DOL’s New Fiduciary Standard: Devil in the Word

What does it take to be a fiduciary to a retirement plan for the first time?

Broker-dealers and other investment advisors that give clients of retirement plans recommendations on what assets to buy and sell will be struggling to answer this question as they create policies and procedures to fulfill the new fiduciary standard of responsibility imposed by the US Department of Labor (DOL).

At issue is how can firms prove that their designated customer-interfacing representatives have met a far higher level of care for a client in an individual retirement account (IRA) or 401k plan than simply ensuring that its advice is suitable for a customer. The problem is that they really can’t with any certainty. The DOL or the client can always say that the firm didn’t meet its obligations. “The new fiduciary standard is subjective and financial firms may have difficulties definitely establishing compliance,” cautions Andrew Oringer, a partner in the law firm of Dechert in New York. “It isn’t black and white and there will be a lot of growing pains.”  Financial firms will have to be ready as of January 2017.

Investment advisors of pension plans, including most 401ks, must already meet a fiduciary standard of business defined by the Employee Retirement Income Security Act (ERISA) of 1974.  Fiduciary standards also apply to mutual funds. However, the DOL is now for the first time bringing advisors of IRAs into an equivalent requirement with the goal of protecting investors in all retirement plans from being charged excessive fees by unscrupulous advisors. Subject to certain exceptions, financial advisors — such as registered representatives at broker-dealers or even registered investment advisors — cannot receive payments which would create conflicts of interest with their retirement plan investors. Although investment advisors are typically paid fees in the form of a percentage of the value of assets they manage — broker-dealers are paid commissions by the client or incentive fees from the sponsor of the products sold. Hence, there is an incentive for wrongdoing.

Two Ways Out

The DOL has given financial advisors two ways to continue earning commissions as long as they meet certain criteria. One called the Best Interest Contract Exemption, or BICE for short, was recently been updated to advisors’ relief. “The original proposals for the BICE were quite onerous,” says Oringer. “They equated to the DOL telling registered representatives they could cross the street as long as they didn’t touch the ground.”

Still, the new version of the BICE doesn’t give registered representatives and others a free pass. In the case of IRAs, firms must sign a contract with investors saying they will act in their best interest with a prudent standard of care. The investment recommendation must be based on a “reasonable compensation” and conflicts of interest must be disclosed along with annual disclosures such as the asset sold, at what price and the advisor’s compensation. The advisor’s firm must also create and update quarterly a public web page that includes information about compensation for all products that the firm sells.

So what’s wrong with that? The BICE has one big catch — vulnerability to legal action. Firms relying on the BICE for IRAs have implemented a fiduciary level of responsibility through their legal contracts with customers. The BICE will also apply to 401Ks, but the legal obligation is established through a written statement that the broker-dealer will adhere to the same fiduciary standard it would for IRAs. As a result, either the DOL or the client has grounds for legal action if the broker-dealer or other advisor doesn’t live up to its word. And there is plenty of room for interpretation. Proving the investment advice was given with “reasonable compensation” will be tricky, because it could all depend on the varying facts and circumstances.

The other way to hold onto commissions is the seller’s exception — far easier to follow, but limited in scope. The broker-dealer can act in purely a sales capacity while another firm — typically a bank or insurance firm — has the legal responsibility for the fiduciary relationship. However, this exception can be used only by broker-dealers selling retirement plans or IRAs which are advised by banks, insurance companies, registered investment advisors or other registered broker-dealers that have at least US$50 million under management. Practically speaking this exception won’t be applicable to retail investors rolling over a 401k into an IRA, say legal experts.

Although the seller’s exception might appear to give selling broker-dealers and others a break from potential litigation by investors, they still shouldn’t breathe a sigh of relieve. They must still certify they “reasonably believe” that the advisor of the plan or IRA is competent enough to advise the plan or IRA. Such a subjective interpretation could also be called into question by a savvy attorney for the investor.

Biting the Bullet

Given that the BICE and the seller’s exception have their shortcomings, financial firms might decide not to take advantage of the loopholes and just follow the fiduciary standard while collecting advisory fees. However, without common industry guidelines, those following the standard for the first time won’t face an easy road. Broker-dealers will have the hardest time meeting an entirely foreign requirement.

“It will come down to additional disclosures to clients on fees and potential conflicts, re-education of registered representatives on how to form a reasonable basis for recommending an investment product or strategy, and the establishment of a new compliance program,” says Charles Field, a partner with the law firm of Sanford Heisler in San Diego. He estimates that the ultimate industry-wide cost will be multiples of the US$6.4 million estimated by the DOL and will be disproportionately shouldered by smaller brokerages.

One of the likely most common approaches taken by compliance managers to ensure compliance will be holding training sessions. Included in those sessions will be information on what products can and can no longer be sold and what to disclose about payments from third parties, predicts Paul Borden, a partner with the law firm of Morrison & Foerster in San Francisco. None of the compliance managers at broker-dealers contacted by FinOps Report were willing to share training scripts, but they offered the following most popular questions from investors they will need to address.

1. “Why is this product better for me than another?” Although the BICE no longer requires broker-dealers to provide a detailed comparative analysis, the most likely popular question will require some calculations. Therein lies the rub. The level of historical and projected information will clearly be up to the firm itself and broker-dealer compliance specialists who spoke with FinOps Report couldn’t reach any consensus.

2. “How much money will you make from this recommendation?” This question will require the registered representative to provide some analysis of its compensation either at a specific transaction level or based on a overall product category. The calculations will likely be done by a back-office operations staffer, but must be understood by the registered representative. Count on a flurry of emails and phone calls, say compliance managers.

3. “How often will you monitor my account to see if any changes are necessary?” This question is likely to be posed by investors whether or not the financial advisor takes on a fiduciary role. However, some brokerages could decide to more frequently monitor retirement and IRA accounts than is currently the case because of the higher risk of litigation, says Borden.

Of course, if firms want to prove to the DOL that they provided a client with the best advice possible they will need some documentation. While such conversations will likely not be recorded, registered representatives at broker-dealers will be asked to write down the who said what to whom. The amount of detail will be a subject of interpretation and there won’t be a one-size fits all approach. It will depend on the size of the account, how long they have known the customer, the type of investment recommended, the type of client and its risk profile. Discussions with new customers will be subject to far more scrutiny by compliance managers, so lengthier notes will be expected.

Field recommends that firms consider develop model investment guidelines tailored to specific investment strategies that match the investor’s objective. Using such an approach, he says, allows registered representatives to discuss the guidelines with investors in advance and either agree or make modifications. Once the investor sets the guidelines it becomes the registered representative’s fiduciary duty to select investments that adhere to the guidelines.

It remains to be seen just how vigorously the DOL enforces the new fiduciary rule or how far investors in IRAs will go to pursue legal action. At the very least, compliance managers will need to get up to speed on the requirements and prepare to tighten their own internal oversight. Large revenue producers can’t get a free ride, cautions Field. If a firm doesn’t get whammied by the DOL, it can always count on a disgruntled plan participant who may complain to the DOL, or an IRA owner seeking to sue for contractual violations. It will take a ton of prevention to prevent reputational risk and legal costs.

What broker-dealers and other financial advisors shouldn’t count on is for the DOL’s new fiduciary requirement to be the guidepost for similar action by the Securities and Exchange Commission. The SEC, say legal experts, could implement less rigorous policies and preserve the broker-dealer’s commission-based compensation system. If that becomes the case, broker-dealers might have to suffer the compliance challenges of two disparate requirements- one for retirement plans and yet another for non-retirement plans.