# Investment Advice-Participants and Beneficiaries

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3AE8-19272

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** August 22, 2008
- **Citation:** 73 FR 49896

## Text

DEPARTMENT OF LABOR
Employee Benefits Security Administration
29 CFR Part 2550
RIN 1210-AB13
Investment Advice—Participants and Beneficiaries

AGENCY:

Employee Benefits Security Administration, DOL.

ACTION:

Proposed rule.

SUMMARY:

This document contains proposed regulations implementing the provisions of the statutory exemption set forth in sections 408(b)(14) and 408(g) of the Employee Retirement Income Security Act, as amended (ERISA or the Act), and parallel provisions in the Internal Revenue Code of 1986, as amended (Code), relating to the provision of investment advice described in the Act by a fiduciary adviser to participants and beneficiaries in participant-directed individual account plans, such as 401(k) plans, and beneficiaries of individual retirement accounts (and certain similar plans). Section 408(b)(14) provides an exemption from certain prohibited transaction provisions in ERISA with respect to the provision of investment advice, the investment transaction entered into pursuant to the advice, and the direct or indirect receipt of fees or other compensation by the fiduciary adviser or an affiliate in connection with the provision of advice or the transaction pursuant to the advice. Section 408(g) describes the conditions under which the investment advice-related transactions are exempt. Upon adoption, the regulations will affect sponsors, fiduciaries, participants and beneficiaries of participant-directed individual account plans, as well as providers of investment and investment advice-related services to such plans.

DATES:

Written comments on the proposed regulations should be submitted to the Department of Labor on or before October 6, 2008.

ADDRESSES:

To facilitate the receipt and processing of comment letters, the Employee Benefits Security Administration (EBSA) encourages interested persons to submit their comments electronically by e-mail to
e-ORI@dol.gov
(Subject: Investment Advice Regulations), or by using the Federal eRulemaking portal at
http://www.regulations.gov
(follow instructions for submission of comments). Persons submitting comments electronically are encouraged not to submit paper copies. Persons interested in submitting paper copies should send or deliver their comments to the Office of Regulations and Interpretations, Employee Benefits Security Administration, Attn: Investment Advice Regulations, Room N-5655, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC 20210. All comments will be available to the public, without charge, online at
http://www.regulations.gov
and
http://www.dol.gov/ebsa
and at the Public Disclosure Room, N-1513, Employee Benefits Security Administration, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC 20210.

FOR FURTHER INFORMATION CONTACT:

Fred Wong, Office of Regulations and Interpretations, Employee Benefits Security Administration, (202) 693-8500. This is not a toll-free number.

SUPPLEMENTARY INFORMATION:

A. Background

Section 3(21)(A)(ii) of ERISA includes within the definition of “fiduciary” a person that renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of a plan, or has any authority or responsibility to do so.
1

The prohibited transaction provisions of ERISA and the Code prohibit an investment advice fiduciary from using the authority, control or responsibility that makes it a fiduciary to cause itself, or a party in which it has an interest that may affect its best judgment as a fiduciary, to receive additional fees. As a result, in the absence of a statutory or administrative exemption, fiduciaries are prohibited from rendering investment advice to plan participants regarding investments that result in the payment of additional advisory and other fees to the fiduciaries or their affiliates.

1
See also Code section 4975(e)(3)(B); 29 CFR 2510.3-21(c).

With the growth of participant-directed individual account plans, there has been an increasing recognition of the importance of investment advice to participants and beneficiaries in such plans. Over the past several years, the Department of Labor (Department) has issued various forms of guidance concerning when a person would be a fiduciary by reason of rendering investment advice and when the provision of investment advice might result in prohibited transactions.
2

Most recently, Congress and the Administration, responding to the need to afford participants and beneficiaries greater access to professional investment advice, amended the prohibited transaction provisions of ERISA and the Code, as part of the Pension Protection Act of 2006 (PPA),
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to permit a broader array of investment advice providers to offer their services to participants and beneficiaries responsible for investment of assets in their individual accounts and, accordingly, for the adequacy of their retirement savings.

2
See Interpretative Bulletin relating to participant investment education, 29 CFR § 2509.96-1 (Interpretive Bulletin 96-1); Advisory Opinion (AO) 2005-10A (May 11, 2005); AO 2001-09A (December 14, 2001); and AO 97-15A (May 22, 1997).

3
Public Law 109-280, 120 Stat. 780 (Aug. 17, 2006).

Specifically, section 601 of the PPA added a statutory exemption under sections 408(b)(14) and 408(g) of ERISA. Parallel provisions were added to the Code at section 4975(d)(17) and 4975(f)(8).
4

Section 408(b)(14) sets forth the investment advice-related transactions that will be exempt from the prohibitions of section 406 if the requirements of section 408(g) are met. The transactions described in section 408(b)(14) are: The provision of investment advice to the participant or beneficiary with respect to a security or other property available as an investment under the plan; the acquisition, holding or sale of a security or other property available as an investment under the plan pursuant to the investment advice; and the direct or indirect receipt of compensation by a fiduciary adviser or affiliate in connection with the provision of investment advice or the acquisition, holding or sale of a security or other property available as an investment under the plan pursuant to the investment advice.

4
Under Reorganization Plan No. 4 of 1978 (43 FR 47713, October 17, 1978), 5 U.S.C. App.1, 92 Stat. 3790, the authority of the Secretary of the Treasury to issue rulings under section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor. Therefore, the references in this notice to specific sections of ERISA should be taken as referring also to the corresponding sections of the Code.

On December 4, 2006, the Department published a Request for Information (RFI) in the
Federal Register
soliciting information to assist the Department in the development of regulations under sections 408(b)(14) and 408(g).
5

Specifically, the Department invited interested persons to address the qualifications for the “eligible

investment expert” that is required to certify that computer models used in connection with the statutory exemption meet the requirements of the statutory exemption. The Department also invited interested persons to provide information to assist the Department in developing procedures to be followed in certifying that a computer model meets the requirements of the statutory exemption. The Department also invited suggestions for a model disclosure form for purposes of the statutory exemption. In response to the RFI, the Department received 24 letters addressing a variety of issues presented by the statutory exemption. These comments have been taken into account in developing the proposed regulations.

5
71 FR 70429, Dec. 4, 2006. The Department, on the same date, also published a Request for Information in the
Federal Register
soliciting information to assist the Department in determining the feasibility of using computer models in connection with individual retirement accounts, as required by PPA section 601(b)(3). 72 FR 70427, Dec. 4, 2006.

On February 2, 2007, the Department issued Field Assistance Bulletin 2007-01 addressing certain issues presented by the new statutory exemption. This Bulletin affirmed that the enactment of sections 408(b)(14) and (g) did not invalidate or otherwise affect prior guidance of the Department relating to investment advice and that such guidance continues to represent the views of the Department.
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The Bulletin also confirmed the applicability of the principles set forth in section 408(g)(10) [Exemption for plan sponsor and certain other fiduciaries] to plan sponsors and fiduciaries who offered investment advice arrangements with respect to which relief under the statutory exemption is not required. Finally, the Bulletin addressed the scope of the fee-leveling requirement for purposes of an eligible investment advice arrangement described in section 408(g)(2)(A)(i). The Department's views on that issue are set forth in the discussion of the proposed regulations that follows.

6
In this regard, the Department cited the following: August 3, 2006 Floor Statement of Senate Health, Education, Labor and Pensions Committee Chairman Enzi (who chaired the Conference Committee drafting legislation forming the basis of H.R. 4), regarding investment advice to participants in which he states, “It was the goal and objective of the Members of the Conference to keep this advisory opinion [AO 2001-09A, SunAmerica Advisory Opinion] intact as well as other pre-existing advisory opinions granted by the Department. This legislation does not alter the current or future status of the plans and their many participants operating under these advisory opinions. Rather, the legislation builds upon these advisory opinions and provides alternative means for providing investment advice which is protective of the interests of plan participants and IRA owners.” 152 Cong. Rec. S8,752 (daily ed. Aug. 3, 2006) (statement of Sen. Enzi).

The proposed regulations contained in this notice would, upon adoption, implement the provisions of the statutory exemption for the provision of investment advice to participants and beneficiaries under sections 408(b)(14) and 408(g). In this regard, the Department notes that, in an effort to ensure broad availability of investment advice to both participants and beneficiaries in individual account plans and beneficiaries with individual retirement accounts, the Department also is publishing a proposed class exemption for the provision of investment advice to such individuals. The proposed class exemption appears in the Notice section of today's
Federal Register
.

B. Overview of Proposed § 2550.408g-1

1. General

In general, proposed § 2550.408g-1 tracks the requirements under section 408(g) that must be satisfied in order for the investment advice-related transactions described in section 408(b)(14) to be exempt from the prohibitions of section 406.

Paragraph (a) of the proposal sets forth the general scope of the statutory exemption and regulation as providing relief from the prohibitions of section 406 of ERISA for transactions described in section 408(b)(14) of ERISA in connection with the provision of investment advice to a participant or a beneficiary if the investment advice is provided by a fiduciary adviser under an “eligible investment advice arrangement.” Paragraph (a) also notes that the Code contains parallel provisions at section 4975(d)(17) and (f)(8).

Paragraph (b) of the proposal provides that, for purposes of sections 408(g)(1) of ERISA and section 4975(f)(8) of the Code, an “eligible investment advice arrangement” shall mean an arrangement that meets either the requirements of paragraph (c) [describing investment advice arrangements that use fee-leveling] or paragraph (d) [describing investment advice arrangements that use computer modeling] of the proposal or both.

2. Fee-Leveling

With respect to arrangements that use fee-leveling, paragraph (c) of the proposal requires that any investment advice be based on generally accepted investment theories that take into account the historic returns of different asset classes over defined periods of time, although nothing in the proposal is intended to preclude investment advice from being based on generally accepted investment theories that take into account additional considerations. Paragraph (c) also requires that any investment advice take into account information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences, although nothing in the proposal is intended to preclude a fiduciary adviser from taking into account additional information that a participant or beneficiary may provide. While section 408(g)(2)(A)(i) does not specifically reference such conditions, the principles are so fundamental to the provision of informed, individualized investment advice that a failure on the part of a plan fiduciary to insist on such conditions in the selection of an investment adviser for plan participants would, in the Department's view, raise serious questions as to the fiduciary's exercise of prudence. For this reason, the Department determined that such conditions are sufficiently significant that they should be included in the regulation implementing the statutory exemption for investment advice.

With regard to compensation and fees for the provision of investment advice, paragraph (c)(1)(iii) provides that any fees or other compensation (including salary, bonuses, awards, promotions, commissions or other things of value) received, directly or indirectly, by
any employee, agent or registered representative that provides investment advice on behalf of a fiduciary adviser
does not vary depending on the basis of any investment option selected by a participant or beneficiary. Paragraph (c)(1)(iv) provides that any fees (including any commission or other compensation) received by
the fiduciary adviser
for investment advice or with respect to the sale, holding, or acquisition of any security or other property for purposes of investment of plan assets do not vary depending on the basis of any investment option selected by a participant or beneficiary.

The individual compensation requirement in paragraph (c)(1)(iii) is designed to safeguard against a firm's creation of incentives for individuals to recommend certain investment products. It appears that, while an individual may have a general interest in the overall success of his or her employing firm, this interest, by itself, would not be inconsistent with the individual compensation requirement. This would not be the case, however, if the individual's direct or indirect compensation or benefits vary based on the selection of particular investment options. In order to determine whether more precise guidance can be developed, we request public comment on the types and formulations of direct and indirect compensation arrangements being utilized, and how they may operate under this provision.

