Thursday, June 4, 2015

Many Ifs, Ands & Buts in EBSA’s Fiduciary Solution

When we were young, we may have been told that beginning a sentence with the word “but” was inappropriate.  We believed it because the people who said so were adults, and were supposed to know such things.  Later, we learned that “but” is a “coordinating conjunction,” and many good writers properly begin sentences with it.  Perhaps we had been intentionally misled because “but” is a word of protest often used by children.  “But I don’t want to eat my broccoli!” “But I’m not sorry!” 

Appropriate or not, “But” was the first word that came to mind when I had digested the Department of Labor’s “conflicted advice” – formerly fiduciary definition – proposed regulations, issued in April.  (Some other words that came to mind are less charitable.)  “But how can you propose,” I wondered, “a solution that seems generous to the present advising environment, but sets a snare that can spring future litigation and fiduciary liability even on principled and conscientious advisers?” 
I’m certainly not unsympathetic to the need for retirement savers to receive principled advice when making critical investing decisions.  They deserve no less.  But the most prominent solution being prescribed by the Department’s Employee Benefits Security Administration (EBSA) – the proposed Best Interest Contract – has some ingredients that beg the question of whether the remedy is worse than the malady.

To the genuine relief of many, EBSA’s proposed regulations did not narrowly limit the types of compensation that can be received by advisers or brokers serving retirement savers.  Some had feared that a fee-only approach might be required to avoid prohibited transactions and their inherent liability, which many believe might have caused advisers to flee the small investor market.   On the contrary, EBSA’s proposed regulations make clear that compensation that may vary depending on the investments chosen – like commissions, 12-b1 fees, revenue sharing, etc. – can continue to be a part of the adviser or advising firm’s compensation structure.
But – and it’s an important “but” – the price for this freedom in compensation arrangements is the Best Interest Contract, or BIC, as it is becoming known in industry shorthand.  If variable compensation structures are used to compensate for investment advice, something normally prohibited, an adviser or advisory firm must agree to enter into this arrangement.  It is a contractual one, make no mistake.  In EBSA’s own words, “It would require retirement investment advisers and their firms to formally acknowledge fiduciary status and enter into a contract with their customers in which they commit to fundamental standards of impartial conduct.  These include giving advice that is in the customer’s best interest and making truthful statements about investments and their compensation.”  Fail to meet either general or specific conditions of the BIC, and an advisor could be exposed to potential EBSA prohibited transaction enforcement, IRS excise taxes, and client litigation. 

There are a number of things that stand out as problematic with EBSA’s proposal, but for now we’ll focus on just two.  One is subjectivity.   “Best interest” may be in the eye of the beholder.  How much emphasis should be given to the lowest possible fees?  Are higher fees justified by facts and circumstances, such as a more expensive fund whose manager has a track record for outperforming others?  Would advice that looks questionable today be considered acceptable in the historical context of the time and options available when it was given?  Will those with enforcement and judicial authority have the expertise and the impartiality to make these and other judgment calls?

Another problematic issue is the potential for litigation if a client does not feel that an advisor has lived up to expectations.  An advisor or advisory firm must warrant that it has not only identified possible conflicts of interest, but has adopted measures to take them into account and prevent financial harm to the investor.  Based on such warranties, clients will have a contract law basis for seeking legal remedies, including class actions, and – specific to IRAs – bringing a case under state law without the benefit of ERISA preemption.   

There is nothing new about risk and return; it’s fundamental to investing.  In the case of EBSA’s BIC it now applies to the advisor, as well.  The potential for legal exposure may prove to be an unacceptable risk for some advisors and advisory firms.  Some might say it is appropriate that risk of a fiduciary nature find its way to the doorstep of folks who dispense investment advice to retirement plan participants and IRA owners.   But how much is “too much?”

A major concern of some who question EBSA’s approach is that instead of conflicted advice, some retirement savers will get little or no advice.