The new fiduciary challenges

Once the new fiduciary rule is in effect, many advisors who previously were not subject to fiduciary standards, will find themselves subject to these higher requirements. In order to determine to what extent you will be impacted by the rule, ask yourself the following three questions:

1. Are you making a “recommendation?”

A recommendation includes advice relating to the advisability of acquiring, holding, disposing of, or exchanging investments, as well as advice related to rollovers (discussed in greater depth below).

2. Will you receive any fee or other compensation, whether directly or indirectly?

3. Is your advice being given to a “retirement investor?”

According to the fiduciary rule, “Retirement investors include plan participants and beneficiaries, IRA owners, and ‘retail’ fiduciaries of plans or IRAs (generally persons who hold or manage less than $50 million in assets, and are not banks, insurance carriers, registered investment advisors or broker- dealers), including small plan sponsors.”

If the answer to ALL three of the above questions is yes, then unless you are specifically exempt from fiduciary status, you will be subject to the new rules.

Rollovers are advice: a key change for advisors

Perhaps the most significant change for advisors under the new rules, outside of their newfound (in many cases, at least) “fiduciary” status, is that the fiduciary requirements extend beyond just investment recommendations. In addition to recommendations made to clients to buy, hold, sell, exchange or manage an investment — which would obviously fall under the new fiduciary rule — recommendations related to the rollover process itself are also covered under the rule. In other words, if an advisor suggests to a client they roll over their 401(k) into an IRA and purchase X investment, there are two recommendations there which would be subject to fiduciary standards. The recommendation to purchase investment X would have to meet those standards but so would the actual recommendation to complete a rollover in the first place.

Per the final fiduciary rule, “recommendations with respect to rollovers, distribution or transfers from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer or distribution should be made” will be subject to fiduciary standards.

This additional requirement places a new burden on advisors but certainly not one that is unfair. Advisors of all types will now have to increase their knowledge of the benefits and drawbacks of various rollover options. Even a hypothetical infallible investment guru, who never makes even a single investment mistake, will need to make sure he/she is properly evaluating the merits of a rollover in order to avoid potential regulatory issues.

Unfortunately, acting as a fiduciary and evaluating which rollover option is in a client’s best interest is no easy task. For starters, when a client retires or otherwise has access to plan funds, they may have as many as six potential rollover options. They are:

• Leave the funds in their existing employer plan
• Move the funds to a new/alternate employer plan
• Roll the funds over to an IRA
• Convert the funds to a Roth IRA
• Complete an in-plan Roth conversion (aka in-plan Roth rollover)
• Take a lump-sum distribution

Further complicating matters is the fact there is no one-size-fits-all template that can be used to determine which option is best for a client. Each client — and in fact, each client’s retirement plan — must be evaluated individually, based on its own merit. And there is no shortage of variables to consider either. For instance, in recommending a rollover (or a “don’t rollover”) or distribution, an advisor should, among other factors, consider impacts relating to:

• Fees
• Available investments
• Services provided
• The 10 percent early distribution penalty
• Creditor protection
• Simplicity/convenience
• Required minimum distributions
• Estate planning

Tax code and exemptions

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, principle- based prohibited transaction exemption, known as the Best Interest Contract Exemption.

Best Interest Contract Exemption (BICE)

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 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, 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 BICE