Compliance Consult | PLANADVISER November/December 2015

Is This the Age of the Robot?

Robo-advisers in light of the fiduciary rule

By David C. Kaleda | November/December 2015

PLANADVISER-January-February-2015-Compliance-Consult-June-KimArt 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.