The Department of Labor has issued its final regulation defining fiduciary status for investment advice to retirement investors and the related exemptions for prohibited conflicts—PTEs 2020-02 and 84-24. The exemptions provide relief from prohibited compensation resulting from fiduciary recommendations to “retirement investors”—private sector retirement plans, participants in those plans (including rollover recommendations), and IRAs (including recommendations of transfers and exchanges). The fiduciary regulation will be effective on September 23, 2024. Parts of the PTEs will be effective on that date, but other parts will not be effective until a year later—September 23, 2025.

The split effective dates for the PTEs are as follows. The Impartial Conduct Standards and the Fiduciary Acknowledgement disclosure are effective September 23, 2024—this year. The remaining conditions in the PTEs are effective on September 23, 2025. That includes all of the remaining disclosures, the policies and procedures, and the annual retrospective review.

Both PTEs have provisions on the mitigation of the possible effects of incentive compensation. For example, PTE 2020-02 provides:

Financial Institutions may not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, or other similar actions or incentives in a manner that is intended, or that a reasonable person would conclude are likely, to result in recommendations that do not meet the Care Obligation or Loyalty Obligation.

Some people have taken that to mean that incentive compensation is prohibited. That is not the case. The quoted language is from the policies and procedures condition in the PTE—which, incidentally, is not effective until September 23, 2025. The language immediately preceding the language quoted above is:

The Financial Institution’s policies and procedures must mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for the Financial Institution or Investment Professional to place their interests, or those of any Affiliate or Related 128 Entity, ahead of the interests of the Retirement Investor.

Reading the two quotes together, it means that, where a reasonable person would conclude that an incentive is likely to (or intended to) cause an advisor or agent to put his or her interests ahead of a retirement investor’s, the incentives must be mitigated to reduce the effect of the incentive to the point that it no longer would reasonably cause the advisor or agent to prioritize himself or herself above the retirement investor.

In other words, the Care Obligation must prevail so that, taken together with the Loyalty Obligation, it produces a recommendation that is in the best interest of the retirement investor, notwithstanding any incentives to the contrary. Here is how the DOL describes the Care Obligation and the Loyalty Obligation:

Investment advice must, at the time it is provided, satisfy the Care Obligation and Loyalty Obligation. As defined in Section V(b), to meet the Care Obligation, advice must reflect the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor. As defined in Section V(h), to meet the Loyalty Obligation, the advice must not place the financial or other interests of the Investment Professional, Financial Institution or any Affiliate, Related Entity, or other party ahead of the interests of the Retirement Investor or subordinate the Retirement Investor’s interests to their own.

Since the policies and procedures requirement isn’t effective until September 23, 2025, it could appear that compliance is in the distant future (over 1 year away). But don’t jump to that conclusion.

The Care and Loyalty Obligations apply this September 23 and, under PTE 2020-02, they are imposed on both the Financial Institution and the advisor or agent. That is, both are  fiduciaries for purposes of the Care and Loyalty Obligations.

The description of the Impartial Conduct Standards (of which the Care Obligation is part) in PTE starts with:  The Financial Institution and Investment Professional must comply with the following “Impartial Conduct Standards”….

The PTE later defines the Care Obligation as:

Advice meets the “Care Obligation” if, with respect to the Retirement Investor, such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor.

As a result, any incentive that causes an advisor or agent to make self-interested recommendations to retirement investors (including, e.g., rollover recommendations) will cause a violation of the Care Obligation beginning this September. And since the “investment professional” and the “financial institution” are fiduciaries for that recommendation, it will result in a fiduciary breach and a loss of relief under the PTE. That is clearly a problem. So, from a practical perspective, financial institutions using PTE 2020-02 for protection should be evaluating their incentive practices and, if needed, mitigating them beginning September 23 of this year.

Moving on to mitigation issues, it is hard to know when an incentive has been adequately mitigated. But the DOL give some indication of their areas of concern. For example, this is from the preamble to PTE 2020-02:

The Department understands that many Financial Institutions, particularly insurance companies, rely on educational conferences, and stresses that this provision does not prohibit them. The exemption merely requires reasonable guardrails for conferences, especially if they involve travel. [The bolding is by me.]

As I said earlier, the issue is mitigation, and not prohibition. However, the DOL is clearly signaling that it is particularly concerned about incentives that involve travel.

The preamble continues:

These conferences must be structured in a manner that ensures they are not likely to lead Investment Professionals to make recommendations that do not meet the exemption’s Care Obligation or Loyalty Obligation. In addition, the Department notes that properly designed incentives that are simply aimed at increasing the overall amount of retirement saving and investing, without promoting specific products, would not violate the policies and procedures requirement. Similarly, notwithstanding contrary language in the preamble to the Proposed Amendment, the Department recognizes that it can be appropriate to tie attendance at conferences to sales thresholds in certain circumstances (for example, insurance companies could not reasonably be expected to provide training for independent agents who are not recommending their products).

Here the DOL is signaling a concern about incentives that promote specific products (akin to sales contests).

The preamble continues:

On the other hand, Financial Institutions must take special care to ensure that training conferences held in vacation destinations are not designed to incentivize recommendations that run counter to Retirement Investor interests. Firms should structure training events to ensure that they are consistent with the Care and Loyalty Obligations. Recommendations to Retirement Investors should be driven by the interests of the investor in a secure retirement. Certainly, Financial Institutions should avoid creating situations where the training is merely incidental to the event, and an imprudent recommendation to a Retirement Investor is the only thing standing between an Investment Professional and a luxury getaway vacation.

“Vacation” and “luxury” speak for themselves, although people could disagree on what they mean in some cases. The concern about only incidental education and training also is relatively clear…there must be substantial educational content to minimize the risk of being labeled a “vacation”. However, I think businesses have dealt with that issue for years now due to the relevant income tax provisions.

Concluding Thoughts

There is more to mitigation than discussed in this article. My point here is that, especially under PTE 2020-02, financial institutions should take care to ensure that their “co-fiduciary” recommendations to retirement investors satisfy the Care and Loyalty Obligations this September 23 and, as a part of that, should examine their incentive programs to determine if they could reasonably have the effect of “over” incenting advisors and agents. If there is a risk of that, then appropriate mitigation changes should be made.

One last thought. While PTE 84-24 has similar provisions, the issues are somewhat different. That is for a future article.