Resources for Plan Sponsors

DOL finalizes advice regulation

October 26, 2011

On October 24, 2011, the Department of Labor released final regulations on investment advice. In this article we begin with a very brief discussion of what's new and then review the regulation in detail.

What's new (and significant)

The regulation implements the statutory exemption, added by the 2006 Pension Protection Act (PPA), for flat-fee and model-driven investment advice provided by a person affiliated with funds offered under a 401(k) plan. We discussed the proposed regulation in detail in our article DOL re-proposes advice regulations.

For those familiar with the original proposal, the final regulation contains two significant changes to the model-driven exception.

First, the proposal included language that was read by some to prohibit consideration of historical returns on specific funds. Taken with the mandate to consider fees, this approach was read by some to introduce a bias in favor of index funds. While the language on fees has been retained, the language with respect to historical returns on specific funds is gone. It is replaced by less specific language that, as a general matter, leaves the definition of "generally accepted investment theories" open.

Second, under the final regulation, unless the participant instructs that they be excluded from consideration, the computer advice model must take into account employer securities. The proposal allowed the model to ignore employer securities. This may present problems for plans with an employer securities option.

That's the "news." Now, let's turn to a detailed discussion of the regulation.

Background

Oversimplifying somewhat, persons affiliated with funds offered under a 401(k) plan generally can't offer "advice" to participants about which funds to invest in. Doing so would (or may) be an ERISA prohibited transaction. Let's call this sort of advice "conflicted" advice, as distinguished from "third party advice" provided by someone unaffiliated with funds offered under the plan.

Prior to the PPA, DOL had carved out three administrative exceptions to the rule prohibiting conflicted advice. A person affiliated with funds offered under a 401(k) plan could provide:

"Education" — e.g., generalized asset allocation recommendations.

"Model-driven advice" — advice that is the result of the application of methodologies developed, maintained and overseen by a party independent of the fiduciary.

Advice under a "wrap fee arrangement" — under which, for instance, additional fund management fees paid to the adviser or an affiliate that are generated when conflicted advice is followed are offset against fees that the plan otherwise is obligated to pay.

Provisions of the PPA

The PPA included "new" exemptions for conflicted advice in two circumstances. First, where the advice arrangement "provides that any fees ... received by the fiduciary adviser for investment advice ... do not vary depending on the basis of any investment option selected." Let's call this the "flat-fee exception." And second, where the advice is "model-driven" (in effect, writing into ERISA the exception for model-driven advice developed administratively by DOL).

The new DOL regulation implements those PPA provisions.

Flat-fee exemption

Investment advice qualifies for the flat-fee exemption if:

It is based on generally accepted investment theories that take into account the historic risks and returns of different asset classes over defined periods of time (although additional considerations may also be taken into account).

It takes into account investment management and other fees and expenses attendant to the recommended investments.

The fiduciary adviser requests from a participant, and, to the extent furnished, the advice utilizes, information relating to age, time horizons (e.g., life expectancy, retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income, and investment preferences; other information may be solicited and taken into account.

No fiduciary adviser (including any employee, agent, or registered representative) that provides investment advice receives from any party (including an affiliate of the fiduciary adviser), directly or indirectly, any fee or other compensation (including commissions, salary, bonuses, awards, promotions, or other things of value) that varies depending on the basis of a participant's selection of a particular investment option.

Treatment of affiliates

How the PPA flat-fee rules worked was one of the more controversial questions presented by the new PPA advice rules. Here's the issue. The PPA provides that, to qualify for the flat-fee exception, "any fees ... received by the fiduciary adviser for investment advice ... [may] not vary depending on the basis of any investment option selected." When you're determining the "fees received by the fiduciary" do you look at the individual giving the advice (who may be on a simple salary), or his or her employer or all the affiliates of that employer? Generally, under the final rule (as under the proposal), the individual and his or her employer must get level fees; the affiliate is not subject to this restriction.

