This spring, the Department of Labor (DOL) is expected to release the final version of a rule that will lead to some significant changes in the financial services industry. Advisors with clients in retirement plans, including 401(k) plans and individual retirement accounts (IRAs), will need to meet new guidelines to document that they are acting in the best interests of their clients.

More Financial Advisors Become Fiduciaries

Under the proposed rule, investment professionals who advise investors in retirement plans and IRAs will become fiduciaries. Fiduciaries by definition must put their clients’ needs ahead of their own. While most advisors already do this in practice, the new rule will require new compliance processes and potential legal consequences for violations.

Fiduciaries:

• Must avoid conflicts of interest
• Need to disclose sources of compensation
• Cannot receive commissions for investment products they recommend unless they receive an exemption

Proposed Definition Broadens Investment Advice

Under current rules, investment advice in retirement accounts is already subject to the fiduciary standards, but more narrowly defined. Today the term refers to regularly occurring recommendations on specific plan investments, with a mutual understanding between the advisor and client that the advice is individualized and serves as the primary basis for investment decisions.

The DOL’s proposed rule significantly broadens this definition to include advice that is offered relating to the general management of retirement investment portfolios. To be considered fiduciary under the new definition, investment advice would no longer have to:

• Be delivered on a regular basis,
• Be individualized, or
• Serve as the primary basis for investment decisions.
  

Rollover recommendations would also be considered fiduciary advice.

Fiduciary Status Affects Compensation

Fiduciary status obligates investment advisors to act solely in the best interest of their clients. Advisors must follow strict standard of care laws. They must avoid and disclose potential conflicts of interest and act with full transparency.

In practice, the requirements under the proposed rule encourage advisors to avoid commissions and instead charge clients fees based on the size of their investments. These costs could be prohibitive to small-balance investors.

Best Interest Contract Exemption Allows for Commissions

The proposed rule does provide an exemption that would allow advisors to continue receiving commissions. To qualify for the exemption, advisors would have to enter into a Best Interest Contract (BIC). Specifically, the advisor and client would enter into a contract with mandatory terms, stipulating that the advisor:

• Act as a fiduciary
• Provide advice that is impartial, commensurate with compensation and in the client’s best interest

In addition to this written contract, the advisor would be required to provide comprehensive disclosures, such as:

• Payments from sales
• Point-of-sale annual reports
• One-, five- and 10-year cost projections for each product purchased

Moreover, the advisor would need to suggest a range of investment options across asset classes, and only suggest covered investments. These include:

• Mutual funds
• Insurance/annuity products
• Most publicly traded securities

While the BIC exemption is not yet finalized, the draft rule did not include non-traded real estate investment trusts (REITs) or alternative investments.

Significant Concerns

As currently drafted, the BIC exemption raises concerns that disclosure and other requirements could prove to be burdensome and expensive for both the advisor and the investor.  Additionally, the mandated contract could subject advisors to frivolous lawsuits. These provisions create regulatory obstacles for advisors to continue servicing their clients under the commission-based compensation model.