New DOL Fiduciary Rule – What You Need to Know

Ever since ERISA was passed in 1974, advisors to retirement plans have been required to “act in the best interest of plan participants.” Unfortunately, brokers, insurance agents and bank financial salespeople have not been held to that standard, known as the fiduciary standard, when they work with their clients. They have only been required to recommend “suitable” investments.

Now, with the much-talked-about passage of the fiduciary rule by the Dept. of Labor, financial advisors can no longer earn commissions and other forms of conflicted compensation without having clients sign a Best Interests Contract (BIC) saying that the financial firm will act in the best interests of clients on IRA accounts and when rolling money over from a 401(k) or other retirement plan. As a late concession to the financial industry, the BIC will not be a separate contract but incorporated into their basic new account documents. That’s a major disappointment, as few people actually read those papers. As another late concession, the rule will not go into effect until April 2017 and then will have a year-long phase-in.

An exception to this BIC requirement is made for “level fee advisors” like me because by their level fee structure they do not have these conflicts of interest. That is a big deal and acknowledges the superiority and greater safety of the fee-only model. However, I have for years acknowledged fiduciary status voluntarily and have encouraged investors only to work with advisors who adhere to the best interests of the client standard of care.

The new rule does not apply to regular brokerage accounts. I hope that will change. By the way, the rule came from the Dept. of Labor and not the Securities and Exchange Commission (SEC) because the DOL has always overseen company retirement plans and it was a good place to start. Hopefully, the SEC will get on board and craft an identical rule for brokerage accounts and insurance products.

Did you assume brokers and agents were already acting in your best interest? No, banks, brokerage firms and insurance companies fought hard against this new rule. Let me list some of their common sales practices:

  • Incentive vacation trips for selling limited partnerships or insurance policies
  • Cushy “due diligence” trips that are glorified sales meetings in very nice locales
  • Huge differences in commissions between suitable products – as much as 1% vs. 10%
  • Weekly sales meetings to push specific investments, especially those developed by the firm
  • Life insurance sales commissions averaging 80% of first year premiums and as high as 7%/year afterwards
  • Being paid only on transactions rather than only when it was in the client’s best interest to sell something and buy something new, often earning commissions on both transactions
  • Not explaining to clients the hidden fees that brokerage firms and especially insurance companies are so good at hiding – did you know insurance companies are not required to disclose your costs on whole life insurance? Did you know mutual fund B shares often have 1%/year higher fees and a 5-7-year surrender schedule? Did you know variable annuities often have commissions of 6-10% taken out of your investment?

None of these practices are specifically prohibited by the new rule (though the third may come under pressure) but under the new rule some of these will probably not be able to stand up in court. That’s another important new thing – you cannot be forced into arbitration and now have the right to sue.

Certain things are prohibited transactions for advisors under the new rule and they may surprise you.

  • Shifting from a 401(k) or IRA account with lower fees into an IRA with a higher fee. Since 401(k) plans nearly always have lower fees than IRAs, advisors to company plans cannot advise participants to roll over into an IRA the advisor manages. BUT, neither can an advisor who was not managing the company plan – see the next point.
  • Rolling over to an IRA that would allow the advisor to earn a fee that he/she wasn’t previously earning (because the advisor had no relationship to the prior 401(k) but will now get paid for advising on the IRA)

So, does that mean that a financial advisor cannot tell you to roll over your 401(k) into an IRA? No, the DOL created a prohibited transaction exemption (PTE) if the client will sign the Best Interests Contract mentioned above. Again, there iis an exception for level fee advisors.

BUT, you as a client should require a potential financial advisor to convincingly demonstrate that it would be in your best interest to pay him commissions or pay a higher level fee than you paid in the 401(k). If they can’t leave the money in the plan as long as the company allows it. Don’t know your costs in the plan? Call the HR Dept. and ask them. If they don’t know, ask them for a copy of the 408(b)2 required annual fee disclosure from the plan provider and take that to a financial advisor.

Or, figure that in a medium or large employer’s 401(k) your advisor costs were likely 0.10% – 0.50% per year, maybe a bit higher if the plan is under $1 million in size. By comparison, the brokerage industry has a rule of thumb that individual client commissions should average 1%-1.5% of the account value per year. Insurance products are normally much higher.

What are you getting in an IRA for several times the fees in the plan? Remember, in many retirement plans, you do not have to roll over when you terminate employment unless your balance was under $5,000. Even the document may allow small balances to stay. Ask yourself – do you get significantly more individual service or gain more choices of investments in the IRA? Are they worth it? If you are a small client (under $100,000) you might be better off with an online “robo-advisor” like Betterment.

These are huge changes because one of the biggest sources of new business for financial advisors has been IRA rollovers from company plans. Many advisors primarily managed qualified retirement plans so they could get rollover business. For advisors to 401(k) and other qualified company plans I think it means they should pass on doing rollovers unless they want to do them for the same low fee they charged in the company plan.

In practical terms though, things will not change as much as the industry fears. Because they can put the BIC language in the depths of their paperwork, because advisors have huge incentives to say that their advice and service are worth much more than what the client paid in the 401(k), because sales meetings will continue, because differences in commissions are still huge and because not many clients will be knowledgeable about this rule, in many ways it may end up business as usual for many brokers, agents and their firms.

That was certainly the case with the much-heralded 408(b)2 fee disclosure agreement for 401(k) providers passed in 2013. Most HR people I call on don’t even have a copy and most CEOs and CFOs have not looked through it or even done a cost comparison in years. It’s truly sad.

Still, this is a step forward that should have been done decades ago. For questions, give me a call at 704-698-1040. – Dave Hoshour