How to Comply With DOL’s Best Interest Standard of Care

In my last post, (Don’t Let BICE Hubbub Drown Out Burden of DOL Best Interest Standard), I noted that advisors are underestimating the significance of the best interest standard of care in the Department of Labor's fiduciary rule. While I believe that focused 401(k) advisors understand ERISA’s prudent man rule and duty of loyalty, I'm concerned that many advisors don’t understand how the best interest standard of care will impact their advice to IRAs (once the new DOL rules apply on April 10, 2017).

In my opinion, the change is much greater than people think.

To explain the impact, I divide the best interest standard of care duties into two categories: macro and micro.

The macro requirement is that the investment products be generally prudent for retirement investors. The micro requirement is that the recommended combination of investment products and services be prudent for the particular retirement investor. Let’s look at each of those.

Macro Prudence

For insurance products—including traditional fixed annuities, variable annuities and fixed indexed annuities, one macro issue is whether the insurance company is financially stable—that is, based on current circumstances, will it be able to make annuity payments 30, 40 or more years from now?

That requires a financial analysis of the insurance company, including consideration of its general account investment practices. It also requires an evaluation of the terms and conditions in the annuity contract. For example, when discussing fixed indexed annuities, the DOL said:

Assessing the prudence of a particular indexed annuity requires an understanding of surrender terms and charges; interest rate caps; the particular marked index or indexes to which the annuity is linked; the scope of any downside risk; associated administrative and other charges; the insurer’s authority to revise terms and charges over the life of the investment; and the specific methodology used to compute the index-lined interest rate and any optional benefits that may be offered, such as living benefits and death benefits. In operation, the index-lined interest rate can be affected by participation rates; spread margin or asset fees; interest rate caps; the particular method for determining the change in the relevant index over the annuity’s period (annual, high water mark, or point-to-point); and the method for calculating interest earned during the annuity’s term (e.g., simple of compounded interest).”

That raises the question of whether an individual advisor has the knowledge and experience to perform the analysis in a prudent manner. If not, then the advisor will need help from his supervisory entity (for example, a broker-dealer) or from reputable outside sources.

Similarly, for individual securities, ETFs and mutual funds, there needs to be a prudent analysis of the merits of the recommended investment. For example, is the investment generally prudent for a retirement investor? That analysis could be done by an investment firm (for example, an RIA or broker-dealer) on behalf of the advisor. Alternatively, the advisor could evaluate the quality of the investments. That would include, for example, for mutual funds, an analysis of the expense ratios, quality of investment management, past performance compared to appropriate benchmark, adherence to investment style, and so on. Either way would be acceptable, but for a financial institution with a large number of advisors, such as a broker-dealer, the decision about who will do the analysis and about what tools will be used for the analysis would probably be made by the broker-dealer.

Micro Prudence

The second level of analysis—the micro level—involves the individualization of the products and services to the particular investor. Having said that, though, it is important to keep in mind that, regardless of whether we are talking about a 35-year-old investor or a 65-year-old investor, the purpose of an IRA is to provide retirement benefits. It should not be viewed simply as a pool of investment money.

For the micro analysis, an advisor should take into account the needs and circumstances of the retirement investor, such as age and risk tolerance, and should develop a portfolio that is prudent based on that analysis.

Under ERISA, investment decisions are to be made using generally accepted investment theories (such as modern portfolio theory and diversification) and prevailing investment industry practices. That approach works well when an advisor develops a prudent asset allocation of diversified investment vehicles. However, it is not clear whether prudent investment advice could be non-diversified and not based on modern portfolio theory.

As a result, good risk management suggests that, if the retirement investor wants to invest in a manner that might be viewed as imprudent (for example, an older investor in a limited number of individual equity securities), the fiduciary advisor should receive written directions from the retirement investor. If the retirement investor provides written instructions to the fiduciary advisor that limit the scope of the advisor’s recommendations, then the advisor will only be obligated to be prudent in fulfilling the instructions of the retirement investor.

Forewarned is forearmed. Make sure to use insurance and investment products that are prudent on a macro basis, and make sure to provide investment advice that is prudent on a micro basis (that is, are prudent based on the needs and circumstances of the investor and that consider the retirement purpose of the IRA). If the retirement investor wants something different than that, make sure to get written directions to that effect.

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See Fred Reish's previous related blog on this subject, Don't Let BICE Hubbub Drown Out Burden of DOL Best Interest Standard.

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