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DOL Fiduciary Rule as Proposed May Not Stop Investor Losses as Claimed

DOL Fiduciary Rule as Proposed May Not Stop Investor Losses as Claimed
October 06
00:03 2015

The DOL, with very public backing from the President, unveiled its new proposal Fiduciary Rule (a.k.a. “Conflict-of-Interest” Rule) earlier this year. The White House Fact Sheet on this proposal (released February 23, 2015) states conflicted baggage-claim-6-1231642-300advice leads to, on average “1 percentage point lower annual returns on retirement savings” and “$17 billion of losses every year for working and middle class families.” Indeed, these facts reiterate academic studies (see, “Does New Study Seal the Deal for Fiduciary Standard – or Just Warn Plan Sponsors?, January 19, 2011 and “Study: SEC Fiduciary Delay Costing Retirement Investors $1 Billion per Month,”, February 12, 2013).

Ironically, under the current proposed Fiduciary Rule, it appears the DOL will, as long as there is a contract that says they’re acting in the ‘best interests’ of the client, continue to allow brokers to receive the very same form of compensation the cited studies say is responsible for the investor losses mentioned prominently by the White House. This contract has been vilified by the brokerage industry, even as it may benefit the most from the Rule as presently drafted.

“To some,” Marcia Wagner of The Wagner Law Group in Boston, Massachusetts, “the ability of brokers to receive conflict-of-interest fees (which we will assume to mean variable compensation, or commissions) as part of the Best Interests Contract Exemption (‘BICE’) is a ‘solution.’ It recognizes the industry concern that variable compensation is deeply embedded in the delivery structure for retirement plan services and products, and must be maintained while simultaneously adding additional criteria to address conflicts. To others, these fees are prima facie evidence of an insurmountable conflict and their survival within the scheme of the proposed fiduciary regulation package, including BICE, is a ‘loophole.’”

While the DOL has, in the past, focused on variable compensation, the academic studies that have been used by journalists to identify the billion dollar losses do not make a distinction between variable and non-variable compensation. Instead, they highlight specific conflict-of-interest fees. (N.B.: these fees do not represent a conflict-of-interest when limited to brokerage services, they only represent a conflict-of-interest when received under the guise of offering advice.) Braden Perry, partner in the Kansas City, Missouri based law firm Kennyhertz Perry, says, “The BICE allows brokers and advisors to receive otherwise prohibited compensation (12b-1 fees, commissions, trailing commission) if the Best Interest Terms are met.”

Under the wording now used for the DOL’s Fiduciary Rule, this loophole may allow for these conflict-of-interest fees and, as a result, nullify the claims that the Rule will help retirement savers avoid losses. Some, who may otherwise be in favor of a universal fiduciary standard, are now questioning if the DOL’s proposed cure won’t, in fact, be worse than the disease. “Most people in the financial service industry don’t think the BICE, as proposed, will work,” says Terry Dunne, managing director of the Rollover Solutions Group at Millennium Trust Company in Oak Brook, Illinois. “The BICE is probably the most controversial element of the lengthy proposed regulations and it is pretty easy to see why. The BICE will be difficult from a process standpoint, from a compliance standpoint, and importantly – it will create litigation issues. It also seems to run counter to the DOL’s purpose of cleaning up the conflicting advice.”

How Does the Proposed Best Interest Contract Exemption Work?

On the face of it, the BICE is fairly straightforward. Professor and Associate Dean Nelson Miller of Western Michigan University-Cooley Law School in Grand Rapids, Michigan, says, “Fiduciary advisers gain an exemption from other onerous requirements of the proposed DOL rule by having clients execute the BICE. The BICE becomes the adviser’s promise to provide advice in the client’s best interest, that the adviser’s firm has adopted policies to mitigate conflicts of interest, and to clearly and prominently disclose any such conflicts.”

The issue arises when one realizes exactly what kind of otherwise prohibited fees would now be permitted under the new regulation (as it is at the moment worded). “The BICE was developed/included by the DOL to allow advisors (who would now be defined as fiduciaries) to receive payments/compensation such as brokerage or insurance commissions, 12b-1 fees and revenue sharing payments while providing investment advice,” says Dunne. “Yet, for a fiduciary, this represents a ‘conflict-of-interest’; using their authority to affect or increase their own compensation for investment advice. The logic would be that the investor would understand that there was a conflict-of-interest and they would be comfortable signing a document because there must be some ‘added value.’ The BICE basically brings brokerage or insurance commissions, 12b-1 fees, and revenue sharing payments back in play…probably because these forms of compensation have been and are so common in the marketplace.”

