9 Observations and 5 Questions About the DOL Fiduciary Rule


This post originally appeared on my blog, www.scholarfp.blogspot.com. I have updated it to reflect recent discussions and events.

Two weeks have now passed since the DOL's fiduciary rules (i.e., its "Conflict of Interest Rule" and related prohibited transaction class exemptions) have been partially implemented. And the world of financial services continues to evolve.

Over the past few weeks I've had a number of thoughts about the rule:

1. Who do you represent? It seems to me that most of the problems exist when a person tries to wear two hats. In the end, you either represent the manufacturer of a product well (in an arms-length relationship, typically), or you represent the client well (as a fiduciary). You can't do both - successfully.

If you are an employee (or independent contractor) of a BD firm or an insurance company, some have written that you cannot be a fiduciary to a client. That's not true. Your primary fiduciary duty is to your client (as is your firm's). Your fiduciary duty to your employer is secondary - always. In the event of any conflict between your obligations, the obligations owed to the client come first.

Here's a rule designed to keep you out of trouble ... If you represent the client, get paid only by the client. If you represent the product manufacturer, and you distribute products, get paid from the product. Don't mix the two. Most of the problems that will arise in client complaints, leading to arbitrations and/or litigation, will likely involve not the amount of total compensation received, but the manner in which it was received.

2. The impartial conduct standards, with their application of the prudent investor rule, are tough in their application of the investment adviser's duty of due care. 

Advisers of all ranks need to step up their due diligence. To me, there have always been two key inquiries: investment strategy; and investment security or product due diligence.

     A) Investment Strategy Due Diligence. You have the duty to minimize idiosyncratic risk, under the prudent investor rule. This is more than just minimizing a portfolio's standard deviation. It also involves not suffering a permanent long-term underperformance of the portfolio.

Perhaps one way to address this issue is by asking this question ... "If you deviate from a "total stock market" / "total bond market" / "total universe of publicly traded REITs" portfolio, what solid reasons do you have for doing so?"

There are many solid reasons for deviating from such a total stock market / total bond market portfolio. But which ones are supported by strong evidence? Can you back up your asset class selection, and your means of mixing those asset classes (i.e., through strategic or tactical asset allocation), via proper evidence, or is what you are doing more akin to speculation?

If your investment strategy is challenged, you are likely to possess the burden of proof. (Generally speaking, those who claim the use of a prohibited transaction exemption bear the burdens of demonstrating their allegiance to their conditions. Additionally, where a conflict of interest is present, the burden of proof often shifts to the advisor to prove that the client was not harmed by the existence of the conflict of interest.) Accordingly, can you prove that your investment strategy is defensible? Specifically, can you prove your investment strategy makes sense by the support of expert testimony, and is not just based upon speculation? Will your expert's testimony even be admissible?

Note that to have your expert's testimony admitted in a judicial proceeding, Rule 702 of the Federal Rules of Evidence incorporates the Daubert standard, which is also followed by more than half of the state courts:


A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

(a) The expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;

(b) The testimony is based on sufficient facts or data;

(c) The testimony is the product of reliable principles and methods; and

(d) The expert has reliably applied the principles and methods to the facts of the case.

(Emphasis added.)

Very generally, your expert's opinion must be based either on strong academic evidence, extensive back-testing, or some other robust and reliable analysis.

Ultimately, the judge is the gatekeeper, ruling upon whether an expert's testimony is reliable (and hence relevant to the matter at hand), and therefore admissible.

    B) Is Your Investment Product Due Diligence Up to Par?

Under the prudent investor rule, you possess the duty to not waste the client's assets. In the world of pooled investment vehicles, such as mutual funds, this means paying close attention to fees and costs. A huge amount of academic research supports the conclusion that higher investment product fees and costs lead to lower returns, especially over the long term.

While mutual funds and ETFs provide a means of diversification among individual securities, the fees and costs of such funds deserve intense scrutiny. In essence, as seen in many cases brought against plan sponsors over the past decade, if you have the ability to recommend a lower-fee-and-cost mutual fund or ETF versus a higher-cost mutual fund or ETF, all other things being equal, do so!

It's time to up your game, when you undertake due diligence. Do the factors you apply in selecting investment products (to implement your strategy) flow from either common sense or do they possess academic support? Are you examining all of the fees and costs of the fund at hand? Are you comparing the product to all others in the marketplace?

