The Department of Labor’s April release of its conflict of interest (fiduciary) rule may be more far-reaching in its impact than critics feared.
Among the potential unintended consequences: the universal application of a core component of the DOL rule, the best interest contract or BIC, to all products and producers, irrespective of the rule’s scope.
This was among the scenarios explored during a panel discussion at the 2016 annual meeting of the (AALU), held in Washington, D.C., May 1-3. A highlight of the conference, the “Washington Live” update featured Bradford Campbell, a counsel at DrinkerBiddle, which is advising the AALU on the rule; Caleb Callahan, chief operating officer and executive vice president of ValMark Securities; and Chris Morton, the session’s moderator and AALU’s senior vice president of government Affairs.
The prospect of an all-encompassing BIC standard — a Draconian regulatory regime that individual insurers and broker-dealers might impose on their producers to minimize operational risk — might be too much for affiliated brokers to stomach. And that could prompt a parting of ways.
“Insurers and broker-dealers will be making an institutionally based decision about what’s best for them,” said Campbell. “That may not be what’s best for you as an advisor.”
Eye on the rule’s mechanics
In determining whether the fiduciary rule applies to a transaction, said Campbell, advisors need to ascertain whether a plan recommendation falls under Part 4 of the 1974 Employee Retirement Income Security Act (ERISA), which sets forth standards and rules for the conduct of plan fiduciaries. All ERISA-qualified plans, such as 401(k) and 403(b) plans, are subject too this regulatory regime.
Another issue to consider: whether a plan is subject to Internal Revenue Code (IRC) Section 49-75 prohibited transaction rules. These generally bar transfers between a self-directed IRA or solo 401(k) and a disqualified person. The fiduciary rule also applies if a participant is taking distribution from any of these plans.
Excluded from the rule’s purview are retirement plans for governmental entities, such 403(b)s for school districts. Likewise, the rule doesn’t apply to Safe Harbor 403(b) plans because they’re exempted from ERISA. Additionally exempted are non-qualified “top hat” plans, including life insurance-funded executive bonus and split-dollar plans for highly compensated employees, plus health and welfare plans incorporating group or term life insurance.
Ultimately, the panelists noted, the rule’s applicability will hinge on whether the financial professional is giving advice respecting investable asset.
“If you’re selling a group life insurance plan to an ERISA plan, it’ won’t be subject to rule in that there is no investable asset,” said Campbell. “But if there is investable asset, the rule would cover it.”
The rule extends also — directly or indirectly — to plan distributions. Thus, whereas an IRC Section 1062 executive bonus plan is not covered directly by the DOL rule, advice respecting distributions from one is.
While establishing separate “silos” in which the DOL rule will or won’t apply, its scope may be more far-reaching than anticipated. That’s because insurers and broker-dealers may not be inclined to establish different procedures and documentation for different products, plans and distribution channels.
In this respect, the rule is already having an impact.
Callahan pointed to the recent announcement by American Equity Investment Life to no longer distribute fixed indexed annuities to qualified plans or IRAs through non-FINRA registered producers. The reason: They’re not affiliated with a financial institution (i.e., broker-dealer), which must be party to the rule’s best interest contract (BIC) prohibited transaction exemption (PTE), which allows payments of otherwise “conflicted compensation” (i.e., commissions) if the terms of the BIC exemption are met.
“You’re already seeing disruption not more than three weeks into the final rule,” said Callahan. “The extent of the changes will depend on a carrier’s risk management assessment as to whether they want to risk being a party to the BIC.”
Should more insurers follow American Equity’s path — choosing only to distribute indexed products through FINRA-registered broker-dealers — then producers unaffiliated with a B-D will be left with fewer product options. Campbell suggested, however, that this outcome can be avoided if the DOL provides a special exemption for these producers.
“The DOL may come up with a way to have a supervisory relationship, other than through a broker-dealer,” he said. “We don’t know under what terms that would establish an exemption or how long it might take. We’ll have to stay tuned on this issue.”
