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Cooley: Fiduciary Rule Better Protects Investor Interests

The Department of Labor’s new rules advance investor interests without imposing excessive costs on the financial-services industry, writes Morningstar’s Scott Cooley.

On April 4, the Department of Labor (DOL) published its long-awaited fiduciary rule, officially called “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule—Retirement Investment Advice.” It should be no surprise that an agency that turns “fiduciary rule” into a 12-word title was similarly verbose when it detailed how advisors should interact with their retirement clients: Where you and I would have said “Act in your clients’ best interests,” the DOL generated a manifesto that, with associated documents, explanations, and exemptions, runs to more than 1,000 double-spaced pages.

So, the DOL will not win any awards for brevity. But it does deserve some sort of prize for developing a final rule that will advance investor interests without imposing excessive costs on the financial-services industry—which, of course, would have passed on the costs to investors. With that in mind—and despite some much-criticized concessions to the financial-services industry versus the DOL’s May 2015 proposal—I believe that the final rule better protects investor interests.

The Rule
So, what does the rule do anyway? Any attempt to summarize such a complex rule will necessarily fall short, but in essence, the rule imposes a best-interest test on those who provide advice on retirement accounts, including IRAs and 401(k)s. An advisor may still recommend that an investor roll over money from a 401(k) into an IRA, may collect a commission on an IRA, or may even sell an investment product with high fees. But, among other obligations—and there are many—he or she will need to establish documentation showing that a particular investment decision was in the best interest of the client.

If they cannot document that they serve investors’ interests, broker-dealers, 401(k) plan providers, and other retirement advisors face potential private legal actions, including possible class-action lawsuits.

The Final Fiduciary Rule
One should approach an evaluation of such a complex and nuanced rule with a fair amount of humility. As one knowledgeable ERISA attorney told me, many of the things we think we know about the rule right now will turn out not to be true. But with that caveat in mind, here are a couple of the changes in the final rule that, in my mind, better protect the interests of investors. In short, the theme that runs through these and other improvements to the rule is that they ease the operational burden of the rule (versus the initial proposal) without compromising investor protections.

First, for those investors who are currently in commission-based retirement accounts, there is an improved grandfathering mechanism that should allow them to maintain this relationship if it is in the clients’ best interests. The original proposal would have made it very difficult to maintain a commission-based relationship, even if doing so would have been the best outcome for an investor.

By providing a streamlined grandfathering provision, the DOL has allowed advisors to keep investors in what, for some of them, will be lower-cost accounts. (If they have already paid the commission on the account, the ongoing trail will likely be much lower than the 1% charged by many fee-based advisors.) Importantly, if an advisor wishes to move an investor from a commission-based to a fee-based account, he or she must document that it is in the investors’ best interests.

Second, in a win for the industry and investors, the DOL’s final rule streamlined the documentation associated with the best-interest contract exemption (BIC exemption), an agreement between an advisor and a client that commits the advisor to acting in a client’s best interests, even when paid in a manner that the DOL considers conflicted. Moreover, in the final rule the DOL determined that investors need only sign the BIC exemption with the firm, not every individual advisor at the firm who provides the client with advice.

An example may illustrate the problem with the initial proposal. Consider a plan provider that operates a call center and serves millions of participants. Let’s say an investor called the plan provider call center and requested a full, early distribution from her 401(k). Under the original proposal, before the call center representative attempted to dissuade the investor from taking the distribution—perhaps by pointing out that the plan allows for partial distributions to meet a financial emergency, which would save her thousands of dollars in taxes and penalties—the representative would need to receive a signed BIC exemption. (By its very nature, that advice would be considered conflicted because the plan provider would receive more revenue if the investor left part of the money in the plan.) If the caller elected to think about it, called back the next day, and spoke to a second person in the call center—a very real possibility—before engaging in a substantive discussion about her individual circumstances, she would have needed to sign another BIC exemption with the second call center rep.

It is difficult to see how an investor’s interests would have been better protected by signing all those additional papers. Moreover, the initial proposal would have produced an operational and costly nightmare for advisors and plan providers—unnecessary costs that investors, no doubt, would have paid in the end. It is worth noting that the final rule incorporates the investor-protection elements of the original proposal, including the right to participate in a class-action lawsuit.

Thoughts About the Rule
To be sure, that DOL’s fiduciary rule is not perfect. No rule ever is. But the Labor Department did a good job of listening to industry concerns, sifting through them, and responding to those that merited attention. As attorney Marcia Wagner of the Wagner Law Group told The Wall Street Journal, the DOL “took a rule which would have been impossible to fully comply with and made a rule that is going to be difficult but not impossible to comply with.” And the DOL accomplished these improvements while leaving intact the key investor protections in its original proposal. That is a great outcome for investors.

What does the rule mean for investors? This rule will make it a bit more of a hassle for a broker to handle rollovers, which may lead to some brokers handling fewer rollovers, especially smaller ones.

But the rule provides important protections to investors. In the past, when brokers needed to meet only a suitability requirement, they frequently persuaded investors to roll money out of low-fee 401(k) plans to higher-fee IRAs. That sales-oriented conduct simply imposed unacceptable costs on retirement investors—many of whom, surveys showed, already thought their broker had to work in their best interests.

The Next Steps
Although the revisions to the fiduciary rule are welcome, there is still much that the Labor Department can do to improve the retirement outcomes of Americans. In particular, the DOL needs to take steps to ensure that money stays in 401(k) plans when participants change jobs, and to address the coverage gap for 401(k)s, which leaves tens of millions of Americans without access to a workplace retirement plan.

First, the DOL could take steps to make it easier for people to move assets from one 401(k) plan to another. Right now, when a 401(k) participant changes jobs, it is often very difficult to move assets from one plan to another. The Labor Department has reportedly considered issuing guidance to plan sponsors that would reduce liability concerns about providing auto plan-to-plan rollovers. In short, plan sponsors could ensure that participant assets follow them to their next job unless the employee makes a different election. This approach would lead to more assets remaining in 401(k) plans, where investors’ retirement holdings would benefit from the often-lower fees that these plans feature. The Labor Department should move forward with this initiative.

Second, the DOL should rethink its approach to multiple-employer 401(k) plans, which allow smaller employers to band together to offer a lower-cost 401(k). Making it easier for companies to cooperate to form larger plans should result in greater availability of low-fee 401(k)s at smaller employers.

Late in 2015, the Labor Department issued guidance making it possible for state governments to offer multiple-employer plans, but it has not yet made it easier for private organizations to offer them. The DOL should move to make it easier for private-sector providers to compete with state governments to offer these multiple-employer plans.

In short, in finalizing a sensible fiduciary rule, the DOL has taken an important step toward protecting Americans’ retirement security. But in terms of improving the policy framework around retirement savings, there is still much to do. Here is hoping the Labor Department seizes the opportunity to score some big wins for retirement investors.