What is the rule?

Despite prominent press coverage there are many people that do not understand what a uniform fiduciary standard is and what it means for them. In today’s marketplace, many financial professionals act as brokers and are held to a “suitability” standard only. This means that when they make a recommendation to clients regarding investments, the recommendation simply needs to be “suitable” for them, regardless of fees or commissions. The Department of Labor has been working for almost 6 years to introduce a “fiduciary” standard across multiple channels of financial professionals, especially amongst those giving retirement advice. This can be confusing for many clients as people automatically assume the folks giving them financial advice are acting in their best interest. The reality is that many “financial advisors” are not highly trained professionals but rather, highly compensated salespeople. The Department of Labor’s goal was to obligate advisors to put clients’ needs ahead of their own. Specifically, the DOL has found that when a broker sells a commissioned investment product like a mutual fund, life insurance, or an annuity the resulting costs in clients’ accounts can be devastating. Averaged out, this “conflicted advice” results in losses of approximately 1% annually or $17 billion. Understandably, such a change would result in lower commissions and fees paid to brokerage firms. Subsequently, the DOL rule was met with significant opposition from firms, politicians, and financial industry interest groups. 

In practical application, a fiduciary rule would require advisors to sign a contract with a client that legally obligates the advisor and the firm they represent to act in a clients’ best interest. In theory this would result in better recommendations from advisors and, at a minimum would give clients legal recourse against firms giving bad advice. The types of “bad advice” clients currently receive covers several areas. Currently brokers can sell clients “proprietary” investment products. This could be anything from mutual funds to life insurance. The issue with these types of products is cost. Rarely is a firm’s own investment vehicle the lowest cost option. Additionally, many brokers receive additional forms of compensation to sell their firm’s products. As a client, do you want your advisor to recommend buying ABC investment because it’s good for you or because it helps them win a vacation? Apart from prohibiting these types of transactions, a fiduciary standard would prevent advisors from recommending inappropriate investment vehicles to clients, like buying an expensive variable annuity in a retirement account. As a fiduciary, Gainplan is obligated to be exceptionally transparent with costs and fees that clients will pay. Under a fiduciary standard fees are often not disclosed but buried in a stack of legal disclosures. In short, a fiduciary standard would significantly affect the business practices of financial advisors operating in a brokerage business model. Additional compliance and oversight would need to be implemented and commissions and fees would be cut. The resounding opposition from the industry included over 3,000 comment letters and resulted in 100 DOL meetings and 4 days of public hearings. Given their druthers, many in the industry would prefer to keep the status quo. However, the rules governing financial advisors have remained largely unchanged since 1975. Since then, the industry has seen dramatic changes in the way investors work with professionals. The primary driver of these changes stems from corporations’ shift from defined benefit plans (pensions) to self-directed retirement accounts (401(K)s). Investors face more complexity in the realm of personal finance but remain largely uneducated about investments, the markets, and their costs.

Clearly, a change is needed. The DOL’s proposed rule had teeth but the final publication leaves a lot to be desired. It is obvious that they listened to the industry and watered down the final proposal. A stringent fiduciary standard would not change the way Gainplan works with clients but it also seems that the new rule will not really change the way brokers work with clients either.                                                                                                                                                                                                                                     

What were we hoping for?

