On April 7th, the U.S. Department of Labor issued a final rule addressing conflicts of interest for retirement-account advice that will change how millions of Americans save. This fiduciary standard is a shift from the current rule, which requires recommendations to simply be “suitable,” which critics argue has allowed advisors to charge excessive fees and give misleading advice. Now, the rule will require financial advisors to act solely in the best interest of their clients without regard to personal compensation. This rule is more than six years in the making and is a key part of the Obama administration’s “middle-class economics” initiative. Though the change could save investors financial losses resulting from advice based on misaligned incentives, more regulation may mean less choice and higher fees for consumers.
The rule comes into effect in April 2017 and allows for a transitional period through January 1, 2018. It encompasses recommendations for products that involve compensation, such as IRAs and employer-sponsored plans, but excludes educational information and general correspondence about such products. This change has extraordinarily wide-ranging effects. The Department of Labor estimates that the rules will affect 21 million retirement plans and IRAs and 2,800 firms. According to the Investment Company Institute, 60% of U.S. households have retirement plans through 401(k)-type plans or IRAs, with a total of $7.3 trillion in IRAs and $6.7 trillion in employer-sponsored plans.
Best Interest Contract
The rule creates a “Best Interest Contract” that allows advisory firms to continue to receive most common forms of compensation as long as they meet a set of requirements. According to the Department of Labor fact sheet on the rule, “financial institution and advisers must adhere to basic standards of impartial conduct, including giving prudent advice that is in the customer’s best interest, avoiding making misleading statements, and receiving no more than reasonable compensation.” This language provides a framework for disclosure of conflicting interests as well as accountability for recommendations.
Costs of Conflicting Interests
According to the White House Council of Economic Advisers, conflicts of interest in retirement-account advice lead to an average of 1% lower annual returns on retirement savings and $17 billion of losses for American families every year. The Department of Labor especially aims to protect investors when they roll over their savings from an employer-sponsored plan to an IRA. These rules intend to reduce the often exorbitant fees for rollovers. Brokers are currently free to charge upwards of 5% upfront when rolling a 401(k) over to an IRA, and this drain on investors is magnified by missed compound growth moving forward. In addition to these fees, investors will be protected from biased recommendations during rollovers, as advisers have financial incentives to aggressively market their own products whether or not those products are the best options for their clients.
By committing firms to put their clients’ best interests first, the Administration argues that the playing field will be leveled for financial advisors, as many are already doing right by their clients. These advisors will be judged solely on the quality of their advice, rather than on the size of the commissions they earn. Additionally, the new rules ensure that financial advisers are held accountable if they provide advice against their clients’ best interest. Firms are required to provide written disclosures of potential conflicts of interest. If an investor feels that they have been wronged, they now have legal grounds to sue for breach of contract.
Less Choice and Higher Fees
As a result of the requirement for “reasonable compensation,” a change from commissions for selling products to proportional compensation based on the account size is likely. These restrictions put pressure on advisers to recommend lower-cost products such as index funds that track the market and to de-emphasize riskier offerings like variable annuities, commodity pools, and real estate investment trusts. These firms will have to recuperate lost commission-based revenue by charging higher annual fees. For investors with smaller account balances, the annual fees may actually be more costly over time than commission-based compensation. Also, servicing accounts under $50,000 may no longer be economical for many brokerages due to compliance costs, convoluted paperwork, and the risk of litigation, meaning that small investors may be left to fend for themselves. This decrease in accessibility to advice is a cost in itself.
In order to comply with the new rules, financial institutions will have to produce an estimated 86 million written disclosures and notices in the first year alone. The costs of compliance are subject to debate. According to a survey by SIFMA and Deloitte, start-up costs would be $4.7 billion and on-going costs are estimated to be $1.1 billion, which is almost double that of the Department of Labor estimates. As SIFMA Chief Executive Kenneth Bentsen argues, “The department woefully underestimated
the cost, and that will have to be passed on to the client.” Many smaller firms may be unable to afford the compliance costs, reducing choice and access to advice for
Despite the noble intentions of the Department of Labor to protect the average investor, the regulation may ultimately have unintended consequences that negatively impact those it is intended to benefit. Though the increased transparency and legal accountability of financial advisors serves to protect consumers from predatory recommendations and rollover fees resulting from conflicts of interest, compliance with the new rules comes at a cost. The government’s regulation of rollovers from 401(k)-type plans into IRAs will keep many more people in these investments even though it may not be best for each individual. Under the threat of litigation for poor advice, brokers will recommend less risky investments that earn smaller returns for investors. In order to recover the costs for compliance and lost revenue from commissions, firms will have to charge high annual fees. By getting involved in how individuals save for retirement, the federal government may constrain consumer choice and incite higher fees, resulting in a net loss for consumers