There have been concerns raised by some professionals that the term “best interest” as used in the DOL rule is undefined and the industry should act to define what the term means before the courts do.

While I recognize that many practitioners, especially those from the insurance industry, would like to have detailed check lists regarding “best interest,” it is not true that the DOL has “done little in the way of defining best interest.” In fact, the DOL clearly stated:

Give advice that is in the retirement investor’s best Interest (i.e., prudent advice that is based on the investment objectives, risk tolerance, financial circumstances and needs of the retirement investor, without regard to financial or other interests of the advisor, financial institution, or their affiliates, related entities or other parties).

And in an expanded definition:

Best interest means advice that, at the time of the recommendation 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, without regard to the financial or other interests of the advisor, financial institution or any affiliate, related entity or other party.

In fact the best interest standard is one of the three elements of the Impartial Conduct Standards (ICS) that require:

The disconnect between the desire of some practitioners to have a clear set of rules and the DOL’s definition of best interest is the difference between Suitability Rules Based regulation (e.g., Finra) and Fiduciary Principals Based regulation (RIAs). In discussing the BIC Exemption, the DOL makes it very clear that the Best Interest Standard (BIS) is principles based.

The exemption takes a principles-based approach that permits financial institutions and advisors to receive many forms of compensation that would otherwise be prohibited, including, inter alia, commissions, trailing commissions, sales loads, 12b-1 fees and revenue-sharing payments from investment providers or other third parties to advisors and financial institutions.

The exemption neither bans all conflicted compensation, nor permits financial institutions and advisors to act on their conflicts of interest to the detriment of the retirement investors they serve as fiduciaries. Instead, it holds financial institutions and their advisors responsible for adhering to fundamental standards of fiduciary conduct and fair dealing, while leaving them the flexibility and discretion necessary to determine how best to satisfy these basic standards in light of the unique attributes of their particular businesses. The exemption’s principles-based conditions, which are rooted in the law of trust and agency, have the breadth and flexibility necessary to apply to a large range of investment and compensation practices, while ensuring that advisors put the interests of retirement investors first.  

 

Furthermore, in adopting the rule the DOL was well aware of concerns by some industry participants that the ICS (including the BIS) were “vague.”

Some commenters asserted that some of the exemption’s terms were too vague and would result in the exemption failing to meet the “administratively feasible” requirement under ERISA section 408(a) and Code section 4975(c)(2). The Department disagrees with these commenters’ suggestion that ERISA section 408(a) and Code section 4975(c)(2) fail to be satisfied by this exemption’s principles-based approach, or that the exemption’s standards are unduly vague. It is worth repeating that the Impartial Conduct Standards are built on concepts that are longstanding and familiar in ERISA and the common law of trusts and agency. Far from requiring adherence to novel standards with no antecedents, the exemption primarily requires adherence to basic, well-established obligations of fair dealing and fiduciary conduct. Moreover, as discussed above, the exemption’s reliance on these familiar fiduciary standards is precisely what enables the Department to apply the exemption to the wide variety of investment and compensation practices that characterize the market for retail retirement advice, rather than to a far narrower category of transactions subject to much more detailed and highly-proscriptive conditions (i.e., rules).

As previously discussed, the Impartial Conduct Standards are not unduly vague or unknown, but rather track longstanding concepts in law and equity. In response to interpretive questions posed in the comments, the Department has provided a series of requested interpretations in the preceding preamble section.

The financial institutions and advisors must adhere to basic standards of impartial conduct. In particular, under this standards-based [i.e., principals] approach, the advisor and financial institution must give prudent advice that is in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation. 

The DOL addressed the principal concept of the BIS on numerous occasions throughout the discussion of the rule adding even more specificity to the concept and repeatedly emphasizing that the concept is not new and unknown but rather well founded in the 40-year application of ERISA and the even older law of trusts.

