Figuring out Fiduciary
Now comes the hard part
Game Changer /
The DOL fiduciary rule will forever change financial advice, and the industry has to adapt
Every corner of the advice industry now faces the challenge of adapting to the new fiduciary reality
By Liz Skinner — May 9, 2016
Americans won hard-fought protections regarding the purity of their retirement advice last month. Now it's up to the nation's financial advisers to decide whether they'll meet the letter — and spirit — of the historic investor protection regulation.
The Labor Department's fiduciary rule is aimed at stopping the $17 billion a year the government claims investors waste in exorbitant fees. The idea is that the regulation will stop advisers from putting their own interests in earning high commissions and fees over clients' interests in obtaining the best investments at the lowest prices.
The final rule contained several important concessions to the advice industry that will make implementation easier for financial advisers. But there still appears to be enough meat to the rule that advisers will have litigation to fear if they can't prove their retirement advice prioritized the client over themselves.
“This is going to be a bigger change than the industry expects,” said John Anderson, managing director of practice management solutions for the SEI Advisor Network.
The nation's thousands of brokerage, advisory and insurance firms that impart advice within the $25 trillion retirement services market will have to adjust their operations and procedures to comply with the rule. Some changes will be drastic, while others will be minor, but all promise to fundamentally shift the advice landscape.
As the DOL fiduciary rule begins to take effect next April, all financial advisers will be required to recommend what is in the best interests of clients when they offer guidance on 401(k) plan assets, individual retirement accounts or other qualified monies saved for retirement.
The rule does not apply to after-tax investment accounts that may be earmarked as retirement savings.
Independent broker-dealers, who currently operate under a less stringent standard that only requires that investment advice be “suitable,” face the greatest disruption. They'll need to craft new administrative steps and invest millions in technology and training to meet the rule's requirements. Many advisers will face changes in how they are paid.
The DOL rule doesn't ban commissions or revenue sharing, but it requires advisers who accept them to have clients sign a best interest contract exemption, or BICE. It pledges the adviser will act in the client's best interests and only earn “reasonable” compensation. The exemption also must disclose information to clients about fees and conflicts of interest.
Investors with such a contract in place will be able to sue their advisers in court if they believe their interests haven't come first.
That threat of increased liability will push some advisers away from a long tradition of charging clients based on transactions, to a compensation method that carries lower liability risks, that of billing clients a set fee.
“Financial advisers will have to have conversations with many clients about what they want to do,” said John Taft, CEO of RBC Wealth Management. “Certain clients may elect to be guided to fee-based accounts.”
But fee-based accounts often don't make economic sense for firms if the accounts have low balances, so many advisers are expected to drop undersized retirement accounts.
Regardless of the path advisers and clients decide on, there will be compliance costs and a lot of documentation and monitoring, broker-dealer executives said.
LPL Financial, Ameriprise Financial Inc., Raymond James and other large independent broker-dealers have said they are still evaluating exactly what the rule issued on April 6 requires and figuring out how they will change their platforms to meet it.
“We always want to make it easy for advisers to do what is best for their clients,” said Mark Casady, LPL's chairman and chief executive.
He said advisers will have to look closely at the needs of each client to determine if they can still be met under the existing account structure or whether a change will be in the client's best interest.
In fact, only the largest IBDs are expected to have the resources to build comprehensive compliance programs around the rule's requirements, which include requisites such as benchmarking information to measure the reasonableness of adviser compensation, according to the 1,023-page rule that was six years in the making.
Smaller broker-dealers will struggle with the costs of compliance and may need to pursue mergers to help build scale and the skills they'll need to adjust, such as a familiarity with the Employee Retirement Income Security Act, the 1974 federal law that governs tax-advantaged retirement programs.
In contrast to the burden the rule lays on IBDs, registered investment advisers should be dancing a jig.
“This is a huge win for RIAs,” Mr. Anderson of SEI said.
RIAs, who already are held to a fiduciary or “best interest'' standard, will have small operational changes to make to serve retirement plans and IRAs. They'll need additional documentation under the DOL to show how clients' interests are being put first.
That could be challenging with 401(k) rollovers, for instance, if the fees the client will owe the RIA for managing the IRA will be greater than the existing plan's fees. The DOL rule also incorporates a contract some have dubbed “BICE lite,” which fiduciary advisers may need to have signed by clients to transition retirement assets.
The cost of these changes could be a challenge for small RIAs, who will likely react by looking to merge with larger firms, a trend that's been occurring in recent years anyway because of extra compliance costs due to other regulations.
