Everyone is talking about the U.S. Department of Labor's final fiduciary rule and related Best Interest Contract Exemption (BICE). Some like them, some really don't. It's still early, but the emerging consensus seems to be that much of the industry can work with them.
Full implementation will not come until January 2018, but strategies for compliance — and for seizing upon the new opportunities these changes offer — are already in play.
These changes were promulgated because the DOL estimated that conflicts of interest in retirement advice cost American investors $17 billion a year, and undermined confidence in the markets. How the industry evolves in response to the changes promises to have a significant impact on financial advisers and their clients.
The DOL set out to give retail investors who may have viewed the markets with trepidation more confidence that the retirement system can serve their interests. The most publicized of the rule changes — holding advisers to a fiduciary standard, compelling them to act in the “best interests” of clients rather than their own — should give investors comfort.
In particular, the DOL wanted to address the market segment of smaller investors with rollover individual retirement accounts (IRAs).
The DOL believed a portion of them were being disadvantaged by “product steering” on the part of some financial advisers who pushed client savings into funds with large up-front loads and annuities that paid large commissions. The industry will need to pursue new ways of serving the smaller end of the market efficiently and profitably. Digital offerings, with less human interaction but enough substance to be useful, may help.
The many advisers who have always pursued a genuinely “clients first” approach should see these changes as opportunities, since they should increase transparency and innovation. Hopefully this will foster greater trust and bring more retirement savings back into the market, a potential victory for the investing public and for those who faithfully advise them.
The new DOL rules only cover retirement accounts, including employer retirement plans and IRAs. They do not cover a typical taxable brokerage investment account. This promises to create two standards of investment advice: one for taxable accounts (bank or brokerage), and one for tax-deferred accounts (IRA or employer retirement plan).
Although the BIC exemption and the DOL's release address variable fees such as commissions — and promise to further increase downward pressure on them — they include language that says: advisers do not need to automatically recommend the lowest cost vehicles; fees are important but not the exclusive factor that a fiduciary should consider; and a fiduciary can recommend products that are more expensive, as long as they can justify them as being in the best interest of the client.
Passive products likely will continue to take market share, as some advisers will simply recommend exchange-traded funds (ETFs) for their low costs. To meet this investor demand, asset managers (including Legg Mason) have introduced ETFs that incorporate rules-based approaches, or active ETFs that also seek to fix weaknesses, such as market-cap weighting problems, in passive ETF products. This trend should accelerate, leading to broader varieties of ETFs that can serve clients' specialized needs at attractive costs.
With the regulatory changes, pure actively managed products may become harder sells, since they will require more explanation and justification of their higher fees. This is not new; those of us who practice active management have to earn those fees. In these volatile markets, I like our chances.
According to a survey Legg Mason co-sponsored with InvestmentNews, advisers believe the biggest product losers under the new rules, defined as those they expect to decrease usage of, will be: variable annuities (57%); nontraded real estate investment trusts (49%); and business development companies (45%).
There was less consensus on product winners, but advisers reportedly expect to increase usage of separately managed accounts (SMAs) (39%), passively-managed ETFs (36%) and actively-managed ETFs (26%).
Whether we like it or not, these rule changes and resulting cost pressures should signal a more competitive environment for mutual fund vehicles. We expect broker-dealers to pare back their offerings from asset managers, moving away from (or killing) performance laggards and small products that lack the scale to offer competitive pricing. Me-too funds should suffer.
Traditional target-date funds will need to evolve or risk becoming extinct. They have begun to lose market share to managed accounts and other solutions which offer superior service: customization, not off-the-shelf funds.
Asset managers must expand the depth and breadth of their product offerings to become more relevant and differentiated, specifically for income and retirement needs. In addition to ETFs, momentum should shift to SMAs and collective investment trusts (CITs), which can offer flexibility, customization and better pricing.
All of this should lead to greater investor choice and enhanced service. New approaches likely will emphasize risk management and risk-adjusted returns, income and more outcome-oriented and differentiated strategies. Alternatives (liquid and illiquid) should continue to gain market share.
Costs and compliance burdens should favor large firms who can leverage technology to efficiently service the growing number of smaller retail accounts. The role of the adviser will evolve, and those with smaller books of business may be challenged by tech solutions that may better serve investor needs at lower costs. Small broker-dealers may have to exit some businesses or merge with larger providers to improve scale.
The new rules will push the industry to evolve in a way that puts the best interests of clients first. I like to think that is something most of us do every day. Now we'll have more company.
Thomas Hoops is head of business development at Legg Mason.