The DOL fiduciary rule was a hot topic at LIMRA’s retirement industry conference earlier this month in Boston. The association presented a panel about the rule during one of its general sessions hosted by Bob Kerzner, LIMRA’s CEO. Kerzner opened the session by predicting the rule will create seismic change throughout the industry.
“In my 43 years in the business, I cannot think of anything I think will have as broad an impact as what we will see over the next 3 to 5 years coming from the rule,” Kerzner said.
The panel focused on perspectives and predictions about the rule from the distribution, manufacturer and legal points of view.
The three panelists who participated in the panel were:
- Jim Jorden, senior partner with Carlton Fields Jorden Burt LLP
- Nick Lane, senior executive director and head of U.S. life and retirement products at AXA, and chairman of the Insured Retirement Institute
- Scott Stolz, CFP, senior vice president of Raymond James
Kerzner posed a series of 14 questions to the panelists, ranging from predictions about the impact the rule will have on distribution, to how annuities will be affected and what legal challenges may be in the offing.
Continue reading to find out the panel’s thoughts and predictions about the rule. (Note: Some answers have been paraphrased for clarity.)
Bob Kerzner: First, I’d like for each of you to comment on any part of the regulation you find particularly interesting.
Scott Stolz: If you think about what the department’s really done here is they said, “You guys told us that you can offer and recommend products and get paid commissions and other revenue streams — some of which cost more than other alternatives, maybe pay more commissions or may be liquid or not liquid — and you can do all of that and still put the client’s best interest first, so we’re going to take you at your word and we’re going to give you a means to do that through the best interest contract exemption.” There are certain conditions with that. They’ve basically thrown down the gauntlet in my mind to be prepared to prove when somebody challenges you in court that you were able to do that, and that will cause huge changes in how we do the business and how we oversee it. Over the next 12 months, every firm is going to have to think about every time they recommend anything that pays more commission or more compensation than somebody else, how do they make sure it is indeed in the client’s best interest and how do they document that so that if they are ever challenged, or maybe more appropriately when they are challenged, they can prove that they put the client’s best interest first.
Nick Lane: I’ve gone through the three phases with this rule. I went through denial, then anger and now I’m at acceptance. I think the current version is moderately better than the original proposal. Within the rule I would say you have the good, the bad and then the unclear. But the most interesting part of this rule for me is they’ve said if you touch ERISA assets, you’re going to be a fiduciary. The first order of consequence of what it means for annuities or other products I think is pretty clear. It’s the second and third order of consequences that people are now discussing. Anything that operates in this domain, you’re going to have the debate of does that expose you to a fiduciary liability? When we go through our legal counsel they will say, “Well this is how the rule is written, but the real question is how is it going to be interpreted by a jury five years from now?”
BK: Jim, I think you had some strong opinions on whether the DOL overstepped what you might perceive as its legal rights and historic purpose?
Jim Jorden: I believe that they really stretched out well beyond any reasonable basis. I understand that as a practical matter, particularly after Dodd-Frank, there’s going to be a fiduciary standard that’s applicable throughout the industry either from the SEC or from the Department of Labor associated with the sale of investment products. That does not give the DOL the authority to create a brand new cause of action, which was done under this regulation, enforceable by the purchaser in state court and in arbitration. That particular step taken by regulation by a federal agency is beyond I think the authority they had — among other reasons why the rule has problems.
BK: Nick, over half of the retail annuity business is IRA rollover, so what’s your prediction about the impact of the rule on sales of annuities?
NL: We had publicly disclosed in the original ruling that it would be the worst-case scenario. We would now say it’s a moderate impact. I think it impacts anybody in the qualified space. The bottom line is the complexity is going to go up. Litigation is going to go up. The demand is still there though. And so people are going to continue to innovate to try to figure out how to tap that demand. I think in the short-term people are going to figure out how to use the Best Interest Contract (BIC) exemption. I think that’s a short-term solution, and I think in a long term, you’re going to see a lot of evolution and transformation in terms of the way these products are structured and how we meet those needs in new ways.
BK: Scott, it’s been hard to get independent producers to sell more annuities the last 3 to 5 years. How do you see this making your job even tougher to get retail producers to sell annuities?
SS: What we’ve seen over the past 12 months is a huge shift in our annuity mix. A year ago, 60 to 70 percent of the annuities we did at Raymond James were in the fixed and indexed category. Today that has completely flipped. Last month, only 33 percent of what we did was in the variable annuity space, and variable annuity sales over the past 3 months are down about 25 percent. I think that’s pretty much in line with what the industry is seeing overall, whereas both fixed and indexed product sales have more than doubled over the last 12 months. It’s more than just this rule in my view. I think there’s been a shift with investors toward more conservative investments, and every time the market goes down 10 percent, they seem to shift a little bit more. All of the momentum is clearly on the fixed and indexed side.
