The dust is still settling from the recent Department of Labor fiduciary rules and most people I talk with don’t know quite what to make of it. Of course, that hasn’t put a damper on their willingness to express strong opinions — both pro and con.
Some have criticized the DOL for being overly accommodating to the industry. Others call it a government takeover of investment advice. A recent editorial in The Wall Street Journal predicted that retirees would all be forced to buy Treasuries.
The most important question to most advisors is how the new rules will affect their ability to recommend investments. Will they have to recommend index funds? What about products that pay commission or the sale of proprietary investments by captive agents?
I haven’t met anyone who knows more about the arcane details of securities law than University of Mississippi law professor Mercer Bullard. I asked Bullard, who also practiced securities law in D.C. and was a former assistant chief counsel at the SEC, whether the revised DOL rules were actually going to have an impact on the industry.
According to Bullard, “The DOL stuck to its guns and kept the provisions that’ll have the most significant impact on broker-dealers’ sales practices.”
This position is echoed by longtime fiduciary expert and Western Kentucky University professor Ron Rhoades. To Rhoades, the DOL rules will have a “transformational” impact on the advising industry as it hastens the movement from commission to fee compensation. In essence, fee compensation can be seen as a carrot that has been slowly driving a change in compensation through promises of smoother and more generous (in some cases) advisor revenue. But the DOL rules act as a stick by increasing the risk of commissions. The size of the stick will be measured in the courts.
According to Rhoades, “if there is such a thing as a tipping point — this is it.” Is this really a tipping point? We may not know until long after the rules start taking effect in April 2017, but the experts say that the new rules could drop a bomb on the world of asset management as we know it.
Death of the Active Mutual Fund?
Despite the popularity of index funds, broker-channel active mutual funds are still a major player in the fund industry. That could change quickly according to Rhoades.
The reality is that most active funds have significantly higher expense ratios and commissions, but a portion of the expense ratio indirectly covers advising services. Investors pay higher ongoing expenses and commissions, a portion of this amount is routed by the fund to the advisor in 12b-1 fees, commissions, soft dollars, shelf space and marketing support, and the fund family keeps its share as a cost of managing and marketing the fund.
There is also plenty of objective evidence that active funds don’t outperform passive funds, and the size of this underperformance is almost exactly equal to the size of their higher fees. But this is to be expected if the higher fees are part of the compensation model (many advisors point out that 25 basis point 12b-1 trails are a lot lower than 1% asset management fees, and some active funds have modest expense ratios). The problem is that the compensation model includes quite a few characteristics that could run afoul of the DOL rules.
This current system provides an incentive to recommend more generous active funds, and research bears this out. The new Best Interest Contract Exemption standards (BICE) allow a range of compensation models including commissions, but they explicitly state that advisors can’t make recommendations that pay them more when the recommended investment isn’t best for the client.
The real problem for active funds is that the newest version of the DOL rule contains further incentive for advisors, even advisors who were formerly paid through commissions, to adopt a fee compensation model in order to become a so-called “level fee fiduciary.” Level fee advisors are exempt from the full requirements of the BICE, which serves as a strong incentive to adopt a level fee compensation model.
Bullard points out that “there are really only two lobbying successes in this, and one of them was that the financial planners got a huge exemption which allows them to give conflicted rollover advice if they charge level fees without having to enter into a best-interest contract. So, what was previously a fairly unbiased proposal between transaction-based compensation and asset-based compensation became, in the final version, heavily biased in favor of asset-based fees because they now offer a complete out because the DOL decided that conflicted, asset-based fee advisers, with respect to rollovers, don’t need to enter into the BICE.”
There are also significant conflicts in the traditional active fund compensation model — for example, compensation practices such as ratchet grids that provide bonuses when advisors meet sales targets. If advisors can make more money by recommending funds that help them meet their sales threshold and provide a significant payout, then they face differential compensation that presents a conflict of interest. This is a big no-no under the new rules.
Rhoades and Bullard have different views on whether the fiduciary rules are going to impact active funds. Bullard believes that there is nothing in the rules that would compromise an advisor’s ability to accept commission compensation. “It’s going to be very difficult to make the case that an advisor failed to make a prudent recommendation case as opposed to a failure to have procedures that prevent conflicts of interest,” notes Bullard.