Since the Department of Labor’s April 6 publication of a finalized fiduciary rule for investment professionals who advise on retirement plan accounts, industry stakeholders have begun combing through the mammoth document. Their top concern: whether the DOL made enough changes to the earlier (and widely criticized) draft proposal as to be rendered workable.
The initial assessment: The DOL proved responsive to prior critiques on the margins, streamlining, clarifying and delaying execution of regulations that advisors and insurers earlier deemed onerous. But the finalized rule leaves the core of the new fiduciary requirements intact for those advising on retirement accounts governed by ERISA (The Employee Retirement Security Act of 1974). To boot, the regulations now also encompass products not addressed in the draft proposal.
The result is changes to producer compensation, product portfolios and compliance costs that will prove transformative to the industry.
Common among the industry’s reactions to the new rules is a mix of approval and caution. They’re relieved the regulations are not as severe as under the earlier draft, but remain concerned as to long-term impact on advisors and clients.
“It remains to be seen how the practical application of the rule will affect middle-market consumers who need retirement planning advice and services,” says Jules Gaudreau, president of the National Association of Insurance and Financial Advisors. “NAIFA is pleased to see that the DOL has incorporated our suggestions on the effective date of the rule, grandfathering of existing clients, and timing of when signatures are required on best interest contracts.”
Delving into the verbiage
The DOL rule mandates that advisors put their client’s best interest first by providing impartial retirement plan advice. To receive so-called “conflicted compensation” (commissions, trailing commission 12b-1 fees, etc.) on product sales they must qualify for a best interest contract (BIC) prohibited transaction exemption (PTE 84-24). The exemption requires compensation and fee disclosure, public-facing websites detailing contract disclosures and policies/procedures adopted to mitigate against potential conflicts, plus a written understanding between client and advisor of a fiduciary duty.
The exemption tentatively allows sales of proprietary products if they’re in the consumer’s best interest. Advisors may also receive “reasonable” commissions (as yet undefined) for using annuity contract or mutual fund shares. In a departure from the earlier draft, the finalized rule provides some relief for advisors. Prominent among the modifications is the extended deadline for implementation.
In a phased approach, the DOL lengthened the compliance timeline under the rule to one year from the original eight months. In April 2017, the “broader definition of fiduciary will take effect, but to take advantage of the BIC exemption, firms will only be required to comply with more limited conditions, including acknowledging their fiduciary status, adhering to the best interest standard, and making basic disclosures of conflicts of interest,” the DOL states in a fact sheet released in conjunction with the final rule. The revised language of the rule also provides for these changes:
- Greater clarity for participant communications.Under the final rule, education is not considered advice. So financial professionals and plan sponsors can continue to provide general education on retirement saving without triggering fiduciary duties.
- The availability of the best interest contract (BIC) exemption for advice to small businesses that sponsor 401(k) plans. To streamline and simplify requirements with the exemption, the final rule eliminates the contract requirement for ERISA plans and their participants and beneficiaries. Firms must still acknowledge in writing that they, and their advisors, are acting as fiduciaries when providing investment advice to the plan, participant or beneficiary.
- A safe harbor for recommendations to certain plan sponsors. The DOL will not tag as investment advice (nor will it require a BIC exemption for) recommendations to plan sponsors that manage more than $50 million in assets. This compares with $100 million in assets under management in the prior draft.
- A streamlined “level fee” provision in the BIC exemption. The new provision will enable advisors who receive only a “level fee” for their recommendations to dispense with a BIC contract. They need only document that advice, including a recommendation to roll assets from an employer-sponsored plan to an individual retirement account, are in the client’s best interest.
Not all of the DOL’s revisions are advantageous. Unexpectedly, the final rule extends the fiduciary standard to financial professionals advising on IRAs and fixed indexed annuities (in addition to, as previously envisioned, defined contribution and defined benefit plans). As under the earlier draft, variable annuities are subject to the new rules.
While softening the impact of the prior language, the finalized regulations portend big changes for retirement plan stakeholders. According to a first quarter report of Cerulli Associates, “The Cerulli Edge Retirement Edition,” the requirement to disclose variable compensation as part of the BIC exemption (BICE) will likely result in a “period of product and platform innovation.” To sidestep the BICE requirements, the report notes, broker/dealers will begin serving small retirement accounts on a “flat-fee basis.”
The change will also prompt life insurers to reduce VA expenses and commissions so as to be consistent with compensation for other financial products, including mutual funds and other fee-based managed account platforms.
A March 23 “Sector Comment” from Moody’s Investor Services echoes Cerulli’s outlook. “The new rules will accelerate the shift from commission-based accounts toward fee-based accounts,” the report states. “Firms that already incorporate level fees or compensation that does not vary by investment recommendation … are early winners, since these firms will have less need to defend their recommendations or manage the expectations of current agents/distributors.”
Not all clients already paying fees for advice will necessarily see lower charges. Caleb Callahan, chief operating officer and executive vice president of Valmark Securities, says affluent clients of registered investment advisors (RIAs) should expect some lowering of investment expenses because of increased fee transparency under the rule.
A dip in fees may, however, not be operationally feasible for individuals with small retirement accounts. Absent such a decline, Callahan warns, asset under management (AUM) charges could render investment advice unaffordable.
As with compensation, the new regulations will impact product pricing. Ben Yahr, a senior manager at Ernst & Young (EY), says the pricing modifications will cut across the spectrum of investment products in the qualified plan space: variable and fixed indexed annuities, plus mutual funds.