If you are using alternative investments, then the degree of due diligence required only increases. Intense due diligence is required. Do you possess the expertise to undertake such due diligence? Have you throughly documented your due diligence efforts?

Here again, we see where the major problems will exist under the DOL fiduciary rule. You can charge fees, but if you derive your fees in part from third-party payments (i.e., sales loads or commission, 12b-1 fees, payment for shelf space, other revenue-sharing arrangements, etc.), then you face an uncertain outcome during litigation or arbitration proceedings in which the prudent investor rule is applied. Those third-party payments come from higher investment product fees. And higher investment product fees, all things being equal, violate the duty to not waste the client's assets.

But, charge fees directly to the client, and choose very-low-cost pooled investment vehicles to implement the investment strategy, and it is very, very difficult to challenge the amount of your fees.

3. The impartial conduct standards impose a strict fiduciary duty of loyalty.

The impartial conduct standards override every other consideration in the DOL's rules.

Want to offer proprietary products? - Beware. Very, very difficult to justify, in my view. Yes, an exemption exists. But read it carefully. Your due diligence needs to be thorough, and it must (effectlvely) conclude that your firm's product is the best for the client. For example, if your firm offers proprietary stock mutual funds, using objective criteria can you conclude that your firm's fund is better than all of the other similarly-situated funds? (Very difficult.) BUT ... a way exists to do this. Credit all of the fund management fees and 12b-1 fees received against your firm's investment advisory fees; this is the way it is done with bank proprietary mutual funds used in bank-trusteed accounts, in many of the states (applying state statutory law applicable to bank's products). And, ensure that the administrative fees of the fund are benchmarked against similarly situated funds and are at the median of administrative fees, or less.

Want to recommend products that pay your firm additional compensation over and above your investment advisory fees? - Beware. You are probably wasting the client's assets. Unless you credit the additional compensation received against advisory fees paid.

Want to use B.I.C.E. to accept product-related compensation, including 12b-1 fees, payment for shelf space, soft dollar compensation, etc.? You are walking into a minefield. Smart individual advisers will avoid using B.I.C.E. The problem is not with the impartial conduct standard's "no more than reasonable compensation" requirement. If you are providing services which are difficult to quantify or compare (such as financial planning which is goals-based, and especially life planning services), you won't need to be concerned much about challenges to your fees. It is very, very difficult to "benchmark" professional counseling fees against other fees. In fact, courts resist interfering in fee disputes, unless the fees are clearly outrageous for the services provided.

But, if part of your fees are derived from the products, those fees come from somewhere. For example, payment for shelf space is derived from higher fund management fees. And 12b-1 fees that provide little or no benefit to fund shareholders. It is very, very difficult to justify higher product costs, especially when they increase your compensation. That's why it is important to levelize compensation (at the firm level), such as by crediting third-party compensation received against advisory fees.

Of course, it is far simpler - and less costly from a systems and technology standpoint - to just adopt an approach where all compensation is received from the client, directly, and product-related compensation is eschewed.

4. The Amount of Your Compensation Is Not Likely to Be Challenged by the DOL or IRS, But the Manner In Which You Receive Compensation Can Lead to Troubles.

It is very, very hard for a government agency to bring, and prevail in, an action on the basis that your compensation is unreasonable. And courts don't like to intercede in this cases. In essence, if only the amount of compensation is at issue, then you have little to fear. You have even less to fear if you are providing financial advice and/or life planning advice in addition to investment advice.

However, as I mentioned above, if your compensation is not levelized (including the compensation paid to your firm) through fee offsets, then a much, much easier case exists - at least in private litigation or private arbitration. Again, if you receive payments from third parties (i.e., product manufacturers, or via custodians who receive product manufacturer's compensation and pass on some of that to your firm), and if those third-party payments are not credited against your previously agreed advisory fees, then the manner of your compensation is likely to be challenged as a potential "waste of the client's assets" and a conflict of interest that is not properly managed and harms the client.

5. American business owners (i.e., plan sponsors) should rejoice.

Plan sponsors run businesses. They are not investment experts. So they turn to retirement plan consultants to assist them in fulfilling the plan sponsor's fiduciary duty. Plan sponsors rely upon the recommendations these consultants make.

But, as so often seen in the class action cases brought against plan sponsors to date, in nearly every instance the "retirement plan consultant" (broker-dealer) is dismissed from the case. Why? Because the consultant, under the DOL's prior definition of fiduciary, was not a fiduciary and did not possess a duty of care. They only possessed something less - the vague duty of suitability.

