IMPACT ANALYSIS: DOL fiduciary rule may require multiple paths to compliance

June 27, 2016

Manisha Kimmel, Thomson Reuters

(NEW YORK) – What makes the U.S. Department of Labor’s (DOL) “fiduciary rule” so transformational is that unlike most regulations which have a major cost and operational impact, the DOL rule package will also have a material impact on the front office. This impact will include financial adviser compensation and revenue associated with Individual Retirement Accounts (IRAs) and other retirement accounts.

DOL has approved a principle-based rule with multiple implementation options for firms to consider. While this flexibility allows firms choices for complying, it also necessitates real business decisions by all affected firms.

Below are a list of paths to compliance for firms to consider:

Comply as a Fiduciary

It is possible to comply with the fiduciary rule without the use of a new or existing exemption. Choosing this route means avoiding prohibited transactions, essentially operating free of conflict. It is important to recognize that the DOL states that, “fiduciaries’ dealings with IRAs are governed by the [IRS] Code, not by ERISA, and the [IRS] Code, unlike ERISA, does not directly impose responsibilities of prudence and loyalty on fiduciaries.”

One option firms may be considering is exiting the brokerage model altogether in favor of an advisory model that engages in no prohibited transactions.

Rely on the Best Interest Contract Exemption (BICE)

It is through the use of the BICE that DOL offers firms the ability to maintain existing forms of compensation but only by accepting “Impartial Conduct Standards” that need to be contractually warranted for IRA accounts.

In using the BICE, firms are required to insulate advisers from conflicts of interest but are permitted to receive third party payments and sell proprietary products, subject to appropriate disclosure. Existing forms of adviser compensation may include fees based on commissions, assets under management, or fee offset to name a few. While these forms of compensation may remain, firms will need to ensure that any variability in differential compensation is based on “neutral factors.”

While the disclosure requirements have lessened from the original proposal, it should be noted that clients may make ad hoc requests for additional information. Additionally, the web site disclosure will require business model, compensation model and third party relationships to be provided on a public website.

In support of the BICE, firms will need well-documented policies and procedures addressing their adherence to the Impartial Conduct Standard including anti-conflict policies and procedures. Systematizing these policies and procedures into an effective supervisory structure will also be required.

Rely on Streamlined BIC for Level Fee Fiduciaries

For firms willing to level compensation not just at the adviser level but also at the firm level, DOL offers the “level fee fiduciary” option. According to DOL, level fee fiduciaries are those “that, together with their affiliates, receive only a level fee in connection with advisory or investment management services with respect to plan or IRA assets (e.g., investment advice fiduciaries that provide ongoing advice for a fee based on a fixed percentage of assets under management)…It is important to note that the definition of level fee explicitly excludes receipt by the adviser, financial Institution or any affiliate of commissions or other transaction-based payments. Accordingly, if either the financial institution or the adviser or their affiliates, receive any other remunerations (e.g., commissions, 12b-1 fees or revenue sharing), beyond the level fee in connection with investment management or advisory services with respect to, the plan or IRA, the financial institution and adviser will not be able to rely on these streamlined conditions.”

Ordinarily, a firm that offers level fees would not require an exemption. However, in cases where a level fee fiduciary is making recommendations as it relates to (1) switching from a commission to fee-based account, or (2) recommending a rollover, the streamlined exemption is required. The DOL explains that in order to take advantage of the streamlined exemption, firms “must provide a written statement of fiduciary status, adhere to standards of fiduciary conduct, and prepare a written documentation of the reasons for the recommendation.”

Rely on the Principal Transaction Exemption (PTE)

In order to allow principal trading in certain circumstances, the DOL offers the principal transaction exemption, or PTE, which would allow the purchase in a principal capacity of a debt security, unit investment trust, or CD based on certain credit and liquidity standards. Additionally, the exemption allows the sale in a principal capacity of all securities.

Much like the BICE, the PTE includes requirements to adhere to the impartial conduct standards, provide disclosures and establish policies and procedures. Unique to the PTE is a requirement to achieve best execution and provide an annual disclosure.

