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Are You Conflict-Free?

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The most appealing position statements in financial services businesses profess a freedom from conflicts of interest. At the same time, this position may be the most difficult to prove. The Department of Labor’s newly released Conflict of Interest rule is poised to raise the bar on the fiduciary standard even higher.

The DOL finally released its long-awaited rule redefining who is a fiduciary under ERISA on April 6, giving advisors until Jan. 1, 2018, to come into compliance. 

The DOL’s regulation of retirement business will clamp down on advisors who seem to serve their own interests before the interests of their clients. News of these additional requirements has stirred a hornet’s nest throughout the financial services industry. The DOL’s emphasis on a fiduciary standard of care likely will apply to the general delivery of advice in all of its manifestations, not just retirement accounts.

Acting in a client’s best interests is always the proper stance. Can you imagine a doctor proclaiming disdain for the Hippocratic Oath, which requires physicians to swear by certain ethical standards? Yet how are these standards defined in the financial services arena? The DOL’s regulations identify an ethical tipping point in the payment of commissions to brokers who sell financial products.

The DOL seems to view the payment of commissions as self-dealing and conflicted, as advisors may be incented to trade to generate income. They believe that conflicts may be mitigated by contractual obligations that will create a higher standard of client care. Pressure on the industry is causing many to shift to an advisory or, as some broker-dealers term it, fee-based model to diminish the threat of self-dealing.

RIAs ‘Validated’ by Rule

Registered investment advisors (RIAs) who are fiduciaries under the Investment Advisers Act, and probably already act as fiduciaries under ERISA, are thrilled to point out how their fee-only approach positions them as client advocates rather than product advocates. Consequently, they feel validated by the government’s efforts to control conflicts of interest in the professional management of retirement savings. Now RIAs must surrender one of their best differentiators to a competing business model.

Many contend that “what’s good for the client is good for the profession” and assume that there is enough business to go around. However, before RIAs become too self-righteous about their business models, this community must examine its own conflicts.

If you accept dinner with a fund company or tickets to an event from a technology provider, does this create a conflict? If you accept a referral from your custodian in return for keeping the assets on their platform forever, are you acting in your client’s best interests — or your own? If you charge fees based on the amount of assets a client brings, are your interests truly aligned? If you talk your client out of paying down their mortgage, thus keeping more assets under your management, do you disclose how this benefits you?

One of the greatest conflicts I see in financial services occurs when the client pays a fee based on the value they bring instead of the value the professional offers. How does a person’s net worth dictate the amount they should pay? That is like a doctor charging by the pound. In this comparison, both professions would be equating size to complexity, and the amount accumulated (in dollars or pounds) to the effort needed to serve the client.

The financial services industry is in dire need of a reputational facelift, but the new regulations raise some important questions about how the business of financial advice will be conducted post implementation. It would be a mistake for RIAs to think that a new fiduciary standard for the management of retirement accounts will not influence their business, including the vehicles they use such as options and derivatives; differentiated fee-based pricing for equities, fixed income and cash; or even actively managed mutual funds. If there is a massive shift to passive investment vehicles, will active managers provide enough thrust to lift the indexes that the passive vehicles depend on?

Second Rule in the Works

The Securities and Exchange Commission is currently working on its own rule to create a uniform fiduciary rule to apply to brokers and advisors, but SEC Chairwoman Mary Jo White has declined to commit to a timeline for when a rule might be released. White said in March that while the two agencies would “talk about coordination and making our rules and the regime as compatible as possible,” it may not be possible to have matching rules. “You try to make them land identically if you can, but [the SEC and DOL] are separate agencies, [with] separate statutory mandates,” she told the House Subcommittee on Financial Services and General Government Committee on Appropriations.

More clarity is required, but I see two separate government agencies with two different definitions of fiduciary standard: one being a rule and one being a guidance policy. This will create complexity for RIA firms including new compliance standards, new tests for managing certain assets and perhaps new certifications and examinations to ensure the business is competent and compliant.

Up until 1998, with a short interruption imposed by the federal government, motorists were allowed to drive on Montana highways at the speed limit of their choice as long as it was reasonably prudent. As soon as they crossed into Idaho or Wyoming, they had to adhere to the 55- or 65-mile-per-hour speed limit that governed drivers in those states. Montana said, “Use your judgment as to what’s reasonable and prudent.” The other states said, “By law, we will tell you what’s reasonable and prudent.”

In this comparison, Montana’s system represents the fiduciary standard under the SEC, while the standard under the DOL resembles Idaho’s law-based approach. How will you govern the fiduciary behavior inside your firm? Will the new standard cause you to change your strategy in order to go under the radar?

These questions are academic at this point as we don’t know how clients, advisors and supporting organizations will adjust their ways of doing business. We can assume that the push for greater transparency, fewer conflicts of interest and more complete disclosures will improve the behavior of those motivated purely by the sale of a product and instill more faith and confidence in this industry.

Regardless of how the DOL regulations are interpreted and how the industry implements and monitors these changes, consumers should benefit from greater transparency and objectivity when they invest for their retirement.

Advisors themselves, including those who shift from a brokerage to a fee-based model, must check that conflicts are adequately disclosed or resolved and ensure they have an adequate command-and-control structure in place to manage the fiduciary standard under both the SEC and DOL.

— Read more about the DOL’s landmark rule on our DOL Fiduciary Compliance homepage.


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