Posted by Fred Reish on May 09, 2017
The new—and very broad—definition of fiduciary advice will apply on June 9. That means that investment recommendations to ERISA plans, participants or IRAs will be fiduciary advice. Broker-dealers and their advisors will, in essence, be co-fiduciaries for providing that advice.
As a result, broker-dealers need to develop internal policies, procedures, training and supervision as quickly as possible in order to be in compliance by June 9. The areas of focus should be:
- Fiduciary education for home office management, supervisory, and sales and marketing personnel. As explained below, some of the fiduciary responsibilities will need to be satisfied by the broker-dealer, rather than the advisors.
- Fiduciary training for advisors. The best interest standard of care requires that advisors engage in a prudent process to develop recommendations for plans, participants or IRA owners. That process should take into account the needs and circumstances of the investor, as well as generally accepted investment principles and prevailing investment industry standards. Advisors will need to understand and apply those concepts. As a result, they need training on the basics of the requirements for the best interest standard of care.
- Reasonable compensation for broker-dealers and for advisors. Broker-dealers need to determine the amounts of reasonable compensation that can be paid to themselves and to their advisors for the services associated with each investment category (for example, mutual funds, variable annuities, individual securities). The reasonable compensation limitations need to be communicated to advisors and then appropriately paid and supervised. Broker-dealers will need data about industry pricing in order to establish their reasonable compensation limitations.
- Selection of investments. Recommendations of investments to ERISA retirement plans and participants’ accounts are governed by ERISA’s prudent man rule and duty of loyalty. It is well-settled that the prudent man rule requires that advisors must engage in the same prudent process as is familiar with retirement investing practices. Similarly, the best interest standard of care imposes the prudent man rule (and its processes) on advice to IRAs. Compliance with those requirements should be documented. Broker-dealers should consider using well-regarded providers of databases and software for those purposes.
The new fiduciary definition and the Best Interest Contract Exemption (BICE) impose the fiduciary standard on both broker-dealers and their advisors. In that sense, broker-dealers and their advisors are “co-fiduciaries.” Because of that arrangement, broker-dealers need to decide which of the fiduciary and BICE requirements will be handled at the entity level and which will be delegated to the advisors. For example, for the recommendation of mutual funds to IRAs, some broker-dealers are managing their fiduciary responsibility by specifying which fund families can be recommended to IRA owners. On the other hand, other broker-dealers will not limit the number of fund families that can be used by advisors, but will instead require that advisors use pre-approved software for the prudent selection of mutual funds and for the appropriate asset allocation for the IRA owner. Generally speaking, the prudence, or best interest, standard requires that broker-dealers and advisors more rigorously vet the expense ratios of mutual funds and the quality of the mutual fund management. Consequently, broker-dealers need to have procedures and practices in place to satisfy those heightened standards.
With regard to the compensation received by broker-dealers and advisors as a result of their investment recommendations, the new rules require that the compensation be reasonable as compared to the services rendered. In other words, the standard commission, or other compensation, attributable to a particular product may or may not properly reflect the value of the services provided by the broker-dealer and the advisor. And, to make matters worse, the burden of proof of reasonableness will be on the broker-dealer. (This is because a prohibited transaction exemption is considered to be an exception to a general rule. As a legal matter, in those cases, the burden of proof shifts to the person claiming the exception, that is, the broker-dealer.) As a result, broker-dealers need benchmarking data for each of their categories of investment services or products. Examples of different services and products include recommendations of mutual funds, discretionary investment management services, referrals to third-party asset managers, individual variable annuities and fixed-rate annuities. Those are just examples; there are other categories that need to be considered.
This article covers some of the more important changes that apply on June 9. Because of that deadline, broker-dealers and RIAs need to immediately focus on these issues.