Final DOL Fiduciary Rule Predicted to Significantly Alter Sale of Annuity Products

As the Department of Labor’s (“DOL’s”) proposed fiduciary rule awaits final adoption, market participants are starting to predict how it will affect retirement investment advice given that financial advisers such as broker-dealers, investment advisers, insurance companies, and other financial institutions, as well as their representatives, may soon be subjected to heightened fiduciary standards. Specifically, the sale of annuity products is predicted to face a large amount of change given its commission-based nature.

Currently, under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986 (“Code”), financial advisers are generally only fiduciaries if they provide investment advice or recommendations for compensation to employee benefit plans or participants and such advice is given on a regular basis and pursuant to a mutual understanding that the advice will serve as the primary basis for investment decisions and will be individualized to the particular needs of the plan. While investment advisers already have fiduciary duties under the Investment Advisers Act of 1940, the current narrow definition of fiduciary under ERISA and the Code generally does not encompass broker-dealers.

Instead, broker-dealers are held to the less-stringent suitability standard, which requires them to have a reasonable basis for recommending investments to clients based on each client’s financial circumstances. In contrast, fiduciaries such as investment advisers must act in the client’s best interest and must disclose any conflicts of interest. Fiduciaries under ERISA and the Code have even higher standards of care: they must provide unbiased advice in their client’s best interest and cannot accept any payments that may create a conflict of interest.

In an effort to increase consumer protection, DOL seeks to broaden the definition of fiduciary investment advice under both ERISA and Code regulations in order to encompass a wider array of advice relationships. Under DOL’s proposed fiduciary rule, the definition of fiduciary under ERISA and the Code will include all financial advisers who provide investment advice or recommendations for compensation to employee benefit plan sponsors or participants and IRA owners. Therefore, broker-dealers providing this type of fiduciary investment advice will no longer be able to receive commissions, which create a conflict of interest, absent some exemption.

DOL’s proposed rule amends and creates certain exemptions to prohibited transactions. One of the new proposed exemptions is the Best Interests Contract (“BIC”) exemption. This proposed exemption provides that fiduciaries may continue to receive common forms of compensation such as commissions so long as the fee is reasonable and they enter into a formal contract with each client stating that they will act in the client’s best interest. In addition, they must fully disclose any conflicts of interest and warrant that their firm has adopted policies and procedures reasonably designed to minimize the harmful impact of conflicts of interest.

These new rules are predicted to have a relatively large impact on sales practices, particularly in the sale of annuity products. Annuity contracts typically involve up-front commissions; however, these will no longer be permissible unless under an exemption such as the BIC exemption. Just last month, Lee Covington, senior vice president and general counsel at the Insured Retirement Institute, was quoted by Investment News as concluding that, “as drafted, the rule clearly provides a safe harbor for fee-based products, and those going outside that do so at their own peril,” and that it was “uncertain whether commission-based products would be permissible under the BICE at all.”

Therefore, fiduciary financial advisers will have to either switch to annuities which have zero commissions and can be sold in fee-based accounts, or they will have to proceed cautiously under the BIC exemption if they believe it permits commission-based products. More than likely, fiduciary financial advisers will increasingly switch to annuities sold in fee-based accounts given the uncertainty surrounding the BIC exemption and what constitutes a reasonable fee. If fiduciary financial advisers do proceed under the BIC exemption, they will probably do so under low-commission annuity contracts with annual trails which can be more easily defended as reasonable. Either way, the structure of annuity contracts as they exist now with up-front commissions of 5% or more is unlikely to continue under the new DOL fiduciary rules.

Parker MacIntyre provides legal and compliance services to investment advisers, broker dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Visit our website for more information.

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