DOL Fiduciary Rule, Pt. 2 (Apr. 6)

Mike & Co. —

Good seeing you and others at Julie Chon’s tonight.  

As you know, Labor Secretary Tom Perez announced the final DOL Fiduciary Rule this morning at the Center for American Progress.  The Rule was six years in the making, the product of tense negotiations between some moderate Democrats and the Secretary as well as a strong lobbying effort from the financial industry.

Secretary Clinton lauded new Rule today, saying they would “stop Wall Street from ripping off families” and that it can help boost the economy for the middle class and said she would protect President Obama’s efforts to curb Wall Street’s power. Though the Rule’s compliance requirements will not be fully implemented for another two years, the Rule announcement is landmark: with $24 trillion dollars held in retirement savings, including $7 trillion in IRAs, it’s not a surprise that it is getting attention. 

Treasury’s inversion policy initiative, which got even more attention this week, is covered tomorrow. 

Best,

Dana 

 

———

The Rule, first proposed last April, will require brokers to act in their clients’ best financial interest when offering retirement investing advice. That’s a higher standard than brokers face now.

In one of the biggest changes from the initial proposal, the final rule simplifies the “best interest contract,” a provision that allows brokers to continue to get paid commissions as long as they make a host of disclosures to customers. Specifically, the final version eliminates a list of financial products that would have effectively been banned in retirement accounts, a key break for listed options and non-traded “Real Estate Investment Trusts,” for example.

In addition, the rule loosens previously proposed disclosure requirements for fees. While the initial rule required annual disclosure of fees, the final rule removes that requirement. The final rule also eliminates a requirement to provide clients with one-, five- and ten-year projections of fees at the point of sale.

Secretary Clinton lauded new White House rules on financial advisers today, saying they would “stop Wall Street from ripping off families” and that the new Rule can help boost the economy for the middle class and said she would protect President Obama’s efforts to curb Wall Street’s power.

Per Labor Secretary Perez: “Are you for consumers, putting their best interests first, or do you think that the only way financial advisers can provide advice is to put their financial interests first?”

The Rule has been among the largest regulatory undertakings for the Labor Department under Obama, as the most recent comment period spanned five months, generated 3,000 comment letters and involved over 100 meetings.

The Rule streamlines earlier requirements — they give advisers a flexible time frame to present a contract outlining any potential conflicts, after industry groups raised concerns that advisers would have to present such paperwork before even beginning a conversation with a potential client.

It also jettisons the idea of requiring firms to provide projections for possible investments, amid concerns such a system would be difficult and expensive to implement.  Investment advisers do not have to meet as strict of data retention requirements as originally envisioned in the proposed Rule.  DOL originally  suggested an eight-month window to fully comply with the new rules.  That window has now expanded to at least one year, but full compliance is not required until the beginning of 2018.

As a result of an extraordinarily lengthy comment and negotiating process, the final Rule issued today contains some key concessions for industry interests aimed at softening the transition period for advisers, curbing disclosure and paperwork requirements, and allowing advisers some leeway to continue hocking their firm’s own products.

How did we get here?

Changes from the Proposed Rule

Foremost among these:

  •  Longer implementation period:

Firms will have until April 2017 to come follow some provisions, and January 2018 to be fully compliant with the new rule – a boon to both small firms and opponents, as skeptical lawmakers will have more time to dilute or reverse the rule during that time.

  •  Proprietary products exemption

Advisers can continue to sell their firm’s proprietary products, as long as they follow best interest standards laid out in the final rule.  For instance, a MetLife employee wouldn’t be obligated to mention a competitor’s products if they had a reasonable basis to believe his firm’s own products are within the client’s best interests.

  •  Commission-based activities clarified:

The final Rule makes more clear what commission-based activities are acceptable under the fiduciary guidelines.

  •  Paperwork reduction:

The Rule clarifies that advisers and clients only need to sign one “best interest contract” when an account is opened, rather than each time they speak with each other or do business.  It also allows firms to simply notify existing clients of the it obligations, rather than sign a new contract.

