ERISA Advisory - Labor Department Issues Proposed Regulations and Class Exemption Addressing Provision of Investment Advice to Participants and Beneficiaries of Self-Directed Individual Account Plans and IRAs

Introduction
On Friday, August 22, 2008, the Department of Labor published in the Federal Register two proposals relating to provision of investment advice to the participants and beneficiaries of self-directed individual account plans (“IAPs”) and individual retirement accounts (“IRAs”) (collectively, “Plans”).  The proposals include: 

• regulations (“Regulations”) implementing the statutory “eligible investment advice arrangement” exemption in sections 408(b)(14) and 408(g) of ERISA, and the parallel provisions of the Internal Revenue Code, sections 4975(d)(17) and 4975(f)(8) (collectively, the “Statutory Exemption”); and
• an administrative class exemption supplementing the relief provided by the Statutory Exemption (“Class Exemption”).

Each proposal relates to relief from the prohibited transaction provisions of Section 406 of ERISA and Section 4975 of the Code for three transactions:

• the provision of investment advice to the Plan by a fiduciary adviser;
• the investment transactions entered by the Plan in reliance on such advice; and
• the receipt of fees by the fiduciary adviser in connection with such investment advice or transactions.

However, the scope of relief and the conditions for relief in each proposal differ.  We discuss those differences below.

Due Date for the Public Comments on the Proposals
Public comments on the Regulations and the Class Exemption must be submitted to the Department of Labor on or before October 6, 2008.

Genesis of the Proposals
Under ERISA,[1] a person is a fiduciary to a Plan to the extent that the person provides investment advice for a fee to the Plan.  Absent a statutory or administrative exemption, the prohibited transaction rules in ERISA section 406(b) prohibit a fiduciary from (i) dealing with Plan assets in the fiduciary’s own interest or for the fiduciary’s own account, (ii) acting on behalf of or representing a party whose interests are adverse to the Plan’s interests in any transaction involving the Plan, or (iii) receiving any personal consideration from any party dealing with the Plan in a transaction involving the Plan’s assets.  Thus, absent an exemption, an investment adviser may not provide advice to a Plan where the adviser will earn additional fees in connection with transactions entered upon that advice, has a conflict of interest or will receive compensation or other things of value from third parties involved in such transactions. 

Before Congress created the Statutory Exemption under the Pension Protection Act of 2006 (“PPA”), there were few exemptions providing relief in connection with the provision of investment advice to the participants and beneficiaries of Plans.  Thus, advisers generally had to structure their products to avoid the prohibitions of section 406(b) altogether.

Advisers utilized three main approaches in structuring their products.  First, advisers structured certain products as “investment education” in accordance with Department of Labor Interpretive Bulletin 96-1, 29 CFR § 2509.96-1 ("IB 96-1"), which describes four types of investment-related participant information that the Department views as outside the definition of fiduciary “investment advice.”  Second, advisers structured their fiduciary investment advice products, through fee leveling or offsets, to ensure that their fees did not vary with the advice provided.  The Department of Labor conditionally sanctioned such methods in Adv. Op. 97-15A (May 22, 1997) and Adv. Op. 2005-10A (May 11, 2005).  Third, advisers based their products on independently developed and maintained financial advice or programs, without any fee leveling or offset.  The Department conditionally sanctioned this approach in Adv. Op. 2001-09A (Dec. 14, 2001). 

The Statutory Exemption represents a variation on these prior practices, providing relief for “eligible investment advice arrangements” (“Eligible Arrangements”).  Eligible Arrangements include certain advisory products under which either (i) the fiduciary adviser’s compensation does not vary with the investment option selected or (ii) a computer model generates the investment advice.

The Statutory Exemption’s “computer model” provisions do not apply automatically to IRAs.  Congress directed the Secretary of Labor to determine, by the end of 2007, whether a computer model exists that would be feasible for IRAs.  If the Secretary of Labor were to find such a model, the Statutory Exemption’s computer model provisions would apply to its use in connection with IRAs.  If no such model were found, the Secretary was required to issue a class exemption for IRAs to supplement the Statutory Exemption.

In early 2007, the Department of Labor released Field Assistance Bulletin 2007-01 (Feb. 2, 2007) ("FAB").  The FAB confirmed that the Department’s prior guidance on the pre-PPA methods of structuring advisory programs around the prohibitions of Section 406(b) remains effective.  The FAB also addressed the scope of the fee-leveling requirement (and in particular clarified that the fee leveling requirement applies to the fiduciary adviser and not all of its affiliates, leaving open whether "fiduciary adviser" means the company employing the individual acting as a fiduciary or the individual himself) and other interpretive issues, but left other issues, such as the mechanics of incorporating employer stock and brokerage window options into the computer model, unresolved.

