What advisors need to know about the new fiduciary rule: Part 1
May 3, 2016 by Jeffrey Levine
Editor’s note: This is part one of a two-part series on the impact of the fiduciary rule on advisors. Part one focuses on the Best Interest Contract Exemption. Part 2, which will focus on who and what products are subject to the fiduciary rule.
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 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 way 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 (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 (DOL).
For years, the 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, 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 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 BICE 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 BICE 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 that 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 uses 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
Click HERE for part two of this series on the impact of the fiduciary rule on advisors.
