Recommendations that 401(k) participants take distributions from their plans and roll them over to individual retirement accounts are coming under increasing scrutiny. That scrutiny is focused on both the quality of the recommendation, including the analysis supporting it, and the disclosure of any conflicts of interest.
Registered investment advisers need to understand the increased scrutiny of rollover recommendations and the steps needed to comply with the Securities and Exchange Commission's requirements.
This article focuses on rollover recommendations as conflicts of interest and on the disclosure requirements for those conflicts.
The starting point is to consider whether an investment adviser's rollover recommendation is a fiduciary act. The Securities and Exchange Commission's Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers answers that question: "This [fiduciary] obligation to provide advice that is suitable and in the best interest applies not just to potential investments, but to ... advice about whether to roll over a retirement account so that the investment adviser manages that account."
The SEC interpretation should not be dismissed as a mere proposal. The SEC explained that: "[W]e believe it would be appropriate and beneficial to address in one release and reaffirm ... certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act."
In other words, the proposed interpretation represents the SEC's current views of the fiduciary duties owed by investment advisers to their clients.
The next question is whether a recommendation of a rollover to an IRA is a material conflict of interest. The SEC did not address that question in its proposed interpretation; however, it did in the proposed Regulation Best Interest that was issued on the same date.
Even though Reg BI is applicable to broker-dealers, rather than RIAs, the logic is the same. For example, in its discussion in the proposed Reg BI, the SEC noted that a rollover recommendation to an IRA would result in compensation, while a recommendation to leave the money in the plan "likely results in little or no compensation for a firm or its registered representative." That is true regardless of whether the firm is an RIA or a broker-dealer.
In that regard, Reg BI identified a recommendation to roll plan benefits to an IRA as a material conflict of interest. In its discussion in the proposal, the SEC listed a number of material conflicts of interest, including: "The rollover or transfer of assets from one type of account to another, such as a recommendation to roll over or transfer assets in an ERISA account to an IRA."
The third question is whether the conflict must be disclosed, and if so, how. The SEC's interpretation addresses the general requirements for disclosures of material conflicts of interest: "An adviser must seek to avoid conflicts of interest with its clients, and, at a minimum, make full and fair disclosure to its clients of all material conflicts of interest that could affect the advisory relationship ... An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser's conflicts of interest and business practices well enough to make an informed decision. For example, an adviser disclosing that it 'may' have a conflict is not adequate disclosure when the conflict actually exists."
In other words, the disclosure must be made and it must be clear and detailed. For example, the SEC's position is that a disclosure that a rollover recommendation "may" be a conflict of interest is not adequate.
In almost all cases, a rollover recommendation will be a conflict of interest because the investment adviser's fees for advising the IRA will be more than would have been earned for advising that portion of the plan, even if the adviser also worked with the plan.
Where the adviser doesn't work with the plan, the adviser will only be compensated if the participant takes a distribution and rolls to an IRA with the adviser. In order for a participant to consent to that conflict, the participant will need to know the nature of the conflict and how it might affect the participant.
Unfortunately, the SEC has not issued any guidance on the particulars of that disclosure. As a result, RIAs should consider taking a conservative position, which would include, for example, a statement that the adviser would not earn any compensation if the money were left in the plan.
RIAs should review whether their disclosures include rollover recommendations and whether they are adequate to reveal the conflict in a way that participants will be deemed to have provided informal consent.
Fred Reish is a partner at the law firm Drinker Biddle & Reath.