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  • Fiduciary Q&A: Must Conflicts Be Avoided or Just Disclosed?

    April 28, 2016 by Karen Damato

    Ask the Experts: Our panel tackles this question and two more about the Labor Department’s new conflict-of-interest rule

     

    Labor Secretary Thomas Perez announced the new conflict-of-interest rule in Washington on April 6.

    Labor Secretary Thomas Perez announced the new conflict-of-interest rule in Washington on April 6. PHOTO: DREW ANGERERBLOOMBERG NEWS

    Under the Department of Labor’s new fiduciary-duty rule, will advisers working with retirement accounts have to avoid conflicts of interest or just disclose them?

    For answers to this question and two others, Wealth Adviser at WSJ.com once again sought help from our panel of experts: lawyers Andrew Oringer and Jason Roberts,academics Julie Ragatz and Ron A. Rhoades and practice-management consultantChristine Gaze. (More details on our panelists are below.)

    This is the third of three Q&As for advisers about the new rule requiring those who work with retirement accounts to act as fiduciaries in their clients’ best interests. (Our panelists answered five questions in the first installment and three in the second one.)

    Q: Must conflicts of interest be avoided or just disclosed or “managed” under the new rule and its best-interest contract exemption?

    Ron A. Rhoades: If an adviser provides advice to 401(k)-type accounts or to individual retirement accounts after April 1, 2017, the adviser can operate either in a relatively conflict-free manner or, when there are potential conflicts involving compensation from parties other than the investor, under the best-interest-contract exemption. Under the BIC exemption, a firm’s receipt of differential compensation from third parties (including commissions, mutual-fund 12b-1 fees, etc.) may be permitted, but only if the customer’s best interests remain paramount.

    The DOL stated in its release that any advice under the BIC exemption must adhere to “impartial conduct standards.” These standards require that the advice be provided “without regard to financial or other interests” of the adviser, the company or any affiliate. Also, firms “must refrain from giving or using incentives for advisers to act contrary to the customer’s best interest.”

    While some brokerage firms have opined in recent weeks that they foresee “business as usual” under the BIC exemption, I would suggest that substantial liability and enforcement risks exist for advisers and their firms who accept third-party compensation and who don’t offset the higher fees received against other fees the customer may pay. Recommending higher-cost products can negatively impact the returns the customer receives. Yet it is incumbent upon any firm and adviser, when operating as a fiduciary, to not favor their own interests in any manner that harms the customer.

    Jason Roberts: It is important to note, however, that not all conflicts can be avoided—even for fee-only registered investment advisers. Consider the common example of a recommendation to roll over a 401(k) plan to an advisory IRA. If I have no existing relationship with the plan or the individual, then my compensation is zero if he/she stays invested in the 401(k) plan. If I recommend a rollover (the fiduciary act under the new rule) to an advisory IRA with a 1% annual fee, then I have prohibited compensation and need to comply with the BIC exemption. While the DOL created a “streamlined” BIC exemption for recommendations to advisory accounts, the majority of the risks of the BIC exemption are still present (e.g., adherence to the impartial-conduct standards, documentation regarding best interest, reasonable compensation, etc.).

    Mr. Rhoades: I agree, Jason. In each instance of an IRA rollover, the adviser must justify his or her value in recommending the rollover. This might be done with lower-cost investment products, investments in preferred asset classes that may not be available in the 401(k) plan, greater flexibility in arranging distributions or the provision of additional services such as financial planning. A benefits and cost comparison is required, contrasting the client’s current situation and the new arrangement the adviser proposes.

    Andrew Oringer: The liability point is an important one. Just because an institution can find a way to try to satisfy the new rules doesn’t always mean that the institution will want to have the new liability profile that would come with fiduciary status.

    Q: I’m an independent adviser licensed to sell securities through a brokerage firm. How much of the burden of complying with the new rule will fall on me versus the brokerage?

    Christine Gaze: The brokerage firm will be responsible for developing policies and procedures that comply with the new rule that you will be expected to abide by. Most brokerage firms are currently focused on analyzing the rule and providing training support to their advisers. These efforts will kick into high gear as the applicability date of April 10, 2017, draws nearer.

    For the adviser, a prudent step in these early days is to conduct a thoughtful review of your business model. That would include, but not be limited to, an analysis of fees, services offered and potential conflicts of interest (even for those who qualify as a “level fee fiduciary” under the rule). The burden of complying will vary widely by adviser practice, with the greatest burden falling to those whose business will require best-interest contract agreements on a frequent basis.

