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The SEC’s 'Fiduciary Rule' and the Tools Government Uses to Help Investors

The proposal fits with tools the government uses to help investors

Aron Szapiro

 

On April 18, the SEC proposed its version of a new fiduciary standard by proposing a package of rules. The SEC is picking up the mantle from the U.S. Department of Labor, which has yet to decide if it will appeal the court ruling that struck down its “fiduciary rule” in mid-March. It is important to keep in mind that this is a first proposal. During the last major effort to dramatically change how the U.S. regulates advice, the Department of Labor changed its final rule from the initial idea. Further, since the rule comes in at 1,000 pages, it will take time to uncover some of the subtleties in the draft. Still, this SEC proposal gives us some insight into how the commission is thinking about changing the way it regulates advisors’ conduct, and we expect the main ideas in the proposal to underpin the final rule.

Why is the SEC fiduciary rule being proposed now and how does it fit into other government efforts to help investors?

Let’s take a big step back and put this in context. As we explained in a recent paper, regulating advice and promoting disclosure are some of the key ways the government tries to help ordinary investors, and both these tools have grown a little dull in recent years. (The third tool, tax incentives, are perhaps just as important, but they are in the jurisdiction of the Treasury Department, Internal Revenue Service, and Congress, not the SEC.)

When it comes to advice, the bottom line is that investors are confused about whether their advisor operates like a salesperson or put their interests first. There's a good reason for this confusion: Two very different sets of regulations govern advisors’ conduct and the differences between these standards confuse professionals almost as much as individuals. Specifically, advisors registered as standard of broker/dealers provide a different standard of advice than do those who are registered investment advisers (note the “e” in adviser is a legal distinction).

Here’s how we got to such a confusing regulatory environment: Historically divergent regulations have been overtaken by converging business models.

Brokers have always provided a much wider range of services than registered investment advisers, and providing advice is supposed to be solely incidental to their business model by law. For that reason, the government has not regulated them the same way as registered investment advisers, who are principally in the advice-giving business.

As brokers started to act more like RIAs by providing financial plans and other kinds of advice, investors understandably became confused about the distinction. At the same time, as corporate America shifted away from traditional pensions to 401(k)s, tens of millions of ordinary people became investors, and most of them are not investment experts. (These new investors have also moved more than $7 trillion out of 401(k)s and into IRAs, which is why the Department of Labor—the principal regulator of 401(k)s—got involved.)

This history has left a key problem for regulators to solve: ensuring that investors understand the nature of their relationship with their advisors, creating a more uniform standard of advice, and ensuring that ordinary people saving for retirement have access to high-quality advice that leaves them with the best chance at financial stability in retirement.

4 key features of the SEC’s rule package

The SEC fiduciary rule tries to address this mismatch between the state of advice and investors’ understanding of it, as well as advance other goals. Four big takeaways I found from my first read are:

  1. For first time ever, the SEC would require broker/dealers to act in the best interests of their client when they provide advice, by imposing a new rule with the on-the-nose name of “Regulation Best Interest.” This best-interest standard applies to recommendations to buy securities, follow an investment strategy, or roll money over from a 401(k) to an IRA. (The last kind of recommendation was a key concern for the Department of Labor.) The crux of this new regulation is that it requires broker/dealers to have policies and procedures to mitigate conflicts, particularly those caused by financial incentives to recommend one product over another. This kind of conflict of interest and the harms these misaligned incentives could cause investors was a main rationale for the Department of Labor’s “fiduciary rule” as well. Over the coming weeks, we will analyze the SEC proposal to assess how effectively this approach will work and ways we might suggest improving it.

  2. Despite the new “Regulation Best Interest,” it is important to keep in mind that while broker/dealers would have to follow a higher standard of conduct when providing advice, they will not operate under the same fiduciary standards that apply to RIAs under the proposal. In other words, the SEC is not seeking to fully align standards across broker/dealers and RIAs.
  3. Nonetheless, the rule aims to reduce investor confusion by requiring financial professionals to provide investors with a new form called CRS, which would provide a “relationship summary” to clients and prospective clients. This summary is designed to help investors understand the services they can expect, conflicts of interest that might influence the advice they receive, and fees they will pay, among other disclosures. Additionally, broker/dealers will no longer be able to use the term “advisor” (or adviser, with an “e,” the spelling used in law for “registered investment advisers”), a further effort to reduce investor confusion about whether they are working with a broker/dealer or an RIA.
  4. The rules package also contains additional clarifications of the fiduciary obligations for RIAs, much of which have come from court decisions over the years. As with “Regulation Best Interest,” this guidance notes that advice on rolling retirement savings over to an account the RIA manages must be in the best interests of the client.

As we analyze the rules package, we will explain whether we think the new rules will achieve the SEC’s goals, and ways the proposal could be improved.

The SEC’s proposal is different from the approach the Department of Labor took

As we expected, the SEC’s fiduciary rule diverges from the Department of Labor’s in three key ways.

  1. The SEC rule does not rely on lawsuits as an enforcement mechanism, which allows much more certainty in firms' compliance plans.

  2. The SEC rule would apply to both retirement and non-retirement accounts, although it would not regulate some kinds of advice that are subject to state regulation, particularly very small investment advisers and certain insurance products, such as single-premium annuities.
  3. The SEC rule is much more focused on mitigating conflicts of interest than avoiding them altogether. The Department of Labor’s warranty requirements explicitly prohibited sales quotas differential compensation for selling similar products, and sales contests, among other potential practices that could lead to conflicted advice. In contrast, the SEC rule relies on requiring written procedures to mitigate conflicted advice stemming from broker/dealer’s misaligned financial incentives, but it is far less prescriptive than the DOL’s rule.

The differences in approach are due to the different laws empowering the SEC and the Department of Labor and historical differences in the agencies’ approach to regulation.

Going Forward: A Collaborative Model of Government in Action

Next up, it’s time for another round of comments after the SEC officially publishes the rule in the federal register. This seems boring, but it's an important period for the commission to hear form industry groups and consumer advocates. As our recent paper points out, helping investors is a massive public-private partnership, and the government needs to ensure that any of its solutions are ultimately workable.

After that, it may take a few more months for a final set of rules. Although this is a proposal, it represents a major change to how the SEC thinks about regulating financial advisors' conduct as it aims to hold financial advisors to high standard of conduct, even if they are not registered as advisers but rather as brokers. Although the SEC has had the authority to write these kinds of regulations since 2010, earlier efforts petered out in 2013 before the Department of Labor took on its “fiduciary rule” project.

In the end, no matter what the final rule looks like, we expect this rule to have an effect similar to the Department of Labor’s rule, and it accelerates an existing trend: Advisors are moving away from a sales model and toward a relationship where they provide best-interest advice to their clients. This proposal adds fuel to the fire.

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