Down the road, though, the rule's impact could surprise some RIAs, especially those that are just sitting back on their laurels. These RIAs could find that they now have much more competition than before the DOL fiduciary rule was adopted.
Mr. Anderson said many advisers are not going to want to use the BICE because of the perception issue it creates with clients. As a result, he predicts more brokers and hybrids will be joining the ranks of fee-only RIAs.
Sheryl Garrett, founder of the Garrett Planning Network and a fee-only advisor, agrees that a more competitive RIA market is around the corner.
“There will be more competition because 'fiduciary' by itself isn't going to be your claim to being different,” she said. “There's a lot more public awareness coming to this issue.” President Barack Obama recognized Ms. Garrett as exemplary when he threw his full support behind the fiduciary rule last year.
The nation's four large brokerages at Wall Street investment banks — Wells Fargo & Co., Bank of America Corp., Morgan Stanley and UBS Group AG — scored a major victory with the final rule because it allows them to sell their proprietary products more easily than they would have under the proposed rule that came out in April 2015.
These firms also have the infrastructure and resources to comply with the rule, and they have been moving over the past decade toward a fee-based model.
Bank of America Merrill Lynch executive John Thiel threw his support behind a best interest standard of care more than a year ago, and his firm recently said that meeting the rule requirements won't have a material impact on the firm's earnings.
“We are pleased that Secretary Perez and the Department of Labor staff have worked to address many of the practical concerns raised during the comment period,” Mr. Thiel said.
Financial advisers who operate as both RIAs and brokers will have to implement all the procedural changes already mentioned. They will have to be especially careful and well-trained on the procedures they'll need to follow as client conversations delve into retirement.
“There will be additional things we need to do, but we won't be running away from commissions any time soon,” said Ed Gjertsen, vice president of Mack Investment Securities and chairman of the Financial Planning Association.
That said, as hybrid firms look at what's in the best interests of clients, the commission side of the business will probably slow, he said.
The overall compliance headache and expense the DOL rule will cause could even persuade older advisers to exit the business, years before they planned to, just to avoid dealing with the changes. That would worsen the nation's overall shortage of financial advisers.
Bernie Clark, head of Schwab Advisor Services, said he believes people who have trusted relationships with their clients can continue to provide advice using different business models.
“If they are getting out of the business because of this, maybe they should be getting out,” Mr. Clark said. “Maybe their model isn't bringing value to the consumer.”
The DOL rule will force financial advisers to satisfy the BICE conditions in order to sell variable annuities and indexed annuities in qualified accounts.
Analyst Ryan Krueger, who heads up insurance company coverage for Keefe Bruyette & Woods Inc., anticipates sales of variable and indexed annuities within qualified plans to fall between 25% and 50%, which would equate to a sales decline of about 15% to 35% overall.
Lincoln Financial Group, Prudential Financial Inc. and MetLife Inc. face losing about 1% in annual earnings from lower variable annuity sales, according to the company's research.
Insurers had expected that fixed indexed annuities — a high commission product mostly sold within qualified retirement plans — would remain an option under the former, easier-to-meet, exemption category. But in the final rule, indexed annuities made a surprise shift to the BICE.
Cathy Weatherford, CEO of the Insured Retirement Institute, has concerns the rule will limit investor choice. She said she's still evaluating whether the changes made to the proposal will avoid those harmful consequences.
Regardless, insurers are likely to increasingly develop new retirement income products that cater to the demand for products on a fee-only basis and those that won't need to comply with the stricter BICE standards.
“What consumers crave is transparency,” said Mitch Caplan, CEO of Jefferson National, whose variable annuity business already is sold in the fee-based space. “This rule puts the consumer in the driver's seat.”
Additionally, insurers that have their own broker-dealer units, including American International Group and NFP Corp., already have begun to shed those subsidiaries to help deflect conflict-of-interest concerns. That trend is expected to continue.
Retirement accounts that advisers deem too small to profitably provide conflict-free advice to will be welcomed by the nation's growing crop of digital advice providers, such as Betterment, Wealthfront and Personal Capital.
“We are delighted to see the progress of the industry toward a fiduciary standard,” said Bill Harris, CEO of Personal Capital, which also has a human-adviser element. “What we are doing is not only compliant with the rule, but we have always supported its objectives.”
Even robos, though, will need to be more aware when executing 401(k) rollovers to ensure the fees won't exceed what the client currently pays the plan without a reason.
Other digital advice providers that are created especially for advisory firms could benefit, as advisers seek an in-house solution for small accounts.
