DOL Fiduciary Rule

Sumatran Tiger

On June 9, 2017 the Department of Labor (DOL) implemented the “Fiduciary Rule” beginning with a transition phase for all managers to work towards full compliance by January 1, 2018. During the transition phase the DOL has agreed to allow some leniency in enforcement of managers who are making a good faith effort to transition their business models to adhere to the rule.

The Rule itself is 1,023 pages long and fundamentally changes the investment management business. In its most simple form the rule requires all managers who offer advice to prospects or clients with retirement accounts (IRAs, Roth IRAs, 401(k)s, 403(b)s, and so forth) to in all instances place the interests of their clients above their own. While this rule will in some way affect all managers who advise on retirement accounts those investment professionals who are paid by way of commissions, variable fees, trailers and kickbacks are impacted the most. The rule forces advisers of retirement plans who previously only had to provide suitable investment recommendations to adhere to a much higher standard of conduct. Allow us to demonstrate the difference with a hypothetical scenario:

A non-fiduciary investment adviser, Mark, notices one of his client’s IRA has accumulated a significant amount of cash. Mark doesn’t make investment decisions on individual securities, rather his firm utilizes outside or “3rd party” investment advisers to manage their clients’ funds. Per an investment policy statement Mark and his client created the IRA should maintain roughly 50% of its value in US large cap stocks. However the account currently only has 30% invested in US large cap stocks while the cash position has swollen to 25%.  Mark realizes he needs to recommend excess cash be invested in US large cap stocks to bring the account in to compliance with the policy statement. Mark has several different investment options which would accomplish this goal.

Mark could recommend a S&P 500 Index fund with internal management fees of 0.15% annually or utilize one of his several outside active investment manager options. Mark knows that one option in particular, The Louse Fund (Ticker LOUSY), has an internal management fee of 1.00% annually and the fund will pay Mark 0.025% each quarter for every dollar he invests in it. It’s his best compensation option as the S&P 500 Index fund offers no additional compensation to the investment manager. Unfortunately for Mark’s clients the Louse Fund has failed to outperform versus its index (the S&P 500) for the past five years in a row. However Mark knows that many funds tend to under-perform versus their index for periods of time before once again performing well. So Mark justifies his recommendation with the following reasoning: “Eventually it should out-perform its index as surely it can’t keep on lagging forever.  Besides it is perfectly suitable for this client as the fund invests in exactly what the investment policy statement requires, US large cap stocks.” Therefore without mentioning the lower cost and better performing Index Fund or that he stands to receive additional compensation he buys the (LOUSY) Fund.

Prior to the new DOL Fiduciary Rule Mark’s actions were not only acceptable, but one might argue commonplace among non-fiduciary advisers. Mark’s new account documents and annual regulatory filing fully disclosed that Mark need only provide suitable investment advice to clients and that he may receive compensation from outside managers in addition to his normal fees.  However many clients don’t read the fine print on new account forms, trust their adviser to always place the clients’ interests first even though though he or she has no obligation to do so or simply don’t have the sophistication to understand the difference.

Now that the DOL Fiduciary Rule has been implemented Mark must adhere to the fiduciary standard when advising or managing his clients’ retirement accounts. Purchasing the (LOUSY) Fund as described in our hypothetical after the implementation of the Rule on June 9th may be a breach of his fiduciary duty as it seems he placed his own interests above the interests of his clients. Mark and Mark’s firm could face disciplinary action upon review.

Please note at this point the DOL Fiduciary Rule only applies to retirement accounts.  Mark may not be able to dump his clients’ IRA assets into the Louse Fund but there are no restrictions on purchasing it in his clients’ individual or joint accounts.

There are many more examples of how managers who once were only required to provide suitable advice now must place their client’s interest above their own.  Recommending a client roll their 401(k) into an IRA under Mark’s management may not be in the client’s best interest if they have another option such as rolling their 401(k) into a new employer’s plan. Especially if the new plan has a significantly lower fee structure.

At Monarch we are and have always been fiduciary managers exclusively.  As fiduciaries we act in our clients’ best interest regardless of type of account. We accept no outside compensation from 3rd party investment managers in the form of trailers or kickbacks. The Department of Labor is forcing firms to change their practices to resemble what we have always been. We look forward to seeing if tigers can change their stripes.

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