The Labor Department is working up new regulations for financial advisors. The proposed rules would, among other things, broaden who is a fiduciary on retirement accounts. The department tried to walk down this same path in 2010 but abandoned the attempt in the face of intense industry resistance. The same thing may yet happen with this latest effort. The final rules will almost surely have differences from the current proposals.
If anything like the current proposals go into effect, however, the rules will likely have six unintended consequences: (1) Compliance departments will grow in scale and influence. (2) For better and worse, the scope of advice offered savers will become more constrained and conventional. (3) Advisors will alter the way they charge clients, raising costs to some and reducing them to others. (4) Because the rules will allow exceptions, some advisors will acquire a marketing edge quite apart from their demonstrated investment skills. (5) Small investors will have greater difficulty getting individual advice. (6) Litigation will increase as will opportunities for the plaintiff’s bar.
It is, of course, doubtful that the Labor Department intends such results. Rather, the department, according to its own statements, intends to “protect families from conflicted retirement advice,” or “backdoor payments and hidden fees.” These rules, it claims, will “save tens of billions of dollars for middle class and working families.” Whatever the department’s good intentions, a sober look at the preliminary proposals should show that if the rules accomplish their stated goals, they will do so only at the expense of these surely unintended consequences. Here, in summary form, are the Labor Department’s proposals and its interpretations of what compliance means.
An expansion of “the types of retirement advice covered by fiduciary protections” would involve buy or sell recommendations by a brokers, registered investment advisors, insurance agents, or other type of advisors. It would demand that these advisors provide “impartial advice in the clients’ best interests and that they avoid any payments creating conflicts of interest.” The department’s proposals provide exceptions from fiduciary duties for “general education on retirement savings,” to “distinguish ‘order taking’ as a non-fiduciary activity,” and for “sales pitches to plan fiduciaries with financial expertise.”
Although compliance would ask these advisors to act as fiduciaries and carry fiduciary liabilities, the Labor Department proposals allow for what it calls a “best interest contract exemption.” This would allow firms to “set their own compensation practice so long as they, among other things, commit to putting their clients’ best interest first and disclose any conflicts that might prevent them from doing so.” This exemption would, according to the Labor Department, allow commissions and revenue sharing, whether “paid by the client or a third party, such as a mutual fund.” To qualify, firms would have to contract with the client and “adopt policies and procedures designed to mitigate conflicts of interest” and “prominently disclose any conflicts, such as those proverbial backdoor payments.”
The scope and vagueness of these rules would lead directly and indirectly to the unintended consequences listed above. Because they would impel financial advisors to interpret the rules, interact with rule makers, and monitor advisors, the first unintended consequence above – larger and more active compliance departments – would be all but assured. Because there is always room for interpretation, the new rule regime would also encourage litigation, the sixth unintended consequences listed above, even though there is mention of using arbitration to settle disputes. Because advisors, even those in companies that use a “best interest contract exemption,” would worry about violations, they would tend to limit the kind of advice they give clients, prompting advisors to lean toward conventional investment solutions that presumably have already proved acceptable to the Labor Department and avoided the tender mercies of the plaintiffs’ bar.
Because any advice that deviates from conventional channels runs a risk in such a regime, only larger investors would warrant the efforts demanded of truly individualized investment advice. In most cases, investment firms would likely move toward a flat fee approach that draws from a limited investment menu of carefully vetted alternatives that would increase fees on some investors compared to the present and decrease fees to others. Meanwhile, firms that can arrange a “best interest contract exception” would presumable have a marketing edge, one that is quite separate from its investment record. Since the Labor Department offers no specifics about which firms could gain such an advantage, a cynic can only conclude that it would likely have something to do with the firm’s political connections and their influences.