Proposed Best Interest Contract Exemption for Insurance Intermediaries

Practical Law Legal Update w-005-5456 (Approx. 7 pages)

Proposed Best Interest Contract Exemption for Insurance Intermediaries

by Practical Law Employee Benefits & Executive Compensation

Background

On April 6, 2016, the DOL issued a final rule that replaces the existing regulatory interpretation of fiduciary investment advice under ERISA Section 3(21)(A)(ii) (81 Fed. Reg. 20945 (Apr. 8, 2016)) (final rule). In connection with this final rule, the DOL also issued several new prohibited transaction exemptions (PTEs) and amendments to existing PTEs currently used throughout the financial industry for certain investments made by ERISA plans. Since that time, the DOL has also issued two substantive sets of frequently asked questions (FAQs) on the final rule and the PTEs issued in connection with the final rule.

For more information on this guidance, see:

Without an exemption, compensation received by a fiduciary investment adviser from an investment product provider for transactions involving employee benefit plan assets or IRA assets is prohibited because the fiduciary investment adviser's advice can be influenced by the compensation he receives, potentially creating a conflict of interest. The primary exemption that the DOL issued in connection with the final rule is PTE 2016-01, known as the best interest contract exemption (BICE) (see Practice Note, Best Interest Contract Prohibited Transaction Exemption).

BICE was issued to permit investment advice fiduciaries to receive reasonable compensation when plan participants and beneficiaries, IRA owners, and certain small plans purchase, hold, or sell certain investment products as advised by those fiduciaries. However, BICE limits the available relief to "financial institutions" which include only:

An entity that employs an adviser or otherwise retains the adviser as an independent contractor, agent, or registered representative.
A registered investment adviser under the Advisers Act or under the laws of the state in which the adviser maintains its principal office and place of business, bank, insurance company, or registered broker-dealer.

BICE also permits entities that do not qualify as financial institutions to apply individually to the DOL for a proposed exemption. Under that provision, the DOL received 22 applications for individual exemptions from insurance intermediaries that contract with independent insurance agents to sell fixed annuities.

Proposed Exemption for Insurance Intermediaries

Insurance intermediaries do not qualify as financial institutions under BICE and therefore cannot take advantage of the exemption it provides. This proposed PTE would provide similar relief to BICE for insurance intermediaries that agree to act as "financial institutions," but includes additional conditions and limitations specific to insurance intermediaries and fixed annuity products. By permitting insurance intermediaries to serve as financial institutions, the proposed exemption facilitates their continued sale of fixed annuities under a single set of policies and procedures.

Insurance Intermediaries

Insurance intermediaries or independent marketing organizations (IMOs) recruit, train, and support independent insurance agents and market and distribute insurance products. Since the independent agents are not associated with any one insurance company, the intermediary steps in to develop sales processes, provide marketing materials, and formulate supervisory procedures and methods for the independent agents to use. Insurance companies rely on these intermediaries for many functions relating to the distribution of fixed annuities through independent agents, including relying on them for compliance with suitability and other required standards under state insurance law.

These services generate multiple forms of compensation for the insurance intermediaries. Most significantly, the sale of an annuity triggers the payment of a commission to the intermediary. These commissions are generally based on contractual agreements between the intermediary, the insurance company, and the agent. Because insurance agents recommending fixed annuity products will generally be considered fiduciaries under the final rule, the compensation payments received by these intermediaries may trigger prohibited transactions under ERISA and the Code.

Fixed Annuity Contracts

The proposed PTE is limited to transactions involving fixed annuity contracts. The DOL defines fixed annuity contracts for purposes of the PTE as an annuity contract:

That satisfies applicable state standard nonforfeiture laws at the time of issue.
For which the benefits do not vary, in whole or in part, on the basis of the investment experience of a separate account or accounts maintained by the insurer.

This includes both fixed rate annuity contracts and fixed index annuity contracts. This definition is intended to include fixed immediate annuities but exclude variable annuity contracts.

Definition of Financial Institution

The proposed PTE defines a financial institution as an insurance intermediary that has a direct written contract regarding the distribution of fixed annuity contracts with both the:

Insurance company issuing the contract.
Adviser or another intermediary (sub-intermediary) that has a direct written contract with the adviser.

The DOL is requesting comments on whether this condition should be adjusted to allow for multiple levels of intermediaries.

Conditions

In addition to the baseline contract requirement, the proposed PTE sets out a series of conditions that would apply to the insurance intermediary to qualify as a financial institution, including that it must:

Satisfy the applicable licensing requirements of the insurance laws of each state in which it conducts business.
Have financial statements that are audited annually by an independent certified public accountant and provide these statements on the financial institution's website.

