“Best Interest,” BICE and Class Action Targets, Part II

Much has been written about the Department of Labor’s (DOL) new fiduciary rule and the accompanying Best Interest Contract Exemption (BICE). Several writers have suggested that the group that will benefit the most from the rule and BICE are class action attorneys.

Unless Financial Institutions and their Advisers understand and successfully adapt to the shift from a culture of “suitability” to the more demanding “fiduciary/’best interest’/prudence” culture required under the DOL’s new fiduciary rule and BICE, the likelihood of successful class actions against them will definitely increase.

In Part I of this article, we discussed the fiduciary issues that exist for Financial Institutions and their Advisers with regard to actively managed mutual fund, including so-called “closet index” funds and the popular “preferred provider” programs that many Financial Institutions have adopted. In Part II, we will address the issue of 401(k) Rollovers and IRAs, variable annuities and equity/fixed index annuities.

401(k) Rollover and IRAs Accounts

The abusive marketing and sales strategies directed toward Retirement Investors in connection with 401(k) rollovers and individual retirement accounts (IRAs) were one of the primary reasons for the DOL’s new fiduciary rule and BICE. In many cases, a 401(k) rollover into an IRA is a prudent move, as it often provides a Retirement Investor with a wider selection of investment options that provide better returns and lower fees.

However, experience has shown that far too often unethical financial advisers were recommending that Retirement Investors execute 401(k) rollovers into actively managed mutual funds with historically poorly performing mutual funds and with excessively higher fees. In other cases, financial advisers were recommending questionable products such as variable annuities and fixed/equity indexed annuities in order to receive the high commissions associated with such products, despite the fact that such products raise obvious “best interest” issues for a Retirement Investor.

Under the new fiduciary rule and BICE, making recommendations with regard to 401(k) rollovers and IRA investments is classified as a fiduciary act. Under the new rule and BICE, a financial adviser must determine whether a rollover would be in the “best interest” and prudent of a Retirement Investor. In making such decisions, Financial Institutions and their advisers are required to consider such factors as

  1. the costs associated with the plan versus the costs associated with the IRA;
  2. the Retirement Investor’s available alternatives to a rollover; and
  3. the different levels of services and investments available under each option.

One question that I have received in connection with a financial adviser’s duty to perform a “best interest” analysis in connection with rollover and IRA advice is whether an adviser will be required to perform an analysis similar to that provided by the AMVR metric. Given the continuing legal actions and settlements involving the quality of current 401(k) plans, is it prudent for a Financial Institution and their Advisers to simply assume that a Retirement Investor’s 401(k) plan is prudent with regard to its investment options, both in the quality of the investment options and their fees.

I do not know the answer to the question, but it would seem to be an area that needs to be addressed to further the goals of the new rule and BICE, namely to ensure that Retirement Investors are protected and receiving investment advice that is prudent and in their “best interest.” The question becomes even more relevant if the financial adviser proving the rollover and IRA advice is the same adviser who advised the 401(k) plan as to its investment options, as there would definitely be, at a minimum, a potential conflict of interest since the adviser would be unlikely to admit to making poor investment recommendation for the 401(k) plan. My guess is that someone will eventually raise these questions, again in furtherance of the goals of the rule and BICE.

Variable Annuities

Variable annuities are among the leading grounds for customer complaints each year. The abusive sales strategies, as well as the issues regarding the excessive fees and quality of investment options offered by such products, makes such products imprudent for most investors. Given the fact that most variable annuities charge cumulative annual fees of 2-3 percent, and that each additional 1 percent in fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period, it is easy how a variable annuity could reduce an investor’s end return by over 50 percent. Hardly prudent or in an investor’s “best interest.”

The impact of excessive fees and the poor quality of investment subaccounts within variable annuities is  the reason why smart investment advisers have avoided variable annuities since investment advisers have always been held to a fiduciary standard. Smart investment advisers have also realized that the method used by most variable annuity issuers to calculate the annuity’s annual M&E, commonly known as “inverse pricing,” is inherently inequitable. Using “inverse pricing,” the variable annuity issuer bases the annuity’s annual M&E on the accumulated value of the variable annuity, even though the variable annuity issuer’s legal obligation under the death benefit is usually limited to the amount of the variable annuity owner’s actual contributions, which are usually far les than the annuity’s accumulated value.

Experience has shown that in most cases, the variable annuity issuer does not even have to pay a death benefit, as the accumulated value of the annuity at the owner’s death is greater that the death benefit. This makes the inequitable nature of the choice of “inverse pricing” to calculate annual M&E fees even more inequitable and egregious, as it guarantees a windfall at the variable annuity owner’s expense. This results in a situation that is clearly imprudent and not in the variable annuity owner’s “best interest,” as the law clearly states that “equity abhors a windfall.”

Equity/Fixed Indexed Annuities 

A relatively newcomer to the financial services industry, equity/fixed indexed annuities (EIAs) are marketed in such as way as to entice investors to invest in a product that will allow them to benefit from the returns of the stock market without all of the risk associated with the stock market. However, it is the various restrictions and other limitations on an investor’s returns that may result in class action suits involving these products.

EIAs are not technically securities. They are an insurance product that uses the returns on a stock market index or other benchmark to calculate the interest rate earned by the annuity. Given the popularity of EIAs and the confusion and complaints resulting from the restrictions on interest earned by investors, the DOL obviously chose to take steps to protect investors and ensure that Retirement Investors are treated fairly.

The issue with EIAs has to do with the fact that EIAs usually contain various “caps” and restrictions and limitations that result in an investor receiving a level of interest that is far below the return of the applicable market index. Two of the most common restrictions are the “cap rate” and the “participation rate.”  The “cap rate” is just that, a cap on the amount of interest an investor can receive, regardless of the actual return of the applicable market index. Based upon my experience, most EIAs use a cap rate of approximately 10 percent.

The “participation rate” is then applied to further reduce the rate of return actually received by an investor. Again, based on my experience, 2 percent is a popular “participation rate.” Therefore, for example, assume an EIA based its interest rate payable on the S&P 500, with a “cap rate” of 10 percent and a “participation rate” of 2 percent. If the  S&P 500 had an annual return of 30 percent, the investor would only be credited with an interest rate of 8 percent (10 percent “cap rate”) minus 2 percent “participation rate’).

These various restriction and limitations can be confusing to an investor when combined with the marketing materials that tout an interest rate based on the enticing returns of the stock market. Under BICE’s new Impartial Conduct Standards, Financial Institutions and their Advisers are prohibited from making misleading statements about investment transactions, compensation and conflicts of interest. The combination of marketing discussing interest based on market gains with the restrictions on interest actually earned by an investor can obviously raise issues as to misleading statements. Fortunately for Financial Institutions and their Advisers, this is an issue that should be easily resolved through better disclosure , both in terms of the disclosure language itself and the prominence of same.


The bad news – the DOL’s new fiduciary rule and BICE impose strong requirements on Financial Institutions and their Advisers in connection with the provision of investment advice to Retirement Investors. The good news – the requirements, while demanding, can and must be complied with to avoid the potentially severe legal penalties, both from regulators and class actions. The shift from a culture of “suitability” to a much more demanding “fiduciary/”best interest”/prudence culture definite change, but one that can actually help increase business for Financial Institutions and their Advisers by regaining the trust of Retirement Investors by promoting a system that produces win-win situations for all parties. For those unwilling to comply with the DOL’s new fiduciary rule and BICE to produce such result, the guarantee of successful class actions should come as no surprise.

© Copyright 2016 The Watkins Law Firm, LLC. All rights reserved. 

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.


About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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