Loophole May Gut Proposal on Advisers' Conflict of Interest

Financial Advisor Talking To Senior Couple At Home
Catherine Yeulet

By Daniel Solin

Washington bureaucrats seem to have a way of making everything complicated. Have you perused the tax code lately? According to The Washington Times, it has 4 million words, making it seven times the length of the novel "War and Peace."

On April 21, the U.S. Department of Labor issued its highly anticipated Conflicts of Interest Proposed Rule. If you thought a rule requiring that all advisers to retirement plans place the interests of their clients above their own was a fairly simple matter, you would be mistaken. An article in InvestmentNews noted the newly minted rule and its exemptions take up more than 300 pages of text.

The Purpose of the Proposed Rule

According to the department, the purpose of the rule is simple. It seeks to require retirement advisers to abide by a "fiduciary" standard, which means they will be obligated to put their clients' best interests "before their own profits." The department believes conflicted advice costs retirement plan participants $17 billion in losses every year.

Most participants are blissfully unaware the advice they are receiving may not be in their best interests. It's often biased in favor of investment recommendations that generate the most profits for the adviser.

The Position of the New York City Comptroller

As I reported in a recent blog post, New York City Comptroller Scott Stringer does not find the "fiduciary" issue confusing at all. Until an appropriate rule is issued by the department to protect retirement plan participants, and by the Securities and Exchange Commission to protect individual investors, he is proposing a New York state law that would require non-fiduciaries (like brokers and insurance companies) to make the following statement to their clients:

"I am not a fiduciary. Therefore, I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks, and expected returns for you."

If Stringer was the U.S. secretary of Labor, I suspect his proposed rule might read something like this: "As fiduciaries, retirement plan advisers are required to act in your best interests, and must recommend investments that have the best combination of fees, risks and expected returns for you." That's only 30 words, which is a fraction of the verbiage in the department's proposed rule.

The Exemption That Guts the Rule

The department's proposed rule has a "best interest contract exemption." That exemption would allow broker-dealers and insurance companies to provide plan participants with fiduciary advice while still receiving commissions, revenue-sharing payments and 12b-1 fees. They would still be required to put the interests of their clients before their own. And they would also have to disclose conflicts of interest related to their compensation.

But it's difficult to see how this exemption would work as a practical matter. Revenue-sharing payments are commonly made by mutual funds to plan trustees, record keepers and other investment platform providers. Mutual funds that don't make these payments quickly learn they are the price of admission for inclusion as an investment option in the plan.

Disclosure Is Not Enough

Here's the kind of disclosure concerning revenue-sharing payments formulated by one prominent broker-dealer: "We want you to understand that Edward Jones' receipt of revenue-sharing payments represents a potential conflict of interest in the form of additional financial incentive and financial benefit to the firm, its financial advisers and equity owners in connection with the sale of products from these partners."

The problem with this type of disclosure is that it fails to disincentivize retirement plan advisers from including high-cost, actively managed funds among the investment options in retirement plans. It places a burden on the plan sponsor or participants to demonstrate these funds are not in the best interest of plan participants.

Disclosure of this conflict of interest, and after-the-fact rationalization that the advice was nevertheless in the best interest of plan participants, will engender endless litigation. The securities industry has the resources to stoutly defend its position, likely leaving plan participants no better off than they were before enactment of the fiduciary rule.

A true fiduciary would be prohibited from having its integrity compromised by receiving payments from anyone other than the plan sponsor (who could delegate all or a portion of these expenses to the plan participants).

Permitting "fiduciaries" to accept payments from vendors will gut the proposed rule, likely making it ineffective. It will be bad for plan sponsors and plan participants, and good for costly actively managed funds, brokers, insurance companies and their lawyers.