Be aware that "suitability" as a concept was originally formulated in the early 20th Century to prevent liability for brokers who were engaged in trade execution services (order-taking), only. This was appropriate at the time, as brokers should not be held liable for the decline in price of a company's stock, where investment advice to purchase such stock was not provided. In essence, suitability negates the ordinary duty of care most providers of services  Unfortunately, in the 1970's the SEC extended the application of the doctrine to the selection of investment managers (e.g., mutual funds), and suitability has been improperly used as a shield by broker-dealer firms (with the assistance of FINRA) to guard against liability.

Under the current DOL rule, now applicable, plan sponsors will be able to hold their consultants responsible. And, as a result, consultants will give (collectively) much better recommendations on which funds to include in 401(k) and other ERISA-covered plan accounts.

The result is a shifting of costs (relating to potential liability for inappropriately choosing products) away from American business owners and onto the retirement plan consultants. As it should be - for when advice is provided by retirement plan consultants, they should be held accountable for that advice.

6. The American economy's future is brighter.

As consumers continue to possess savings from less fees and costs, their retirement account balances will grow larger over time.

These accumulated assets, in turn, provide the fuel for the American economy. As greater savings and larger investment balances take place, over time, greater capital is available. This lower the cost of capital for American business. It will provide the fuel to transform innovation into new products and services that benefit us all.

It is difficult to quantify the amount of increased capital accumulation, here in the United States, as a result of the new DOL rules. In part because the DOL's quantitative analysis focused on IRA accounts, and the often-cited "$17 billion a year in savings for retirement investors" does not include the additional savings likely in 401k and other ERISA-covered qualified retirement plans. Nor do the savings include the spillover likely to result as non-qualified assets are increasingly likely to be managed under a fiduciary standard.

Still, it might be speculated that the pool of capital available to American business owners, as a result of the DOL's fiduciary rule alone - should the rule continue - will be 10% greater in 15-20 years (and perhaps much, much greater). And, the effect is compounding, spurring on U.S. economic growth for generations to come.

7. Changes in law and regulation creates winners and losers; competition is enhanced.

ERISA, and the old DOL regulations, created winners and losers. For example, plan sponsors incurred liability to employees, while brokers (upon whom they relied) usually possessed none. This shifted costs from Wall Street and the insurance companies (the product manufacturers and their distributors) to American business owners (plan sponsors). In essence, the old DOL regulation, adopted in 1975 and much out-dated, prevented (through ERISA's preemption) the application of state common law fiduciary duties on those providing advice to sponsors of ERISA-covered retirement plans.

The changes in the law and regulation create winners and losers as well. There are many in American business that stand to benefit. First and foremost are plan sponsors - business owners that strive to do the right thing for their employees, by providing retirement security for them.

Of course, many of those who stand to lose under the changed regulations have, and continue to, scream the loudest. As seen in the media, they profess that they embrace acting in their customers' "best interests." But they resist being held to a "best interests" standard - and hence resist real accountability for the advice they provide.

The fact of the matter is - when investment and insurance products are forced to compete on their merits - and not on the basis of how much revenue-sharing or other payments they provide - true competition among product providers results. And isn't true competition in the marketplace what we desire to promote?

8. Insurance companies and asset managers will continue to fight hard.

When you create true competition in the marketplace, the strong will survive. As it should be.

Some insurers stand to lose billions and billions of dollars a year from the changes in the proposed regulation. Even more than the DOL predicts, in my view, as a "tipping point" may have been reached in the marketplace. Not only IRA accounts and ERISA-covered retirement plans are affected, but the application of fiduciary principles will increasingly occur to other accounts, as well.

Low-cost investments will win out. This includes many but not all passively managed investments, and some low-cost actively managed investments. The academic research is fairly conclusive that high-cost actively managed investment products are very likely to underperform over the long term. But the academic research on low-cost actively managed investments remains inconclusive, in my view.

As a result, high-cost active fund (pooled investment vehicle) management is on its way out the door (at least, substantially). Most high-cost variable annuities, hedge funds, and non-publicly traded REITs cannot be recommended under the prudent investment rule, once you undertake an independent, objective cost-benefit analysis of the product involved.

