement investor’s particular needs or individual circumstances, and
- may be relied upon by the retirement investor as intended to advance the retirement investor’s best interest
In applying this standard, the term ‘‘recommendation of any securities transaction or other investment transaction or any investment strategy involving securities or other investment property’’ is broadly defined to mean “recommendations as to:
- the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, investment strategy, or how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
- the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., account types such as brokerage versus advisory) or voting of proxies appurtenant to securities; and
- rolling over, transferring, or distributing assets from a plan or IRA, including recommendations as to whether to engage in the transaction, the amount, the form, and the destination of such a rollover, transfer, or distribution.”
The reader can see how these provisions seek to close the gaps in the 1975 rules; for example, even a one-time recommendation to roll over funds from an employer-sponsored plan into an IRA can now trigger fiduciary status.
Revised PTE 2020-02: Availability of a Prohibited Transaction Exemption
To accompany the new expanded fiduciary definition the DOL has also revised Prohibited Transaction Exemption (“PTE”) 2020-02. PTE 200-02 permits financial professionals that are fiduciaries to engage in (otherwise) prohibited transactions. The most significant example of the kinds of transactions permitted under the PTE are transactions where the professionals’ compensation varies with the advice given (e.g., commission-based transactions). Under PTE 2020-02 a transaction is permitted if the financial professional meets the “impartial conduct standards.” These standards require:
- Advice provided “must reflect the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character” and “with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs” of the investor.
- Advice “must not place the financial or other interests” of the advisor ahead of the interests of the investor or subordinate the investor’s interests to their own.
- Compensation received by the advisor for their services must be reasonable.
- Disclosure made regarding the recommendation must not be misleading.
In addition, the financial institution must meet a number of disclosure requirements and maintain a variety of procedures designed to ensure compliance with the requirements of the PTE. The disclosure rules include a written acknowledgement do that the investment professional is serving as a fiduciary and a written statement to the investor describing the standard of care that is owed to the investor under the PTE.
The PTE contains specific rules regarding rollover recommendations. Per the PTE, before recommending a rollover out of an ERISA plan or making a recommendation as to the post-rollover investment of assets currently held in an ERISA plan, the advisor “must consider and document the bases for their recommendation to engage in the rollover.” Relevant factors for consideration include (but are not limited to):
- “the alternatives to a rollover, including leaving the money in the Plan, if applicable”
- “the fees and expenses associated with the plan and the recommended investment or account”
- “whether an employer or other party pays for some or all of the Plan’s administrative expenses” and
- “the different levels of services and investments available under the plan and the recommended investment or account.”
Revised PTE 84-24: Insurance Products
Another component of this new regulatory package revises PTE 84-24 and focuses on the sales of annuity products by independent agents (“producers’). The new regulatory package affects the insurance industry in some special ways:
- The revised PTE 84-24 is available only to independent agents.
- The revised PTE 84-24 is only applicable to insurance products that are not securities (such as fixed annuities).
Transactions that are precluded from using the revised PTE 84-24 are forced to rely on the revised PTE 2020-02 described above.
What Now?
If past efforts by the DOL are indicative, we can expect a few things:
- Certain segments of the financial services industry will complain about these new rules. The complaints will likely focus on the costs of compliance and on the argument that these rules will reduce the financial products and services available to retirement plan participants. Although it is hard to gauge, this opposition does not (yet) seem as vociferous as opposition to previous DOL efforts to revamp the 1975 five-part test.
- The DOL estimates the rule will save retirement plan participants billions in reduced fees. One could (cynically) observe that these savings, in effect, represent reduced revenue to service providers.
- Opposition to the DOL rule will generate legal challenges.
Indeed, one of these expectations—a legal challenge–has already been realized in a case filed in Texas (Federation of Americans for Consumer Choice v. United States Department of Labor). The complaint focuses on the types of claims that would have been expected—that the DOL exceeded its legal authority, the process for adopting the new rules was flawed, and that the new rules are indistinguishable from the rules issued in 2016 and struck down by the court in 2018. Interestingly, this first case focuses on the changes to PTE 84-24 and was brought on behalf of/by insurance producers.
Some Perspective
In the author’s opinion, the 1975 five-part test should be replaced. It predates the growth of defined contribution plans as the predominant retirement vehicle and precedes the very existence of the 401(k) plan. It contains too many gaps—and, therefore, is easily evaded.
However, the DOL must walk a fine line. Based on the previous (unsuccessful) efforts to revise the 1975 five-part test, the courts have already articulated a number of barriers to the new regulations. Financial professionals who do not act in a traditional fiduciary capacity (such as brokers executing sales or sales representatives who do not have a true position of trust) will resist any changes that sweep them into fiduciary status. Similarly, financial professionals who focus on (one time transactions) encouraging rollovers from ERISA plans to IRAs will also resist fiduciary status.
In issuing the new rules the DOL went to great lengths to distinguish these new rules from the efforts that were previously struck down. It will take time to determine if the DOL has successfully walked that fine line and succeeded in replacing these 1975 rules—in a way that withstands legal challenges but truly expands protections for plan participants.