With regard to the foregoing, the Department, in interpreting the scope of the fee-leveling requirement for purposes of section 408(g)(2)(A)(i), expressed its view, in Field Assistance Bulletin 2007-01 (February 2, 2007), that only the fees or other compensation of the fiduciary adviser may not vary. In contrast to other provisions of section 408(b)(14) and section 408(g), the Department explained, section 408(g)(2)(A)(i) references only the fiduciary adviser, not the fiduciary adviser or an affiliate. Inasmuch as a person, pursuant to section 408(g)(11)(A), can be a fiduciary adviser only if that person is a fiduciary of the plan by virtue of providing investment advice, an affiliate of a registered investment adviser, a bank or similar financial institution, an insurance company, or a registered broker dealer will be subject to the varying fee limitation only if that affiliate is providing investment advice to plan participants and beneficiaries. The Department further noted that, consistent with past guidance, if the fees and compensation received by an affiliate of a fiduciary that provides investment advice do not vary or are offset against those received by the fiduciary for the provision of investment advice, no prohibited transaction would result solely by reason of providing investment advice and thus there would be no need for a prohibited transaction exemption.
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The Department, therefore, concluded that Congress did not intend for the requirement that fees not vary depending on the basis of any investment options selected to extend to affiliates of the fiduciary adviser, unless, of course, the affiliate is also a provider of investment advice to a plan. This continues to be the view of the Department.

7
See AO 2005-10A; AO 97-15A.

The Department also noted in the Bulletin that, although section 408(g)(11)(A) generally limits “fiduciary advisers” to certain types of entities, it also permits employees, agents, or registered representatives of those entities to also qualify as fiduciary advisers if they satisfy the requirements of applicable insurance, banking, and securities laws relating to the provision of the advice.
See
section 408(g)(11)(A)(vi). As with affiliates, such an individual must, for purposes of section 408(g)(11)(A), not only be an employee, agent, or registered representative of one of those entities, but also must provide investment advice in his or her capacity as employee, agent, or registered representative. The Department, therefore, concluded that the language of section 408(g)(11)(A) required a finding that, for purposes of the statutory exemption, when an individual acts as an employee, agent or registered representative on behalf of an entity engaged to provide investment advice to a plan, that individual, as well as the entity, must be treated as the fiduciary adviser for purposes of section 408(g)(11)(A) and, accordingly subject to the limitations of section 408(g)(2)(A)(i). In an effort to accommodate a wider variety of business structures and practices, making investment advice more available while protecting participants and beneficiaries, the Department is proposing a class exemption addressing fee leveling requirements for employees, agents and registered representatives, also appearing in today's
Federal Register
.

In addition to the foregoing, fiduciary advisers utilizing investment advice arrangements that employ fee-leveling must comply with the requirements of paragraphs (e) [authorization by plan fiduciary], (f) [audits], (g) [disclosure], (h) [miscellaneous], and (i) [maintenance of records] of the proposal, each of which is discussed in more detail below.

3. Computer Models

Paragraph (d) of the proposal addresses the requirements applicable to investment advice arrangements that rely on computer models. In this regard, paragraph (d) provides, consistent with the provisions of section 408(g)(3)(B), (C) and (D), that an arrangement shall be an eligible investment advice arrangement if the only investment advice provided under the arrangement is advice that is generated by a computer model described in paragraphs (d)(1) and (2) of this section under an investment advice program, and with respect to which the requirements of paragraphs (e) [authorization by plan fiduciary], (f) [audits], (g) [disclosure], (h) [miscellaneous], and (i) [maintenance of records] of the proposal are met and any acquisition, holding or sale of a security or other property pursuant to such advice occurs solely at the direction of the participant or beneficiary.

Paragraph (d)(1), consistent with section 408(g)(3)(B)(i)-(v), sets forth the standards applicable to computer models. Specifically, paragraph (d)(1) requires that a computer model be designed and operated to: apply generally accepted investment theories that take into account the historic returns of different asset classes over defined periods of time, although nothing in the proposal is intended to preclude a computer model from applying generally accepted investment theories that take into account additional considerations; utilize information furnished by a participant or beneficiary relating to age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and investment preferences, although nothing in the proposal precludes a computer model from taking into account additional information that a plan or a participant or beneficiary may provide; and utilize appropriate objective criteria to provide asset allocation portfolios comprised of investment options available under the plan. See paragraph (d)(1)(i)-(iii) of the proposal.

In addition to the foregoing, a computer model, consistent with section 408(g)(3)(B)(iv),
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must be designed and operated to avoid investment recommendations that: inappropriately favor investment options offered by the fiduciary adviser or a person with a material affiliation or material contractual relationship with the fiduciary adviser over other investment options, if any, available under the plan; or inappropriately favor investment options that may generate greater income for the fiduciary adviser or a person with a material affiliation or material contractual relationship with the fiduciary adviser. In order to determine if further guidance can be developed with respect to this provision, the Department seeks public comment on circumstances under which it would be appropriate or inappropriate to favor particular investment options. For example, the Department believes that favoring a higher-cost investment alternative over an otherwise identical investment alternative with lower cost would be inappropriate.

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Pursuant to section 408(g)(3)(B)(iv), a computer model must operate “in a manner that is not biased in favor of investments offered by the fiduciary adviser or a person with a material affiliation or contractual relationship with the fiduciary adviser.”

As reflected in the language, a computer model would not fail to meet this requirement merely because the only investment options offered under the plan are options offered by the fiduciary adviser or a person with a material affiliation or material contractual relationship with the fiduciary adviser. The language also makes clear that models cannot be designed and operated to inappropriately favor those investment options that generate the most income for the fiduciary adviser or a person with a material affiliation or material contractual relationship with the fiduciary adviser. The proposal defines

a “material affiliation” and “material contractual relationship” at paragraphs (j)(6) and (j)(7), respectively.

Paragraph (d)(1) further requires, consistent with section 408(g)(3)(B)(v),
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that computer models take into account all “designated investment options” available under the plan without giving inappropriate weight to any investment option. See paragraph (d)(1)(v) of the proposal. The term “designated investment option” is defined in paragraph (j)(1) of the proposal, to mean any investment option designated by the plan into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts. The term “designated investment option” does not include “brokerage windows,” “self-directed brokerage accounts,” or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.

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Section 408(g)(3)(B)(v) provides that computer models must take “into account all investment options under the plan in specifying how a participant's account balance should be invested and is not inappropriately weighted with respect to any investment option.”

Paragraph (d)(1)(v) also provides that a computer model shall not be treated as failing to take all designated investment options into account merely because it does not take into account an investment option that constitutes an investment primarily in qualifying employer securities. Any such limitation on the investment advice to be generated by the computer model, however, must be disclosed to participants and beneficiaries under paragraph (g)(1)(vi) of the proposal, discussed below. Information received by the Department in response to both of its RFIs indicated that there are challenges attendant to developing computer models, which generally are based on underlying theories that rely on diversified asset classes, that address a single undiversified security, such as qualifying employer securities, in connection with generating investment recommendations that would enable a participant to construct a well-diversified investment portfolio. The Department is concerned that extending this requirement to qualifying employer securities might discourage arrangements based on utilization of a computer model, or otherwise limit their availability.
10

Accordingly, the Department has excluded investments primarily in qualifying employer securities from the requirement of paragraph (d)(1)(v) of the proposal.

10
It should be noted that, even in the absence of individualized advice, participants are reminded on a quarterly basis, via their pension benefit statements, of the importance of maintaining a diversified portfolio. Model language for purposes of this disclosure was set forth in Field Assistance Bulletin 2006-03 (Dec. 20, 2006). Among other things the model language provides that “[I]f you invest more than 20% of your retirement savings in any one company or industry, your savings may not be properly diversified. Although diversification is not a guarantee against loss, it is an effective strategy to help you manage investment risk.”

Paragraph (d)(2) of the proposal requires that, prior to utilization of the computer model, the fiduciary adviser obtain a written certification that the computer model meets the requirements of paragraph (d)(1), discussed above. If the model is modified in a manner that may affect its ability to meet the requirements of paragraph (d)(1), the fiduciary adviser, prior to utilization of the modified model, must obtain a new certification. With regard to the certification, paragraph (d)(2) requires that the fiduciary adviser obtain a certification that meets the requirements of paragraph (d)(4) from an “eligible investment expert,” within the meaning of paragraph (d)(3).

Paragraph (d)(3) of the proposal defines an “eligible investment expert” to mean a person that, through employees or otherwise, has the appropriate technical training or experience and proficiency to analyze, determine and certify, in a manner consistent with paragraph (d)(4), whether a computer model meets the requirements of paragraph (d)(1) of this section; except that the term eligible investment expert does not include any person that has any material affiliation or material contractual relationship with the fiduciary adviser, with a person with a material affiliation or material contractual relationship with the fiduciary adviser, or with any employee, agent, or registered representative of the foregoing. After consideration of the public comments, the Department has concluded that it would be very difficult to define a specific set of academic or other credentials that would serve to define the appropriate expertise and experience for an eligible investment expert.

Accordingly, under the proposal, it is the fiduciary adviser who is responsible for determining whether an eligible investment expert, itself or its employees, possesses the requisite training and experience to certify whether a given computer model meets the requirements of paragraph (d)(1) in a manner consistent with paragraph (d)(4) of the proposal. Paragraph (d)(5) of the proposal provides that, for purposes of the statutory exemption, the selection of the eligible investment expert by the fiduciary adviser is a fiduciary act governed by section 404(a)(1) of ERISA.

The Department notes that, although the proposal gives latitude to a fiduciary adviser in selecting an eligible investment expert to certify a computer model, as the party seeking prohibited transaction relief under the exemption, the fiduciary adviser has the burden of demonstrating that all applicable requirements of exemption are satisfied with respect to its arrangement. We also note that section 404 of ERISA requires the fiduciary adviser to act reasonably and prudently in its selection.

Paragraph (d)(4) of the proposal provides that a certification by an eligible investment expert shall be in writing and contain the following: an identification of the methodology or methodologies applied in determining whether the computer model meets the requirements of paragraph (d)(1) of this section; an explanation of how the applied methodology or methodologies demonstrated that the computer model met the requirements of paragraph (d)(1) of this section; and a description of any limitations that were imposed by any person on the eligible investment expert's selection or application of methodologies for determining whether the computer model meets the requirements of paragraph (d)(1). In addition the certification is required to contain a representation that the methodology or methodologies were applied by a person or persons with the educational background, technical training or experience necessary to analyze and determine whether the computer model meets the requirements of paragraph (d)(1); and a statement certifying that the eligible investment expert has determined that the computer model meets the requirements of paragraph (d)(1). Finally the certification must be signed by the eligible investment expert.

With regard to the certification described in paragraph (d)(4) of the proposal, public comments suggested a number of different approaches that could be followed in determining computer model consistency with the statutory criteria. The comments did not, however, suggest a single suitable approach. The Department, therefore, is wary of mandating a methodology under the proposal. The Department also believes that as computer models and their use under investment advice arrangements continue to develop, experts may need the flexibility to develop new methodologies for examining those models. Accordingly, paragraph (d)(4) does not require a particular methodology to be applied for purposes of certification.

4. Authorized by a Plan Fiduciary

Consistent with the section 408(g)(4) of ERISA, the proposal provides, at paragraph (e), that the arrangement pursuant to which investment advice is provided to participants and beneficiaries must be expressly authorized by a plan fiduciary (or, in the case of an IRA, the IRA beneficiary) other than: the person offering the arrangement; any person providing designated investment options under the plan; or any affiliate of either. The proposal further provides that for purposes of such authorization, an IRA beneficiary will not be treated as an affiliate of a person solely by reason of being an employee of such person, thereby enabling employees of a fiduciary adviser to take advantage of investment advice arrangements offered by their employer under the exemption.