The final DOL rule was a pleasant surprise for the $10-billion-a-year industry of nontraded real estate investment trusts. The final rule allows these products to be sold in qualified plans, as opposed to the proposed rule, in which they effectively could not.
Nontraded REITs are a high-commission product, typically paying brokers a 7% sales commission, and brokers have sold them to retirees as a way to create an income stream. They've been especially desirable in recent years as interest rates have hovered around zero.
While advisers can still put retirement clients into nontraded REITs, they will have to meet the requirements of the BICE, including fee disclosure and reasonable compensation parameters, which could make them a tougher sell.
Mutual fund companies will be looking to adjust their product offerings to investments that advisers and broker-dealers will use to populate IRAs and other retirement accounts, such as lower-cost passive investments.
Charles Schwab Corp. announced less than a month after the rule was issued that it's moving away from mutual funds with sales loads and higher fund expenses in general.
Analysts expect other firms will look for less expensive options too, as advisers and their clients become more conscious of cost.
With the new rule pushing more IRA accounts into fee-based structures, cheap exchange-traded-fund sellers, such as BlackRock Inc. and the Vanguard Group, stand to benefit, according to Morningstar analyst Greggory Warren.
ETFs also will benefit if the amount of assets under management with robo-advisers surges as they take over small accounts that broker-dealers or even RIAs shed. Digital advisers rely heavily on ETFs.
Small companies that want to help their employees sock away retirement funds may have to pay more to offer 401(k)s and other qualified plans because the stricter rule could boost the costs of running them.
It may even heighten legal liability for plan sponsors if they hire advisers who are later accused by participants of not acting in the plan's best interest.
John Berlau, senior fellow with the Competitive Enterprise Institute, said small firms also will have fewer choices among retirement plan providers.
Some providers won't want to take on the risk of private litigation in exchange for the revenue a small-company plan generates for a provider.
“It's the 'let them eat robo-advice' approach,” he said, suggesting small companies may be pushed toward digital retirement plan solutions.
Experts expect client lawsuits to start flying the first time the market tanks after the DOL rule is fully implemented in January 2018.
Sections of the rule are not descriptive enough to set clear boundaries, and that opens the advice industry up to myriad litigation risks, establishing a brisk business for lawyers.
The BICE is the area in which advisers are most likely to make the wrong judgment call.
The exemption is a contract under state law principles, which is different from the class-action hurdles that are part of ERISA, said Brian Graff, CEO of the American Retirement Association.
A “cottage industry” of lawyers will develop to become experts on the exemption, and firms are going to have to see litigation as a cost of doing business, he said.
“Lawyers do win when it comes to massive regulations,” Mr. Graff said. “Certainly 1,000 pages of regs will create a massive amount of legal work.”
Surveys show clients are nearly clueless as to what the word “fiduciary” means. But some will discover the rule will force them to find a new adviser for retirement assets.
Investors with smaller retirement accounts may hear their adviser tactfully suggest that their needs can be better met elsewhere, possibly recommending their own firm's digital advice solution or another robo-adviser.
Kurt Schacht, a managing director of the CFA Institute and chairman of the Securities and Exchange Commission's Investor Advisory Committee, believes such a move is not the worst outcome for consumers. Individuals may be better off with services that are better scaled and less expensive, he said.
The hope is that the rule's biggest benefit for consumers will be cleaning up the more egregious advice businesses, which put clients into expensive investments that don't pay off enough for them in the long run.
Additionally, the media attention the rule has attracted, as well as ad campaigns sponsored by fiduciary advisers, should lead clients to ask more questions about conflicts and compensation.
“I'm so optimistic about the future of what financial planning means, what it stands for and how it can positively impact people's lives,” Ms. Garrett said.
Will it refresh the fairly negative view that the general public has of financial professionals?
Probably not, said George Kinder, founder of the Kinder Institute of Life Planning, who's often considered the father of holistic planning. That's mostly because the rule doesn't simply state outright that client interests always have to come first — no matter what.
“It's a drop of water in a big bucket,” he said. “It doesn't do much to fix the public perception consumers have of financial advisers.”
Court challenges from industry groups to try to derail the DOL fiduciary rule are likely. An injunction could push the implementation date further down the road into the next administration, which would allow those new agency officials to decide the remaining details of the rule's implementation.
Republican lawmakers have already passed congressional resolutions to kill the DOL regulation, but President Barack Obama has pledged to stop those with a veto, and opponents don't have enough votes in Congress to override that veto.
Meanwhile, the DOL's final rule is increasing the pressure on the SEC to approve a uniform fiduciary standard, something SEC Chairwoman Mary Jo White has indicated she supports.