Most employers imagine that the Department of Labor (DOL)’s fiduciary rule only applies to financial advisers and brokers. To some extent this is true. The fiduciary rule is mainly intended to streamline the operations of brokers and Registered Investment Advisers (RIAs).
However, since employers normally contract brokers and RIAs to act as advisers for 401(k) plans, the fiduciary rule indirectly applies to them. Therefore, it is essential that every employer who sponsors 401(k) plans understands the implications of DOL’s fiduciary rule.
The first thing employers need to understand is the basic premise behind the new rule. The DOL passed the fiduciary rule to ensure that, when advising people on their 401(k) or Individual Retirement Account (IRA) plans, financial advisers act in the “best interest” of the clients.
What this means is that the rule bars financial advisers from knowingly offering people advice which isn’t in their best interest, simply because it benefits the advisers. A good illustration of this is that some brokers would recommend IRA plans which are too expensive for employees, simply because the plans offered brokers higher commissions. The fiduciary rule is intended to eliminate such practices.
The second thing employers need to know is how the DOL rule redefines the roles of 401(k) plan brokers. Previously, brokers were held to a “suitability” standard (unlike RIAs who were held to a fiduciary standard). When interacting with employees, brokers could classify any information they pass on as “education” rather than “advice”. This enabled them to shirk the “best product” clause which mandates financial advisers to recommend the best products from a client’s perspective.
Under the new rule, all brokers now operate under a fiduciary standard. The loophole of classifying recommendations as “education” rather than “advice” is also closed. This means that when interacting with employees, brokers are mandated to place the employee’s best interests first. This requirement extends to employers who contract the brokers to handle their 401(k) plans.
Operating under a fiduciary standard means that the previous method of compensating brokers (through commissions which are paid as 12(b)1 fees) is outlawed. This payment method is classified as a “prohibited transaction” because it causes a conflict of interest.
The redefinition of brokers’ roles can have implications for employers. This is because, following the rule, some brokers may choose to become RIAs. Others may decide to get out of the 401(k) business altogether. Others may hire external fiduciaries to handle 401(k) plans – and charge the extra cost on the employer. Each employer needs to find out from their broker what action they intend to take.
The last thing which employers need to know is the exception to the prohibition on commissions which is available under the rule. This is called the Best Interest Contract Exemption (BICE). Under the BICE, brokers can continue receiving the old commission-based compensations – on condition that both they and employers speak openly about their respective conflicts of interest, and reveal any hidden fees.
Now, the BICE is a potential double-edged sword. On the one hand, it offers employers (and other sponsors of 401(k)) plans and opportunity to continue their existing relationships with brokers without making lots of changes. On the other hand, it is a potential legal problem: if employers and brokers agree to the BICE, the position can be difficult to defend if it turns out that the 401(k) products they agree upon aren’t the best options available for the employees. Basically, the BICE has the potential for raising questions of conflict of interest.
The potential risk has caused some legal experts to warn employers to steer clear of BICE. They see it as the kind of clause which an employer can unknowingly violate without intending to, or even realizing it. However, other experts claim that BICE – if handled with dexterity – can provide a helpful option for both employers and brokers. Given that the legal opinion in BICE is split, the onus is on every employer to examine it (and seek counsel from trusted attorneys) before deciding whether or not to use it.
The bottom line is that the DOL fiduciary rule applies to sponsors of 401(k) plans – not just brokers and RIAs. Therefore, every employer who sponsors such plans needs to examine the rule and adjust their contracts with brokers accordingly. Otherwise, the next time a broker is accused of flouting the rule, an employer may find themselves caught up in the muddle.