Rely on Pre-Existing Transaction Relief for the BICE or PTE

When considering taking the BICE or PTE, firms also need to decide whether they will avail themselves of the pre-existing transaction relief. The purpose of the exemption is to preserve compensation already in place and would apply from April 10, 2017 to January 1, 2018. While relief is provided from making most disclosures, there are several requirements associated with this relief including that the impartial conduct standard is in place by April 10, 2017.

While extra time for disclosures may be useful, much of the work associated with the exemptions will be required by the April 10, 2017 applicability date of the rule even if a firm takes the pre-existing transaction relief.

Rely on Amended Prohibited Transaction Exemption

It is important to note that several other exemptions were amended as part of the DOL package published in the Federal Register on April 8, 2016. Firms relying on these exemptions should review these exemption carefully as most of them seek to impose the Impartial Conduct Standard in order to continue to use the exemption.

Worth noting is the change to PTE 84-24 which is now restricted to fixed rate annuities, prohibited transaction relief associated with variable rate and fixed index annuities is now covered by the BICE.

Rely on Existing Advisory Opinion or Statutory Exemption

DOL acknowledges that “nothing in the final rule alters” existing advisory opinions. They also reference the uses of statutory exemptions that were established as part of the Pension Protection Act (PPA) of 2006.

As DOL stated at the time of implementing final rules in support of the PPA in 2011, “The statutory exemption allows fiduciary investment advisers to receive compensation from investment vehicles they recommend if either (1) the investment advice they provide is based on a computer model certified as unbiased and as applying generally accepted investment theories, or (2) the adviser is compensated on a “level-fee” basis (i.e., fees do not vary based on investments selected by the participant). “  There are a number of conditions associated with the statutory exemption but they may be less burdensome than the BIC exemption.

Additionally, existing advisory opinions may be relied on including 2005-10A (Country Trust Bank), 2001-09A (SunAmerica Retirement Markets), 1997-15A (Frost National Bank), 1997-16A (Aetna).

Rely on an Exception to the Definition of Fiduciary

Another way of complying with the DOL fiduciary rule is simply to not be a fiduciary by qualifying for an exception to the definition. Possible approaches include offering investment education only, taking orders without the provision of advice, or performing transactions with independent fiduciaries with expertise.  There are more exceptions available for ERISA Plans rather than IRAs given the DOL’s interest in ensuring that IRAs receive more fulsome protection under the rule.

Next Steps

It is anticipated that within a firm multiple paths to compliance will be considered, potentially based on client segmentation. These are crucial business decisions that should include an analysis of the following questions:

  • Client experience: While this rule governs retirement plans only, what paths to compliance will ensure a seamless experience for your clients? Do decisions need to be made at the account or household level?
  • Financial Adviser Impact: How will different paths to compliance impact financial adviser compensation and incentives?
  • Revenue Impact: How will current rebates and other distribution fees be impacted by different paths to compliance?
  • Litigation risk: Both the BICE and PTE establish a private right to action and enforcement with the rule is expected to be via class action lawsuits. How will litigation risk be managed across the multiple paths to compliance? What supervisory structures need to be in place?
  • Cost: What are both the implementation and on-going costs of each path to compliance?
  • Time to Market: While lawsuits have been filed, the current implementation date is April 10, 2017. What can reasonably be accomplished in that time?
  • Operating Under Certainty: How can implementation be flexible in order to accommodate any new guidance by DOL or changes as a result of litigation.

DOL clearly represents a challenge for the financial services industry, particularly those engaged in wealth management. The result of business decisions will drive technology and operations changes as well as structural changes to fees and compensations. Achieving compliance with DOL is not just a matter of establishing compliance; it’s a wholesale re-examination of the business.

 (Manisha Kimmel is the Chief Regulatory Officer, Wealth Management, Thomson Reuters where she focuses on identifying regulatory risk and implementing strategic regulatory initiatives, acting as a regulatory liaison on behalf of Thomson Reuters and its customers.  Manisha is a member of the Security and Exchange Commission’s Equity Market Structure Advisory Committee and serves on the Consolidated Audit Trail (CAT) Development Advisory Group. Her role on these committees is to provide an implementation perspective on topics under discussion.)


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