So, what happens now, particularly since indexed annuities have been moved out of PTE 84-24? Everyone’s going to find a way to utilize this BIC exemption so they can continue to sell products and maintain as much of the business model as they currently have. However what they are really going to have to think about is what is the advisor going to choose to do for new recommendations going forward? I believe the process we’re going to build around almost all IRA recommendations, regardless of the product, because of the differential compensation, is going to be very similar to the process we have today with 1035 exchanges, and that’s going to be a tremendous amount of hoops the advisors are going to have to jump through. It seems likely they’re going to say, “I’m not going to do this. Its not worth my time and the trouble.” Any advisor that does that will become a fee advisor only.
So then the question on the annuity side is, how much annuities can we sell if commissions are minimal and have to be sold in an advisory account. To date there have been no successful efforts with that, however to date there’s always a commissionable alternative. Once that commissionable alternative goes off the table for that advisor, how many annuities do they need to sell? The need is greater than it ever has been so I think there will be a stretch where annuity sales of all kinds drop dramatically, but as advisers get used to the new model, I think that annuity sales will come back particularly on the fixed and indexed side because if you take out the commissions the pricing gets better. The pricing the client is going to see on the contract itself will be better and should make it easier and more acceptable.
BK: As you think about RIAs, we’ve not had much luck as an industry getting those folks to sell annuities. Is there a way to make lemonade out of lemons here with new kinds of products with very different fee structures to open up the market to new producers?
NL: I think there was a premise going in that fee-based was going to be a little bit of a safe harbor, but fee-based is now going to be subject to BIC Lite. If you have any differential in compensation when you move it over, you’re going to have to explain why. So that’s a little bit of a caveat. I do think a lot of firms are discussing and beginning to think through fee-based. Most manufacturers have them. I think we’ve got the process but the demand wasn’t there.
BK: Jim, could you talk a little bit about the RAND Report, which certainly influenced DOL thinking.
JJ: The DOL commissioned RAND Corp. to do an analysis before they proposed the first rule. What’s interesting about the RAND analysis is it made two final conclusions. The first was there will be a substantial reduction in advisors as a result of this rule. The second was that after studying this rule, they couldn’t conclude as a matter of fact on any basis and by any measure whether the rule will be beneficial or detrimental to the investment purchaser.
Fast forward to the actual study. There’s extensive analysis of insurance companies and they go through the cost-benefit analysis and on the last page they say they know independent agents will be impacted by this, but they don’t have any data so they passed on the impact on independent agents. There was nothing in the RAND study that supports what’s happening to the independent agents and there’s certainly nothing in the study that the DOL has done.
BK: Nick, when you think about the BIC from a manufacturer’s point of view, which things do you see as most problematic?
NL: The BIC is a contract that allows the enforcement to actually be trial lawyers. In the original rule, three people had to sign — the client, the advisor and the firm. A lot of firms came out and said if they have a call center and somebody calls in, they’ll have to sign a BIC. If they call the call center tomorrow and speak to a different person on the phone they’re going to have to sign another BIC. So the DOL changed the definition of the BIC and said it’s between the client and the firm. That way, one firm can have multiple advisers all helping the same person.
The second thing that’s really interesting is what is the definition of a financial institution? The definition of a financial institution is an insurance company, a bank, an RIA and a broker-dealer. So as we think through it from a manufacturing standpoint, it’s really with the eye to who are our partners and who are our clients. AXA advisors are going to be the person signing the BIC. The cost of figuring out those processes, procedures and systems is taking a lot of effort.
Our concern is I’ve got 690 other partners, and we’ve had a lot of convergence in the industry in the back office to create efficiencies, but you could conceivably come up with 690 different versions where they’re calling on you as the manufacturer saying I want this type of information. If a consumer owns your annuity and they call the manufacturer and want to change their asset allocation, the liability sits with the broker-dealer. You’re going to have to give me that information. I think we’re going to move through a little bit of a period of divergence where people are going to come up with different systems and different processes, and manufacturers are going to have to figure out how they support all those different models.
The second question is what about all the revenue shares between manufacturers and distribution platforms. How are people going to treat that? Clearly being on both sides, the distribution companies are going to say we want one level fee from all of our revenue-share partners, and guess what? We want the highest fee. And the manufacturers will say we also wnt one level fee and we want the lowest fee. That’s part of doing business. If you’ve got proprietary, you’re tied and you can affect how people are going to do business. If you’re doing it through third-party, you’re going to actually have to think about supporting many different models and there’s going to be some decisions if it’s still economic based on the way you have to support the business.
BK: Scott, from the distribution side, which parts of the BIC concern you the most?
SS: I mentioned earlier the similarities to 1035 exchanges and gave examples to clarify why I feel that way because I think it’s a good example. If you think about how we got to where we are with the 1035 exchange processes it came from regulators, primarily with FINRA concerned that too many 1035 exchanges were being done and motivated because of the new compensation the advisor would get for moving from contract A to contact B. FINRA never said “Here is what you need to do,” they simply said “You need to make sure that that transaction as in the client’s best interest.”