And recommendations to purchase immediate fixed annuities, or equity index annuities (also called fixed index annuities) - from insurance companies that are not highly rated as to their financial strength - are also problematic. (In Australia, when a similar standard was imposed, financial advisors largely discontinued recommending immediate lifetime annuities from insurers with low financial strength ratings). Fortunately, some good low-cost VAs, and immediate annuities from strong insurers exist. [And I hope that financial advisers will increasingly suggest for their retired clients annuitization of a portion of the retirement nest egg over the client's lifetime, given the robust academic support for this approach.]

The underlying investment concept of EIAs is a good one, from the standpoint that they could form a portion of a client's overall portfolio (generally, as part of a fixed income allocation, although other approaches to how EIAs are incorporated into an investment portfolio are possible). But the control by the insurance company of its own profits, the lack of transparency in the products, their complexity, and their high embedded costs create an opportunity for some company to come along and provide a much better EIA from a highly rated insurer. Some new EIA products are coming to the marketplace, however, and I am hopeful that better EIA products will soon exist that pass due diligence.

Cash value life insurance sold as a retirement planning vehicle? Just say no - at least most of the time. The explanation of the tax trap that awaits, the the fees/costs incurred versus the benefits achieved, could occupy a dozen or more pages. However, there are instances, such as for asset protection purposes for clients engaged in high-risk professions, that the limited use of such tools can make sense. Please refer to a Discussion Board post by me, in which I elaborated on the cost-benefit analysis, in greater detail.

With so much money at stake, the insurance lobby's fight over the DOL rule's continuation, after 1/1/2018, will be brutal. In particular, the insurance lobby has always been among the most powerful in Washington, D.C. But, hopefully, common sense will prevail. But only if we continue to educate policy makers that the imposition of bona fide fiduciary obligations:

  • Creates true competition in the marketplace;
  • Aids American business;
  • Will spur on U.S. economic growth, especially over the long run; and
  • Provides increased retirement security to our fellow Americans.

9. We possess an inflection point that accelerates the trend toward fiduciary advice and away from product sales.

The transition from a product seller (paid from products) to a fiduciary adviser (paid by the client) can be a tough one. Especially so when credits must be provided against future advisory fees, due to commissions recently paid. Adviser's compensation may be depressed, at least for a period of time.

Yet, when the transition is made by the advisor, it is readily apparent that:

   - Clients are happier; they have greater trust in their adviser; and

   - Advisers are happier; they prefer being on the same side of the table as the client; and

   - It is simply a better business model. Under an advisory model where fees continued to be paid by the client, regardless of the activity taking place, the advisor is free to provide more holistic and comprehensive advice. (Of course, "reverse churning" must be avoided, as the DOL and other regulators have warned against.) Advisers who have transitioned from commission-based compensation (product sales) to fee-based compensation (advisory fees, in a fiduciary relationship) report that they enjoy going to work every day. Free from the need to undertake transactions to make a living, they can focus more on the objectives of the client. They tend to increase their own personal counseling abilities.

One can easily question the "value proposition" of many broker-dealer firms today. Especially from the fiduciary adviser's standpoint. Many RIA firms utilize discount brokerage firms as custodians (such as TD Ameritrade, Schwab, Fidelity, and several others). These discount brokerage firms compete to provide their services, to RIAs. The result is often far less costs incurred by clients.

So many registered representatives have left to form, or to join, fiduciary RIA firms in recent years. Yet, one hardly ever hears of advisers that move from RIA firms to broker-dealer firms (or from a fiduciary relationship with their clients to a non-fiduciary one).

The DOL fiduciary rules, even if only effective for 7 months or so, will accelerate the long-observed trend away from commission-based compensation and toward fee-based accounts.

As will the CFP Board's proposed revisions to its Code of Ethics and Standards of Conduct, which impose a "fiduciary at all times" status on Certified Financial Planners(tm) (assuming the standards are adopted in their present draft form).

Questions Remain. In the months ahead, perhaps we will have answers.

    A. How enforceable are the impartial conduct standards today, via private action? Do they constitute implied terms of express contracts? (Even though the DOL does not require during this transition period that the warranties to act in the client's best interests be expressly included in client agreements). If so, then these standards apply to existing IRA accounts that are not grandfathered. And that is a huge event - as the standards would be enforceable by private legal action (judicial actions or, much more commonly, individual arbitration proceedings).

