There were a number of excellent comments to my last blog, “For IRA Investors, a Warning on DOL’s Fiduciary Rule,” including a tome-like tutorial by Ron Rhoades on “best interest” and “sole interest” standards as they apply to the new DOL rules, which I highly recommend that you read in its entirety if you haven’t already done so. Some of these comments warrant comment or clarification — or simply deserve to be highlighted.
[Editor’s note: Some of these quotes have been lightly edited for typos and clarity.]
First, let’s clear up a misconception of my own making. Frank Prazma commented in part: “Sole interest means no compensation and no advice. What kind of strong fiduciary advocacy would that be?” And “AdvisorGuy” chimed in: “Mr. Aikin’s writing clearly states that a sole interest standard basically eliminates compensation to advisors, and would make even disinterested expert advice hard to come by.”
Both Prazma and AdvisorGuy are referring to a quote from fi360 CEO Blaine Aikin’s May 13 blog: “What’s the Difference Between ‘Sole Interests’ and ‘Best Interests?’” which read: “The sole interest standard [in ERISA] is the more rigid standard, requiring that conflicts of interest in a fiduciary relationship be avoided entirely. Strictly speaking, a sole interest standard forbids even mutually beneficial transactions or compensation for the advisor.”
While this makes it sound as if pension advisors can’t be compensated under ERISA, obviously this isn’t the case. I had omitted Aikin’s follow-up comment: “Because of the strict interpretation of a sole interest standard, prohibited transaction exemptions are put into effect to allow for even a minimum of commerce to occur within the confines of the client-advisor relationship.”
In other words, the authors of ERISA felt so strongly about the harmful effects of conflicted advice that they first ruled them out entirely — and then created specific exemptions that detail how each “acceptable” conflict must be handled to mitigate its effect on advice to investors. (A similar format was used by the DOL in its BICE rules for charging sales commissions.)
As Rhoades pointed out, in ERISA “there are 20 statutory exemptions from the prohibited transaction rule, including the main exemption used by fee-only financial advisors, wherein the provision of services necessary for the operation of a plan is permitted for no more than reasonable compensation.” The takeaway here is that pension advisers do get paid, but their compensation must meet reasonable industry standards.
Prazma also reiterated the securities industry’s current mantra that the DOL’s “biased” rules are also “harmful to all retirement savers, as they will be left with fewer advisors and diminished investment choices.” Forgive me for beating this limping horse once again, but I can’t resist: Isn’t this just another way of saying that if we have to act in our investors’ best interests, many of our current investment recommendations won’t qualify, and consequently, many brokers won’t be able to make a living?
The fact of the matter is that many of the transactions that Prazma and others in the securities industry fear won’t be allowed under the new DOL rules probably aren’t permissible today under common law fiduciary standards, either. According to Rhoades, “There are some who believe that acting in the ‘best interests’ of a client only requires disclosure of a conflict of interest, followed by mere consent of the client. Yet under the common law applicable to fiduciary relationships […], the best interests test is fairly strict. It requires, when a conflict of interest is present: (1) affirmative disclosure to the client of all material facts; (2) understanding by the client of the material facts, including their ramifications […]; (3) the informed consent of the client; and (4) even then, that the transaction be fundamentally fair to the client. The courts […] do not believe that clients will provide informed consent to be harmed.”
Rhoades’ point here is that “while the body of law around the ‘best interests’ standard is robust in similar relationships (such as attorney-client), it needs to be further developed with respect to financial advisors and clients.” He also noted that “the existence of mandatory arbitration has hindered the development of the law in this area, over the past several decades.”
That means the only reason brokers today can get away with the type of behavior that Prazma fears will be eliminated by the DOL rules is because FINRA controls the vast majority of broker oversight (under its mandatory arbitration requirement) and has redefined “best interests” to mean “suitability” and “disclosure.”
According to Rhoades: “FINRA already (incorrectly) has used this term [‘best interests’] in describing aspects of the suitability standard. SIFMA and FINRA last summer touted a disclosure-based suitability standard to the DOL in their comment letters when promoting a ‘new federal best interests’ standard. […] Rightfully, the DOL rejected the SIFMA/FINRA proposal.”
As Rhoades pointed out, the securities industry (including FINRA) likely will continue trying to erode even the best interest standard as opposed to the stronger ERISA “sole interest” standard that’s not used in the new DOL rules, in much the same way that the SEC has, in the wake of many brokers becoming RIAs over the past two decades, watered down the fiduciary standard for investment advisers to mean “disclosure.” But Rhoades is more optimistic than I (and far more knowledgeable on the subject) that the new DOL “best interests” standard will be a major advance in retirement investor protection.
“I submit,” he wrote, “that the ‘best interests fiduciary standard,’ as set forth by the DOL, is a very tough standard. Moreover, as a principles-based standard, its requirements have been imposed in similar situations for centuries. […] Properly applied, the ‘best interests’ standard is not all that different from the ‘sole interests’ standard in terms of its effectiveness to safeguard the client [...], and the DOL’s language in its issuing releases bolsters its strict application.”