Last week, Secretary of the Department of Labor (DOL) Thomas Perez released the final version of the long awaited “fiduciary rule” as it applies to any professional who is advising clients on retirement assets.
Here is our initial reaction to some of the common questions regarding the new rule below:
What were the changes made in the final rule, and what do they mean?
In general, the bulk of the proposed rule is still in the final rule, which focuses around putting the client’s best interest first at all times. The biggest difference between the proposed rule from almost a year ago and the final rule is the “Best Interest Contract Exemption (BICE)”. Under current ERISA law, anyone acting in a fiduciary capacity must avoid any prohibitive transactions. For example, if you are advising a client to rollover any 401(k) assets into an IRA, an advisor is not allowed to charge an AUM fee that is higher than what the client had been charged in the 401(k) plan. This puts a lot of pressure on advisory practices’ business models since most 401(k) plans pool many participant assets, which justify a lower AUM fee, but this may not be sustainable in the case of just an individual participant.
Further, many advisors provide additional services such as estate, tax, and insurance planning alongside asset management. A higher fee may be justified depending on the scope of the new relationship. The final rule includes a “Best Interest Contract (BIC)” exemption, which allows an advisor to not be penalized for potential prohibitive transactions depending on the scope of the service provided. What is crucial is that a contract is initiated before actual recommendations are given. It would need to include a number of specific provisions, including the acknowledgement of fiduciary status, various warranties, and financial disclosures.
There is also an investment education “carve-out” which allows advisors to circumvent prohibitive transactions. In this vein, advisors would provide complete coverage of all of the options for investors as well as their pros and cons. The education provided would need to be unbiased and complete.
Further refinements have been made to the implementation of the new rule, disclosures, flexibility for commission based business models, use of proprietary products, data retention, applicability to small business plans, and assets listed in BICE. You can find a more comprehensive list on the DOL website.
In our opinion, we believe that allowing for certain exemptions allows flexibility in terms of accommodating investment advisor business models without sacrificing the crux of the rule which is putting the client’s best interest first at all times. In this case, it is better from a practicality standpoint. We would obviously like to see the rule be taken further to include empirical evidence of topics like investment strategies, but this is still a big step in the right direction.
Impact of the DOL rule on products including rollovers, annuities, ETFs, mutual funds, or SMAs
In terms of products, the DOL rule does not prohibit the use of any product, including complex variable annuities. There may be some justification for the use of products such as separately managed accounts or annuities. What is crucial is that the advisor can justify the use of a particular product. For example, if an advisor uses an expensive separately managed account of a particular strategy, which has a cheaper but identical version in an open-end mutual fund, then it doesn’t make any sense to not use the mutual fund.
Again, we have our personal preference in terms of which types of investments should be used and we have a process to justify the recommendations we make. As long as the advisor has a process and justification for their recommendations for retirement assets, then their recommendations do not violate the proposed rule.
What does this mean for the investor saving for retirement?
First, it at least puts the advisor on the same side of the table as the client. Being forced to act in a fiduciary capacity is intended to more closely align the best interests of the client with that of the advisor. It does not protect the investor completely in terms of what the advisor is going to recommend. For example, the advisor may recommend a portfolio of actively managed mutual funds or index annuities. It is our opinion that these are not in a client’s best interest, but once again, it does not violate the final rule as long as the advisor can provide justification for their recommendation if they were to ever be sued by a client.
The DOL also mentioned that non-Fiduciaries are costing investors somewhere near $17 billion dollars per year without giving a reciprocal benefit. This is no chump change. By adopting more stringent standards for which investment advice must be given, this cost will slowly move back into the pockets of investors.
We have always held ourselves to the fiduciary standard since it is the right thing to do when providing assistance with someone’s personal finances. We even promote our fiduciary capacity in our own tagline, “Fiduciary Wealth Services.” We like to put it front and center for prospects and clients so they never have to question our motive for providing the advice that we do.
Our thoughts
We are extremely happy with the final rule as it will move our industry, which has been wrought with conflicts of interest, in the right direction in terms of doing right by investors. This is especially important given that there is a current epidemic in terms of retirement readiness.
We would like to see developments in the future, which would require empirical evidence of the strategy that the advisor is recommending. We are big proponents of using index funds and there is a mountain of academic research spanning decades that support this approach to investing. We hope that this type of scrutiny will be adopted in the future to anyone who is acting in a fiduciary capacity since it is in the client’s ultimate best interest to do so.
Mark Hebner is founder and president of Index Fund Advisors.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
