On June 9, 2017, the Department of Labor’s (DOL) new fiduciary rule (Rule), or at least parts of same, go into effect for retirement plans covered by the Employees’ Retirement Income Security Act, commonly known as ERISA.

The Rule was originally drafted to address perceived abusive marketing tactics that the investment industry was using in connection with advising retirement plans, such as 401(k) plans, and participants in such plans. One particular area that the Rule sought to address was the provision of advice to plan participants as they were retiring. In many cases, retiring workers will take their 401(k) funds and transfer them to an individual retirement account (IRA). These transfers from 401(k) plans to an IRA are commonly referred to as “rollovers.”

A common ploy by the investment industry was to try to convince retirees to take their retirement funds and put them into a variable annuity (VA). Salesmen would tout the fact that VAs allow an owner to benefit from tax-deferred investing.

What such salesmen would not tell customers is that IRAs also offer tax-deferred investing, often at a much lower cost. Many VAs charge minimum cumulative fees of around 2.5-3 percent a year, representing both the VA’s annual fees and the annual fees of the investment subaccounts Given the fact that each additional 1 percent of fees reduces an investor’s end return by approximately 17 percent a year over a twenty year period, an investor would be looking at a minimum loss of between 42-51 percent of their investment returns in the VA. Even more egregious is the fact that a landmark study by Moshe Milevsky found that in most cases, the VA issuer was charging an annual fee that was generally 10-15 times what it was worth to the VA owner.

So why would a financial adviser recommend such a product that was clearly not in the best interests of most investors? Financial advisers often earn substantial commissions on sales of VAs, often as much as 7 percent. Find a retiree with a nice nest egg, say $500,000, sell them a VA, and earn a commission of $35,000 on one sale. Forget the fact that the product will result in a substantial loss of end returns for the investor.

So that explains the “why” behind the Rule. The Rule was intended to promote fair treatment of pension plans and plan participants. In large part, the Rule was intended to address the inherent conflict of interests involved when a financial adviser recommends and sells investment products for a commission.

So what is the Rule’s “what”?

The Rule as passed basically has two sets of rules for anyone advising and making investment recommendations to pension plans and pension plan participants. The first set of rules require that as of June 9, 2017, anyone advising plans and plan participants will be held to a fiduciary standard and must adhere to the new so-called “Impartial Conduct Standards.” (Standards)

Stockbrokers and insurance agents would often argue that they were only selling products to pension plans and plan participants, not providing advice, so they were legally allowed to put their own financial best interests ahead of those of a plan or a plan participant. (FYI – that is still the applicable rule with many stockbrokers and insurance agents.)

That “dodge” will no longer work, at least when a financial adviser is working with an ERISA-covered pension plan or plan participant. All such financial advisers are now deemed “fiduciaries’ and must adhere to the Standards. There are three Standards:

• The Best Interest Standard – The Best Interest standard is a combination of ERISA’s prudent man rule and a fiduciary’s duty of undivided loyalty. ERISA’s prudent man rule states that a fiduciary must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims…”
• Reasonable compensation – The Reasonable Compensation standard requires a financial adviser to only offer pension plans and plan participants services and investment products that are reasonable in terms of market prices and the inherent value of the services and products being provided and recommended.
• Misleading statements – The Misleading Statements standard prohibits a financial adviser from making materially misleading statements about the fees, investments, and any potential or actual material conflicts of interest regarding either their advice and/or product recommendations or other matters that would be material to the investment decision.

So, as of June 9, 2017, any financial adviser advising and making recommendations to plans, participants and IRAs must comply with all three of the Standards and always act in the plan’s or plan participants best interests. The investment industry knows that some, perhaps many; of their investment products do not currently and cannot meet these high standards. Some broker-dealers are totally prohibiting their financial advisers from advising plans, plan participants and IRAs. Some broker-dealers are restricting the advice and products that their financial advisers can use. Other investment firms are modifying their compensation programs when plan, plan participants and IRAs are involved.

Some investment firms are not making any significant changes in their approach to offering investment advice to IRAs. Those firms have made the decision to attempt to rely on one of applicable exemptions to the Rule, commonly known as the Best Interest Contract exemption, aka “BICE.” BICE is the second part of the Rule.

The BICE requirement does not apply to financial advisers who provide advice on a level-fee basis, e.g., hourly or monthly fees or based on the value of assets under management, since those types of compensation do not create the same sort of potential conflicts of interest issues that commissions and other types of variable compensation create.

Financial advisers and financial institutions that wish to receive variable compensation in connection with advising plan participants on IRAs and IRA rollovers must comply with all of the BICE requirements or face substantial fines and other severe penalties. Most of BICE’s requirement are disclosure oriented so that plans and plan participants are provided with “sufficient information to make informed decisions,” as guaranteed by ERISA.

At this, I am not going to go through all of the BICE requirements since the decision was made not to require the BICE contract and the various disclosures until 2018. However, as of June 9, 2017, the Impartial Conduct Standards will apply to any advice provided to plan participants regarding the use of IRAs and IRA rollovers as investment options, including product recommendations. Consequently, the protections afforded under the fiduciary “best interest” standard will go into effect on June 9, 2017 to cover advice and recommendations with regard to IRAs and IRA rollovers.

As mentioned earlier, one of the primary abusive marketing/sales tactics used by the investment industry was to convince retirees and the elderly to put their retirement funds in a variable annuity or its equally undesirable cousin, the fixed indexed annuity, aka equity indexed annuity. For a complete discussion about these products and how to decipher the various marketing spiels used in trying to sell them, please read my white paper, “Variable Annuities: Reading Between the Marketing Lines,” by clicking here.

For pension plans and plan participants that want to check-up on the prudence and overall quality of their plan’s investment options, my metric, the Active Management Value Ratio™ (AMVR) provides plan sponsors and plan participants with a quick and simple way to determine the cost efficiency of their plan’s investment options. For more information about the AMVR, click here.

Conclusion
The new DOL fiduciary rule is somewhat complicated, but a much needed law to address the abusive marketing tactics that the investment and insurance industries were using in connection with advising pension plan, plan participants and IRAs. It was estimated that such strategies were costing America’s pension plans and retirees in excess of $17 million dollars a year.

Although the need for the new rule is clear, the rule still faces challenges, as the new Secretary of the Department of Labor has already indicated his desire to “freeze” the Rule in its entirety, this

• even before the study requested by the Trump administration has even been completed;
• in direct opposition to Mr. Trump’s campaign problems to help protect the people; and
• despite the fact that the investment industry and other opponents of the rule have put forth only rhetoric and speculation, neither of which will be admissible if the battle over the rule goes to court.

Many American workers depend heavily on their 401(k)/403(b) accounts to provide for their retirement income. The DOL’s new fiduciary rule does not prevent financial advisers and financial institutions from continuing to make money by advising pension plans and plan participants. The rule simply seeks to create a fair win-win situation by requiring financial advisers and their companies to always put a plan’s and plan participant’s best financial interest ahead of their own.

© 2017 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.