It is against this background that the Department issued the two proposals.

The Regulations
The Regulations reiterate and expand upon the definition of Eligible Arrangements provided by “fiduciary advisers” under ERISA section 408(g).  Fiduciary advisers include only U.S. or state registered investment advisers, trust departments of U.S. or state supervised banks, state regulated insurance companies, U.S. registered broker-dealers, their affiliates, and those of their employees, agents and registered representatives that satisfy the requirements of applicable insurance, banking, and securities laws relating to the provision of advice.  Notably, the Regulations do not expressly restrict the type of “affiliates” that may qualify as fiduciary advisers, leaving open the question of whether foreign affiliates and non-trust departments of bank affiliates may qualify.  

Fee-Leveling Products.  Under the Regulations, a fee-leveling advisory product must meet the following conditions, among others:

• The advice is based on generally accepted investment theories that, at a minimum, take into account the historic returns of different asset classes over defined periods of time;
• The advice takes into account, at a minimum, information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences;
• Compensation (including salary, bonuses, awards, promotions, commissions or other things of value) received, directly or indirectly, by any employee, agent or registered representative that provides investment advice on behalf of a fiduciary adviser does not vary with the investment option selected by a participant or beneficiary; and
• Any fees (including any commission or other compensation) received by the fiduciary adviser for investment advice or in connection with the investment of plan assets do not vary with the investment option selected by a participant or beneficiary.

Note that, on their face, the level fee conditions apply to the fiduciary adviser, as well as to the employees, agents and registered representatives providing advice on the adviser’s behalf.  However, those conditions do not apply to fees and other compensation received by affiliates of the fiduciary adviser (provided that the affiliates do not provide advice to the plan).

Computer Model Products.  Under the Regulations, a computer model advisory product must meet the following conditions, among others:

• The advice is generated by a qualifying computer model;
• Any investment pursuant to that advice occurs solely at the direction of the participant or beneficiary.

A qualifying computer model is one that is designed and operated to:

• Apply generally accepted investment theories that take into account, at a minimum, the historic returns of different asset classes over defined periods of time; and
• Utilize, at a minimum, information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences;
• Utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the plan;
• Avoid recommendations that inappropriately favor options (i) offered by the fiduciary adviser or a person with a material affiliation or contractual relationship with the fiduciary adviser or (ii) that may generate greater income for the fiduciary adviser or such a person; and
• Take into account all designated investment options available under the plan (other than brokerage windows and options investing primarily in employer securities) without giving inappropriate weight to any investment option.

The requirement that the product avoid recommendations inappropriately favoring options that may generate greater income is new; it does not appear in the statute.  In the preamble to the Regulations, the Department invited comment on this addition, citing, as an example of inappropriate favoring, a bias toward more expensive investment options. 

The exception for brokerage window and employer security options is also new.  It addresses the practical difficulty of factoring such options into a computer model, as the statute would otherwise seem to require.

The Regulations echo the statutory requirement that a qualified, independent expert certify that a computer model (and any subsequent modification) meets the applicable requirements before it may be utilized.  Departing from the statute, however, the Regulations require that the certification be in writing and that it detail the basis for and limitations to the expert’s opinion.

General Conditions. 

(1) Express Authorization.  The Regulations repeat the statutory requirement that an independent fiduciary expressly authorize the arrangement, but clarify that, in the case of an IRA, the IRA beneficiary must provide the authorization.  The Regulations also clarify that IRA beneficiaries will not fail the independence requirement merely because they are employed by the adviser, thus permitting IRA beneficiaries to participate in advisory arrangements offered by their employers.

(2)  Annual audit.  The Regulations repeat the statutory requirements of an annual compliance audit by an independent auditor and a written audit report.  However, the Regulations clarify that it is the duty of the fiduciary adviser to engage the auditor and adds a requirement that the auditor issue its report to the fiduciary adviser and each authorizing fiduciary within 60 days of completion of the audit.  The Regulations establish a special notice rule for IRAs, requiring that   the fiduciary adviser, within 30 days of receiving the report, either furnish a copy to the IRA beneficiary or make the report available on its website.  The Regulations also go beyond the statute and require the fiduciary adviser to send the Department a copy of any report identifying noncompliance.

