The brokerage industry is disgruntled – not to mention confused and jittery – about the Department of Labor’s pending rule requiring FAs who advise on employee-sponsored and IRA retirement plans to abide by a fiduciary standard. The controversial regulation is likely to become a fact of life as soon as early April and implemented in September or October.
Rollovers will be subject to the most rigorous changes, Lou Harvey, president and founder of Dalbar, the Boston-based financial services market research company that evaluates firms and practices, told ThinkAdvisor, in an interview shedding light on the DOL rule. Dalbar conducts studies on service quality and regulatory compliance and does annual research into investor behavior.
“Success in the rollover market will almost certainly require BICE,” Harvey stresses, alluding to the DOL rule’s Best Interest Contract Exemption, which requires advisors to sign contracts with clients that indicate potential conflicts of interests concerning recommended investments.
The BICE allows advisors to retain commissions as well as 12b-1 fees, revenue-sharing agreements and noncash incentives, among other compensation, but it must include disclosures of all indirect compensation.
Violating the BICE will mean damaging lawsuits against FAs and their firms, Harvey says. Regulators anticipate that “one or two of every advisor’s clients will take the advisor to court if he/she fails to live up to the contract terms,” he writes.
How to avoid BICE? Give no advice or else forfeit traditional means of compensation. Only if advisors promise or imply to provide advice must they execute a BICE contract.
Under the rule, advisors must show written proof that their recommendations were in the client’s best interest by keeping extensive records relating to their clientele’s personal circumstances. Obtaining this information will necessitate a substantial discovery process, much more thorough than typical current efforts.
Dalbar, which is offering BICE self-study courses on the complexities of and systems for complying with the DOL rule, is conducting beta tests on an automated, cost-reducing discovery system.
The estimated cost for BICE compliance is between $600 and $1,500 per client annually, according to Harvey. So for an advisor with, say, 300 clients, that could total as much as $450,000 a year.
Who will foot this cost? Clients, says Harvey, president of the independent Fiduciary Standards Board, which focuses on expanding use of the fiduciary standard. Dalbar offers the Registered Fiduciary Certification, a non-mandatory designation that prepares FAs to comply with regulatory fiduciary requirements.
ThinkAdvisor chatted recently with Harvey, who is based in Boston. He sees the DOL rule as “a new engine for business growth,” especially for advisors who use the fiduciary standard across the board rather than limiting it to Employee Retirement Income Security Act (ERISA) plans and IRAs. Here are highlights of our conversation:
THINKADVISOR: Under the DOL rule, what are advisors’ options?
LOUIS HARVEY: The basic choice is whether financial advice will remain a core part of their business. One level is to become a fiduciary under the Employee Retirement Income Security Act [ERISA] without conflict. The second is being an ERISA fiduciary where the conflict of interest exists but is neutralized through the best interest contract exemption (BICE). The third option – and minimum standard – is pure educator, a Series 7 broker delivering no advice, in which case, you can’t say you’re an “advisor.” You can just educate customers and put things on the table for them to buy. What are some of the required disclosures on the BICE contract?
Potential conflicts of interest and indirect compensation, such as 12b-1s, the payments that mutual fund managers make to advisors for selling their product.
Results of an Eaton Vance survey of 1,000 FAs, released last month, show that 71% of FAs don’t understand the DOL rule. Only twenty-nine percent say they fully understand it.
Seventy-one percent is too low: I’ve not come across a financial advisor who has in-depth knowledge of even the [basics]. The folks who say they understand it still have more to learn.
How will the DOL rule phase in?
The first stage of the conversion is insuring that new business meets the requirements. So there’s a provision that forgives your past sins! That is, you don’t have to go back and fix every client account and move them all to BICE [if that’s the option you’ve chosen] on Day One.
But you still have to do so later?
Yes, if you want to continue earning money from them.
What’s the biggest change for advisors as a result of this rule?
Opposition has run in a number of ways. For instance, nothing is going to change or advisors will no longer be able to handle small accounts. That’s just an excuse and an unreasonable assumption. There’s no way that the investment community will sweep half their accounts out the door because they’re no longer profitable. Certainly, that’s one of the [industry’s] objections that caused rejection of its objection to the rule.
What will be impacted the most?
Rollovers, potentially the largest growth area. The conflict-of-interest portion of the regulation says if you recommend that a client move their money out of a 401(k) plan, that that is a fiduciary act. Therefore, you must prove it was in the client’s best interest. You have the burden of offering concrete proof.
It gets really tricky; for example, when the investment in the plan outperforms the rollover and the client says, “You moved me out of that plan and put me in this leveraged investment, and I lost my shirt!”
You say that the rule can increase an FA’s business. How so?
Advisors that adopt these standards fully will take away business from those that choose not to and hide in the corner. The advisors that will win business are the ones who go out and pound the pavement, telling clients, “I’m going to be acting in your best interest, and I’m asking you to consolidate your assets with me. Bring me your business because you can trust me.”