Let's take an example. ABC Funds has an affiliate, ABC Funds Advisers, that provides advice to participants about which ABC funds offered under a plan a participant should invest in. An employee of ABC Funds Advisers tells participant X in plan Y to invest all of her account in the ABC Aggressive Growth Fund, which has a higher expense ratio than any other fund offered under the plan. The compensation and fees received by ABC Funds Advisers and its employee do not vary "depending on the basis of a participant's selection of a particular investment option." Fees do vary for ABC Funds Advisers' affiliate, ABC Funds — it receives additional fees with respect to investments in the (higher expense ratio) ABC Aggressive Growth Fund.

This arrangement would generally qualify for the exemption.

Model-driven advice

For a computer model to qualify for the model-driven advice exception, the model must be designed and operated to:

Apply generally accepted investment theories that take into account the historic risks and returns of different asset classes over defined periods of time (although additional considerations may also be taken into account).

Take into account investment management and other fees and expenses.

Appropriately weight the factors used in estimating future returns of investment options.

Request from a participant, and, to the extent furnished, utilize, information relating to age, time horizons (e.g., life expectancy, retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income, and investment preferences (other information may also be solicited and taken into account).

Utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the plan.

Avoid investment recommendations that inappropriately favor investment options offered by, or that may generate greater income for, the fiduciary adviser or an affiliate.

Take into account all designated investment options available under the plan. "Designated investment options" do not include brokerage windows. The computer model need not take into account annuity options or options "[t]he participant ... requests to be excluded from consideration ...."

Historical returns

Perhaps the most controversial provision of the 2010 proposal was a requirement, with respect to model-driven advice, that the model not "[i]nappropriately distinguish among investment options within a single asset class on the basis of a factor that cannot confidently be expected to persist in the future."

In discussing this proposal in the preamble, DOL stated:

While some differences between investment options within a single asset class, such as differences in fees and expenses or management style, are likely to persist in the future and therefore to constitute appropriate criteria for asset allocation, other differences, such as differences in historical performance, are less likely to persist and therefore less likely to constitute appropriate criteria for asset allocation. Asset classes, in contrast, can more often be distinguished from one another on the basis of differences in their historical risk and return characteristics.

Commenters identified two problems with this language. First, how do we determine (what are the criteria for determining) whether any particular distinction is "inappropriate?" In this regard, and specifically, DOL seemed, in the preamble, to be of the opinion that historical performance within an asset class is an inappropriate factor. Second, what is an asset class, e.g., is an actively managed growth fund in the same "class" as an S&P 500 Index fund?

Among other things, commenters argued that this language, read broadly, and considering the additional requirement that the model "[t]ake into account investment management and other fees and expenses attendant to the recommended investments," could be understood to require that computer models include a bias towards low-cost index funds. That is, if an index fund is in the same asset class as a (higher cost) actively managed fund, and charges lower fees, and historical returns on the two funds must be disregarded, what possible "objective criteria" would there be for recommending the actively managed fund?

In response to these comments, DOL eliminated the provision prohibiting distinctions "among investment options ... on the basis of a factor that cannot confidently be expected to persist in the future." It replaced that language with the language described above — the requirement that the model"[a]ppropriately weight the factors used in estimating future returns of investment options ...."

In explaining this change, DOL, in the preamble to the final regulation, stated:

The [proposed] provision was not intended to prohibit a computer model from any consideration of an investment option's historical performance, as some commenters interpreted. Rather, as some commenters recognized, the provision is intended to ensure that in evaluating investment options for asset allocation, it would be appropriate and consistent with generally accepted investment theories for a computer model to take into account multiple factors, including historical performance, attaching weights to those factors based on surrounding facts and circumstances. As with the consideration of fees and expenses attendant to investment options, commenters generally recognized the importance of ensuring that historical performance of options is not given inappropriate weight. The Department is not persuaded by the comments received that the provision should be eliminated, however, to avoid further misinterpretation of the provision, the requirement has been clarified and moved .... This provision requires that a computer model must be designed and operated to appropriately weight the factors used in estimating future returns of investment options.