  •  Annuities rules tightened:

Originally exempted from the Rule, so-called fixed-index annuities have been added to the pool of products requiring a “best interest contract.”  This is one of the few cases of a rule being tightened between the first and final rule.

Impact on Industry

A major concern from independent advisers and small-medium sized firms was the cost of a short period for compliance (originally set to eight months) and the cost of strict disclosure and paperwork requirements.  The Rule aims to quell those worries through its lengthy compliance period and streamlined paperwork and reporting requirements.  When discussing the first draft rule, from April 2015, a mid-size firm with 2,800 advisers estimated its compliance cost at $15 million in the first year.  As companies pore over the new Rule costs in the wake of the new changes will become clearer.

Beyond the cost of compliance, perhaps the greatest cost of all will be through lost business at smaller firms and with independent advisers.  Exemptions for giving advice to independent fiduciaries (such as company plan sponsors), using asset allocation models, and clarifying that an adviser marketing himself is not an “investment recommendation” is meant to help these firms stay competitive.

Big firms stand to gain the most from the new rule, and low-cost annual fee-based investment companies are especially fortunate.  BlackRock, Vanguard, WisdomTree, and State Street all offer low-cost options through index mutual funds or ETFs, which critics claim were given an unfair advantage in the proposed rule; the final rule has removed that particular provision (called the low-fee streamlined option).  Nevertheless, larger firms will be better able to bear the burden of compliance, reporting and paperwork.  They are also able to offer a more comprehensive list of products for investors that comply with the rule, and their business models already favor annual-fee contracts versus commission-based income.

As the final Rule is studied further and its implications are better understood, the picture moving forward will become clearer.  It’s reasonable to expect large firms, like those listed above, to rapidly gain market share as small-account investors move their money over.  Index mutual funds will see a surge and businesses like Vanguard will take an even larger portion of stock ownership to satisfy their new customers.

Impact on investors and Retirees

Per the administration, investors stand to gain back $17 billion lost each year to conflicted advice.  For holders of existing accounts who may be concerned that their current investments will become defunct because of conflict of interest provisions, the final rule contains a grandfathering clause allowing for “recommendations to hold [current investments] and systematic purchase agreements” to continue carrying commission fees.  After the Applicability Date, however, new investments must comply to “basic best interest and reasonable compensation requirements.”

What does that mean in practice?  More retirement advisers will recommend to their smaller accounts that they invest in low-cost fixed-fee products, rather than more complex investments that can contain withdrawal penalties and commission fees.  The DOL sees this as a benefit of the rule, while industry advocates and opponents think it translates to poorer quality advice for savers.

With carve outs for the use of investment models and the provision of advice to “independent fiduciaries” with financial training (more likely to be found heading company-sponsored plans), it’s likely that these plans won’t operate much differently than before.  Adding to that, most company plans are large enough to operate with annual fees rather than through commission, meaning that the reasonable compensation requirements shouldn’t affect their fee structure.

Next Steps

Initial reactions from industry are more or less positive.  No doubt we will hear their full opinions once the rule has been properly analyzed, but the truth is that much of the final Rule dovetails rather nicely with the changes that industry leaders have been making for the past few years.  Shifting to an annual fee-based model, pushing low-cost index funds and ETFs, and increasing education for retirement savers are all popular services offered by leading investment advisory firms.

The future of the myriad bills in Congress aimed at stopping the rule from taking effect isn’t certain – if the changes seen in today’s rule (of which there are many) are enough to placate moderate Democrats and Republicans then their chances will be severely diminished.

The SEC, which has previously warned DOL that its preliminary rule could be harmful, has not yet released an opinion on the Rule.   SEC Commissioner Piwowar, a Republican, said the Obama administration’s rule “seems to ignore the chorus of voices that questioned whether it will restrict middle-class families’ and minority communities’ access to professional financial advice.”

Brokers will need to comply with certain aspects of the rule by April 2017 to take advantage of the best-interest contract. Other requirements will go into full effect on Jan. 1, 2018.

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