On October 25, 2011, the Department of Labor (DOL) issued a final regulation regarding the rendering of investment advice by a fiduciary to participants and beneficiaries in participant-directed individual account plans and individual retirement plans (e.g., plans subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The final regulation, effective for transactions occurring on or after December 27, 2011, is the culmination of a five-year effort by the DOL to implement a prohibited transaction exemption to allow fiduciary investment advisers to render investment advice to plan participants and beneficiaries while receiving compensation from investment funds. The final regulation introduces additional safeguards to protect the interests of participants and beneficiaries, and brings much needed clarity to the limited scope of the method and form of investment advice that may be provided by fiduciary investment advisers without causing a prohibited transaction.
The prohibited transaction rules of ERISA section 406 generally preclude a plan fiduciary from participating in any transaction involving the plan on behalf of a party whose interests are adverse to the interests of the plan, its participants or beneficiaries. This has long been interpreted to prohibit fiduciary investment advisers from rendering investment advice to plan participants or beneficiaries where the fiduciary is compensated by investment funds in connection with a participant or beneficiary’s investment in a particular fund.
A growth in participant-directed plans over the last two decades resulted in increased recognition of the importance of ensuring that participants and beneficiaries receive professional investment advice, a need which conflicted with the prohibited transaction rules of ERISA section 406. In response, Congress amended the prohibited transaction rules of ERISA in the Pension Protection Act of 2006 (PPA). Specifically, Congress created a prohibited transaction exemption where, under certain conditions, the rendering of investment advice by a plan fiduciary receiving compensation in connection with a participant’s or beneficiary’s investment would not result in a prohibited transaction. The statutory exemption is limited in scope and is designed to provide sponsors of participant-directed individual account plans (hereafter “plan”) with conditions under which they may provide plan participants and beneficiaries with access to investment advice in a way that will not result in an impermissible conflict of interest.
Statutory Exemption under the Pension Protection Act
Under the PPA, if the requirements of ERISA section 408(g) are met, a fiduciary investment adviser (or affiliate) may receive compensation from an investment manager in connection with:
- the fiduciary investment adviser providing investment advice to a participant or beneficiary with respect to an investment available under the plan; or
- the fiduciary investment adviser conducting an acquisition, holding or sale of a security or other property pursuant to the investment advice. ERISA section 408(g) requires that:
- the investment advice provided by a plan fiduciary be the product of an “eligible investment advice arrangement” which is audited by an independent auditor;
- the transaction be authorized by an independent plan fiduciary; and
- plan participants and beneficiaries receive adequate disclosures regarding the financial relationships involved in providing the investment advice.
The Final Regulation
The final regulation provides significant clarification on the definition of “eligible investment advice arrangement” and establishes additional safeguards against conflicts of interest which a fiduciary investment adviser must comply with in order to satisfy the requirements of the prohibited transaction exemption.
Under the final regulation, an “eligible investment advice arrangement” is either a fee-leveling arrangement, or an arrangement using a computer model. The fee-leveling arrangement is designed to prevent undue influence or conflicts of interest of a fiduciary investment adviser by leveling the fee the fiduciary receives regardless of the investment elected by the participant or beneficiary. An arrangement using a computer model is designed to prevent undue influence or conflicts of interest by removing potential bias from investment advice. A plan fiduciary that is not offering the eligible investment advice arrangement or providing the designated investment option under the plan (and is not an affiliate of either) must expressly authorize the arrangement prior to its use. Furthermore, the investment advice fiduciary must inform the authorizing fiduciary in writing that it intends to comply with the requirements of ERISA section 408 and related regulations.
The final regulation explains that in order for an arrangement to qualify as a fee-leveling arrangement, the compensation received by the fiduciary investment adviser, whether received directly or indirectly, must not vary by the particular investment option selected by the participant or beneficiary. Notably, the fee-leveling arrangement does not extend to an affiliate of a fiduciary investment adviser, and therefore the compensation of an affiliate may vary by the investment option selected by the participant or beneficiary. Investment advice provided under a fee leveling arrangement must be based on generally-accepted investment theories, taking into account historic returns of different asset classes over defined periods of time. In addition, the investment advice fiduciary must request and, if provided with, consider information related to the participant’s age, life expectancy, retirement age, risk tolerance, current investment, and other assets or other sources of income.
