1. NotesSeptember,2016
DOL Conflict of Interest Final Ruling: Radically Changing the Mutual
Fund Ecosystem
In April 2016, the Department of Labor introduced its Final Conflict of Interest Ruling,
the first major change to ERISA legislation since 1975. Below are four of the most
significant changes affecting mutual fund companies and the broker dealer advisers.
First, the DOL reversed its earlier position exempting IRA rollovers from fiduciary
advice standards. The new ruling treats paid advice with respect to distributions and
rollovers as fiduciary advice and will impact almost $2.4 trillion between 2016 and
2020. Financial institutions that are “level-fee fiduciaries” will be required to make
disclosures of their fiduciary status to retirement investors, and document the reasons
for the recommendation of a rollover from an ERISA plan to an IRA, from another IRA
or from a commission-based account to a fee-based account.
Secondly, the ruling greatly expands the number of advisers considered to be
fiduciaries by tightening guidelines. Now, anyone paid to advise 401k/IRA or IRA
rollovers will be held to the fiduciary standard, which means they must put their
client’s interest ahead of their own. Broker dealers formerly governed by the suitability
standard of care will be held to the more stringent fiduciary standard of care.
Third, the DOL strongly advocates for level-fee compensation programs that reduce
the incentives for conflicted advice. However, the legislation does include a Best
Interest Contract Exemption, which allows firms to continue using commission based
compensation programs provided they meet specific conditions intended to insure the
firm and its advisers act in the best interest of their client.
Finally, the Best Interest Contract Exemption provides that contracts with retirement
investors may require pre-dispute binding arbitration of individual disputes with the
adviser or financial institution. The contract, however, must preserve the retirement
investor’s right to bring or participate in a class action or other representative action in
court in such a dispute.
The DOL Arguments Are Flawed
The Department’s ruling may be well intentioned, but the arguments upon which the
legislation is based are quite flawed and unjustly punish broker sold mutual funds.
Below are just a few of the key shortcomings.
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§ The most significant failure is the DOL’s core argument. It highlights a few
legitimate sales abuses that should be and have been prosecuted by the SEC
under existing federal law. The ruling goes on to imply the harmful issues are
systemic, but provides no government numbers to actually quantify the scope
of the problem. The Department then switches gears and uses the average fee
differential between broker dealer sold mutual funds and no-load mutual funds
to redefine and quantify the problem.
The DOL uses the incendiary, misleading terms “conflict” and “harm” hundreds
of times throughout the report to portray the broker dealer distribution/service
model as villainous. The agency ignores the higher costs of the personalized
distribution/service model and the fact that investors freely choose to work with
advisers versus impersonal no-load funds.
§ The Department relies on dated studies, skewed almost exclusively toward
large cap US equities, to determine simple average fee differentials between
broker sold funds and no-load funds. It dismisses meaningful more up to date
data from the ICI showing smaller fee and performance differentials that are
more representative of actual broker dealer sales.
§ The DOL excludes from its analysis the rapid growth of index ETFs within
broker dealer discretionary advisory accounts; a trend that has been driving
down fees and embracing fiduciary responsibilities for over 10 years.
§ The ruling obsessively focuses on low fees and index performance throughout
the report at the expense of the more relevant after-fee performance. The
implication is that fees will supersede all other important factors when
determining fiduciary/best interest advice.
§ The Department recognizes American’s desperate need for professional
retirement help. It recognizes a study showing investors are happy with their
advisers, but then goes out of its way to portray the investor’s choice of using
advisers as financial ignorance. The DOL suggests over and over again that
investors are victims incapable of making intelligent decisions. It virtually
dismisses personal service, education, asset allocation, risk management or
retirement planning as meaningful services provided by advisers in exchange
for a higher fee.
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Impact on Asset Management Firms
The mutual fund, exchange traded fund and annuity industries will bear the brunt
of the ruling initially, but soon SMAs and traditional brokerage accounts will be
affected as fiduciary practices and standards take hold throughout broker dealer
firms. A few of the most important trends resulting from the legislation will be:
§ The rapid growth of low cost index ETFs within broker dealer fiduciary
accounts will accelerate. The combination of the two are a tailor made solution
for the legislation.
§ The growth of consistently high performing active mutual funds will rapidly
accelerate. Advisers will flock to funds that compare favorably to index funds
and jettison perennially weak funds that represent possible legal liabilities.
§ Fee-based advisory accounts, both discretionary and non-discretionary, will
grow more rapidly in response to a view that level-fee commissions generally
reduce conflicts of interest as well as potential legal liabilities.
§ The industry will dramatically increase its focus on performance after fees.
Advisers will demand literature for their files that will justify their
recommendation to use a fund and that will stand up to fiduciary scrutiny.
§ Average active mutual fund performance will improve significantly relative to
index funds. The elimination of 12b-1 fees and lower management fees
dramatically reduces drag on their performance.
§ The DOL ruling will accelerate the current trend toward lower fees. A
combination of market forces and increased regulatory scrutiny will force
mutual fund companies and annuity firms to lower fees.
§ Lower fees and increased focus on performance will radically change mutual
fund economics and ignite a new round of mergers and acquisitions.
§ Broker dealer shelf space will shrink. Long-standing relationships that allowed
marginal performing funds a home will be usurped by concerns over fees,
performance and potential legal liabilities.
The conflict of interest ruling and its failed argument may be challenged in the
courts, but it has set the industry on a radical course that is unlikely to change any
time soon.
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