How prohibited transaction exemptions will change under DOL's fiduciary rule

May 14, 2024 3:13 PM

A package of regulatory amendments attached to the Labor Department's new "retirement security rule" may carry just as much impact as the primary guidelines.

The slideshow below displays 17 provisions from three amendments to the rules for so-called prohibited transaction exemptions under the Employee Retirement Income Security Act that the Labor Department issued last month as part of the new regulation. Opponents of the rule have already cited the amendments in a lawsuit challenging the new rule as an "assault on insurance agents selling annuities" that is contrary to ERISA's language and decades of industry practices.

Labor's new rule came six years after another industry lawsuit resulted in an appeals court decision that vacated the rule and four years after another attempt at codifying prohibited transaction exemptions encountered legal challenges that have left it in flux as well. The new regulation expands the fiduciary duty to retirement advice from financial advisors or other industry professionals to 401(k) savers on rollovers and certain insurance sales. Proponents argue the rule will remove conflicts of interest and close loopholes that hurt retirement savers.

"To elevate the awareness and responsibilities for fiduciaries, I think, speaks to addressing conflicts. There have been conflicts in the target-date fund industry for many years," said Ronald Surz, the president of San Clemente, California-based investment management and due diligence firm Target Date Solutions. He wrote an article in industry publication 401K Specialist on the implications of the rule for target-date funds.

Reactions to the rule have varied widely across the industry's many stakeholders, from the vocal rejections among insurance companies and their advocacy groups to welcoming praise from consumer groups. In remarks on their companies' first-quarter earnings calls after the agency released the final version of the rule, the CEOs of Stifel, LPL Financial and Raymond James described it as "less restrictive than what was proposed," reflecting "some hopeful changes from the original proposal" and "much more manageable than the draft rule was." The Financial Planning Association also responded positively to the shifts in the final language.

"While we take the needed time to fully review the final rulemaking, we are pleased that the Department appears to have been responsive to FPA and others' requests by extending the effective date from 60 days to 150, which will give our members who don't have the support of in-house legal counsel more time to understand and come into compliance with the rule," the organization said in a statement. "Furthermore, although there are many compliance details left to review, we appreciate that the Department appears to have responded to our requests for confirmation and clarification of how the new definition of a fiduciary activity would harmonize with other pieces of the complex regulatory framework to which many FPA members are subject."

A trade group for independent agents called the Federation of Americans for Consumer Choice and five other insurance distribution plaintiffs struck a much different tone in their lawsuit. One of the regulatory amendments "will require all levels of the annuity distribution chain to transform their businesses, compensation models and disclosures," the lawsuit said.

"The DOL's assault on insurance agents selling annuities does not stop at unlawfully turning them into fiduciaries; instead, the DOL also tries to subject insurance agents and indeed the entire insurance industry to an onerous new regime that promises to upend longstanding business practices already subject to comprehensive state insurance regulation," it stated.

Scroll down the slideshow to see the new rules for prohibited transactions. For a summary of the initial proposed amendments, click here. To see the final version of the "retirement security rule" itself, click here. And for a roundup of the reactions to Labor's issuance of the final rule last month from key stakeholders, follow this link.

The meaning of ‘prohibited transaction’ and intent of the new amendments

"In addition to fiduciary obligations, ERISA has prohibited transaction rules that 'categorically bar' plan fiduciaries from engaging in transactions deemed 'likely to injure the pension plan.' These prohibitions broadly forbid a fiduciary from 'deal[ing] with the assets of the plan in his own interest or for his own account,' and 'receiv[ing] any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan."

Congress gave the Department of Labor (the Department) broad authority to grant conditional administrative exemptions from the prohibited transaction provisions, but only if the Department finds that the exemption is (1) administratively feasible for the Department, (2) in the interests of the plan and of its participants and beneficiaries, and (3) protective of the rights of participants and beneficiaries of such plan.

As discussed below, the Department is broadening PTE 2020-02 to cover more transactions and revising some of the exemption's conditions to emphasize the core standards underlying the exemption. Consistent with the proposed amendment and PTE 2020-02 as it was originally granted in December 2020, this final amendment ensures that trusted advisers adhere to fundamental standards of fiduciary conduct when they receive compensation that otherwise is prohibited by ERISA and the Code as a result of recommending investment products and services to retirement investors."

