PTE 2020-02 and Compensation-Related Conflicts

The Retirement Security Rule and accompanying Prohibited Transaction Exemption amendments, finalized in April, elaborate on differential pay between products offered by advisers and how advisers should manage their compensation-related conflicts.

The amendments to PTE 2020-02 provide exemptive relief to financial professionals that sell investment advice to plans governed by the Employee Retirement Income Security Act. To make use of the exemption, professionals must manage their conflicts through policies and procedures, which include receiving varying compensation for different products, or differential compensation, which could incentivize an adviser to recommend a product that does not advance the investor’s best interest.

PTE 2020-02 maintains the traditional principles-based approach to mitigating conflicts, says Jason Roberts, CEO of the Pension Resource Institute, “for better or worse, very few things are categorically banned under PTE 2020-02.”

The amendments describe how advisers should mitigate their conflicts in the PTE’s preamble and section on policies and procedures. The amended PTE 2020-02 reads, “The Financial Institution’s policies and procedures must mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests, or those of any Affiliate or Related Entity, ahead of the interests of the Retirement Investor.”

The DOL says explicitly that they do “not require Financial Institutions to categorically eliminate all sales quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation, sales contests, quotas, or bonuses.”

However, advisers must be sure to “eliminate such incentives that are ‘intended, or that a reasonable person would conclude are likely, to result in recommendations that do not meet the Care Obligation or Loyalty Obligation.’” The DOL adds that “it is not imposing an obligation on firms to eliminate all differential compensation, but rather to manage any conflicts of interest caused by such differentials so that the interest of the Retirement Investor is paramount.”

Reg BI

Regulation Best Interest, enforced by the Securities and Exchange Commission, requires advisers to act in the best interest of their retail clients when recommending securities, and served as inspiration for the DOL’s final rule. Reg BI does, in fact, have a per se ban on “sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”

PRI’s Roberts says that though PTE 2020-02 lacks this explicit and unqualified prohibition, “the same types of contests Reg BI expressly prohibits would also not be allowable under the PTE,” because no reasonable conflict mitigation policy could permit them.

The DOL provides some examples in the PTE for policies designed to mitigate conflicts where differential compensation exists. Policies “could provide for increased monitoring of Investment Professional recommendations at or near compensation thresholds, recommendations at key liquidity events for investors (e.g., rollovers), and recommendations of investments that are particularly prone to conflicts of interest, such as proprietary products and principal-traded assets.”

Not Prohibited

Roberts notes that the DOL says that eliminating differential compensation actually does not on its own satisfy the reasonable policies and procedures requirement: “It is not enough merely to pay Investment Professionals the same percentage of the Financial Institution’s compensation for a recommended investment product, as for other products, if the Financial Institution receives more compensation from recommending that product.” This is because the firm’s conflict is passed on to the adviser.

Roberts says that the “DOL is reluctant to categorically prohibit things and prefers to let affected firms evaluate their policies in light of how a reasonable person would view them. After all, a reasonableness standard has been the foundation for ERISA’s fiduciary duties for 50 years.”

However, Roberts points out that in the amended PTE 2020-02, the DOL “moved the reference to differential compensation and incentives from the preamble into the actual text of the exemption. That signals to me that this is an area to which DOL thinks firms should be paying more attention.”