Both fiduciary and non-fiduciary advocates are likely to find some language that appeases them in the Labor Department's new Proposed Rule to greatly expand the application of fiduciary duties to those who provide investment advice to most qualified retirement plans and IRA accounts -- but both sides will also find language which causes much concern.

Fiduciary advocates, in particular, will worry that the proposal, unveiled Wednesday, waters down the fiduciary standard currently applicable to fiduciaries under ERISA, and that some of the exemptions provided could be so expansively interpreted that they permit the egregious conduct that bona fide fiduciary standards are designed to constrain.

The new proposal comes more than four years after the U.S. Department of Labor announced its "Definition of the Term 'Fiduciary'" proposed rule in late 2010 -- and more than three years after the DoL withdrew that prior proposal in 2011.,

If enacted, the new proposal could dramatically change the landscape for providers of advice to retirement plan sponsors, retirement plan participants, and IRA account holders. However, enactment of a final version of the rule is far from certain, as the 2015 Proposed Rule will likely receive intense opposition from SIFMA, the American Council of Life Insurers, and many of the players associated with broker-dealer firms and life insurers.

WHAT'S IN THE PLAN

A few of key points of what's being called the "2015 Proposed Rule":

  • It applies a broad "best interests" fiduciary standard to brokers who provide advice to certain qualified retirement plans and to IRA accounts.
  • It permits commissions, 12b-1 fees, and other forms of revenue-sharing by brokers subject to the fiduciary standard, provided the brokerage firm has in place procedures to mitigate such conflicts of interest and provide clear disclosure of fees. Fees charged must also meet a "reasonableness" test.
  • It permits the limitation of products provided to those approved by the firm -- such as proprietary funds or those funds for which payment for shelf space is provided -- subject to a new requirement that the firm makes a specific written finding that the limitations do not prevent the advisor from providing advice that is in the best interest of the retirement investor, and provided further that payments derived by the firm from such a limited range of offerings must be reasonable in relation to the value of specific services provided to the investors.
  • It significantly limits the "sales exemption" previously posed in 2010 to large employer plans that possess investment experts.
  • It provides an "order-taking" exemption from the application of fiduciary duties, if no investment advice is provided.
  • It does not address the misleading use of titles as a factor in determining whether fiduciary status might attach, and only applies a functional test as to whether individuals are actually providing investment advice.

WHAT'S NEXT?

The new proposal begins anew much debate regarding Labor's extension of fiduciary duties, fostered in part by the department's release of its economic analysis along with the 2015 Proposed Rule.And it may provide impetus to the SEC to extend fiduciary duties to brokers under the authority of the Dodd-Frank Act, as well as to revisit a decade-old SEC proposal that would require point-of-sale disclosures.

After the proposal is published in the Federal Register, it enters a 75-day period for written comments. Within 30 days after the comment period ends, the DoL's Employee Benefits Security Administration plans to host a public hearing, after which more written comments will be accepted.

Finalization of the rule, if it occurs, could take six months or much longer, given the extensive lobbying that everyone expects to take place.

DRAWING THE LINE: 'ADVICE' OR 'SALES'?

One key question posed by the DoL's rule-making is the location of the new line to be drawn between "investment advice" and "product sales."

By way of background, in 1975 the question arose of whether broker-dealers would be deemed to be providing investment advice for compensation (and, therefore, fiduciaries) by reason of providing routine stock buy and sell recommendations to plan fiduciaries. And at the time, the DoL issued exemptive relief from the definition of "fiduciary" under ERISA -- saying such recommendations would not make persons fiduciaries if the recommendations were not provided on a regular basis, were not individualized to the needs of the particular plan and did not serve as a primary basis for plan investment decisions.

This exemption was thereafter applied broadly, and most of those brokers and insurance firms that made product recommendations to ERISA plan sponsors aimed to fit within the exemption so as to not be considered fiduciaries. As a result, the majority of providers of investment recommendations to plan sponsors, even on a repetitive basis, were not considered fiduciaries.