The final regulation explains that a computer model must satisfy a number of requirements to ensure its objectivity. Every person involved in the development or marketing of the computer model will be considered an investment advice fiduciary unless an election is made to identify one person as the investment advice fiduciary, and the authorizing fiduciary is provided with notice of such election. The election must identify the investment advice relationship, the person offering the arrangement, and contain an acknowledgment and signature of the person electing to be treated as the sole investment advice fiduciary. The fiduciary, or fiduciaries, must ensure the model complies with the following:
- The investment information provided by the computer model must be based on generally-accepted investment theories taking into account historic returns of different asset classes over defined periods of time. In addition, the investment advice fiduciary must request and, if provided with, consider information related to the participant’s age, life expectancy, retirement age, risk tolerance, current investments, and other assets or other sources of income.
- The investment information provided by the computer model must consider the fees and expenses related to the recommended investments.
- The computer model must be designed to appropriately weigh factors used in estimating future returns of investment options.
- The computer model must utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the Plan, and must avoid investment recommendations that:
- inappropriately favor investment options offered by the fiduciary adviser or certain other persons over other investment options; or
- inappropriately favor investment options that may generate greater income for the fiduciary adviser or certain other persons.
- The computer model must be designed and operated to consider all designated investment options under the plan without giving inappropriate weight to any investment option, except that the model may exclude:
- any investment option the participant or beneficiary specifically requests be excluded; or
- an in-plan annuity option, if the fiduciary investment adviser provides an explanation of how the in-plan annuity option works simultaneously with the computer generated advice.
A fiduciary investment adviser intending to rely on the computer model must first have the model certified for compliance with the above listed provisions by an “eligible investment expert.” In order to be an “eligible investment expert,” the investment expert must satisfy certain technical expertise requirements and be sufficiently independent from both the fiduciary investment adviser and the designer of the computer model. The fiduciary investment adviser should be aware that the act of selecting an eligible investment adviser is in itself a fiduciary act, and therefore the investment advice fiduciary should act with prudence in making a selection. However, unlike the investment advice fiduciary, the eligible investment expert will not be considered a fiduciary.
To further ensure that a fiduciary investment adviser is not unduly influenced, the regulations require the fiduciary investment adviser to engage an independent auditor on an annual basis to audit the investment advice arrangement and issue a written report to the fiduciary adviser and each fiduciary authorizing use of the arrangement within 60 days of the audit.
Finally, the fiduciary investment adviser must provide (free of charge) a written notification to participants and beneficiaries prior to giving investment advice. A model written notification is contained within the final regulation and requires disclosure of the following:
- The role of any party that has a material affiliation or contractual relationship with the fiduciary adviser in the development of the investment advice program and in the selection of investment options available under the plan
- The past performance and historical rates of return of the investment options available under the plan
- All fees or other compensation relating to the advice that the fiduciary adviser or any affiliate thereof is to receive (including compensation provided by any third party) in connection with the provision of the advice or in connection with the sale, acquisition, or holding of the security or other property
- Any material affiliation or contractual relationship of the fiduciary adviser or affiliates thereof in the security or other property
- The manner, and under what circumstances, any participant or beneficiary 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 by the fiduciary adviser
- That the fiduciary 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
The final regulation is effective for transactions commencing on or after December 27, 2011. The final regulationmarks a major step forward in helping participants and beneficiaries receive valuable investment information, and while the final regulation does not impose an affirmative obligation on a plan fiduciary to make any investment advice available to a participant or beneficiary, it clarifies how an investment advice fiduciary may provide such critical advice without engaging in a prohibited transaction. For further information please contact the Trucker Huss attorney you normally work with.
1 Individual Retirements Plans (e.g. IRAs) are not discussed in this article.