Beware the Fiduciary Rule's Unintended Consequences

As the details of the U.S. Department of Labor’s final version of its fiduciary rule were leaked on Tuesday and Wednesday, many fiduciary advisors felt optimistic, even vindicated after a long debate between competing revenue models, but others questioned how the law would impact investors and advisors on the front lines of retirement planning.

Specifically, they worry about the law of unintended consequences.

“It’s great that additional legislation is coming out,” says Tony D’Amico, CEO of the Fidato Group, a Strongsville, Ohio-based RIA. “I hope it produces its intended result, since previous legislation has come out and defined different advisors and their level of care but has largely been ignored and unenforced. I hope that this leads to disclosures and required practices that make a difference for retirement investors.”

Brian Menickella, managing partner at the Beacon Group of Companies, a King of Prussia, Pa.-based comprehensive wealth management company, says the changes were long overdue.

“Broker-dealers haven’t been advertising that they don’t necessarily act in their clients’ best interest for the past 70 years, so they’re probably happy that the rule isn’t getting the fanfare that common sense dictates it should,” says Menickella. “The investment public is going to be surprised when they’re told that their advisor hasn’t had to act in their best interest.”

Menickella says that Beacon’s advisors, like other RIAs, have been advertising and extolling the virtues of the fiduciary standard for years as part of their pitch to clients.

Janney Montgomery Scott, a Philadelphia-based comprehensive wealth management firm and subsidiary of Penn Mutual, acknowledged that its business was likely to change after it campaigned against the rule.

“For our clients, we have prepared for a variety of likely outcomes and will begin to review the rule in detail,” the company said in a written statement. “It’s important to remember that this is a regulatory change to which we must adhere. It is not a fundamental change to our ongoing commitment to clients and our focus on putting our clients’ needs first.”

Preston McSwain, managing partner of Fiduciary Wealth Partners, a Boston-based RIA, says that the finalized rule validates the arguments of fiduciaries and should put the debate over competing revenue models to rest.

“For too long the industry has protested too much about putting the interest of clients first,” McSwain says. “It is about time that business models are structured based on the value that clients place on advice, versus being structured based on how much value and/or profit is generated from products sold to clients. Over my 25-plus years in the industry, I have seen many different ways relationships are structured and products are priced and pitched. I understand what drives profits and incentivizes sales behavior inside investment firms, and it’s long overdue for this to all be more transparent to investors.”

Pure RIAs say they will see little impact on their businesses since they already operate under a fiduciary standard, while many hybrid firms, which offer fiduciary advice and some proprietary and at times commission-based products, have already adjusted their revenue models.

The Beacon Group has already eliminated revenue share classes in recent years in anticipation of the rule and in response to class action litigation.

“We’ve been practicing what we felt would be the rule’s impacts for the last couple of years, especially as it impacts advice at the rollover level,” Menickella says.

Most advisors sounded positive about the late changes to the rule, which included an exemption that allows advisors to advise their clients on rolling over their employer defined contribution plans into a higher-fee IRA (which is allowed as long as the decision is in the customer’s best interest and certain other conditions are met). In previous versions of the rule, advisors would have been prohibited from rolling accounts over if there were any difference in compensation.

“I think the rule should have some flexibility,” Menickella says. “There are circumstances where added value comes into the equation if the participant goes outside the 401(k), like if they were able to access a wider selection of investments or more strategies that could be implemented. It’s difficult to quantify what that value is.”

In the updated rule, advisors will also be able to recommend proprietary products like fixed index and variable annuities that allow them to avoid telling clients about similar products offered by competitors.

Advisors will also be exempted from the best-interest standard for general communications like newsletters, TV programs, radio shows and conference sessions.

The final version of the DOL rule also gives those businesses providing advice to retirement plans a yearlong grace period to acknowledge their fiduciary status, up from eight months in previous versions.

At the Beacon Group, Menickella predicts an exodus of retirement plans from brokerage platforms to the RIA channel.

“Plan sponsors haven’t really heard this story yet; they’re just starting to today,” Menickella says. “If more brokers come over to the RIA world, it’s going to be more commonplace that people understand what the differences are between broker-dealers and fiduciaries, so to a great extent this is going to help us.”

Menickella says that the changes will restrict the funds and share classes advisors can offer to things with minimal fees—meaning an end to share classes that involve revenue sharing with advisors or brokerage reps, and likely the elimination of 12b-1 fees.

Steven Dudash, president of IHT Wealth Management, a Chicago-based RIA, supports the rule, but says it will eliminate smaller and less-efficient firms when some of their revenue streams dry up.

“Formalizing this will squeeze out many small players, and we will see further consolidation as a result in our industry,” says Dudash. “Size will matter, scale will matter, true expertise will matter. The small, inefficient and unqualified firms and advisors will get forced out. And that is a very positive thing for the industry and for retail investors.”

The squeeze will occur because of fee compression, says Ross Gerber, president and CEO of Gerber Kawasaki Wealth and Investment Management, a hybrid RIA in Santa Monica, Calif.

Gerber predicts that in the absence of A share funds and 12b-1 fees, advisors will have less incentive to work with smaller accounts.

“Basically, only small clients will be hurt, as no one will work with them except computers or robots,” Gerber says. “Unfortunately for them, pure play ‘robo advice’ is not truly financial advice, and many people need actual financial advice. If the intent is to help people pay less in fees, that will work, but it will also mean they get no advice. I can’t see how this improves the world. With all the information on the Internet, clients are informed about loads and fee structures and should have a choice which way they want to pay.”

Gerber says the eventual fallout from the fiduciary rule is likely to be chalked up as proof of the law of unintended consequences: “Like all things the government does, they mean well but end up hurting the very people they are trying to help, with the prime recent example of this being Obamacare. The new DOL rule is Obamafinance. However well-intentioned it is, it’s unfortunately only going to cause more of a mess in our industry and for many retail investors. There will be some good that comes out of all this, but mostly it’s a nightmare.”

By Christopher Robbins

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.

Gerber Kawasaki, 2716 Ocean Park Blvd. #2022 Santa Monica, CA 90405. Contact us at (310) 441-9393.