The proposed Fiduciary Rule is intended to addresses conflicts-of-interest in a segment of the retirement plan market not addressed today. “BICE is designed to provide relief to fiduciary advisors who earn variable compensation, such as commissions, from retail retirement clients,” say Wagner. “The covered retirement clients include participants and IRA owners. They also include sponsors of non-participant-directed plans with less than 100 participants, such as small defined benefit plans. However, it does not extend to sponsors of small 401k plans and other plans with participant-directed investments… so there are limits to the ‘loophole’ if you will.”

The DOL currently (under the Frost Advisory Opinion Letter) permits 401k plan fiduciaries to charge normally prohibited self-dealing transaction fees. Yet the language surrounding the proposed new Rule suggests the new Rule will eliminate those fees. This contradiction has not gone unnoticed. Dunne says “Yes, this seems to be at odds with the intention of the proposed regulations. The proposed regulations are based on the concept that the DOL wants investors to receive advice from a fiduciary that is always in the best interest of the investor. So it seems strange that an exception would be created to allow an advisor to provide conflicting advice if there is an agreement that says he or she can. The DOL’s intention with this exception is to allow the advisor to offer conflicting advice if the participant/investor fully understands what advice/product/service is being offered via an agreement. The advisor is saying, ‘Sign this BICE document and I will be providing you something that you need that is better than what you were receiving before, it helps you more than what you had before, and/or this advice is in your best interest and this is how I will get paid.’”

While the loophole gives the impression it is a wide open gateway for the continued use of conflict-of-interest fees, that doesn’t mean there are no hurdles for the broker intent on conducting business as usual. “BICE also imposes substantial and rigorous requirements to be satisfied for compliance,” says Wagner. “In other words, the ‘loophole’ does not earn its way easily. The exemptive relief under BICE is specifically restricted to certain listed investment products which do not include private placements and alternative investments. There must be a written agreement between the fiduciary advisor and the retirement client that contains specific mandatory provisions and warranties. For example, the advisor must acknowledge that it is a fiduciary for purposes of ERISA. It must incorporate the ‘Impartial Conduct Standard’ as defined under the BICE – meaning that the advice will be provided by the advisor in accordance with the ‘best interest’ fiduciary standard, very similar to the ERISA fiduciary standard itself. Even though allowing variable compensation, it still must be ‘reasonable.’  The advisor’s firm must have adopted compliance policies reasonably designed to address conflicts, and that it has eliminated sales incentives that would influence the advisor’s recommendations. And finally, I would note, the written contract must include specific disclosure items, including the fact that the advisor’s conflicts of interest include the ability to influence its own variable compensation.”

How Brokers Can Continue to Receive Conflict-of-Interest Fees Under the DOL’s Current Language

Once these obstacles are sufficient addressed, the bottom-line is that, short of a substantial change in the DOL’s current language in the proposed new Fiduciary Rule, brokers can continue to receive the same conflict-of-interest fees they always have. The industry applauds this as “not impacting the existing business model.” To continue to receive this conflicted compensation, Perry says “the advisor or broker must acknowledge their fiduciary duty; provide disclosers regarding fees and compensation; provide warranties and representations regarding information on the investments and are prohibited from providing misleading statements; advise how he or she will mitigate the conflicts; and provide performance statements on a quarterly, annual, and website publication basis showing performance and fees.”

Miller agrees, saying, “Advisers may still receive conflict-of-interest fees under a Best Interest Contract if the adviser has acted in the client’s best interest, the firm has adopted the conflict-mitigation policies, and the adviser has clearly and prominently disclosed the conflict that generated the fees.”

Perry says, “Conflicts of interest come in many ways, and are not solely related to fees. The best interest contract takes the approach that fees are only a part of the analysis on conflicts. It’s an umbrella under which a potential conflict may fall; but not prohibited completely. You view an investment as a whole. Service, investment options, fees, etc. all go into the mix and the advisor must find the best value for the client, not just the lowest fees. There could be an investment suitable for an investor with high fees but appropriate value because of the diverse selection of investment options.”

