The legacy of the DOL fiduciary rule: Almost gone, but never forgotten

Having caused significant shifts among advisers, firms and consumers, can the push for a higher investment-advice standard really be erased by one court's decision?

Jun 2, 2018 @ 6:00 am

By Mark Schoeff Jr.

Even as the Labor Department'sfiduciary rule teeters on the edge of demise, its legacy will continue to profoundly influence how investment advice is delivered.

The regulation's likely obituary will not be as heart-wrenching for its supporters as one might expect. Despite its sudden revocation by a three-judge panel's split decision, after parts of the rule had been upheld in federal district courts across the country, the push the rule gave the marketplace to demand a higher investment-advice standard cannot be erased.

"The DOL fiduciary rule really made the discussion of fiduciary for consumers mainstream," said Michael Kitces, partner and director of wealth management at Pinnacle Advisory Group. "You can't un-ring that bell."

The rule's influence goes beyond a philosophical change in the giving and receiving of investment advice; it also has had a practical impact on the industry. It gave momentum to a market trend toward lower fees, and forced many brokerages to make changes to product lineups and compensation structures that are likely to remain in place long after the DOL rule is gone.

But some say the advances forged by the Labor Department's fiduciary regulation came at a significant price. These critics welcome the death notice, which is straightforward: The DOL fiduciary rule, which requires brokers to act in the best interests of their clients in retirement accounts, had been vacated in its entirety by the 5th U.S. Circuit Court of Appeals. The Trump administration is no longer defending the rule, and the court won't allow advocates to step into the fray in an attempt to rescue it.

The Financial Services Institute, one of the plaintiffs in the 5th Circuit lawsuit, commissioned a study by Oxford Economics that estimated the cost to broker-dealers for implementing the rule would be $37 million to $49 million — much steeper than the DOL's estimate of $14 million to $16 million.

A portion of that spending has already occurred, as firms geared up for the rule, which was partially implemented last June.

"It was a deeply flawed and unworkable rule [that] in so many aspects undermined the good public policy intention behind it," said Dale Brown, FSI president and chief executive.

(Video: Senior columnist Mark Schoeff discuss the the Fifth Circuit's decision to vacate the fiduciary regulation.)

Opponents of the DOL regulation argue that it curtailed the use of investments in retirement accounts that are important for portfolio diversification, such as variable annuities, nontraded real estate investment trusts and business development companies.

"We saw numerous instances where the array of product choices was narrowed significantly," Mr. Brown said.

Independent broker-dealers were scrambling, particularly in 2016, as enactment of the regulation neared and some firms struggled to keep up. Consolidation was rampant — from the biggest names in the industry to the more modest shops — but it was small firms that had the hardest time fronting the money for new technology and staff to comply with the rule. Add to that the fact that the rule hampered the sale of high-commission products, and it becomes clear that the pressure on many firms intensified.

"This has been a significantly more challenging operating environment for wealth management firms," Richard Lampen, CEO of Ladenburg Thalmann, told InvestmentNews senior columnist Bruce Kelly in early 2017 for a report examining the state of the independent broker-dealer market in 2016.

Revenue impact

InvestmentNews has been tracking the leading IBDs since 2003 and charting an annual assessment of the industry's growth. Over that 14-year period, the top 25 IBDs reported an average 10.1% in annual revenue growth. In 2016, that figure was -1.4%. Several factors played into that drop, including compressed margins and record-low interest rates. But additional regulatory expenses and lower-commission products also ate into firms' bottom lines.

Some financial advisers whose businesses were based on sales of commission products shifted to charging fees based on assets, according to Dean Harman, owner of Harman Wealth Management.

"In many cases, their revenue has dropped precipitously while preparing to be in compliance for fiduciary," Mr. Harman said.

Although his firm was mostly fee-based before the DOL rule became final, Mr. Harman said he has talked to many advisers who have cut 20% to 40% of their books of business by dropping clients with modest assets as they migrated from brokerage accounts to fee accounts.

"Some advisers who shifted their business models won't go back to serving smaller clients," Mr. Harman said. "There's a point of no return."

As the threat of the DOL rule waned with the presidency of pro-business, anti-regulation Donald J. Trump in 2017, the industry bounced back. Due to many factors, including a roaring stock market, revenue growth last year hit 13.1%.

But some changes the DOL rule brought about during its short life could ultimately make for a more resilient financial advice industry going forward.

In anticipation of the rule going into effect, advisory firms worked to reduce conflicts of interest in the sale of certain products, and the fees clients paid for various investments received sharper attention.

A Morningstar Inc. report released in April showed that average mutual fund and exchange-traded fund fees declined by 8% in 2017, saving investors approximately $4 billion in fund expenses. It was the largest year-over-year decline that the research firm had ever recorded.

Aron Szapiro, Morningstar's director of policy research, said that while the DOL rule couldn't claim all the credit for the fee reduction, it played an important role.

"This was the direction [fees] were going, and then the DOL rule poured fuel on the fire," Mr. Szapiro said. "The DOL rule was a massive accelerant."

One product innovation was so-called "clean shares," a class of mutual funds that eliminated payments for distribution to brokers. About 12 money managers, including American Funds, Janus Capital Group, Fidelity, J.P. Morgan and BlackRock, had either started using clean shares or were developing products that met the clean-share definition as of last fall, according to an Institute for the Fiduciary Standard analysis of data compiled by the Consumer Federation of America.

