Setting the Record Straight on the DOL's Fiduciary Proposal

An Unpopular Idea You may have heard about the Department of Labor's proposal to tighten fiduciary standards for financial advice. Entitled "Conflict of Interest Rule--Retirement Investment Advice," the new regulations extend the protections given to investors in tax-sheltered plans under the Employee Retirement Income Security Act of 1974, or ERISA. ERISA protections already apply to ongoing 401(k) assets. Under the new rules, they would also cover 401(k) rollovers, as well as IRAs and IRA rollovers.

As the DOL reminds us, ERISA was created under different circumstances. At that time, in the '70s, tax-sheltered retirement plans were almost universally advised, in that they were professionally managed pension plans. ERISA was drafted to impose "trust law standards of care and undivided loyalty on plan fiduciaries." Since 1974, of course, the development of 401(k)s and IRAs has changed the field, so that much advice on tax-sheltered plans falls outside of ERISA's beat. The DOL believes that updating its rules would restore the legislation to the authors' original intent.

That's a problem for Wall Street, because most financial advice that it sells does not meet ERISA standards. Under ERISA, plan fiduciaries must operate solely in the investor's best interest. There cannot be a divided loyalty. If there is, ERISA holds "fiduciaries accountable when they breach those obligations." Wall Street's brokerage rules, however, permit both conflicts of interest and divided loyalties. The recommendation must be "suitable" for the client, but it can also be selected with the broker's wishes in mind.

Unsurprisingly, most of Wall Street dislikes the proposal and wishes it would die a quiet death (although noisy and messy would also suffice, if need be). Equally clearly, the opponents can't state their case directly. "We find it unreasonable and unnecessary to be required to act in our clients' best interests" is not a sentence that will appeal to many on Main Street.

Clear as Mud The tactic, instead, is to obfuscate. Take Monday's Opinion article in The Wall Street Journal, "Democrats Against ObamaSave." ObamaSave? The current proposal is a sequel to the Pension Protection Act of 2006, when, if memory serves, George W. Bush was President. True, the recent proposal is more consumerist than would likely have been floated under a Republican administration, but the DOL's interest in tax-sheltered plans is ongoing. Obama makes the headline because the Journal's Opinion writers believe he is even less popular with its readers than is Wall Street. (Putin was a degree of separation too far.) (No link because the article is paywalled.)

The article's argument is not, shall we say, strong. It begins by implying the proposal bans commission-based brokers. This is not so. When the DOL initially floated this proposal in 2010, it stated that fiduciaries could not be paid on commission. Since then, however, it has bowed to pressure and admitted commission-based schemes as long as the broker signs an agreement stating that the advice is given in the customer’s best interest. Brokers would also be required to disclose any conflicts of interest, to charge a “reasonable” fee, and to show the recommendations’ costs in dollar terms.

I'm fine with that change. While most financial writers--and many if not most of this column's readers--believe that commission-based advice is inherently worse than advice that is purchased by ongoing fees (mostly asset-based, sometimes flat), I do not. A front-end load fund that is bought and held for the long term is a relatively cheap investment and often a relatively good one at that. What matters is not the payment structure for the advice, but if it is offered solely in the client's best interest and comes at a fair cost. The DOL arrived at the right place.

So, at least in relative terms, I am a fan of commission-based brokers. But I cannot remotely go where the Journal chooses to tread. Rather than argue about the real operational difficulties that brokers would face in abiding to the DOL's proposal--which even the DOL has acknowledged needs some adjustments--the Opinion writers take the broker's extinction as granted and then bemoan the loss. The commission-based broker, it turns out, is the friend of the small investor. So, in opposing the proposal, Wall Street stands arm-in-arm with Main Street.

George Orwell would be amused.

Look, as I have already written, I am happy to defend commission-based sales. I will patiently explain why a broker who puts a $25,000 401(k) rollover (the dollar amount is taken directly from the Journal's definition of a small account) into an A share mutual fund has earned that 5% (or so) upfront commission and how the investor who asked for that advice was well served if the broker made a well-researched recommendation in good faith. And I certainly grant the Journal's point that asset-based advisors aren't interested in a $25,000 client.

But the article oversteps, greatly, in two places.

First, it claims (from a research study) that the average annual cost to an investor is 0.5% annually. Half a percent of $25,000 is $125. If you believe that experienced, high-quality brokers are happy and willing to serve clients for $125 per year, I have a bridge for sale. Assume that the firm that employs the broker receives 60% of gross commissions, with the broker retaining 40% (a typical split). Under those terms, the broker would need to generate $500,000 in annual gross revenues to net a $200,000 salary. At $125 per year, that would be ... 4,000 clients. Uh-huh.

At the very least, anybody reasonable would grant that customized website pages, computerized recommendations, and robo-advisors that offer telephone assistance are a competitive solution for the $25,000 investor. Wealthfront, to cite one example, charges $37.50 per year to place its customers in a diversified portfolio of index exchange-traded funds, with an advisory board that includes Burton Malkiel. Is that not an acceptable alternative to the broker who has 4,000 clients?

Nope, sniffs the Journal. Robo-advice is for those who are "willing to settle" for less.

See, that's not being serious. It's just not.

Loud Bark, Soft Bite I get that same sense when reading even the news articles of the Wall Street trade publications, which have been banging the gong about the regulation's alleged complications. For example, InvestmentNews headlines "BlackRock, Vanguard, and Fidelity push back on DOL fiduciary" rule. (Once again, paywalled). That sounds bad--three of the world's largest asset managers aligned against the proposal. But that is not the case. The article shows that the companies have three separate claims, two of which are easily addressed.

BlackRock, the giant index ETF provider, wants a carve-out that gives index funds special protections. Big surprise there. (Giving index funds special dispensation would be a major item and is worthy of a long discussion, but it's a side point to the main item for requiring a fiduciary standard for 401(k) and IRA advice.)

Vanguard has a complaint about how certain conversations are classified; it wishes to ensure that general investment-education and -guidance discussions are not considered as crossing the line and becoming advice. That, too, is a minor item.

Fidelity wishes for the best-interest clause to be eliminated. That is a major item; it means scuttling the proposal. ("Push back" to me implies negotiating for a change, not outright rejection, but that could be just me.) That is understandable, given the nature of Fidelity's businesses, but the DOL of course cannot--and should not--please everybody with its legislation.

Then there's the "grass-roots" organization that opposes the DOL's effort, the Coalition to Protect Retirement Security and Choice. (That is not be confused with the Coalition to Preserve Retirement Security, which seeks to protect the pension benefits for state and local employees.) This organization that opposes the DOL's effort is sponsored by the American Council of Life Insurers, with a steering committee consisting of brokers and insurance agents. Grass roots, eh?

In short, the public opposition to the DOL's fiduciary standards is dominated by those with vested interests, where the natural answer is "no," with the reasons to come later. As the main point cannot be directly stated, the arguments tend to obfuscate and they should be treated very skeptically.

Reader Beware The DOL's proposal tends to have the right friends--Jack Bogle, for example. It asks for reasonable things. It seems like a benefit for investors. However, despite appearances, I cannot officially endorse the proposal, as I have not spent enough time on the details to vouch for its soundness. Perhaps the opposition is correct in stating that the proposal is unworkable as written. That could be. Unlike the opposition, I do not claim perfect knowledge of how these regulations will play out if implemented.

However, the more the opposition speaks, the less that I believe them. They are their own cause's worst enemy.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.