Compliance FAQ: How an RIA Firm Can Comply with the New DOL Fiduciary Rule

This month, Lexington Compliance looks at how an RIA firm can comply with the new DOL Fiduciary Rule:

Since the final Department of Labor (“DOL”) fiduciary rule (or Best Interest Contract Exemption) was released on April 8, 2016, there has been much discussion about the potential impact to financial advisors. There is also continued speculation as to whether the rule will ultimately be implemented. However, as of now, we are recommending that all registered investment adviser (RIA) firms continue to prepare for the DOL fiduciary rule to be implemented as scheduled on April 10, 2017. Despite the present uncertainty around the future of the rule, the good news for the vast majority of RIA firms is that the new rule should not require significant operational changes. In particular, the DOL explicitly acknowledged that fee-based fiduciary advisors generally are less likely to conflict with a retirement investor's best interests. However, retirement account rollover recommendations are one area in which the DOL believes "there is a clear and substantial conflict of interest when an Advisor recommends that a participant roll money out of a plan into a fee-based account that will generate ongoing fees for the Advisor that he would not otherwise receive, even if the fees going-forward do not vary with the assets recommended or invested. Similarly, the prohibited transaction rules could be implicated by a recommendation to switch from a low activity commission-based account to an account that charges a fixed percentage of assets under management on an ongoing basis."

Thus, the DOL fiduciary rule does create new specific requirements for RIA firms that are advising clients to roll over retirement assets from an ERISA plan or an individual retirement account (IRA) into an IRA managed by the investment advisor. However, in most such circumstances, RIA firms should be able to take advantage of the "Level Fee Exemption" rather than needing to utilize the more substantial "Best Interest Contract Exemption" often referred to as the "BICE," which does require a series of additional procedures. The streamlined "Level Fee Exemption" available to fee-based advisors has at times been referred to as "Best Interest Contract Light" or "BIC Light" due to the greatly reduced requirements.

The DOL in its official rule release defines a "Level Fee Fiduciary" as:

"A Financial Institution and Advisor are Level Fee Fiduciaries if the only fee or compensation received by the Financial Institution, Advisor and any Affiliate in connection with the advisory or investment management services is a “Level Fee” that is disclosed in advance to the Retirement Investor."

Furthermore, the DOL defines a "Level Fee" this way:

"A Level Fee is defined in the exemption as a fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee."

It's important to note that a "Level Fee" is not only defined as a traditional percentage of assets under management, but can also include other fixed-fee or subscription models. However, to qualify for this exemption as presently articulated, the investment advisor must likely charge the same "Level Fee" regardless of the client's retirement asset allocation. Thus, it is currently assumed that the advisor cannot charge a lower fee for fixed-income assets versus a higher fee for equity assets. Rather, the entire portfolio of the investor's IRA or retirement assets must be charged the same "Level Fee." 

In order to utilize the "Level Fee Exemption," the DOL says an RIA firm needs to take three steps:

  • Give the retirement investor the written fiduciary statement

"With respect to IRAs and non-ERISA plans, if this acknowledgment of fiduciary status does not appear in a contract with a Retirement Investor, the exemption is not satisfied with respect to transactions involving that Retirement Investor. With respect to ERISA plans, this acknowledgment must be provided to the Retirement Investor prior to or at the same time as the execution of the recommended transaction, but not as part of a contract. This fiduciary acknowledgment is critical to ensuring clarity and certainty with respect to the fiduciary status of both the Adviser and Financial Institution under ERISA and the Code with respect to that advice."

  • Comply with the Impartial Conduct Standards

"Generally stated, the Impartial Conduct Standards require that Advisers and Financial Institutions provide investment advice in the Retirement Investor's Best Interest, not recommend transactions that they anticipate will result in more than reasonable compensation, and not make misleading statements to the Retirement Investor about recommended transactions. As defined in the exemption, a Financial Institution and Adviser act in the Best Interest of a Retirement Investor when they provide investment advice “that reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.”

