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.
