Monday, April 27, 2015

The New Fiduciary Rule is Here. But Where is “Here?”

There has probably not been a retirement plan regulations proposal more contentious or debate-stirring than the “conflicted advice” regulations recently issued by the Department of Labor’s Employee Benefits Security Administration (EBSA).  That’s a bold statement, but as a retirement industry professional for nearly three decades, I don’t make it casually.  Controversy and government regulation seem to go hand-in-hand, but these regulations take that maxim to a new level; certainly as far as retirement plans are concerned.

Given the history of this proposal – formerly known as “fiduciary definition” regulations – some may have been in denial that it would ever see the light of day.  After all, the regulations were first proposed in 2010, withdrawn in 2011 after an extremely hostile reception, underwent extensive public comment and cost-benefit analysis, and several promised release deadlines were missed.  Seen by many as a potential political liability for supporters, some questioned whether the proposal might languish, unreleased.

But such unbelief was dispelled when – in February of this year – President Obama spoke at an American Association of Retirement Persons (AARP) event, his message alleging massive losses of retirement income as a result of investment decisions that were based on poor advice.  President Obama quoted from a White House Council of Economic Advisors study entitled The Effects of Conflicted Investment Advice on Retirement Savings.  A fact sheet, FAQs, and other items advising savers on how to protect their retirement assets were also released with this press conference. 
At roughly the same time, the federal Office of Management and Budget (OMB) took delivery of EBSA’s new proposed conflicted advice regulations, rules intended to reduce or prevent the kind of growth-robbing investment advising spoken of by the President.  One might note that the title “conflicted advice” now being used sends a more calculated and urgent message than “fiduciary definition” regulations ever could. 

In an unusually short time, less than two months, OMB cleared these regulations for release to the public.  The package of supporting materials EBSA released with the regulations was impressive, if not unprecedented.  In addition to the regulations and new and amended prohibited transaction exemptions, the non-technical explanatory materials were voluminous.  They included not only a typical news release, but the simultaneous release of a fact sheet and frequently-asked-questions (FAQs), elaborations that are commonly issued sometime after actual guidance.  All this, and a cost-benefit analysis document longer than the actual regulations.  “Well-defended” might be a good way to describe the new regulations.

Without going into minute detail of the new proposed fiduciary definition, it clearly is more inclusive, and if adopted would make it harder for many advisors to be found not to be fiduciaries.  One of the more telling departures from the existing regulations is the inclusion of IRA owners and IRA transactions, with particular emphasis on rollover transactions.  While it’s sometimes noted that the DOL does not have authority over IRAs, a 1978 presidential executive order transferred to the Secretary of Labor the authority to write regulations under Internal Revenue Code Section 4975, the statute governing prohibited transactions.  IRC Sec. 4975 applies to both employer-sponsored retirement plans and IRAs.  Thus EBSA’s claim to the right to regulate those who provide IRA investment advice.

One of the surprises of EBSA’s proposed regulations – surprising to some, at least – was allowing investment advisors as fiduciaries to continue to receive variable compensation for different investments chosen by their clients.  Many had expected that advisor-fiduciaries might be forced into a flat fee or “levelized” fee business model.  Instead, such compensation methods as commissions, revenue sharing, or 12-b1 fees can continue to be part of compensation for investment advice.
But the variable fee option does not come without strings.  An entirely new prohibited transaction exemption would have to be satisfied in order to maintain the option for variable compensation.  It is known as the Best Interest Contract Exemption, and the term “contract” is well chosen.  I'm not going to go over all its details in this particular blog, but several stand out as worthy of mention. 

An advisor or advisory firm would have to inform EBSA of their intent to use the exemption;  potentially attracting examination attention?  The provider of advice must warrant – guarantee – that it has identified possible conflicts of interest, and has adopted measures to prevent financial harm to the client.  Investment advice given must be in the client’s best interest, not merely suitable.  The formidable “prudent person” standard with which we are familiar from ERISA Section 404(c) would apply.  Clients would have recourse under contract law for breaches committed by the advisor, and contractual language limiting or disclaiming liability for violations could not be used.  Strong medicine to be sure.

Some questions, for now unanswered, present themselves.  Does this proposal have a chance to take effect in its present form?  And, how would the advising industry respond if it does?  The 2010 version of the regulations, withdrawn in 2011, generated a preponderance of criticism of a “too restrictive” flavor.  This proposal, however, has drawn criticism from both proponents and opponents of tighter fiduciary regulations.  That being the case, might EBSA be inclined to conclude that it has found a middle ground between its rules being too restrictive and too liberal?  We will be keeping a close eye on the official public comments, which will surely be made available for review.

Will Congress itself make a move to affect the implementation of these proposed regulations?  Well before their issuance, the Republican-controlled House of Representatives passed legislation that would require EBSA to wait for the Securities and Exchange Commission (SEC) to issue fiduciary regulations first.  The Senate has not acted on it, and there are no indications that it is anywhere near the top of that body’s agenda.  The point is probably moot, because any such legislation would certainly be vetoed by President Obama, and there is reason to doubt that enough Democrats would join Republicans in a vote to override such a veto.  In fact, while a number of Democrats openly and actively opposed the 2010 proposed regulations, that has not been heard with this regulatory effort to date.

Still beyond prediction is whether – if regulations closely resembling this take effect – advisors that would fall under a broadened fiduciary definition will maintain existing business models with variable compensation, given the disclosure, contractual and prudence stipulations that would be required.  Will some advisors move to fixed or levelized compensation models?  Will some decline working with small balance investors altogether?

Much, much more to come!