U.S. Department of Labor’s Conflict of Interest Rule is a hot and controversial topic in the financial services profession. Since the rule was finalized in April 2016, its reception has been predictably divisive. Already, the first of what will likely be a parade of lawsuits has been filed, aiming to stop, dismantle or delay the rule from taking effect next year. Legal hurdles in place, the industry and consumers alike will know soon enough if the DOL rule has strong enough legs.
However, waiting for the outcome of a challenge before preparing for the implementation of the rule should remind us of the fable of the hardworking ant and the carefree grasshopper. While the ant diligently prepares, the grasshopper spends the summer singing the days away and finds itself unprepared to survive through winter.
Let’s not find ourselves like the grasshopper, outside in the cold, shivering and unprepared come next April’s deadline.
Defining a Fiduciary Duty
The DOL rule expands an existing fiduciary duty to include recommendations concerning retirement assets. This will target IRA account holders, rollovers and those who are acquiring, holding, exchanging or distributing retirement assets. This broad net definition covers just about every working or retired American, from a coffee-shop employee saving $50 weekly into a ROTH IRA, to a small business owner opening her first 401(k) plan, to a corporate officer facing retirement with a few million dollars in a profit sharing plan. All of the above are owed a fiduciary duty of care. A better understanding this fiduciary duty requires a visit to the world of academia.
A fiduciary duty can be illustrated as a relationship between two parties. Writing in the Journal of Financial Economics, authors Jensen and Meckling set up the discussion of principal and agent conflicts in their 1974 publication,”Theory of the firm: Managerial behavior, agency costs and ownership structure.”
According to Jensen and Meckling, a client (young employee, business owner, retiree) is viewed as the principal. The principal has an interest in retirement. It may be accumulation of capital, developing an income strategy, meeting bequest motives, developing an appropriate risk tolerance, or a combination of motives. In financial planning we refer to this interest as helping the client understand and meet his specific goals. The counterpart to a principal is an agent. The agent may be an insurance agent, investment adviser, broker, banker or other financial service professional. The agent also has a set of goals and motivations, such as profit, sustainability, growth and financial success.
The Conflict Over ‘Conflict of Interest’
The principal/agent model has natural conflicts. An agent has a set of best interests (success and profit) which may not lead to the principal best realizing his goals and dreams. The model is often complicated by including firm interests, such as the interest of the shareholders or the interest of the policy owners of an insurance company. Multiple interests can be in conflict. The conflict between agents, principals and firms can resolve itself in any number of ways. One party could win at the expense of the others, a natural market may develop that balances interests, or a regulatory policy can be imposed on a principal, agent, and firm to ensure consumer interests are met. When we view the DOL fiduciary rule, we need to consider this framework.
The Department of Labor stated that retirees and accumulators (principals) were vulnerable, and this vulnerability was leading to excess costs and fees. The excess costs and fees, coupled with increases in consumer longevity, contributed to underfunded or unsafe retirement strategies. Enforcing a fiduciary standard requires all parties (principals, agents and firms) to align their interests to that of the principal. Requiring a fiduciary standard puts profit and growth secondary to meeting the financial planning goals of a client, which is the first priority. The fiduciary standard is in place to ensure that consumers, who may not have as much knowledge as the professionals they work with, will not be taken advantage of because of the information asymmetry inherent in the relationship. In other words, the Department of Labor is requiring financial planners to work in the best interest of their clients, rather than in the best interest of themselves.
And this leads to the core of the rule. The DOL questions certain compensation structures that might lead to biased advice. Commissions, assets under management models, even hourly fees have the potential to create conflicts between principals and agents. Conflicted compensation is prohibited under the new rule, unless the agent works under a prohibited transaction exemption. The DOL can then influence the principal/agent relationship by setting specific processes and rules regulating the allowable uses of prohibited transactions. The DOL is not trying to discredit the financial services industry with this rule. It is, instead, attempting to set specific parameters around the retirement advice provided to potentially vulnerable consumers.
The Grasshopper and the Ant
Additional challenges will likely come forward as the rule’s deadline continues to approach. Phase one of the rule rolls out April 10, 2017; the remaining phase requires compliance by January 1, 2018. Challenges may adjust the timeline and the details of the possible prohibited transaction exemptions (BICE, 84-24), but are not likely to change the rule’s overarching alignment of principal, agent and firm interests.
Remember, the ant prepares for change in seasons, stores food and devises strategies for survival. Let’s not take the short-sighted perspective of the grasshopper when preparing for the future of financial planning.
Take a lesson from the ant and recognize the opportunities that exist today to create new models and procedures that will benefit not only the profession, but also the retirement security of the clients whose best interests we are pledged to serve.
Text by Craig Lemoine, PhD, CFP®, Director of The American College Northwestern Mutual Granum Center for Financial Security.
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