The 24-pages of government-speak only make a dent in comprehending the 1,000-page rule -- and the DOL says there's more guidance on the way

November 8, 2016 — 6:46 PM UTC by Irwin Stein

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Brooke's Note: As a career securities attorney Irwin is a clear-eyed reader of DOL FAQs. He also has clear misgivings about the way that the Department of Labor is trying to interrupt the massive conflicts of interest built into the financial advice business in the United States.  Why the DOL's Draconian and premature interpretation of its new rule is the 'end of the world as we know it' for wirehouse recruiting but a bonanza for the RIA business He is troubled by how the DOL is using the most inhuman language as a means of addressing a very human problem. He is concerned about its reductionist philosophy of judging all things advice in terms of cost when quality is so important. But Irwin also becomes concerned when the language suddenly takes a turn as it offers its much softer stance toward insurance products. From his standpoint, you don't need to be an expert in linguistic forensics to see that insurance lobbyists bent the DOL's ear back like taco. Irwin's ears really perked up when he saw that the DOL has finally drawn a bead on "the grid."

It's never just what you say. It's also how you say it.

And the way that the Department of Labor is speaking to me, a veteran securities lawyer, with its latest official remarks on its new fiduciary rule, is in language that is certainly obtuse, perhaps insulting, with willfully soul-numbing bureaucratic words laced with a thinly veiled contempt for brokers.

The 24-page report sets forth 34 questions that the DOL claims to get asked frequently and provides answers that add some clarity but surely will displease most people in the industry. I found what the missive revealed as interesting as the original document, for which I crafted crib notes for RIABiz readers when the rule was released in April. See: A veteran of securities law killed his weekend reading all 1,000 pages of the DOL rule -- and has a takeaway to share

A carping drone that persists for most of the 24 pages until the topic turns to insurance brokers and their sale of life insurance and annuities. Then the use of words sharpens and meanings are clear -- a sign of the insurance lobby's power as clear as boot prints in freshly fallen snow. At that point, the spotlight is trained on cost and more cost as if no other factor -- like quality of advice or an advisor's attentiveness -- gets brought to bear; as if brokers operate with the sole objective of making a sale and never with the objective of retaining assets or clients.

In other words, the unrelenting wattage is cast on the brokerage industry's most riveting four-letter word: grid.

Registered representatives

"Grid" hits home with brokers because of the two factors that dominate brokerage compensation: How much a broker generates in revenue from product sales and what percentage cream skimmed off the top of those revenues ends up in the brokerage's pitcher. See: Merrill Lynch unveils changes to broker compensation

If the payout percentage to brokers is the same regardless of the product he or she is selling, then the grid is said to be "neutral.” Some firms vary the payout between products, which the DOL sees as an incentive to offer some products over others.

In its FAQs, the DOL cautions firms to review grids carefully and to consider the amounts used as the basis for calculating advisor compensation to avoid transmitting firm-level conflicts to the advisor. If, for example, different mutual fund complexes pay different commission rates to the firm, the grid cannot pass along what is now deemed a conflict of interest to brokers by paying the broker more for the higher commission funds and less for the lower commission funds (e.g., by giving the advisor a set percentage of the commission generated for the firm). Such an approach would incentive the advisor to recommend investments based on their profitability to the firm, rather than their value to the investor. See: Tick, tick, tick ... FINRA rewrites 'culture,' 'conflicts of interest' and 'ethics' into a farcical 'best interests' code after DOL drops a bomb on its suitability ethos

The firm can, according to the DOL's latest guidance, define the “compensable” revenue that goes into the grid in such a way that it is level within different broad categories of investments based on neutral factors that aren’t tied to how lucrative the investments are for the firm.

Firms can also pay different commission amounts for different broad categories of investments based on neutral factors. Under this approach, the firm eliminates variations in commissions within reasonably designed investment categories, but variation is permitted between these categories based on neutral factors, such as the time and complexity associated with recommending investments within different product categories.

Easy does it

Thus, for example, a firm might adopt one commission structure for mutual fund investments, while providing a different structure for annuities, assuming there is a neutral basis for the distinction.

