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Friday, February 15, 2013

Ron Answers the Question: Must IRAs Be Handled in a Fee-Based Account?

In an article appearing at, and specifically at, Ed Slot opined in pertinent part:  "The Department of Labor does not require IRAs to be in a fee-based account, including wrap fees. Wrap fees are fees for investment services where the fee is a percentage of money under management."

While Ed Slott's answer is true, it does not address the potential consequences of the "Definition of Fiduciary" rule, if it is re-proposed (as expected) by the U.S. Dept. of Labor's Employee Benefit Services Administration (EBSA) later this year and subsequently finalized late in 2013 (or more likely in 2014 or 2015).

First, here's the technical explanation as to why the DOL's rules might impact IRA accounts.

  • As to the Dept. of Labor and IRA accounts, under the Internal Revenue Code issue: First, section 4975(e)(3) of the Internal Revenue Code of 1986, as amended (Code) provides a similar definition of the term "fiduciary" for purposes of Code section 4975 (IRAs).  However, in 1975, shortly after ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c), that defines the circumstances under which a person renders ``investment advice'' to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA. The Department of Treasury issued a virtually identical regulation, at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor.

Hence, when the DOL/EBSA, as is expected later this year, issues a re-proposal of its "definition of fiduciary" regulation, in essence the broad exemptions previously provided disappear, and virtually any provider of personalized investment advice to a plan sponsor or plan participant would be a "fiduciary" and subject to ERISA's strict "sole interests" fiduciary standard and its prohibited transaction rules.

Does this means commissions would be outlawed for IRA accounts?  Not necessarily.  In my view, the fiduciary standard, whether under ERISA ("sole interests" fiduciary standard) or under the Advisors Act or state common law ("best interests" fiduciary standard), does not outlaw the receipt of commission-based compensation.  However, the receipt of differential compensation (a.k.a. variable compensation) (i.e, if commissions and/or other compensation varies depending upon product recommendation) becomes problematic.

I would also opin that 12b-1 fees, as seen in Class C and Class R shares, are also not likely to be outlawed by EBSA, although some pundits have stated otherwise.  However, 12b-1 fees are already under scrutiny by the SEC (although no action on this issue is likely soon), and some on the Commission would like to see the authorization for 12b-1 fees rescinded.  In addition, some concerns exist that, since 12b-1 fees cannot typically be negotiated (beyond various share classes, such as R-1, R-2, etc. in the retirement plan context), the Sherman Antitrust Act may apply and the practice of 12b-1 fees, especially as to retail investors, may be an unlawful fixing of prices and an unlawful restraint of trade.  Whether the U.S. Department of Justice's Antitrust Division will ever bring an action to stop 12b-1 fees remains an outstanding issue.

Note that there is likely to be an exemption granted to the prohibited transaction rules for brokerage firms who receive brokerage commissions for doing trading for funds.  Whether the exemption will cover higher brokerage commissions paid in the nature of soft dollars is unknown.  And whether mutual funds will have to prove that "best execution" is undertaken by using brokerage firms (who sell the funds to ERISA and IRA accounts) - especially when trading costs can be minimized through the use of electronic crossing networks (and dark pools, a variation of same), is another issue.  There can be a vast disparity between brokerage commissions paid by some mutual funds relative to others, even of the same relative size of fund, type of security, and portfolio turnover characteritics, due to these "back-door" forms of compensation.

I would note that the receipt of "payment for shelf space" by a brokerage firm is very problematic under the ERISA standard.  It is difficult to see how the DOL could issue a blanket exemption for this, where there does not appear to be any benefit to a fund shareholder from same (a requirement for an exemption to be granted). In theory, payment for shelf space payments deter funds from reducing their management (investment advisory) fees, and are contrary to the interests of fund shareholders.

Hence, I suspect that mutual funds and brokerage firms will need to change their business practices.  A good approach would be to only have one method of compensation, with no other forms of compensation provided by the fund to the brokerage firm / registered representative.  This could be commissions, or could be 12b-1 fees (if not otherwise outlawed), or could be AUM-based compensation paid by the plan participants (and deducted from account balances), or could be even flat fees paid by the plan sponsor (and/or deducted from account balances).

In any event, I believe some of the brokerage firm / mutual fund arrangements must change, such as payment for shelf space and soft dollar compensation - and any arrangement in which a fund is granted "preference" (in return for some form of compensation).  Payment of "educaitonal" or "marketing" expenses by fund companies would likewise be outlawed under ERISA's prohibited transaction rules.

Other interesting issues exist, including the sharing of securities lending revenue with distributors of funds, and many issues involving proprietary mutual funds.

We will have to see what EBSA comes up with, if and when their re-proposed regulation emerges. (I hope the DOL/EBSA submits its re-proposed rule soon).  And the EBSA's final rule, if ever adopted, would not likely be effective until 2014 (or later).

So, keep your eyes peeled, and be ready to change certain business practices and compensation methods if necessary.  If you only have a Series 6 or 7 license, you may desire to pursue Series 65 licensure, as a means of providing yourself greaterly flexibility in fee arrangements in the future.  Hope this helps.

More to come.

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