In April 2016, the Department of Labor (DoL) released its much-anticipated regulation regarding the Conflict of Interest Rule for retirement investment accounts. Under the new rule, advisors will be held to a fiduciary standard—acting solely in the client’s best interest. This change will affect advisors’ compensation, and has caused controversy in the industry since the DoL put forth the proposal last year. Advisors claim the implications of the rule will have a negative impact on small firms and individual advisors while benefiting large companies. The DoL and proponents of the rule claim that this will protect investors from unscrupulous advice.
Under the old rules, advisors and brokers simply had to adhere to a standard of “suitability” when recommending financial products to retirement investors. This meant that they were free to potentially choose products with greater commissions for themselves. Some advisors, particularly fee-based RIAs, already adhered to the fiduciary standard, but brokers were not required to do so. Investments such as commodity pools, some REITs, and variable annuities could provide significant commissions but were not always appropriate—or beneficial—for their clients.
Now, the new regulation prohibits commissions on 401(k) products unless the advisor provides a contract stipulating that all investment decisions are in the best interest of the client. This is known as the best interest contract exemption (BICE), and was one of the main changes the financial community sought after the initial proposal. The advisor must state that their compensation from the sale of products is reasonable and that the investment strategy is appropriate. The advisor will also have to disclose any conflicts of interest. What remains to be seen, however, is what the DoL deems “reasonable” and how the rule will be enforced. If clients do not sign a BICE contract, they will likely be moved to a fee-based account where compensation is driven by the overall size of the account and not the sale of individual products.
Hurting the Little Guy?
The objections to the regulation assert that smaller investors as well as small broker firms or individual advisors will be penalized. Firms will likely move small accounts to a fee-based model with fewer investment options. In addition, the fee-based account may cost the investor more than a commission-based account. On the advisor side, professionals fear that the requirements to adhere to the regulation will prove too costly. They say that large firms, with greater resources and infrastructure, will withstand the changes. Indeed, many large firms do seem to be moving towards fee-based accounts, according to the WSJ:
“Among brokerages, large firms focused on affluent investors, such as Morgan Stanley and Bank of America Corp.’s Merrill Lynch, already have many customers in fee accounts—which can be more profitable for them than commission-based accounts…The transition is expected to be much tougher for brokerages and individual advisers that rely more on commissions and have many smaller accounts, which the industry has said may be tough to serve profitably in a fee model.”
The regulation makes it easier for investors to sue advisors for failing to adhere to the fiduciary standard, and this might ultimately be what is causing the industry some anxiety. According to financial planner Michael Kitces:
“…[a] second requirement that clients can no longer be forced to waive 100% of their legal rights and accept mandatory arbitration, instead stipulating that while an individual client dispute may be required to go to arbitration, consumers must retain the right to pursue a class action lawsuit against a Financial Institution that fails to honor its aggregate fiduciary obligations.”
And while the current regulation applies only to 401(k)s, it is possible that the SEC will begin to look at this requirement for all investment accounts. Investment firms may even beat them to the punch since it might make sense to apply these standards across all accounts, retirement and non-retirement, in a “lowest common denominator approach.”
Many aspects of the new rule will go into effect on April 10, 2017, with a transition period until January 1, 2018. It is likely that the industry will undergo significant changes to both business models and investment product offerings. It remains to be seen how far the ripples will go.