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The Impact of the New Fiduciary Rule on Investors

Financial planning expert Michael Kitces reviews the new rule, what to expect as the industry transitions to it, and what it really means for consumers in the financial services industry.

Michael Kitces is a Partner and the Director of Wealth Management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The Department of Labor's fiduciary rule has major implications for consumers in the financial-services industry. Joining me to discuss that topic is financial planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Great to be here.

Benz: This has been really some groundbreaking, earth-shattering news in the financial-services industry.

Kitces: Yes, it is.

Benz: Let's discuss the Department of Labor's fiduciary rule, just kind of a basic explanation about what this rule is what it attempts to do.

Kitces: So, at the most basic level, the word "fiduciary" is kind of a fancy legal term for "you have to act in the best interest of your clients." And that's been a long-standing rule across, frankly, most professions. The attorneys have to act in the interest of their clients. The doctors have to benefit the patient first. Sadly, that hasn't been there as a rule for much of the financial-services industry historically. Our roots for huge swaths of the industry is that functionally we created financial-services products, we sold them to people, and we were regulated as salespeople. And going back for nearly 80 years now we've had, kind of, two regulatory regimes that ran in parallel: investment advisors who typically manage money and had to do that in the interest of their clients; and brokers who were legally salespeople, and the legal standard was one that you apply to salespeople which basically was, don't sell anything to people that's not suitable and appropriate for them. And that was the limitations. So, investment advisors that manage money were fiduciaries all along and had to act in their clients' interest. Historically, these were registered investment advisors or what we call RIAs. And then we had brokers that simply had to sell things that were not unsuitable for their clients.

The problem in the landscape though is, they all kind of described themselves the same way. Everybody called themselves financial advisors and financial consultants. Many of them had marks like CFP certification regardless of which side of the divide they are on, and we had a growing number of consumer surveys that said, "I didn't even realize there was a difference." No one really explains this. And that's been a growing regulatory concern for a long time. Now, the Department of Labor has come in and said at least within their purview, which is retirement investors, anybody who is giving advice to a retirement account, whether it's for a 401(k) plan or for an IRA, has to actually give advice as a fiduciary advisor in the best interest of their clients.

Benz: So, how will this work from a practical standpoint for people who had been held to that suitability standard in the past, now they have to act in the clients' best interest? What will that transition be like?

Kitces: So, it's a big retooling for that side of the industry. Historically, that's been insurance companies, broker-dealers, who now have this different standard to which they are going to be held. I think the way you are likely going to see this play out is, the biggest change will actually be for those companies themselves and the way that they relate to their brokers. They are going to have to shift to what products they make available. They are going to be subject to a lot more scrutiny about are the products that you put in front of your brokers to bring consumers actually good products or just the ones that you make a lot of money off of as a company, because you can't treat yourself as a sales business when you are giving advice, because you have to give the advice to the consumer and not just to sell your product anymore. So, it will shift the nature of the products. 

It will likely shift compensation. Much of the sales channel historically has been compensated by commissions. Technically, the Department of Labor didn't ban commissions because if the thing is truly, actually in your interest and I happen to get paid a commission, it's not necessarily a problem because it was really in your interest, but I'm going to have to be able to substantiate that, both on an individual sale and as a company that I've created an environment where my advisors are actually giving advice in the best interest of consumers to the point where the Department of Labor actually require that every advisor that's working with clients will have to sign a contract with them. It's called a best interest contract. It says, "I acknowledge, I'm a fiduciary that's acting in your interest," and if I violate that across a wide range of clients, the clients are allowed to sue the firm in a class-action lawsuit. And what that means from the practical perspective is, if I'm in a large firm and I run their compliance, I'm now very concerned actually to make our brokers give advice in the interest of consumers because it's one thing even when a broker makes a mistake, but I certainly don't want my company sued in a class-action lawsuit. And from the consumer protection, that's a good thing, like we've changed the incentives for companies to want to protect consumers more in a way that I think is a huge step forward for advice.

Benz: So, there have been some legislative and legal challenges for this rule. Let's talk those through and I'd like to hear your opinion on where you think those stand and what we'll see in the future on that front.

Kitces: So, we've seen a couple of categories or challenges. The first round were legislative challenges, proposals in Congress that would either delay or strike down the rule. They generally split along party lines. The Democrats were supporting the rule. The Republicans were against the rule. In practice, the legislative challenges have gone nowhere primarily because President Obama has said pretty strongly, they view this as one of their, kind of, landmark regulations while the president is in office and he has vowed to veto any kind of legislation that comes forward and the Republicans certainly don't have enough votes to overwrite a veto. So, the legislative end has, kind of, been dead on arrival.