The best interest standard, as set forth in the exemption, is intended to effectively incorporate the objective standards of care and undivided loyalty that have been applied under ERISA for more than 40 years. Under these objective standards, the advisor must adhere to a professional standard of care in making investment recommendations that are in the retirement investor’s best interest.  The advisor may not base his or her recommendations on the advisor’s own financial interest in the transaction. Nor may the advisor recommend the investment, unless it meets the objective prudent person standard of care.  Additionally, the duties of loyalty and prudence embodied in ERISA are objective obligations that do not require proof of fraud or misrepresentation, and full disclosure is not a defense to making an imprudent recommendation or favoring one’s own interests at the retirement investor’s expense.

 

Best interest means advice that, at the time of the recommendation 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, without regard to the financial or other interests of the advisor,fFinancial institution or any affiliate, related entity or other party.

The best interest standard set forth in the final exemption is based on longstanding concepts derived from ERISA and the law of trusts. It is meant to express the concept, set forth in ERISA section 404, that a fiduciary is required to act “solely in the interest of the participants

In responding to concerns regarding the BIS the DOL reiterated its commitment to the princile- based BI standard.

The final exemption retains the best interest definition as proposed, with minor adjustments. The first prong of the standard was revised to more closely track the statutory language of ERISA section 404(a), and, is consistent with the Department’s intent to hold investment advice fiduciaries to a prudent investment professional standard. Accordingly, the definition of best interest now requires advice that “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. . .”

Furthermore, the BIS is not the only Principle-based standard in the rule. For example, regarding compensation the DOL noted:

Rather than create a highly prescriptive set of transaction-specific exemptions, the Department instead is publishing exemptions that flexibly accommodate a wide range of current types of compensation practices, while minimizing the harmful impact of conflicts of interest on the quality of advice.

The obligation to pay no more than reasonable compensation to service providers is long recognized under ERISA and the Code. ERISA section 408(b)(2) and Code section 4975(d)(2) require that services arrangements involving plans and IRAs result in no more than reasonable compensation to the service provider. Accordingly, advisors and financial institutions — as service providers — have long been subject to this requirement, regardless of their fiduciary status. At bottom, the standard simply requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the advisor and financial institution are delivering to the retirement investor. Given the conflicts of interest associated with the commissions and other payments covered by the exemption, and the potential for self-dealing, it is particularly important that advisors and financial institutions adhere to these statutory standards, which are rooted in common law principles.

 

When assessing the reasonableness of a charge, one generally needs to consider the value of all the services and benefits provided for the charge, not just some. If parties need additional guidance in this respect, they should refer to the Department’s interpretations under ERISA section 408(b)(2) and Code section 4975(d)(2) and the Department will provide additional guidance if necessary.

As in other cases, the DOL was aware of complaints that the reasonable compensation standard was too vague. However, it rejected this complaint noting that the concept of reasonable compensation has a long history.

In response to comments on this requirement, the Department has retained the reasonable compensation standard as a condition of the exemption, and requires financial institutions to include the standard in their contracts with IRA and non-ERISA plan retirement investors. As noted above, the “reasonable compensation” obligation is a feature of ERISA and the Code.

The DOL was well aware of the concerns of some in the insurance industry; however, it concluded that the interests of the investor is paramount.

An Insurance Example

In this regard, many commenters expressed concern that the disclosure requirements proposed in this exemption were inapplicable to insurance products and that they would not be able to satisfy the best interest and other Impartial Conduct Standards, or provide a sufficiently broad range of assets to satisfy the conditions of Section IV of this exemption, as proposed. Several raised questions about how the proposed definition of “financial institution” would apply to insurance companies. According to these commenters, the conditions proposed for this exemption would be so difficult and costly that broker-dealers would stop selling variable annuities to certain IRA customers and retirement plans rather than comply.

Both the Securities and Exchange Commission (SEC) staff and Finra have issued guidance on indexed annuities

Given the risks and complexities of these investments, the Department has determined that indexed annuities are appropriately subject to the same protective conditions of the Best Interest Contract Exemption that apply to variable annuities. As a result, retirement investors are acutely dependent on sound advice that is untainted by the conflicts of interest posed by advisors’ incentives to secure the annuity purchase, which can be quite substantial. Both categories of annuities, variable and indexed annuities, are susceptible to abuse, andrRetirement investors would equally benefit in both cases from the protections of this exemption, including the conditions that clearly establish the enforceable standards of fiduciary conduct and fair dealing as applicable to advisors and financial institutions.

