New Fiduciary/Conflict of Interest Rule

For decades, the financial industry has struggled with whether advisors in the qualified plan performed their functions as fiduciaries. The original rules, dating back to the 1970's provided general rules but little guidance. Those rules were written at a time when participant directed investment accounts and rollover IRA's did not exist. The world we now live in, could not have been contemplated by those developing rules at that time. Over years the Department of Labor has made attempts to update these rules. The most recent failed attempt was in 2015. The 2015 rules were roundly criticized as unworkable. A year later, in April of 2016, the DOL came up with a set of rules that the financial industry could live with.

For practical purposes, all advisors will now have fiduciary responsibility. This responsibility will apply to the plan level, for example, helping a plan trustee develop a menu of funds in a 401(k) plan, or helping to select a vendor. It will also apply to dealings with participants. The rules set out in April of 2016 mostly become effective in April of 2017. A few rules are delayed to the beginning of 2018. The prior legal standard for a non-fiduciary was "suitability." The fiduciary standard means the advisor must act in the best interests of participants. This is the highest standard of care under the law. Many brokers operate their practices in this manner even now. Even in these cases, the new rules will impact their practices. Case law developing over the last few years, has much more closely scrutinized fees and compensation. Broker/dealer firms operating under the suitability standard often require practices and documentation similar to what will be required under these new rules.

Will a Trump administration reverse this rule? I feel this is unlikely. There are a lot of hurdles to overturn a final regulation. But mostly, this rule has broad political support, so it is hard to imagine a reversal. Potentially, the effective dates could be delayed, but there has been no definitive word. There have been industry groups that have filed suit to invalidate the rule. I don't think there is a realistic chance of success with these suits. The weakest legal support for the rule might pertain to its application to IRA's. The regulations give participants a private right of action in this area because the DOL's jurisdiction ends with money leaving the qualified plan.

The rule imposes the fiduciary standard on IRA's as well as 401(k) and pension plans. The DOL's main concern was in the rollover transaction. While most brokers made a conscientious attempt to help their clients make the best decisions, a few brokers abused their position. I expect that participants electing to rollover with a broker will have to receive a disclosure explaining the rollover options. There will also have to be case specific documentation that the choice made was the best for the client. This could mean that the participant and broker will need to obtain information about investment options in the plan of a new employer. How can a participant make an informed decision if they do not know the expenses and choices with the plan of their new employer, relative to an IRA the broker is recommending? Informally, I believe many brokers already adhere to this process. Now it will be formalized.

Normally a fiduciary for investments must receive level compensation. Typically this a percentage of assets or a flat dollar amount, assessed equally against all assets. This would seem to eliminate any opportunity for transaction based compensation or non-level compensation. Non-level compensation may give the appearance of providing incentives to investment options that pay the most. Even if this is not the case, the taint exists. The regulations have come up with a "Best Interests Contract" exemption. This is a very complex set of rules that allows the broker dealers some flexibility in this area. Many larger broker dealers are utilizing this exemption. Best interest contract exemption or not, most 401(k) plans currently have level compensation to the broker/dealer.

Many complex issues remain for the broker-dealers and the 401(k) industry. It is common in the industry to have third party payments. That is payments to a service provider that are not directly from plan assets and not directly from the client. These can probably continue, as long as there is full disclosure. As third party administrator (TPA), E.R.I.S.A., Inc. receives some of these payments. We have disclosed them in our service agreements since 2012. Our practices have ranged from providing a complete offset (for example with larger plans that are billed hourly), to no offset with small plans that generate de minimus third party payments. We believe that the new rule will require a complete offset of third party payments. As these payments have been integrated into our fee structure, this will result in a change to our fee schedules. We will do our best to avoid significant increases in our fees and will inform our clients of any changes.

With small plans, occasionally a broker will set up separate accounts, rather than use a record keeping platform. Will this practice be allowed to continue? This generally results in a mix of transactional and level compensation. At least one major broker dealer will permit this to continue, but others have said they will not. Another area of concern is the cost structure of some record keepers. The term "record keepers" refer to the companies that provide the investment platform, infrastructure (such as web access and call center), and of course the record keeping. In a 401(k) plan this is much more complicated that maintaining a simple single account for an investor. It is typical that the funds in a record keeping platform generate revenue. This can be used to pay record keeping cost, a broker, or a TPA. What happens when different funds within a platform generate differing levels of revenue? What about proprietary funds within a platform, particularly fixed income funds that operate on "spreads" rather than have explicit costs? Essentially, this means that some participants are subsidizing the expenses of others. This might be acceptable if this was disclosed to the plan trustees and the participants. In the absence of such disclosure, is this practice compliant with fiduciary standards?

As an industry, we are about to embark on a very interesting era with major changes being implemented. Stay tuned. Here is a link to a Department of Labor explanation of the new rules: