Proposed Department of Labor rule will expand fiduciary responsibility

Publication February 2016

Financial Services Industry Already Bracing for Impact of DOL Fiduciary Rule

The Department of Labor (“DOL”) recently submitted its final proposed fiduciary rule to the Office of Management and Budget (“OMB”), one of the last steps required to implement the controversial rule. With the measure likely to be implemented, the purpose of this report is to crystalize key points of the proposed rule, including the DOL’s rationale and opposition to the rule; discuss specific, demonstrated industry impact already felt as firms discuss the measures they are taking to prepare for the rule; and discuss key steps going forward. 

Consistent with many predictions, the fiduciary rule is having a significant impact. As the industry awaits the final language and likely implementation of the rule, some firms are already taking concrete steps to prepare, such as emphasizing fee-based product offerings at the expense of commission-based products or even exiting the broker-dealer space altogether. For example, LPL Financial recently stated that it intends grow its fee-based variable annuities platform, and AIG cited the anticipated compliance costs of the new rule when it recently sold its broker-dealer arm, AIG Advisor Group. Firms across the industry are developing technological tools to better comply with the rule’s requirements, and many anticipate other operational changes, such as increased minimum asset requirements to provide personal advice for retirement accounts.   

Overview of the DOL’s Proposed Rule

The final rule language has not yet been released, but it will likely be similar to the DOL’s April 2015 proposal. Under the proposed rule, financial advisors of retirement accounts will owe investors a fiduciary duty and must put their clients’ best interests first. The rule expands the current definition of “investment advice” under the Employee Retirement Income Security Act of 1974 (“ERISA”), and broadly covers investment recommendations, investment management recommendations, appraisals of investments, and recommendations of persons to provide investment advice or management services. For broker-dealers and insurance agents previously operating under a “suitability” standard of care, the new fiduciary standard would supersede the suitability standard when they provide investment advice in the context of retirement accounts. 

The rule limits the availability of commission-based compensation in such accounts and presents firms with two choices: shift to fee-based compensation to avoid such conflicts of interest, or comply with the “best interest contract exemption” (“BICE”) and continue commission-based compensation. Under the BICE, an advisor may continue some otherwise prohibited compensation practices if the advisor enters into a contract with his client that (1) commits the advisor to acting as a fiduciary; (2) warrants that the firm has adopted policies and procedures designed to mitigate conflicts of interest; and (3) discloses information relating to fees, compensation, and any conflicts of interest. The BICE carve out, however, only covers certain listed types of assets, and it excludes futures, exchange-traded options, and alternative investments.

If an advisor breaches his fiduciary duty under the DOL’s proposed rule, the DOL can bring an enforcement action against the advisor; the IRS can impose penalizing taxes on the advisor; and customers can bring a private cause of action against the advisor.

Intent of the Proposed Rule

The main stated objectives behind the rule are to protect consumers from conflicts of interest within the financial advising industry and promote transparency regarding compensation practices. According to the White House Council of Economic Advisers, conflicts of interest between advisors and their clients lead to $17 billion in losses every year for working and middle class families. The DOL has also stated that the rule is intended to modernize the statutory scheme in light of more complicated investment products, more individuals managing their retirement assets instead of large employers, and retiring Baby Boomers transferring money from ERISA-covered plans to IRAs, which do not fall within the current definition of “investment advice” for fiduciary purposes. The DOL claims that this landscape necessitates further protections for investors. 

Opponents of the Proposed Rule

The DOL received thousands of comment letters and held lengthy hearings to discuss the proposed rule.  Many commentators believe it will negatively impact the industry, while others challenged the proposed rule’s legality, including the DOL’s the authority to implement parts of the rule. The most significant criticisms cite a high cost of compliance, a failure to create a uniform standard of conduct for advisors across the industry, a unilateral push for fee-based compensation, and a negative impact on the IRA rollover market.

Cost of Compliance

The most frequently cited industry concern is the cost of compliance with the new rule. If firms want to continue the common practices of commission-based compensation and employment of third-party advisors, they must adhere to the BICE’s conditions. Critics contend that firms will have to upgrade technology and make other operational changes while facing greater exposure to the risk of consumer lawsuits. The costs, firms argue, could chill the sale of retirement products, especially proprietary products.  Instead of assuming the expense and risk, firms may move away from providing retirement advice, leaving consumers little guidance for their investment options. Higher costs could lower firms’ incentives to offer retirement advice to less profitable, lower net worth investors. Thus, many critics predict that smaller investors will be forced to rely on “robo-advisors” for retirement advice, and ultimate pay higher costs for fewer options.