As to product evolution, Callahan voiced two widely forecasted changes: (1) that more retirement products will carry guaranteed income riders, an increasingly popular feature with consumers; and that (2) broker compensation for sales of product (including variable and indexed annuities) will shift from heaped commissions to a flat fee or fee-like commissions so as to align with the BIC exemption requirements.
Whether traditional commission payouts will survive — even for products not subject to the fiduciary rule — is an open question. Callahan suggested that product providers will, with a view to streamlining transactions, adopt uniform compensation and disclosures across all products.
For their part, producers will need to rigorously document planning engagements to determine whether a best interest contract, a BIC exemption or traditional insurance (84-24) exemption is justified when offering advice. In the case of rollover to an IRA, the producer will have to weigh:
- The source of the rollover (e.g., ERISA or non-ERISA retirement plan);
- Investment options recommended;
- The compensation arrangement;
- Distribution options (e.g., guaranteed or non-guaranteed income); and
- The plan participant’s goals and objectives.
“For financial institutions that are supervising these arrangements, you’ll have to develop a checklist of items to review so that you can document you’re findings,” said Campbell. “At the end of the day, there will be a judgment call that is inherently a part of the fiduciary decision. A big change for advisors will be going through this documentation process.”
Callahan concurred, adding that agents and brokers will have to prepare for a greater supervisory role that insurers will play in approving transactions. And each carrier may view certain types of sales differently.
“Insurers will be on the hook for determining whether a finding as to the appropriateness of a BIC is handled impartially,” he said. “We have to prepared for this increased carrier oversight.”
And a long documentation trail. Even when recommending non-variable life insurance annuities to a client, the producer will have to retain records on the transaction — disclosure of product costs, compensation and a non-BIC finding — for 6 years. Should a BIC be needed because of a investment component, representations and warranties made during client engagement will also have to be documented. One final point: Disclosures will have to be “extremely robust” — updated every three months — on the broker-dealer’s website.
“The DOL rule has gone from being impossible to comply with the previous draft rule to merely very painful in the final version,” said Campbell. “In respect to the BIC, the financial institution [B-D] is on the hook of providing those disclosures. How much you will be responsible for will depend on the product recommendation, [the above-referenced checklist] and the financial institution you’re affiliated with.”
Among the few changes to the final DOL draft that the panelists viewed positively concern education. Financial professionals can instruct clients in products and plans — explore how they work, detail options available, project retirement income under various scenarios — without invoking the fiduciary rule. So long as they don’t go the “extra step” of recommending a product, they’re on safe ground.
Less clear is the applicability of a fiduciary standard in situations where the producer is transacting two product sales for a retirement plan participant, each subject (when considered independently) to different regulations. Example: (1) a 401(k) plan rollover to an IRA using the BIC exemption; and (2) a life insurance sale.
Might the fiduciary rule apply to the life sale in this case? Callahan believed not, indicating the transactions are (technically) separate. But he cautioned the rule may apply if the BIC contract for the rollover is framed too broadly.
“You have to be careful to not hold yourself to a fiduciary advice standard in your BIC contract that’s applicable to more than just qualified plan or distribution advice,” he said. “If you want to sell a life insurance policy using non-qualified, non-plan assets, that’s a separate transaction that should be subject to normal regulation — assuming you don’t write yourself into a corner in the BIC contract.”
Or that the product provider doesn’t write you into a corner. Callahan said that producers will have to “think carefully” about the insurers and broker-dealers they choose to affiliate with, as each will be making an independent risk assessment as to necessary disclosures for products that or may not be subject to the fiduciary rule. What’s best for a particular provider may not be appropriate for you and your practice.
“From an operational standpoint, carriers will be deciding whether they want different disclosure silos or universally apply a single set of disclosures and the BIC standard to all products,” said Callahan. “It will be interesting to see how this plays out over the next 12 months.”