Update on the Fiduciary Rule

Summary: The Department of Labor’s April 7 Federal Register update on the Fiduciary Rule (which we covered in February) established June 9 as the Rule’s implementation date with a transition window until January 1, 2018. The Fiduciary Rule will allow investment advisers working with retirement account and plan owners and custodians to continue to receive compensation from product vendors so long as the adviser can demonstrate, “adherence to certain Impartial Conduct Standards: providing advice in retirement investors’ best interest; charging no more than reasonable compensation; and avoiding misleading statements . . . .” The DOL will use the intervening time to report back to the president on any issues it discovers regarding the costs and benefits of implementing this rule. Industry insiders and lobbyists are actively seeking to ensure the rule is never implemented. The intent of the rule is to protect retirement investors from predatory sales practices.

Why You Care About This Issue

Analysts report retirement investors losing billions in retirement account payoffs due to predatory sales practices. While the rule does not proscribe the conflict-of-interest-producing, compensation practices, it does create a very high bar to continuing them. Some industry insiders have indicated that the potential for lawsuits will increase so much as to eliminate the practices in general with a resulting decrease in offerings and services.

Compensation Created Appearance of Conflict of Interest

The core issue in the Department of Labor’s rule, which it began compiling and socializing during the Obama administration, is the exemption granted to “investment advice fiduciaries” that allows them to receive payments that would, in almost any other context, create a presumption of a conflict of interest. In the case of investment advisors, much of their compensation, except for the fee-only component of the industry, comes from the providers of the products they recommend to their retirement clients. In other words, these advisers function as salespersons for the product providers including insurance companies, brokerages that owned or had custody of equities (stocks for example) and debt instruments (such as bonds), and institutional arrangements such as hedge funds, real estate trusts, and the like. The entities write checks to the “advisers” based on their performance, with the retirement investors themselves generally ignorant of these arrangements.

Buyer Beware or Regulation?

Many contacts have expressed seeing little or no problem with the conflict of interest arrangement, with the “caveat emptor” ethos characterizing the main thread. A sharper version occasionally even resorts to the Darwinian or Ayn Rand framework. Rule advocates call for eliminating the conflicts of interest it indirectly addresses. They cite the combined effects of the severe informational and financial power imbalances (insider information), the wholesale transformation of retirement plans from defined benefit to contribution and the resulting reliance on 401(k) type plans and IRAs at the household level: The net impact limits most retirement investor’s ability to recover from poor decision-making.

Third Party Comp Allowed Within New Safe-Harbor

In this case, however, the rule has never sought to eliminate the conflicts of interest, instead establishing a small safe-harbor for receiving compensation from instrument sellers. The safe-harbor was created by providing exemptions to other rules prohibiting the conflict-of-interest-creating compensation. Rather than flatly prohibiting compensation structures that, “could be beneficial in the right circumstances (italics ours; see comment), the exemptions are designed to permit investment advice fiduciaries to receive commissions and other common forms of compensation.” Advisers will need to be able to demonstrate that even though they are taking what amounts to kickbacks and bribes in other industries, that they are still able to act in their clients’ best interests. They will also have to fully disclose the compensation they receive from the third parties to these transactions. This will be a change from the current standard in which a particular recommended investment is just expected to meet “ . . . the objectives and means of an investor.” No disclosure of compensation from the third parties is currently required nor is any generally provided. Advocates of the rule stress that this situation allows brokers to establish relationships that appear to be necessarily in the investor’s best interests while the adviser is actually functioning as a salesperson for the third party.

Delay for Reporting

The President’s memorandum mandating the delay requires the DOL to answer three questions before implementing the rule:

  • Whether the anticipated applicability of the Fiduciary Rule and prohibited transaction exemptions (PTEs) has harmed or is likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice;
  • Whether the anticipated applicability of the Fiduciary Rule and PTEs has resulted in dislocations or disruptions within the retirement services industry that may adversely affect investors or retirees; and
  • Whether the Fiduciary Rule (and ongoing PTEs) is likely to cause an increase in litigation and an increase in the prices that investors and retirees must pay to gain access to retirement services.

The memorandum states that, “. . . the priority of the Administration ‘to empower Americans to make their own financial decisions, to facilitate their ability to save for retirement and build the individual wealth necessary to afford typical lifetime expenses, such as buying a home and paying for college, and to withstand unexpected financial emergencies,’ then the Department shall publish for notice and comment a proposed rule rescinding or revising the Fiduciary Rule, as appropriate and as consistent with law.”

Comments Period Results

Of the 378,000 comments provided to the DOL on the Rule delay up to April 7, 173,000 favored immediate implementation of the rule. Frequent reasons provided included that the DOL had already analyzed the reporting issues the Administration’s memorandum required and that the harm to investors should end as quickly as possible. For example, the DOL summarized this argument explaining that, “ . . . under the current regulatory structure, investors lose billions of dollars each year as a result of conflicts of interest, and [they] argued that delay would compound these losses.” Opponents challenged the legal authority of the DOL to extend the rule to IRAs and other authoritative challenges and contended that the variety and type of offerings presented to individual investors would decrease.

Comment: We observed, in the months leading up to last February’s delay of the original April 10, 2017, implementation date, a tectonic movement toward an industry-wide transition to a fee-only basis for retirement investment advisers, with several major brokerages eliminating access to traditionally-compensated advisors to all but the most “sophisticated” investors. Of course, this transition is likely to affect the breadth of offerings in the traditional and fee-only marketplaces. We argue that the disappearing products never belonged in the menu for run-of-the-mill retirement investors. Among those are products like high 12(b)1 and similar fee mutual funds and front loaded mutual funds. But, this change clearly conflicts with the Administration’s previously-mentioned goal of “empowering” Americans, in some cases, to impoverish themselves. Ultimately, then, this issue, like many, depends more on one’s underlying values than on the facts at hand. Where the DOL will eventually end up, given the sheer volume of the proponents’ efforts contrasted with the absolute financial clout of the rule’s opponents, is anyone’s guess. We come down in favor of protecting “the little guys” from powerful forces against which they can do little but rail against the gods, given that even the DOL experts presented the instruments likely most affected by the rule as ones that, “could be beneficial in the right circumstances.”  The finely tuned word choice describes investments that generally would be harmful to investors in most cases. The fact that industry insiders and lobbyists are actively seeking to ensure the DOL never implements the rule speaks volumes to the disruption in industry practices the rule threatens. It’s an issue we’ll continue to watch so you don’t have to.