Under the Department of Labor’s new fiduciary rule, financial services providers are required to acknowledge fiduciary status for themselves and their advisors when giving retirement advice. The rule presents sweeping changes for the money management industry. Smaller advisory firms currently relying on third-party fees and commissions for the lion’s share of their revenue could be heavily affected by the compliance costs. Larger firms, on the other hand, may actually see their bottom line improve. If you haven’t already done so, we recommend you start talking with your existing client base, embrace a technology-supported workflow system and consider segmenting your client base to clarify the necessary next steps.
IS LONG-GESTATING LEGISLATION GOOD NEWS?
The U.S. Department of Labor’s new fiduciary rule, the first financial advisory regulatory effort in more than 40 years, was released April 6, 2016. After six years in development plus a lengthy commentary period that encompassed a wide range of stakeholders, the resulting rule is being met with some mixed reviews and a fair amount of caution, but with largely positive pronouncements from several key lawmakers, investment bankers and many established and successful financial advisors.
As communicated by the Department, the rule’s mission is straightforward: Require more retirement investment advisors to put their clients’ best interests first, by expanding the types of retirement investment advice covered by fiduciary protections.
During the proposal review period, many of our advisor clients asked us to offer guidance on the “new landscape” of retirement investment advice. Due to the many conflicting opinions in the marketplace and the fact that the Department of Labor (DOL) itself forecast several changes to the proposed rule, we waited for the final version. To little surprise, many of the restrictions in the original proposed rule have been softened. We think the final ruling will actually help strengthen the discipline of retirement advice and elevate the industry in investors’ eyes. Yes, it may cause some firms to dramatically change the way they do business, however, many firms could thrive in the newly transparent environment.
Let’s take a look at the new rule, how it may affect certain advisors, and what those advisors should do manage change under the new law.
Since 1974, the Employee Retirement Income Security Act (ERISA) has provided the DOL with authority to protect America’s tax-deferred retirement savings accounts. Despite the dramatic change in the financial markets over the last few decades, not the least of which is the seismic shift from defined benefit plans to self-directed IRAs and 401(k)s, the rules governing investment advice have not substantively changed since 1975. Under the old rules, broker and financial advisor recommendations only had to meet a “suitable” criterion, considered a much less demanding standard critics insist led to excessive fees from some advisors and/or a reliance on high-commission-paying products rather than less costly products that would perform equally well.
Today, more than 75 million American households have savings in an employer-based retirement plan, an IRA or both. More than 40 million families hold $7.3 trillion in IRA assets. An additional $6.7 trillion is held in 401(k)s and other employer-sponsored plans. Plus, hundreds of billions of these dollars roll over into IRAs each year1 – much of it saddled with transfer commissions that can be as high as 10%.2 The Obama administration maintains these savings are particularly at risk because advice regarding IRA investments (and IRA rollovers) is rarely protected under ERISA and Internal Revenue Code rules. According to the Government Accountability Office, under the old suitability rule, retirement savers often were subject to “biased information and aggressive marketing of IRAs.”3 In fact, the regulatory impact analysis released along with the proposed rule estimated families with IRAs could save more than $4 billion per year if the proposed rule at the time was fully implemented.4
Fast forward to today. While the new rule by no means does away with onerous fees and commissions entirely, it places a major disclosure requirement on all advisors dealing with retirement savings. However, it also details several “carve-outs” that have been characterized as Wall Street dodging a bullet.
THE NEW RULE: AN OVERVIEW
The effective date of the new rule is June 7, 2016, with an applicability date of April 10, 2017, and full compliance date of January 1, 2018 – allowing financial services providers ample time to make the basic changes from non-fiduciary to fiduciary status. The rule, with its near 1,000 pages and several amendments, is published in the Federal Register and is available in its entirety at federalregister.gov. Here are the highlights.
Fiduciary – A Broadened Definition5 Under the new rule, financial services providers are required to acknowledge fiduciary status for themselves and their advisors when giving retirement advice. While there are other terms linked to the definition of fiduciary, the full scope is:
- Exercises discretionary authority or control with respect to the management of a plan;
- Exercises any authority or control respecting management or disposition of plan assets;
- Has discretionary authority or responsibility in the administration of a plan; and
- Provides investment advice for a direct or indirect fee with respect to money or property of a plan.6
The final rule also delineates the types of communications that constitute investment advice or recommendations and the kinds of relationships in which such communications trigger fiduciary investment advice responsibilities. Specifically, a person is providing investment advice if they charge fees or other forms of compensation for giving either:
- Recommendations as to the advisability of acquiring, holding, disposing of or exchanging securities or other investment property; or a recommendation as to how securities or other investment property should be invested after they are rolled over, transferred or distributed from the plan or IRA.
- Recommendations on the management of securities or other investment property, including investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., brokerage versus advisory); or recommendations with respect to rollovers, distributions or transfers from a plan or IRA (e.g., advisability, amount, destination, etc.).
