Broker-dealers and advisers who rely on the Best Interest Contract Exemption need to comply with the Impartial Conduct Standards. In short, these include three requirements: recommendations to plan and IRA investors must be in the “best interest” of the customer, communications with customers must not include materially misleading statements and the firm’s and adviser’s compensation must be reasonable. If any of these standards are not met, the broker-dealers and advisers have engaged in a non-exempt prohibited transaction.
The reasonable compensation requirement is more than a condition imposed by the DOL. The requirement is statutory. That is, it is imposed under ERISA for employer-sponsored plans.
It is imposed under the Code for all service arrangements with both plans and IRAs. The reasonable compensation limit applies to service providers regardless of whether or not they are fiduciaries.
This means two things. First, the requirement is not going away. Because it is embedded in the statutes, it can only be repealed by Congress — not the DOL, the SEC or any state rule — and this is not likely.
While the DOL will undoubtedly make changes to BICE and other exemptions during the current transition period, firms and advisers cannot expect the reasonable compensation requirement to go away, or even be changed.
Second, it applies to all service relationships. Even for level-fee advice arrangements, which do not have to satisfy BICE or any other similar exemption, compensation must be reasonable.
What does “reasonable” mean? The requirement is that compensation be reasonable in relation to the services and benefits being provided. As the DOL explains in the BICE preamble:
At bottom, the standard simply requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the (adviser) and Financial Institution are delivering to the Retirement Investor.
For compensation to be reasonable, it is not necessary to recommend a product that pays the least compensation. It is not necessary that compensation be below average. It just cannot rise to a level that is excessive in relation to the services and benefits provided.
Note that the reasonableness requirement applies to the compensation received by the broker-dealer and to the amount passed on by the firm to the adviser. If, for example, a firm receives an excessive level of commissions for recommending a product, this would violate the standard even if the adviser’s “share” of the commission were within industry norms.
Value of services
The BICE preamble also makes clear that all services and benefits provided can be taken into account — not just the advice services — in determining if compensation is reasonable. The DOL offers the following example:
In the case of a charge for an annuity or insurance contract that covers both the provision of services and the purchase of the guarantees and financial benefits provided under the contract, it is appropriate to consider the value of the guarantees and benefits in assessing the reasonableness of the arrangement, as well as the value of the services.
In other words, the value of the services may be enhanced by the complexities and services associated with a product, and those can be considered in determining whether the compensation is reasonable.
Factors in determining reasonableness
How is “reasonableness” determined? While the requirement is imposed by law, the standard itself is an industry, or market standard. Per the DOL, there are “several” factors involved. They include, but are not necessarily limited to, the:
- market pricing for similar services and products
- scope of monitoring, if any
- complexity of the product
To help determine market standards for compensation, broker-dealers use benchmarking or similar services. In fact, the DOL has said that firms may want to seek “impartial reviews” of their fee structures.
At the same time, firms should recognize that “reasonable” and “customary” do not necessarily mean the same thing. That is, in limited circumstances, the markets may not provide competitive pricing.
However, where markets are transparent and competitive, the benchmarking information should properly define reasonable compensation.
Finally, firms may wish to consider “re-benchmarking” their compensation structures at reasonable intervals. After all, what is reasonable this year might not be reasonable next year.
Originally published 2/2/18 on Drinker Biddle’s Broker-Dealer Regulation and Insights blog.
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