From the June 2016 issue of Research Magazine • Subscribe!

Finke: DOL Rule May ‘Drop Bomb’ on Asset Management Industry

Mutual funds, annuities and more face a transformed environment because of DOL fiduciary rule

Illustration by Daniel Zalkus Illustration by Daniel Zalkus

The dust is still settling from the recent Department of Labor fiduciary rules and most people I talk with don't know quite what to make of it. Of course, that hasn't put a damper on their willingness to express strong opinions — both pro and con.

Some have criticized the DOL for being overly accommodating to the industry. Others call it a government takeover of investment advice. A recent editorial in The Wall Street Journal predicted that retirees would all be forced to buy Treasuries.

The most important question to most advisors is how the new rules will affect their ability to recommend investments. Will they have to recommend index funds? What about products that pay commission or the sale of proprietary investments by captive agents?

I haven't met anyone who knows more about the arcane details of securities law than University of Mississippi law professor Mercer Bullard. I asked Bullard, who also practiced securities law in D.C. and was a former assistant chief counsel at the SEC, whether the revised DOL rules were actually going to have an impact on the industry.

According to Bullard, “The DOL stuck to its guns and kept the provisions that’ll have the most significant impact on broker-dealers’ sales practices.”

This position is echoed by longtime fiduciary expert and Western Kentucky University professor Ron Rhoades. To Rhoades, the DOL rules will have a “transformational” impact on the advising industry as it hastens the movement from commission to fee compensation. In essence, fee compensation can be seen as a carrot that has been slowly driving a change in compensation through promises of smoother and more generous (in some cases) advisor revenue. But the DOL rules act as a stick by increasing the risk of commissions. The size of the stick will be measured in the courts.

According to Rhoades, “if there is such a thing as a tipping point — this is it.” Is this really a tipping point? We may not know until long after the rules start taking effect in April 2017, but the experts say that the new rules could drop a bomb on the world of asset management as we know it.

Death of the Active Mutual Fund?

Despite the popularity of index funds, broker-channel active mutual funds are still a major player in the fund industry. That could change quickly according to Rhoades.

The reality is that most active funds have significantly higher expense ratios and commissions, but a portion of the expense ratio indirectly covers advising services. Investors pay higher ongoing expenses and commissions, a portion of this amount is routed by the fund to the advisor in 12b-1 fees, commissions, soft dollars, shelf space and marketing support, and the fund family keeps its share as a cost of managing and marketing the fund.

There is also plenty of objective evidence that active funds don't outperform passive funds, and the size of this underperformance is almost exactly equal to the size of their higher fees. But this is to be expected if the higher fees are part of the compensation model (many advisors point out that 25 basis point 12b-1 trails are a lot lower than 1% asset management fees, and some active funds have modest expense ratios). The problem is that the compensation model includes quite a few characteristics that could run afoul of the DOL rules.

This current system provides an incentive to recommend more generous active funds, and research bears this out. The new Best Interest Contract Exemption standards (BICE) allow a range of compensation models including commissions, but they explicitly state that advisors can't make recommendations that pay them more when the recommended investment isn't best for the client.

The real problem for active funds is that the newest version of the DOL rule contains further incentive for advisors, even advisors who were formerly paid through commissions, to adopt a fee compensation model in order to become a so-called “level fee fiduciary.” Level fee advisors are exempt from the full requirements of the BICE, which serves as a strong incentive to adopt a level fee compensation model.

Bullard points out that “there are really only two lobbying successes in this, and one of them was that the financial planners got a huge exemption which allows them to give conflicted rollover advice if they charge level fees without having to enter into a best-interest contract. So, what was previously a fairly unbiased proposal between transaction-based compensation and asset-based compensation became, in the final version, heavily biased in favor of asset-based fees because they now offer a complete out because the DOL decided that conflicted, asset-based fee advisers, with respect to rollovers, don't need to enter into the BICE.”

There are also significant conflicts in the traditional active fund compensation model — for example, compensation practices such as ratchet grids that provide bonuses when advisors meet sales targets. If advisors can make more money by recommending funds that help them meet their sales threshold and provide a significant payout, then they face differential compensation that presents a conflict of interest. This is a big no-no under the new rules.

