D.O.L. Blog Posts

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Consequences of Unrestricted MEPs

With the lifting of restrictions on Multiple Employer Plans “MEP” two major shifts are likely to occur in the retirement plan market. First is that all small plans will gravitate to local MEPs that do not include their direct competitors. The second is a massive increase in demand for local MEPs.

The MEP requirement that participating employers must be in the same industry has stunted any chance of growth. Small businesses for whom MEPs would offer great benefits would have to join forces with the very companies they face every day on the competitive battlefield. This problem is made even more acute by the fact that most small businesses serve a local area so the baker would have to join forces with the baker in the same town. To provide economies of scale, the small businesses must be geographically close together.

The unrestricted MEP would permit multiple MEPs in one locality, each serving a diverse set of non-competing businesses. With the removal of the requirement to collaborate with competitors, it is reasonable to assume that small businesses would find the better, cheaper and less risky plan to be irresistible.

The second shift is anticipated to be for new MEPs. This market would be unattractive for large service providers with centralized operations. Locally situated advisors could fill the need but often lack the technical expertise to administer an MEP. The most likely sector are third party administrators (TPAs) who possess the knowledge and skill and already serve these local customers.

The TPA need only become familiar with how to mitigate the fiduciary risk and could almost immediately establish an MEP.

The MEP also opens a new market that consists of small businesses that do not currently offer plans to employees. There is the potential to double the size of the small plan market within two years.

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Mitigating Conflicts of Interest - Part 2

In Part 1 of this series on mitigating conflicts of interest, I discussed the SEC’s proposed Regulation Best Interest and the potential significance of the mitigation requirements for financial incentives.  The mitigation requirement would appear to be one area where broker/dealers and their reps could be responsible for some significant changes.

When tackling conflicts of interest, it’s helpful to look to a place where disclosure has never been a sufficient remedy; employer-sponsored retirement plans. ERISA is perhaps the strictest regulatory regime related to financial services and under ERISA, an advisor’s conflict of interest is always a prohibited transaction (subject numerous potential exemptions).  Even those not familiar with ERISA parlance can surmise that a prohibited transaction is bad news. However, there are two well established methods of avoiding prohibited transactions in ERISA that serve as a good starting point to neutralizing conflicts of interest in the broker community. Those two methods are (1) fee leveling and (2) the use of a computer model. Fee leveling is the subject of this Part 2 article. Subsequent parts to this series will discuss the use of computer models and other financial technology as a means for elimination and mitigation of conflicts.  

Fee leveling is not the same as fee-only and does not require a shift to a wholly new business model; it simply implies an offsetting arrangement to avoid variable compensation. The distinction between fee leveling and fee-only is an important one.  First, shifting to a model where fees are deducted directly from the client’s account could be disruptive to some client relationships.  Second, shifting to a truly fee based compensation structure and no longer relying on commissions, markups, and markdowns would constitute “special compensation,” in which case the broker may magically morph into an investment adviser with respect to that client.

Regulators have been consistent that when compensation cannot be increased by the advisor, there is no conflict of interest. The Department of Labor stated in a landmark advisory opinion known as the Frost Letter that when fees are passed through to the investor, the advisor is not being benefited. Congress would later codify the concept of level fee in the Pension Protection Act when it created a new level fee exemption for advisors under ERISA §408(g). The SEC specifically mentioned the option of an offsetting arrangement in its Regulation Best Interest proposal.

Fee leveling does more than mitigate conflicts of interest, it eliminates them. Firms should explore the possibility of eliminating some conflicts altogether because in some cases it may be the only appropriate action. The SEC noted that the nature of the conflict, its inherent lack of transparency involved, and the level of sophistication of a particular investor are all factors which may lead to a determination that disclosure and mitigation are insufficient. In these cases, elimination will be the firm’s only viable option. Nonetheless, fee leveling will often be over and above what is required to mitigate a financial incentive, but serves as a preemptive strike against the continuous cost of procedures designed to police lingering incentives. It may pay long term to simply cut the head off the snake and eliminate financial incentive completely through fee leveling or other methods.

