Updated Thursday, October 23, 2014 as of 2:49 AM ET

Ask Ed Slott: Do IRAs Need to Be in a Fee-Based Wrap?

My financial advisor told me I was going to have to put money in my IRA in their fee-based account.

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Comments (1)
As to the Dept. of Labor and IRA accounts, under the Internal Revenue Code issue: First, section 4975(e)(3) of the Internal Revenue Code of 1986, as
amended (Code) provides a similar definition of the term fiduciary
for purposes of Code section 4975 (IRAs). However, in 1975, shortly after ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c), that defines the circumstances under which a person renders ``investment advice'' to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA. The Department of Treasury issued a virtually identical regulation, at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor.

Hence, when the DOL/EBSA, as is expected later this year, issues a re-proposal of its "definition of fiduciary" regulation, in essence the broad exemptions previously provided disappear, and virtually any provider of personalized investment advice to a plan sponsor or plan participant would be a "fiduciary" and subject to ERISA's strict "sole interests" fiduciary standard and its prohibited transaction rules.

Does this means commissions are outlawed? Not necessarily. The fiduciary standard, whether under ERISA or under the Advisors Act or state common law, does not outlaw the receipt of commission-based compensation. However, the receipt of variable compensation (i.e, if commissions vary depending upon product recommendation) is problematic.

Nor are 12b-1 fees likely to be outlawed by EBSA, although some pundits have stated otherwise. However, 12b-1 fees are already under scrutiny by the SEC (although no action is likely soon). In addition, some concerns exist that, since 12b-1 fees cannot typically be negotiated (beyond various share classes, such as R-1, R-2, etc. in the retirement plan context), the Sherman Antitrust Act may apply and the practice of 12b-1 fees, especially as to retail investors, may be an unlawful fixing of prices and an unlawful restraint of trade.

There is likely to be an exemption granted to the prohibited transaction rules for brokerage firms who receive brokerage commissions for doing trading for funds. Whether the exemption will cover higher brokerage commissions paid in the nature of soft dollars is unknown.

Also, the receipt of "payment for shelf space" by a brokerage firm is very problematic under the ERISA standard.

I suspect that mutual funds and brokerage firms will need to change their business practices. A good approach would be to only have one method of compensation, with no other forms of compensation provided by the fund to the brokerage firm / registered representative. This could be commissions, or could be 12b-1 fees (if not otherwise outlawed), or could be AUM-based compensation paid by the plan participants (and deducted from account balances), or could be even flat fees paid by the plan sponsor (and/or deducted from account balances).

In any event, I believe some of the brokerage firm / mutual fund arrangements must change, such as payment for shelf space and soft dollar compensation - and any arrangement in which a fund is granted "preference" (in return for some form of compensation). Payment of "educaitonal" or "marketing" expenses by fund companies would likewise be outlawed under ERISA's prohibited transaction rules.

We will have to see what EBSA comes up with. And the final rule, if ever adopted, would not likely be effective until 2014 (or later). So, keep your eyes peeled, and be ready to change certain business practices and compensation methods if necessary. Hope this helps.
Posted by Ron R | Friday, February 15 2013 at 2:48PM ET
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