“Neutral factors” are not based on the financial interests of the firm (e.g. the profitability of the investment), but rather on significant differences in the work that justify drawing distinctions between categories and compensation. Brokers cannot preferentially recommend particular product categories simply because they increase advisor compensation. See: Borzi: Exemptions from conflict of interest will be part of new fiduciary proposal

The message I read from this is: Easy does it. Grids with modest or gradual increases are more acceptable than grids spiked by large increases. A kosher grid avoids increases in compensation as the advisor reaches a threshold. Financial institutions must exercise care to avoid dramatic increases in compensation that undermine the best interest standard and create misaligned incentives for advisers to make recommendations based on their own financial interest, rather than the customer’s interest in sound advice.

As the advisor reaches a threshold on the grid, any resulting increase in the advisor’s compensation rate should generally be prospective – that is, the new rate should apply only to new investments made once the threshold is reached.

Don't go retro

And yet, if the consequence of reaching a such a threshold is not only a higher compensation rate for new transactions, but also retroactive application of an increased rate of pay for past investments, the grid is likely to create acute conflicts of interest. 

That's because the rules also extend to recruitment practices and signing bonuses. Recruitment incentives may involve a “signing” or “front-end” award that is not tied to the movement of accounts or assets to the firm or on achievement of particular asset or sales targets, but rather is paid as a fixed sum contingent on the advisor’s continued service in good standing at the financial institution. Such signing awards and bonuses are permissible because the payments do not turn on the advisor’s particular recommendations or create inappropriate incentives to give advice that is not in the customer’s best interest. See: How Ex-Morgan Stanley powers are rolling up ex-colleagues and how big Raymond James cash fits into the picture

However, financial institutions may not use large “back-end” awards or rely on bonuses, special awards, differential compensation or other actions or incentives “that are intended or would reasonably be expected to cause brokers to make recommendations that are not in the Best Interest of the Retirement Investor.” See: Fidelity Investments recognizes power of RIAs in 401(k) market and has increased efforts to work with advisors

Nothing in this new guidance will affect recruitment contracts that have been signed and are already in place even if they go out for a period of years. Most of the provisions of the new rules take effect in April with a transition period following through the end of next year. This particular provision regarding recruiting contracts went into effect with the publication of this guidance, i.e. last week. 

DOL-conflicted RIAs

The DOL does not see fee-based RIAs whom it calls “level fee fiduciaries” as having a significant conflict of interest problem because they are not incentivized to offer one investment product over another. See: How Wall Street emasculated the DOL rule with an old-fashioned end game: 'Somebody made a deal' -- and why tort lawyers are licking their chops

Yet, the DOL still sees RIA conflict jeopardy in two cases.

First, when an advisor advises an investor to roll assets out of an ERISA plan into a fee-based account that will layer on new and ongoing fees for the advisor, a conflict arises, even if those fees do not vary with the assets recommended or invested.

Second, advising investors to switch from a commission-based account to an account that charges a fixed percentage of assets under management on an ongoing basis could be a prohibited transaction. See: Why RIAs should hedge their fee income to stay aligned with client interests

The DOL offers a simplified Best Interest Contract Exemption procedure for RIAs: The financial institution must provide a written acknowledgment of its and its advisors’ fiduciary status to the retirement investor. The financial institution and its advisors must satisfy the impartial conduct standards -- requiring fiduciaries to act in the best interest of their clients, charge no more than reasonable compensation and make no misleading statements -- and document the reasons why the advice was considered to be in the best interest of the retirement investor. See: Why I disagree with Don Trone's characterization of Obama's fiduciary stance as 'punitive'

In the case of investment advice in regard to rolling over assets from an ERISA plan to an IRA, this documentation must include consideration of the retirement investor’s alternatives to a rollover, including leaving the money in his or her current employer’s plan, if permitted, and must take into account the fees and expenses associated with both the plan and the IRA; whether the employer pays for some or all of the plan’s administrative expenses; and the different levels of services and investments available under each option.