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     Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds a law degree from New England Law |Boston where he graduated Cum Laude and earned his Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.

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DOES ROLLBACK OF FIDUCIARY RULE THREATEN ROBO ADVICE?

The 5th Circuit decision to vacate the DoL Fiduciary Rule (“Rule”) creates a dilemma for the Robo Advice arrangements that depend on the relief granted by that Rule.

Rolling back the Rule means that regulations revert to the 1975 rules[1]. Applying 1975 rules make virtually all Robo advisors to IRAs and defined contribution plans into fiduciaries, without the benefit of an exemption (since the Best Interest Contract Exemption also goes away).

It would appear that institutions that have created/acquired Robos will be unable to use these automated solutions for IRAs or DC Plans, without some additional exemption being created for them.

Presumably, the roll back would include the “no enforcement policy[2]”. Without that policy, Robos may not be permitted to operate.

Financial institutions and advisors must therefore make changes necessary to qualify for an existing exemption or seek a private exemption.



[1] In 1975, the Department issued a regulation, at 29 CFR 2510.3-21(c), defining the circumstances under which a person is treated as providing “investment advice” to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA (the “1975 regulation”), and the Department of the Treasury issued a virtually identical regulation under the Code.[15The regulation narrowed the scope of the statutory definition of fiduciary investment advice by creating a five-part test that must be satisfied before a person can be treated as rendering investment advice for a fee. Under the regulation, for advice to constitute “investment advice,” an adviser who is not a fiduciary under another provision of the statute must—(1) render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property (2) on a regular basis (3) pursuant to a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary that (4) the advice will serve as a primary basis for investment decisions with respect to plan assets, and that (5) the advice will be individualized based on the particular needs of the plan or IRA. The regulation provides that an adviser is a fiduciary with respect to any particular instance of advice only if he or she meets each and every element of the five-part test with respect to the particular advice recipient or plan at issue.



[2] FAB 2017-01…during the phased implementation period ending on January 1, 2018, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions, or treat those fiduciaries as being in violation of the fiduciary duty rule and exemptions.

On March 28, 2017, the Treasury Department and the IRS issued IRS Announcement 2017-4 stating that the IRS will not apply § 4975 (which provides excise taxes relating to prohibited transactions) and related reporting obligations with respect to any transaction or agreement to which the Labor Department’s temporary enforcement policy described in FAB 2017-01, or other subsequent related enforcement guidance, would apply. The Treasury Department and the IRS have confirmed that, for purposes of applying IRS Announcement 2017-4, this FAB 2017-02 constitutes “other subsequent related enforcement guidance.”



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Consequences of Unrestricted MEPs

With the lifting of restrictions on Multiple Employer Plans “MEP” two major shifts are likely to occur in the retirement plan market. First is that all small plans will gravitate to local MEPs that do not include their direct competitors. The second is a massive increase in demand for local MEPs.

The MEP requirement that participating employers must be in the same industry has stunted any chance of growth. Small businesses for whom MEPs would offer great benefits would have to join forces with the very companies they face every day on the competitive battlefield. This problem is made even more acute by the fact that most small businesses serve a local area so the baker would have to join forces with the baker in the same town. To provide economies of scale, the small businesses must be geographically close together.

The unrestricted MEP would permit multiple MEPs in one locality, each serving a diverse set of non-competing businesses. With the removal of the requirement to collaborate with competitors, it is reasonable to assume that small businesses would find the better, cheaper and less risky plan to be irresistible.

The second shift is anticipated to be for new MEPs. This market would be unattractive for large service providers with centralized operations. Locally situated advisors could fill the need but often lack the technical expertise to administer an MEP. The most likely sector are third party administrators (TPAs) who possess the knowledge and skill and already serve these local customers.

The TPA need only become familiar with how to mitigate the fiduciary risk and could almost immediately establish an MEP.

The MEP also opens a new market that consists of small businesses that do not currently offer plans to employees. There is the potential to double the size of the small plan market within two years.

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FIDUCIARY RULE: WHAT IF I DO NOTHING, AGAIN?

