Alert September 02, 2008

DOL Issues Proposed Regulation and Proposed Exemption on Investment Advice for Participant-Directed ERISA Plans

The Department of Labor (the “DOL”) issued a proposed regulation (the “Proposed Regulation”) under new Sections 408(b)(14) and 408(q) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), as well as a proposed prohibited transaction class exemption (the “Proposed Exemption”), addressing the provision of investment advice by a firm to participants in Section 401(k) plans and individual retirement account (“IRA”) holders regarding investments in products offered by the firm or its affiliates.  The Proposed Regulation provides guidance regarding two statutory prohibited transaction exemptions that were included in amendments to ERISA and the Internal Revenue Code in 2006.  One exemption relates to “Fee-Leveling Arrangements” while the other concerns “Computer Model Arrangements.”  The Proposed Exemption goes further than the statutory exemptions by, in effect, relaxing certain conditions that must be satisfied in order for financial services firms to advise plan participants and IRA holders to invest in proprietary funds or other products that result in the receipt of compensation or other amounts by the firm or its affiliate.

General Requirements of Proposed Regulation

The Proposed Regulation sets forth and clarifies the following statutory requirements, which apply to both the exemption for Fee-Leveling Arrangements and the exemption for Computer-Model Arrangements:

  • Fiduciary Adviser.  The advice must be provided by a “Fiduciary Adviser,” which must be a registered investment adviser, a bank, an insurance company, a registered broker or dealer, or certain affiliates, employees, agents, and registered representatives of one of these entities.
  • Authorization.  The advice arrangement must be authorized by a plan fiduciary or the IRA holder.  In general, the person authorizing the arrangement cannot be the Fiduciary Adviser or any entity providing any designated investment options under the plan or IRA, or any of their affiliates.  (In the case of an IRA, it is permissible to have the arrangement authorized by the IRA holder, even if the beneficiary is an employee of the Fiduciary Adviser or provider of an investment option.)
  • Decision Making.  The investments by the plan or IRA must be made at the direction of the plan participant or IRA holder.  While the Fiduciary Adviser may provide advice, it must not make the investment decision.
  • Annual Audit.  At least annually, an “independent auditor” (as defined in the Proposed Regulation) must audit the advice arrangement for compliance with the exemption.  The Proposed Regulation provides that the independent auditor may use information obtained from a reasonable sampling of arrangements and advice provided by the Fiduciary Adviser.  In the case of an ERISA plan, results of the audit must be communicated to the fiduciary who authorized the advice arrangement.  In the case of an IRA, the results must be communicated to the IRA holder (through, for example, publication on a website); results showing non-compliance with the exemption’s conditions must be communicated to the DOL.
  • Disclosure.  The Fiduciary Adviser must disclose to the plan participant or IRA holder information relating to various matters, including, for example, compensation to be received by the Fiduciary Adviser or any affiliate in connection with an investment by the plan or IRA, any affiliation or material contractual relationship with securities or other property with respect to which advice is to be provided under the arrangement, and that the plan participant or IRA holder may separately arrange for advice from another adviser that may have no relationship with the relevant investments.
  • Reasonable Compensation/Arrangement.  The compensation received by the Fiduciary Adviser and its affiliates in connection with the investment by the plan or IRA must be reasonable, and the terms of the investment transaction must be arms-length.
  • Records.  For at least six years, the Fiduciary Adviser must maintain records showing the applicable conditions of the relevant exemption were satisfied.

Additional Requirements Applicable to the Fee-Leveling Exemption

In addition to satisfying the general requirements described above, an advice arrangement will be eligible to utilize the “Fee-Leveling Exemption” only if it also satisfies the following conditions:

  • Advice Standards.  Advice provided under the arrangement must be based on generally accepted investment theories that take into account historic returns of different asset classes over defined periods of time.  Further, the advice must take into account information provided by the plan participant or IRA holder relating to age, life expectancy, retirement age, risk tolerance, other assets and income sources, and investment preferences.
  • Fee-Leveling.  Fees received (directly or indirectly) by the Fiduciary Adviser cannot vary based on the investments selected by the plan participant or IRA holder.  Compensation (e.g., salary, bonuses, commissions, awards) received, directly or indirectly, by an employee, agent, or registered representative of the Fiduciary Adviser cannot vary based on the investments selected by the plan participant or IRA holder.

Note that this fee-leveling requirement does not apply to affiliates of the Fiduciary Adviser.  For example, this condition of the exemption would not be violated solely because a brother-sister affiliate of the Fiduciary Adviser received management fees from a mutual fund in which an IRA invested based on the advice of the Fiduciary Adviser.

Additional Requirements Applicable to the Computer Model Exemption

In addition to satisfying the general requirements described above, an advice arrangement will be eligible to utilize the “Computer Model Exemption” only if it also satisfies the following conditions.

  • Solely Computer-Generated Advice.  The only investment advice provided under the arrangement must be generated by a computer model.
  • Computer Model-Standards.  The computer model used under the arrangement must meet various requirements – for example, the model must apply generally accepted investment theories that take into account historic returns of different asset classes over defined time periods, utilize personal information received from the plan participant or IRA holder, avoid recommendations that inappropriately favor investment options that are offered by, or that generate greater income for, the Fiduciary Adviser (or its affiliate), and take into account all designated investment options (other than employer securities) under the plan or IRA.
  • Certification.  An “eligible investment expert” (as defined in the Proposed Regulation) must certify that the advice arrangement satisfies the standards described above.  The Proposed Regulation includes detailed requirements for this certification.

Proposed Class Exemption

The Proposed Exemption shares some similarities with the statutory exemptions discussed above – for example, the Proposed Exemption has a fee-leveling component and a computer model component, and also incorporates a number of conditions that are similar to the general requirements described above.  However, the Proposed Exemption would go further than the existing statutory exemptions in several respects.  For example, the fee-leveling component of the Proposed Exemption would prohibit fees from varying only at the individual (employee, agent, or registered representative) level, and not at the business-entity level of the Fiduciary Adviser.  In other words, if an employee of a bank were providing advice to an IRA that invested in a bank-managed product, this condition of the Proposed Exemption would prohibit the compensation of the employee who provided the advice from varying based on the investment in that proprietary investment product, but would not prohibit the bank’s fees from varying on that basis.

Another example of the difference from the existing statutory exemptions is that under the computer model component of the Proposed Exemption the advice is not required to be based solely on the computer model.  Rather, under the Proposed Exemption, once computer-generated advice has been provided to the plan participant or IRA holder (or, in certain circumstances, once investment education information has been furnished to the IRA holder) the Fiduciary Adviser may also provide individualized advice not based on a computer model.

We note that within days after the DOL released the Proposed Exemption, Representative George Miller, chair of the Labor and Education Committee of the House of Representatives (which has jurisdiction over these types of ERISA issues) objected strongly to the proposal as providing insufficient protections for plan participants.  It is unclear at this time when (if ever) the Proposed Exemption will be issued in final form or, if it is, whether additional conditions will be added when it is finalized.

Effective Dates and Comment Deadline

The Proposed Regulation is proposed to be effective 60 days after the final version is published in the Federal Register (the statutory exemptions are generally effective already).  The Proposed Class Exemption is proposed to be effective 90 days after the final version is published in the Federal Register.  Comments are due by October 6, 2008, and the Proposed Regulation is expected to be finalized by the end of the year.