After reading chapter and verse through the entirety of the Department of Labor’s fiduciary regulations, I’ve concluded that it amounts to a brilliantly executed strategy of conceding to the financial services industry the exact parts that didn’t actually matter in the long run (while still reducing the risk of a legal challenge), yet keeping the key components that mattered the most.

As I see it those are:

  • A requirement for financial institutions to adopt policies and procedures to mitigate material conflicts of interest and eliminate incentives that could compromise the objectivity of their advisors (or risk losing their best interests contract exemption and cause all their advisory compensation to be a prohibited transaction).
  • Another requirement that clients can no longer be forced to waive 100% of their legal rights and accept mandatory arbitration, instead stipulating that while an individual client dispute may be required to go to arbitration, consumers must retain the right to pursue a class-action lawsuit against a financial institution that fails to honor its aggregate fiduciary obligations.

In essence, financial services product companies claimed that they can offer often illiquid and opaque, commission-based and sometimes even proprietary products to consumers, while also receiving revenue-sharing agreements, and still act simultaneously in a client’s best interests as a fiduciary. And so the Labor Department’s response essentially was: “Fine. If and when consumers disagree, you’ll have a chance to prove it to the judge when the time comes.” In other words, while the fiduciary rule didn’t outright regulate what the financial industry can and cannot do, it did change the legal standard by which the industry’s actions will be judged, and ensure that eventually the courts will have the opportunity to rule on these fiduciary conflicts. And in the long run, that will be a world of difference.

Bloomberg News

In the meantime, though, the clock is ticking for the onset of an incredibly far-reaching new fiduciary rule, and one that will impact not just broker-dealers, but RIAs as well (albeit to a lesser extent), insurance companies and annuity marketing organizations that sell variable and equity-indexed annuities, and more. The key provisions of the rule will take effect April 10, 2017, with a transition period through Jan. 1, 2018, by which time the last of the detailed disclosure and other policies and procedures must be put in place.

The biggest caveat regarding the new regulations is that all the new rules apply only to retirement accounts, and not any form of taxable investment account or other investment purchased with after-tax dollars. That means the SEC will likely step up on its fiduciary rule as well, as it’s clearly untenable in the long run for advice to retirement accounts to be held to a fiduciary standard while everything else remains the domain of suitability and caveat emptor.

It’s important to note that officials are expected to release several rounds of interpretations and updates on guidance in the coming months, so the understanding of the specifics of the regulations will likely shift.

Prohibited Transactions

The new rule not only updates the existing fiduciary standard for employer retirement plan investment advice under ERISA from its 1975 roots (when the world of retirement planning was very different from the 401(k)- and IRA-centric reality of today), but more importantly expands the scope of fiduciary duty for retirement accounts to include IRAs as well as employer retirement plans.

The essence of the new rule is the idea that when a fiduciary provides advice, it must be in the best interests of the client (not for the benefit of the advisor and his/her own compensation), and advisors must manage and mitigate their conflicts of interest that may taint their client-centric advice. In addition, the rule recognizes that some conflicts of interest are so severe, it is best to prohibit them.

The concept of prohibited transactions for fiduciaries – requiring them to avoid untenable conflicts of interest – is not new. The rules pertaining to both IRAs and employer retirement plans have long prohibited a list of transactions between fiduciaries and their clients that are viewed as being too rife with conflicts of interest to be allowed at all, including a ban on self-dealing transactions (where a fiduciary invests client dollars into his/her own ventures), a limitation on other forms of transactions between a fiduciary and the investment account he/she is overseeing, and a prohibition on exercising discretion in a manner that provides the fiduciary higher compensation (such as shifting client investments into higher-paying investment selections).

While these rules have long been in place for employer retirement plans subject to ERISA, extending the rule to IRAs (both the fiduciary reach and scope of prohibited transactions) is new territory. Doing so creates problems for the existing landscape of advisors and brokers serving IRAs.

After all, in a fiduciary context, the receipt of a payment from a third party (meaning a commission) would generally be a conflict of interest that is prohibited, as would revenue-sharing agreements with investment providers that can inappropriately incentivize advisors to recommend some investments over others. In theory, even the act of soliciting a client to roll money out of an existing account into one managed by the advisor can be a conflict of interest – albeit the most fundamental one for anyone in the business of being a fiduciary – given that the fiduciary advisor is not paid on the existing account but would be paid to provide fiduciary advice to the new one.

Of course, in the extreme, prohibiting a fiduciary from even soliciting business as a fiduciary, because of the implicit conflict of interest, could grind all fiduciary engagements to a halt. In addition, some conflicts may be minor enough to realistically be manageable.

Accordingly, the Labor Department has the legal ability to provide prohibited transaction exemptions that effectively state: “Notwithstanding that this transaction might normally be prohibited for fiduciaries, it is in the interests of consumers for the DoL to allow it – to grant an exemption from the prohibited transaction rules – if certain requirements are met.”

It is within this framework – that the manner in which most financial advisors engage consumers is rife with conflicts of interest that should be prohibited, except where otherwise allowed under a prohibited transaction exemption – that forms the basis of the fiduciary rule.

Best Interests Contract Exemption

Advisors will face three core scenarios that trigger prohibited transactions, which would otherwise bar them from engaging a client in a (conflicted) advice relationship, including when an advisor recommends:

  • Shifting from a 401(k) or IRA account with a lower fee into a new IRA with a higher fee, such as when the advisor already manages a low-cost 401(k) plan and recommends a rollover to an IRA with higher costs.
  • Rolling over to an IRA that would allow the advisor to earn a fee that he/she wasn’t previously earning because the advisor had no relationship to the prior 401(k) but will now get paid for advising on the IRA.
  • Switching a client to a fee-based wrap account for which the advisor will earn ongoing fee revenue not previously earned from a commission-based account.

