Sitting in the comfort of your home or office, you may not have felt the tectonic shockwaves unleashed through the brokerage community by a new regulation from the Department of Labor (DOL), but you can be sure everything is about to change. If you are a retirement investor with money in a 401(k) plan or an individual retirement account, you should know how and why this new rule is about to fundamentally transform the entire financial advice landscape and how it will affect you.
The new rule, dubbed the "fiduciary rule," is aimed at preventing retirement investors from wasting the $17 billion a year the government claims is paid for high fees and commissions. High fees diminish the long-term returns on retirement savings, making it more difficult for people to reach their retirement goals. The rule seeks to keep advisers from putting their own interests in generating higher fees and commissions above the interests of their clients in selecting the most appropriate investments at the lowest prices. When the rule is fully implemented in April 2017, all financial advisers who provide investment advice for retirement investors, whether it be for an employer-sponsored plan, an IRA or a health savings account, will be subject to a fiduciary standard, which requires them to put their clients' interests first.
Are There Different Standards of Care?
Since the enactment of the Investment Adviser Act of 1940, two types of relationships have existed between financial intermediaries and their clients: One is the "arms length" relationship that characterizes the transactions between registered representatives and clients in the broker-dealer space. The second is the fiduciary relationship that requires advisers registered with the Securities and Exchange Commission (SEC) as Registered Investment Advisers (RIA) to exercise duties of loyalty, care and full disclosure in their interactions with clients.
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Whereas the former is based on the principle of "caveat emptor," guided by self-governed rules of "suitability" and "reasonableness" in recommending an investment product or strategy, the latter is grounded in federal laws that impose the highest ethical standards. At its core, the fiduciary relationship relies upon the necessity that a financial adviser must act on behalf of a client in a way that the client would act for himself if he had the requisite knowledge and skills to do so.
To Know Where Interests Lie, Follow the Money
Until now, the only way a client could discern which type of advisory relationship they were engaged in was by understanding how the different types of advisers derive their compensation and, more importantly who is in the revenue food chain. An adviser acting purely in a fiduciary capacity is paid directly by the client in the form of a flat fee. All fees and compensation are fully disclosed up front, there is no third-party involvement and the adviser answers only to the client. Advisers who are not acting in a fiduciary capacity are paid by their firm or third-parties in the form of commissions or fees, and they are not required to fully disclose their fees or how they are compensated. They must answer to their sales manager and are typically accountable to production quotas.
What the client doesn't know about the way commission-based advisers are compensated, or how the revenue food chain works, allows the broker-dealer to mark up the price of products or increase their share of the revenue generated by third party fees charged against the client's assets. Whatever the method used by the broker-dealer, the net result is a more expensive investment product for the client in the long run. To understand the revenue food chain is to understand that investments sold through broker-dealers must be able to compensate all parties in order to make it worthwhile to offer the product. The problem is not the commission, or sales charges, per se, because some of that front-end compensation to the broker has to be disclosed at some point. The actual problem is transparency and the way brokers and the firm get compensated on the back end, which is where the "hidden conflicts" occur.
Regardless of whether a commissioned-based adviser intends to work in the best interests of the client, there will always be a conflict of interest when recommending an investment product. Conflicts of interest take many different forms including recommending an unnecessary rollover of a 401(k) plan or recommending expensive investment products that offer the adviser a revenue-sharing arrangement. Following the implementation of the fiduciary rule, none of that will be allowed, except if the adviser has the client sign a disclosure agreement which leaves the adviser liable for the transaction.
What it Means for Retirement Investors
There have been several attempts by the SEC to level the playing field between fiduciary RIAs and commissioned-based advisers, but they all merely scratched the surface of the issue. At least for retirement-related investment advice and products, the DOL fiduciary rule not only levels the field, it ensures that the adviser and the client will be sitting on the same side of the table. For clients, there will be greater transparency, less concern over whose interests are being served and no overhang of conflicted advice. In dispensing client-centric investment advice and recommending the most appropriate investments at the lowest cost, your adviser is accountable only to you. The DOL estimates the new rule will save investors up to $40 billion in fees over the next 10 years.
Although the fiduciary rule primarily affects your advisory relationship as it pertains to retirement advice and investing, industry observers are convinced that it will spread to all aspects of the advisory relationship in the future to create a uniform standard.
It is surprising that it has taken until now to confront this issue and upsetting that many industry professionals needed the authorities to force them to make good decisions for their clients. But now that the wheels are in motion, the end of the sale of commission-based products and conflicted advice for all investors may be on the horizon. That would be a plus.
Craig Slayen is a principal at Cypress Partners., a financial planning and investment management firm in the San Francisco Bay Area.
Pete Woodring, a partner with Cypress Partners, contributed to this article.
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