How can the rule help commission-based advisors?
It can certainly help them leverage their business. If you tell your clients, “I’m acting in your best interest, and I’m here to help you,” that’s a competitive advantage. If an [entire] account is under the client’s-best-interest standard of care and you’re selling against someone who’s limiting a best-interest arrangement to IRA accounts only, you have the advantage.
This regulation is intended to produce better investment recommendations. But who will pay for all the additional requirements?
They probably aren’t aware of this.
That’s the absolute truth. Nobody, including the regulators, have actually sat down and said, “Who will bear this cost?” – because as soon as you ask that question, it becomes obvious. Do you think the wirehouses are going to bear the cost? No – it’s going to end up costing the consumer more. Granted, they’ll have a better deal because of the best interest [standard]. But there’s no question that they’ll bear the cost of that. Just how will the rule change life for FAs?
The actual impact is a little subtle and has to do with their day-to-day routine. The regulation puts front and center the need to learn what the client’s best interests are. [With BICE], they have to sign a contract with the client saying, “I’m acting in my client’s best interest” – and if I’m not, I’m in trouble.
How will advisors determine what that best interest is?
It won’t be from just doing a risk-tolerance questionnaire. It’s far more complex than only knowing that the client’s best interest is “to retire.”
What sort of client information does the FA have to dig out, then?
It’s necessary to discover and document a great deal about his or her personal circumstances. So you can’t use a simplistic approach, such as asking them to pick one of a few investment categories. Imagine the client’s argument: “I don’t know what it means to be a ‘moderate investor’!” So the onus is on the advisor to talk in terms the client can relate to and understand.
How will the rule affect FAs who sell annuities?
They are almost by definition going to be registered reps. There’s an exemption for people who sell only fixed annuities, but that universe is really small.
You write that under the rule, “advisors must make no misleading comments.” This is nothing new.
Though under FINRA [Financial Industry Regulatory Authority], advisors are prohibited from making false and misleading statements, the Department of Labor included that in their rule because if someone is operating outside BICE and says, “I’m here to advise you,” it will give them an instant violation.
How will the new rule be enforced?
One of the express goals of the BICE contract that advisors are being forced to sign was that the Department of Labor won’t enforce it. It’s a simple contract that falls under contract law. So clients can go to their local court and say, “This advisor violated the contract I have with him — he didn’t do what it said.”
And the parties don’t need to go to FINRA arbitration.
Right, nor through the really complex ERISA process.
You write, “To avoid the dire consequences of [client] litigation and regulatory action, the advisor must be able to prove that [their] actions were in the client’s best interest and that certain requirements have been met.” What are the “dire consequences” of regulatory action?
The Department of Labor shutting down your ERISA business and the IRS shutting down your IRA business. You don’t want to mess with either of those!
How will the rule affect existing RIAs?
Most RIAs are dually registered: they have both conflicted compensation and unconflicted compensation. On one hand, they’re an RIA but on the other, they’re a registered rep earning commissions and other conflicted compensation.
What will the rule mean to RIAs who aren’t dually registered?
They’re already operating on a fiduciary standard. The biggest impact for them involves rollovers because the rules about them will change. So existing RIAs that are not dually registered aren’t upset about the rule?
I haven’t heard them complaining much. Most of the complaints are from the commission-driven folks because the bulk of their business is threatened unless they either stop giving advice or go under BICE. In the broad scheme of things, you can [rank] the change that brokers have to make at 100 and the change RIAs have to make at 5.
What about FAs who have discretion over their clients’ accounts?
That’s the full fiduciary. You don’t need BICE if you have a discretionary arrangement because you have no conflicts of interest. Advisors who decide to go down that path will have to contact all their clients and tell them that they should switch to a discretionary relationship. If you have some untrusting clients, that will be a challenge.
What’s the genesis of the DOL rule? The proposal that surfaced last year seemed sudden.
The Labor Department has been trying to do this even before Dodd-Frank [was proposed]. A version of it was included in the Pension Protection Act of 2006. So DOL has been working in this direction, recognizing that the fiduciary rules they had for ERISA and IRAs weren’t achieving their hopes concerning clients’ best interest and eliminating conflicts of interest.
So the DOL put some speed on it?
I guess it was [partly the issue] of the Obama administration getting the Dodd-Frank [fiduciary] rule out in time so that the next administration won’t reverse it. But the answer to that is [they won’t]. The Dodd-Frank version hasn’t even seen the light of day yet. The [fiduciary aspect] involves a long rule-making process, which the Labor Department has been working on for the last five years. The Obama administration would have to do that in the next five months, which is not likely.
Why should FAs need training in the DOL rule?
Without additional training, the risk is enormous that advisors are going to get themselves entrapped.
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