The new prohibited transactions effectively states that a fiduciary advisor must sign a best interests contract with a client. If an advisor engages in such an agreement and follows its stipulations, the otherwise-prohibited transactions are allowed.
More specifically, to gain the protections of the exemption, the financial institution overseeing the advisor-client relationship must:

  • Acknowledge fiduciary status with respect to investment advice to the retirement investor.
  • Adhere to impartial conduct standards, which requires a fiduciary advisor to give advice that is in the retirement investor’s best interest, charge no more than reasonable compensation and make no misleading statements about investment transactions, compensation and conflicts of interest.
  • Implement policies and procedures reasonably and prudently designed to prevent violations of the impartial conduct standards.
  • Refrain from giving or using incentives for advisers to act contrary to a customer’s best interests.
  • Fairly disclose the fees, compensation and material conflicts of interest associated with their recommendations.

In practice, the first two points would be captured in the best interests contract with the client, while the remaining three become an obligation of the financial institution to follow, or lose its eligibility for such contracts.
Key Elements of the Best Interest Contract Exemption

  • The fact that advisors must explicitly acknowledge fiduciary status eliminates, once and for all, the classic defense that an advisor was operating technically as a salesperson and not actually acting in a fiduciary capacity. There will no longer be an opportunity for a broker after the fact to give advice to a retirement investor and later claim the fiduciary standard for advice shouldn’t apply.
  • Despite all the buzz about advisors being required to act in a client’s best interests and the debate about whether an advisor even can feasibly act perfectly in a client’s best interests at all times (Does that mean we have to search the ends of the earth to find the one product on the planet that is the cheapest and best, no matter what?), the DoL rule clarifies that the real expectation is that an advisor’s advice be prudent, not actually the difficult-to-define best. The rule states: “Prudent advice is advice that is based on the investment objectives, risk tolerance, financial circumstances and needs of the retirement investor, without regard to the financial or other interests of the advisor, financial institution or their affiliates, related entities or other parties.” The prudence standard draws upon ERISA Section 404, which in turn states that a fiduciary is required to act “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims.” In other words, the best interests standard is meant to determine whether a similar prudent professional in a similar role would have given a similar client-centric recommendation.
  • The Impartial Conduct Standards of the best interest contract exemption will also require that an advisor earns “reasonable compensation,” which is predicated not on the “lowest possible” compensation. This means an advisor does not have to be the cheapest, but simply that compensation must not be excessive based on the going market value for services rendered. Similar to the best interests standard, the determination of reasonable compensation is based on prevailing practices in the marketplace and a comparison to peers, not simply an arbitrary regulator’s view on what an advisor should earn. Notably, such a standard is actually very accommodating of advisors providing a wide range of services, for a wide range of costs; it simply means that the costs must be commensurate to the going rate for such services. Or as employee benefits lawyer Fred Reish stated at the recent Fi360 fiduciary conference: “You can charge Walmart prices for Walmart service or Tiffany’s prices for Tiffany’s services, but don’t provide Walmart services for Tiffany’s prices.”
  • The requirement to make no misleading statements may significantly increase the scrutiny on sales disclosures and illustrations, particularly for certain products that were not previously subject to such scrutiny but will be now (for example, equity-indexed annuities).
  • The policies and procedures requirement appears to be a meaningful attempt to drive financial services institutions to change their culture (or at least for their subsidiaries that actually deliver retirement advice). Financial institutions will be expected to create policies and procedures that the DoL will review and retain jurisdiction over. If a firm does not create the proper environment by establishing mechanisms to police its own conflict of interest, the institution can lose its prohibited transaction exemption, which instantly renders all of its activity as a prohibited transaction breach. Firms will not want this to happen, and it will drive them to create a stricter fiduciary culture to avoid the ramifications.
  • While some fiduciary advocates have lamented the fact that the final fiduciary rule relegated many of the key disclosures to only be provided “upon request of the client” or on the advisory firm’s website, as opposed to being handed to the client directly, the depth of the disclosures is still significant. To meet the requirements, the institution must disclose all material conflicts of interest, adopt measures to prevent those conflicts from causing violations of the Impartial Conduct Standards (and disclose what those measures are), and name a person responsible for addressing and monitoring this process (the chief conflict-avoidance officer?). In essence, this means that an Institution will be required to announce both its material conflicts of interest and its policies and procedures to handle them – which means if the process isn’t up to fiduciary snuff, the institution will effectively have handed a roadmap to a class-action lawyer.
  • A key aspect of the policies and procedures requirement is that institutions will be barred from having “quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives that are intended or would reasonably be expected to cause advisors to make recommendations that are not in the best interest of the retirement investor.” This may cause a substantial reform to how many institutions compensate brokers, since it potentially bars a wide range of common practices, from quota requirements to validate a sales contract, to bonuses for certain sales volumes, to incentives for selling one particular line of products over another, etc. The fact that the rules look not only at the compensation of an advisor, but also the institution, its affiliates and related entities, means that even behind-the-scenes differential compensation (for example, a wide range of common shelf-space and revenue-sharing agreements) will likely be barred under the new policies and procedures requirement. Notably, not all differential compensation is barred completely; substantively different products with differential compensation can co-exist as long as the institution can show it did not influence advisor recommendations inappropriately.

Coming tomorrow: Kitces on Fiduciary, part 2.

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Michael Kitces

Michael Kitces

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.