The 2010 proposed rule would have greatly expanded the definition of "fiduciary," and put in place a much narrower "sales exemption." In Monday's proposal, the DoL takes what is arguably an even more expansive approach.

Under the 2015 proposal, any individual receiving compensation for providing advice that is individualized or specifically directed to a particular plan sponsor (e.g., an employer with a retirement plan), plan participant, or IRA owner for consideration in making a retirement investment decision is a fiduciary -- whether a broker, RIA, insurance agent or other type of advisor.

Exemptions are now provided under the 2015 proposal for "order-taking" (when a customer calls a broker and tells the broker exactly what to buy or sell without asking for advice), and for sales pitches made to large employer-based plans (with $100 million in assets or greater) managed by "independent plan fiduciaries" who possess "sufficient expertise to evaluate the transaction and to determine whether the transaction is prudent and in the best interest of the plan participants."

Most controversially, the 2015 Proposed Rule extends the fiduciary obligation to brokers and insurance agents who provide investment advice to IRA account holders, and applies the "best interests" fiduciary standard to the IRA rollover decision. As was the case with the 2010 proposal, these extensions of fiduciary duties will likely be the subject of intensive opposition in the months to come from the B-D and insurance industries.

PERMITTED COMPENSATION

As Phyllis Borzi, the assistant secretary of Labor, has stated on many occasions over the past several years, the 2015 Proposed Rule will permit brokers who operate as fiduciaries to continue to receive commission-based compensation. The proposal also allows for 12b-1 fees and other forms of revenue sharing. Brokers (and other fiduciaries) would be required to charge only "reasonable fees," however, for the advice provided.

The 2015 Proposed Rule provides a broad "best interest contract exemption" that permits common forms of compensation currently in use in the financial services industry -- such as commissions and revenue sharing -- whether paid by the client or a third party such as a mutual fund.

To qualify for the new "best interest contract exemption," the company and the individual providing the retirement investment advice must enter into a contract with its clients that does a few things:

  • It commits the firm and advisor to providing advice in the client's best interest.
  • It warrants that the firm has adopted policies and procedures ("Impartial Conduct Standards") designed to mitigate conflicts of interest.
  • It provides a "point of sale disclosure" that clearly and prominently discloses any conflicts of interest, such as platform fees and other backdoor payments, which might prevent the advisor from providing advice in the client's best interests.

As part of this exemption, firms may limit the availability of products to customers -- by offering proprietary funds, for instance, or funds for which payment for shelf space is received -- provided the firm makes "a specific written finding that the limitations do not prevent the advisor from providing advice that is in the best interest of the retirement investors." Compensation must be "reasonable in relation to the value of the specific services provided," and the individual investor must be given "clear written notice of the limitations."
But I would note that since payments for shelf space flow to brokerage firms, and often are paid by fund's investment advisors out of the management fees they receive from a fund, it is difficult to ascertain how such payments may be "reasonable" in relation to the value of services received by the investor. Only if the broker offsets with payments for shelf space other fees charged to investors would there appear to be any benefit to the individual investor. Otherwise, payments for shelf space tend to keep fund management fees elevated, to the detriment of fund investors.

Another possible problem: While the proposal notes that both ERISA and the Internal Revenue Code bar fiduciary advisors to employee benefit plans and IRAs "from receiving compensation that varies based on their investment recommendations," the 2015 proposal's "Best Interest Contract Exemption" does allow such variable compensation. Yet, the variance in compensation (due to different fees paid by product providers to the broker) has been the source of many insidious breaches of fiduciary duty.

I have long opined that the problem with commissions and other compensation structures is not their existence, but the fact that economic incentives exist to recommend higher-cost investment products over lower-cost products. It is difficult for fiduciaries to justify higher-cost investment products that are substantially the same, given the enormous weight of academic evidence that higher fees, on average, translate to lower returns for investors.

