The Conflict of Interest Rule: Fiduciary Standard Impact on Investors

By Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS® Portfolio Manager

Earlier this month, the Department of Labor (DOL) released its long-awaited Conflict of Interest Rule, and the investment industry is still parsing through the language to gauge how it will impact business models. This will likely continue up to and through the date that the new rule becomes effective—April 10, 2017. In the meantime, it’s important for investors to understand the protections offered by the new rule, as well as its limitations. If none of this sounds familiar, this article aims to bring you up to speed.

As my colleague noted the day of the announcement, the DOL has issued a rule that requires anyone who provides an investment recommendation to a retirement plan or IRA to meet the fiduciary standard.

Prior to this rule, registered representatives from broker dealers and insurance agents need only to have met a standard of suitability when making a recommendation.

The difference between fiduciary and suitability standards will be covered below, but the substance is this: the standard has been raised for many investment professionals when it comes to the investment recommendations that they provide.

I say “many” and not “all” investment professionals because Registered Investment Advisors (RIAs) like ACG have always been required to adhere to the fiduciary standard. Our company has done this since the inception of our advisory services in 1990 because putting clients’ interests first seemed like the best business model. That notion has proven to be true.

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Suitability vs. Fiduciary Standards

What’s the difference between suitability and fiduciary standards? To many, it seems like semantics. After all, under both standards the advisor is required to make a reasonable effort to understand a client’s unique situation (time horizon, liquidity needs, financial circumstances, risk tolerance, tax status, etc.) and to make sure that the investment recommendation is appropriate given those factors.

For example, it would be inappropriate under either standard to recommend that an elderly couple in the middle of retirement put all of their liquid assets into a high-risk, all stock portfolio. Having said that, there is one aspect in particular that separates the fiduciary and suitability standards. Take a look at a line from the DOL’s Fact Sheet on the matter from the Department’s website:

“The Department’s conflict of interest final rule and related exemptions will protect investors by requiring all who provide retirement investment advice to plans and IRAs to abide by a ‘fiduciary’ standard—putting their clients’ best interest before their own profits.”

The last part, about putting clients’ best interest before the advisor’s own profits, is the key distinction between someone who is acting as a fiduciary and someone who is simply meeting a suitability standard.

Meeting the Fiduciary Standard in Practice

For example, consider an advisor who recommends a particular share class of mutual fund to a client when a more cost effective share class is available. Perhaps the advisor recommends a commission based share class that charges nearly six percent up front, even though a lower, level-fee share class is available. In this instance, the advisor is not putting the client’s interest above his profits and is therefore not meeting a fiduciary standard.

The fiduciary standard applies to more than just using the most cost effective share class, though. The DOL has explicitly listed other types of recommendations that must meet a fiduciary standard.

401(k) Rollovers Will be Impacted by the Rule

An important one is the recommendation to roll over a 401(k) into an IRA. Sometimes such rollovers result in a higher expense to the client than if he had kept the account in his 401(k) plan. For this reason, advisors will need to begin documenting their justification for making such a recommendation.

After all, employees roll over their 401(k) accounts for a number of reasons—a wish to disassociate from the company, a desire for more investment options, and of course, the desire to work with an advisor that they know and trust. The DOL made it clear that it does not disapprove of rollovers per se; it simply wants investors to be informed and better protected from some advisors who target these rollovers without any real plan to add value.

Fee-Based Services and the Conflict of Interest Rule

A similar recommendation that falls under the fiduciary rule is the recommendation to a client or prospective client who owns a self-directed brokerage account to sign up for a fee-based service. If the advisor is adding value then it’s appropriate, but the justification needs to be documented.

The Conflict of Interest Rule Aims to Protect Clients from Excessive Fees

If it sounds like the overarching objective of the rule is to prevent clients from paying excessive fees, that’s because it is. The DOL estimates that fees that result from conflicts of interest cost Americans an average of $17 billion every year. It is very important to note, though, that the DOL is not sending the message that the lowest available fee is always the most appropriate option. It has made this clear during the rollout of this rule. ACG agrees—fees are not the sole criteria for choosing the right fund to use. We feel it’s appropriate to select managers who we believe will offer the best performance after fees have been taken into consideration.

The Fiduciary Standard's Limitations

In addition to knowing how this new rule will protect investors, it’s important to know the rule’s limitations. The biggest misconception that investors will likely have is that this rule covers any and all recommendations that an advisor makes to them.

Conflict of Interest Rule Only Applies to Retirement Assets

In fact, the rule only applies to retirement assets, like 401(k) accounts and IRAs. This is because the DOL does not have jurisdiction over non-retirement investment accounts. The impact of this distinction is that advisors (except RIAs, which are fiduciaries regardless of the type of account) will still be allowed to recommend investments with excessive fees if they are providing advice to a client for their non-retirement, taxable assets.

The DOL Will Rely on Consumers and Advisors to Enforce the Fiduciary Standard

Another limitation of the rule is the way it will be enforced. Don’t expect the DOL, SEC, IRS, or any other agency for that matter, to go out and search for the bad apples that are making bad recommendations. It will be up to the client to identify when a malpractice has been committed and bring suit against the advisor.

For this reason, it is imperative that investors remain vigilant and stay informed about the recommendations that they are receiving. The DOL has equipped you, the investor, to hold your advisor accountable; however, they are not going to do it for you.

There are a few other considerations for investors, including:

  • Any recommendation made prior to the April 2017 effective date will be “grandfathered” in and does not need to meet the fiduciary standard.
  • The rule only applies to recommendations, which the DOL defines as an advisor “suggesting that an investor take action.” Discussing the condition of the markets, educating someone about various investing principles or other generalized communications do not need to adhere to a fiduciary standard.
  • It is entirely possible that a new presidential administration could decide to retract this rule before it is effective.

The investment industry is complicated, and a good advisor is one who helps clients navigate that complexity. Unfortunately, there are many advisors out there who exploit client confusion in order to pad their wallets.

ACG commends the DOL for taking this step to improve the quality of advice given to investors no matter who their advisor is. Ideally, this will result in an increased level of trust between advisor and client; that will be good news for the industry and, obviously, the investor.

Still, investors cannot view this rule as a panacea that enables them to blindly trust any advisor. They should make sure to ask the advisor the right questions to ensure they have integrity. Competence helps, too.

For more information, or questions on the fiduciary standard and how it may impact you contact ACG.  If you liked this article, you may want to check out our free checklist for plan fiduciaries below.

Are you aware of your options and responsibilities as a plan sponsor?

— Topics: Investments, Retirement