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Six Months Later and It’s Now Clear the Current DOL Fiduciary Proposal Worsens Investor Protections

Six Months Later and It’s Now Clear the Current DOL Fiduciary Proposal Worsens Investor Protections
September 15
00:03 2015

As you know, the DOL is aggressively seeking to broaden the definition of “fiduciary” (the SEC is, too, but less aggressively). Nearly six months ago, in one of the most anticipated public policy announcements for this industry, the nest-1569454_free_images_royalty_free_300Department of Labor unveiled its specific re-proposal of their earlier new Fiduciary Rule. Retitled the “Conflict-of-Interest Rule,” it was been heavily endorsed and promoted by the President himself (see “Obama Fires Fiduciary Starter Pistol to Mixed Reviews,”, February 24, 2015). Since then, unfortunately, the same unilateral decision-making that went into the administration’s health care and internet regulation seems have to inspired more opposition than agreement with the DOL’s proposal. Ironically, while promoted with much fanfare as a needed regulatory improvement to help protect retirement savers, the DOL’s proposal may serve only to confuse the issue further.

When the DOL first proposed its Fiduciary Rule several years ago, their objective seemed clear and fairly reasonable. The concept of fiduciary duty is fairly straight forward. “A fiduciary is legally required to act in the best interest of a party for whom he or she has a duty.  It is a simple concept which ‘everyone’ understands,” says Len Hayduchok, President of Dedicated Financial Services in Hamilton, New Jersey. “But,’ he adds, “most consumers aren’t informed about the ‘standard’ ethical requirement in the financial services industry – suitability. Consumers largely do not understand that the potential conflict-of-interest exists.” Hayduchok believes this can lead to “the offering inferior products or financial arrangements that are more favorable to financial representative than to the client are allowed.”

Prior to the DOL’s newly proposed Conflict-of-Interest Rule, the difference between a fiduciary (i.e., a Registered Investment Adviser or a trust company) and a non-fiduciary (i.e., a broker or insurance agent) was easily measured. “Advisers are compensated only by the fees they charge and not by commissions earned for selling investment products,” says Clark Kendall, President and Founder of Kendall Capital Management in Rockville, Maryland. “He or she only works for you, the client. Clients may not understand the differences between an adviser working under fiduciary standards and an advisor that isn’t because most clients believe that the either investment professional is working in their best interest. In reality, a traditional financial advisor may make money from the commissions based on the financial advice that may or may not meet the long-term financial goals and objectives of the client.”

As the investment industry has have moved from emphasizing individual securities to focusing on selling products, the resulting convolution has only further blurred the lines between adviser and advisor. “Most people feel overwhelmed by a financial services industry wherein intentionally complex investment vehicles, obscure and hidden fees, and avalanches of jargon-packed disclosure represent business as usual,” says Bobby Monks, of Portland, Maine, former Chairman of Institutional Shareholder Services and author of Uninvested: How Wall Street Hijacks Your Money – and How to Fight Back. “When 90% of financial advisors don’t have to put their customers’ interests first, it creates a strong incentive to sell what’s best for them, the advisor – not the client. Challenged by the excruciating, intentional complexity of the system that facilitates their investing, many seek refuge in money managers’ aura of sophistication, pretense of competence, and projection of certainty. Many investors hand over their money and assume that they’ll be taken care of. Of course, this is not necessarily the case.”

Fiduciary Advisers Play a Critical Role in Protecting Clients Interests

There’s never been greater urgency in regulators addressing the confusion among retail investors between advisers and advisors. “There are too many ways for an adviser (who is not a fiduciary) to game the system through back door payments, 12b-1 incentives, and other options that work against the client,” says Nathan Garcia, Managing Director at Westbourne Investments in Alexandria, Virginia.