The Department of Labor is expected to impose new regulations that require financial advisors to enter into a written contract with each client (“Fiduciary Rule”). This contract requires that the financial advisor act in the client’s best interest as well as a number of additional provisions and warranties.

There has been an unprecedented level of resistance to the Fiduciary Rule that is scheduled to take effect in the fall of 2016. Opponents argue that these regulations pose a threat to the financial services industry and its clients and that the upheaval will cause more damage than any benefit that could be derived.

There have been a series of threats to the status quo of financial advisors in last 10 years. These have had little effect on the way business is done. In spite of the potential for massive changes, financial advisors and institutions have had to do little more than make minor adjustments and add more disclosures.

Some examples of these threats to the status quo that occurred in the last decade were:

  • The pension protection act of 2006 threatened to neutralize incentives by limiting advisors to computer models or level fees. Thwarted by favorable rulemaking by regulators.

  • Dodd/Frank threatened universal fiduciary standards. Still awaiting regulatory action

  • Fee Disclosure promised radical changes in pricing by disclosing what clients were paying and what they were getting in return. Poor compliance and weak enforcement turned this tidal wave into a ripple.

  • 12b-1 repeal would prohibit the largest compensation source for financial advisors. These efforts have died on the vine.

  • Government sponsored retirement plans have been proposed to replace private sector plans. Moving at a snail’s pace, the automatic IRA is being adopted in only a few states

  • Repeal of tax advantages threaten to undermine a key benefit of retirement plans, annuities, IRAs, etc.

  • Overhaul of tax laws threaten to change the tax treatment of all investments. No overhaul has made it through the Congress.

The lesson from this past decade of threats may well be that the best bet is to sit back and do nothing, for this too shall pass.

Is the Department of Labor Fiduciary Rule any different?

While the Fiduciary Rule may suffer the same fate as previous initiatives, it may be instructive to understand how this differs from previous attempts at major changes. Here are 10 ways in which the Fiduciary Rule differs from previous proposals/changes.

  • Populace issue with a winning message… Opponents must win the argument that acting in a client’s best interest is too disruptive, too expensive, too risky and exclusionary to be a prerequisite for financial advisors.

  • High visibility… Repeated demands of the President and active involvement of Congressional Leaders with associated media coverage continues to make consumers aware of the planned regulation.

  • High awareness of how previous changes failed to materialize… The administration and regulators are keenly aware of the ways that previous attempts to change have been thwarted and have implemented tactics to overcome them.

  • No fear of reprisal from disapproving Congress… Unlike any time in recent history, the current administration has shown disdain for the Congress after suffering no reprisals for standing against Congress in the past.

  • No action required from Congress for adoption… The Fiduciary Rule is a regulatory change that requires no action from Congress to take effect. While Congress could vote to stop the Fiduciary Rule, there is little chance such an action would survive a certain presidential veto.

  • Low interest in campaign support from the financial sector (AKA Wall Street)… The current administration appears to have little interest in support from the financial sector and has been unwilling to negotiate.

  • Enforcement not dependent on regulatory inspection… The Fiduciary Rule is embodied in a written contract that permits any client to take action against financial advisor or institution, needing only to prove a breach of contract.

  • Explicit agreement required of each client… Clients play an active role since each will be required to sign a best interest contract, thus opening the door for clients to review the arrangement with their attorneys.

  • Risk of non-compliance… Clients may have to be reimbursed for market losses. The exposure exists for losses if the protection of the contract is not in place.

  • Liability for failure to comply increases over time… The likelihood of a loss occurring increases with the time of the exposure since the period over which the loss is calculated could be any period.

Is it really different this time? “What if I do nothing?”

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About Lou Harvey

Louis S. Harvey
President & CEO

Founder and leader of DALBAR, Lou Harvey is relentless in the search for the forces that are shaping the world of financial services today, tomorrow and for years hence. Using Dalbar’s research capabilities, Lou Harvey seeks insights from inside and outside the industry to understand and anticipate changes in customers’ needs and the ways products are distributed.