5. Annual Audit

Paragraph (f) addresses the audit requirements of section 408(g)(6) of ERISA. Specifically, paragraph (f)(1) provides that the fiduciary adviser shall, at least annually, engage an independent auditor, who has appropriate technical training or experience and proficiency, and so represents in writing to the fiduciary adviser, to conduct an audit of the investment advice arrangements for compliance with the requirements of the proposal and within 60 days following completion of the audit, issue a written report to the fiduciary adviser and, except with respect to an arrangement with an IRA, to each fiduciary who authorized the use of the investment advice arrangement, consistent with paragraph (e) of the proposal, setting forth the specific findings of the auditor regarding compliance of the arrangement with the requirements of the proposal.

Given the significant number of reports that an auditor would be required to send if the written report was required to be furnished to all IRA beneficiaries, the Department framed an alternative requirement for investment advice arrangements for IRAs. This alternative is set forth in paragraph (f)(2) of the proposal. The alternative provides that, with respect to an arrangements with an IRA, the fiduciary adviser shall, within 30 days following receipt of the report from the auditor, furnish a copy of the report to the IRA beneficiary or make such report available on its website, provided that such beneficiaries are provided information, along with other required disclosures (see paragraph (g) of the proposal), concerning the purpose of the report, and how and where to locate the report applicable to their account. With respect to making the report available on a website, the Department believes that this alternative to furnishing reports to IRA beneficiaries satisfies the requirement of section 104(d)(1) of the Electronic Signatures in Global and National Commerce Act (E-SIGN)
11

that any exemption from the consumer consent requirements of section 101(c) of E-SIGN must be necessary to eliminate a substantial burden on electronic commerce and will not increase the material risk of harm to consumers. The Department solicits comments on this finding. Paragraph (f)(2) also provides that, when the report of the auditor identifies noncompliance with the requirements of the regulation, the fiduciary adviser must send a copy of the report to the Department. As proposed, the fiduciary adviser must submit the report to the Department within 30 days following receipt of the report from the auditor. The submission of this report will enable the Department to monitor compliance with the statutory exemption in those instances where there is no authorizing ERISA plan fiduciary to carry out that function.

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15 U.S.C. 7004(d)(1) (2000).

For purposes of paragraph (f) of the proposal, an auditor is considered independent if it does not have a material affiliation or material contractual relationship with the person offering the investment advice arrangement to the plan or any designated investment options under the plan. The terms “material affiliation” and “material contractual relationship” are defined in paragraphs (j)(6) and (7) of the proposal.

With regard to the scope of the audit, paragraph (f)(4) provides that the auditor shall review sufficient relevant information to formulate an opinion as to whether the investment advice arrangements, and the advice provided pursuant thereto, offered by the fiduciary adviser during the audit period were in compliance with the regulation. Paragraph (f)(4) further provides that it is not intended to preclude an auditor from using information obtained by sampling, as reasonably determined appropriate by the auditor, investment advice arrangements, and the advice pursuant thereto, during the audit period. The proposal, therefore, does not require an audit of every investment advice arrangement at the plan or fiduciary adviser-level or of all the advice that is provided under the exemption. In general, the proposal leaves to the auditor the determination as to the appropriate scope of their review and the extent to which they can rely on representative samples for determining compliance with the exemption.

6. Disclosure

The disclosure provisions are set forth in paragraph (g) of the proposal and generally track the disclosure provisions of the statutory exemption at section 408(g)(6) of ERISA. In this regard, the proposal, at paragraph (g)(1), requires that the fiduciary adviser provide to participants and beneficiaries, prior to the initial provision of investment advice with regard to any security or other property offered as an investment option, a written notification describing: the role of any party that has a material affiliation or material contractual relationship with the fiduciary adviser in the development of the investment advice program, and in the selection of investment options available under the plan; the past performance and historical rates of return of the designated investment options available under the plan, to the extent that such information is not otherwise provided; all fees or other compensation relating to the advice that the fiduciary adviser or any affiliate thereof is to receive (including compensation provided by any third party) in connection with the provision of the advice or in connection with the sale, acquisition, or holding of the security or other property; and any material affiliation or material contractual relationship of the fiduciary adviser or affiliates thereof in the security or other property.

The notification to participants and beneficiaries also is required to explain: the manner, and under what circumstances, any participant or beneficiary information provided under the arrangement will be used or disclosed; the types of services provided by the fiduciary adviser in connection with the provision of investment advice by the fiduciary adviser, including, with respect to an arrangement described in paragraph (d) utilizing a computer model, any limitations on the ability of the model to take into account an investment primarily in qualifying employer securities, as provided for in paragraph (d)(1)(v) of the proposal; that the adviser is acting as a fiduciary of the plan in connection with the provision of the advice; and that a recipient of the advice may separately arrange for the provision of advice by another adviser that could have no material affiliation with and receive no fees or other compensation in connection with the security or other property.

Paragraph (g)(2) of the proposal requires that the notification furnished to participants and beneficiaries be written in a clear and conspicuous manner and in a manner calculated to be understood by the average plan participant and must be sufficiently accurate and comprehensive to reasonably apprise such participants and beneficiaries of the information required to be provided in the notification.

The appendix to the proposal contains a model disclosure form that may be used for purposes of satisfying the fee and compensation disclosure requirement of paragraph (g)(1)(iii), as well as the requirements of paragraph (g)(2), of the proposal. The proposal makes clear, however, that the use of the model disclosure form is not mandatory.

Paragraph (g)(3) makes clear that the required disclosures may be provided in written or electronic form.

Paragraph (g)(4) of the proposal, like section 408(g)(6)(B) of ERISA, sets forth miscellaneous recordkeeping and furnishing responsibilities of the fiduciary adviser. Specifically, paragraph (g)(4) provides that, at all times during the provision of advisory services to the participant or beneficiary pursuant to the arrangement, the fiduciary adviser must: Maintain the information described in paragraph (g)(1) in accurate form; provide, without charge, accurate information to the recipient of the advice no less frequently than annually; provide, without charge, accurate information to the recipient of the advice upon request of the recipient; and provide, without charge, accurate information to the recipient of the advice concerning any material change to the information required to be provided to the recipient of the advice at a time reasonably contemporaneous to the change in information.

7. Other Conditions

Paragraph (h) of the proposal, like section 408(g)(7) of ERISA, sets forth additional conditions applicable to the provision of advice under the statutory exemption. These requirements are as follows: The fiduciary adviser must provide appropriate disclosure, in connection with the sale, acquisition, or holding of the security or other property, in accordance with all applicable securities laws; the sale, acquisition, or holding occurs solely at the direction of the recipient of the advice; the compensation received by the fiduciary adviser and affiliates thereof in connection with the sale, acquisition, or holding of the security or other property is reasonable; and the terms of the sale, acquisition, or holding of the security or other property are at least as favorable to the plan as an arm's length transaction would be.

8. Maintenance of Records

Paragraph (i) of the proposal sets forth the record maintenance requirements. Consistent with section 408(g)(9) of ERISA, paragraph (i) of the proposal provides that the fiduciary adviser must maintain, for a period of not less than 6 years after the provision of investment advice pursuant to the arrangement, any records necessary for determining whether the applicable requirements of the proposal have been met. Also, paragraph (i), as with section 408(g)(9), makes clear that a prohibited transaction shall not be considered to have occurred solely because the records are lost or destroyed prior to the end of the 6-year period due to circumstances beyond the control of the fiduciary adviser.

9. Definitions

Paragraph (j) of the proposal sets forth a number of definitions relevant to the statutory exemption and this proposed regulation.

Paragraph (j)(1), as discussed earlier, defines the term “designated investment option.” Paragraph (j)(2) sets forth the definition of “fiduciary adviser,” as it appears in section 408(g)(11)(A) of ERISA. With regard to that part of the fiduciary adviser definition that treats persons who develop computer models or market investment advice programs or computer models as a fiduciary of the plan by reason of providing investment advice and as a fiduciary adviser for purposes of section 408(b)(14), the Department is proposing a separate regulation (§ 2550.408g-2), discussed below, pursuant to which a single fiduciary adviser may elect to be treated as a fiduciary with the respect to the plan.

Paragraph (j)(3) of the proposal adopts the statutory definition of “registered representative” set forth in ERISA section 408(g)(11)(C), which states that a registered representative of another entity means a person described in section 3(a)(18) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(18)) (substituting the entity for the broker or dealer referred to in such section) or a person described in section 202(a)(17) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)(17)) (substituting the entity for the investment adviser referred to in such section).

Paragraph (j)(4), consistent with section 601(b)(3)(A)(i) of the Pension Protection Act of 2006, defines the term “Individual Retirement Account” to mean plans described in paragraphs (B) through (F) of section 4975(e)(1) of the Code, as well as a trust, plan, account, or annuity which, at any time, has been determined by the Secretary of the Treasury to be described in such paragraphs.

Paragraph (j)(5) of the proposed rule defines the term “affiliate.” For purposes of the proposal, an “affiliate” of another person means: Any person directly or indirectly owning, controlling, or holding with power to vote, 5 percent or more of the outstanding voting securities of such other person; any person 5 percent or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person; any person directly or indirectly controlling, controlled by, or under common control with, such other person; and any officer, director, partner, copartner, or employee of such other person. Consistent with ERISA section 408(g)(11)(B), this definition is based on the definition of an “affiliated person” of an entity as contained in section 2(a)(3) of the Investment Company Act of 1940 (ICA), except that it does not reflect clauses (E) and (F) thereof. The Department has initially determined that including provisions similar to clauses (E) and (F) is unnecessary, because these clauses appear to focus on persons who exercise control over the management of an investment company.
12

Also, such parties will nonetheless be treated as an affiliate because they would be a person directly or indirectly controlling, controlled by, or under common control with, such other person. See paragraph (j)(5)(iii) of the proposal. Additionally, the Department is concerned that including provisions similar to clauses (E) and (F), which focus on functions involving investment companies, but not other types of vehicles in which plans may invest, could have the unintended consequence of possibly subjecting persons associated with investment companies to different requirements under these proposed regulations. Therefore, the Department is proposing to define affiliate without regard to clauses (E) and (F) of section 2(a)(3) of the ICA.

12
ICA section 2(a)(3)(E) and (F) include in the definition of affiliated person: If the other person is an investment company, any investment adviser thereof or any member of an advisory board thereof; and if such other person is an unincorporated investment company not having a board of directors, the depositor thereof. 15 U.S.C. 80a-2(a)(3)(E)-(F).

In a variety of places in the regulation reference is made to persons with

“material affiliations” and “material contractual relationships.” See paragraphs (d)(1)(iv), (d)(3), (f)(3), (g)(1)(i), (g)(1)(iv) and (g)(1)(viii) of the proposal. For purposes of this regulation, those terms are defined in paragraphs (j)(6) and (j)(7), respectively.

Paragraph (j)(6) of the proposal describes a person with a “material affiliation” with another person as: Any affiliate of such other person; any person directly or indirectly owning, controlling, or holding, 5 percent or more of the interests of such other person; or any person 5 percent or more of whose interests are directly or indirectly owned, controlled, or held, by such other person. In determining “interest,” paragraph (j)(6)(ii) provides that an “interest” means with respect to an entity: The combined voting power of all classes of stock entitled to vote or the total value of the shares of all classes of stock of the entity if the entity is a corporation; the capital interest or the profits interest of the entity if the entity is a partnership; or the beneficial interest of the entity if the entity is a trust or unincorporated enterprise.