The DoL's proposal does not eliminate this problem; instead, it cements into stone certain economic levers that drive investment advisors to render bad advice.

FALLING SHORT

Many in the pro-fiduciary community will believe that the Department of Labor should have pursued a different approach, such as mandating levelized compensation to advisors via fee offsets and/or fee rebates. Rather than having the DoL adapt ERISA's strict "sole interests" fiduciary standard to the current bad practices of today's marketplace, fiduciary advocates would have preferred that the marketplace be forced to adapt to the fiduciary standard.

In the end, adherence to one's fiduciary responsibilities is far easier if conflicts of interest are removed, as proper management of conflicts requires a deep adherence to truth and a thorough, objective analysis of investment alternatives. Yet few would claim that Wall Street and insurance companies possess such depths of integrity; changing the merchandizing culture of broker-dealer firms and insurance companies will not be an easy feat for DoL's enforcement arm.

A great deal of the thrust of the DoL's rules relies upon disclosures of fees, costs and conflicts of interest to investors. But substantial behavioral biases have been shown to underlie what all experienced investment advisors know -- the vast majority of individual investors don't read disclosures, much less understand them.

The DoL's proposal also relies upon firms, in several contexts of the rule, to justify the selection of higher-cost products (including proprietary funds) through a significant due diligence process. Yet many fiduciary advisors observe that, when confronted with perverse incentives to derive additional compensation from certain products, brokerage firms and insurance companies will bend to the lure of profits and thereupon fit their due diligence analysis to the desired results.

'ILLUSION' OF PROTECTIONS?

Unless strict enforcement is undertaken, what may result is the mere illusion of due diligence by brokerage firms and insurance companies. And this "illusion" that strong protections exist for investors may in fact prove counterproductive, as it will likely further lead investors to place undue trust and confidence in conflict-ridden product pushers who masquerade as fiduciary advisors.

Fiduciary advocates will also likely object to the use of the term "investment advisor," used throughout the DoL's 2015 proposal, to refer not only to RIAs but also to brokers and insurance agents. The DoL's failure to address the misleading use of titles in financial services compounds the SEC's failures in this regard. Clear distinctions between "advisors" and "product sellers" are required in order to reduce consumer confusion, and as a means of adherence to the old precept, "Say what you do, do what you say."

So fiduciary advocates will likely applaud the DoL's approach to distinguishing between "advice" and "sales," and welcome enhanced point-of-sale and other disclosures. But wise observers know that sunlight is not the greatest disinfectant.

Other aspects of the DoL's proposal appear to substantially weaken ERISA's fiduciary standard. Incentives exist for broker-dealer and insurance companies to bend the rules. If the DoL's proposed rule is finalized in its present form, the many broker-dealers and insurance companies that lack a firm grounding in a fiduciary culture will work hard to continually expand the boundaries of the granted exemptive relief.

Absent vastly increased enforcement resources at the DoL, perverse economic incentives will foster widespread abuses and harms will continue to be imposed on unsuspecting individual investors.

SEC MUSCLE

The new proposal brings the Labor Department's fiduciary standard much closer to the "best interests" fiduciary standard applied by the SEC under the '40 Act. It also may provide renewed impetus for the SEC to flex its regulatory muscle.

If the 2015 Proposed Rule is finalized in substantially its present form, the SEC may seek to apply fiduciary duties, via the authority granted to the SEC under the Dodd-Frank Act, upon brokers who provide "personalized investment advice" to other types of accounts.

The SEC might also want to revisit its "Point of Sale Disclosure Requirements" proposal from a decade ago, which was never enacted. As the Department of Labor moves to compel such disclosures, the SEC will likely revisit its March 2005 proposals on this issue, which have long been placed on the back burner.

Ron A. Rhoades, J.D., CFP, will in August begin work as an assistant professor in Western Kentucky University's Financial Planning Program. He is a frequent writer and speaker on the fiduciary obligations of financial planners and investment advisors.

Read more: