Last month, the Department of Labor dropped the “F” bomb—its much-feared fiduciary duty rule for investment advisors who offer advice on retirement plans and related investments. The fallout has begun.
Already, larger firms are on the hunt for smaller ones, ripe for an acquisition or merger because of the post-rule hardships they face. “During this period of disruption, we see potential opportunities,” Ameriprise Financial CEO Jim Cracchiolo said during a recent earnings call, predicting market consolidation as independent broker-dealers and advisers seek partnerships with one-time rivals.
And, it wouldn’t be a controversial regulation if Congress weren’t trying to repeal it. The House of Representatives recently passed a resolution, by a 234-183 vote, that would essentially kill the rule. Among those supporting that effort was Christopher Iacovella, CEO of Equity Dealers of America, a trade group that represents middle market financial services firms.
“We strongly believe that the Department of Labor exceeded its congressionally granted authority when it finalized its rule,” he wrote in a letter expressing his support for Congressional action. “This rule will reduce access to financial advice for low- and middle income Americans; increase costs for retirees by pushing them into inappropriate and expensive fee-based financial solutions; and unnecessarily interfere with an individuals’ personal choices about investing and saving for retirement.”
Strong words, perhaps, but they face off against a pledge by President Obama to veto any legislative effort of the sort.
In the meantime, as deals and legislation alike are negotiated, those covered by the rule are hunkered down to see how they must adapt to their new environment.
The text of the final rule, published in the Federal Register on April 8, further defines who is a “fiduciary” under the Employee Retirement Income Security Act when investment advice is offered to plan participants and beneficiaries. Firms and advisers will be required to make “prudent investment recommendations” without regard to their own interests or those of related parties; charge only reasonable compensation; and make no misrepresentations to customers regarding recommended investments.
To allow advisers to continue receiving commission-based compensation on a case-by-case basis, the Labor Department is authorized to issue Best Interest Contract Exemptions (BICE) and Prohibited Transaction Exemptions (PTE).
“I think those firms that cannot demonstrate they are a fiduciary, cannot provide transparency, and cannot prove they are acting in the best interest of their client will see their customers go elsewhere.”
Thomas Marsh, Specialist Leader, Deloitte Consulting
Not surprisingly, the rule—and all its implications—was a hot topic at a recent industry conference in Boston. Among the debates about the rule is whether those covered should breath a sigh of relief, satisfied that the final version was far less onerous than what was initially proposed.
“What happened is that the Labor Department set the bar so high, and the rule was so impossible, that when the final came out and it was easier to comply with, everybody gave a big sigh of relief,” said Sean Cunniff, investment management research leader at Deloitte, said at Financial Research Associates’ Mutual Fund & ETF Distribution Summit on April 27. “But when you look at the regulation, and what it requires you to do, it is a huge change for the way the industry operates.”
The warning for those who think they have plenty of time before the April 10, 2017, compliance deadline: “You do not.”
“Less than a year from now, the world is going to change for the financial industry,” Cunniff said. Even if the final rule is a bit more palatable, he doesn’t expect that broker-dealers will be spending less on the final rule that they were planning to.
What constituted investment advice under the existing fiduciary rule has greatly expanded. “That is important because even if you are operating as an SEC adviser, this standard of care is more stringent than under the SEC,” Cunniff said. “If you are compensated in a way that is a conflict of interest—for example if you are receiving a revenue share—under the SEC’s rules, as long as you disclose it and the client understands it and is comfortable, you are okay. Under the Labor Department rules, however, that is a prohibited transaction that you need to have an exemption for.”
Even pure intentions will be no help if a firm runs afoul of any aspect of the new rule, Cunniff cautioned.
The new rule, is “going to shine a light down to the end investor,” says Thomas Marsh, a specialist leader at Deloitte Consulting. “They are going to be much better educated and empowered, with more transparency into fees.”
THE BCIE EXEMPTION
The following is from a Department of Labor “fact sheet” on the Best Interest Contract Exemption:
The Best Interest Contract Exemption is a component of the regulatory package that aligns individual advisers' interests with those of the plan or IRA customer, while leaving the adviser and financial institution substantial flexibility in designing the business model that best serves their clients.
Specifically, the exemption allows firms to continue to use certain compensation arrangements that might otherwise be forbidden so long as they, among other things, commit to putting their client's best interest first, adopt anti-conflict policies and procedures (including avoiding certain incentive practices), and disclose any conflicts of interest that could affect their best judgment as a fiduciary rendering advice. Common forms of compensation, such as commissions, revenue sharing and 12b-1 fees, are permitted under this exemption, whether paid by the client or a third party such as a mutual fund, provided the conditions of the exemption are satisfied. This exemption is available to advisers that advise IRA savers, individual plan participants, and small plans.
In addition to this new Best Interest Contract Exemption, the regulatory package revises many existing exemptions. It also includes a new exemption for principal transactions, which allows advisers to recommend investments, such as certain debt securities, and sell them to the customer directly from the adviser's own inventory, or purchase investment property from the customer, as long as the adviser adheres to the exemption's consumer-protective conditions.
In response to comments received during the notice and comment period, the Best Interest Contract Exemption was revised in a number of ways to facilitate implementation and compliance with the exemption's terms. Examples include: streamlining conditions for ‘level fee' fiduciaries that receive only a level fee for advisory or investment management services; eliminating the contract requirement for advisers to ERISA plans and participants; permitting reliance on a negative consent process for existing contract holders; simplifying the pre-transaction disclosure to eliminate the proposed required projections of the total costs of the investment over time; and eliminating the proposed annual disclosure and proposed data collection conditions.
Source: Department of Labor
All that sunshine and education will, however, come at a cost. As much as $20 trillion in U.S. retirement plan assets will be affected with industry estimates pegging the annual cost of compliance as high as $2.4 billion. Those costs, and margin pressures, will lead firms to seek out alternate revenue streams, develop proprietary products, and seek revenue sharing with third-party advisers, IRA rollovers, and cross-selling, he says.
“There has been a lot of ink spilled on whether this rule is going to lead to a decrease in IRA rollovers, or maybe things will stay the same because nobody reads the fine print, they will ‘sign here’ and it will be business as usual,” Marsh says. “I think those firms that cannot demonstrate they are a fiduciary, cannot provide transparency, and cannot prove they are acting in the best interest of their client will see their customers go elsewhere.”
In assessing “winners and losers” of the rule, Cunniff sees it “accelerating a lot of trends that were already happening,” in particular with mergers and acquisitions.
“It was getting harder and harder to operate as a small broker-dealer anyway,” he says. “Scale is very important. The large firms are going to figure it out. They have the resources and the money. Firms that are in the middle are going to have to make a decision. Do they make a bunch of acquisitions? You are already seeing that. It seems like every independent firm on the street is up for sale or has already been sold.”
“Smaller firms are either going to become acquired or become a registered advisor and step away from the brokerage space,” he adds. “The rule is absolutely going to change the landscape.”
There is still a place in the world for active funds as well as passive funds, Cunniff surmises, “but you are going to have to tell that story about why that active fund is the right one, and it can’t be because you have a great relationship with the wholesaler and they took you out to play golf.”
Among the matters that must be handled sooner, not later, is a requirement for covered firms to designate a “chief conflicts and conduct officer.”
“This is something you don’t want to just put out a job notice on Jan. 1 and expect to have them in place by April,” Marsh says. “It is not something where you can just flick a switch and you are going to want to have this person in place as soon as possible as they are going to want to be involved in the process of building all the systems, architectures, methodologies, and policies around compliance.”
The job “is not just something that can be bolted on to your current compliance officer or chief risk officer,” he warns. “It could be more than one person because this is going to be a really big and important job.”
An important job, but perhaps not a desirable one given its heavy burden. As one participant at the conference quipped: “No matter how much they offer you, do not take that job.”