Paragraph (j)(7) of the proposal provides that persons shall be treated as having a “material contractual relationship” if payments made by one person to the other person pursuant to written contracts or agreements between the persons exceed 10 percent of the gross revenue, on an annual basis, of such other person. The Department believes that one person's receipt of more than 10 percent of gross revenue from another person is sufficiently significant to be considered material. However, the Department specifically invites comments on whether the percentage test should be higher or lower and, if so, why.

The proposal, at paragraph (j)(8), defines “control” to mean the power to exercise a controlling influence over the management or policies of a person other than an individual.

C. Overview of Proposed § 2550.408g-2

Proposed § 2550.408g-2, as indicated above, addresses the requirements for electing to be treated as a fiduciary and fiduciary adviser by reason of developing or marketing a computer model or an investment advice program used in an eligible investment advice arrangement. See section 408(g)(11)(A).

Section 408(g)(11)(A) provides that, with respect to an arrangement that relies on use of a computer model to qualify as an “eligible investment advice arrangement,” a person who develops the computer model, or markets the investment advice program or computer model, shall be treated as a fiduciary of a plan by reason of the provision of investment advice referred to in ERISA section 3(21)(A)(ii) to the plan participant or beneficiary, and shall be treated as a “fiduciary adviser” for purposes of ERISA section 408(b)(14) and (g). Section 4975(f)(8) of the Code contains a parallel provision to ERISA section 408(g)(11)(A). Proposed § 2550.408g-2 sets forth requirements that must be satisfied in order for one such fiduciary adviser to elect to be treated as a fiduciary under such an eligible investment advice arrangement. See paragraph (a) of § 2550.408g-2.

Paragraph (b)(1) of § 2550.408g-2 provides that if an election meets the requirements of paragraph (b)(2) of the proposal, then the person identified in the election shall be the sole fiduciary adviser treated as a fiduciary by reason of developing or marketing a computer model, or marketing an investment advice program, used in an eligible investment advice arrangement. Paragraph (b)(2) requires that the election be in writing and that the writing: Identify the arrangement, and person offering the arrangement, with respect to which the election is to be effective; and identify the person who is the fiduciary adviser, the person who develops the computer model or markets the computer model or investment advice program with respect to the arrangement, and the person who elects to be treated as the only fiduciary, and fiduciary adviser, by reason of developing such computer model or marketing such computer model or investment advice program. Paragraph (b)(2) of § 2550.408g-2 also requires that the election be signed by the person acknowledging that it elects to be treated as the only fiduciary and fiduciary adviser; that a copy of the election be furnished to the plan fiduciary who authorized use of the arrangement; and that the writing be retained in accordance with the record retention requirements of § 2550.408g-1(i).

D. Effective Date

The Department proposes that the regulations contained in this notice will be effective 60 days after publication of the final regulations in the
Federal Register
. The Department invites comments on whether the final regulations should be made effective on a different date.

E. Request for Comments

The Department invites comments from interested persons on the proposed regulations. To facilitate the receipt and processing of comment letters, the Employee Benefits Security Administration (EBSA) encourages interested persons to submit their comments electronically by e-mail to
e-ORI@dol.gov
(Subject: Investment Advice Regulations), or by using the Federal eRulemaking portal at
http://www.regulations.gov
(follow instructions for submission of comments). Persons submitting comments electronically are encouraged not to submit paper copies. Persons interested in submitting paper copies should send or deliver their comments to the Office of Regulations and Interpretations, Employee Benefits Security Administration, Attn: Investment Advice Regulations, Room N-5655, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC 20210. All comments will be available to the public, without charge, online at
http://www.regulations.gov and http://www.dol.gov/ebsa
and at the Public Disclosure Room, N-1513, Employee Benefits Security Administration, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC 20210.

The comment period for the proposed regulations will end 45 days after publication of the proposed rule in the
Federal Register
. The Department believes that this period of time will afford interested persons an adequate amount of time to analyze the proposals and submit comments. Written comments on the proposed regulations should be submitted to the Department of Labor on or before October 6, 2008.

F. Regulatory Impact Analysis

Summary

The Department anticipates that this proposed regulation and proposed class exemption, by extending quality, expert investment advice to more retirement plan participants, together will improve their investment results by approximately $14 billion or more annually, at a cost of $4 billion, thereby producing a net financial benefit of $10 billion or more. The improved investment results will reflect reductions in investment errors such as payment of higher than necessary fees and expenses, poor trading strategies, and inadequate diversification. The provisions of this proposed regulation and the conditions attached to this proposed class exemption reflect the Department's efforts to ensure that the advice provided pursuant to them will be affordable and of high quality.

Introduction

Workers' retirement security increasingly depends on their investment decisions. Unfortunately

there is evidence that many participants and beneficiaries in participant-directed defined contribution (DC) plans and beneficiaries of individual retirement accounts (IRAs) (collectively hereafter, “participants”), beset by flawed information or reasoning, make poor investment decisions. These participants may pay higher fees and expenses than necessary for investment products and services, engage in excessive or poorly timed trading or fail to rebalance their portfolios, inadequately diversify their portfolios and thereby assume uncompensated risk, take more or less than optimal levels of compensated risk, and/or pay unnecessarily high taxes. Financial losses (including foregone earnings) from such mistakes likely amount to more than $100 billion per year. These losses compound and grow larger as workers progress toward and into retirement.

Such mistakes and consequent losses historically can be attributed at least in part to provisions of federal law that effectively preclude a variety of arrangements whereby financial professionals might otherwise provide retirement plan participants with expert investment advice. These “prohibited transaction” provisions of ERISA and the Internal Revenue Code prohibit fiduciaries from dealing with DC plan or IRA assets in ways that advance their own interests. These provisions prohibit plan fiduciaries from exercising the authority, control, or responsibility that makes such persons fiduciaries when they have an interest which may conflict with the interests of the plan for which they act. Under these provisions financial advisers who have a direct or indirect stake in participants' investment decisions generally may not provide them with investment advice. In recognition that certain transactions could nonetheless be beneficial to plans and their participants and beneficiaries, subject to safeguards appropriate to protect against potential abuses, Congress enacted a number of statutory prohibited transaction exemptions, and also gave the Department conditional authority to grant prohibited transaction exemptions. In this regard, the prohibited transaction exemption for the provision of investment advice added by the Pension Protection Act of 2006 (PPA) opened the door to more types of investment advice arrangements by conditionally permitting arrangements where the fiduciary adviser or an affiliate thereof has a financial stake in the advised participants' investment decisions. The Department is proposing a regulation to further specify the PPA's applicable conditions, together with a class exemption to establish alternative conditions under which such arrangements may operate. Together these actions are intended to increase the availability of investment advice.

The results of this proposed regulation and proposed class exemption will depend on their impacts on the availability, cost, use, and quality of participant investment advice. The Department expects that, as a result of these actions, quality, affordable advice will proliferate, producing significant net gains for participants.

Investment Mistakes

The Department believes that many participants make costly investment mistakes and therefore could benefit from receiving and following good advice. In theory, investors can optimize their investment mix over time to match their investment horizon and personal taste for risk and return. But in practice many investors do not optimize their investments, at least not in accordance with generally accepted financial theories.

Some investors fail to exhibit clear, fixed and rational preferences for risk and return. Some base their decisions on flawed information or reasoning. For example some appear to anchor decisions inappropriately to plan features or to mental accounts or frames, or to rely excessively on past performance measures or peer examples. Some suffer from overconfidence, myopia, or simple inertia.
13

13
See,
e.g.
, Richard H. Thaler & Shlomo Benartzi,
The Behavioral Economics of Retirement Savings Behavior,
AARP Public Policy Institute White Paper 2007-02 (Jan. 2007); and Jeffrey R. Brown & Scott Weisbenner,
Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans,
Social Science Research Network Abstract 631886 (Dec. 2004).

Such informational and behavioral problems translate into at least five distinct types of investment mistakes,
14

which together generate financial losses (including foregone earnings) of $109 billion or more annually
15

for DC plan and IRA participants, the Department estimates.

14
It should be noted that much of the research documenting investment mistakes does not account for whether advice was present or not. At least some of the mistakes may have been made despite good advice to the contrary; some may have been made pursuant to bad advice. There is evidence both that advice sometimes is not followed, and that it sometimes is bad. This is explored more below.

15
As discussed below, this estimate is subject to wide uncertainty.

Fees and Expenses

Investors sometimes pay higher fees and expenses than necessary for investment products and services. There is evidence that mutual funds with poorer gross performance (that is performance before deducting fees) also have higher fees. This suggests that higher fees sometimes do not reflect value added by managers. Investors often pay inadequate attention to fee differences, even in connection with highly comparable products like competing S&P 500 index funds.
16

16
A number of studies conclude that investors often pay higher fees than necessary.

Javier Gil-Bazo & Pablo Ruiz-Verdú,
Yet Another Puzzle? Relation Between Price and Performance in the Mutual Fund Industry,
Social Science Research Network Abstract 947448 (March 2007) find that funds with worse before-fee performance charge higher fees. They suggest that funds faced with insensitive investors charge higher fees, finding that even after controlling for performance sensitivity, funds with lower expected performance set higher fees. They hypothesize that lower performing funds lose sophisticated investors to higher performing funds, then are left with relatively unsophisticated investors who are not as responsive to price.

According to Ali Hortacsu & Chad Syverson,
Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds,
Social Science Research Network Abstract 405642 (April 2003), 75 percent of S&P 500 Index Funds have expense ratios in excess of 47 basis points, 50 percent in excess of 72 basis points and 25 percent in excess of 149 basis points. The highest cost fund charged annualized investor fees that were nearly 30 times greater than the lowest-cost fund (268 vs. 9.5 basis points). Low-cost funds have a dominant market share, but the asset share of the low-cost funds has fallen consistently since 1995.

Paul G. Mahoney,
Manager-Investor Conflicts in Mutual Funds,
The Journal of Economic Perspectives, Volume 18, Number 2 (2004) extends the Ali Hortacsu & Chad Syverson,
Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds,
Social Science Research Network Abstract 405642 (April 2003) result of two classes of investors, the experienced that buy low-cost no-load funds, and the novice who uses a broker and buys high-cost load funds. He finds that, even after separating the expense ratio into administrative fees and 12b-1 fees, funds with loads still have administrative fees 15 basis point higher than the no-load funds.

Brad M. Barber
et al., Out of Sight, Out of Mind, The Effects of Expenses on Mutual Fund Flows,
Journal of Business, Volume 79, Number 6 2095, 2095-2119 (2005) find that investors are sensitive to load fees. They argue that front-end load fees are generally observable as a dollar amount on the first statement while the effects of administrative fees on the account balance are hidden by the volatility of fund returns. They find evidence of learning; repeat mutual fund purchasers pay on average about half the load fees of first time mutual fund purchasers.

Todd Houge & Jay W. Wellman,
The Use and Abuse of Mutual Fund Expenses,
Social Science Research Network Abstract 880463 (Jan. 2006) present evidence that less knowledgable investors pay consistently higher asset management fees than more knowledgable investors holding similar funds. Less sophisticated investors are more likely to invest in funds with loads. Load funds on average have annual expense ratios that are 50 basis points higher than no-load funds. While a large part of the higher expense ratio is composed of 12b-1 fees, load funds also have higher asset management fees. They conclude that “Load fund shareholders often pay high fees to market and grow the fund, but the

fund's advisor is the most likely beneficiary of this growth.”