How little time will be spent updating disclosures

"Of the 70% of the broker-dealers, registered investment advisers and insurance companies assumed to be currently reliant on the existing exemption, the Department assumes that 10% will need to update their disclosures and that it will take a legal professional at a financial institution, on average, 10 minutes to update existing disclosures."

The cost of disclosures: $114.7 million

"The Department estimates that approximately 44.6 million plan participants and 67.8 million IRA owners will receive disclosures annually, of which, 20.9 million (1.7 million retirement investors and 19.1 million IRA owners) will receive paper disclosures. The Department estimates that preparing and sending each disclosure would take a clerical worker, on average, five minutes, resulting in an hour burden of 1,737,781 hours with an equivalent cost of $114,676,201"

The cost of five or 30 minutes of advisors’ labor: $142 million

"The Department estimates that documenting each rollover recommendation will require 30 minutes for a personal financial adviser whose firms currently do not require rollover documentations and five minutes for financial advisers whose firms already require them to do so. This results in a labor cost estimate of $142 million."

Phase-in period added in response to input

"Several commenters stated that the proposed amendment's applicability date (60-days after publication in the Federal Register) did not provide sufficient time for financial institutions and Investment Professionals to fully comply with the amended conditions. In response to these comments, the Department is adding a new Section VI, which provides a phase-in period for the one-year period beginning September 23, 2024. Thus, financial institutions and investment professionals may receive reasonable compensation under Section I of the amended exemption during this phase-in period if they comply with the Impartial Conduct Standards in Section II(a) and the fiduciary acknowledgment requirement under Section II(b)(1). This one-year phase-in period is the same as the one-year compliance period the Department provided when it originally granted PTE 2020-02."

No fine-print disclaiming of fiduciary status

"Several commenters pointed to the history of financial institutions including fine print disclaimers of their fiduciary status. Disclosures have been used to undermine investors' reasonable expectations and the purpose of the fiduciary acknowledgment in Section II(b)(1) is to match the facts to the reasonable expectations of the retirement investor. Under the final amendment, financial institutions cannot acknowledge fiduciary status with respect to a recommendation, only to disclaim it in the fine print. The final amendment requires the financial institutions and investment professionals to acknowledge their fiduciary status with respect to the investment recommendation. This change prevents financial institutions from making the fiduciary acknowledgment and then including exclusions in fine print."

Rules for insurance conferences

"The Department understands that insurers significantly rely on educational conferences for independent producers, as commenters indicated, and that such conferences and training can promote retirement investors' interests. Accordingly, the Department stresses that it is not prohibiting such conferences. However, participation in and reimbursement for these conferences must be structured in a manner to ensure they are not likely to cause independent producers to make recommendations that violate this exemption's care obligation or loyalty obligation. In addition, the Department notes that properly designed incentives that are simply aimed at increasing the overall amount of retirement saving and investing, without promoting specific products, would not violate the policies and procedures requirement."

New rules for training conferences

"Financial institutions must take special care to ensure that training conferences held in vacation destinations are not designed to incentivize recommendations that run counter to retirement investor interests. Firms should structure training events to ensure that they are consistent with the care and loyalty obligations. Recommendations to retirement investors should be driven by the interests of the investor in a secure retirement. Certainly, financial institutions should avoid creating situations where the training is merely incidental to the event, and an imprudent recommendation to a retirement investor is the only thing standing between an investment professional and a luxury getaway vacation."

Principal transactions carry ‘clear and direct’ conflicts

"Although the Department is expanding the scope of the exemption, the Department continues to be concerned about the heightened conflicts of interest inherent in principal transactions. Principal transactions involve the purchase from, or sale to, a plan or an IRA of an investment on behalf of the financial institution's own account or the account of a person directly or indirectly, through one or more intermediaries, controlling, controlled by, or under common control with the financial institution. Because an investment advice fiduciary engaging in a principal transaction is involved with both sides of the transaction, a financial institution or investment professional providing fiduciary investment advice in a principal transaction has a clear and direct conflict of interest."

