Art by Jun KimThe Department of Labor (DOL)’s proposal to change the
definition of “investment advice” has challenged financial services firms to
fundamentally rethink the way they provide products and services to retirement
plans and individual retirement accounts (IRAs). Many of these firms are
considering whether and how “robo-advice” will fit into their future business
models. Importantly, whether via a computer program or otherwise, the provision
of investment advice is a fiduciary activity subject to the fiduciary and
prohibited transaction provisions of the Employee Retirement Income Security
Act (ERISA) and the Internal Revenue Code (IRC).
One of the biggest challenges firms will face in
implementing the DOL’s proposal is compliance with the “best interest contract”
(BIC) exemption. However, as proposed, that exemption specifically excludes
robo-advice, defined as “investment advice that is generated solely by an
interactive website in which computer software-based models or applications
[apps] provide investment advice to retirement investors based on personal
information each investor supplies through the website.” To some companies, the
ability to avoid the BIC exemption is very attractive, and they will look to
robo-advice in order to do so.
In Favor of Robo-Advice
The DOL’s favoring of the robo-advice model is readily
apparent. Secretary Perez spoke about the fiduciary rule in an address at the
Brookings Institution on June 23 and argued that robo-advice would work well
under the proposal and could “accommodate even those with only a few thousand
dollars to invest.”
In light of the above, firms are looking at how robo-advice
may fit into their business model. However, in deciding to take this course of
action, they should consider that the provision of investment advice, even
through a computer or other electronic medium, implicates ERISA’s fiduciary
duty rules and the prohibited transaction provisions in both ERISA and the IRC
when the advice is provided to participants in ERISA-governed,
participant-directed defined contribution (DC) plans. Additionally, firms
should consider that investment advice provided to IRAs is governed by the
IRC’s prohibited transaction provisions.
The DOL has issued exemptions and other guidance that allow
for different approaches to provide robo-advice without running afoul of ERISA
or the IRC’s prohibited transaction provisions. Such exemptions and guidance
include, among others: 1) prohibited transaction exemption (PTE) 77-4; 2) the
statutory exemption under ERISA Sections 408(b)(14) and 408(g); 3) a managed
account program, described in Advisory Opinion 2001-09A (the SunAmerica
opinion); and 4) fee leveling, described in Advisory Opinions 97-15A (the Frost
opinion) and 2005-10A (the Country Trust Bank opinion). The above present both
opportunities and challenges.
Some of the exemptions and guidance require that the
robo-adviser or its developer be completely independent from the firm and the
adviser representative, while others do not. According to the SunAmerica
opinion, the developer of a robo-advice program must be independent of the
firm. This means the developer should not be an affiliate of the firm or
receive too much revenue from it. On the other hand, for purposes of ERISA
Section 408(b)(14), the developer need not be independent of the firm, but the
robo-advice program must be audited each year by an independent third party.
Additionally, some of the exemptions and guidance allow for
the firms or their affiliates to receive a wider array of revenue streams.
Under the SunAmerica opinion, there are no restrictions on the receipt of
mutual-fund level management fees, third-party payments—e.g., 12b-1 fees—and
other compensation by the representative, the firm and its affiliates paid in
connection with the advice. Alternatively, the ERISA Section 408(b)(14)
exemption provides that the compensation paid to the representative and the firm
must be level, or not otherwise designed to incent a recommendation of one
investment option over another, but may allow the receipt of non-level
compensation by affiliates.
In conclusion, the popularity of robo-advice appears to be
on the rise and, in some cases, may prove to be an important addition to a
firm’s service model. However, as described above, there are a number of
factors that firms should consider, regarding how a robo-adviser will be
structured and implemented. In addition, some firms may determine that the use
of a human adviser can be important and will comply with the BIC exemption or
other exemptions; those firms should consider whether multiple exemption
strategies are desirable.
In any event, in light of the DOL’s investment advice
proposal, firms will revisit how they deliver such advice to their clients, and
by robo may be an attractive way to do so.
David C. Kaleda is a principal in the Fiduciary
Responsibility practice group at the Groom Law Group in Washington, D.C. He has
an extensive background in the financial services sector. His range of
experience includes handling fiduciary matters affecting investment managers,
advisers, broker/dealers, insurers, banks and service providers. He served on
the DOL’s ERISA Advisory Council from 2012 through 2014.