What is the Department of Labor’s Proposed So-Called Fiduciary Rule?

The 1972 Employee Retirement Income Security Act (ERISA) is a law governing employer and other pension plans. A U.S. Regulatory agency, the Department of Labor (DOL), was charged with implementing its requirements, including the conduct of those persons distributing and administering those plans. A high degree of responsibility for advice is established for those who administer it. It must be in the best interest of the plan participant, not that of the product manufacturer or investment advisor. This is referred to as fiduciary duty.

Since 1977, the DOL has afforded an exemption from the prohibited transaction rules of ERISA to allow certain transactions with plan assets of insurance or annuity contracts, and the receipt of sales commissions in connection with such sales (PTE 77-9, 42 fed. Reg. 32395). The DOL amended and superseded this exemption with PTE 84-24, allowing for the purchase of plan assets of mutual funds or an insurance or annuity contract so that such would not violate the provisions of section 406 of ERISA (49 Fed. Reg. 13208). The original language of ERISA and the PTEs to ERISA were designed to cover certain transactions involving “qualified plans” covered by ERISA but not the plethora of other qualified plans. When qualified money in a pension plan leaves that plan and is transferred to another non-pension qualified vehicle, like an IRA, the ERISA fiduciary standard of care requirements do not follow that money.

The DOL had previously proposed amending PTE 84-24 in 2004 and again in 2010, but withdrew such amendment under a firestorm of comments and some congressional sentiment opposing it. They re-proposed the amendment in April 2015 for comment. After redrafting and strengthening it, a second comment period occurred and ended on July 21, 2015. The third comment period ended September 24.

The DOL’s proposed rule applies a fiduciary duty to anyone who gives “investment advice” and may receive “compensation.” The current proposal broadens “investment advice” to include individuals who, advise clients at any frequency (does not have to be regularly, as before), for any use by the client (doesn’t have to be the “primary basis” for a client’s decision, could be just informational).

This broadened class of advisors must comply specifically with new duties if they are to avoid the penalties of engaging in a prohibited transaction. “The Department believes that some of the transactions involving IRAs that are currently permitted under PTE 84-24 should instead occur under the conditions of the Best Interest Contract Exemption (BICE).” BICE requires a number of constraints on anyone who may be compensated on a sale and effectively assigns that person a fiduciary duty.

The DOL leaves in place an exemption from having to comply with BICE for non-securities like fixed annuities and also variable annuities, but adds a new requirement to remain exempt: an advisor must follow new “Impartial Conduct Standards (ICS),”which has most of the same requirements as BICE.

When transacting business with qualified money, agents, consultants and company personnel must do the following:

• Exercise care and skill of a prudent person
• Act without regard to their own financial interest (for example, commissions and incentives cannot be a consideration)
• Make no misleading statements, including failure to disclose any conflict of interest (possibly either explicitly or implicitly includes commissions)
• Only be paid commissions considered “reasonable”
• Comply with federal law, but; not necessarily warrant that to the prospect.

This sounds like BICE, which sounds a lot like fiduciary responsibility, except for the up-front signing of a contract between advisor and client. The DOL wonders in its request for comment whether they should even allow this slight relaxation of BICE for fixed products and just throw them in with the securities requirements.

What Would It Mean for Financial Distribution?

The changes are substantive, cumbersome, ill-defined and expensive. For securities representatives who are advisors (e.g., Series 65 registration) already possessing fiduciary responsibility, there would seem to be little change here for qualified money sales. However, there are a few change. For example, they would no longer be able to shield themselves from class- action lawsuits.

For other non-advisor, securities representatives selling securities to clients with qualified money, their current regime of suitability of sale to clients governed by FINRA and a BD compliance officer will still apply, but a new, overlapping, potentially conflicting, fiduciary duty will be laid on top. This may seem inapplicable to a rep’s fixed annuity business—which would be under ICS standards—but it seems likely if a BD must require its reps to follow BICE for securities sales then it will result in a push to remove OBA treatment for annuity sales, and they may apply full- blown BICE to it. This refers to the National Association of Securities Dealers (NASD) push in 05-50 to subject all FIAs to supervision. Uniformity may be the call once again by FINRA and BDs.

