Parsonage Vandenack Williams LLC
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South Dakota, Texas, Arizona, and Colorado

New Regulations Aim to Help Retirement Account Owners

Recent estimates by the federal government show that almost 700,000 defined contribution plans exist, with more than 88 million participants. These plans include the well-known 401(k) and individual retirement account (IRA), but may also include a profit sharing plan, money purchase pension plan, or other less known retirement vehicles. For the millions of participants in a tax-favored retirement plan, the funds in those accounts will be invested and grow during the participant's working years. What many do not know, however, is the interests and loyalties of the advisors directing the participant's investments.

These advisors will often advocate for the investment of retirement account funds in a certain manner, but may simultaneously have special deals in place to receive hidden fees or payments for rendering such advice. This can result in investment advice that is driven by a hidden conflict of interest, where the advisor can make more money by rendering advice that may not necessarily be in the best interest of the retirement account owner. Estimates by the White House Council of Economic Advisers show that approximately $17 billion is lost, on an annual basis, because of the investment advisor's conflict of interest advice. This equals about a 1 percentage point loss, on an annual basis, which can significantly compound over the decades that a retirement account is investing. As illustrated by the White House Council of Economic Advisers, for example, a 1 percent annual loss would mean that a $10,000 investment, 35 years later, would be $27,500 instead of $38,000.

These types of issues are nothing new, with the federal government regulating tax-preferred retirement accounts for decades. Besides the internal revenue code as a source of regulation, the Employee Retirement Income Security Act (ERISA), as administered by the Department of Labor (DOL), regulates retirement accounts. ERISA became law in 1974, when the majority of plan assets were held by defined benefit plans, often referred to as a pension. In fact, section 401(k) of the internal revenue code, with the common retirement vehicle based on its namesake, did not come into existence until 1978. However, in 1975, the first full year of ERISA, approximately $186 million in assets were held in defined benefit plans, compared to $74 million in defined contribution plans. The characteristics of the defined benefit plans placed the risk and burden on the employer, who had to fully fund and direct the funds' investments.

Today, the majority of investments are through individual accounts, under the rules for defined contribution plans, making them portable and giving the individual retiree greater power to investment the funds. Although the individual is empowered and given more control under these rules, ERISA generally continued to regulate the industry in the same manner as 1975, leading to various conflicts of interests by those who advise the investments of retirement accounts.

In an effort to protect individuals from the investment advisor's hidden conflicts, the DOL issued final regulations in 2016 that adapt the rules of ERISA to the modern retirement vehicles. These regulations broaden the definition of fiduciary, bringing investment advisors under the definition. The new fiduciary definition now includes those who render advice as a recommendation, and receives a fee as compensation for the recommendation to invest ERISA plan assets or IRA assets. Advice under the new fiduciary definition can mean direct advice or indirect advice.

To determine whether the advisor is an ERISA fiduciary, the definition requires a review of whether the advice is a recommendation and whether the advisor received compensation in exchange for the recommendation. Under the new regulations, both questions have been answered broadly, meaning that a recommendation is any communication, based "upon the content, context, or presentation of the communication," that encourages an individual to "engage or refrain from taking a particular course of action." Similarly broad, compensation includes both direct and indirect fees, which could entail actual payments, gifts, finder's fees, revenue sharing agreements, expense reimbursement arrangements, or virtually any type of compensation. Notably, however, the regulations carve out certain activities from this classification system. For example, a general or public communication is not a recommendation for purposes of the new ERISA regulations.

If an investment advisor qualifies as a fiduciary, the individual is subject to the ERISA prohibited transaction rules and, most importantly, required to put the best interest of the investor first. Thus, an investment advisor's conflict of interest can create a breach of their fiduciary obligations to the retirement account owner. Although this will help individuals with retirement accounts, several exceptions and exemptions apply. These exceptions and exemptions, in general, allow an investment advisor to continue certain activities when there is little risk of undue influence, hidden conflicts of interests, or unfair dealings.

These new regulations, for the first time, will allow for private causes of action against investment advisors for breaches of their fiduciary duty in certain contexts. The DOL similarly increased their ability to enforce the regulations against fiduciaries that fail to put their client's interests first. The new regulations will be applicable in 2017. As the new regulations are implemented over the next year, the most significant change will be for the investment advisors, now having to meet the new fiduciary standards.

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