DOL Fiduciary Rule Proposal: Questions for Readers

As the DOL, with political backing from President Obama and Senator Warren (among others), ramped up efforts early this year in advance of the DOL's release of its proposed rule extending fiduciary duties, so did Wall Street and the insurance companies. Millions and millions of dollars have been flowing from broker-dealer firms, insurance companies, and others opposed to fiduciary rule-making. No surprise here.

Yet, the DOL's efforts continue. Despite an extension of the initial comment period, the DOL hearings are to be scheduled the week of August 10th, followed by another comment period, all leading to a final rule expected in early 2016.

Still, obstacles to the DOL's proposal are huge, in a city where money often sways personal, responsible judgment. There exist many ways the rule can be side-tracked in the months ahead.

Pro-fiducairy advocates largely support the DOL's proposed rule. Many consumer groups and pro-fiduciary advocates are scrutinizing the intricacies of the DOL's complex proposal, seeking to point out ways for improvement. Of particular concern is the Best Interests Contract Exemption, the terms of which remain subject to varying interpretations and concerns regarding effective enforcement.

Some fiduciary advocates have simply chosen to oppose the DOL's proposal. While I sympathize with their leaning, I do not believe that such "blanket opposition" is constructive. It is easy to say "no" to any regulation, and such opposition often leads to headlines and popular articles.

But let us not just seek publicity via blanket opposition. It is highly likely that the DOL won't "stop in its tracks." We must, accordingly, not be pure idealists, but rather undertake a more practical pursuit toward our objectives. Hence, I believe the best course is to engage with the DOL and seek to improve the rule and to close any perceived loopholes.

So, below, I seek out your insights, in response to some very specific questions.

In summary, the DOL has proposed expanding the definition of “fiduciary” and, in conjunction therewith, proposes a new “Best Interest Contract Exemption” (BICE). In essence, the BICE exemption abandons the long-standing requirement that compensation must be “level” – i.e., it authorizes the receipt of additional compensation by BD firms and insurance companies, but only if certain requirements are met. In essence, the “sole interests” standard under ERISA (which prohibits most conflicts of interests) is abandoned under BICE, in favor of a “best interests” standard which has many conditions to it.

Much has been written already which outlines the DOL's rule-making; this post does not seek to replicate such summaries, which can be found elsewhere via simple online searches. Instead, I assume the reader is familiar with the DOL's rule and with BICE, as proposed, and seek your input on some of the more intriguing questions posed by the DOL's draft rule.

Specific Questions Posed for Discussion.

1. How Can Higher-Cost, Similar Products Be Justified?  Given the substantial (and some would say “overwhelming”) academic evidence in support of the proposition that, on average, higher-fee investments underperform lower-fee investments, particularly over longer periods of time, under what circumstances would a higher-fee mutual fund (that provides additional compensation to the BD firm), possessing the same characteristics, be permitted to be recommended over a lower-fee mutual fund, under BICE?

a.     What would the “due diligence memorandum” (prepared by the BD firm, as justification for permitting such a higher-cost product to be recommended) look like, and/or contain?

b.     At its most basic level, when can differential compensation be justified for recommending one product over another product which is substantially similar in terms of its composition and risk characteristics? Does differential compensation in such circumstances create the very economic incentives, leading to conflict-ridden and poor advice, which ERISA’s sole interests standard was designed to avoid?

2. How Can Bonuses Be Awarded?  How would compensation structures change within BD firms and insurance companies? Since under the proposal bonuses to register representatives and insurance agents are not to be based upon receipt of differential compensation by the BD firm or insurance company, upon what criteria would “bonuses” be based for registered representatives and insurance agents, in a way which would not violate the requirements of BICE as to firm policies? Would firms likely adopt a largely qualitative approach to bonuses, with a “wink,” in which managers consider how much additional compensation is received by the firm as a result of a registered rep’s production, while not actually stating this in the award of bonus compensation?

