Alert November 01, 2011

DOL Issues Final Regulation Regarding Prohibited Transaction Exemptions for Investment Advice Arrangements

The Department of Labor issued a final regulation (the “Regulation”) regarding two statutory prohibited transaction exemptions relating to the provision of investment advice to beneficiaries of IRAs and participants in 401(k) plans and other defined contribution plans that provide for participant direction of investments.  The Regulation is for the most part similar to the proposed regulation published by the DOL in March 2010 (see the March 2, 2010 Financial Services Alert), although there are some differences.  The Regulation becomes effective December 27, 2011.

The Regulation sets forth standards regarding two prohibited transaction exemptions added to ERISA and the prohibited transaction provisions of Section 4975 of the Internal Revenue Code by the Pension Protection Act of 2006.  In general, absent an exemption, a fiduciary providing investment advice to an IRA beneficiary or plan participant would be engaging in a prohibited transaction if the advice would result in the receipt of incremental compensation by the fiduciary advisor or its affiliates -- e.g., if the fiduciary advises the IRA beneficiary or plan participant to invest in investment vehicles that pay a fee to the adviser or its affiliates.  The statutory exemptions permit such advice under a “fee-leveling” arrangement or a “computer-model” arrangement, subject to certain limitations and conditions that are set forth in the statute and explained the Regulation.

One condition applicable to fee-leveling arrangements under the Regulation is that neither the fiduciary adviser, nor any of the adviser’s employees, agents, or registered representatives, may receive from any party (including an affiliate) any fee or other compensation that varies depending on the basis of any particular investment selected by the participant or beneficiary.  Significantly, this does not preclude the receipt by affiliates of the fiduciary adviser (other than employees, agents, or registered representatives) of fees or compensation that vary based on the selection of investments by partcipants or beneficiaries (e.g., the selection by participants or beneficiaries of investment vehicles advised or sponsored by such affiliates).  The Regulation makes clear that this condition applies to compensation (including salary, bonuses, and commissions) and “other things of value” (including promotions) received by employees of the fiduciary adviser.  The DOL’s preamble to the Regulation includes a discussion of the applicable considerations in determining whether this condition is satisfied with respect to compensation received by employees of the adviser.  The exemption for fee-leveling arrangements is also subject to a number of other conditions, which (among other things) establish standards for the advice provided under the arrangement, and require specified disclosures by the adviser, authorization by an independent fiduciary, and an annual independent audit of compliance with the applicable conditions.

One condition regarding computer model arrangements under the Regulation is that the computer model used in providing the advice generally must take into account all available designated investment options without giving inappropriate weight to any specific option.  (For this purpose, designated investment options do not include brokerage windows and similar arrangements.)  Under the March 2010 proposal, this condition would not have required the computer model to take into account certain excepted categories of designated investment options – i.e., employer stock, certain asset allocation funds, and annuities (providing a stream of retirement income guaranteed by an insurer).  The final Regulation changes this rule so that employer stock and asset allocation funds must be taken into account if they are available as designated investment options (although the final Regulation retains the proposal’s exclusion of annuities from this requirement).  The Regulation also imposes a number of other conditions applicable to computer model arrangements – including (among other things) standards applicable to the computer model used to provide the advice, disclosure requirements, approval by an independent fiduciary, and an annual independent audit of compliance with the relevant conditions to the exemption.

Notably, in its preamble to the Regulation, the DOL makes clear that the existence of the statutory exemptions addressed in the Regulation does not affect the availability of other potentially applicable prohibited transaction exemptions or other DOL guidance relating to participant investment advice and prohibited transactions (such as the 2001 SunAmerica advisory opinion).