Edwin J. Elton
et al., Are Investors Rational? Choices Among Index Funds,
Social Science Research Network Abstract 340482 (June 2002) find that buying S&P 500 index mutual funds using expenses as the predictor of future success leads to picking funds with better returns. They find that the ten percent of funds with the lowest expenses out performs the ten percent of funds with the highest expenses by 0.92 percent a year. They find that for S&P 500 index mutual funds, the incentive for brokers and financial planners to push the fund (as represented by loads) is more important for new flows than is avoiding high cost and poorly performing funds. They are unable to find any effect of the quality of services on flows.

James J. Choi
et al., Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,
National Bureau of Economic Research Working Paper W12261 (May 2006) offer experimental evidence that index fund investors are largely insensitive to fees.

Some other studies suggest, however, that fee levels may in fact be competitive and efficient. Many studies fail to measure potential non-financial benefits investors might derive from professional investment advice. Victoria Leonard-Chambers & Michael Bogdan,
Why Do Mutual Fund Investors Use Professional Financial Advisers?,
Investment Company Institute Research Fundamentals, Volume 16, Number 1 (April 2007) present results of a survey “that identifies the benefits investors say they receive from using professional financial advisers,” and contrast this perspective with that of studies that rely on “performance and other publicly available measures to examine the value” of such advice. Other studies find that investors with more intelligence or financial literacy often pay similar fees as those with less, and suggest this is consistent with the hypothesis that fees are competitive and efficient (see,
e.g.
, Sebastian Miller & Martin Weber,
Financial Literacy and Mutual Fund Investments: Who Buys Actively Managed Funds?,
Social Science Research Network Abstract 1093305 (Feb. 2008); and Mark Grinblatt
et al., Are Mutual Fund Fees Competitive? What IQ-Related Behavior Tells Us,
Social Science Research Network Abstract 1087120 (Nov. 2007)).

The Department understands that some of what might otherwise appear to be higher than necessary fees paid by investors pursuant to advice may in fact reflect indirect payment of the reasonable cost of the advice itself.

The Department estimates that DC plan participants
17

and IRA beneficiaries together recently paid fees and expenses that were higher than necessary by $8 billion or more annually on aggregate.
18

Good advice could eliminate some of this unnecessary expense.
19

17
DC plan participants' investment choices typically are limited to a menu selected by a plan fiduciary who is responsible for ensuring that the associated fees and expenses are reasonable. However, such participants may pay more overall than would be optimal if they do not appropriately consider fees and expenses when allocating their assets across available investments.

18
“Higher than necessary” here means that the participant could have obtained equal value without incurring the expense. This calculation assumes that participants on average pay 11 or more basis points in unnecessary fees and expenses, in the form of expense ratios or loads. This assumption is likely to be conservative in light of evidence on the distribution of investor expense levels presented in Deloitte Financial Advisory Services LLP,
Fees and Revenue Sharing in Defined Contribution Retirement Plans
(Dec. 6, 2007) (unpublished, on file with the Department of Labor); Brad M. Barber
et al., Out of Sight, Out of Mind, The Effects of Expenses on Mutual Fund Flows,
Journal of Business, Volume 79, Number 6 2095, 2095-2119 (2005); Edwin J. Elton
et al., Are Investors Rational? Choices Among Index Funds,
Social Science Research Network Abstract 340482 (June 2002); James J. Choi
et al., Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,
National Bureau of Economic Research Working Paper W12261 (May 2006); and Sarah Holden & Michael Hadley,
The Economics of Providing 401(k) Plans: Services, Fees and Expenses 2006,
Investment Company Institute Research Fundamentals, Volume 16, Number 4 (Sept. 2007). This estimate of excess expense does not take into account less visible expenses such as mutual funds' internal transaction costs (including explicit brokerage commissions and implicit trading costs), which are sometimes larger than funds' expense ratios (Deloitte Financial Advisory Services LLP,
Fees and Revenue Sharing in Defined Contribution Retirement Plans
(Dec. 6, 2007) (unpublished, on file with the Department of Labor); Jason Karceski
et al., Portfolio Transactions Costs at U.S. Equity Mutual Funds,
University of Florida Working Paper (2004), at
http://thefloat.typepad.com/the_float/files/2004_zag_study_on_mutual_fund_trading_costs.pdf)
.

19
Conversely, there is evidence that some higher than necessary expense currently is a direct result of what might be called bad advice, meaning certain marketing activities carried out by intermediaries such as brokers as well as direct consumer advertising by vendors of funds and competing financial products.

Poor Trading Strategies

There is evidence that some participants trade excessively, while many more trade too little, failing even to rebalance. In DC plans, participant trading often worsens performance, and those with automatic rebalancing generally fare best.
20

Relative to automatic rebalancing, inferior trading strategies recently cost participants perhaps $56 billion or more annually, the Department estimates.
21

Among inferior strategies, it is likely that active trading aimed at timing the market generates more adverse results than failing to rebalance. Many mutual funds investors' experience badly lags the performance of the funds they hold because they buy and sell shares too frequently and/or at the wrong times.
22

Investors often buy and sell in response to short-term past returns, and suffer as a result.
23

Good advice is likely to discourage market timing efforts and encourage rebalancing, thereby ameliorating adverse impacts from poor trading strategies.

20
See,
e.g.
, Takeshi Yamaguchi
et al., Winners and Losers: 401(k) Trading and Portfolio Performance,
Michigan Retirement Research Center Working Paper WP2007-154 (June 2007).

21
This estimate is derived from the risk adjusted returns attributed to participants with different trading strategies, see id.

22
See,
e.g.
, Dalbar Inc.,
Quantitative Analysis of Investor Behavior 2007
(2007).

23
See,
e.g.
, Rene Fischer & Ralf Gerhardt,
Investment Mistakes of Individual Investors and the Impact of Financial Advice,
Science Research Network Abstract 1009196 (Aug. 2007); Julie Agnew & Pierluigi Balduzzi,
Transfer Activity in 401(k) Plans,
Social Science Research Network Abstract 342600 (June 2006); and George Cashman
et al., Investor Behavior in the Mutual Fund Industry: Evidence from Gross Flows,
Social Science Research Network Abstract 966360 (Feb. 2007).

Inadequate Diversification

Investors sometimes fail to diversify adequately and thereby assume uncompensated risk and suffer associated losses. For example, DC plan participants sometimes concentrate their assets excessively in stock of their employer.
24

Relative to full diversification,
25

employer stock investments recently cost DC plan participants perhaps $3 billion
26

annually, the Department estimates.
27

Other lapses in diversification may involve omission from portfolios of

asset classes such as overseas equity or debt, small cap stocks, or real estate. Such lapses may sometimes reflect limited investment menus supplied by DC plans.
28

Yet even where adequate choices are available and company stock is not a factor, investors sometimes fail to diversify adequately.
29

Inadequate diversification other than excessive concentration in company stock recently cost participants perhaps $42 billion annually, the Department estimates.
30

Good advice should address over concentration in employer stock and other failures to properly diversify.

24
See,
e.g.
, Olivia S. Mitchell & Stephen P. Utkus,
The Role of Company Stock in Defined Contribution Plans,
National Bureau of Economic Research Working Paper W9250 (Oct. 2002); and Jeffrey R. Brown & Scott Weisbenner,
Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans,
Social Science Research Network Abstract 631886 (Dec. 2004).

25
This comparison should be viewed as an outer bound. Full diversification of the same assets might not be feasible if companies are unwilling to alter the compensation mix in this way (see,
e.g.
, Olivia S. Mitchell & Stephen P. Utkus,
The Role of Company Stock in Defined Contribution Plans,
National Bureau of Economic Research Working Paper W9250 (Oct. 2002)). It also neglects some potential tax benefits of employer stock investments that might offset losses from reduced diversification (see,
e.g.
, Mukesh Bajaj
et al., The NUA Benefit and Optimal Investment in Company Stock in 401(k) Accounts,
Social Science Research Network Abstract 965808 (Feb. 2007)).

26
Following findings reported in Lisa K. Meulbroek,
Company Stock in Pension Plans: How Costly Is It?,
Social Science Research Network Abstract 303782 (Mar. 2002), this estimate reflects losses amounting to 14 percent of the employer stock's value, assuming 10 percent of DC plan assets are held in employer stock, the DC plan is one-half of total wealth, and the holding period is 10 years. For comparison, following findings reported in Krishna Ramaswamy,
Company Stock and Pension Plan Diversification, in The Pension Challenge: Risk Transfers and Retirement Income Security
71, 71-88 (Olivia S. Mitchell & Kent Smetters eds., 2003), the annualized cost of an option to receive the higher of the return on a typical company stock or the return on a fully diversified equity portfolio over a three-year horizon would amount to approximately $24 billion, the Department estimates. This measure probably exaggerates the loss to participants, however, insofar as it would preserve for the participant the potential upside of a company stock that outperforms the market.

27
These estimates neglect any behavioral impact full diversification might have on asset allocation. There is some evidence that investing in employer stock increases participants' exposure to equity overall, which might increase average wealth (see,
e.g.
, Jack L. Vanderhei,
The Role of Company Stock in 401(k) Plans,
Employee Benefit Research Institute T-133 Written Statement for the House Education and Workforce Committee, Subcommittee on Employer-Employee Relations, Hearing on Enron and Beyond: Enhancing Worker Retirement Security (Feb. 2002),
at http://www.ebri.org/pdf/publications/testimony/t133.pdf).

28
See,
e.g.
, Edwin J. Elton
et al., The Adequacy of Investment Choices Offered By 401(k) Plans,
Social Science Research Network Abstract 567122 (Mar. 2004), which finds that menus are frequently inadequate, and Ning Tang and Olivia S. Mitchell,
The Efficiency of Pension Plan Investment Menus: Investment Choices in Defined Contribution Pension Plans,
University of Michigan Retirement Research Center Working Paper WP 2008-176 (June 2008),
at http://www.mrrc.isr.umich.edu/publications/papers/pdf/wp176.pdf,
which finds that most menus are efficient.

29
See,
e.g.
, Laurent E. Calvet
et al., Down or Out: Assessing the Welfare Costs of Household Investment Mistakes,
Harvard Institute of Economic Research Discussion Paper No. 2107 (Feb. 2006).

30
See id. This estimate assumes annual return decrements from inadequate diversification of 0.3 percent of invested assets for investors that are already investing in risky assets (like stocks and mutual funds) and 3.3% for investors that are not yet investing in risky assets. The Department estimates that in the U.S. about 85% of investors include risky assets in their portfolios.

Inappropriate Risk

Investors who avoid the foregoing three mistakes might be said to invest efficiently, in the sense that they generally can expect the maximum possible return given their level risk. However, they may still be making a costly mistake: they may fail to calibrate the risk and return of their portfolio to match their own risk and return preferences. As a result, their investments may be too risky or too safe for their own tastes. The Department lacks a basis on which to estimate the magnitude of such mistakes, but believes they may be common and large. A diversified portfolio's risk and return characteristics generally is determined by its allocation across asset classes. As noted above, there is ample evidence that participants' asset allocation choices often are inconsistent with fixed or well behaved risk and return preferences. If participants' true preferences are in fact fixed or well behaved, then observed asset allocations, which often appear to shift in response to seemingly irrelevant factors (or fail to shift in response to relevant ones), certainly entail large welfare losses.
31

Good advice might help participants calibrate their asset allocations to match their true preferences.

31
The potential financial effects of changes in asset allocation hint at the likely magnitude of these welfare effects. The Department previously has estimated that movement of DC plan default investments from stand-alone, low-risk capital preservation instruments to diversified portfolios that include equities will improve investment results for a large majority of affected individuals, increasing aggregate account balances by an estimated $5 billion to $7 billion in 2034 (See 72 FR 60,452, 60,466 (Oct. 24, 2007)).