In the above, “recommendations” means advisory communications that would reasonably be viewed as a suggestion the recipient take a particular course of action, or not. The more individually tailored the communication, the more likely it will be viewed as a recommendation. (Note: The rule also makes a point of including recommendations by computer software programs as fiduciary communications.)
Who is NOT an investment advice fiduciary?
- A seller or counterparty who provides an arm’s length sale, purchase, loan or bilateral contract between an expert plan investor (ERISA-covered plans in excess of $50 million) and the advisor
- Counterparties to ERISA-covered employee benefit plans in swap and security-based swap transactions
- Employees of plan sponsors, plans or plan fiduciaries
- Registered broker-dealers who execute transactions for the purchase of securities on behalf of a plan or IRA
What is NOT a fiduciary communication?
- General communications and commentaries on investment products (such as financial newsletters)
- Certain activities and communications in connection with marketing or making available a platform of investment alternatives from which a plan fiduciary could choose
- Information and materials that constitute investment education or retirement education (plan information; general financial, investment and retirement information; asset allocation models; interactive investment materials)
It should be noted the final rule allows educational asset allocation models and interactive investment materials to reference specific investment alternatives. This is acceptable as long as they are presented as hypothetical examples to help plan participants and beneficiaries understand the educational information and not as investment recommendations.
Exemption status has been granted to communications in arm’s length transactions with certain plan fiduciaries who are licensed financial professionals (broker-dealers, registered investment advisors, banks, insurance companies, etc.) or plan fiduciaries who have at least $50 million under management. In an important turnabout from the proposed ruling, the final rule also grants exemptions to financial product providers to continue to conduct otherwise ERISA-prohibited transactions under certain circumstances.
ERISA and the tax code generally prohibit fiduciaries, their agents and representatives from receiving payments from third parties and from acting on conflicts of interest in connection with transactions involving a plan or IRA. The prohibition includes certain types of fees and compensation common in the retail market, such as brokerage or insurance commissions, 12b-1 fees and revenue-sharing payments. Via several important exemptions granted by the final rule, however, these fiduciaries may receive such compensation, subject to protective conditions.
Accordingly, fiduciary advisors may always give advice without need of an exemption if they avoid the sorts of conflicts of interest that result in prohibited transactions. However, when they choose to give advice in which they have a conflict of interest, they must rely upon an exemption, such as the following.
Best Interest Contract Exemption (BICE)
The Best Interest Contract Exemption requires financial institutions to acknowledge their fiduciary status and that of their advisors in a written contract and adhere to enforceable standards of fiduciary conduct and fair dealing with respect to their advice. The exemption is broadly written and covers a wide variety of current compensation practices, and permits advisors to receive commissions and other common forms of compensation, provided they safeguard clients against any harmful impact of conflicts of interest on investment advice.
“Level fee” fiduciaries who receive a fee only in connection with advisory or investment management services do not have to enter into a contract with retirement investors, but they must provide a written statement of fiduciary status, adhere to standards of fiduciary conduct and prepare written documentation of the reasons for the recommendation.
Class Exemption for Principal Transactions in Certain Assets between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs
This exemption allows investment advice fiduciaries to engage in purchases and sales of certain investments out of their organization’s inventory (i.e., principal transactions). However, the exemption limits the type of investments that may be purchased or sold and mandates that the advisor/institution give the client a written statement acknowledging their fiduciary status and serves as an enforceable contract.
Under the exemption’s terms, there is no requirement to enter into a contract with ERISA plan investors, but the same written acknowledgement of fiduciary status is required. Additionally, advisors must adopt policies and procedures to mitigate any harmful impact of conflicts of interest and must disclose their conflicts of interest to retirement investors.
Transactions otherwise prohibited under ERISA that can be exempted under the new rule are defined as:
- Statutory exemptions: the acquisition, holding or sale of any investment property as a result of investment advice, provided the investment’s fees do not vary based on any investment option selected, or the advisor uses a computer model under an investment advice program meeting ERISA requirements (for example, an electronic execution system designed to match purchases and sales at the best price available, in accordance with the Securities and Exchange Commission’s applicable rules).
- Administrative exemptions: available to investment advice fiduciaries who are “market-makers,” this exemption permits principal transactions with broker-dealers and banks only if the broker-dealers and banks do not have or exercise any discretionary authority or control over the investment of plan or IRA assets involved in the transaction and do not render investment advice.
