So be it: the Department of Labor released its fiduciary rule on April 6 and closed the supposed retirement-advice loophole. But in mandating what it deemed that the Employee Retirement Income Security Act of 1974 (ERISA) lacked, the DOL imposed a whole new layer of regulation and surveillance on the financial services industry.
The immediate task is for firms and advisors to untangle knotty questions raised in the rule, which holds FAs to a fiduciary standard of care when giving clients advice on 401(k) plans and IRAs, among other retirement accounts.
Beyond that, to be sure, the 1,000-plus page rule foreshadows the future regulatory environment: a fiduciary standard for all advisors that encompasses the full range of investment products and services.
The rule — first phase of implementation, effective April 10, 2017; second phase, Jan. 1, 2018 — is expected to trigger a number of important business shifts in the retirement space. These include gravitation away from high-priced, high-commissioned products, a reduced level of IRA rollover recommendations, a stepped-up move to fee-based and fee-only advisor compensation, more holistic planning, heightened robo-advisor business, an increase in compliance apparatus and additional advisor training programs.
“You won’t see as heavy an emphasis on capturing IRA rollovers as you do today, and sales of variable annuities will be slowed down,” says Blaine Aikin, executive chairman of Fi360, an organization providing fiduciary expertise to advisors.
Among further anticipated changes: consolidation among IBDs via a wave of M&As, the advent of brand-new innovative financial services firms designed to operate in the new regulatory world and a rise in the number of wirehouse breakaway brokers.
The extended implementation date is pegged to the best interest contract exemption part of the rule, aka the BICE. That’s the required contract between firm and client allowing advisors to retain sales commissions, as well as 12b-1 fees and other revenue-sharing arrangements and non-cash incentives, but which must include disclosure on all such compensation. Some firms may force the FA to be a party to the contract as well.
As precisely stated in the rule, advisors must “give advice in the retirement investor’s best interest, charge no more than reasonable compensation and make no misleading statements about investment transactions, compensation and conflicts of interest.”
Neither “best interest” nor “reasonable compensation” is spelled out. But advisors should be aware that violating BICE will mean damaging lawsuits against them and their firms. BICE poses the biggest challenges to insurance-licensed reps, brokers whose business is heavily transactional and small independent shops.
How to avoid the BICE bite? Give no advice. That, obviously, will result in forfeiting traditional means of compensation.
In a poll of the industry three weeks after the rule’s release, ThinkAdvisor found that nearly half (48.43%) the respondents felt so negative about the rule that they said the DOL should be sued for adopting it: “Yes. Get me a pitchfork and the District Attorney now — I’ll lead the charge,” they checked off. If it’s any consolation, the word “fiduciary” comes from the Latin meaning “trust” — certainly what FAs want to generate in client relationships.
The rule’s creation stems from the assumption that advisors put their own best interest before that of clients. The purpose of the BICE is to give investors a mechanism to hold FAs accountable. Clients have the option of resolving disputes trough either arbitration or in court. The latter opens the door to potential class-action suits. This is likely the worst aspect of BICE.
“In the event of a conflict, the fiduciary standard shifts the burden from the client to the firm. The jury is out as to whether or not wirehouses will embrace BICE as a way to mitigate risk,” says Matt Lynch, managing partner, Strategy & Resources, a financial services consulting firm.
The amorphous BICE wording troubles many industry participants, including, and perhaps especially, the wirehouses and other large firms.
“BICE is replete with ambiguity, leaving open litigation and interpretation risks [particularly] centered around … conflicts of interest, revenue sharing … and proprietary products — key hot button topics,” says a report that Citi Research, a division of Citigroup Global Markets, published six days after the rule came down.
The report continues: “The complexity of the fiduciary standard and ambiguity of BICE are likely to pressure margins from both lower revenues and higher expenses … BICE will result in lower sales of high-commission products (annuities, structured products…), which could pressure revenues and [which] tend to have higher margins than lower-fee product.”
Unknown indeed is if the wirehouses and other big firms will adopt BICE, which, though not so severe as in the rule’s original proposal — for instance, FAs just need to include a copy of the contract in the sheaf of other documents they provide rather than make the client sign it — is problematic largely because of its deliberate ambiguity.
“We need to decide where the potential friction points are in our ability to offer a brokerage IRA, a fee-based IRA and so on, and to make a determination as to how we’re going to approach them,” says a wirehouse management executive, who spoke on condition of anonymity because the person’s firm was still examining the rule.
The three other wirehouses and large firms contacted for this article declined to be interviewed because, they said, they had not completed analysis of the rule.
However, in a media conference call, Bank of America CFO Paul Donofrio said that, given the rule’s initial implementation is a year away, the firm expects little, if any, impact in 2016: “If you look at roughly the $2 trillion of [Global Wealth and Investment Management] client assets we have, outside of deposits, we see the DOL rule impacting less than 10% of those balances.”
Raymond James Financial issued a statement noting that its objectives in complying with the rule include “keep[ing] costs down for clients, and support[ing] … and protect[ing] advisors.”
According to the anonymous wirehouse source, “the big question is: will this dumb down the offerings that firms are willing to give around retirement accounts to, for example, a plain vanilla index-related fund that may be low-cost but not ideal in terms of asset allocation, particularly for high-net-worth investors? All the firms need to determine what kind of behavior they’re willing to permit that will be within the bumper rails of this rule.”
Wirehouses are indeed expected to reduce the list of products they permit reps to sell in an effort to protect themselves against the risk of lawsuits. In question would be high-priced, complex, less transparent products, such as variable annuities, that have inherent potential conflicts of interest.
Some fiduciary experts anticipate that the wirehouses will refrain from using the BICE and go almost entirely to level-fee arrangements, chiefly fees based on clients’ investable assets, as has been the general industry trend.