Excess Taxes

It is likely that many households pay excess taxes as a result of disconnects between their investment and tax strategies. Households saving for retirement must decide not only what assets to hold, but also whether to locate these assets in taxable or tax-deferred accounts. For example, households may be able to maximize their expected after-tax wealth by first placing heavily taxed bonds in their tax-deferred account and then placing lightly taxed equities in their taxable account. A significant number of households do not follow this practice, however. By one estimate, to fully implement this practice in 1998, U.S. households would have had to relocate some $251 billion in assets.
32

It is not clear, however, whether such households are in fact making investment mistakes. In practice, this simple asset location rule may fail to minimize taxes.
33

As a result the Department has no basis to estimate the magnitude of excess taxes that might derive from DC plan and IRA participants' investment mistakes. In any event it is unclear whether or to what extent investment advisers would be positioned to provide advice on tax efficiency.

32
See,
e.g.
, Daniel B. Bergstresser & James M. Poterba,
Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances,
Journal of Public Economics, Volume 88 1893, 1893-1915 (2004).

33
For example, tax-exempt municipal bonds are available, and actively managed equity mutual funds are not always tax-efficient (see,
e.g.
, James M. Poterba
et al., Asset Location for Retirement Savers, in Public Policies and Private Pensions
290, 290-331 (John B. Shoven
et al.
eds., 2004); and John B. Shoven & Clemens Sialm,
Asset Location in Tax-Deferred and Conventional Savings Accounts,
Journal of Public Economics, Volume 88 (2003)). Using historical returns data and tax rate data for the period 1962-98, James M. Poterba
et al., Asset Location for Retirement Savers, in Public Policies and Private Pensions
290, 290-331 (John B. Shoven
et al.
eds., 2004) find that when investing in actively managed mutual funds, and with the availability of tax-exempt bonds, households would have more after-tax wealth in most cases if they had first placed equities in the tax-deferred account. Gene Amromin,
Portfolio Allocation Choices in Taxable and Tax-Deferred Accounts: An Empirical Analysis of Tax-Efficiency,
Social Science Research Network Abstract 302824 (May 2002) describes how accessibility restrictions on assets in tax-deferred retirement accounts create a tension between making tax-efficient placements and the risk of having to make costly withdrawals in the event of a bad labor income shock. He presents empirical evidence that holding apparently tax-inefficient portfolios is related to accessibility restrictions and to precautionary motives. Lorenzo Garlappi & Jennifer C. Huang,
Are Stocks Desirable in Tax-Deferred Accounts?
, Journal of Public Economics, Volume 90 2257, 2257-2283 (July 2006) explain how a tax-deferred account essentially confers a tax subsidy onto its holdings. While the level of the tax subsidy may be maximized by first placing bonds in the tax-deferred account, this strategy may lead to a more volatile tax benefit. Risk-averse households may wish to smooth this volatility by holding a mix of equities and bonds in both tax-deferred and taxable accounts, as some are observed to do in practice. Robert M. Dammon
et al., Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,
The Journal of Finance, Volume LIX, Number 3 999, 999-1037 (2004) find that even when tax-exempt bonds are available and even when there are liquidity shocks, for most investors it is best to put taxable bonds in the tax-deferred account and equity in the taxable account.

Promoting Investment Advice

Permissible Arrangements

Federal law limits the variety of arrangements whereby participants may obtain investment advice. Specifically, ERISA and the Internal Revenue Code generally prohibit fiduciaries from dealing with DC plan or IRA assets in ways that advance their own interests. These provisions effectively preclude participants from obtaining advice under arrangements that are widely used by other investors. For example, under many common arrangements, the adviser may receive a commission or other consideration when the investor enters into a transaction pursuant to the advice. The adviser's employer or an affiliate thereof may receive a sales load or other consideration in connection with the transaction. Stated generally, many common investment advice arrangements present financial advisers with opportunities to self deal.

While generally prohibiting arrangements that present such opportunities, federal law also provides for conditional exemptions whereby otherwise prohibited transactions are permitted. Some exemptions are contained in the statute. The Department has authority to grant others. The conditions attached to such exemptions serve to mitigate the adverse effects of the conflicts of interest that are present and thereby protect participants' interests. However, the Department invites suggestions for other safeguards against conflicts of interest that would be consistent with the goal of making quality advice more widely available.

The Pension Protection Act of 2006 opened the door to more types of investment advice arrangements by conditionally permitting arrangements where the fiduciary adviser or an affiliate thereof has a financial stake in

the advised participants' investment decisions. The Department is proposing a regulation to further specify the PPA's applicable conditions, together with a class exemption to establish alternative conditions under which such arrangements may operate. Table 1 summarizes the effect of the PPA and this proposed class exemption on permissible investment advice arrangements.

The Department calibrated this proposed regulation to in an effort to protect participants while promoting the affordability of investment advice arrangements operating pursuant to the PPA's statutory exemptive relief, in order that such arrangements will proliferate and thrive, to the benefit of participants.

The PPA's relief (listed at B. in table 1) is conditioned in part on audits. In order to promote the affordability of advice, this proposed regulation provides that audits may rely on a representative sample of similar arrangements. In order to protect participants, this proposed regulation requires that audit reports identifying noncompliance in connection with advice provided to IRA beneficiaries be furnished to the Department.

1—Permissible Investment Advice Arrangements

Is it permissible for compensation to vary
depending on participants' investment decisions?

Person
providing
advice

Fiduciary
adviser entity

Fiduciary
advisers'
affiliates

A. Absent any exemptive relief:

1. Except as described at 2. below
No
No
No.

2. Advice is determined solely by a computer model that is provided by an independent entity and over which the fiduciary adviser has no control
N/a *
Yes
Yes.

B. Under PPA statutory exemption:

1. Subject to conditions including authorization by a separate fiduciary, independent audits, disclosure, and recordkeeping
No
No
Yes.

2. Subject to conditions listed above at 1., and advice is provided by a computer model that is certified by an independent expert and satisfies conditions including conformance to investment theories and objectivity
N/a *
Yes
Yes.

C. Under proposed class exemption:

1. Subject to conditions including conformance to investment theories, authorization by a separate fiduciary, independent audits, disclosure, and recordkeeping
No
Yes
Yes.

2. Subject to conditions listed above at 1. and additional conditions including prudence and loyalty, advance provision of benchmark recommendations or educational material, and documentation
Yes
Yes
Yes.

* Under these arrangements, the investment advice is formulated exclusively by use of the computer model.

The PPA's statutory exemptive relief for investment advice arrangements that use computer models (listed at B.2. in table 1) is conditioned in part on independent expert certification of such models. The expert must meet requirements specified by the Secretary and certifications and renewals thereof must be completed in accordance with rules established by the Secretary. This proposed regulation establishes such requirements and rules.

In advance of formulating these requirements and rules the Department invited and considered extensive public input on the nature, functions, and performance of existing models. The Department also closely examined and road tested some popular models with particular attention to the criteria set forth in section 408(g)(3)(B) of ERISA. The Department came to the conclusion that existing computer models can take into account various information about individuals, their preferences and available investment options and, in its limited attempt to examine whether recommendations provided were optimal, the Department did not find evidence of computer models recommending investment portfolios that have risk return profiles inferior to any individual investment alternative available.

On these bases the Department understands that models capable of satisfying the exemption's conditions are various and evolving. The variety and evolution reflect healthy competition to develop superior products that deliver more value to participants.

The Department sought to calibrate this proposed regulation to nurture such competition while keeping advice affordable and protecting participants' interests. This proposed regulation consequently provides for transparency and procedural rigor but generally does not attempt to specify precise and fixed substantive standards. For example, pursuant to the proposed regulation the experts' qualifications will be reviewed by a fiduciary, and each certification will be documented in detail. The proposed regulation also provides that models may be certified once for similar applications across multiple DC plans or IRAs, rather than separately for each individual application, thereby promoting affordability of arrangements using models.

The Department likewise sought to calibrate this proposed class exemption to protect participants while promoting the affordability of investment advice arrangements operating pursuant to it, in order that such arrangements likewise will proliferate and thrive, to the benefit of participants. As detailed below, the proposed class exemption, by relaxing bars against arrangements that place fiduciary advisers in positions where they have potential conflicts of interest, will increase the variety of investment advice arrangements that are available and potentially lower the cost and promote the marketing of such arrangements, to the benefit of participants. Conditions attached to the proposed class exemption will mitigate the adverse impact of the conflicts and thereby ensure the quality of advice provided pursuant to it.

Availability and Use

Participants have always had the option of obtaining permissible investment advice services directly in the retail market. DC plan sponsors likewise have had the option of obtaining such services in the commercial market and making them available to plan participants and beneficiaries in connection with the plan.

Prior to the 2006 enactment of the PPA, a substantial fraction of DC plan sponsors already made investment advice available to plan participants and

beneficiaries. Today, as the PPA's implementation progresses, many more have begun providing or are gearing up to provide such advice. It is likely that 40 percent or more of DC plan sponsors currently provide access to investment advice either on line, by phone, or in-person. Where offered, approximately 25 percent of participants use advice. In-person advice seems to be offered by the most plan sponsors. On-line advice and to a lesser degree telephone advice are favored more by large sponsors. Smaller plan sponsors appear to offer advice generally and in-person advice in particular more frequently than larger plan sponsors.
34

34
This assessment is based on the Department's reading of Hewitt Associates LLC,
Survey Findings: Hot Topics in Retirement, 2007
(2007); Profit Sharing/401(k) Council of America,
50th Annual Survey of Profit Sharing and 401(k) Plans
(2007); and Deloitte Development LLC,
Annual 401(k) Benchmarking Survey, 2005/2006 Edition
(2006). In addition to investment advice, a majority of sponsors also provide one or more other types of support to participants' investment decisions. Other types of support include providing general investment education via seminars or written materials, offering one-stop, pre-mixed investment alternatives such as lifestyle funds, and offering managed accounts.

Investment advice is also already used by a substantial fraction of IRA participants, the Department believes. A majority of IRA participants that invest in mutual funds purchase some or all of their funds via a professional financial adviser.
35

Overall 60 percent of U.S. workers and retirees say they use the advice of a financial professional when making retirement savings and investment decisions; 40 percent say this advice was more helpful to them than alternatives.
36

It is not clear how recently this advice was obtained, however: In the same survey just 28 percent say that in the past year they obtained investment advice from a professional financial adviser who was paid through fees or commissions.
37

35
Eighty-two percent of mutual fund shareholders who hold funds outside of DC plans purchase some or all of their funds from a professional financial adviser such as a full-service broker, independent financial planner, bank or savings institution representative, insurance agent, or accountant (see,
e.g.
, Victoria Leonard-Chambers & Michael Bogdan,
Why Do Mutual Fund Investors Use Professional Financial Advisers?,
Investment Company Institute Research Fundamentals, Volume 16, Number 1 (April 2007)). Because families owning IRAs outnumber those owning pooled investment vehicles outside of retirement accounts (see,
e.g.
, Brian K. Bucks
et al., Recent Changes in U.S. Family Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances,
Federal Reserve Bulletin 92 A1, A1-A38 (2006)), it is reasonable to conclude that a large majority of IRA beneficiaries who invest in mutual funds purchase them via such professionals. The Department has no basis to estimate the fraction of these beneficiaries that receive true investment advice from such professionals, however. It is possible that some make their purchase decisions without receiving any recommendation or material guidance from the professional making the sale.

36
Alternatives including advice of peers, written plan materials, print media, television and radio, seminars, software, on-line information or advice, and retirement benefit statements were all less likely to be characterized as “most helpful.”

37
See,
e.g.
, Employee Benefit Research Institute,
2007 Retirement Confidence Survey, Wave XVII,
Posted Questionnaire (Jan. 2007).

