A significant rule change goes into effect in the spring of 2017 that impacts the financial advisory business. After years of deliberation, the Department of Labor is implementing a rule that requires that any financial professional who gives advice related to retirement accounts such as IRAs and 401(k)s to act as a fiduciary for the client. This means financial professionals must act in the best interest of the client when dispensing advice.
The obvious question is, Hasn’t this been the standard all along? The answer is that it has been for some financial advisors but not others. The Investment Advisers Act of 1940 established rules of conduct for those providing investment advice (Registered Investment Advisers [RIAs]) that included acting as a fiduciary. But the brokerage industry successfully argued that their stockbrokers were transactional sales people who should be exempt from the rules of the Investment Advisers Act because they were not providing holistic investment advice. The standard that evolved for stockbrokers was called “suitability.” This means that brokers could recommend investment products if those products were considered suitable for a client based on their situation, even if the investment product involved significant fees that benefited the broker.
Thus, you had a divide between RIAs, who primarily advised institutions such as mutual funds and pension plans, and retail stockbrokers, who worked with individual investors in non-retirement accounts. But the advent of IRAs changed the landscape, and today these lines are blurred — both groups serve these individuals and both call themselves financial advisors while being held to very different standards.
The new fiduciary rule will now require that anyone providing advice related to retirement accounts be held to a fiduciary standard. For example, if an advisor recommends that a client roll over a 401(k) to an IRA and the advisor benefits in any way, the advisor must document why that move is in the best interest of the client. The rule, however, does not define what “best interest” means. It will be left to the courts to determine that.
This change will clearly have a big impact on the brokerage industry, which has resisted it for years. The excessive fees that will be scrutinized and challenged going forward are a significant profit driver for brokerage firms. As an example, a product generally considered suitable in the past that will have a much harder time being considered “in the client’s best interest” under the fiduciary standard is variable annuities, which can have annual fees as high as 4%.
Existing RIAs like myself will also be impacted. A greater burden of proof will be required to ensure that any recommendation is clearly in the best interest of the client. In particular, RIAs who charge a fee based on a percentage of assets will need to be exceptionally careful since some inherent conflicts of interest exist in that model. That is one of the reasons I opted for a flat fee model when I started out and believe that the industry will eventually gravitate in that direction.
There are some open questions. One is with whether the incoming presidential administration will pursue this rule change as strongly as the outgoing one. Some prominent individuals from the financial services industry who opposed the rule are now advisors to the president elect. It may be difficult to reverse the rule in the short run, but the new administration could deprioritize enforcement, thus watering it down. But some brokerage firms are further ahead in adopting the rule and will now likely resist a reversal since full implementation will give them a competitive advantage.
The other open question is whether a similar rule will be applied to non-retirement accounts. The regulator for these accounts is the SEC not the Labor Department, and the SEC has not yet announced any move to a fiduciary standard. Again, the incoming administration will impact any future adoption.
The good news is that public awareness of the need to have financial advisors act in the best interest of their clients is increasing, no matter what happens with the fiduciary rule. It is difficult enough for individuals to save for a comfortable retirement without having to worry about the financial services industry enriching themselves at their expense.
As always, let me know if you have any questions.