The Department of Labor (DOL) recently issued final regulations (“the rule”), many years in the making, that clarify and greatly expand the definition of a fiduciary as it applies to retirement accounts. This will be a very brief summary, primarily intended for retirement plan sponsors and participants who want a quick and very general understanding of it, as it applies to my clientele. Anyone looking for a detailed explanation should google “fiduciary rule 2016” and read the DOL summary and/or any of hundreds of articles that have been written since it came out.
First, readers should understand that the DOL’s job is to enforce the parts of ERISA (Employee Retirement Income Security Act of 1974) that protect participants. (The IRS, in contrast, largely enforces tax aspects of ERISA and related Internal Revenue Code provisions.) I have no doubt that the rule is well-intentioned, and I have no doubt that there are many existing abusive relationships that warrant such changes. It may be overreaching, and unfortunately, it is (incredibly) long and difficult to interpret.
The gist of it is to make more service providers subject to a “fiduciary” standard. A fiduciary must act in the best interest of participants and avoid self-dealing. Under current rules, most investment advisors who receive commission-based compensation are not fiduciaries. They are held to a less stringent standard in which investments must merely be “suitable” (this is a Securities and Exchange Commission standard). Registered Investment Advisors (RIAs) are now generally and will continue to be fiduciaries.
The rule is effective June 7, 2016, but the applicable date is April 10, 2017. (When something doesn’t make sense, think “money” or “politics” or both. In this case, it is politics – they can’t make changes like this with true immediate effect, so they made it “applicable” a year after the rule was issued. But by making it “effective” in 2016 it is harder for a new administration to un-do it.)
So…advisors must now act in the best interest of investors. That seems reasonable, and in fact, there is little doubt that some investors were getting “ripped off.” But, if you take it to an ultimate conclusion, an advisor can’t get paid at all. With so many share classes and investment structures available today, there are a nearly infinite variety of ways to earn compensation on plan assets. Paying 50 basis points (bps) is better than paying 75 bps, right (?), and paying 25 is better than paying 50, so…paying 0 is better than 25, right? Acting in the “best interest” of the client would presumably mean taking as little compensation as possible on otherwise equivalent investments, and that drives compensation right down to…0. Well, the DOL understood that in order to provide services, an advisor must get paid, so there are two “outs” that will probably be used in most cases.
- The Best Interest Contract Exemption (often called the BICE or, my own preference, the BIC exemption – it will be a red flag if you ask an advisor for a BIC and he or she gives you a pen). Sparing you the details, the financial institution is allowed to get paid provided that it makes certain disclosures and essentially demonstrates that the contract is in the “best interest” of the investor.
- Limited compliance for “level fee” fiduciaries. As the name implies, receiving a level fee means receiving a fixed percentage of assets or flat dollar amount that does not vary with the investment recommended. This is inherently less prone to conflicts of interest, since the advisor gets the same compensation no matter what investment or fund is used, and has no temptation to use a higher compensation investment. Acknowledgement of fiduciary status and advance disclosure of the fee are required.
I believe that the impact of the rule on qualified retirement plans will not be that significant – there will be a flurry of paperwork as providers try to comply under the BIC exemption or the level fee limited compliance rules. But as far as actual investments and transactions, it will be business as usual – in my world, the vast majority of plans are paying some kind of level compensation, and if it doesn’t truly meet the level fee limited compliance, it can likely fit under the BIC exemption.
IRAs might see some significant operational changes – a major change was expanding the rule to IRAs, not just qualified retirement plans (e.g pensions and 401(k)s). Up-front commissions on individual transactions can be significant, and there are many, many rollovers done every day that are generating these up-front commissions. Let me be clear – I have no problem with paying commissions, and often it is better to pay a modest up-front commission than to pay relatively high ongoing asset-based fees (in fact the new rule more-or-less blesses these type of level fees, but they are not necessarily better!). But I suspect it will be a stretch to qualify some of these transactions under the BIC exemption, so we will likely see a decrease in transaction-based commissions on rollovers, and an increase in level-fee advisory business…
…which, as just noted, is not necessarily better! It is often possible (currently and under the new rule) for a participant to roll over funds from a plan to an IRA, within the same fund family, and pay no up-front commission at all and pay the same – or even lower – annual expenses than they were paying in the plan. Yet we often see these assets being rolled out to “advisory” accounts in IRAs where the participant winds up paying more on the nest egg that they have diligently accumulated over the years than they did when it was in the plan. Frankly, it’s a very subtle distinction, and the rule doesn’t really change the landscape – it is (still) up to the individual investor to pay attention and understand their options. (Although the advisor is supposed to research plan funds and expenses and consider whether it is better to leave the money in the plan.) Example – a plan participant has assets in a plan using “R” shares that cost 1% per year. The participant can roll out to A shares that cost .65% per year, with no up-front sales charge. An advisor recommends a managed account, where the fund charges are .50%, and the advisory fees are .75% – at total of 1.25%. That’s significantly more than .65% (what they would pay with an “in-kind” rollover) and more than they would pay by doing nothing and leaving the money in the plan. It might be worth it if the advisor value added is more than .75% (i.e. if they make up the .75% fee in higher returns), but to be honest, that’s a steep hill to climb. Often, investors do not understand the “all in” costs and think they are paying .75%, when in reality, there are fund fees in addition to the advisory fee which lead to a fairly high total expense.
Caveat emptor still applies, and investors should always take the time to understand what they are getting and what they are paying for. It might also be wise for individual investors to ask their advisor “would your recommendation meet the BIC exemption if it were applicable today?” even before the rules are “applicable” come April 10, 2017.