(It is clear that the impartial conduct standards now apply to plans and accounts governed by ERISA, and also now apply during the IRA rollover decision-making process. But I continue to hear varied opinions as to whether the impartial conduct standards can be enforced as to IRA accounts where BICE applies or 84-24 applies and where no IRA rollover takes place, and grandfathering of the account has not taken place.)

Be aware that in addition to possible claims brought under the DOL's rules, as an adviser you are now far more likely to be found to be in a "relationship of trust and confidence" with a client. As a result, in many, many states your liability may rest under state common law principles, in which fiduciary status is applied. And, in such cases, the courts (or arbitrators) may well turn to the impartial conduct standards as evidence of the standards to which you are held (even if the impartial conduct standards are not an implied term of your express contract with the client).

    B. Is commission-based compensation for mutual fund sales, such as Class A mutual fund share sales, incompatible with Modern Portfolio Theory (which, in turn, is incorporated into aspects of the prudent investor rule)? Given that asset classes need to be rebalanced - whether you are undertaking either strategic or tactical asset allocation - and that previous funds purchased on a commission basis would need to be sold (at least in part) within what, in some market situations, is a relatively short time, how can the payment of commissions not be deemed a waste of client assets?

For Class A shares, often "free exchanges" within the fund family are available. Yet, you possess a duty of due diligence. By limiting yourself to one fund family, are you fulfilling this fiduciary duty of due care?

Newer classes of shares have lower commission structures, but don't appear to offer "free exchanges" at all. This is a greater concern.

   C. Will registered representatives see their U-4s dinged to a very large degree, if they utilize BICE? One of the many things I don't like about B.I.C.E. is that firms can receive additional product-related compensation, but advisers' compensation arrangements must generally be level. That means that the economic incentives of broker-dealer firms and their advisers are different and distinct. Broker-dealer firms possess the incentive to seek out greater compensation paid to the firm, while advisors should not share in any additional compensation (with a few limited exceptions).

And this creates, in turn, a terrible risk for advisers. Should clients file complaints and/or sue (or compel arbitration), firms may see the resulting liability simply as a "cost of doing business." Brokerage firms' reputational risks are generally minimal, as such firms can overcome bad publicity by extensive advertising, by blaming occurrences on "rogue brokers," or even by preventing publicity at all (in settlement agreements). But advisers have their U-4 at risk - and the adviser's reputation is everything.

I am concerned that advisers who practice in firms that use B.I.C.E. to receive additional compensation (paid to the firm) are putting themselves at risk. I suggest advisers insist on not using B.I.C.E. (except its requirements, under BICE Lite, for IRA rollovers). And ... no proprietary products. No principal trades. No products that pay 12b-1 fees or other forms of revenue sharing to the firm. And no substantial limits placed upon the adviser's ability to survey the universe of investment products and to recommend the best ones out there.

Again, keep your compensation received from the client completely separate from products fees and costs. When you mix them, bad results will occur.

   D. What Will Happen Come Jan. 1, 2018?

I expect another delay in the application of the final rules. I also anticipate that B.I.C.E. will be modified (particularly as to the amount of disclosures required). Lastly, a new exemption from the DOL Rules may be in the works, but its parameters remain unclear. The remedies available under the DOL rules may be modified, particularly as to the issue of the availability of class actions.

I doubt that the Impartial Conduct Standards will be modified significantly, as they are rooted in the language of ERISA. The key issue will be whether they will be enforceable as to IRA accounts, after the rollover takes place (and is initially implemented). Will subsequent advice on IRA accounts be subject to the impartial conduct standards? Note that subsequent advice is not subject, under the DOL rules, when the firm receives level compensation (i.e., fee-only compensation). But if the firm is using full B.I.C.E. or 84-24, then the impartial conduct standards apply to the ongoing management of the IRA account, after Jan. 1, 2018, under the DOL rules that have been adopted.

I don't think Congress will act before Jan. 1, 2018, with a final bill that reverses or stops the DOL rule making process. The U.S. Senate will likely only consider the issue of the DOL Rules in a comprehensive bill on banking, and this bill is likely pushed off to next year due to other pressing issues. And, even then, the banking bill will require 60 votes in the U.S. Senate. I don't see the Democrats agreeing to any compromises that would reverse the DOL rule making already accomplished.

    E. Will the DOL Rules Be Robustly Enforced in FINRA arbitrations?

I'll leave this question there ... otherwise I'll write 20 pages about FINRA.

These and many other questions exist. Until next time. - Ron