The new statutory exemptive relief provided by the PPA is expected to increase the availability of advice, but it is too early to observe by how much.
38

The Department believes that absent this proposed class exemption some segments of the plan and participant market will lack adequate access to quality, affordable investment advice. Some potential fiduciary advisers will be deterred from entering the market by the complexity of advice arrangements that conform to the conditions of the PPA's statutory exemptive relief.
39

Some plan sponsors and participants will be deterred by the cost of such arrangements,
40

or by dissatisfaction with the types of advice arrangements that are available at lower costs, such as automated computer investment advice programs.
41

As a result some DC plan sponsors will not offer advice, and where it is offered some participants will not use it.
42

IRA beneficiaries may face similar obstacles to obtaining affordable, quality investment advice.

38
The statutory exemptive relief for investment advice provided by the PPA generally became effective for advice provided after December 31, 2006. In February 2007 EBSA issued guidance on the new statutory exemptive relief for arrangements using fiduciary advisers whose affiliates' revenue might vary depending on the fiduciary advisers' fiduciary acts. It is likely that some such arrangements exist today, and that more will in the future. The PPA also provided relief for arrangements that provide advice via independently certified computer models. The PPA withheld this exemptive relief in connection with IRAs, however, unless and until the Department found and reported to Congress that a model satisfying certain criteria exists. Concurrent with issuance of this proposed class exemption, the Department has reached this finding and reported it to Congress. Therefore statutory relief for this latter type arrangement is just now being extended to IRAs. In addition, the PPA provides that the Department will by regulation specify the process by which computer models will be certified. Concurrent with issuance of this proposed class exemption, the Department is proposing such a regulation. Given this timing it is unlikely that many such latter type arrangements yet exist.

39
Such complexity can include the need to enlist an adviser who is independent of or merely affiliated with the plan's or IRA's investment manager, in order to avoid direct exposure of the adviser to potential conflicts.

40
As discussed below, arrangements that avoid potential conflicts may entail higher or more visible costs.

41
In one survey of DC plan sponsors, among those offering investment advice, “access to financial counselors in person” was rated most effective, followed by “access to financial counselors via telephone.” “Web-based” advice received the lowest effectiveness ratings (see,
e.g.
, Deloitte Development LLC,
Annual 401(k) Benchmarking Survey, 2005/2006 Edition
(2006)). This finding is corroborated by another survey, in which in-person advice appears to be used by participants more often than advice delivered via the Internet (see,
e.g.
, Profit Sharing/401(k) Council of America,
Investment Advice Survey 2001
(2001)).

42
Where investment advice is available to DC plan participants, only one in four uses it, according to one plan sponsor survey (see,
e.g.
, Profit Sharing/401(k) Council of America,
50th Annual Survey of Profit Sharing and 401(k) Plans
(2007)). On-line advice appeals more to higher-salaried, full-time workers (see,
e.g.
, Julie Agnew,
Personalized Retirement Advice and Managed Accounts: Who Uses Them and How Does Advice Affect Behavior in 401(k) Plans?,
Center for Retirement Research Working Paper 2006-9 (2006)). In one survey, two-thirds of workers and 85 percent of retirees expressed discomfort with “obtaining advice from financial professionals on-line. This raises the possibility that many participants, perhaps especially lower-paid, part-time participants, may be underserved if the regulatory environment excessively favors on-line advice.

From the point of view of DC plan sponsors, the PPA and this proposed class exemption could help relieve certain concerns that have impeded some from providing investment advice in the past. A few years prior to the enactment of the PPA less than one in four surveyed DC plan sponsors provided advice, according to one survey.
43

Those not providing advice were asked to cite reasons and rate the reasons' importance on a 0-to-5 scale. Two reasons cited by large majorities and rated moderately important might be ameliorated by this proposed class exemption: “Fiduciary concern about ensuring that the advice provider has no conflict of interest”
44

(cited by 84 percent and rated 3.1) and “cost of providing advice”
45

(cited by 69 percent and rated 2.0).
46

In another pre-PPA survey 35 percent of DC plan sponsors not offering advice cited cost as a reason.
47

43
See,
e.g.
, Profit Sharing/401(k) Council of America,
Investment Advice Survey 2001
(2001).

44
Both the PPA and this proposed class exemption extend conditional relief from ERISA's prohibited transaction provisions, but neither relieves plan fiduciaries of their general obligations under ERISA.

45
The cost of advice is discussed further immediately below.

46
Other fiduciary concerns, cited more frequently and rated more important, are not addressed by this proposed class exemption.

47
See,
e.g.
, Deloitte Development LLC,
Annual 401(k) Benchmarking Survey, 2005/2006 Edition
(2006).

From the point of view of prospective fiduciary advisers whose business models involve conflicts—
e.g.
, who are compensated by the companies that manufacture, manage, and/or trade the investment products that they recommend—the PPA and this proposed class exemption grant conditional access to a very large and

fast growing new market segment.
48

These advisers might be in a position to offer their services at low or no direct cost to the companies' DC plan and IRA clients (relying instead on compensation from the companies). They might market their services to the companies' clients more actively than have independent advisers historically.

48
Combined participant directed DC plan and IRA assets exceed $7 trillion.

For purposes of this impact assessment, the Department anticipates that owing to the statutory exemptive relief provided by the PPA, advice of some type (on-line, telephone and/or in person) will soon be available to perhaps one-half of DC plan participants, with in-person advice available to perhaps one in four. This proposed class exemption will boost these fractions to perhaps 60 percent and 35 percent, respectively. The Department's assumptions are summarized in Table 2.
49

49
The Department based its assumptions on its reading of Hewitt Associates LLC,
Survey Findings: Hot Topics in Retirement, 2007
(2007); Profit Sharing/401(k) Council of America,
50th Annual Survey of Profit Sharing and 401(k) Plans
(2007); and Deloitte Development LLC,
Annual 401(k) Benchmarking Survey, 2005/2006 Edition
(2006).

2—Availability of Advice to DC Plan Participants

Policy context

Any advice
(computer or live)
(percent)

Live advisor
(percent)

Pre-PPA
40
20

PPA
50
25

Class exemption
60
35

The effect of investment advice depends not merely on its availability but on its use by DC plan and IRA participants. Do the participants seek advice, and if so do they follow it? According to one survey, among DC plan participants offered investment advice, approximately one in four uses it. There is some evidence that historically in-person advice has achieved higher use rates than on-line advice, with on-line advice appealing more to higher-income participants.
50

In another survey large fractions of workers say they would be very likely (19 percent) or somewhat likely (35 percent) to take advantage of advice provided by the company that manages their employer's DC plan. Of these, two-thirds said they would implement only those recommendations that were in line with their own ideas; 21 percent said they would implement all of the recommendations as long as they trusted the source.
51

In a subsequent survey, among those obtaining investment advice, 36 percent say they implemented “all” of the advice, 58 percent “some,” and just 5 percent “none.”
52

50
See,
e.g.
, Profit Sharing/401(k) Council of America,
50th Annual Survey of Profit Sharing and 401(k) Plans
(2007); and Julie Agnew,
Personalized Retirement Advice and Managed Accounts: Who Uses Them and How Does Advice Affect Behavior in 401(k) Plans?
, Center for Retirement Research Working Paper 2006-9 (2006).

51
See,
e.g.
, Employee Benefit Research Institute,
2007 Retirement Confidence Survey, Wave XVII,
Posted Questionnaire (Jan. 2007). In practice this might translate into a high rate of compliance with recommendations, if recommendations turn out not to diverge too much from participants' own ideas.

52
See,
e.g.
, Employee Benefit Research Institute, 2008 Retirement Confidence Survey, Wave XVIII, Posted Questionnaire (Jan. 2008).

The PPA and this proposed class exemption together could boost DC plan participants' use of advice where offered, in at least two ways. First, because it appears that in-person advice arrangements are more heavily used than automated computer advice programs, wider availability of in-person advice programs wherein advisers can exercise discretion in formulating personalized advice (rather than merely communicate the recommendations of a computer model)—a likely consequence of this proposed class exemption—might be expected to boost use rates. The shift anticipated by the Department (discussed immediately above) would increase the use rate slightly from 25 percent to 26 percent.
53

Second, if the cost of advice falls, participants who must pay for advice will become more inclined to use it. However, historically employers have usually paid directly for advice, or passed the cost to all participants whether they use advice or not,
54

and as explained below it is unclear by how much the cost of advice will fall. Therefore for purposes of this impact assessment the Department did not take into account any cost-driven increase in use of advice by DC plan participants, but assumed that this proposed class exemption will increase the fraction of DC plan participants using advice where available from 25 percent to 26 percent.
55

Given the Department's assumptions regarding availability of advice to DC plan participants, this translates into an increase in the incidence of advice due to this proposed class exemption from 10 percent to 16 percent.

53
This assumes that the use rate for where in person advice is available is approximately 50 percent higher (30 percent) as where only on-line or telephone advice is available (20 percent) (see,
e.g.
, Employee Benefit Research Institute,
2007 Retirement Confidence Survey, Wave XVII,
Posted Questionnaire (Jan. 2007)).

54
See,
e.g.
, Profit Sharing/401(k) Council of America,
Investment Advice Survey 2001
(2001).

55
One survey found that 64 percent of workers already use professional financial advice when making retirement savings and investment decisions, and that 54 percent are very or somewhat likely to use advice if offered by their employer in connection with a DC plan (see,
e.g.
, Employee Benefit Research Institute,
2007 Retirement Confidence Survey, Wave XVII,
Posted Questionnaire (Jan. 2007)). This seems to suggest a higher baseline rate of advice use than assumed here. However, because the latter fraction is smaller than the former, it is unclear whether this suggests that this proposed class exemption would increase DC plan participants' use of advice by more or less than assumed here.

The PPA and this proposed class exemption could also boost IRA participants' use of advice. As noted above, advisers doing business pursuant to this class exemption are likely to actively market advice services to IRA participants and to offer them reduced prices for such services. The reduced prices will reflect both the availability to advisers of other compensation and possible cost saving in the production and delivery of advice. Advisers doing business pursuant to this proposed class exemption may thereby attract business both from IRA participants who otherwise would be without advice and from IRA participants who otherwise would obtain advice through an arrangement that does not require the relief provided by this proposed class exemption. IRA participants who would otherwise be without advice may obtain advice in response to such marketing and pricing activity because the activity reduces their search cost to find and select an adviser, and/or because the reduced price falls below their reservation price. Likewise, IRA participants who would otherwise have obtained advice via some other arrangement may switch to an arrangement pursuant to the PPA or this proposed class exemption (and may increase the amount of advice services they use) because the advisers' marketing activity broadens their search and/or in pursuit of lower prices.

In proposing this class exemption the Department considered carefully the importance of transparency in pricing. Participants' decisions whether and where to obtain advice should be well informed with respect to the cost associated with alternative arrangements. As a condition of this proposed class exemption an adviser must disclose to the participant certain information regarding other revenue sources. This condition is intended to enable participants to decide whether, where, and how much advice to obtain, in light of the associated direct and indirect costs to them.
56

Therefore the

Department intends that any cost-driven increase in use of advice by IRA participants will be driven by overall cost decreases and not solely by direct price reductions.

56
In particular, participants should be able to adequately compare the prices offered by advisers

doing business pursuant to this exemption with those offered by other advisers such as those offering their services for a flat fee.