The DOL already permits a discretionary fiduciary to invest assets of a plan or IRA in the fiduciary’s -- or its affiliate’s -- proprietary mutual fund. It also allows for discretionary fiduciaries or their affiliates to receive a commission for effecting or executing a securities transaction for a plan or IRA provided the individual RIA does not share in the commissions. See: Why luring 401(k) assets to IRA rollovers in a post-DOL-rule world remains child's play, which keeps $7.6 trillion in the IRA game and growing

Troublesome BICEs

Meanwhile, “insurance-only” agents may continue to sell fixed-rate and fixed-indexed annuities to retirement investors and indexed and variable annuities as well if they use a BIC exemption. See: As variable annuities face 'existential crisis,' LPL's Casady is latest to warn of end to commission-sold VAs in retirement plans

The rules released in April specifically require advisors and financial institutions to give advice that is in the “best interest” of the retirement investor. The rules provided for a BIC exemption that allows for a written contract where the investor essentially agrees to permit some of the practices the DOL finds troublesome.

A BIC exemption has two chief components: prudence and loyalty. Under the prudence standard, the advice must meet a professional standard of care. Under the loyalty standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the advisor or firm. The advisor must charge no more than reasonable compensation and make no misleading statements about investment transactions, compensation, and conflicts of interest.

The rule does not treat individuals or firms as investment advice fiduciaries if they give no investment advice but merely execute transactions at the customer’s direction. Similarly, even if a person recommends a particular investment, the person is not a fiduciary unless the person receives compensation, direct or indirect, as a result of the advice.

Insurance agents

Insurance agents are required to comply with “impartial conduct standards,” which are consumer protection standards that ensure that brokers adhere to fiduciary norms and basic standards of fair dealing. The standards specifically require advisors and financial institutions to give advice that is in the “best interest” of the retirement investor. This best interest standard has the same two chief components as the BIC exemption: prudence and loyalty.

Nothing in these exemptions, the impartial conduct standards, or ERISA, prohibits investment advice by “insurance-only” agents, or requires such insurance specialists to render advice with respect to other categories of assets outside their specialty or expertise. 

A prudent adviser should be careful, however, in accordance with the exemptions, to disclose any limitations on the types of products he or she recommends, and would refrain from recommending an annuity if it were not a prudent choice for the retirement investor. If, for example, it would be imprudent for the investor to purchase an annuity in light of the investor’s liquidity needs, existing assets, lack of diversification, financial resources, or other considerations, the adviser should not recommend the annuity purchase, even if that means the agent cannot make a sale. See: Found innocent after being sentenced to jail for alleged bilking of an old lady, Glenn Neasham struggles to rebuild his career

While insurance companies may rely on a captive sales force to distribute their proprietary products, they may also distribute annuities through independent insurance agents or other channels. Insurance intermediaries such as independent marketing organizations can continue to distribute the products of an insurance company through independent insurance agents after the applicability date of the Rule. An IMO can receive compensation as a result of an annuity purchase recommended by an insurance agent. See: Skip Schweiss awakens FPA NorCal crowd with must-do DOL laundry list that starts with IRA billing and the need for chief laundering officers

Throughout the guidance is the requirement that the financial institution carefully supervise the account and the salesperson. For independent insurance agents who may represent multiple carriers, each company is responsible only for the supervision of sales of its own products. 

More to come

Several questions answered by the DOL deal with how existing investments will be handled once the rule comes into effect on April 10. Among other conditions, any new advice with respect to the grandfathered investments must meet the best interest standard including advice to sell any pre-existing investment if compensation is being paid for the advice or sale.

Systematic purchase programs such as dividend re-investments would be grandfathered. Adding an additional $100,000 to an existing annuity would not. Giving advice to sell a pre-existing investment would not require an exemption. 

Before you change your business model or even buy expensive, speculative advice surrounding stiffening ERISA rules, you should know that the DOL has promised further guidance by year's end.

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Stephen Winks said:

November 9, 2016 — 5:06 PM UTC

The most fundamental questions pertaining to expert counsel are not addressed by the DOL's FAQs: (1) treatment of trade execution as a cost center to be minimized in the client's best interests, (2) retooling of product menus to (a) streamline cost and (b) facilitate real time client holdings data necessary for continuous, comprehensive counsel of fiduciary duty and (3) adoption of prudent process (asset/liability study, investment policy, portfolio construction, performance monitor) authenticated back to objective fiduciary criteria (statute, case law, regulatory opinion letters) which put "financial services" back into the financial services business. These fundamental considerations inculcate the new rules required for all who wish to render advice. Wall Street will never be the same if it chooses to compete in the best interests of the investing public. SCW

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