While this language does eliminate any explicit (and to some extent, implicit) prohibition on considering historical returns of a specific fund, it leaves the rules as to what may be taken into account very un-specific. How useful the rule will be may depend on how much deference DOL (and, for that matter, the courts) are prepared to give to the determination by an independent expert that the model satisfies generally accepted investment theories.

Employer securities and target date funds

With respect to the requirement that the computer model "take into account all designated investment options available under the plan," the 2010 proposal permitted the model to ignore employer securities and target date funds. In eliminating this provision — and thus (unless the participant requests their exclusion) requiring the model to consider, e.g., investments in employer securities — DOL stated (in the preamble to final regulation):

The Department believes that it is feasible to develop a computer model capable of addressing investments in qualifying employer securities, and that plan participants may significantly benefit from this advice. The Department also believes that participants who seek investment advice as they manage their plan investments would benefit from advice that takes into account asset allocation funds, if available under the plan. Based on recent experience in examining target date funds and similar investments, the Department believes it is feasible to design computer models with this capability.

Whether DOL's "belief" is in fact the case remains to be seen. As noted at the beginning of this article, a requirement to apply modern portfolio theory to employer stock holdings may present problems for some sponsors.

Certification

Finally, before using an advice computer model, the fiduciary adviser must obtain, from an "eligible investment expert," a written certification that the computer model meets applicable requirements.

An "eligible investment expert" is a person that has the appropriate technical training or experience and proficiency to make the required certification and that does not have any "material affiliation or material contractual relationship with the fiduciary adviser, with a person with a material affiliation or material contractual relationship with the fiduciary adviser, or with any employee, agent, or registered representative of the foregoing; or develops a computer model utilized by the fiduciary adviser to satisfy [the model-driven exemption]."

The last provision — that the model developer does not qualify as independent — was not in the proposal. In explaining its addition, DOL stated "the Department does not believe that a person who develops a computer model should be considered sufficiently independent to conduct a certification of the same model." It is likely that this requirement will add to the cost of model construction. In effect, two experts will have to be hired, one to develop the model and the other to certify it.

The fiduciary adviser (and not, e.g., the plan sponsor) must select the expert and is responsible for determining whether he or she meets the foregoing criteria.

The certification must be in a signed writing and contain the following:

An identification of the methodology or methodologies applied in determining whether the computer model meets applicable requirements.

An explanation of how the applied methodology or methodologies demonstrated that the computer model met those requirements.

A description of any limitations that were imposed by any person on the eligible investment expert's selection or application of methodologies.

A representation that the methodology or methodologies were applied by a person or persons with appropriate educational background, technical training or experience.

A statement certifying that the eligible investment expert has determined that the computer model meets the model-driven exception requirements.

Who is a fiduciary?

Generally, the selection of the independent expert (by the fiduciary adviser) is a fiduciary act. Certification is not, and thus, generally, the independent expert is not a fiduciary.

Additional requirements

To qualify for either the flat-fee or model-driven exemption, the following additional requirements must be met:

The arrangement must be expressly authorized by a plan fiduciary not related to the adviser (typically this will be the plan sponsor).

The arrangement must be independently audited annually, with the audit issued to the adviser and the authorizing fiduciary. The auditor is selected by the fiduciary adviser, who must, in advance, notify the authorizing fiduciary of the audit requirements.

The fiduciary adviser must provide appropriate disclosure, in connection with the transaction, in accordance with all applicable securities laws.

The transaction must occur solely at the direction of the recipient of the advice.

The compensation received by the fiduciary adviser and affiliates must be reasonable, and the terms of the transaction must be at least as favorable to the plan as an arm's length transaction would be.

