Effective April 10, 2017, the Department of Labor’s fiduciary rule will impose a “best interest” standard on advisors and firms making investment recommendations to qualified retirement accounts in the United States.
The DOL rule aligns the definition of best interest to that of a fiduciary under the Employment Retirement Income Security Act (ERISA). The rule defines investment advice to be in the client’s best interest when the advisor and firm “act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use … .”
In addition, best interest advice is required to be “based on the investment objectives, risk tolerance, financial circumstances, and needs” of the customer, without regard to the advisor’s or firm’s own financial or other interests.
Although best interest is a higher standard than suitability, the DOL acknowledges that, “An investment recommendation that is not suitable under the securities laws would not meet the Best Interest standard,” drawing a baseline for best interest determinations. While many firms believe they already act in the customers’ best interest, they are not currently serving as ERISA fiduciaries in the retail retirement market.
The good news is that broker-dealers (BDs) and registered investment advisors (RIAs) will be able to leverage many of their existing business processes, tools and technology as they adjust their business models to meet this higher standard of care. As firms transform their businesses, the challenges are centered in the following four areas, each of which is explored in greater detail below:
- Formalize the investment advice process.
- Analyze the product menu and ongoing product governance (e.g., benchmarking).
- Capture and maintain the appropriate information.
- Enhance supervisory processes to identify new risks.
Formalize the investment advice process
The heart of DOL rule compliance (and the advisory process) is to act as a prudent person when providing investment advice and transaction recommendations. Some financial institutions are establishing clearly defined and rigorously structured decision criteria regarding matching products to client objectives, which advisors will be expected to follow closely. Other firms are opting for broad guidelines, and defer to their advisors’ experience and client knowledge when making recommendations.
The variety of distribution networks across the industry can make finding the right level of prescription tricky. (Photo: iStock)
Finding the right level of prescription is tricky, however, because of the variety of distribution networks across the industry. Some distribution networks mandate compliance with narrowly defined sales practices and the use of centrally managed planning tools.
Other distribution networks classify their advisors as independent contractors, which creates a delicate organizational balancing act between allowing advisors free will to design and implement solutions, along with effective supervision and managing compliance risk. These firms are more likely to use a guideline approach.
Distributors are also using a guideline approach for higher-net-worth clients. These clients tend to have more complex situations, which increases the need for advisor flexibility in designing solutions tailored to their needs.
Further, the analytical framework to determine which products to recommend to which customers will likely differ by firm. Some firms will rely heavily on quantitative approaches, while others will use a more qualitative approach based on academic research to develop the necessary rule sets.
Regardless of approach, the following factors should be considered, plus others in specific circumstances (e.g., the need for asset consolidation prior to retirement):
- Investment quality and performance
- Fees and expenses
- Fit with financial plan and investment goals
- Risk tolerance
- Time horizon
- Need for guaranteed income
- Client preference
Expanded offerings in the industry, such as goals-based planning, are even more relevant now with this new fiduciary standard.
Implementing a robust product governance process is key to ensuring a product menu contains solid building blocks to use when designing customer portfolios. (Photo: iStock)
Analyze the product menu
Equally important is designing and implementing a robust product governance process so that the product menu contains sound building blocks to use when designing customer portfolios. Key product considerations include historical performance, features, benefits, goal alignment, risk, cost, compensation and financial strength of the counterparty.
Additional distributor considerations include the skill and knowledge levels of its advisor base, its compensation models, its customer base and its client segmentation approach.