    In my view, the biggest challenge many advisers will face is adequately preparing for the “new-client conversation.” Numerous studies have highlighted how abominably many advisers explain fees to clients, and this could get even harder for heavy BIC users.

    Mr. Roberts: I would add that while the compliance burden will fall initially on supervising firms (e.g., determining whether or not the BIC exemption is an option for different client/account types, what products the firm will allow to be distributed under the BIC exemption, drafting the required disclosures, etc.), downstream, day-to-day compliance and documentation will fall squarely on the adviser. After all, it’s the adviser that is having the conversation with the clients/prospective clients regarding their needs or “interests.” Advisers can expect to see significantly enhanced information-gathering requirements and detailed protocols for delivering written recommendations that align with the client’s best interests.

    Additionally, fiduciaries are obligated to act prudently. Prudence, at a minimum, requires the adviser to consider relevant information (or that which he/she should know to be relevant) to arrive at a well-informed recommendation. If push comes to shove in a litigation or arbitration, advisers will need demonstrable proof that they not only acted in the client’s best interest but also that their advice was prudent. Capturing the needs of the client and the basis for the recommendation(s), in writing, is the only way to avoid the “he said/she said” scenario—a worst-case scenario for a financial adviser or institution attempting to defend a claim filed by a sympathetic investor who experienced losses in his/her retirement account.

    Mr. Oringer: A whole class of providers who have never in the past thought about fiduciary rules now will have to be retrained. An example would be a broker for a retirement account who wasn’t previously considered a fiduciary, but who now might be a fiduciary if he or she makes recommendations for the account. For those who have lived in a fiduciary world already, like trust officers, the transition might not be as daunting.

    Mr. Rhoades: I’ve seen numerous instances of insufficient due-diligence efforts at firms. This leads to liability for both the firm and the adviser. For some firms, the liability exposure is treated as a “cost of doing business.” And little reputational harm occurs to the firm, given marketing campaigns that overwhelm the rare public disclosure of transgressions. Yet, for an adviser, one mark on that adviser’s record could affect that adviser’s reputation for the rest of his or her career. I strongly recommend that advisers undertake their own due diligence, fully understand every aspect of any investment product recommended, and be certain that they are adhering strictly to the impartial-conduct standards found under the BIC exemption.

    Q: Can you explain the grandfathering rule for existing holdings in client accounts? What would constitute new advice on those investments?

    Mr. Roberts: Recognizing that some advisers and financial institutions don’t consider themselves to be fiduciaries today or in the past when they made recommendations to retirement investors, the DOL created the “pre-existing transaction exemption.” This exemption permits the receipt of continuing compensation from transactions that were recommended prior to, as well as recommendations to adhere to a “systematic purchase program” established before April 2017. It also covers compensation from recommendations to “hold” an investment purchased prior to that applicability date.

    The following five conditions must be met to use the exemption, however:

    1) The pre-existing arrangement must not have expired or come up for renewal after the applicability date;

    2) The exemptions wouldn’t cover the transaction if it were a prohibited transaction under the rules that existed at the time the arrangement was entered into with the client;

    3) It also wouldn’t cover new deposits into the investment after the applicability date (unless the arrangement is subject to rebalancing program established before the applicability date);

    4) The compensation must be reasonable; and

    5) Any additional advice provided after the applicability date must be prudent and made without regard to the adviser’s or firm’s financial interests.

    Our panelists

    Andrew Oringer is co-chair of law firm Dechert LLP’s Erisa and executive-compensation group in New York.

    Christine Gaze is president of Purpose Consulting Group, a practice-management consulting firm for the financial-services industry.

    Julie Ragatz is an assistant professor of ethics at the American College of Financial Services and head of its Cary M. Maguire Center for Ethics in Financial Services.

    Ron A. Rhoades is the director of the financial-planning program in the Gordon Ford College of Business at Western Kentucky University.

    Jason Roberts is an Erisa attorney and the chief executive of the Pension Resource Institute, a consulting firm for advisory and brokerage firms.

    Write to Karen Damato at karen.damato@wsj.com

    Originally Posted at The Wall Street Journal on April 27, 2016 by Karen Damato.

    Categories: Industry Articles
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