Rhoades and Bullard have different views on whether the fiduciary rules are going to impact active funds. Bullard believes that there is nothing in the rules that would compromise an advisor's ability to accept commission compensation. “It's going to be very difficult to make the case that an advisor failed to make a prudent recommendation case as opposed to a failure to have procedures that prevent conflicts of interest,” notes Bullard.

Active funds have time to change sales practices in order to accommodate the new rules. According to Bullard, “the DOL has laid out in detail written documentation examples of material conflicts of interest and the firm's program for mitigating them, which is a virtual roadmap — and also an evidentiary motherlode for bringing both arbitration claims and class actions against firms.” This will, however, “not necessarily have an effect on active funds, nor will it necessarily cancel 12b-1 fees.”

Both Rhoades and Bullard agree that the new rules do mean a broad shift from commission to fee compensation among advisors looking for ways to avoid liability risk. When faced with a decision to take a shortcut through a minefield of potential conflicts associated with commission compensation, advisors will simply choose a safer path. According to Rhoades, this shift in compensation will take away the funds’ sway over commission advisors by limiting the funds’ ability to reward sales.

Bullard points out that many retirement funds operating under strict ERISA rules continue to offer active funds, and recent lawsuits that target higher-priced index funds highlight the risk of recommending an S&P 500 fund when there's a lower-priced S&P fund in another fund family. Because active funds are unique, it can be argued that they provide risk and return characteristics that can't otherwise be purchased at a lower cost.

This is true, of course, but an advisor recommending funds to an employer's 401(k) doesn't have skin in the game. They’re not investing their own money in active funds. When given the choice between a higher and lower expense ratio fund, and the overwhelming evidence that expense ratios are the strongest predictor of mutual fund performance, fee-compensated advisors will maximize their own revenue (and the revenue of their employers) by recommending less expensive funds.

This is why many in the industry are saying that the concessions provided by the DOL that provide greater latitude to operate under the BICE exemption won't really matter in the long run if individual retirement plans move to fees. What is unsettled is whether advisors who move to a fee model and sell higher-priced proprietary funds bear any risk that their recommendations may not be viewed as prudent.

The Product Troublemakers

If we’re being perfectly honest, the DOL rules probably weren't motivated by the sale of active funds in IRA accounts. It is the headline-grabbing sales of opaque, high-commission products with sales practices that present clear conflicts of interest that provided the headlines needed to push the DOL to look for ways to protect retirement savers.

As if nontraded REITs weren't having a bad enough year, they are now among the most dangerous products to recommend. Their primary sales advantage over other financial products was higher advisor compensation, and these types of compensation differentials will be easy pickings for class-action suits.

I asked Bullard whom he would target for a class-action lawsuit — what is the low-hanging fruit? “I immediately go to public websites where they’re going to be required to post their identification of material conflicts of interest and steps to mitigate them and look for an absence of a missing conflict.”

If more profitable products are no longer able to offer higher advisor compensation to build sales, they will lose market share. Couple this with the fiduciary risk that the investment can't be defended as a prudent recommendation and these products may simply disappear from the marketplace.

Annuities are also in danger of losing market share, but not necessarily because of differential compensation. According to Bullard, “the next biggest change will be the possibility that variable annuities and fixed-index annuities will not be able to weather attacks on their prudence as investments.” The rules allow higher compensation for products that are more complex and require greater skill and time to sell. If compensation for variable annuities is higher than other investments, an advisor better be able to justify the difference.

Annuities seem to be the product whose future is most difficult to predict. Bullard believes that “there will probably be more reluctance to sell those products without a pretty strong argument that it is a good fit for the client.”

It is possible that the new liability risk will force annuity providers to create products that can be defended as prudent for retirement investors. This isn't that hard to do if the products are structured and sold in a manner that is most beneficial to retirees seeking liquidity, the ability to capture a risk premium, and longevity protection. It would be a shame if set-it-and-forget-it retirement income products like annuities were viewed as risky because they pay advisors a commission, or if providers felt that they needed to pay ongoing fees on products that don't necessarily require ongoing advice.

Are investments going to change in the brave new post-fiduciary world of retirement investments? If the advising industry moves toward fee compensation, there's no question that the shift in incentives will result in changing advisor recommendations. There will be winners and losers in the industry, and the short timeline of implementation means these changes will happen fast. So buckle up — there's no question that we’re headed for a bumpy ride in the investment business.

-- Related on ThinkAdvisor: 

-- Check out more coverage on the DOL Fiduciary Rule's impact on advisors

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