The Department of Labor issued new rules that will, beginning in April 2017, require financial advisors handling 401(k)s and individual retirement accounts (IRAs) to act in the “best interest” of their clients. Previously, brokers were only required to recommend “suitable” investments, and some firms steered clients into investment products that regulators considered high costs. The government estimates that these fees cost retirement savers $17 billion a year.
The legislation is known in the media as the Fiduciary Rule. Here’s the fine print of the new rule.
What is Fiduciary and Why Does It Matter
An advisor who makes investment recommendations to 401(k) plan participants, 401(k) plan sponsors, or IRA investors in exchange for compensation will now be legally considered a “fiduciary.” Previously, financial advisors recommending retirement investments were not considered fiduciaries. The difference? Fiduciaries are legally required to recommend investments that are in the “client’s best interest.” Any investment that pays a commission or unreasonable fee could be deemed to be in the best interest of the advisor, not the client.
The DOL rule doesn’t ban commissions or revenue sharing, but it requires advisors who accept them to have clients sign a best interest contract exemption or BICE. In the BICE, the advisor pledges to act in the client’s best interests and only earn “reasonable” compensation. The exemption also must disclose information to clients about fees and other possible conflicts of interest. It’s unclear how much protection a BICE provides either investors or advisors.
Defining Client Best Interest
When is a fee unreasonable? How do you know if a recommendation is in the best interest of the client or the advisor? There’s no litmus test. As a result, some speculate that many advisors will simply no longer offer IRA or 401(k) products at all, at least not for small investors. There is simply too much expense in the compliance documentation and too much risk that an investor will at some point become disenchanted with his or her choices and blame the advisor for making money from these choices. “Washington doesn’t need to put another roadblock between people and their financial goals,” Rep. Scott Garrett, R-N.J. said in a statement. “The DOL’s rule will increase the cost of retirement advice for lower- and middle-income Americans while creating a preferred class of rich investors.”
Cost of Compliance
A major issue is the cost of compliance with the new regulations. Large financial advisory firms will need to craft new administrative steps and invest millions in technology and training to meet the rule’s requirements. Small and midsize broker-dealers may not have the money to comply, and the change could force some to merge with larger companies.
Another possible outcome is that investors will be offered a reduced range of funds, mainly index funds, and will be given no guidance on which fund might be right for them. An unintended consequence could leave many investors with retirement funds weighted heavily in the stock market when it would be prudent to diversify as economic conditions change.
Take, for example, the “dot com” crash of 2000. For three consecutive years, the major indexes fell. Investors in stocks did not recoup their losses until 2007, just before the next market collapse and the great recession. People holding stocks in the form of mutual funds or other vehicles would be unlikely to receive any guidance if most IRA and 401(k) advisors simply become order takers rather than advisors.
On the other hand, some believe the new regulations will encourage people to seek advice with new confidence. “This rule isn’t just about protecting investors from bad financial advice; just as importantly it’s about encouraging investors to affirmatively seek investment advice because now they’re going to have a new sense of confidence,” said Maryland Congressman John Sarbanes. “They’re going to be able to step into that world believing that somebody is looking out for them. Too many Americans put off planning for retirement because it’s complex, they don’t understand the rules, and so they stay away from the opportunity. What this will do is give people the confidence and alleviate the anxieties they have knowing that they’re going to be protected.”
Of course, you should always be confident that your financial advisor is acting in your best interests and if you have doubts, discuss your concerns and either regain confidence or perhaps look for a new advisor.
Note that the fiduciary rule only applies to tax-favored retirement accounts, not ordinary savings or investment vehicles for retirement that do not receive special tax savings.
If you have any questions or would like to set up a consultation, please give me a call at (415) 883-5200.