In a recent blog post on the fiduciary rule, Fred Reish notes that the fiduciary and best-interest standards of care, as well as the prohibited transaction rules, will have some unexpected effects — and he offers an example.
When plan or IRA assets are held by a custodian, Reish notes that recommending either transaction-fee (TF) mutual funds or no-transaction-fee (NTF) mutual funds will be a fiduciary act for plan assets, and a best interest act for IRA assets, at least any payment is received beyond a stated fee that is level.
For both the prudence and best-interest standards of care (which Reish notes are “virtually identical”), one must consider whether it is prudent to recommend a TF fund or an NTF fund. Of course, NTF funds typically have a higher expense ratio, while TF funds charge an initial transaction cost but usually have a lower expense ratio — meaning that in general, NTF funds would be appropriate for short-term holdings, while TF funds would be more cost-effective for longer-term holdings, according to Reish.
But wait — to further compound matters, he explains that there are also prohibited transaction issues. “Some custodians pay money to advisors if the advisors select NTF funds (because, I assume, the custodians make more money on NTF funds),” he writes, going on to note that the Department of Labor would consider those payments to be prohibited transactions, “since they result from a recommendation and since they generate payments above and beyond the stated level fee.
“However, not all is lost,” Reish says, going on to explain that, “under the Best Interest Contract Exemption (BICE), where an advisor receives additional compensation that is prohibited under these rules, the additional compensation is permissible, if the conditions of the exemption are met” — one of those being that the total compensation cannot be more than a reasonable amount. (He notes that for plan purposes, the additional compensation would need to be disclosed in the advisor’s 408(b)(2) disclosures.) Moreover, he explains that for both plan and IRA assets, “it is possible, perhaps even likely, that an assertion could be made that undisclosed compensation is impermissible (since, arguably, the advisor is setting its own compensation as a result of the nondisclosure).” All this meaning that, as a result, a disclosure should be made, at the beginning of the fiduciary relationship, all of the compensation that will or may be received, he writes.
Reish elaborates that there are two other conditions for BICE: One cannot make any materially misleading statements about the transactions or the compensation, and one must adhere to the best interest standard of care, including deciding whether the prudent recommendation is to use TF or NTF funds. “If those conditions are not satisfied, the additional compensation is impermissible, at least from the perspective of the Department of Labor,” he notes.
And then, “to make matters even more complex,” Reish explains, “the Best Interest Contract Exemption only protects compensation resulting from non-discretionary advice. So, for example, if the advisor is the one who decides to use NTF funds,that decision amounts to discretion. In that case, BICE would not be available to permit the prohibited payments from the custodian,” he concludes.
Reish closes by cautioning that it is necessary to review all sources of compensation directly or indirectly from “qualified” assets (plans, participants or IRAs) because “the changes are more far-reaching than most people think.”
Indeed.
When plan or IRA assets are held by a custodian, Reish notes that recommending either transaction-fee (TF) mutual funds or no-transaction-fee (NTF) mutual funds will be a fiduciary act for plan assets, and a best interest act for IRA assets, at least any payment is received beyond a stated fee that is level.
For both the prudence and best-interest standards of care (which Reish notes are “virtually identical”), one must consider whether it is prudent to recommend a TF fund or an NTF fund. Of course, NTF funds typically have a higher expense ratio, while TF funds charge an initial transaction cost but usually have a lower expense ratio — meaning that in general, NTF funds would be appropriate for short-term holdings, while TF funds would be more cost-effective for longer-term holdings, according to Reish.
But wait — to further compound matters, he explains that there are also prohibited transaction issues. “Some custodians pay money to advisors if the advisors select NTF funds (because, I assume, the custodians make more money on NTF funds),” he writes, going on to note that the Department of Labor would consider those payments to be prohibited transactions, “since they result from a recommendation and since they generate payments above and beyond the stated level fee.
“However, not all is lost,” Reish says, going on to explain that, “under the Best Interest Contract Exemption (BICE), where an advisor receives additional compensation that is prohibited under these rules, the additional compensation is permissible, if the conditions of the exemption are met” — one of those being that the total compensation cannot be more than a reasonable amount. (He notes that for plan purposes, the additional compensation would need to be disclosed in the advisor’s 408(b)(2) disclosures.) Moreover, he explains that for both plan and IRA assets, “it is possible, perhaps even likely, that an assertion could be made that undisclosed compensation is impermissible (since, arguably, the advisor is setting its own compensation as a result of the nondisclosure).” All this meaning that, as a result, a disclosure should be made, at the beginning of the fiduciary relationship, all of the compensation that will or may be received, he writes.
Reish elaborates that there are two other conditions for BICE: One cannot make any materially misleading statements about the transactions or the compensation, and one must adhere to the best interest standard of care, including deciding whether the prudent recommendation is to use TF or NTF funds. “If those conditions are not satisfied, the additional compensation is impermissible, at least from the perspective of the Department of Labor,” he notes.
And then, “to make matters even more complex,” Reish explains, “the Best Interest Contract Exemption only protects compensation resulting from non-discretionary advice. So, for example, if the advisor is the one who decides to use NTF funds,that decision amounts to discretion. In that case, BICE would not be available to permit the prohibited payments from the custodian,” he concludes.
Reish closes by cautioning that it is necessary to review all sources of compensation directly or indirectly from “qualified” assets (plans, participants or IRAs) because “the changes are more far-reaching than most people think.”
Indeed.
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