Companies and professionals ‘must take special care’

"Financial institutions and investment professionals must take special care to protect the interests of retirement investors and to avoid favoring their own financial interests at the expense of retirement investors' interests. The greater the dangers posed by conflicts of interest, complexity, or risk, the greater the care investment professionals and financial institutions must take to ensure that their investment recommendations are prudent, loyal, and unaffected by either the financial institutions' or the investment professionals' conflicts of interest."

Disclosure language

"To assist financial institutions and investment professionals in complying with these conditions of the exemption, the Department confirms the following model language will satisfy the disclosure requirement in Section II(b)(1) and (2): 'We are making investment recommendations to you regarding your retirement plan account or individual retirement account as fiduciaries within the meaning of Title I of the Employee Retirement Income Security Act and/or the Internal Revenue Code, as applicable, which are laws governing retirement accounts. The way we make money or otherwise are compensated creates some conflicts with your financial interests, so we operate under a special rule that requires us to act in your best interest and not put our interest ahead of yours.'"

Rollover disclosures

"The Department continues to believe that the information required to be included in the rollover disclosure is relevant to retirement investors. A retirement investor should understand what they are giving up in their employer's plan, as well as what they may gain from rolling over their retirement savings to an IRA. While the Department is not specifically adding a blanket requirement to document consideration of a retirement investor's Social Security benefit, it also agrees that the retirement investor's Social Security benefit may be an important component of the overall analysis to ensure any recommendation will meet the care obligation and loyalty obligation."

Response to industry concerns about disqualifications

"The crimes listed as disqualifying are extraordinarily serious. Implicit in some of the comments is the notion that the Department and retirement investors need not be concerned about serious crimes if they involved non-plan assets or non-advisory financial activities, such as asset management. In the Department's view, however, the commission of a serious crime, such as a felony involving embezzlement, price fixing, or criminal fraud, calls into question the parties' commitment to compliance with the law, loyalty to their customers, and insistence on appropriate oversight structures. In such circumstances, it would be imprudent for the Department to disregard the previous felonies on the basis that the crimes were aimed at another class of customers or parties."

Contrast with rule vacated by 2018 court decision

"For that reason, arguments that the fiduciary acknowledgment requirement is inconsistent with the Fifth Circuit's opinion in Chamber of Commerce v. U.S. Department of Labor are unsupported. In that case, the Fifth Circuit faulted the Department for having effectively created a private cause of action that Congress had not provided. Under this exemption the Department does not create new causes of actions, mandate enforceable contractual commitments, or expand upon the remedial provisions of ERISA or the Code. Requiring clarity as to the nature of the services and relationship is a far cry from the creation of a whole new cause of action or remedial scheme. The Department does not compel fiduciary status or create new causes of action. It merely conditions the availability of the exemption, which is only necessary for plan fiduciaries to receive otherwise prohibited compensation, on financial institutions and investment professionals providing clarity that the transaction, in fact, involves a fiduciary relationship."

Response to insurance industry criticism

"Retirement investors are no less in need of the protective conditions simply because the individual who is advising them relies on a different business model. Additionally, as discussed above, the Department has authority to regulate the business of insurance with respect to investment advice provided to retirement investors and has carefully tailored the conditions of this exemption to address the specific conflicts that can arise for independent producers that are compensated through commissions and other compensation when providing investment advice to retirement investors regarding the purchase of an annuity."

The need for a universal standard

"Several commenters emphasized the need for a universal standard covering investment advice provided to retirement investors. These commenters described retirement investors who reasonably expect their relationship with an investment advice provider to be one in which they can — and should — place trust and confidence in the advice provider's recommendations. In light of the asymmetry of information and knowledge between a retirement investor and an advice provider, commenters noted that the retirement investor is at increased risk that the advice provider will prioritize its own compensation at the expense of the retirement investor's savings."

‘Not demanding the impossible’

"The Department recognizes that it is impossible to eliminate all conflicts of interest with respect to the commission-based sale of insurance products, and the Department is not demanding the impossible. Instead, the Department is requiring insurers and independent producers to avoid and mitigate conflicts of interest to the extent possible and to rely on oversight structures that prevent those conflicts of interest from driving investment recommendations, rather than the financial interests of retirement investors."