However, “more firms than you can imagine are contemplating fee-only, including one wirehouse, which is contemplating it seriously, and a large regional,” notes Louis Harvey founder-president of Dalbar, a financial services market research company that evaluates firms and practices. “The burden to comply with BICE is so onerous that it will give them a competitive disadvantage.”
The rule should increase the trend — for both firms and clients — toward automated, lower-touch options, such as robo-advisors. This is a main reason that Charles Schwab is “best positioned … to take market share in the post-fiduciary standard landscape” of the BDs that Citi Research covered in its report, which notes Schwab’s early adoption of and success with “robo-advice.”
In fact, “to prevent breach of fiduciary duty,” Citi points out, more firms will acquire or build robos to handle some of the rule’s added compliance challenges.
Because the DOL rule increases the potential for liability and litigation exposure, “firms must make a calculation as to what systems, protections and limitations they need to put in place to limit that exposure — because at the end of the day, a lot of the rule’s ambiguity is probably going to be resolved through litigation,” the wirehouse source says.
Right now, at least, much of the industry’s anxiety about the rule has been alleviated, although up ahead worse angst could be in store.
“In the short run, there’s great relief. But in the long run, [the rule] is a real problem because when markets go down, all this stuff has to be answered. Attorneys will be on the bandwagon to recover money that has been lost: ‘Show me how you acted in the client’s best interest!’” Harvey says.
To some in the industry, the rule is a virtual model of fairness. “I was extremely pleased with the results. For all intents and purposes, it doesn’t change my business at all,” says Harold Evensky, chair, Evensky & Katz/Foldes Financial, which 25 years ago Evensky turned into a fee-only financial planning practice.
The DOL rule is packed with exceptions, making its fiduciary standard less stringent than the one to which RIAs are held, according to Evenksy.
Meanwhile, some who championed the fiduciary standard for retirement-plan advice are disappointed. They think the final rule is watered down.
“Simplifying the rule became softening it. And the more it’s softened, the more the fiduciary standard ends up not being strictly enforced,” says Knut Rostad, president of the Institute for the Fiduciary Standard.
One component that was removed required advisors to issue one-, five- and 10-year reports of anticipated performance results to clients annually. That excision was welcomed by many, although stripped out along with it was a stipulation to inform clients of total costs upfront. Now FAs need only direct folks to a website to discover for themselves how the costs are calculated.
“It’s worse than slippery. It’s just awful,” Rostad says.
The rule means that billions of dollars must be spent on expanded compliance systems and department employees. Big firms probably won’t feel the pinch much. Other entities, especially many IBDs and independent advisors, will be under cost pressure, some markedly.
Even large, successful independent RIAs may be squeezed.
“Compliance is my biggest expenditure other than human capital. And now have three masters to answer to — FINRA, the SEC and the DOL,” says Ron Carson, founder-CEO of Carson Wealth, with about 80 advisors and 38 offices nationwide.
Because of the anticipated move away from high-margin products for retirement investing, smaller independents who operate proprietary models or those who conduct most of their business on the low end could see significant profit-margin erosion.
To protect themselves against the risk of lawsuits, wirehouses will likely reduce the array of products they allow reps to sell.
“Entire brokerage firms may see a dramatic reduction in revenue as high-commissioned products are no longer sold to the degree they once were,” says Ric Edelman, CEO, Edelman Financial, whose independent financial planning firm manages more than $15 billion in assets for 30,000-plus clients.
“Many of the firms generate a majority of their revenue from commissioned products. Some have 100% of their revenue from products such as non-traded REITS, life insurance or equity-indexed annuities that pay 8% commissions,” Edelman continues. “It’s highly unlikely that those products will survive the fiduciary standard.”
It’s also expected that firms’ increased costs will be passed on to clients.
“There’s a bit of folly in folks’ discussion about reducing fees. People are going to have to raise them to cover the cost of being in the business; otherwise, they’re going to go out of business,” Harvey says.
The DOL will least impact independent firms that operate as RIAs, including those supporting hybrid or dually registered FAs. They already abide by a fiduciary standard.
Product-agnostic advisors compensated with an hourly fee won’t feel much burn, though they’ll have more fiduciaries competing with them.
“We have much less of a transition to the new reality,” says Sheryl Garrett, founder of The Garrett Planning Network, whose advisors work with clients on an hourly, fee-only basis. A greater emphasis on retirement planning and distribution will be the order of the day for Garrett planners. Also upcoming is a change in “how [their] hours [will] be spent: instead of lots of sales-type meetings with clients, there will be a lot more consultative meetings not specifically related to investments — yet,” Garrett shares.
Most business models will face what Citi Research has dubbed the “Consideration Trifecta” — a tradeoff between fees, liquidity and higher risk/alpha generation — though with greater potential for litigation.
Under the rule, firms are permitted to sell proprietary products. But “the incentive has been taken out of incentives,” Harvey comments, alluding to proprietary products and indirect forms of compensation.
FAs whose business is chiefly in IRA rollovers are advised to be circumspect. “To roll [retirement savings] out of a plan, they’ll have to show ‘process and proof’ with documentation that they’ve made the recommendation in the best interest of the client,” says Marcia Mantell, president of Mantell Retirement Consulting, which supports financial firms. “The wirehouse home office ‘mothership’ will have to do more oversight.”
In the not-too-distant future, the DOL rule will result in bad brokers fleeing the industry, fewer would-be advisors entering the industry and an uptick in wirehouse breakaways.
For now, though, “the bottom line,” according to Garrett, is: “The rule is a catalyst to propel the industry to the place it was going naturally. The DOL is just pushing us there faster.”
— Check out Prohibited Transactions in a Post-Fiduciary Rule World on ThinkAdvisor.