Another type of share class inspired by the DOL fiduciary rule is so-called "T shares," which create level compensation across fund categories and families. Morningstar lists 123 funds currently in existence with T shares, down from 311 because of liquidation. But because funds don't have to call shares by a particular letter or name, there could be shares out there that look a lot like T shares but use some other designation.

The DOL rule also played a role in encouraging product innovations in the variable-annuity sector, said Robert DeChellis, president of Allianz Life Financial Services.

"The impact that the DOL intended to have, it's had," Mr. DeChellis said recently at a conference of the Insured Retirement Institute, a trade association representing the annuity industry. "It's forced our industry to raise its game in a way that I don't think, candidly, would have happened unless you had something like this occur."

The DOL rule also has caused brokers to address conflicts of interest in recommending clients roll retirement funds from 401(k) plans to individual retirement accounts, according to state regulators.

In an April report, the North American Securities Administrators Association said no brokerage provided a standard of care other than suitability prior to the partial implementation of the DOL rule in June 2017. With the advent of the rule's impartial conduct standards — which required brokers to act in the best interests of their clients, charge reasonable fees and not make misleading statements — things began to change.

"Many broker-dealers undertook significant steps and expended considerable time and resources to modify their policies and practices for handling IRA rollovers to bring these activities into compliance with the best-interests standards in the rule," the report stated. "These efforts included developing new policies and procedures and providing guidance to agents administering these accounts."

Brokers also are now more likely to curb practices such as sales contests and proprietary sales, said Mark Goldberg, chief executive of Griffin Capital Securities.

"The Department of Labor, having started that dialogue, is to be credited for identifying internal conflicts of interest that need to be eliminated or mitigated," Mr. Goldberg said.

But will brokerages stay the course?

Much of the DOL rule's legacy, as officially written into federal regulation anyway, will be determined by the outcome of the Securities and Exchange Commission's work on its own advice-reform package. Proposed in April, the rules apply more broadly to all investment advice but face a long and likely bumpy road toward enactment.

"I'm concerned that the majority of firms will be back to business as usual," said Barbara Roper, director of investor protection at the Consumer Federation of America. "How the SEC interprets its standard will determine whether any of the changes adopted by firms to comply with the [DOL] rule will be preserved."

Eye on SEC

The industry is keeping an eye on the SEC. LPL Financial developed its Mutual Fund Only platform to offer investors access to more than 1,500 mutual funds while reducing incentives that favor the sale of one fund over another. For now, though, that project has been put on hold.

"We're on pause to try to figure out and get better clarity of the SEC's rule itself and then ultimately the timing of it," LPL chief executive Dan Arnold said in a recent earnings call. "That will then allow us to better understand how to pivot relative to any adjustments in the products."

Financial firms aren't likely to scrap the compliance systems they've built for the DOL rule until they see the outcome of the SEC rulemaking process, said Matt Grinnell, compliance strategist at Fidessa, a global trading technology firm.

"Because of the overlap, they're looking to reuse the procedures and controls they used for the DOL rule where they match up with the [SEC] rule," Mr. Grinnell said. "They're trying to be smart about meeting compliance requirements without starting from scratch."

It's unclear whether the SEC rule will be as stringent as the DOL rule when it comes to mitigating conflicts of interest. But part of the proposal — Regulation Best Interest — mirrors the language of the DOL rule in outlining steps required to act in a client's best interests, said Fred Reish, a partner at Drinker Biddle & Reath. The SEC rule, however, lacks the DOL provision that allows clients to sue brokers when they violate the rule.

"The enforcement mechanisms are quite different, but the substantive rules themselves are very much the same," Mr. Reish said. The SEC proposal "is remarkably similar to the best-interest standard of care in the [DOL rule's] best-interest contract."

The SEC rule has to have strong enforcement provisions to stand up well to the DOL rule, said Knut Rostad, president of the Institute for the Fiduciary Standard.

"Without regulatory enforcement, we are left to the honor system," he said. "The SEC's philosophy is based on disclosure; the DOL's philosophy was not."

The SEC rules may be changed many times before the agency settles on a final version, which could drift farther away from the DOL rule. But another standard that was influenced by the DOL's work has become final.

The Certified Financial Planner Board of Standards Inc. earlier this year strengthened its fiduciary requirements for everyone holding the designation, including brokers. The rule will go into effect in October 2019.

"We were very much aware of the DOL rule, and it is a document we examined in putting together the CFP Board's own standard," said Leo Rydzewski, CFP Board general counsel. "The underlying fiduciary principles are very similar."

Several states, too, have advanced legislation, regulations or enforcement actions around meeting a fiduciary standard for investment advice, including Maryland, Massachusetts, Nevada, New Jersey and New York. Activity at the state level could expand if the final nail is driven into the DOL fiduciary rule's coffin and progress on the SEC's proposal stalls.

It took six years for the Labor Department to give birth to its fiduciary rule — and a little more than a year after that for it to reach the grave. Despite its short life, though, the DOL rule has made a profound statement on how far regulators could go to protect investors, Ms. Roper said.

"The DOL taught us that you could think big," Ms. Roper said. "We didn't have to limit our thinking to tweaking the existing standards."

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