Lack of Uniform Standard

Opponents also complain that the DOL did not sufficiently consult with other regulatory bodies in the financial advising industry, such as the SEC and FINRA, before adopting the proposed rule. The DOL states that it worked closely with the SEC to draft the proposal, but a recent report from Republican Senators claims that the DOL disregarded SEC recommendations and clashed with SEC staff members. Recent legislative challenges to the rule by Republican lawmakers seek to delay implementation until the SEC weighs in on the issue, but such measures are likely to be vetoed by President Obama.  The SEC has stated its intent to propose its own rule, but it has yet to do so or provide any public feedback on the DOL’s proposal. The SEC still maintains that it is working towards a proposal, but political realities may delay such a proposal until late 2016 or beyond. Without a uniform standard of conduct recognized industry-wide, opponents argue, advisors will have a hard time navigating a complex regulatory landscape, wherein different rules and standards of care may apply to the same customer based upon the assets, account, or type of advice at issue.    

Push for Fee-Based Compensation Structure

The proposed rule promotes a shift to fee-based compensation since commission-based compensation can present conflicts of interest that are prohibited under the fiduciary standard. Some opponents argue that fee-based compensation is not always in the best interest of an investor, as commission-based products can better serve some types of consumers over the long-term. For example, for low frequency trading investors with portfolios complicated enough to require more than robo-advice, paying commissions could be cheaper than annual fees.  Although firms could continue commission-based compensation under the BICE requirements, compliance with the BICE causes its own problems and has certain limitations, as illustrated above. 

Impact on IRA Rollover Market

Another criticism of the rule is that it will slow down IRA rollover activity. Currently, a broker-dealer advising an investor about moving money to an IRA from a direct contribution plan or another IRA is held to the less strict suitability standard of care. Many in the industry worry that, when advisers are held to a fiduciary standard, they will abandon providing rollover advice to avoid increased liability and cost.

Industry Impact

Even though the final rule language has not yet been published, firms are already preparing for its impact in various ways. 

Most notably, AIG recently announced the sale of its broker-dealer arm, AIG Advisor Group.  AIG’s CEO Peter Hancock stated that the DOL’s pending rule played a major role in AIG’s decision to sell; specifically, the sale will allow AIG’s broker-dealer operation to avoid conflicts of interest that arise from distributing its parent company’s products. MetLife Inc. just announced that it is also selling its U.S. adviser unit, and many expect merger activity to increase in response to the fiduciary rule.  Others have noted that broker-dealers owned by insurance parent companies are at the “greatest risk” of violating the new rule in part because insurance-owned broker dealers tend to focus on middle market investors with a greater portion of their wealth in retirement accounts than other market segments.

LPL Financial and Raymond James have taken a different approach as two of the few broker dealers to support the rule despite some specific concerns, with LPL publicly acknowledging that regulatory scrutiny of retirement investments will only continue to increase. To that end, LPL says that it has increased risk management expenditures in anticipation of the rule. Large firms, whether independent broker-dealers such as LPL, or full-service wealth management firms such as Raymond James, may be better situated to absorb and adapt to the compliance costs of the rule than smaller, independent brokerages.

But all firms are taking stock.  62.3% of respondents to a recent DST Kasina survey are exploring technology solutions related to new disclosure requirements, including tools for “investment policy statement development, fund monitoring, plan benchmarking and fee comparison.” Cambridge Investment Research Inc. estimates that it will spend $15 million to $17 million on technology upgrades and other operational changes in anticipation of the rule. In addition to expected costs, firms foresee customer impact as well.  Over half of the DST Kasina’s survey respondents believe that advisors will require minimum balances of either $50,000 or $100,000 to offer personal advice, leaving millions of IRA accounts at risk of being “orphaned” by firms and shifted to automated advice platforms. LPL stated, in the same survey, that it may have to orphan retirement accounts with less than $15,000, accounting for approximately 3% of retirement assets on its brokerage platforms.

Much of the product-specific discussion has focused on variable annuities because of their popularity as retirement vehicle.  LPL has stated that it intends to grow its already developed fee-based variable annuities platform to avoid conflicts of interest issues with commissions. TL Financial Group stated that it is abandoning products with fluctuating advisor payments and will only sell annuities in a wrapper, collecting a wrapper fee rather than commissions, with President Tony LaJeunesse declaring that the rule is “already putting downward pressure on commissions.

Looking Forward

At this point, it appears that it is not a matter of if but when the new rule will be implemented.  The OMB has up to 90 days from January 28, 2016, to complete its review, and upon approval, publish the final version of the rule in the Federal Register.  Some are predicting that publication will happen as early as March, especially if the Obama Administration is seeking to complete and implement the rule before the end of his term. While Congress is empowered to adopt a joint resolution of disapproval in response, President Obama will likely veto such a resolution or any other legislation seeking to delay or block implementation of the rule. According to the proposed rule’s language, the rule will become effective eight months after its publication with the exception of a “short-delay” for advisors who elect to operate under the BICE. Once the rule is published, opponents in the financial advising industry will likely challenge the rule in court.

Norton Rose Fulbright will continue to closely monitor the DOL’s proposed rule and will provide updates when the finalized rule language is available and as the industry continues to respond.

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