  • Document why the level fee arrangement is in the best interest of the retirement investor

"Specifically, the documentation must take into account the fees and expenses associated with both the plan and the IRA; whether the employer pays for some or all of the plan's administrative expenses; and the different levels of services and different investments available under each option. In this regard, Advisers and Financial Institutions should consider the Retirement Investor's individual needs and circumstances, as described in FINRA Regulatory Notice 13-45. If a Level Fee arrangement is recommended as part of a rollover from another IRA, or a switch from a commission-based account, the Level Fee Fiduciary's documentation must include the reasons that the arrangement is considered in the Retirement Investor's Best Interest, including, specifically, the services that will be provided for the fee. The exemption does not specify any particular format or method for generating or retaining the documentation, which could be paper or electronic, but rather gives the Level Fee Fiduciary flexibility to determine what works best for its business model, so long as it meets the exemption's conditions."

Furthermore, in order for an RIA firm to qualify for the "Level Fee Exemption," it's required that the firm, or any affiliate, does not receive any other form of compensation besides the "Level Fee" in regard to the retirement account:

"It is important to note that the definition of Level Fee explicitly excludes receipt by the Advisor, Financial Institution or any Affiliate of commissions or other transaction-based payments. Accordingly, if either the Financial Institution or the Adviser or their Affiliates, receive any other remunerations (e.g., commissions, 12b-1 fees or revenue sharing), beyond the Level Fee in connection with investment management or advisory services with respect to, the plan or IRA, the Financial Institution and Advisor will not be able to rely on these streamlined conditions."

In addition, RIA firms need to recognize that they will need to likely utilize the "Level Fee Exemption" whenever the firm's amount of compensation is increased due to the rollover recommendation. Thus, even if the current fee paid by the retirement investor is greater than the fee that will be charged by the RIA, given that the RIA firm is receiving new compensation from the client as part of the recommendation it will still likely need to utilize the "Level Fee Exemption." However, there may be some limited circumstances in which the advisory firm is not required to comply with the exemption if the firm is already charging the same level fee for the management of the client's retirement assets before a recommended rollover transaction.

Investment advisors that are able to make use of the "Level Fee Exemption" should not expect to make significant changes to firm operations. Technically, investment advisors should already be performing much of this diligence and documentation when recommending rollover transactions as part of their pre-existing fiduciary obligation to clients. However, it is important to note that the fiduciary standard required by the DOL is more of a principles-based rule that may be stricter than the traditional rules-based fiduciary standard set forth by Section 206 of the Investment Advisers Act of 1940. The DOL's definition of a "sole interest" fiduciary standard under ERISA is generally viewed as a higher standard compared to the "best interests" fiduciary standard required of investment advisors. Whereas federal and state securities laws may require an investment advisory firm to properly disclose all conflicts of interest, under the DOL fiduciary standard, investment advisors may be prohibited from having such conflicts of interest at all.

Please also remember that there may be other elements of the new rule that will have significant impact to different subsets of investment advisory firms. For example, hybrid investment advisors that operate independent RIA firms but are also affiliated with an independent broker dealer (IBD) may be more impacted and will need to lean heavily on the IBD home office to ensure proper compliance across the entire business.

To read the full DOL Conflict of Interest Rule, please click here. In addition, in October the DOL issued its first set of frequently asked questions in regard to the fiduciary rule, which help to clarify the potential use of the “Level Fee Exemption.”

Note: RIA in a Box LLC, the parent of Lexington Compliance, is not a law firm and does not provide legal advice. We strongly advise all RIA firms that provide services to individual retirement investors, pension plans, profit-sharing plans, and/or retirement plans to consult with a qualified Employee Retirement Income Security Act of 1974 (ERISA) attorney in matters relating to DOL and ERISA law. This overview is provided for general information purposes only and should not be relied upon to take any action.

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