BICE requires:

• A statement to clients informing them the financial institutions and advisor are now fiduciaries.
• The product or investment recommended must be in the “best interest of the client.” An advisor must put the clients’ interests above himself or any other related party. Does that mean what registered advisors with that duty today believe it means? With no further guidance, in the end, it probably means what trial lawyers and courts eventually think it means.
• The registered rep must enter into a written agreement with the client at the beginning, before any recommendation (or probably any discussion) can be made.
• The reasonable commissions and fees requirement would likely result in product commission reductions, standardizing at low levels or even a race to trail commissions. Companies will design products to avoid allegations of abetting prohibited agent behavior. (Will it mean 4-5% maximum commissions? No one knows.)
• Disclosure of commissions and fees at point of sale, on a BD website, and on annual client statements are to be individual-specific, and include all products and investments. No systems that exist currently do this.
• Must warranty statements about commissions and fees are not misleading.
• Up-front disclosure to clients of material conflicts of interest. Must also warranty that there are no incentives of any type used to encourage the advisor against the “best interest” of the client.
• Financial institution must disclose and warrant they have adopted written processes and procedures for mitigating material conflicts of interest.
• Advisor must warranty they are following all applicable state and federal laws.
• Prohibits allowing client to waive any rights to representative legal action or class action.
• An extensive supervisory, record-keeping review system is required.

Insurance-only agents will face nearly the same future as a result of the ICS:

• Today, fiduciary advisors do not generally solicit clients with less than $100-$200k in manageable funds. To accept full advisory responsibility, most advisors will find it is not worth the time and liability risk to solicit these funds for management now that there will be more liability with the prohibition, excluding lawsuits. It is likely we will see the same happen for insurance-only agents, leaving a market vacuum for small-asset clients.
• Commissions will begin a precipitous drift downward, with full disclosure at all levels of distribution as an ultimate and inevitable result.
• Many agents may exit the field as qualified funds represent a huge segment of the financial market, (over half of fixed annuity sales and even higher in VA sales), especially with the litigation possibilities under the vaguely written, 900-page DOL proposal.
• There may be fallout as lower- rated carriers withdraw from the market, unable to distribute their products due to a low rating being prima facie evidence of not acting in the best interest of the client all other things being equal.
• There is also uncertainty of how “best interest” can be proven if an agent is captive and may sell only one company’s products. Agents only selling a limited catalog of financial products may effectively be violating the DOL’s requirement that the advisor consider the “full range of assets” for the retirement consumer when meeting these new requirements.
• The new rule uses the vague phrase “generally accepted investment strategies” as a measure of “best client interest.” Would this rule out more esoteric IRA investments like real estate, gold, coins, etc.? Unknown.

What is DOL’s Authority and Purpose?

The DOL was given authority over corporate and other pension plans under ERISA, not the funds wherever they eventually went, and not IRAs, which were given, at their inauguration, in 1975 to the Department of Treasury. The displacement of defined benefit plans over the past 30 years by defined contribution plans has resulted in a vast pool of qualified, untaxed money, which has been leaving those pensions and will continue to flow to IRAs, where trillions of dollars already exist. It was not the intent of Congress at the time to have the DOL follow the pension money around regulating it after it exits a plan. The DOL is relying on a white paper from the Office of the President, alleging there is ubiquitous bad advice and over-expensive charges in qualified sales as a result of “conflicted advice,” advice not in the clients’ best interests, but rather the seller’s.

This report alleges consumers are being taken advantage of by the financial services industry to the tune of $17 billion per year. As several leading commentators have demonstrated, this so-called economic analysis report is seriously flawed with unsupportable assumptions and conclusions.

Notably, nowhere in this 250-page report is there any economic impact analysis on the insurance industry. The DOL’s justification for its authority is purportedly derived from an Executive order by President Jimmy Carter in 1975, allowing responsibility for IRA sales practices to flow to DOL, and there it has slumbered for the past 40 years. This seems to be another one of numerous examples of the regulatory arm of government extending its authority and reach into citizens lives unilaterally, without the authority of law.

What Problem Is this Fixing?

This fixes a problem we don’t have: if a client with qualified- money desires an advisor whom is required to act in the best interest of a client with nothing smacking of conflicted interest, there are advisors on every street corner who have that business model. An informed consumer has many options. If anything, the proposal reduces options for many consumers.

What is the Process from Here and Likely Outcome?

There are several prospects to modify the proposal or derail it. First, the DOL has been informed by various trade groups and insurance companies of the deficiencies in the proposal; they may alter it, especially with respect to fully exempting fixed products and perhaps VAs under 84-24. The rule will probably be published in January 2016 and become effective September 2016. There will be legal challenges based on their lack of authority after publication. There will likely be an attempt by Congress at some point to explicitly prevent DOL from receiving any funding for their effort to implement this proposal.

Finally, if their authority for proceeding is based on an Executive order of the President, the next President could rescind the order with the stroke of a pen.

Who is Advocating Against this DOL Proposal?

Many of the trade associations oppose the proposal as drafted, including NAFA, NAIFA, IRI and ACLI. Many insurance companies oppose it as well. The state insurance regulators, represented by NAIC, also oppose.

What Can You Do?

CreativeOne is a member of NAFA and urges others to join advocating against it as well. They, and other organizations, can assist you in distilling this complicated issue into a communication to the DOL for comment, and to your congressional representatives for legislative input.