The U.S. Department of Labor has released its package of proposed changes to the regulation defining fiduciary advice and to the exemptions for conflicts and compensation for investment recommendations to retirement plans, participants (including rollovers), and IRAs.
Key Takeaways
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- ERISA’s fiduciary and prohibited transaction rules require consideration of costs and compensation when fiduciary recommendations are made to “retirement investors,” that is, to private sector retirement plans, participants in those plans, and IRA owners.
- Where the Internal Revenue Code’s prohibited transaction rules are violated, the protection of an exemption will be needed. In that case, the protections of PTEs 84-24 and 2020-02 will require that costs and compensation be considered.
- The consideration is that the costs and/or compensation cannot be more than a reasonable amount.
- However, the determination of what is reasonable is largely left to industry practices—that is, what would the costs for a product or service, or the compensation of an advisor or agent, be in a transparent and competitive market.
The ERISA fiduciary responsibility rules require that plan costs, for both investments and services, be no more than a reasonable amount. In other words, a prudent process will consider the costs of investments and services relative to the value of those investments or services to the retirement investor. The ERISA prohibited transaction rules impose a similar limit on compensation where there is a fiduciary recommendation that results in a conflict of interest, that is, the compensation cannot be more than a reasonable amount when compared to the value of services being offered (and, in most cases, that would be the compensation paid for those services in a transparent and competitive marketplace). These rules apply to all ERISA-governed retirement plans and participant accounts in those plans.
The Code has prohibited transaction provisions with a similar limitation on compensation, that is, compensation cannot exceed a reasonable amount relative to the services provided. The Code limits apply to both tax-qualified retirement plans and IRAs (including individual retirement annuities). However, the Code does not have a standard of care for advice to IRAs. Instead, the applicable standard of care is imposed by other laws and regulations (for example, the fiduciary standard for investment advisers, the best interest standard for broker-dealers, and the NAIC model rule’s best interest standard for insurance agents and brokers).
But that is only part of the story. When a fiduciary recommendation results in a conflict of interest that is a prohibited transaction, the advisor or agent will need the protection of a PTE, a prohibited transaction exemption—either PTE 2020-02 or PTE 84-24. And both PTEs require a “best interest” process that would necessarily involve consideration of cost of the investments or services being recommended. (Common examples of fiduciary prohibited transactions in retirement accounts are: rollover recommendations, recommendations to transfer IRAs, any recommendation that involves transaction-based compensation to the advisor/agent or the firm.)
The question for this article is, how do you determine the reasonableness of compensation and costs. Neither ERISA nor the Code have a formulaic answer to that question.
A practical definition is that reasonableness is what an informed investor, operating in a competitive marketplace and with knowledge of the material facts, would agree to.
Importantly, reasonableness is not a percent or an amount. Instead, it is a range. That is because, in the private sector, competitors may charge a range of costs or pay a range of compensation for a particular product or service. If an investor were to know the range of private market costs or compensation for a particular product or service, the investor could see where those costs and compensation congregated . . . the investor would also be able to see the outliers. Stated differently, the congregated numbers are reasonable, while the outliers on the high side are probably unreasonable (assuming substantially identical products and services).
In that regard, it should be obvious that costs or compensation that are above average are not necessarily unreasonable. As one court (Singh v. Deloitte) has said:
“Moreover, the mere fact that a fund charges an expense ratio higher than the mean or median, in and of itself, does not imply that the cost was excessive. Otherwise, by definition, half of all funds would charge excessive fees.”
While that doesn’t say where the outer limit of reasonableness lies, it does make clear that “reasonable” does not mean “below average”.
Another court (Dupree v. Prudential) explained:
“For any particular type of investment, there is a range of fees that is considered reasonable. Fees charged by competing strategies-even in a single investment class-will vary somewhat based on different ideologies and styles.”
In that case, the judge agreed with expert testimony that the expense ratios of any of the plan’s investments at or below the 75% percentile of expenses of peer investments was reasonable. The judge further concluded, again based on an expert’s testimony, that one investment’s expense ratio that was at the 90% percentile compared to peer investments was also reasonable.
Court decisions tend to be based on the facts and circumstances of the particular case. Don’t interpret this decision as saying that the 75 percentile is always safe (and, of course, don’t interpret it as saying that the 90% a good measurement of a reasonable expense ratio).
Instead, a fair reading of these cases is that (1) “reasonable” does not mean below average, and (2) there are a range of costs that can be reasonable, and that, within the range some are below average and others are above average. That range is determined by common costs for similar investments or services. That is, the determination of the range of reasonableness is a comparative analysis. Look at where the data points on the costs or compensation congregate as being the range. This is best visualized as a scatter gram.
Those cases were about the reasonableness of costs associated with investments. However, the same principles should apply to the reasonableness of compensation for services. What is the range of compensation for substantially similar services…and what is the value of the service to the retirement investor based on the investor’s profile?
As a word of caution, this discussion does not apply to the issue of share classes. Where an investment (e.g., a mutual fund) has multiple share classes, fiduciaries need to consider the availability of the share classes and determine which is in the best interest of the participants. For example, an institutional share class may be the least expensive, but a revenue sharing share class may have a lower net expense. In this case the investment is the same, the only difference is the associated cost.
Concluding Thoughts
Costs and compensation are both critical factors in providing advice and recommendations to retirement investors. A prudent process for making recommendations, e.g., for rollovers, mutual funds, annuities, should consider the relative costs of the alternatives. But that does not necessarily mean that the more expensive option is impermissible. Instead, the question is whether the recommended alternative provides sufficient additional value to the retirement investor to justify the higher cost.
Similarly, while the analysis of reasonable compensation includes looking at what others charge for similar services, it also includes consideration of the value provided. More time-consuming services, or more complicated analysis, can justify higher compensation…if the additional work is justified by the needs of the retirement investor.