There are insurance and premium requirements to satisfy, as well. The intermediary must:

Maintain fiduciary liability insurance, or unencumbered cash, bonds, bank certificates of deposit, US Treasury Obligations, or a combination of all of these, available to satisfy potential liability under ERISA or the Code as a result of the firm's failure to satisfy the terms of the PTE or the contract entered into under the PTE. The aggregate amount of these items must equal at least 1% of the average annual amount of premium sales of fixed annuity contracts by the financial institution to retirement investors over the prior three fiscal years of the financial institution.
Have had annual fixed annuity contract sales averaging at least $1.5 billion in premiums over each of the three prior fiscal years. The DOL states that this threshold is intended to identify intermediaries that have the financial stability and operational capacity to implement the anti-conflict policies and procedures required by this proposed PTE. The preamble also provides that smaller intermediaries that cannot satisfy this threshold independently could obtain relief from ERISA's prohibited transaction rules provided there is an intermediary in their distribution hierarchy that acts as the financial institution and provides the requisite anti-conflict and supervisory role under the PTE, including executing the best interest contract.

There are several other conditions that are the same as BICE in many respects. With regard to transactions with retirement investors that are IRAs and non-ERISA plans, the intermediary must enter into a written best interest contract that includes the same provisions as in BICE. It must also warrant that it maintains anti-conflict policies and procedures reasonably and prudently designed to ensure that the advisers adhere to the impartial conduct standards required under the PTE.

There is a condition specific to incentives that provides that the intermediary's policies and procedures must prohibit the use of quotas, appraisals or performance or personnel actions, bonuses, contests, special awards, differential compensation, or other actions or incentives if they are intended or would reasonably be expected to cause advisers to make recommendations that are not in the best interest of the retirement investor.

Other new requirements include that the intermediary:

Approve in advance all written marketing materials used by advisers after determining that those materials provide a balanced description of the risks and features of the annuity contracts to be recommended.
Designate a person responsible for addressing material conflicts of interest and adhering to the impartial conduct standards. This requirement would require the person to approve, in writing, recommended annuity applications involving retirement investors before transmitting the applications to the insurance companies.
Require advisers to provide the transaction disclosure required under the PTE to retirement investors and orally review the annuity-specific information.

The PTE provides requirements that would govern the compensation of the adviser and sub-intermediary with regard to the purchase of an annuity contract. It provides that the intermediary may elect one of the two (or a combination of both) permissible approaches. The first approach would require that all compensation to be paid to the adviser or sub-intermediary is paid exclusively by the insurance intermediary. The second approach would permit advisers or sub-intermediaries to receive commissions from insurance companies for the sale of annuities to retirement investors, provided that the commission structure was approved in advance by the intermediary and all forms of compensation other than commissions are paid to the adviser or sub-intermediary exclusively by the intermediary.

There are several other conditions to satisfy, including disclosure requirements, which are similar to those required in BICE. There is an additional annuity-specific disclosure requirement in the transaction disclosure that is otherwise similar to the disclosure required under BICE.

Available Relief

The proposed class exemption for insurance intermediaries would apply to commissions and compensation received by an insurance agent, insurance intermediary, insurance companies, and any other affiliates and related entities, as a result of a retirement plan's or IRA's purchase of fixed annuity contracts. It would provide relief from ERISA Section 406(b) and the sanctions imposed under Code Section 4975(a) and (b) by reason of Code Section 4975(c)(1)(E) and (F).

If this proposed PTE is granted, relief would be available for the sales of fixed rate annuities sold by insurance intermediaries and independent insurance agents under several different exemptions:

Relief for all annuity sales is available under BICE if an insurance company acts as the financial institution under the terms of that exemption (see Practice Note, Best Interest Contract Prohibited Transaction Exemption).
Relief for fixed rate annuity contracts is available under PTE 84-24 (see Practice Note, Definition of Fiduciary Investment Advice: Prohibited Transactions Exemptions and the "Best Interest Standard").

The DOL indicates in the preamble to this proposed PTE that it does not intend to indicate that these other exemptions are unavailable but rather to provide flexibility to parties depending on their individual circumstances.

Comment Period and Transition Relief

The proposed PTE was published in the Federal Register on January 19, 2017. Written comments and requests for a public hearing on the proposed exemption must be submitted to the DOL by February 18, 2017, which is 30 days from the date of publication.

The proposed PTE includes transition relief for the period from April 10, 2017 (the implementation date of the final rule) through August 15, 2018, during which time fewer and less onerous conditions would apply.

Practical Implications

This newly proposed PTE provides relief to insurance intermediaries, IMOs, and the insurance companies and agents with which they contract from potential prohibited transactions resulting from the services they routinely provide to retirement plan sponsors and related service providers. However, it may be difficult for an intermediary to have sufficient time to establish the required policies, procedures, and contracts that will be required for them to comply with the requirements of the PTE and take advantage of this relief before the effective date of the final rule.

Proposed Best Interest Contract Exemption for Insurance Intermediaries | Practical Law