What we've now seen is outright legal challenges as well. There's now two lawsuits that have just cropped up in the past few weeks that are challenging the rule. One comes from the National Association of Fixed Annuities, an organization that represents companies that sell products that are not so happy about this shift in the environment because it's hard to transition lots of annuity agents into advisors. And then one that's been put together by a coalition that includes SIFMA, which represents essentially Wall Street firms; the Financial Services Institute, which represents broker-dealers, all companies that produce and create products and sell them to the public that are similarly questioning the scope of the rule, whether the Department of Labor really had the authority to do the rule, whether they took enough comments and feedback over the roughly six-year process that the Department of Labor actually went through in rulemaking and raising the question about whether just the costs outweigh the benefits. And it's a hard thing to measure to say, well, what's the cost of conflicted advice because we don't really have a very good A versus B example. We didn't get to do a controlled experiment where we said, let's send a bunch of brokers out subject to a fiduciary standard and a bunch out to a suitability standard and see what happens.

We see microcosms of that though. The RIA industry has always been subject to a fiduciary standard and doesn't seem to have been too terribly hindered in their ability to give advice and the Department of Labor has relied heavily on that by looking at the landscape and saying, there actually are pockets that have given fiduciary advice already; they are still capable of serving small consumers; they are still capable of serving a wide range; they have not been overly burdened with compliance cost and legal problems. And so, that's what's continued to drive a lot of the rule forward.

Benz: So, let's talk about some of the big positives of this rule. From a consumer standpoint, it seems like there will be more clarity in terms of who you can trust with your retirement assets, but let's kind of tick through what you think are the big positives for consumers as a result of this rule.

Kitces: So, actually, the biggest positive for consumers is now when someone says they are giving advice, they are actually regulated to someone that's giving advice. It's sort of like if I go in the clothing store and they say they are a fashion consultant, I still kind of get the end of the day like they are going to get paid when they sell me some clothing. The problem in the financial services industry is that that wasn't always clear. Like we could really say that we were advisors and purely work as a product salesperson for the company that they represented in a manner that wasn't very clear for consumers because we don't necessarily know off-hand which companies create products to sell, which companies are independent. That was a hard landscape. So, this simplifies the landscape greatly. When someone says they are giving advice about retirement accounts, they are actually going to be regulated though they are giving advice on retirement accounts.

Now, the caveat to that and probably the biggest challenge is, the Department of Labor is limited in what it's allowed to put rules on. They can oversee retirement accounts. That's it.

Benz: So, if I have taxable assets …

Kitces: So, the employer retirement plans and IRAs get covered, taxable assets don't. So, we're frankly in a little bit of an awkward regulatory environment because I could actually work with an advisor who has different regulatory requirements about how good the advice has to be for my IRA account versus my taxable brokerage account, at the same firm with the same advisor. And ultimately, I don't think that's tenable in the long run. The organization that ultimately has jurisdiction over all of the accounts is the SEC, the Securities and Exchange Commission. I think what you're going to find over the next couple of years is the SEC is going to put forth their own version of a fiduciary rule to try to bring this all together. But the warning sign at least for consumers in the near term--we still have a little bit of this mystery when it says financial advisor on the business card, whether they are really in the business of giving advice and subject to fiduciary standard because they might be for a retirement account and not for a brokerage account even for the same advisor, and that's going to continue to be a difference for a couple of more years.

Benz: Would you say that that is the key way that the rule didn't go far enough or isn't encompassing enough, that it just doesn't touch those other accounts that the person might hold?

Kitces: Yeah. I mean, ultimately, I think it's not encompassing enough and that's not the Department of Labor's fault. They are only capable of going as far as their jurisdiction and frankly, they were very cognizant if you go outside of your jurisdiction, you get a legal challenge that you'll actually lose. So, the odds still look very good for the Department of Labor that the rule will hold that they put forth but that's because they limited in scope to what they legally have jurisdiction over. For the rest, it still requires the SEC to bring kind of better unity for the regulations across the board.

The biggest warning sign what that means for consumers though in the near term is be aware of someone that says they are a financial advisor but is pushing you really hard to only invest money in taxable accounts or nonqualified accounts or in the extreme is saying, "Hey, I've got an investment that's better than your IRA; you should invest in over here." I guess, in theory, that may be true, but the first question that's going to crop up, well, if it's so good, why can't I buy it in my IRA because the warning sign is, maybe they are not selling it to your IRA because they actually couldn't meet the legal standard in your IRA. So they are trying to dissuade the investor to go outside where you can sell more high-commission products and just represent your company and not the consumer. So, probably the biggest warning sign in the next couple of years is, watch out for someone that says they are an advisor but really pushing you not to invest in retirement accounts. Maybe that's legitimate advice but maybe that's because there's actually a product there that wouldn't have even been legally permitted in an IRA and that's probably not a good thing.

Benz: OK, Michael. Great insights. Important topic. Thank you so much for being here.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.