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How to Comply With IRA Comp Rules Under DOL Fiduciary

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Advisors take note: ERISA concepts are coming to IRAs under the Department of Labor’s new fiduciary rule, and you need to change your practices accordingly before the April compliance date kicks in.

It is a prohibited transaction under the Employee Retirement Income Security Act for a tax-qualified, ERISA-governed retirement plan to pay more than reasonable compensation to the plan’s service providers. That includes investment advisors and financial advisors, regardless of whether they are fiduciaries or simply service providers.

In addition, under the Internal Revenue Code, it is a prohibited transaction for a service provider, including advisors, to receive more than reasonable compensation. However, while the rule is well known in the retirement plan area, there has been little, if any, focus on the reasonableness of compensation for IRAs.

The DOL’s new fiduciary rule and the Best Interest Contract Exemption will soon change that (see ThinkAdvisor’s DOL Fiduciary Compliance resource page).

Beginning on April 10, the expanded definition of fiduciary advice will cause almost every advisor to retirement plans and IRAs to be a fiduciary.

When the advisor is a “pure” level fee fiduciary to an IRA, the advisor will be regulated by only the prohibition against unreasonable compensation in the Internal Revenue Code, which is enforceable only by the IRS. (Having said that, an emerging trend that I’ve noticed is the Securities and Exchange Commission recently raising issues about advisors’ prohibited transactions in plans and IRAs.)

My reference to “pure” level fee advisor is to a situation where the advisor, his supervisory entity (e.g., a broker-dealer or RIA), and all affiliates and related parties receive no more than a stated level fee. For example, an advisor might charge 1% per year for advising an IRA, which would be a level fee.

However, there cannot be any other compensation for the aggregated related entities. That means there can’t be any proprietary products, 12b-1 fees, commissions, revenue sharing, other payments, or gifts or awards. (“Compensation” includes money and items of monetary value.)

Where the advisor is not a pure level fee fiduciary, the advisor and his supervisory financial institution (e.g., broker-dealer or RIA) will need the relief provided by a prohibited transaction exemption, for example, BICE. In that case, the financial institution will need to contractually agree with the IRA owner (called the “Retirement Investor”) to receive no more than reasonable compensation relative to the services rendered.

In my experience, many RIA firms and broker-dealers have not benchmarked the compensation paid from IRAs to determine whether it is reasonable relative to the services provided. I expect that will change on or before April 10.

But that raises the question: what is reasonable compensation? The DOL explained the concept in the preamble to the BICE:

The obligation to pay no more than reasonable compensation to service providers is long recognized under ERISA and the Code. ERISA section 408(b)(2) and Code section 4975(d)(2) require that services arrangements involving plans and IRAs result in no more than reasonable compensation to the service provider. Accordingly, Advisers and Financial Institutions – as service providers – have long been subject to this requirement, regardless of their fiduciary status. At bottom, the standard simple requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the Adviser and Financial Institution are delivering to the Retirement Investor.

The reasonableness of the fees depends on the particular facts and circumstances at the time of the recommendation. Several factors inform whether compensation is reasonable including, inter alia, the market pricing of service(s) provided and the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.

As the quoted language states, the reasonableness of compensation is based on market pricing for comparable services. However, that does not mean that every customary form of compensation is necessarily reasonable. The DOL explains in the preamble:

Ultimately, the ‘‘reasonable compensation’’ standard is a market-based standard. At the same time, the Department is unwilling to condone all ‘‘customary’’ compensation arrangements and declines to adopt a standard that turns on whether the agreement is ‘‘customary.’’ For example, it may in some instances be ‘‘customary’’ to charge customers fees that are not transparent or that bear little relationship to the value of the services actually rendered, but that does not make the charges reasonable.

In other words, the reasonableness of compensation must be established by a truly transparent and competitive marketplace. When fees are obscured or hidden, there is a good chance that they are not being scrutinized as they should be in an open marketplace. As a result, there is a risk that those fees could be unreasonable.

In addition, compensation consists of more than just money. It also includes any items of monetary value. That could include trips and gifts. As the DOL explained in the preamble, the determination of whether a trip, gift or other payment is compensatory is based on a “but for” test. That is, but for the business placed with the payor, would the advisor have received the compensation, trip, gift, etc.? In that regard, the DOL said:

A fee or compensation is paid ‘‘in connection with or as a result of’’ such transaction or service if the fee or compensation would not have been paid but for the transaction or service or if eligibility for or the amount of the fee or compensation is based in whole or in part on the transaction or service.

So, if an advisor receives a payment from an investment or a third party (such as a custodian or a wholesaler), that would not have been received “but for” for the new business or aggregate business placed with the custodian or investment represented by the wholesaler, that money or item of monetary value would be additional compensation and would be included in the compensation for the purpose of evaluating its reasonableness. (As an aside, that additional payment could be a prohibited transaction in its own right.)

— See these additional stories by and about Fred Reish on complying with the DOL fiduciary rule:


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