Last Wednesday the US Department of Labor (DOL) released a several hundred page ruling that essentially requires investment advisors who advise people on investments for their retirement accounts (IRAs, 401(k) plans, etc.) act in the client’s best interest – or at least to disclose potential conflicts. (You wouldn’t think it would take them hundreds of pages.) The DOL has been working on this since 2010. They did so under their authority for enforcing the Employee Retirement Income Security Act (ERISA) of 1974, although some believe they have overstepped their bounds and encroached on the SEC’s turf. Nevertheless, the Office of Management and Budget (OMB) has approved the rule and President Obama endorsed it.
In the wake of this new so-called fiduciary rule, some are asking if it will put an end to a gravy train of unwarranted, excessively high commissions on ill-suited investment products. Many in the know seem to think so. And they may be right. But I’m not so sure that the net result of the new rule always will be to the benefit of the smaller retirement account investors.
We’re not investment advisors, as the SEC defines them. We’re investment bankers. But we regularly work with firms that sell data, technology and services to investment advisors, including products and services that help investment advisors comply with government regulations. Further, some of our clients are investment advisors as well as providers of technology and services to others. So when we see changes like this we’re always trying to figure out how it is likely to change our market – and our customers’ market.
Given that it has taken over five years since the initial draft of the rule was issued in April 2010, and there have been many bumps, twists and turns along the way, it looks as if meaningful change may be coming. But exactly what shape it will take is far from clear.
With this new rule, DOL is addressing a well-known perceived problem. Investment advisors often get paid commissions and fees from the people who produce the investment products that they sell (Mutual funds, etc.) that can set up an inherent conflict. The SEC already requires Registered Investment Advisors to act as a “fiduciary” to their clients. Plan sponsors also have a similar requirement. But many others including FINRA-regulated brokers and “wealth managers” as well as insurance/annuities companies and others who offer retirement products are only required to ensure that those products meet a “suitability” standard for the particular client. That has never meant that they were required to act in their client’s best interests. Heretofore, that has been more about ethics than regulation. And from our perspective it has appeared that most of them do put the client’s interests first. However, supported by a detailed study of the problem by the White House Council of Economic Advisers, DOL felt there is indeed a larger issue than most realized. The study concluded that out of roughly $23 trillion in US retirement assets, about $1.7 trillion is invested in products that generate possible conflicts of interest. Further, they concluded that so-called “backdoor payments”, hidden fees and other conflicted advice leads to about a 1% lower return. Using simple math, the report suggests that investors are being short-changed by some $17 billion ANNUALLY – and that’s not small change.
While the rule has been promulgated it is not yet in effect and there is plenty of resistance. House speaker Paul Ryan is one notable vocal opponent, vowing to defeat the rule before its final implementation in January of 2018. He and many opponents cite the rule as creating a void of advice for some 7 million small retirement plan holders, suggesting that many investment advisors, who are already under considerable margin pressure as a result of the rise of passively managed accounts and so-called robo advisors, may prefer to end their relationships with smaller individual investors than suffer the consequences of being a fiduciary and bearing the resulting compliance burden. Further, nothing in the new rule prevents advisors from continuing to receive commissions and other third-party revenue; they just have to disclose it. Some fear that this disclosure may encourage financial advisors to shift their fees onto individuals rather than receiving them from funds. There have been myriad other issues and objections, evidenced by the 3000+ letters of comment the DOL has received during its five year drafting period. The cost to implement and manage the adherence to the rules is significant. Oxford Economics concluded in its report that costs for advisors to comply could amount to $3.9 billion. Morningstar estimated that the advisors could lose another $2.4 billion in commissions per annum. Those are big dollar costs for an industry already in major upheaval, which we’ve written about HERE.
At Marlin we follow the software markets closely, and there are none more exciting lately than the Wealth Management and GRC spaces in terms of growth, investment, and general excitement. I believe that the new rule will indeed result in higher costs to the advisor much of which will be passed on as higher fees to investors. It will make some accounts unprofitable which will push some advisors to move away from advising smaller accounts. That in turn is likely to further spur passive investing including relying on low cost ETF’s by an increasingly complex set of robo-advisors. On the other hand, the new rules will be a bonanza for providers of compliance services – both for the initial compliance needs for advisors sorting out how to best handle their clients, and second, on the ongoing specific record-keeping and monitoring requirements of the new rule. Having followed the GRC space for many years, one thing I have observed over time is the tremendous opportunity for software business as a direct result of new regulation. Given the complexity of the rule and the focus of the regulators, there will undoubtedly be star performers in the GRC space, who quickly come to market with solutions to fill the need.
Clearly the DOL believes that this new rule will be a huge victory for investors. They foresee better products, lower costs, more transparency for consumers, and stronger legal protection against bad advice. I certainly agree with the need for full disclosure and avoiding conflicts. I agree that every investment advisor (and banker) should put the client’s interests ahead of the firm’s. But there is a lot more to these hundreds of pages of rule than we yet fully understand. When the dust settles, we certainly hope that the small investors will be no worse off than before.