DOL’s Fiduciary Rule Poses New Litigation Threat to IRA Advice

August 15, 2016 | Retirement Plans

Shelby George

Senior Vice President, Advisor Services

401(k) lawsuits have been a large topic of conversation in the retirement planning space, however the conversation is starting to take a different shape with the DOL’s Fiduciary Rule. Financial advisors working with individual investors need to take note since the Fiduciary Rule holds financial planners providing investors with IRA advice to an ERISA-like standard of care. In addition to holding planners providing IRA advice to the highest standard under law, the Fiduciary Rule also opens the door to unhappy clients filing class action lawsuits. The evolution of 401(k) class action litigations can help planners become more aware of what they can do to act in their clients’ best interest and manage new litigation risk that could come with the Fiduciary Rule in effect in April 2017.

The Fiduciary Rule’s Significance for RIAs

While the Fiduciary Rule holds more advisors to an ERISA-like fiduciary standard, the requirements imposed on ERISA fiduciaries have not changed. ERISA fiduciaries must act in the best interest of their client. Furthermore, ERISA fiduciaries are restricted from self-dealing, certain dealings with parties who may be in a position to exercise improper influence, and other conflicts-of-interest that could harm their clients. This rule-making is very different from the fiduciary standard of care under securities law that many RIAs are used to. Under securities law, nondiscretionary fiduciaries must act in investors’ best interest, a somewhat squishy concept that often relies on the fiduciary disclosing the transaction to the investor. In contrast, disclosure alone is not sufficient under ERISA; a specific exemption must apply to prevent a prohibited transaction.

Imagine: An advisor makes a recommendation to an investor about her IRA assets, including a recommendation to a retiring employee to rollover a 401(k) account to an IRA or a recommendation to a current IRA holder to transfer IRA assets. The advisor’s recommendation is investment advice, making the advisor a fiduciary under the Fiduciary Rule. Exemptions become critical in this context because they allow advisors to receive otherwise prohibited compensation for recommendations about IRA assets.

And this is where the Best Interest Contract Exemption introduced in the new Fiduciary Rule is so important. The Best Interest Contract, or BIC, is a new exemption to the prohibited transaction rules and allows advisors to continue to get reasonable, but otherwise prohibited compensation from non-ERISA plans and IRAs. The BIC creates a new contractual agreement between the advisory firm and the investor. A number of provisions are required in the BIC, not the least of which is the promise that the financial institution and its advisors will act in the investors’ best interest, charge no more than reasonable fees, and avoid conflicts of interest. The BIC must also give investors the right to enforcement by class action lawsuit.

Managing Litigation Risk

As 401(k) plan fiduciaries know all too well, there is a lot at stake. According to an article published by BenefitsPro, in 2015 alone, 6,925 suits were brought under ERISA and the 10 largest ERISA class action claims were settled for a total of $926.5 million. With a threat of class action lawsuits on the horizon, 401(k) litigation has new relevance for advisors making recommendations to IRA account-holders. Here are the three lessons learned:

1. Unhappy Clients Pose the Highest Litigation Risk

As the market declines and investors suffer losses, the number of class action lawsuits generally increases. The DOL and longstanding ERISA case law are clear that subpar investment results alone is not a breach of fiduciary duty. Fiduciaries can prove that they have acted in their clients’ best interest by establishing and documenting a reasonable process, even if that process resulted in poor returns. However, it is not surprising that the clients most likely to sue are those who are unhappy. High-touch customer service is critical not only to demonstrate the advisor’s value, but also to manage litigation risk.

2. Fiduciary Best Practices Evolve as Industry Capabilities and Markets Change

The fiduciary’s mandate to act in the best interest of participants has not changed since the first class action complaint was filed in 1998, but the law has evolved as the retirement landscape has changed. Initial class action suits against notable companies like Enron and Worldcom were egregious “stock drop” cases alleging outright fraud. More recent filings are much broader, alleging everything from lack of fee transparency, failure to use the least expensive share classes and inappropriateness of selected investment options including: mutual funds vs. CITs, money markets vs. stable value, and the use of hedge funds and alternative investments. Over time, plaintiff’s lawyers and the courts have acknowledged that seemingly small differentials between share classes can have a meaningful impact on prospective-retirees’ savings. The lesson to fiduciaries is that no fiduciary decision is insignificant and decisions should be reevaluated regularly as the clients’ needs change.

3. Best Interest is Unique to Your Client

ERISA’s fiduciary mandate is to act in the best interest of the client and that means understanding what is in your client’s best interest. Applying general best practices isn’t enough – advisors must have a holistic approach and take a look at their client’s unique circumstances to determine any particular or customized needs. The specific advice from advisors is not as important as the process and documentation that lead to the advice given. With the added scrutiny of fiduciary decisions, documentation of policies, procedures, and due diligence is the sponsors most effective way of mitigating risk. Only after understanding an investor’s needs, should the advisors price the options that best meet the investor’s objectives.

The Fiduciary Rule will undoubtedly change the retirement planning landscape. Amidst the uncertainty, the advisors who will benefit are those who can focus on a process that identifies their clients’ unique needs and best interest.

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