In June 2020, the U.S. Department of Labor issued a highly anticipated re-proposal expanding the definition of “investment advice fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA). The change will have a dramatic impact on the Wealth Management industry as it relates to IRA rollovers, and will require firms and investment professionals to quickly adjust their business models and practices to not run afoul of new standards.
The rollover market is a profitable one. As of September 2020, employer-sponsored retirement plan assets totaled approximately $9.3 trillion according to the Investment Company Institute. As those assets are rolled into IRAs, they represent a lucrative revenue stream for those in a position to manage the rollover process while adhering to the new standards. Of course, there are factors that could influence the demand for rollovers. As Fidelity demonstrated last year, plan administrators can make the decision to reverse their long-standing position of aggressively pushing for rollovers of their custodied accounts and agreeing to advise assets that stay with the old plan sponsor. Regardless of such factors, the market opportunity will remain significant.
Firms participate in this market in two primary ways. Broadly, firms with a fee-based business model typically take on a higher standard of care for their clients as fiduciaries and must adhere to stricter standards in the advice they give and the products they suggest. Commission-based firms have more leeway with the products they are able to provide as both fiduciaries and non-fiduciaries, which can give clients more options to choose from but may require more diligence and sophistication on the part of the individual to navigate.
So, what’s new in the Proposal?
The Proposal, in summary, has two major components. First, the rule reaffirms the Five-Part Test for determining what constitutes investment advice under ERISA. Second, the proposal introduces a Notice of Proposed Class Exemption regarding rollovers of employer-sponsored retirement plans to IRAs. The Notice requires fiduciary investment advice on such accounts to be provided in accordance with the DOL’s Impartial Conduct Standard. The DOL believes that, unless provided on a one-off basis, advice to take a distribution of assets from an employer-sponsored retirement plan is advice to sell, withdraw, or transfer investment assets currently held in the plan, and therefore is covered by the Five-Part Test. It does not, however, prohibit firms and their investment professionals from entering into compensation arrangements or engaging in certain principal transactions that would otherwise be prohibited under ERISA. In short, the Proposal suggests that investment professionals making rollover recommendations now need to adhere to a new set of fiduciary standards.
This raises a lot of questions for the industry. Have we reached an inflection point in the rollover market, one that will push many non-fiduciary investment professionals in the industry to finally embrace a fiduciary model? Will we see a shift in products and a flight to value, much like we saw in the EU as a result of MiFID II? What solutions, technology, and process will firms have to put in place to ensure adherence to the new standards? The answers are not yet clear, but we can identify several topics of particular interest.
How will things change?
Let’s start with the potential impact on the advisory model. It seems logical to assume new standards would result in an uptick in fiduciary advisors. Inherently, fiduciaries already adhere to the Five-Part Test and the Impartial Conduct Standard, so rollovers falling under this umbrella should have no impact on their day-to-day business. One may conclude that the Proposal could be the push needed to move many non-fiduciaries with significant revenue tied to rollover business toward the fiduciary model, allowing them to continue reaping the rewards of this lucrative business while adhering to the new standards. What exactly this migration would look like is not certain, but it will surely involve a combination of firms and investment professionals modifying their business model. We are also likely to see individual professionals moving to firms that already meet the new standards. For those firms considering modifying their business model, they will have to determine if the opportunity is worth the time, resources and cost necessary to ensure compliance or if they should focus efforts elsewhere and simply exit the rollover market.
The new standards have the potential to lead product manufacturers to revisit and re-engineer some investment offerings to provide more favorable fee structures and risk characteristics.
Investment products may also be impacted by the new standards. There could be a shift toward more tailored products that minimize compensation agreement (commissions, 12b-1 fees, revenue sharing) conflicts and the need for professionals to overtly justify their product recommendations. This would represent a proactive approach to reducing the likelihood of the DOL pursuing prohibited transaction claims. Additionally, the new standards have the potential to lead product manufacturers to revisit and re-engineer some investment offerings to provide more favorable fee structures and risk characteristics. The implementation of MiFID II in the EU, which stated products targeted to the retail market should be identified based on investment knowledge, loss tolerance, risk/reward profile, as well as objectives and needs, led to just this outcome – manufacturers modified and tailored their products for certain segments of the market. Although the Proposal is unlikely to push the industry that far, it is conceivable that product manufacturers may take notice and incorporate some of these aspects so that their products are more rollover friendly.
The rollover recommendation process itself will also be impacted, with a greater focus on increased transparency, documentation, and reporting. From a transparency perspective, prior to a transaction, institutions will need to provide written disclosures to investors, acknowledging their fiduciary status, outlining the services being provided, and disclosing any material conflicts of interest. As for documentation, firms themselves will need to establish, maintain, and enforce written procedures to ensure compliance with the Impartial Conduct Standards and document why a rollover is in the best interest of their client prior to execution. Lastly, from a reporting perspective, reviews must be conducted on an annual basis to determine a financial institution’s compliance with the impartial conduct standards and include an annual certification from the institution’s executive or equivalent officer. Detailed documentation records must then be maintained for six years and made available to authorized requesting parties
There will be firms that have existing solutions in need of simple tweaking or configuration to align with the new standards, while others will need to implement a new technology solution for the first time.
What can be done?
How non-fiduciary advisors and firms choose to adhere to the new standards will vary widely, but technology will no doubt be at the forefront of any approach. There will be firms that have existing solutions in need of simple tweaking or configuration to align with the new standards, while others will need to implement a new technology solution for the first time. Regardless of the approach, the technical solution will have several key requirements:
- Workflow – There are a number of solutions available in the market today, each with varying levels of sophistication, configuration, and workflow. Implementation of a repeatable process through an application that touches the entire lifecycle of a rollover – qualification, account opening/initiation, investment selection, implementation/execution, and ongoing maintenance, each of these representing a “checkpoint” in the process – will be paramount.
- Documentation – The necessary documentation will need to be provided at most, if not all of the checkpoints throughout the recommendation process. The documentation serves two purposes – internal compliance and client notification and/or approval.
- Signoff/Approval – Aspects of the process will need to encompass client signoff prior to execution while others will require manager approval if firms so desire.
- Reporting – Periodic and ad-hoc reporting across all rollover accounts to proactively identify potential compliance risks while adhering to the new standards.
Given the experience of the past year and the changing political environment, it’s clear that more change is imminent, and the industry needs to remain agile and prepared for the various scenarios that may arise.
Ultimately, how the final Proposal plays out and the resulting impact on the industry is an unknown at this point. Given the experience of the past year and the changing political environment, it’s clear that more change is imminent, and the industry needs to remain agile and prepared for the various scenarios that may arise. While no one can say with certainty what’s next, we are here to put our depth of experience to use and help out our clients however we can.