Thursday, July 30, 2020

The Department of Labor's Test for "Investment Advice" Should Be Changed

On June 29, 2020, the Department of Labor reinstated it’s “five-part test” for determining what constitutes investment advice under the Employee Retirement Income Security Act (ERISA).  The test first went into effect in 1975 and remained the governing standard as financial products and the investment advice industry changed significantly.  In 2016, as part of its fiduciary rulemaking, Labor embraced a broader test which was later invalidated by the Fifth Circuit.

The reinstated five-part test governs when someone giving investment advice for a fee will be classified as a fiduciary under ERISA and subject to its obligations. To be subject to ERISA, the person must:

  • render advice with respect to the plan [or IRA] as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property;
  • on a regular basis;
  • pursuant to a mutual agreement, arrangement, or understanding with the plan, plan fiduciary or IRA owner, that,
  • the advice will serve as a primary basis for investment decisions with respect to plan or IRA assets; and that
  • the advice will be individualized based on the particular needs of the plan or IRA.

The five-part test should be modified to better cohere with the current economic environment.  When Labor promulgated the five-part test in 1975, Congress had not yet modified the tax code to allow for employees to contribute a portion of their salary to 401(k) plans and most retirement assets were in defined-benefit pension plans.  That change came in 1978 and eventually ushered in the current defined-contribution era.  At present, the test does not cohere with the current legal and business environment and should be modified. 

Remove the Regular Basis Requirement

Labor could do substantial good by removing second part of the test, the requirement that advice must be given “on a regular basis.”  Single-shot events, such as the sale of annuities or other insurance products or a decision about whether to “roll over” assets from one account type to another have substantial impacts on a person’s retirement.   Labor previously recognized this issue in its 2016 rulemaking and found that trillions of dollars shifted each year with rollover transactions.  The “regular basis” requirement now excludes these transactions from ERISA’s scope and allows assets accumulated under ERISA’s protection to be dissipated without protection.

The “regular basis” requirement results in applying different standards to identical activities with identical effects.  A consultant who regularly provides advice about small issues would be subject to fiduciary requirements when giving advice about the disposition of an entire pool of assets.  Yet if a different consultant were hired to invest an entire pool of assets in a single transaction, the second consultant would not be bound by fiduciary obligations even though she would do the exact same thing with the same effects.  Maintaining the “regular basis” requirement effectively allows single-shot transactions to misallocate ERISA-protected assets with impunity.

Remove Requirements That an Investor and Advisor
Mutually Agree That Advice Will Serve as the Primary Basis for an Investment

Labor should also reaffirm its prior conclusion the “mutual agreement” and “primary basis” requirements should be modified because it does not cohere with the current defined-contribution plan environment.  Under the five-part test, a person may escape fiduciary status by arguing that there was no “mutual agreement” that their advice would be the “primary basis” for an investment decision.  Fine print in sales contracts disclaiming any mutual agreement and claiming that the purchaser warrants that they have made their own decision by signing the agreement may be proffered to rebut the existence of any mutual agreement.

This requirement allows salespeople to exploit the wide financial sophistication gap between Americans and the financial services industry.  Americans often struggle to understand even rudimentary financial concepts.  Labor should not abdicate its responsibility to protect retirement assets by allowing simple disclaimers to greenlight profiting from shoddy advice.

Moreover, Labor should not allow any financial professional to give substandard or self-serving advice merely because it may not be the “primary basis” for an investment decision.  Consider one scenario where a retirement saver hears from an uncle that his assets have been placed inside some complex annuity contract.  The saver may meet with an insurance company’s representative to inquire about the product because an uncle purchased it.  Here, the representative should not be free to give low-quality advice simply because the primary basis for exploring the option was the uncle’s purchase.

Identifying whether financial advice, independent research, or some other reason served as the “primary basis” for an investment decision may be impossible.  In any event, persons giving financial advice for a fee should not be able to dispense lower-quality advice on the theory that an investor should not rely on that advice as the primary basis for their investment.  This approach debases investment advice and turns it into a predatory trap.

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