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Who Does the DOL's Conflict of Interest Rule Apply To?

Three elements must be present in order for the Rule to apply to an advisor communicating with a plan participant or an IRA owner.

W. Scott Simon, 12/01/2016

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

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This month's column constitutes Part 3 of my series on understanding the Conflict of Interest Rule (Rule), which was promulgated by the U.S. Department of Labor (DOL) on April 8. To--hopefully--help gain a better understanding of this very long, quite complicated Rule, let's first have a look at what I call "Fiduciary Central" of the Employee Retirement Income Security Act of 1974 (ERISA).

Fiduciary Central of ERISA
ERISA section 3(21)--Fiduciary Central of ERISA--defines the three "kinds" of fiduciaries to plans:

The first kind (pursuant to ERISA section 3(21)(A)(i)) is a fiduciary that exercises any discretionary authority or discretionary control with respect to management of a plan, or exercises any authority or control with respect to management or disposition of its assets.

This kind of plan fiduciary can be thought of as a discretionary decision-maker. An example of this kind of 3(21) fiduciary is an ERISA section 3(38) investment manager that is appointed by a plan sponsor (or a named fiduciary of the plan) to take on sole responsibility (and any associated liabilities) to select, monitor, and (if necessary) replace all (or some) of a plan's investment options.

The second kind of fiduciary (pursuant to ERISA section 3(21)(A)(ii)) is one that renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of a plan, or has any authority or responsibility to do so.

This kind of fiduciary can be thought of as a non-discretionary advice-giver. Although it is a 3(21) plan fiduciary, it has no legal power or ability--that is, no legal discretion--to make decisions concerning a plan. That discretion (and any associated liabilities) typically remains lodged with the plan sponsor.

Providers of "bundled" retirement plan solutions--typically insurance companies and mutual fund families--almost never assume the responsibilities (and liabilities) of any kind of 3(21) plan fiduciary. Even in those truly rare cases where they do, they will limit themselves to being an ERISA section 3(21)(A)(ii) non-discretionary advice-giver. As I've said innumerable times in this column over the years, such providers just don't want to have anything do with being a fiduciary. They are much more comfortable in their role as fee-generating machines within a caveat emptor environment in which they enjoy a vast asymmetrical information advantage over plan participants--and what's worse, plan sponsors--even many that consider themselves to be sophisticated.

The proof of the pudding for how rare it is for a bundled provider to be any kind of ERISA fiduciary is found in the contracts that insurance companies, mutual fund families, et al. draft (which are typically largely accepted intact by plan sponsors) in which they always make very clear that "ultimately" (a favorite word used in these contracts within this context) the plan sponsor is on the hook--that is, solely legally responsible and liable--for any decisions concerning a plan's menu of investment options. This means that legally the "buck stops" with the plan sponsor.

That situation contrasts sharply with one where the buck stops with an ERISA section 3(21)(A)(i) discretionary decision-maker such as an ERISA 3(38) investment manager. A plan sponsor, in effect, can legally "pass the buck" to a 3(38).

At this point, it may be useful to examine an issue that commentators often refer to as the "3(21) vs. 3(38)" dichotomy, which is somewhat of a misnomer. The 3(21) referred to in this dichotomy is a non-discretionary fiduciary advice-giver (pursuant to ERISA section 3(21)(A)(ii)), while the 3(38) referred to is counterpoised as a discretionary fiduciary decision-maker (pursuant to ERISA section 3(21)(A)(i)).

The lynchpin between the two, of course, is discretion. When discretion is conferred under ERISA, legal responsibility and liability ensue, but if no such conferral occurs, then they don't. The significant difference between the legal protection provided to plan sponsors by a discretionary decision-maker such as an ERISA section 3(38) investment manager (which also happens to be a 3(21) fiduciary (little i)) and a non-discretionary advice-giver such as an ERISA section 3(21) fiduciary (little ii)) cannot be overstated. As such, the 3(21) vs. 3(38) dichotomy is a false one because a 3(38) is also a 3(21)--that is, one that's a discretionary decision-maker. Both kinds of fiduciaries are, in fact, 3(21) fiduciaries but with vastly different legal responsibilities and liabilities and, hence, vastly different protections they can provide to plan sponsors and, by implication, to plan participants and their beneficiaries.

The third kind of fiduciary (pursuant to ERISA section 3(21)(A)(iii)) is one that has any discretionary authority or discretionary responsibility in the administration of a plan.

The Conflict of Interest Rule Pertains to One Kind of ERISA Fiduciary
In understanding the Rule, we can see right off the bat that the third kind of ERISA fiduciary--a 3(21) administrative fiduciary (little iii)--is irrelevant because it has nothing to do with investing. Remember, part of the title of the Rule is "retirement investment advice."

We can also ignore the first kind of ERISA fiduciary--a 3(21) discretionary decision-maker (little i) such as an ERISA section 3(38) investment manager because, in making such decisions, the benefits of the Rule are not available to fiduciaries that receive variable compensation in exchange for rendering discretionary investment advice--only non-discretionary advice.

Indeed, it's only the second kind of fiduciary--a 3(21) non-discretionary advice-giver (little ii)--which the Rule pertains to: (1) a fiduciary (2) that renders (non-discretionary) investment advice (3) for compensation.

All three of these elements must be present in order for the Rule to apply to an advisor communicating with a plan participant or an IRA owner.

The Conflict of Interest Rule Pertains to One Kind of Investment Advice
The Rule pertains only to non-discretionary investment advice provided in accordance with ERISA section 3(21)(A)(ii) and not to discretionary investment advice provided in accordance with ERISA section 3(21)(A)(i). Relief is therefore not available when an adviser has or exercises any discretionary authority or discretionary control with respect to a recommended transaction.

(It should be noted here that the term "discretionary advice" isn't actually defined in ERISA. But it's widely interpreted to mean an exercise of authority or control respecting management or disposition of plan assets. See ERISA section 3(21)(A)(i)), which describes the duties of a fiduciary falling within the ambit of that section: exercises any discretionary authority or discretionary control with respect to management of a plan or exercises any authority or control with respect to management or disposition of its assets.)

The Rule doesn't apply to discretionary advice rendered to plan participants or to IRA owners; it only expands the definition of "investment advice." The DOL's stance in this regard appears to be that a fiduciary exercising discretion should already have been in compliance, so the protections of the Rule won't be available to it. In the absence of that relief, advice rendered to discretionary accounts--whether held by plan participants or IRA owners--will have to be conflict-free (i.e., no variable compensation) or somehow be able to secure the protections of a Prohibited Transaction Exemption. (This position may be somewhat convoluted with respect to IRAs given that the Internal Revenue Service, which has sole enforcement jurisdiction with respect to IRAs, has not enforced the Prohibited Transaction rules against service providers under section 4975 of the Internal Revenue Code.)

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understandingis the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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