Creating a uniform fiduciary standard could address this problem. It was hoped by those advocating for such a standard that the DOL might be able to make up for the SEC’s lack of movement on the issue. Monks says, “The stakes couldn’t be higher: working with a corporation or advisor who is not a fiduciary can cost an investor hundreds of thousands of dollars over a lifetime. The White House Council of Economic Advisors estimates that advice tainted by conflicts-of-interest costs investors $17 billion annually.”

Beyond avoiding the downside of conflict-of-interest, plan sponsors have added liability protections in hiring fiduciaries rather than brokers. “A fiduciary has to take on some responsibility whether it be 3(21), 3(38) or 3(16) to help offset some of the risk that comes with the plan,” says Garcia. “Someone who bears responsibility that could impact their career and livelihood is going to be more entrenched than someone who only risks a client.”

By using fiduciaries, plan sponsors can effectively delegate the investment management duties; thus, shifting the liability for investment selection away from the plan sponsor. “Some legal advantages to 401k sponsors who hire a fiduciary is that a fiduciary investor has a duty to monitor and make prudent decisions on behalf of the plan because their investment decisions will affect the on-going performance of the plan,” says Kendall. “Secondly, some 401k plans can be set up to give clients control over the investments in their account and limit a fiduciary’s liability for the investment decisions made by the participants. One way they can demonstrate they’ve been prudent in their decisions is by properly documenting the processes they used to carry out their fiduciary responsibilities. There are additional protections plans such as a fidelity bond that protects the plan against loss resulting from fraudulent or dishonest acts of those covered by the bond.”

More broadly, though, RIAs have been able to use their fiduciary role to uniquely differentiate their services from those of brokers. “The potential advantage is obvious – particularly in a market where there are significant opportunities for non-fiduciaries to benefit from selling inferior products,” says Hayduchok. “Certainly, market dynamics have the effect of pushing financial representatives toward the fiduciary standard and act in the best interest of the client due to competitive forces, but this impact is directly reduced to the extent the 401k sponsor is uninformed or less than fully informed about options other than what are being presented by the representative.”

The Initial Objective: Level the Playing Field

But what good is this differentiator if the customers don’t recognize its significance? RIAs have long recognized the true marketing advantage lay with the brokers. By obtaining their fees through the products, their clients never had to write a check. As incredible as it may seem, many of those clients believed they received their investment advice at no charge. “Fiduciaries tend to charge fees rather than commissions,” says Terry Dunne, managing director of the Rollover Solutions Group at Millennium Trust Company in Oak Brook, Illinois. “Commissions which are a little less transparent are less in favor these days.”

The perception of “free” investment advice tilted the playing field in favor of brokers, who are regulated by a different agency than RIAs. “The current regulatory environment is totally inconsistent, imbalanced, and generally out of whack,” says Monks. “You have an industry-funded organization, FINRA, overseeing non-fiduciary advisors. You have a government agency, the SEC, overseeing registered investment advisors. When you have an industry regulating itself, you’re going to end up with conflicts-of-interest. Fiduciaries and non-fiduciary advisors have vastly different business models. Though both market themselves as financial advisors, the incentives for someone selling a product (like a mutual fund) or driving a transaction are dramatically different than they are for someone selling a service (like a registered investment advisor). It’s an apples and oranges situation that sows general confusion in the marketplace, and investors ultimately end up paying the price.”

How could an RIA – whose fees were transparent, compete in this environment? Initially, the thought was merely to level the playing field. If you claimed to offer advice, you had to follow the same rules. There were two ways of doing this. Either remove the rules from RIAs (a bit difficult given the case law that has come to define the fiduciary standard), or require brokers who services have crept into the traditional investment advice realm, to follow the same rules as RIAs.

There are those that feel the current regulations are adequate, they just need to be enforced. “Apply the rule as it stands today. The law doesn’t need to be adjusted it needs to be executed,” says Garcia.

Others think the regulations need to be strengthened to explicitly level the playing field. “Simply put: There should be a universal standard of protection that requires financial advisers to put clients’ interests first,” says Monks. “But the burden will, ultimately, always fall on the investor.”