Sponsor duties with respect to the audit

DOL rejected a request by one commenter that audits be provided to participants. Instead, it indicated (in the preamble) that it views the sponsor as having the critical review burden:

The Department believes that the furnishing of the audit report to the authorizing plan fiduciary [typically the plan sponsor], who must act prudently and solely in the interest of plan participants, is sufficient to protect the interests of participants and beneficiaries. The fiduciary should examine the audit report furnished and, if noncompliance is identified, take appropriate steps. ... The Department would expect the authorizing fiduciary to take reasonable steps if the report is not furnished in a timely manner, such as making inquiries with the auditor, the fiduciary adviser, or both. [Emphasis added.]

As an aside, we would note that this approach — of focusing on the plan sponsor as the key fiduciary responsible for assuring that outside providers are treating participants fairly — has been typical of recent DOL regulatory initiatives. For instance, the fee disclosure rules contemplate detailed review of provider fees by the plan fiduciary (again, typically, the plan sponsor).

Disclosure to participants

Below we review the disclosure requirements with respect to advice programs. We do so in considerable detail because, for sponsors, one of the consequences of undertaking a conflicted advice program is that participants will be getting a lot of information that they may not get with respect to a third party advice program. Whether that additional information will be positive (in informing and "empowering" participants) or negative (in confusing them) is an element in the advice/no-advice decision.

The fiduciary adviser must provide to participants, in advance, a written (or electronic) notification describing:

The role of any party affiliated with the fiduciary adviser in the development of the investment advice program.

The past performance and historical rates of return of the designated investment options available under the plan.

All fees or other compensation relating to the advice that the fiduciary adviser or any affiliate is to receive.

Any material affiliation or material contractual relationship of the fiduciary adviser or affiliates in the security or other property as to which advice is provided.

The manner, and under what circumstances, any participant information provided under the arrangement will be used or disclosed.

The types of services provided by the fiduciary adviser in connection with the provision of investment advice.

That the adviser is acting as a fiduciary of the plan in connection with the provision of the advice.

That a recipient of the advice may separately arrange for the provision of advice by another adviser that could have no material affiliation with and receive no fees or other compensation in connection with the security or other property as to which advice is provided.

The fiduciary adviser must maintain the foregoing information; provide it, without charge, to the recipient of advice no less frequently than annually and upon request; and provide, without charge, accurate information to the recipient of the advice concerning any material change to the information.

The regulation includes a model disclosure.

Which entities may qualify as fiduciary advisers

Generally, only certain persons (and their affiliates and employees) may be fiduciary advisers: registered investment advisers under the Investment Advisers Act of 1940 or under the laws of a State; banks or similar financial institutions (but only if the advice is provided through a trust department); insurance companies; and brokers or dealers under the Securities Exchange Act of 1934.

Maintenance of records

The fiduciary adviser must maintain, for at least six years, any records necessary for determining whether the applicable requirements of the regulation have been met.

Noncompliance

If the applicable conditions of the regulation are not satisfied, then, generally, the advice would not be exempt from the prohibited transaction rules. Further, in the case of a pattern or practice of noncompliance, the relief does not apply to any transaction (even one that would otherwise comply) in connection with the provision of investment advice provided by the fiduciary adviser during the period over which the pattern or practice extended.

Generally, the financial penalty for a prohibited transaction is an excise tax imposed on the "party in interest" (in this case, the fiduciary adviser). In that regard, DOL states, in the preamble, that "The Department believes that one of the most significant deterrents to noncompliance with the conditions of the statutory exemption is the potentially significant excise taxes applicable to transactions that fail to satisfy its conditions, and that extending the potential for excise taxes to encompass a period over which a pattern or practice of noncompliance extends creates additional incentives on the part of fiduciary advisers that take advantage of the exemptive relief to be vigilant in assuring compliance."

Effective date

The regulation will be effective 60 days from publication in the Federal Register.

The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.

Information set out or referred to above has been obtained from sources believed to be reliable. However, neither Plan Advisory Services nor any of its affiliates has verified the accuracy or completeness of any such information. Neither Plan Advisory Services nor any of its affiliates shall have any liability for any use of the information set out or referred to herein.