The Impartial Conduct Standards represent fundamental obligations of fair dealing and fiduciary conduct. The concepts of prudence, undivided loyalty and reasonable compensation are all deeply rooted in ERISA and the common law of agency and trusts.  These longstanding concepts of law and equity were developed in significant part to deal with the issues that arise when agents and persons in a position of trust have conflicting loyalties, and accordingly, are well-suited to the problems posed by conflicted investment advice. 

 

The headline, “Define ‘Best Interest’ Before A Judge Does” misses one of the key goals of the rule, namely transferring burden of responsibility from the client (the standard in a rules-based suitability regime) to the advisor (the standard in a principles-based fiduciary regime).

The Department’s intent also is to ensure that persons holding themselves out as fiduciaries with respect to investment advice to retirement investors cannot deny their fiduciary status if a dispute subsequently arises, but rather must honor their words. There is no one formulation that must be used to trigger fiduciary status in this regard, but rather the question is whether the person was reasonably understood to hold itself out as a fiduciary with respect to communications with the plan or IRA investor. If a person or entity does not want investment-related communications to be treated as fiduciary in nature, it should exercise care not to suggest otherwise.

Moreover, inclusion of the standards in the exemption’s conditions adds an important additional safeguard for ERISA and IRA investors alike because the party engaging in a prohibited transaction has the burden of showing compliance with an applicable exemption, when violations are alleged. In the Department’s view, this burden shifting is appropriate because of the dangers posed by conflicts of interest, as reflected in the Department’s Regulatory Impact Analysis and because of the difficulties retirement investors have in effectively policing such violations. One important way for financial institutions to ensure that they can meet this burden is by implementing strong anti-conflict policies and procedures, and by refraining from creating incentives to violate the Impartial Conduct Standards. Thus, treating the Impartial Conduct Standards as exemption conditions creates an important incentive for financial institutions to carefully monitor and oversee their advisors’ conduct for adherence with fiduciary norms.

Moreover, as noted repeatedly, the language for the Impartial Conduct Standards borrows heavily from ERISA and the law of trusts, providing sufficient clarity to alleviate industry concerns. Ensuring that fiduciary investment advisors adhere to the Impartial Conduct Standards and that all retirement investors have an effective legal mechanism to enforce the standards are central goals of this regulatory project.

The DOL did very consciously provide appropriate principles-based guidance. To develop “best practices” will be counter productive to the principle-based rule. As an example, a best practice might well include standards such as “the advisor must “reasonably believe” that any statements made to the client are not misleading or that “the standard is violated only if the client reasonably relied on the advisor’s statement.” The DOL recognized the risk of such limiting rules and rejected their inclusion.

 

The Department did not accept certain other comments, however. One commenter requested that the Department add a qualifier providing that the standard is violated only if the statement was “reasonably relied” on by the retirement investor. The Department rejected the comment. The Department’s aim is to ensure that financial institutions and advisors uniformly adhere to the Impartial Conduct Standards, including the obligation to avoid materially misleading statements, when they give advice. Whether a retirement investor relied on a particular statement may be relevant to the question of damages in subsequent arbitration or court proceedings, but it is not and should not be relevant to the question of whether the advice fiduciary violated the exemption’s standards in the first place. Moreover, inclusion of a “reasonable reliance” standard runs the risk of inviting boilerplate disclaimers of reliance in contracts and disclosure documents precisely so the advisor can assert that any reliance is unreasonable.

One commenter asked the Department to require only that the advisor “reasonably believe” the statements are not misleading. The Department is concerned that this standard too could undermine the protections of this condition, by requiring retirement investors or the Department to prove the advisor’s actual belief rather than focusing on whether the statement is objectively misleading.

In conclusion, I do not believe that “the financial services industry is best served by attempting to develop rules to ‘define’ the Department of Labor’s ‘best interest’ standard”.

Harold Evensky, CFP, is the chairman of Evensky & Katz/Foldes Financial Wealth Management and a professor of practice in the Department of Personal Financial Planning at Texas Tech University.