Hayduchok agrees on this latter point. He feels the key is “consumer education – again, fiduciary is a simple concept – consumers simply need to be informed of it.” More importantly, if this education exists, it once again elevates fiduciary as a differentiating factor, giving RIAs a unique advantage. Hayduchok says, “Personally, I feel advisors who are required to act as fiduciaries have the advantage because decision-makers understand the importance of the fiduciary standard, when they are informed of it.”

How the DOL’s Current Proposal Sets Back Consumer Protection

Unfortunately, the DOL’s proposed Conflict-of-Interest Rule, by allowing brokers to continue engaging in self-dealing conflict-of-interest while giving them the opportunity to also call themselves “fiduciaries,” removes that singular advantage that RIAs have had. Of course, the DOL doesn’t admit this, and the opponents of a uniform fiduciary standard are only too glad to maintain the pretense. Melinda C.Garland of New York Life in Richmond, Virginia is “not in favor of a uniform fiduciary standard.” She says, “There is nothing good about the DOL proposal, the outcome of the proposal would mean that Americans would not receive the personalized service and clientele that they deserve. The proposal would limit the ability of agents to provide guidance and guarantees to clients. Insurance and securities are meant to help and preserve ones standard of living and this rule would interfere in that process.”

But is the proposal really that stark? It appears it’s more of a glass half-empty/glass half-full scenario. “The DOL proposed fiduciary rule addressed the level playing field issue because it could ultimately lead to traditional advisors providing impartial advice in their clients regardless of their clients’ best interest,” says Kendall. On the other hand, he says, brokers “will not be able to accept any payments creating a conflict of interest unless they qualify for an exemption.”

Since it supports their end-of-the-work-as-we-know-it thesis, the brokerage industry seeks to emphasize the “half-empty” aspect of the proposal. But it is the “exemption” that offers the half-full side of things. In fact, the exemption language is big enough to drive a truck-load of conflicts-of-interest through. “The DOL proposal failed in regards to the sweeping new exemption which was more broad than the existing ‘prohibited transaction exemption’ which is limited to specific transactions,” says Kendall. “Instead they’ve created a new ‘best interest contract exemption’ which still permits commissions and revenue sharing so long as they are disclosed.”

“As proposed,” says Hayduchok, “the rule would significantly expand the types of activities that would subject financial professionals to fiduciary status and would prohibit a financial professional from receiving compensation in connection with advice or recommendations regarding the investment of tax qualified assets unless they meet a Prohibited Transaction Exemption (PTE). In addition to the proposed rule, the DOL has also proposed several new and modified PTEs, including the Best Interest Contract Exemption (BICE) and PTE 84-24.”

Fiduciary advocates see the DOL’s proposal as a valiant first try, but recognize how it can be improved. Monks says, “The new rule takes some important steps toward leveling the playing field. But it doesn’t go far enough. For example, it should once and for all prohibit the practice of revenue sharing, in which mutual fund companies pay 401k plan administrators or sponsors to put their funds on retirement plan menus.”

Not only do the PTE and BICE exemptions remove the RIAs current advantage of calling themselves fiduciaries, they also defeat the DOL’s stated purpose. In the original research that determined the billions lost each year to retirement investors, (see “Study: SEC Fiduciary Delay Costing Retirement Investors $1 Billion per Month,” FiduciaryNews, February 12, 2013), it was determined that the only way to eliminate those losses would be to eliminate conflict-of-interest fees. The DOL proposed fails to eliminate those fees. Worse, the proposed exemptions institutionalize those fees. And gives those engaged in conflict-of-interest fees the opportunity to call themselves “fiduciaries.”

Is that in the best interest of retirement savers?

Interested in learning more about important topics confronting 401k fiduciaries? Order Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? –  How to Increase the Odds You Will Retire in Comfort is available from your favorite bookstore.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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