When the department of labor first drafted the uniform fiduciary standard they had clearly taken to heart this issues facing investors today. At Gainplan, we were hoping to see a true fiduciary standard: a signed contract between firms and their representatives and the client. A contract that would give the client legal recourse when a firm did not act in their best interest. Acting in a clients’ best interest is hard to define, but when you are working with investment companies that would prefer to act in their own best interest, definitions are needed. Most importantly though, we wanted the Best Interest Contract to exist without exceptions or provisions. This means firms would not be able to sell a client a proprietary mutual fund or other security unless it was truly right for a client and it was the lowest cost option available. A BIC would result in no, or very low, uniform commissions associated with investments and insurance. There would be more fee and cost disclosures and they would be clear and transparent. Certain investments would be prohibited from being sold in certain types of accounts. For instance, advisors would not be able to sell high commission variable annuities in retirement accounts. A true fiduciary would never do this. If selling a commissionable product, advisors would be forced to offer several options to clients, letting them choose the commission structure themselves. This would automatically curb commissions on higher fee products. Finally, introducing a uniform fiduciary standard would also obligate advisors to continue monitoring and evaluating clients and their financial well-being. When an advisor sells a product with a large up-front commission they have no incentive to continue servicing clients. Many don’t even care if the client sells the product or leaves the advisor because they have already gotten paid. Worse still, many advisors practice “churning” or selling the high up-front commission investments for the client and buying another investment with a large up-front fee without considering if the change is necessary. Essentially, other firms would act like Gainplan. Our biggest fear was that the department of labor would cave to industry pressure to maintain the status quo, creating a fiduciary standard with no teeth, further muddying the waters on the difference between a fiduciary and a salesperson.

So what did we get?

The final rule, over 1,000 pages, is a significantly streamlined, watered down attempt at creating a fiduciary standard in the financial advice industry. The DOL did listen to critics and left investors no better off than they were before. The Best Interest Contract (BIC) has many exemptions available, commissions are allowed within the contract provided the contract states the conflicts of interest. Proprietary products and high commission products are also allowed with disclosures. The list of “approved investments” within retirement accounts was expanded and still includes variable and indexed annuities. One of my biggest issues with the rule now, is that the Best Interest Contract, when disclosing fees, only needs to direct the client to a website that has “information on the fees charged.” The website must spell out how the firm decided to charge the fees, not the actual breakdown of the fees and expenses themselves. Lastly, the contract only needs to be signed after accounts have been opened. At Gainplan, and any other fiduciary firm worth their salt, contracts are signed at the start of discussions, before advice is given or recommendations have been made. The final rule gives firms the same latitude they have always had with compensation, commissions, and revenue sharing with investment companies. Apart from the best interest contract exemptions there are also principal transaction exemptions that allow advisors to recommend certain fixed income securities and sell them to the investor directly from the advisor’s own inventory. Additionally, there is a low fee exemption that allows advisors to sell their own firm’s investment products without a side-by-side comparison to another firm if the advisor has “reasonable basis” to believe that their own product has appropriate fees. On the plus side, the finished rule will force advisors to present options when discussing insurance products, hopefully curbing higher commission products. The new rule will also give more power to clients that have been harmed by financial firms and makes financial advisors themselves personally liable for the harm they do to clients. Full compliance with this rule is not mandatory until January 1, 2018.

Final thoughts

Essentially, there are two schools of thought on the fiduciary standard. Our view is that a best interest contact has no latitude to include proprietary funds, high commissions, and inappropriate investment vehicles. Primarily because large commissions and internal incentives for advisors to sell their own firm’s investments represent a conflict of interest. A true fiduciary standard has no room for conflicted advice. The industry currently believes that there are important benefits to conflicted advice. Their argument is that investors cannot afford a true fiduciary relationship and large commissions and fees are the only way for investors to pay for that advice. This argument is fundamentally flawed and stems from an industry focused on looking out for the best interest of the firm. The new Department of Labor rule is a failure because it allows advisors to continue selling the same garbage to investors that they have sold for years all while hiding behind a Best Interest Contract that doesn’t truly obligate them to act in someone’s best interest.

Resources:

http://www.dol.gov/ebsa/regs/cmt-1210-AB32.html

http://www.investmentnews.com/assets/docs/CI99098414.PDF

http://www.dol.gov/ebsa/regs/conflictsofinterest.html

http://www.investmentnews.com/article/20160411/FREE/160419985/financial-planners-foresee-little-disruption-to-practices-from-dol

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