You have probably read numerous headlines, articles, and news stories about the new “Fiduciary Rule,” a law set to go into effect April 10th this year. But what is it and how will it affect Black Cypress and the average investor?

DOL Fiduciary Rule

Fiduciary Rule

Background

The Employment Retirement Income Security Act (ERISA) of 1974 and the Internal Revenue Code of 1986 provide various regulations on the delivery of professional investment advice to retirement plans and retirement accounts. These regulations occur primarily through two means: defining fiduciaries and outlawing “prohibited transactions” that present conflicts of interest. ERISA requires fiduciaries to abide by trust law standards of care and undivided loyalty. In other words, a fiduciary must act solely in the client’s best interest and may not consider its own interests when giving investment advice.

However, many modern investment professionals no longer have an obligation to adhere to ERISA’s fiduciary standards because of significant changes in the investment advice marketplace since the U.S. Department of Labor (DOL) last defined “fiduciary” in 1975. For example, the old definition of fiduciary required an investment professional to render advice on a “regular basis” before being deemed a fiduciary. Anyone providing advice on less than a regular basis was held to a much lower “suitability” standard.

The Problem

Under the suitability standard, an investment professional only had to make recommendations that were suitable for a client. An investment recommendation could be in the professional’s best interest, not the client’s, and still be “suitable.” For example, imagine an investment professional was going to recommend that a client purchase security A or security B. The professional believes security A will produce an 8-10% return over the next ten years, and security B will return 5-7% over the same period, but the professional receives a 3% commission for each security B he sells. Such a scenario produces a conflict of interest because the investment professional is incentivized to recommend the security that gives him a commission, not the one that gives the client the best possible return. Although not in the client’s best interest, such an investment would still be “suitable” for the client and thus permissible under the suitability standard.

As the above example shows, the lack of fiduciary duty among certain investment professionals has allowed conflicted investment advice to flourish. And conflicted investment advice has resulted in significant losses to retirement investors. The DOL estimates that an investor that accepts advice from a conflicted financial adviser and rolls his retirement savings into an IRA could lose 6 to 12 and possibly as much as 23 percent of the value of his savings over 30 years of retirement. Because of the danger of increasing losses to retirement investors, the DOL sought to impose fiduciary duties on a wider array of advice relationships.

Recent Developments

In 2010 and 2015, the DOL issued proposals to modify the definition of “fiduciary” under both ERISA and the Internal Revenue Code of 1986. After consideration of the extensive comments received on the 2015 Proposal, the DOL promulgated a final rule (the new Fiduciary Rule) with an effective date of June 7, 2016 and applicability date of April 10, 2017.

However, on February 3, 2017, President Trump signed a Presidential Memorandum directing the DOL to examine the Fiduciary Rule. On March 1, 2017, The DOL announced a proposed extension of the applicability dates of the Fiduciary Rule and related exemptions from April 10 to June 9, 2017. According to the DOL, the proposed extension is intended to give the DOL time to collect and consider information related to the issues raised in the memorandum before the rule and exemptions become applicable. As of this writing, the fate of the new Fiduciary Rule is still uncertain.

What’s All the Fuss About?

The new Fiduciary Rule imposes fiduciaries duties on many financial entities and types of advice that were previously held to the lower suitability standard. These new duties will upend the pay structure for some of these entities and require them to take additional steps to prove that their investment advice is in a client’s best interest. For example, many broker-dealers (who were generally not fiduciaries previously) receive large, upfront transaction-based commissions. These transactions may be prohibited under the new rule, causing significant consternation among investment professionals whose business model is based on those types of fees and advice.

In contrast, the new Fiduciary Rule has been less disruptive to level fee investment advisers because they were usually already considered fiduciaries under ERISA. Generally speaking, the level fee investment advice model produces fewer conflicts of interest between client and adviser because the adviser’s compensation does not vary depending on which transactions the client engages in. Rather, the level fee investment adviser only increases its compensation when the client’s assets increase.

Our View

In our view, it is remarkable that the practice of “suitable” investment recommendations has been allowed to go on for as long as it has. To be sure, increased government regulation is not always the best solution to problems in the investment marketplace. However, as increasing numbers of individuals move toward retirement, there is simply too much at stake to allow conflicted investment advice to persist unchecked.

We think that most investors probably assumed that their financial advisers were already acting in their best interest. But, under the suitability standard, many advisers were not legally required to do so. We recommend that all investors ask their advisers whether they are providing advice as fiduciaries or are simply complying with the non-fiduciary suitability standard.

Here at Black Cypress, we think that regardless of what happens with the Fiduciary Rule, the financial services industry is generally moving away from variable fee (transaction-based) to level fee compensation. As the DOL has acknowledged, the receipt of a level fee tends to produce fewer potential conflicts of interest than variable fees. An investment adviser that receives only a level fee based on a fixed percentage of assets under management has the same interests as the investor: increasing and protecting account assets.

Black Cypress was a level fee investment adviser before the DOL issued its new Fiduciary Rule. Further, we feel that our fees are some of the best in the industry and that they properly align our interests with those of our clients. Consequently, Black Cypress is on the leading edge of an industry shift to the level fee model of investment advice.

If you would like more information about Black Cypress, its fiduciary status or fees, please contact us at [email protected]m or 904-553-1598.


Disclaimer: This content is not legal advice and is presented for educational purposes only. Please consult your attorney and/or your investment adviser before acting on the Fiduciary Rule.

Article by Black Cyprus Capital Management