Perhaps the biggest advantages brokers have with the current language is its ambiguity, as well as the DOL’s insistence that the Department will rely on arbitration and adjudication when it comes to enforcement. “The problem with the loophole is that brokers would effectively have to weigh conflict-of-interest fees vs client’s best interests and that’s based on facts and circumstances,” says Ary Rosenbaum of The Rosenbaum Law Firm P.C. located in Garden City, New York. “So there isn’t a definitive answer and that’s going to be a problem that will eventually be litigated.”

It doesn’t take a vivid imagination to see the brokerage industry’s best line of defense when it comes to arguing whether they have violated the BICE. “Simply because the adviser receives fees in a conflicted investment transaction, say for instance the sale of an investment product from which the adviser receives a sale commission, does not mean that the investment was not in the client’s best interest,” says Miller. “Presumably, many of the transactions in which advisers have earned conflicted fees over the years were nonetheless good for the investor client. Conflicts don’t automatically mean the investment advice was not in the client’s best interest and otherwise unsound. Conflicts simply create an incentive to modify the advice out of the adviser’s self-interest. To be in the client’s best interest, the investment must serve the client’s investment objectives and goal as well as or better than investment options in which the adviser had no conflict-of-interest.”

Any number of ancillary reasons exist which can help justify why a conflicted product might be in the client’s “best interests.” Dunne says, “As mentioned above, the advisor is saying, ‘Sign this BICE document and I will be providing you something that you need that is better than what you were receiving before, it helps you more than what you had before, and this is how I will be paid.’ Maybe this is additional services like tax planning, cash flow planning, estate planning, or other valuable advice. Maybe it is access to more sophisticated investments to achieve the investor’s goals like alternative investments in an IRA to enhance diversification or enhanced returns. Most qualified retirement plans offer a limited number of investment choices, whereas within IRAs there is more choice. Maybe the consolidation of the investor’s retirement assets represents added value to the investor which is the intention of the advisor. But realistically, few people really read contracts. No matter what, investors still need to have done their homework to determine what advice they need and by whom and at what cost.”

Despite the apparent ease for brokers to defend themselves, there is still a cost associated with the defense. Someone will have to bear that cost, and that someone is likely to be the client. “The big problem for advisers with the BICE specifically and the DOL Rule in general is that they are liable for any damage to the client due to breach of the BICE,” says Miller. “The rule effectively creates a private right of action, giving the client an opportunity to sue the adviser anytime the client has lost money on an investment that no longer looks like one made in the client’s best interest. The rule expands adviser liability. Clients will find greater opportunity to hire private lawyers to pursue recoveries against advisers. The cost of investment advice will go up to cover the cost of that liability.”

How the DOL Can Close the Loophole Created by the Proposed Language

It is possible there are two different issues surrounding the loophole. The first – variable compensation – may be the easiest to address. “The loophole gets closed if the DOL implements a level fee approach like they did with the investment advice regulations,” says Rosenbaum.

By looking only at variable compensation, it appears the DOL can address both the loophole and retain existing business models with adding unduly burdensome regulatory constraints. Wagner says, “The most effective way, or direct way, to close the ‘loophole’ is to require level compensation, compensation which does not vary. I say this because the biggest challenge to BICE may be the requirement that the financial firm adopt compliance policies that eliminate sales incentives, which may be exceedingly difficult to do practically.”

But variable compensation is only one aspect of the loophole. By far the more significant facet is the objective to, as the White House Fact Sheet says, stop the losses suffered by middle class retirement investors.  Unfortunately, as the academic research suggests, this can only be accomplished by eliminating conflict-of-interest fees all together. Such an action, while it would level the regulatory playing between SEC-Registered Investment Advisers and non-SEC registered advisors, effectively outlaws the brokerage/advice business model (although, and this is an important point, it would not outlaw the brokerage business model).

“It is clear,” says Wagner, “the academics and the persons manufacturing and delivering products have a vastly different idea of how the world works and should work – to wit, to truly address the academic concerns might entail the wholesale elimination of variable compensation (12b-1, commissions, etc…), which could be quite disruptive. It would be beneficial if this regulatory initiative increases the disclosure and dialogue between the two communities to find common ground for the greater good.”

As difficult as this may sound, adopting anything short of this may leave the DOL’s claims all but empty.

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s every 401k plan sponsor and service provider wants and needs to know.

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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