 (3)  Disclosure.  The fiduciary adviser must provide, without charge, to a participant or a beneficiary before the initial provision of investment advice, a detailed written notification of, among other things, fees and other compensation received, relationships among relevant parties, fiduciary status of the adviser, the services/products being offered and product limitations and availability of other advisers.  The Regulations include a model disclosure form, which we reproduce below.  Moreover, the fiduciary adviser must maintain and make available (either affirmatively or upon request and without charge) this information, including material changes in such information.

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Model Fiduciary Adviser Disclosure Form

This document contains important information about [enter name of Fiduciary Adviser] and how it is compensated for the investment advice provided to you. You should carefully consider this information in your evaluation of that advice.  [enter name of Fiduciary Adviser] has been selected to provide investment advisory services for the [enter name of Plan].  [enter name of Fiduciary Adviser] will be providing these services as a fiduciary under the Employee Retirement Income Security Act (ERISA).  [enter name of Fiduciary Adviser], therefore, must act prudently and with only your interest in mind when providing you recommendations on how to invest your retirement assets.

Compensation of the Fiduciary Adviser and Related Parties

[enter name of Fiduciary Adviser] (is/is not) compensated by the plan for the advice it provides. (if compensated by the plan, explain what and how compensation is charged (e.g., asset-based fee, flat fee, per advice)).  (If applicable, [enter name of Fiduciary Adviser] is not compensated on the basis of the investment(s) selected by you.)

Affiliates of [enter name of Fiduciary Adviser] (if applicable enter, and other parties with whom [enter name of Fiduciary Adviser] has a material affiliation or material contractual relationship) also will be providing services for which they will be compensated.  These services include: [enter description of services, e.g., investment management, transfer agent, custodial, and shareholder services for some/all the investment funds available under the plan.]

When [enter name of Fiduciary Adviser] recommends that you invest your assets in an investment fund of its own or one of its affiliates and you follow that advice, [enter name of Fiduciary Adviser] or that affiliate will receive compensation from the investment fund based on the amount you invest.  The amounts that will be paid by you will vary depending on the particular fund in which you invest your assets and may range from --% to --%.

Specific information concerning the fees and other charges of each investment fund is available from [enter source, such as:  Your plan administrator, investment fund provider (possibly with Internet Web site address)].  This information should be reviewed carefully before you make an investment decision.

If applicable enter, [enter name of Fiduciary Adviser] or affiliates of [enter name of Fiduciary Adviser] also receive compensation from non-affiliated investment funds as a result of investments you make as a result of recommendations of [enter name of Fiduciary Adviser].  The amount of this compensation also may vary depending on the particular fund in which you invest. This compensation may range from --% to --%.  Specific information concerning the fees and other charges of each investment fund is available from [enter source, such as:  Your plan administrator, investment fund provider (possibly with Internet Web site address)].  This information should be reviewed carefully before you make an investment decision. (if applicable enter, In addition to the above, [enter name of Fiduciary Adviser] or affiliates of [enter name of Fiduciary Adviser] also receive other fees or compensation, such as commissions, in connection with the sale, acquisition of holding of investments selected by you as a result of recommendations of [enter name of Fiduciary Adviser].  These amounts are: [enter description of all other fees or compensation to be received in connection with sale, acquisition or holding of investments].  This information should be reviewed carefully before you make an investment decision.

Investment Returns

While understanding investment-related fees and expenses is important in making informed investment decisions, it is also important to consider additional information about your investment options, such as performance, investment strategies and risks.  Specific information related to the past performance and historical rates of return of the investment options available under the plan (has/has not) been provided to you by [enter source, such as:  Your plan administrator, investment fund provider]. (if applicable enter, If not provided to you, the information is attached to this document.)  For options with returns that vary over time, past performance does not guarantee how your investment in the option will perform in the future; your investment in these options could lose money.

Parties Participating in Development of Advice Program or Selection of Investment Options

Name, and describe role of, affiliates or other parties with whom the fiduciary adviser has a material affiliation or contractual relationship that participated in the development of the investment advice program (if this is an arrangement that uses computer models) or the selection of investment options available under the plan.

Use of Personal Information

Include a brief explanation of the following:  what personal information will be collected; how the information will be used; parties with whom information will be shared; how the information will be protected; and when and how notice of the Fiduciary Adviser's privacy statement will be available to participants and beneficiaries.

