One of the biggest changes ahead for some advisers because of the fiduciary prohibited transaction rules is that they will no longer be able to make recommendations that can affect the level of their compensation.
As April 10 approaches, a recent blog post by ERISA attorney Fred Reish cautions that broker-dealers and RIAs need to closely review their investment practices for “qualified” money — a new terminology for money in IRAs or plans.
Reish cites the example of an adviser that would not be able to recommend a proprietary mutual fund (managed by an affiliate) without committing a prohibited transaction, since under the fiduciary regulation, a recommendation cannot increase the compensation of the adviser, his supervisory entity (e.g., a broker-dealer) or any affiliated or related party. Ditto the situation where a financial adviser with a broker-dealer could not recommend that an IRA invest in mutual funds that pay different levels of 12b-1 fees to the broker-dealer and, indirectly, to the adviser. That’s because in effect, the adviser would be setting his own compensation (as well as the compensation of the supervisory entity). Reish explains that similar issues exist for referral fees and revenue sharing. In all of those cases, the broker-dealer will need to either move to a level fee environment or satisfy one of the prohibited transaction exemptions, most likely the Best Interest Contract Exemption (BICE).
RIAs have similar issues. Reish notes cases where RIAs recommend proprietary products (e.g., affiliated mutual funds) that are a prohibited transaction, or another where the adviser recommends an allocation to fixed income and an allocation to equities, but then charges a higher fee for managing the equities. “By virtue of recommending the allocations, the adviser has determined the level of its compensation… and, therefore, has committed a prohibited transaction,” says Reish.
Action Steps
Reish notes that since virtually all investment and insurance advice to IRAs and plans (including recommendations about distributions, withdrawals and transfers) will become fiduciary advice on April 10, 2017, two steps should be taken.
First, if they don’t already exist, processes need to be put in place so that any advice satisfies the prudent person requirement. Reish notes that, generally speaking, that process should result in portfolio investing.
Second, all payments for the advice (including indirect and non-cash compensation, whether to the adviser, the supervisory entity or any affiliates or related parties) need to be examined. Once these rules are applicable, the compensation arrangements will need to satisfy the prohibited transaction rules in Section 406(b)(1) and (3) of ERISA and the corresponding provisions in Section 4975 of the Internal Revenue Code. Or, in the alternative, the condition of a prohibited transaction exemption must be satisfied.
All, as Reish reminds us, by April 10, 2017.