In addition to the exemption documents, the published ruling includes amendments that further clarify terminology and extend exemptions to fiduciary parties in certain, rarer circumstances. For instance, one amendment permits investment advice fiduciaries to receive compensation when they extend credit to plans and IRAs to avoid a failed securities transaction, a situation which would be prohibited under ERISA. You can review all the language in the amendments listed below at federalregister.gov:
- Amendment to and Partial Revocation of Prohibited Transaction Exemption 84-24 for Certain Transactions Involving Insurance Agents and Brokers, Pension Consultants, Insurance Companies, and Investment Company Principal Underwriters
- Amendment to Prohibited Transaction Exemption 75-1, Part V, Exemptions From Prohibitions Respecting Certain Classes of Transactions Involving Employee Benefit Plans and Certain Broker-Dealers, Reporting Dealers and Banks
- Amendments to and Partial Revocation of Prohibited Transaction Exemption 86-128 for Securities Transactions Involving Employee Benefit Plans and Broker-Dealers; Amendment to and Partial Revocation of PTE 75-1, Exemptions From Prohibitions Respecting Certain Banks
- Amendments to Class Exemptions 75-1, 77-4, 80-83 and 83-1
WHAT DOES THE NEW FIDUCIARY RULE MEAN FOR THE INDUSTRY?
First, all investors and their advisors should remember that the DOL fiduciary rule only applies to advisors who guide investors in IRAs, 401(k) plans and health savings accounts (HSAs). The DOL has no jurisdiction over personal assets in taxable accounts. Yet, several organizations are taking steps that may signal the eventual migration of all advisory accounts to fee-based from commission-bearing.7
Regardless what the future brings, the rule presents sweeping changes for the money management industry. Speculation has it that smaller advisory firms currently relying on third-party fees and commissions for the lion’s share of their revenue could be heavily affected by the compliance costs. Larger firms, on the other hand, may actually see their bottom line improve as, according to Morningstar, flat annual fee-based compensation can yield at least 60% more revenue than traditional commission-based sales.8
The DOL estimates compliance costs will total between $10.0 billion and $31.5 billion over 10 years with most of the costs concentrated in satisfying relevant consumer-protective private transaction exemptions (PTEs) for affected fiduciary advisors. The Department’s primary 10-year cost estimate of $16.1 billion reflects the present value of $5.0 billion in first-year startup costs and $1.5 billion in subsequent annual costs. Savings from technological innovations and market adjustments may reduce costs. Only time will tell whether costs will be more, due to the natural upheaval any major change to business models can cause.
WHAT TO DO TO MANAGE THROUGH CHANGE
Talk to Your Clients
The expanded definition of fiduciary will begin to be applied in April 2017 and will require you to adhere to the best interest standard and make basic disclosures of conflicts of interest, if any. (The full requirements of the BICE will not go into effect until Jan. 1, 2018.)
If you haven’t already done so, start talking with your existing client base. Whether your business model requires major shifts or just a few extra pieces of documentation, make clear what you are doing to comply with the new rule — and remind your clients of the value you already bring to the relationship while you do it.
A technology-supported workflow system that automates all your customer relationship management actions, communications and personal or electronic contacts can make compliance with the new rule easier and less costly.
Consider Segmenting Your Client Base
Your practice is probably not homogenous. You may have clients who use commissionable products. Some may be candidates for fee-based services. Others may require you to apply for rare exemptions. Still others may not be quite suitable for your business model under the new rule. Organizing or classifying your book of business will help clarify what steps your firm must take to comply with the new rule. Keep in mind that, while recommendations to existing clients regarding current investments and any systematic purchase agreements in effect are grandfathered, your advice still must satisfy the basic fiduciary standards of best interest and reasonable compensation.
Don’t Hesitate to Ask the DOL
It is routine for any government body to provide assistance following issuance of highly technical or significant guidance. The DOL is no exception. You’ll find detailed compliance assistance at dol.gov, including compliance guides, tips and fact sheets to assist in satisfying ERISA obligations. DOL staff is also available to answer questions regarding the:
- Final Rule – Contact Luisa Grillo-Chope, Office of Regulations and Interpretations, Employee Benefits Security Administration (EBSA), 202-693-8825
- Final Prohibited Transaction Exemptions – Contact Karen Lloyd, Office of Exemption Determinations, EBSA, 202-693-8824
- Regulatory Impact Analysis – Contact G. Christopher Cosby, Office of Policy and Research, EBSA, 202-693-8425
FOR MORE INFORMATION We would be happy to answer any questions you may have about our concepts, processes and products. Don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383) or visit us here.
1 Council of Economic Advisers. “The Effects of Conflicted Investment Advice on Retirement Savings.” February 2015. www.whitehouse.gov/sites/default/files/docs/cea_coi_report_final.pdf
2 Zweig, Jason. “Saving for Retirement? The Rulebook Is About to Change.” The Wall Street Journal. April 6, 2016.
3 GAO Report to Congressional Requesters. “401(k) Plans: Labor and IRS Could Improve the Rollover Process for Participants.” 2013.
4 Zweig, Jason. “Saving for Retirement? The Rulebook Is About to Change.”
5 Department of Labor. “Definition of the Term Fiduciary; Conflict of Interest Rule – Retirement Advice.” Federal Register FR Document: 2016-0. April 8, 2016.
7 Marsh, Ann. “Fiduciary Rule Expected to Spur Industry Upheaval.” Financial Planning. April 6, 2016.
8 Zweig, Jason. “Saving for Retirement? The Rulebook Is About to Change.”
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