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What the New Department of Labor (DOL) Fiduciary Rule Means to You

What the Department of Labor Fiduciary Rule Means to You

Last May, my first article for SOCO Magazine and New England Monthly was about a proposal from the Obama Administration that would require financial advisors to eliminate their conflicts of interest if they wanted to continue to counsel 401(k) plans and individuals with IRAs.

Well, it is no longer a proposal. On April 6, 2016, the U.S. Department of Labor (DOL) issued the new Fiduciary Rule.

The financial services industry is mostly against it because they believe they are already doing what is in the interest of the client and the new rule will merely increase costs, making it harder for them to help clients with smaller account balances.

Read More: DOL Fiduciary Rule Timeline & Updates

Like most of President Obama’s acts, this one will surely get challenged in the courts. The executive branch, however, oversees the DOL, and the DOL oversees ERISA. So the new Fiduciary Rule appears to be within the President’s powers.

The Employee Retirement Income Security Act (ERISA) was enacted in 1974 to make sure private-sector retirement plans get to run for the benefit of the participants. The next President could see fit to administer ERISA differently and undo the new Fiduciary Rule. However, that seems unlikely, especially after the financial services industry is forced to spend billions to comply with the law.

Remember, the new Fiduciary Rule applies only to private-sector retirement plans, such as 401(k)s, SEPs, SIMPLEs, and 403(b) plans that fall under ERISA. The 403(b) plans of public employees, such as teachers, are not covered by ERISA, so they are not subject to the new law. It only applies to them if they decide to roll over their 403(b) to an IRA. As with all IRAs, Roth’s traditional and rollover IRAs fall under the new rules.

Read More: Financial Advisor Tim Hayes Believes The Department of Labor Got It Right

The administration believes the rule is needed because conflicts of interest are causing 401(k) participants and IRA owners to pay higher fees, resulting in smaller account balances.

What do I mean by ‘conflicts of interest’? Well, some firms pay their advisors bonuses and benefits if the financial advisors sell that firm’s proprietary products. This is no surprise, but what is surprising is that these conflicts go on with retirement plans — given that ERISA forbids conflicts of interest.

But ERISA stipulated that the prohibition against conflicts applied only on five conditions:

  1. The financial advisor must render advice as to the value of securities or other property;
  2. The advisor must do so on a regular basis;
  3. The advisor must do so under an agreement with the client;
  4. That advice will serve as a primary basis for the client’s investment decisions; and
  5. The advice is to be based on the particular needs of the investment or retirement plan.

That the advice must be given regularly and must be the main basis for the client’s investment decisions is what the DOL believes is allowing financial advisors with conflicts of interest to provide advice without violating ERISA’s prohibition.

Plus, the DOL feels that the 1974 exemptions were put in place when there was no such thing as an IRA or a 401(k), and companies invested the retirement money for their employees. But now that individuals are responsible for their own investment decisions, new rules are needed.

For example, the DOL believes that people are being advised to roll over their 401(k)s into IRAs, when it would cost them less if they remained in the 401(k). Moreover, under the old rules, rollover advice never fell under ERISA guidelines, because the rollover happened once.

So the new Fiduciary Rule gets rid of the five-part test and replaces it with the requirement that advisors be paid the same no matter what kind of investment plan is used. If an advisor is paid differently according to each particular plan, then the advisor must sign a contract with the client pledging that they do what is in the customer’s best interest.

What does the new rule mean for you? If you have a 401(k), the advisor fees might come down. If you roll-over the 401(k) to an IRA, the fees in the IRA should be identical to what they were in the 401(k). If they are not, then the advisor must pledge to do what is in your best interest.

The new rule applies to 401(k) plans, SEPs, SIMPLEs, and 403(b) plans that fall under ERISA. If, however, the 401(k) or 403(b) is considered a big plan—e.g., more than $50 million in assets—the best-interest contract exemption will not apply, as these bigger plans already have protections in place. The rule will apply if a financial advisor counsels you on rolling over your 401(k) or 403(b) since all rollover advice falls under the new rule, regardless of the size of the plan from which the rollover comes.

Also, if you have a 403(b) plan that happens to fall outside of ERISA coverage—e.g., a 403(b) in a public school system—the new rule applies only if you decide to rollover that 403(b) into an IRA.

What You Need to Know about the Best Interest Contract Exemption
What You Need to Know about the Best Interest Contract Exemption

If You Have a Retirement Plan, You Will Need to Know about the Best Interest Contract Exemption

The fulcrum of the new Fiduciary Rule from the U.S. Department of Labor (DOL), which becomes law on April 10, 2017, is the Best Interest Contract Exemption.

The Department of Labor believes that conflicts of interest in the financial services industry are hurting individuals who have retirement accounts such as 401(k), SEP, SIMPLE, and IRA, in that these conflicts are causing investors to pay higher costs and receive lower returns.

Their remedy is the 2016 Fiduciary Rule, which requires almost all financial advisors who counsel IRA-holding individuals or 401(k) plans to provide conflict-free investment advice in the customer’s best interest. The problem is that fiduciaries can receive compensation only with a legal exemption, hence the new waiver.

Read More: DOL Fiduciary Rule Timeline & Updates

To receive compensation as fiduciary, financial institutions must enter into an agreement with you, the IRA owner, in which they acknowledge they are a fiduciary and will be working in your best interest, according to the new law.

There are two types of best-interest contract arrangements, and how your financial advisor is paid determines the one used:

  1. If your financial advisor receives a commission or what we call variable compensation, s/he must enter into a signed contract with you, outline the steps the company has made to reduce or eliminate conflicts of interest, and pledge to do what is in your best interest.
  2. If, however, your advisor charges a level fee, as opposed to a commission, no signed contract is required. Instead, the company must pledge to act as a fiduciary and do what is in your best interest. This fee arrangement has fewer requirements, because the DOL believes that the level cost provides protections.

Each agreement must be made between you, the individual investor, and the company your financial advisor represents. The new law also gives aggrieved investors additional recourses.

Merrill Lynch drops the commission model on IRAs

On October 7, 2016, Merrill Lynch announced that their 14,000 brokers would only open level-fee IRA accounts after the new law goes into effect. Many financial firms believe this is just the first step in an industry-wide transition away from commissions in retirement accounts. By making a level fee arrangement allegedly less erroneous, the DOL tipped its hand in the direction it wanted the industry to go.

How about existing IRA accounts?

By January 1, 2018, your financial institution is required to send you a contract outlining the terms of your relationship. Moreover, if after 30 days you do nothing, that contract will go into effect.

What about retirement plans?

The new rule applies to 401(k) plans, SEPs, SIMPLEs, and 403(b) plans that fall under ERISA. If, however, the 401(k) or 403(b) is considered a big plan—e.g., more than $50 million in assets—the best-interest contract exemption will not apply, as these bigger plans already have protections in place. The rule will apply if a financial advisor counsels you on rolling over your 401(k) or 403(b) since all rollover advice falls under the new rule, regardless of the size of the plan from which the rollover comes.

Also, if you have a 403(b) plan that happens to fall outside of ERISA coverage—e.g., a 403(b) in a public school system—the new rule applies only if you decide to rollover that 403(b) into an IRA.

What to do now

If you have an IRA and work with a financial advisor, now is a good time to review the payment arrangement. If you are thinking of rolling over a 401(k) or 403(b) before April 17 of next year, make sure the arrangement you have with your financial advisor is consistent with the new rule.

These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice. 

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