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DOL Fiduciary Rule
Breaking Down the Fiduciary Rule, Part Two: Why Was the Suitability Standard Not Enough?

Breaking Down the Fiduciary Rule, Part Two: Why Was the Suitability Standard Not Enough?

The following is the second 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 This proposal, often called the “Conflict of Interest Rule” was initially proposed in 2010, but was withdrawn for further analysis after numerous industry groups and members of Congress from both political parties objected.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.

We have previously noted the differences between the fiduciary and suitability standards, explaining the wide gulf in responsibility placed on the financial services personnel under the two regimes. However, it is important to also note how these differences can have large impacts on client portfolios.

An example of this difference can be shown by a specific circumstance that has been commonly executed for many years, an example of a situation that most likely provoked the Department of Labor to look at making the rules change in the first place. The scenario described below will no longer be legal under the new rules regime.

A non-licensed financial representative, usually working for non-bank, non-brokerage financial services company and sometimes referred to as an “adviser” by his or her company, determines that a security created by the company and approximating an S&P 500 index fund fits within the risk profile for a 401k client and is a suitable investment for the client. This representative is not a Registered Investment Advisor (RIA), having not taken the necessary FINRA exams to be licensed as such, and does not have a fiduciary responsibility to the client. So long as an investment meets the risk profile for the client, it can be considered to have met the suitability standard.

In many cases that adviser, not to be confused with a registered investment advisor (RIA), was trained as a salesperson and might not have prior financial experience. This salesperson fell outside FINRA’s scope because they are not technically a financial advisor. In fact, many RIAs might not be aware this practice even existed, which might help explain some of the complaints regarding the new rule and why the Labor Department is the agency issuing it.

To continue the example, the financial services company’s proprietary fund pays the salesperson a 5% commission on the sale of that particular fund to the 401k client. The fund will oftentimes have high ongoing annual fees, typically are called manager fees and should not be confused with management fees associated with mutual funds or ETFs. In many cases, the firm might have several variants of the same proprietary fund, each with slightly different underlying assets, but largely similar, and with differing fee structures. In a sales meeting or call with a client, this type of investment might be the only security mentioned to the client.

What might not be mentioned is an identical, or nearly identical, fund by another company offering similar returns, but which only pays a 2.5% commission to the sales representative.  Also going unmentioned would be other securities that might have no commissions at all along with much lower ongoing expenses, like mutual funds or ETFs, which would mimic the same basket of securities.

The suitability-only requirement allowed the sales representative to recommend the higher priced, higher fee proprietary security while the fiduciary standard would require a lower fee or no-fee investment to be purchased, whichever is in the client’s best interest. It appears this conflict-of-interest is the type of action the Labor Department’s rule was specifically designed to prevent as it is estimated that higher fees in situations like this cost employer-sponsored retirement account holders approximately 1% in annual losses per year, lowering returns by more than a quarter over a 35 year period. For the economy as a whole, these losses average nearly $17 billion per year.

Conservative estimates by the Department of Labor say that $40 billion could be saved by employer-sponsored retirement account holders over 10 years just by changing the conflict-of-interest rule, with many billions more being saved via other aspects of the rules changes.


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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