How the Department of Labor’s new fiduciary rule will impact businesses offering 401(k)s

In April 2015, after nearly 40 years of no significant modifications to the rules that govern the retirement investment industry, despite great changes in retirement savings vehicles over time, the U.S. Department of Labor (DOL) issued proposed regulations to curb conflicts of interest in this marketplace.  After a long public comment period, lobbying efforts and subsequent revisions, the final rule became law on June 7 and is set to go into effect on April 10 next year. 

This regulatory development makes it imperative that businesses providing 401(k)s to their employees oversee plan advisors to ensure that they are in compliance with the new law.  According to the DOL, under the new rule, firms advising 401(k) plans and plan participants will be required to:

… make prudent investment recommendations without regard to their own interests, or the interests of those other than the customer; charge only reasonable compensation; and make no misrepresentations to their customers regarding recommended investments.

Historically, certain  retirement investment advisors (such as broker/dealers) have been allowed to invest  retirement dollars in stocks and funds they deemed to be suitable for a client —even if the investment was not in their client’s best interest per se — while accepting commissions and fees from the sponsors of those investment products.   The DOL asserts that the resulting conflicts of interest amounted to an estimated $17 billion in lost wealth annually for American retirement savers.  

The new regulation requires that when offering retirement advice, all financial advisors must now meet the higher “fiduciary standard” — that is, working in the client’s best interest.  In addition, the fees charged to investors and 401(k) plan providers must be both reasonable and clearly disclosed. 

When all is said and done, what the new law boils down to is how the word “recommendation” is defined by the DOL.  If an investment advisor is recommending a retirement product, then he/she must do so in the individual client or business client’s best interest.  Customization of advice is what qualifies a communication as a recommendation.  The DOL’s threshold of whether advice is considered a recommendation is explained below:

A ‘recommendation’ is a communication that … would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action. The more individually tailored the communication is to a specific advice recipient or recipients, the more likely the communication will be viewed as a recommendation.

The DOL further specified what is not considered retirement investment advice and, therefore, not impacted by the rule.  A few of those exceptions are “… education about retirement savings and general financial and investment information…,” marketing materials and general communications such as newsletters and speeches. (For a more detailed description of what is not covered investment advice under the rule, see the DOL’s Fiduciary Rule Fact Sheet. https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest)

During the rule’s public comment period, prior to its finalization, two important exemptions to the rule were developed and ultimately adopted.  The Best Interest Contract Exemption (BICE) states that advisors are permitted to receive commission-based compensation as long as they meet the fiduciary standard for the investment.  The financial institution must “…[give] prudent advice…, [avoid] making misleading statements…and [receive] no more than reasonable compensation.”  Additional requirements of the BICE are that the financial institution must disclose conflicts of interest, must clearly state the cost of their advice and may not compensate their advisors for making recommendations that are not in the best interest of the individual or business clients. Therefore, if a retirement plan advisor recommends investment products or rolls over investments to an IRA for which he will receive a commission, he will be required to sign a Best Interest Contract, guaranteeing that his recommendations are in the best interest of the client.    

The second exemption, the Principal Transactions Exemption (PTE), makes it permissible for fiduciaries “to sell or purchase certain recommended debt securities and other investments out of their own inventories to or from plans and IRAs” — as long as they uphold the same standard as described above for the BICE. 

Many experts have asserted that the requirements of the new regulation will make it impossible for smaller broker/dealers to profitably advise smaller businesses and investors.  They predict that robo-advisors (defined as online, automated, algorithm-based wealth advisors) will grow as a result of this new fiduciary law.  But even robo-advisors will be required to meet the fiduciary standard and prove that their fees are reasonable.

Those businesses that already use a Registered Investment Advisor (RIA) to manage their 401(k) are in luck because RIAs will be compelled to make only small operational adjustments as a result of the DOL’s new rule.  RIAs have always been held to the fiduciary standard, so they are accustomed to meeting the higher requirement of working in their client’s best interest and have the necessary systems in place to do so. 

One year after the publication of the final rule, on April 10, plan sponsors and retirement investment advisors will be legally bound to comply with the rule’s requirements.  Financial institutions will have a phased in implementation period for the BICE and PTE with fewer requirements – until the exemptions are fully applicable on Jan. 1, 2018.  With the new rule and exemptions in place, businesses will need to ensure that 401(k) plan advisors are in compliance with the DOL’s fiduciary regulations.  And their employees will be able to rest a bit easier knowing their retirement plans are better protected.

Despite assertions by some financial industry groups that the new DOL rules will cause costs for qualified plans to rise, it is more probable that the opposite will occur.  Under the bright light of more clear disclosure, costs for qualified plans will likely fall.  And, after all, is there anything wrong with acting in the best interest of financial consumers?

Michael Joyce, CFA, CFP, is founder and president of JoycePayne Partners of Richmond and Bethlehem, Pa. He is responsible for overall invest¬ment strategy, management of investment portfo¬lios and financial counseling services. Joyce can be reached at [email protected].