Over years, every distributor and to some extent the manufacturers, came up with this process that was kind of agreed upon and was refined over the years based on FINRA audits and fines. This is going to be the same process we’re going to go through here. Anytime an advisor is going to make a recommendation for an IRA where they’re going to get more compensation versus something else that a prudent person would believe that something else would make sense at a lower compensation, we’re going to need to document why this made sense — the pros and cons and what are the costs. All of that will have to be presented to the client and signed off on, and then we’ll have to keep that so that if years down the road someone says you didn’t do this right, you don’t end up in court.
The difference is now we’re not talking about just an annuity, we’re talking about anything that there is a recommendation where there is differential compensation, and that is going to create such a huge oversight burden. In the short term with the BIC exemption, to the extent that firms decide to use it, the biggest issue is going to be how do I manage this process and how do I justify the differential compensation?
BK: Nick could you spend a minute digging into BIC Lite. We all thought it was going to be simple and we’d just migrate to fee-based, but how did the BIC Lite sidetrack that?
NL: The original rule didn’t mention differential compensation. Now they say you can have differential compensation. They just don’t tell you how to do it. So when you talk about differential compensation, when you talk about reasonable compensation, when you talk about proprietary products, there’s clearly language in the rule that says you can do it, it just doesn’t give you explicit instructions on how. If you are an optimist, you say I know I can do it. I’ve got to be innovative. If you are a pessimist you say it’s going to be really hard. There was a premise from the DOL that said from a high level, we need to do something to better protect consumers. We have this great regulation, we protect consumers when they’re in their IRA, they’re getting institutional pricing and they’re getting fiduciary protection. And then some firm calls them up and enrolls them into an IRA and they’ve got the same product and now they’ve got retail pricing and they don’t have fiduciary protection.
JJ: I’d also say there’s two other issues with BIC Lite. One is under the rule, if you move to a fee-based level fee, you avoid all of the contract disclosure, all those requirements that would be otherwise applicable. However the rule does require that you give the person who you are making the sale to a signed statement that you are a fiduciary and that you will comply with the impartial conduct standards. The impartial conduct standards are twofold. One is the duty of loyalty prudence, which is the prudence standard. You’re still going to be subject to that. The second is that you are subject to the reasonable compensation standard. So you haven’t avoided those two standards even under BIC Lite. It’s quite a bit better, from the standpoint of what the administrative requirements are, but the substantive requirements are not significantly different.
SS: Today we kind of price things based on the product. Equity funds pay one commission, bond funds pay another, short-term bond funda pay another, variable annuities generally pay one commission, fixed annuities pay a little bit less. It’s all based on the product. Going forward it appears that from the way the rule is written that compensation is going to be based on the service provided and how complex the product is will play into that, but it can’t be solely based on the product. You won’t be able to justify an equity fund paying more than a bond fund. I don’t know how you can justify one variable annuity paying one commission and another paying another commission. So each firm is going to have to, even under BIC Lite, go through their process to determine here are the services we’re providing and here’s what we think is a reasonable compensation exchange for that service, and that in itself has the potential for repricing the entire industry.
NL: I think one of the things the industry has done a really good job of is when you think of cost to the consumer, think of the cost of the advice and don’t equate that with the cost of the guarantee. One of the big wins for the industry was they said if you are getting an income benefit or a death benefit, that has a cost. That’s different than what is the cost of the advice that’s being provided, so clearly it’s a very different value proposition between the passive equity fund and an insurance product. I think with insurance products, with more features and functionalities, you can make a documented case that this is the value of what you’re paying for. What you need to do is document, if the advisor is getting paid a different commission, the amount of effort and time. You better have a documented case that it takes me six times as long to sell an annuity and explain the benefits, and I provide X, Y and Z in service, if you’re going to pay a higher commission rate than with a passive equity that takes 30 minutes to sell.
BK: Jim, plaintiffs bar has to be dancing in the street when this was written, can you talk a little bit about that?
JJ: I was brought here to frighten the hell out of you guys. Under the BIC, the contract is entered into between the financial institution and the customer. It may require that any claim under this new cause of action be arbitrated. However it cannot deny the person the right to bring it as a class action, so either as a class arbitration or in court, you could be facing class actions.
Under the impartial conduct standards, namely the prudency standard, which has special language that says you must make the sale without regard to the compensation you are receiving, there’s absolutely no description of what that means. There were a lot of comments asking the DOL to be more specific. Obviously if someone makes a sale, it can’t be without regard to the compensation they are going to be paid. The DOL refused to provide any advice whatsoever as to that issue.
The second point is reasonable compensation. Your compensation has to be reasonable. Once again, the DOL was asked to give some standards on that and they refused to do it. The only thing they offered up was maybe we can get an independent third party to give you an opinion as to whether the compensation you are getting in this transaction is reasonable.