DOL Fiduciary Rule
Breaking Down the Fiduciary Rule, Part One: Fiduciary Versus Suitability Standard

Breaking Down the Fiduciary Rule, Part One: Fiduciary Versus Suitability Standard

The following is the first in a five-part series exploring the U.S. Department of Labor's final fiduciary rule.

Last month, the Department of Labor released its final rule regarding an amended definition of a fiduciary on retirement accounts under the Employee Retirement Income Security Act of 1974 (ERISA). This proposal, often called the “Conflict of Interest Rule” was initially proposed in 2010, but was withdrawn for further analysis after numerous industry groups and members of Congress from both political parties objected.

On April 14, 2015, President Obama asked the Department of Labor to re-examine the proposal. Over 3500 comment letters were examined by the Department before the final rule was sent to the Office of Management of Budget (OMB) in January 2016, with the final rule being published on April 6, 2016. Full compliance with the rule is expected by the Labor Department within eight months, with full implementation of the rules in one year.

Reaction to the rules changes, perhaps the most significant change to ERISA since its initial passing, have been mixed, but the Labor Department has been assuring the financial services community that it carefully considered the comment letters it received in order to address the concerns from its original 2010 proposal.

The final version of the new Department of Labor Fiduciary Rule requires that any person paid to give advice to an employer-based plan participant act in the best interest of their clients when giving retirement advice. This is an expansion of the “fiduciary standard” already in place since the Investment Advisors Act of 1940 for most types of investment accounts. Previously, the only requirement for certain types of retirement advice was the suitability standard, typically limited to determining risk suitability.

The Department of Labor’s authority to protect tax-preferred employer-based retirement savings accounts was coded into law by the ERISA law in 1974. This was at a time when most retirement plans were defined benefit plans through employers and individuals did not typically take control over their retirement accounts. With the new rules regime, fiduciary requirements will now apply to all 401(k) accounts, corporate defined-benefit plans, employer-administered Simple IRAs and other forms of employer-based retirement accounts, many of which did not exist when ERISA was first enacted. Traditional and Roth IRAs are not covered by ERISA because they are individual accounts, not employer-based, and are therefore still subject to FINRA and SEC regulations which include the 1940 fiduciary standard.

The fiduciary standard holds that advisors must place their client’s interests above their own and includes a duty of “loyalty and care” that has been at the heart of financial advisory services from the law’s inception.

Quite simply, the fiduciary standard stipulates that the advisor must always act in the best interests of the client. For example, an advisor cannot buy securities for his or her own account before buying them for a client. They are also prohibited from making trades that could result in higher commissions for either the advisor or their firm. Under the fiduciary standard client trades have a “best execution” standard, meaning that securities must be bought and sold with the best combination of low cost and efficient execution. Likewise, an advisor must also make every attempt to ensure that all investment advice and analysis is accurate and complete.

But perhaps the most important part of the fiduciary standard is the avoidance of conflicts of interest. If any potential conflicts of interest may exist, those must be disclosed prior to any related trades. This aspect of the fiduciary standard is at the heart of the new Labor Department changes.

These changes were brought about, primarily, because the fiduciary standard, did not always apply to all potential retirement account advisors until the Labor Department’s new rule. Broker-Dealers, insurance representatives or other financial company representatives aside from investment advisors were only required to follow the “suitability standard.”

The suitability standard is very straight-forward, only requiring that those under its purview know a client’s financial preferences and recommend products for that particular situation. This is typically signified in today’s investment climate by determining a client’s risk profile and tolerance.

The differences between these two standards can be summed up briefly. Prior to the rules changes, a broker-dealer or insurance sales representative would have only needed to make sure that an investment was suitable for a client’s risk tolerance. However, a registered investment advisor (RIA), working under the more stringent fiduciary standard, would need to account for many additional considerations. They would need to determine whether fees were reasonable, if the investments were adequately diversified, verify and disclose any conflicts of interest and make sure that the investments be consistent with provisions of a trust or other governing documents.

Additionally, the RIA would need to make sure the recommendation for an investment purchase or sale could be understood by a prudent, reasonable, hypothetical person knowledgeable about investments, strategies and purpose of the investments. Under the new Labor Department rules, these additional standards now apply to all representatives providing advice on all retirement accounts.

 

Ryan W. Smith is a relationship manager and writer at AdvisoryWorld. Prior to AdvisoryWorld, Ryan worked on the trading desk of a mid-sized brokerage firm in Des Moines, Iowa. He then earned his journalism degree and moved to Reuters America in New York where he covered structured finance debt markets. Ryan currently resides in San Diego, Calif. with his wife and son.

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