As noted above there is evidence that a large fraction of IRA participants already use advice. For purposes of this assessment the Department assumes that as a result of the PPA and this proposed class exemption the proportion of IRA beneficiaries using advice will increase from one-third to two-thirds. The Department's assumptions regarding use of advice are summarized in table 3.
57

57
These assumptions are based on the Department's reading of Employee Benefit Research Institute,
2007 Retirement Confidence Survey, Wave XVII,
Posted Questionnaire (Jan. 2007); Hewitt Associates LLC,
Survey Findings: Hot Topics in Retirement, 2007
(2007); Profit Sharing/401(k) Council of America,
50th Annual Survey of Profit Sharing and 401(k) Plans
(2007); and Deloitte Development LLC,
Annual 401(k) Benchmarking Survey, 2005/2006 Edition
(2006). There are a number of reasons to believe that use of advice will be higher among IRA beneficiaries than DC plan participants. The aforementioned survey reports, read together, generally support this conclusion. In addition, relative to IRA beneficiaries, DC participants may have less need for advice and/or easier access to alternative forms of support for their investment decisions. DC plan participants' choice is usually confined to a limited menu selected by a plan fiduciary, and the menu may include one-stop alternatives such as target date funds that may mitigate the need for advice. Their plan or employer may provide general financial and investment education in the form of printed material or seminars. They often make initial investment decisions (sometimes by default) before contributing to the plan so the decisions' impact may seem small. Finally, the availability of advice in connection with the plan is intermediated by the plan sponsor and fiduciary. In contrast, IRA beneficiaries generally have wider choice and are more likely to be without employer-provided support for their decisions. Decision points may more often occur when account balances are large, such as when rolling a large DC plan balance into an IRA or when retiring. Finally, the availability of advice to IRA beneficiaries is not intermediated by an employer—rather IRA beneficiaries interface directly with the retail market and will thereby be more directly affected by the exemptive relief provided by the PPA and by this proposed class exemption. For all of these reasons IRA beneficiaries may use advice more frequently than DC plan participants.

3—Use of Advice by DC Plan and IRA Participants

Policy context
DC plans

Where offered
(percent)

Overall
(percent)

IRA

Dollars
advised
($trillions)

Pre-PPA
25
10
33
$1.7

PPA
25
13
50
2.5

Class exemption
26
16
67
3.2

It seems likely that in practice a large proportion of participants who receive advice will follow that advice either in whole or in part. This is especially likely if the advice turns out to be broadly in line with the participants' own thinking. Nonetheless, some advice will not be followed, and as a result some investment errors will not be corrected. For purposes of this analysis, the Department has assumed that advised participants make investment errors at one-half the rate of unadvised participants. The remaining errors reflect participant failures to follow advice (together with possible flaws in some advice, as discussed immediately below).

Cost

As noted above the PPA and this proposed class exemption are expected to make advice available to participants at a lower direct price, because advisers will be able to rely on alternative revenue sources to compensate their efforts. More importantly, however, the Department believes that the total cost of the advice to participants will be reduced. Bars against transactions wherein fiduciary advisers' and participants' interests may conflict carry costs. Faced with such bars advisers may forgo certain potential economies of scale in production and distribution of financial services that would derive from more vertical and horizontal integration.
58

And to avoid such conflicts they must carefully monitor and calibrate their relationships and compensation arrangements, or incur the opportunity cost associated with exclusive reliance on level fees. The Department therefore expects the PPA and this proposed class exemption to produce cost savings by harnessing economies of scale and by reducing compliance burdens. The Department is unaware of any available empirical basis on which to determine whether or by how much costs might be reduced, however.

58
For example, an adviser employed by an asset manager can share the manager's research instead of buying or producing such research independently.

Quality

The effect of investment advice also depends on its quality. Good advice can reduce investment errors, steering investors away from higher than necessary expenses and toward optimal trading strategies, broad diversification, and asset allocations consistent with the investors' tastes for risk and return. The Department believes that, although there is no universally accepted single and complete theory of optimal investing, and although there is some evidence of lapses in the quality investment advice,
59

professional advisers'

recommendations are likely to be superior to unadvised participants' investment practices.
60

It is therefore likely that participants who obtain and follow advice, including advice provided pursuant to the PPA or this proposed class exemption and advice provided under alternative permissible arrangements, will substantially reduce their investment mistakes and thereby derive substantial financial benefits and improve their welfare.

59
There is no single, complete, universally accepted theory of optimal investment. Instead there are competing and evolving theories which have much in common (what might be called “generally accepted” theories) but also important differences (see,
e.g.
, Martin Wallmeier & Florian Zainhofer,
How to Invest Over the Life Cycle: a Review,
Social Science Research Network Abstract 951167 (Dec. 2006); and Deloitte Financial Advisory Services LLP,
Generally Accepted Investment Theories
(July 11, 2007) (unpublished memorandum, on file with the Department of Labor)). In practice this means that different experts may give different advice; often the differences will be small but occasionally they might be large.

There is some evidence of lapses in the quality of investment advice. Investment advisers' advice does not always conform to generally accepted investment theories. For example, they sometimes neglect investors' debt, or exhibit “home bias” toward domestic investment. Home bias may be larger in advice given to more risk averse investors; this conflicts with theory insofar as home bias reduces diversification and therefore increases risk. Investment advisers in some sense have two functions: to provide
investment
advice and to provide
investor
advice. The former ought to conform to financial theories, while the latter involves helping investors overcome behavioral biases and errors. Together these functions may result in a nuanced balance between what the investor theoretically “should” choose and what the investor is comfortable choosing (see,
e.g.
, Elisa Cavezzali & Ugo Rigoni,
Investor Profile and Asset Allocation Advice,
Social Science Research Network Abstract 966178 (Feb. 2007)). Some advice computer models and educational material may furnish misleading information regarding risk and consequently may do harm (see,
e.g.
, Zvi Bodie,
An Analysis of Investment Advice to Retirement Plan Participants, in The Pension Challenge: Risk Transfers and Retirement Income Security
19, 19-32 (Olivia S. Mitchell & Kent Smetters eds., 2003)). Advice computer models generally fail to coordinate financial investments with financial risks associated with individuals' jobs, homes, and health (see,
e.g.
, John Ameriks & Douglas Fore,
Financial Planning: On the Issue of Advice,
Benefits Quarterly, Fourth Quarter 6, 6-14 (2002)). While it is widely agreed that such coordination is important, theories about how this should be done

continue to evolve (see,
e.g.
, Günter Franke
et al.
,
Non-Market Wealth, Background Risk and Portfolio Choice,
Social Science Research Network Abstract 968096 (Mar. 2007)). Typical advice as reflected in target-date funds conforms to some financial theories but conflicts with others (see,
e.g.
, Luis M. Viceira,
Life-Cycle Funds,
Social Science Research Network Abstract 988362 (May 2007)).

60
Rene Fischer & Ralf Gerhardt,
Investment Mistakes of Individual Investors and the Impact of Financial Advice,
Science Research Network Abstract 1009196 (Aug. 2007) “present financial advice as (potentially) correcting” a variety of investment mistakes that left uncorrected “lead to considerable welfare losses.”

In its effort to ensure the quality of advice, the Department carefully considered the substantial risks attendant to opportunities for self-dealing that may exist among fiduciary advisers doing business pursuant to the PPA or this proposed class exemption. There is evidence that advisers sometimes seize such opportunities and thereby reap profit at investors' expense.
61

The provisions of this proposed regulation and conditions attached to this proposed class exemption are intended to guard against these risks while keeping advice affordable.
62

61
These risks consist of the possibility that some advisers will pursue profit by dispensing advice that increases their own revenue at the expense of participants' interests.

Consideration of these risks is especially important because advice pursuant to this proposed class exemption, while extending to many participants who otherwise would invest without guidance or support, may also extend to many others who absent this class exemption would have benefited from alternative forms of support for their investment decisions, such as alternative permissible advice arrangements, target-date funds, managed accounts, or automatic rebalancing.

In considering these risks the Department devoted separate attention to the application of this proposed class exemption to IRAs. In contrast to DC plan participants, IRA participants may be more vulnerable to risks attendant to conflicts of interest insofar as they: (1) May include more retirees, who may be in greater need of advice, but who also may be more vulnerable to abusive practices (see,
e.g.
, Phyllis C. Borzi & Martha Priddy Patterson,
Regulating Markets for Retirement Payouts: Solvency, Supervision and Credibility,
Pension Research Council Working Paper PRC WP2007-21 (Sept. 2007)); (2) are not represented by a plan fiduciary, independent of the adviser and connected to their interests via an employment relationship, who selects and monitors the advice arrangement and pre-screens the menu of investment options for quality; and (3) may not, under the conditions of this proposed class exemption, have the benefit of specific advice provided by an independent or independently-certified computer model to compare with (and possibly follow in lieu of) advice delivered pursuant to the proposed class exemption. In addition, while advisers to DC plan participants are subject to standards of fiduciary conduct and attendant liability under Title I of ERISA, advisers to IRA beneficiaries are not. Finally, the Department's authority to enforce the conditions of this proposed exemption generally extends only to DC plans and not to IRAs. On the other hand, IRA beneficiaries' vulnerability to risks attendant to conflicts of interest may be mitigated by their ability to make rational and well informed purchases in a vibrant, competitive market for investment advice and other financial products and services in which some vendors will offer unconflicted advice.

The Department believes that absent effective controls conflicts can sometimes bias advice, although it is unclear how much or in exactly what ways. Biased advice may be less beneficial to investors than unbiased advice, or possibly even harmful in some cases.

There is a theoretical basis to believe that investors may be harmed (or may benefit less) where managers pay intermediary advisers for inflows, and that such payments may increase the role of intermediaries (fewer investors may invest directly) (see,
e.g.
, Neal M. Stoughton
et al.
,
Intermediated Investment Management,
Social Science Research Network Abstract 966255 (Mar. 2007)). This suggests that advisers whose fees are not level relative to their clients' investment elections may give biased advice that enriches managers at investors' expense (the motivation for and potential to profit from conflicts and bias may attach more to the manager who compensates the adviser than to the adviser). It also suggests that advisers doing business pursuant to this proposed class exemption might displace alternative forms of investment decision support.

According to one empirical study, “there exists conflict of interests between load fund investors and brokers and financial advisers: brokers and financial advisers apparently serve their own interests by guiding investors into funds with higher loads, which generate higher income to the brokers and financial advisers but increase the expenses of investors.” High load funds have larger inflows than low load funds with otherwise similar performance. Recent increases in fund loads suggest that funds are seeking favor from brokers and advisers (see,
e.g.
, Xinge Zhao,
The Role of Brokers and Financial Advisors Behind Investment Into Load Funds,
China Europe International Business School Working Paper (Dec. 2005),
at http://www.ceibs.edu/faculty/zxinge/brokerrole-zhao.pdf
). Another study reaches similar conclusions. “Relative to direct-sold funds, broker-sold funds deliver lower risk-adjusted returns, even before subtracting distribution costs. * * * Further, broker-sold funds exhibit no more skill at aggregate-level asset allocation than do funds sold through the direct channel.” Even before accounting for the higher distribution expenses, the underperformance cost investors $4.6 billion in 2004. Brokers devote more effort to selling funds that generate more revenue for them (see Daniel B. Bergstresser
et al.
,
Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry,
forthcoming in The Review of Financial Studies).

Yet another study finds that “investors who transact through investment professionals that are compensated through conventional distribution channels incur substantially poorer timing performance than investors who purchase pure no load funds.” The underperformance amounts to approximately 100 or 150 basis points (see,
e.g.
, Mercer Bullard
et al.
,
Investor Timing and Fund Distribution Channels,
Social Science Research Network Abstract 1070545 (Dec. 2007)).

Some other studies are less conclusive. For example, one finds that captive brokers add more value for investors in purchasing funds, while unaffiliated brokers add the most value in redeeming them. Direct, no-load investors'

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AE8-19272. Public record. Not legal advice.