Moody’s expects the product streamlining to extend to low-cost and passively-managed investment products, such as those that track major indices like the S&P 500. Jefferson National President Larry Greenberg agrees, adding that the product evolution will prompt more retirement advisors to narrow their VA portfolios to low-cost products that, while charging a low flat-fee, either jettison (or incorporate into fee structure) popular living benefits, such as the guaranteed minimum accumulation, withdrawal and income benefits.
That would dovetail nicely with the product orientation of Jefferson National, which caters to RIAs and other financial professionals with fee-based practices. The company’s signature VA offering, Monument Advisor, avails buyers of more than 350 investment options for a flat, $20 per month charge.
Whereas Monument Advisor comes without income guarantees, traditional retirement savings vehicles like 401(k) and 403(b) plans may start to incorporate them. EY Executive Director Daniel Bender suggests the rule may spur wider market adoption of retirement products that provide a guaranteed income stream. Example: so-called “contingent deferred annuities” (mutual funds or managed accounts) that incorporate insurance to guard against longevity risk.
Others believe the DOL regulations will result in a net decline in product choice as insurance and investment vehicles are stripped of features to mesh with a fee-based chassis. This dumbing-down would seem to run counter to the DOL’s high fiduciary standard.
“To the degree advisors won’t be offering other kinds of products or services, then almost by definition they’re failing to act in their clients’ best interests,” says Judi Carsrud, NAIFA’s director of government relations. “All the DOL rules will have done is to narrow retirement planning options. I don’t see how that helps consumers.”
Nor will they benefit from cost-shifting: advisors who deem it necessary to pass onto clients added costs of doing business to adhere to the new regulations. For even the best-positioned financial service professionals now operating under a fiduciary standard, the finalized rule’s increased reporting, recordkeeping and disclosure requirements will entail adjustments.
Valmark Securities’ Callahan says the broker-dealer has established an RIA firm to handle the anticipated increase in costs and time devoted to compliance. The additional workload — separate disclosure forms for qualified and non-qualified plans, consulting with outside counsel, plus updating of websites, contracts and literature to reflect the new regulations — could require “five to 10 times” more paperwork than Valmark now devotes to compliance.
“The new regulations are intended to help make the giving of investment advice more transparent and simple for average savers, but I think they’ll only make business more complex,” says Callahan. “We needed to start a new company to try to bring order to the chaos.”
For other broker-dealers less prepared for the DOL rule, the transition to a fiduciary world could be more challenging — particularly those who have stayed clear of securities. In an April 7 comment letter, Fitch Ratings said the inclusion of fixed index annuity writers in the BIC will be “more onerous” for FIA writers than for VA writers who have already devoted “considerable time and effort” to preparing for the change.
One line item to factor into the increased burden: a likely rise in premiums for errors and omission (E&O) insurance needed to guard against potential lawsuits. “Implementation will be more challenging for firms unaccustomed to complex regulation and/or for smaller firms lacking the resources to make the necessary … investments,” Moody’s report states. “We therefore would expect these companies to exit affected business segments or potentially sell out to large players.”
Joseph Adams, an attorney and partner at McDermott Will & Emery LLP, says this shift is already underway.
“We are seeing smaller firms getting out of the market,” he says. “Some have sold their practices because operating under the new rules is no longer feasible.”
Is software the answer?
Those who believe otherwise will be looking to new technologies to help reduce costs and keep fees tolerably low for clients with small accounts. Among the solutions: software tools that can automatically recommend asset allocations and manage portfolios. That translates to less billable time spent on an investment plan, and savings that can be passed onto clients.
Valmark Securities’ Callahan approves of such “robo advisors” — so long as they don’t substitute for the handholding of a live financial professional. His fear is that small retirement account holders, unable to afford the services of a fee-based advisor, may be ill served using these automated investment services on their own.
“For those who believe these robo advisors mark progress, then mission accomplished,” says Callahan. “But if we really want to help people save money and stay the course during volatile markets, the one thing we know from academic research on behavioral finance is that people often make decisions not for logical reasons, but emotional ones.
“I’m very concerned about this move to create electronic platforms and robots,” he adds. “It’s not going to solve America’s retirement savings crisis; it will only compound the problem.”
Automated solutions, Callahan and others contend, will prove less effective than advisors in delivering an essential service: tutoring clients in the fundamentals of financial planning, how to use investments to achieve retirement goals, and why they need to stay disciplined to attain their objectives. That educational role is, laudably, not deemed investment advice under the final rule.
But before schooling clients in products and plans, advisors may need instruction of their own to ensure they’re adhering to the new regime. To that end, says NAIFA’s Gaudreau, the association is providing “training and education” to help bring members up-to-speed on the DOL rule’s requirements and restrictions.
Also filling in the knowledge gap are institutions offering coursework in insurance and financial services leading to professional designations. Craig Lemoine, executive director of The Center for Financial Security at The American College and an associate professor of financial planning, says advisors will need to “meet a high bar” to continue practicing in the retirement plan space.
“All advisors will need to develop a deeper understanding of sources of retirement funds if suggesting that a rollover form a profit-sharing plan is actually in the best interest of the client,” he says. “And does [the rollover] meet fiduciary standards? It may not. That changes the landscape.”
Indeed, the more than 1,000 pages of regulations addressing conflicts of interest in retirement advice could transform the market in unforeseen ways. Long-held objectives of the DOL — reducing investment costs, improving product and plan recommendations, raising the standard of care for financial professionals who advise consumers — are evident throughout the DOL’s imposingly long document.
But whether those aims will be realized is hardly certain. The retirement industry’s stakeholders — life insurers, mutual fund providers, plan sponsors, advisors and the investing public — have a lot riding on the outcome.