DOL Hopes to Thread Needle with Exemption-Based Fiduciary Rule

Retirement industry experts finally got to see DOL’s revised fiduciary standard proposal, and some are worried the new fiduciary rule could prove too unwieldy to function efficiently.

As explained during a conference call with Department of Labor (DOL) Secretary Thomas Perez and other top Obama Administration officials, the DOL appears to be taking an exemptions-based approach to a stronger fiduciary standard. The DOL expects its rule proposal, if made final in current form, to significantly expand the number of advisers and brokers who will be considered fiduciaries in the context of investment advice. However, Perez was quick to add the wider application of the fiduciary standard would also come along with a new set of prohibited transaction exemptions designed to allow fiduciary advisers to continue to receive commissions, 12b(1) fees and other widely practiced forms of compensation—so long as proper disclosures are made.

While the industry is still absorbing the proposal and the form of the prohibited transaction exemptions (PTEs) contained therein, some concern has emerged that enforcing and interpreting the PTEs will be a herculean task—both for compliance teams at covered industry service providers and for DOL investigators themselves.

Like others in the industry, the Insured Retirement Institute (IRI) is still reviewing the latest proposal. However in a January conversation with PLANADVISER, Lee Covington, senior vice president and general counsel for the IRI, questioned the logic behind such an approach.

“We don’t think the approach of making a strict rule and then issuing a long list of exceptions is the best approach,” he said. “Why make somebody a fiduciary and then immediately turn around and issue a prohibited transaction exemption for them? What does that accomplish beyond complicating the system even further? Many ERISA experts that we are in touch with say that it would be next to impossible to effectively craft this kind of a rule in that way—relying on a list of complicated, detail prohibited transaction exemptions. We don’t believe it’s a tenable approach.”

Perez seemed to reject these concerns outright during the conference call announcing the new rule language. He said the proposal includes “broad, flexible exemptions from certain obligations associated with a fiduciary standard that will help streamline compliance while still requiring advisers to serve the best interest of their clients.”

The explanation continues in a DOL fact sheet supplied alongside the new rule language: “Being a fiduciary simply means that the adviser must provide impartial advice in their client’s best interest and cannot accept any payments creating conflicts of interest unless they qualify for an exemption intended to assure that the customer is adequately protected.”

Perez said this determination will be straightforward and facts-based for advisers. Citing President Obama’s own comments on the rule: “It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first.”

Perez explained that, at present, individuals providing fiduciary investment advice to employer-based plan sponsors and plan participants are required to act impartially and provide advice that is in their clients’ best interest. Under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code, individuals providing fiduciary investment advice to plan sponsors, plan participants, and individual retirement account (IRA) owners are not permitted to receive payments creating conflicts of interest without a prohibited transaction exemption (PTE).

This basic scheme continues under the new rule, Perez noted.

“Drawing comments received and in order to minimize compliance costs, the proposed rule creates a new type of PTE that is broad, principles-based and adaptable to changing business practices,” he said. “This new approach contrasts with existing PTEs, which tend to be limited to much narrower categories of specific transactions under more prescriptive and less flexible conditions.”

Perhaps the most important PTE under the new rule is referred to as the “best interest contract exemption,” which will allow advisory firms to continue to set their own compensation practices so long as they, among other things, commit to putting their client’s best interest first in a written contract and agree to disclose any conflicts that may prevent them from doing so.

“Common forms of compensation in use today in the financial services industry, such as commissions and revenue sharing, will be permitted under this exemption, whether paid by the client or a third-party such as a mutual fund,” Perez said. To qualify for the new best interest contract exemption, the company and individual adviser providing retirement investment advice must enter into a contract with its clients that:

• Formally commits the firm and adviser to providing advice in the client’s best interest. Committing to a best interest standard requires the adviser and the company to act with the care, skill, prudence, and diligence that a prudent person would exercise based on the current circumstances, Perez noted. In addition, both the firm and the adviser must avoid misleading statements about fees and conflicts of interest. These are well-established standards in the law, Perez said. 

• Warrants that the firm has adopted policies and procedures designed to actively mitigate conflicts of interest. Specifically, the firm must provide evidence to the DOL that it has identified material conflicts of interest and compensation structures that would encourage individual advisers to make recommendations that are not in clients’ best interests and has adopted measures to mitigate any harmful impact on savers from those conflicts of interest. While firms don't need prior approval from the DOL to use the exemption, the agency may later determine a prohibited transaction occurred if errors or improprieties are found in an advisory's disclosures to the DOL.

• Clearly and prominently discloses any conflicts of interest. Perez said some types of advisory or investment fees frequently get buried in the fine print, which might prevent the adviser from providing advice in the client’s best interest. To this end, the contracts must also direct the customer to a webpage clearly disclosing the compensation arrangements entered into by the adviser and firm and make customers aware of their right to complete information about the fees charged. 

In addition to the new 'best interest' contract exemption, the proposal raises a new, principles-based exemption for principal transactions and “maintains or revises many existing administrative exemptions,” Perez said.

The principal transactions exemption would allow advisers to recommend certain fixed-income securities and sell them to the investor directly from the adviser’s own inventory, as long as the adviser adhered to the exemption’s consumer-protective conditions, Perez said. Finally, the proposal asks for comment about whether the final exemptions should include a new “low-fee exemption” that would allow firms to accept payments that would otherwise be deemed “conflicted” when recommending the lowest-fee products in a given product class, with even fewer requirements than the 'best interest' contract exemption.

Perez reiterated several times that, under these exemptions, advisers will be able to continue receiving common types of compensation. He also urged advisers and other industry insiders with strong opinions to continue sharing them with the DOL—as the rule language is still very much subject to change.

Another retirement industry expert speaking with PLANADVISER after the rule language was made public suggested the DOL “seems to have done a nice job listening to the concerns from the industry about potential unintended consequences of a strengthened fiduciary rule,” so he doesn't necessarily expect big changes to the proposal after the comment period. 

Craig Howell, business development specialist at Ubiquity Retirement + Savings, which focuses on advising the small retirement plan market, says the DOL seems to have directly addressed the two main concerns of the industry following the Labor’s initial introduction and withdrawal of a fiduciary redefinition effort back in 2010 and 2011.

“From our perspective the two big concerns were, will this new rule price lower account balances out of the market, and will this new rule restrict the types of compensation models advisers can use?” Howell explains. “We’re still absorbing the rule and all its nuances, but honestly they seem to have addressed these concerns pretty adequately.”

For example, Howell notes there are blanket exemptions in the rule proposal (distinct from those described above) that explicitly state call center employees offering general investment education will not become fiduciaries. And at the same time, he is highly encouraged by Perez’s apparent willingness to accept the ongoing practice of revenue sharing and other complex compensation mechanisms, as long as advisers start doing better disclosures and pledge to keep clients’ interest top of mind throughout the investment transaction process.

“Beyond these particular concerns, it’s hard to argue that placing clients’ best interest first shouldn’t be the goal for each and every adviser,” Howell concludes. “In that sense this proposed rule is certainly a step in the right direction.”