Is the DOL Fiduciary Rule Really So Bad?

Firing the Broadside As populists go, the President-elect has adopted a rather unusual approach toward Wall Street. In general, he has advocated loosening its restraints, rather than the customary populist tactic of tightening them. "I am going to cut regulations massively," Donald Trump has said.

Although Trump has not directly mentioned the Department of Labor's new fiduciary rule, scheduled to launch in April 2017, there seems little doubt of his intentions. Trump advisor Anthony Scaramucci, a hedge fund managing partner, has savaged the DOL rule, calling it the "dumbest decision to come out of the U.S. government in the last 50 to 60 years." He has publicly promised that the Trump administration would repeal the rule.

(As a reminder, the DOL fiduciary rule proposes to extend ERISA legislation so that it covers not only employee-sponsored retirement plans such as 401(k)s but also rollover and IRA advice. Such legislation requires that financial advisors act in their clients' best interests, rather than meet the lower hurdle of "suitability."

The difference? A mutual fund with a 2% annual expense ratio and middling performance can justified as suitable. However, attempting to convince a court of law that such a fund is in the client's best interests, when many cheaper and better options are available, would be a much sterner test.)

In a The Wall Street Journal editorial earlier this month, Scaramucci claimed that the DOL fiduciary rule has at least four "undesirable effects." Two of his claims are baseless, one is partially correct, and the fourth is very much on target. Ironically, though, that fourth point deconstructs the core of Scaramucci's argument, because it illustrates why market forces will advance the DOL's agenda. Even if the Trump administration kills the rule, its effects are here to stay.

That last part seems a bit mysterious, I know. It will become clear shortly. First, the other three claims. Scaramucci's direct words are in italics.

Index Problems? 1) The rule will push investors excessively into passive index funds.

Over the past decade, passively managed index funds have nearly doubled their market share to around 30% of 401(k) assets, contributing to frothy valuations for indexed stocks.

The new fiduciary rule will accelerate the growth of the indexing bubble by making it impractical and uneconomical for advisors to allocate client money to more-expensive actively managed funds--even if they are deemed more appropriate based on market conditions. As a result, investors will likely be more defenseless than ever heading into the next downturn.

Oh, dear.

Indexing does not affect stock valuations. Supply/demand imbalances do, and they care not whether the assets are actively or passively managed. One could argue, weakly, that because most indexed assets are in the S&P 500, its securities are overpriced relatively to other issues--but the S&P 500 is such a large chunk of the U.S. stock market that the argument, even if true, is of secondary importance.

The second paragraph is worse than the first. If a bear market approaches, financial advisors who use passive funds are trapped, because the only way to escape the bear is to invest in actively run funds? You don't say.

Well, he did say, but it's entirely wrong. Actively managed funds did not successfully time the 2008 market crash. And of course, any financial advisor who was prescient enough to see what was coming--much easier said than done--could have changed his clients' asset allocations by using index funds.

Solo Advisors 2) The rule will punish small and independent Registered Investment Advisors, or RIAs.

Large wire houses will be able to adapt and survive, but small and independent RIAs lacking the resources to set up expensive new compliance systems based on the 1,023-page rule will be forced to exit the business or pursue mergers.

I have no idea what this is about. Registered Investment Advisors are already fiduciaries, and thus meet the DOL's new standards. It is true that they will need to do a few things slightly differently, but I have heard of no RIA who thinks of this as a major issue.

Small Investors 3) Punish small savers.

The increased threat of litigation over commission-based accounts will cause most advisors to switch to fee-based systems that don't make economic sense for accounts with low balances. Advisors will drop smaller accounts, forcing less-wealthy individuals to use robo advisors, whose technology is unproven in more-volatile environments.

Now we're getting somewhere. The threat of litigation will indeed threaten commission-based advice, and the most popular current alternative, charging a fee by assets under management, is indeed impractical for smaller investors. Financial advisors can't run a profitable business from receiving $250 per year on $25,000 accounts (assuming a 1% annual fee).

Then again, that $25,000 customer would not receive much attention from the commission-based structure, either. Some time would be spent on the initial purchase decision, and that would be it; there would be little hand-holding, if any at all, for a $25,000 account that paid a one-time, up-front fee.

The solution for smaller investors, of course, is to leverage technology. Scaramucci's perfunctory dismissal of robo advisors is perhaps to be expected from somebody whose firm follows a very, very different business model, but it is not well supported. At any rate, even if the current crop of robo advisors is somehow flawed, the future of financial advice for small investors surely lies with technology.

Costs Matter 4) Cost investors more money.

The rule is designed to save retirees money by eliminating excessive commissions, but research shows it could lead to tens of billions of dollars in new costs. According to Morningstar Inc., fee-based accounts often yield up to 60% more than commission-based accounts, which could translate into another $13 billion in revenue for the financial industry.

No doubt, you expect me to support a point that is attributed to Morningstar. I will not disappoint you. Say what you like about commission-based sales--and most of you will say much, with little that commission-based companies will like--but they are indeed the lower-cost approach for long-term investors who seek financial advice.

To cite an example,

The math favoring commission-based funds is better yet for the larger investor who qualifies for load breakpoints, which can substantially reduce or even eliminate the initial sales charge.

But here's the thing--the answer to this column's mystery. Financial advisory firms know this too. (This time, the italics are mine.) They are very happy to be paid on assets under management. Of course, it did not take the Department of Labor to teach financial advisory firms about profitability. The advisory firms have known this lesson for many years now and have been striving to move more of their business to the AUM model. The DOL fiduciary rule, while long-winded and sometimes annoying, helped the advisory firms. It accelerated a trend that had already begun.

There's No Stopping Progress That trend will not be reversed. The financial-advisory firms will not be reinstituting commission-based sales, regardless of whether the Trump administration makes preventing the DOL fiduciary rule a First 100 Days priority (unlikely), and regardless of whether such a repeal effort could succeed with legislation that is already being rolled out (also unlikely). The cat is out of the bag, and the horse out of the barn.

Which means that for investors, the fiduciary rule is here to stay. Future financial advice will charge fees, not commissions. The advice cost may well be higher than in the past (although it will surely come down as investors' fee awareness rises, and they exert pressure on advice-givers), but fund costs will be lower. In fact, they will be exceedingly low, as financial advisors squeeze mutual funds harder, to justify to their clients the value that they add as advisors.

The Trump administration will take the U.S. in several directions that the Obama administration would not wish. However, changing the course of how financial advice is delivered will probably not be one of them.

Edit: After writing this article (but before publishing), I have been told by a reliable source that while Scaramucci is officially a Trump economic advisor and speaks of this as being the Trump administration's plans, these are not necessarily the Trump administration's plans. Hmmm. All right, let's just say that if these are the Trump administration's plans, the analysis stands. And if they are not the plans, the analysis still stands, albeit only hypothetically.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

Click here for more from Morningstar on the Department of Labor fiduciary rule.