A specific concern exists in the language of this example provided by the DOL in its release: “Example 5: Alignment of Interests. The Financial Institution's policies and procedures establish a compensation structure that is reasonably designed to align the interests of the Adviser with the interests of the Retirement Investor. For example, this might include compensation that is primarily asset-based … with the addition of bonuses and other incentives paid to promote advice that is in the Best Interest of the Retirement Investor. While the compensation would be variable, it would align with the customer's best interest.”

3. Changing the Relationship Between BD and RR? Tension?  How might this change the dynamic between BD firms (who possess an economic incentive to receive additional compensation, subject to certain requirements) and registered reps [who, at least according to the rule, should not (normally) be incentivized to receive additional compensation for recommending certain products over others].

4. Are VAs and EIAs More Likely to be Recommended in IRA Accounts?  Under “Example 4” the DOL provides in its release, differential compensation to the individual advisor can be justified if the time to “research and explain” annuities is more than that required for mutual funds. Given the higher amounts of commissions and other compensation generally paid in connection with many VA and EIA sales, and the inherent complexity of these products, will this example provide fuel for a large shift into VAs and EIAs, and away from lower-cost mutual funds?

 “Example 4:  Differential Payments Based on Neutral Factors. The Financial Institution establishes payment structures under which transactions involving different investment products result in differential compensation to the Adviser based on a reasonable assessment of the time and expertise necessary to provide prudent advice on the product or other reasonable and objective neutral factors. For example, a Financial Institution could compensate an Adviser differently for advisory work relating to annuities, as opposed to shares in a mutual fund, if it reasonably determined that the time to research and explain the products differed. However, the payment structure must be reasonably designed to avoid incentives to Advisers to recommend investment transactions that are not in Retirement Investors' best interest.”

In my experience, most registered reps don’t fully understand VAs and EIAs, and rarely does the client understand the true nature of the often-illusory “guarantees” of VAs nor the participation rates (and how they are computed) and caps of EIAs, and the insurance company's ultimate control over how such participation rates and caps vary from year to year.

5. How is a One-Time High Commission Amount "Reasonable"?  Suppose a client seeks to rollover a $1,000,000 401(k) account or IRA account into another IRA with an advisor. The “advisor” – acting under the BICE exemption – recommends a variable annuity (paying the firm a  or equity indexed annuity product (to avoid mutual fund breakpoints). Under many VA and EIA sales, the firm is paid a commission – perhaps 5% to 9% ($50,000 to $90,000) – up front. As a result, a surrender charge is imposed for several years should the investor withdraw funds from the annuity (usually in excess of 10% a year). Is this compensation “reasonable”? What if a lower commission is paid (say, 4%) but with trailing fees (perhaps 0.75% or so a year) for “ongoing advice” provided by the firm/registered rep or insurance agent? Should commissions be lower for VA and EIA sales - when higher amounts are invested - as is the case with breakpoints for mutual fund Class A shares?

6. Fixed Annuity, EIA Fee/Cost Determinations.  How can the fees and costs paid by an investor in a fixed income annuity, and in an equity indexed annuity, be determined, in order to satisfy the initial and annual fee/cost disclosure requirements?

7. Less Commissions, More 12b-1 Fees? Will this lead to the abandonment of Class A mutual fund shares (a trend started a decade or more ago) in larger part, in favor of Class C shares? Is this a good thing for investors? Since 12b-1 fees generally cannot be negotiated by an investor, does this present difficulties which caution the use of funds with 12b-1 fees? What if the SEC acts to limit, or even ban, 12b-1 fees in the future?

8. Does the BICE Exemption Meet the Requirements for a PTE? Under ERISA section 408(a) and Code section 4975(c), the DOL cannot grant a PTE (i.e., an exemption from the prohibited transaction rules and other ERISA requirements  unless it first finds that the exemption is administratively feasible, in the interests of plans and their participants and beneficiaries and IRA owners, and protective of the rights of participants and beneficiaries of plans and IRA owners. Is this exemption “in the interests of” investors? Is this exemption “protective of the rights” of investors?

Many other questions exist. Any insights you can provide are much appreciated.

Please comment in the box below, or e-mail me private at: WKUBear@gmail.com.

Thank you. - Ron Rhoades