Consider Impact of Compensation on Advice

The fees and other compensation that [enter name of Fiduciary Adviser] and its affiliates receive on account of assets in [enter name of Fiduciary Adviser] (enter if applicable, and non-[enter name of Fiduciary Adviser]) investment funds are a significant source of revenue for the [enter name of Fiduciary Adviser] and its affiliates.  You should carefully consider the impact of any such fees and compensation in your evaluation of the investment that [enter name of Fiduciary Adviser] provides to you.  In this regard, you may arrange for the provision of advice by another adviser that may have not material affiliation with or receive compensation in connection with the investment funds or products offered under the plan. This type of advice is/is not available through your plan.

Should you have any questions about [enter name of Fiduciary Adviser] or the information contained in this document, you may contact [enter name of contact person for fiduciary adviser, telephone number, address].

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(4)  Other Conditions.  The Regulations echo the statute in requiring certain other conditions, including:  (a) The fiduciary adviser provides appropriate disclosure in accordance with all applicable securities laws, (b) The sale, acquisition, or holding occurs solely at the direction of the recipient of the advice, (c) The compensation received by the fiduciary adviser and affiliates thereof in connection with the sale, acquisition, or holding is reasonable, and (d) The terms of the sale, acquisition, or holding are at least as favorable to the plan as an arm's length transaction would be.

(5)  Maintenance of Records.  The Regulations echo the statute in requiring the fiduciary adviser to maintain, for a period of not less than 6 years after the provision of investment advice pursuant to the arrangement, any records necessary for determining whether the applicable requirements have been met.

General Comments on Definitions.  Like the statute, the Regulations generally sweep into the definition of “fiduciary adviser” the persons who develop the computer model, or market the computer model or investment advice program, utilized under the Statutory Exemption.  A special exception is conditionally made where one such person elects to be treated as the sole fiduciary with respect to such model.  Further, the Regulations retain the statute’s expansive definitions of “affiliate” and add a definition of “material affiliation,” both of which turn, in part, on ownership or control of as little as 5% of a person’s total outstanding stock or other interests.  The Regulations also add a definition of “material contractual relationship,” referring to where payments made by one person to the other person pursuant to written contracts or agreements between the persons exceed 10 percent of the gross revenue, on an annual basis, of such other person.

The Class Exemption
As explained above, Congress directed that the Statutory Exemption’s computer model provisions would not apply to IRAs unless the Secretary of Labor determined that models appropriate for IRAs existed.  The Secretary determined that such models exist.  Thus, IRAs may utilize the Statutory Exemption’s computer model provisions.

The Class Exemption supplements, for both IAPs and IRAs, the relief provided by the Statutory Exemption.  The Class Exemption covers the same three transactions as the Statutory Exemption:  (i) the provision of investment advice by a fiduciary adviser to participants and beneficiaries in participant-directed IAPs and beneficiaries of IRAs, (ii) transactions entered in reliance on such advice, and (iii) the receipt of fees by the fiduciary adviser in connection with such advice or transactions.  The Class Exemption also echoes many of the terms and conditions of the Statutory Exemption.  However, the Class Exemption expands relief in two key ways:

• It permits individualized investment advice after the furnishing of computer model recommendations or, in the case of IRAs with respect to which modeling is not feasible, certain investment education material;
• It limits fee-leveling requirements to compensation received by the employee, agent or registered representative providing advice on behalf of the fiduciary adviser (those requirements do not apply to the fiduciary adviser’s own compensation).

The first change reflects the reality that most IRAs have virtually unlimited investment choices, thus rendering recommendations based on computer modeling infeasible.  Thus, IRA beneficiaries are generally expected to find the Class Exemption more useful than the Statutory Exemption. 

The second change reflects the Department’s view that the conditions of the Class Exemption are protective of participants and beneficiaries even where advice leads to greater income at the fiduciary adviser-entity level.  In this regard, the Class Exemption provides that, if a fiduciary advisor or an affiliate would earn greater income as a result of advice (other than advice generated solely by a computer model within the terms of the Class Exemption), the fiduciary advisor must determine that the recommendation is in the best interest of the IRA owner and explain the reasons for that determination to the client.

You may obtain a copy of the Regulations at (Regulations).  You may obtain a copy of the Class Exemption at (Proposed Class Exemption).  Questions about these proposals may be directed to Melanie Nussdorf at 202.429.3009, Eric Serron at 202.429.6470 or Patrick Menasco at 202.429.6215.

[1]  For convenience, except where the text or context dictates otherwise, references to ERISA hereinafter shall include references to the parallel provisions of the Code.