The U.S. Department of Labor (DOL) has finalized a broad set of new regulations that will greatly impact the retirement investment industry. The Fiduciary Rule (also referred to as the “Conflict of Interest Rule”) is the first significant change since the Employee Retirement Income Security Act (ERISA) of 1974 and has been developed in response to the evolving retirement landscape and the exponential expansion of options available to retirees. Over the past 40 years, participant-controlled 401(k) plans, individual retirement assets (IRAs) and annuities have emerged, often displacing traditional employer-sponsored, defined-benefit plans.
While the variety of investment options has greatly benefited many retirees and families in recent years, the increased complexity has also left some investors vulnerable to plans that do not suit their individual needs. The Fiduciary Rule seeks to protect retirement assets by limiting an
investment professional’s ability to steer client assets into products that reward the advisors more than the clients. The U.S. government estimates suggest an annual loss of $17 billion to investors due to such suboptimal investment advice.
Morningstar estimated that over $3 trillion of advised IRA assets under management and the associated $19 billion of revenue would be affected by the Fiduciary Rule, with more than $1 trillion likely to move into passive investments. With so much money at stake, many in the financial advice industry continue to fight against the rule’s implementation, leading to lawsuits such as the one by the National Association for Fixed Annuities against the DOL, which claims that the rule overregulates IRAs, misclassifies insurance agents as fiduciaries and hurts the average American retiree.
Fiduciary versus Suitability Standard of Customer Care
Generally, two types of entities provide investment advice to plans: investment advisors and broker-dealers. Many retail customers may not realize that the two are held to different standards of customer care. Investment advisors typically provide investment recommendations and/or manage client assets and are registered either with a state or with the SEC, as part of the Investment Advisors Act of 1940. Registered investment advisors are held to a fiduciary standard of client care – they not only must have their clients’ best interests in mind, but also must put their clients’ interests before their own in all situations. As fiduciaries, registered investment advisors are held to the duties of loyalty to and care for their customers. For example, the advisors cannot front-run – trading recommended securities ahead of their clients – or hide potential conflicts of interest.
Investment brokers, working under broker-dealers and selling investment products to their customers, serve as intermediaries between the investors and the products, earning a commission based on the amount sold. Broker-dealers are regulated by a different body – the Financial Industry Regulatory Authority (FINRA) – under the Securities Exchange Act of 1934. Broker-dealers are held to the suitability standard of client care, which means that they make recommendations based on what they perceive as suitable according to the client’s objectives, risk preferences and time horizon at the time of the transaction, but – and here is the difference – they do not need to place the client’s interests ahead of theirs. These brokers are accountable to their broker-dealer firms and not to their clients. Investment banks typically create many products and ask the brokers to sell these investments. In addition, insurers offer structured products such as fixed indexed annuities, and these products are not regulated by the SEC but by state insurance departments, which are not as strict as the SEC.
Conflicts of Interest
One common potential conflict of interest under the suitability standard has to do with fees. Under the fiduciary standard, advisors cannot legally recommend investment products just because they give them higher fees or commissions. Under the suitability standard, investment brokers can sell to customers based on how much they would earn in commissions, thus prompting brokers to sell higher-load or higher-commission products. A 1 percent reduction in returns due to these higher charges can reduce retirees’ nest eggs by 25 percent over 35 years.
Asset managers often pay brokerages an amount for distributing their mutual funds, a practice termed “revenue sharing.” In a 2015 disclosure document, brokerage firm Merrill Lynch disclosed that it received compensation depending on a fund’s upfront sales charges, dealer concessions, asset-based sales charges and/or other service charges. Merrill Lynch rewarded compensation and other promotional programs, based on its volume of mutual fund sales. Some brokers may not fully disclose these payments to their customers.
Fixed indexed annuities, which have been rising in popularity, are actually insurance products and not securities. They have a minimum guaranteed yield plus an extra yield that is tied to the performance of the underlying indices – stocks, bonds or commodities. They are principal-protected but are subject to return caps and a long lockup. How these complex structured products earn their revenues is often opaque to customers. Insurance agents or brokers may receive commissions ranging from 1.5 to 12 percent for selling fixed index annuities, often downplaying their complexity and withdrawal fees in order to coax retirees into buying these products, the returns of which can be manipulated by the insurers.
Impact on Brokers and Advisors
The DOL’s conflict-of-interest final rule, which will become effective in April 2017, requires those who provide investment advice to plans to adhere to the fiduciary rule. Advisors and brokers can still receive their preset compensation. However, they must meet the “Best Interest Contract Exemptions,” whereby the institutions and their professionals sign in writing that they adhere to a fiduciary standard to their clients, act in their best interests, charge reasonable compensation that must be disclosed, and reveal any basic conflicts of interest. This opens the door for unhappy clients to file class action lawsuits against their advisors. At the same time, most believe that the new DOL rule may actually force annuity manufacturers to create better annuities and offer a higher level of due diligence to their investors. This may lead to better and simpler products and lower surrender charges.
Impact on Registered Investment Advisors (RIAs)
RIAs are already held to a fiduciary standard by the SEC and should not be significantly affected by the new DOL rule; however, the fiduciary standard set out by the DOL is more stringent than that of the SEC. Under the DOL standard, not only are commissions an unacceptable form of compensation but advisors also cannot incur any potential conflicts of interest when providing retirement advice. For example, rolling over a client’s 401(k) assets into an IRA constitutes investment advice and triggers the fiduciary standard of care. If the rollover results in higher net fees to the advisor or higher assets under management, such transactions are prohibited under the DOL rule. The exception for continuing with these activities requires that advisors disclose the rationale and dollar costs behind their recommendations.
Conclusion
While the new DOL rule requires brokers and advisors to operate in the best interests of their clients, investors nevertheless should be diligent in selecting advisors and understanding the products they recommend. Remember, too, that the new fiduciary standard for brokers and advisors applies only to retirement advice and not to advice on taxable investment accounts. That would lead to investors having two standards of care when they have two different types of accounts within the same brokerage firm. Over the coming months, many industry participants are likely to announce further changes in their business and compensation structures in order to survive under the new rule.
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