Effective April 10, 2017, the Department of Labor’s fiduciary rule will impose a “best interest” standard on advisors and firms making investment recommendations to qualified retirement accounts in the United States.
The DOL rule aligns the definition of best interest to that of a fiduciary under the Employment Retirement Income Security Act (ERISA). The rule defines investment advice to be in the client’s best interest when the advisor and firm “act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use … .”
In addition, best interest advice is required to be “based on the investment objectives, risk tolerance, financial circumstances, and needs” of the customer, without regard to the advisor's or firm’s own financial or other interests.
Although best interest is a higher standard than suitability, the DOL acknowledges that, “An investment recommendation that is not suitable under the securities laws would not meet the Best Interest standard,” drawing a baseline for best interest determinations. While many firms believe they already act in the customers’ best interest, they are not currently serving as ERISA fiduciaries in the retail retirement market.
The good news is that broker-dealers (BDs) and registered investment advisors (RIAs) will be able to leverage many of their existing business processes, tools and technology as they adjust their business models to meet this higher standard of care. As firms transform their businesses, the challenges are centered in the following four areas, each of which is explored in greater detail below:
- Formalize the investment advice process.
- Analyze the product menu and ongoing product governance (e.g., benchmarking).
- Capture and maintain the appropriate information.
- Enhance supervisory processes to identify new risks.
Formalize the investment advice process
The heart of DOL rule compliance (and the advisory process) is to act as a prudent person when providing investment advice and transaction recommendations. Some financial institutions are establishing clearly defined and rigorously structured decision criteria regarding matching products to client objectives, which advisors will be expected to follow closely. Other firms are opting for broad guidelines, and defer to their advisors’ experience and client knowledge when making recommendations.
The variety of distribution networks across the industry can make finding the right level of prescription tricky. (Photo: iStock)
Finding the right level of prescription is tricky, however, because of the variety of distribution networks across the industry. Some distribution networks mandate compliance with narrowly defined sales practices and the use of centrally managed planning tools.
Other distribution networks classify their advisors as independent contractors, which creates a delicate organizational balancing act between allowing advisors free will to design and implement solutions, along with effective supervision and managing compliance risk. These firms are more likely to use a guideline approach.
Distributors are also using a guideline approach for higher-net-worth clients. These clients tend to have more complex situations, which increases the need for advisor flexibility in designing solutions tailored to their needs.
Further, the analytical framework to determine which products to recommend to which customers will likely differ by firm. Some firms will rely heavily on quantitative approaches, while others will use a more qualitative approach based on academic research to develop the necessary rule sets.
Regardless of approach, the following factors should be considered, plus others in specific circumstances (e.g., the need for asset consolidation prior to retirement):
- Investment quality and performance
- Fees and expenses
- Fit with financial plan and investment goals
- Risk tolerance
- Time horizon
- Need for guaranteed income
- Client preference
Expanded offerings in the industry, such as goals-based planning, are even more relevant now with this new fiduciary standard.
Implementing a robust product governance process is key to ensuring a product menu contains solid building blocks to use when designing customer portfolios. (Photo: iStock)
Analyze the product menu
Equally important is designing and implementing a robust product governance process so that the product menu contains sound building blocks to use when designing customer portfolios. Key product considerations include historical performance, features, benefits, goal alignment, risk, cost, compensation and financial strength of the counterparty.
Additional distributor considerations include the skill and knowledge levels of its advisor base, its compensation models, its customer base and its client segmentation approach.
Firms need to remove any compensation conflicts that exist for their advisors and justify any differential compensation between product categories using neutral factors. This exercise will lead to product reduction, as many similar products available today exist primarily because they have unique compensation arrangements.
As a result, many firms are actively “narrowing their shelf” — reducing the number of fund families and specific products for various customer types. This may be an effective strategy, and one that parallels industry trends toward simpler and more understandable products. Firms are also carefully assessing proprietary products and attempting to evaluate them against the objective criteria within the governance process.
While changing product offerings may be disruptive initially, advisors may find themselves spending less time evaluating products and concentrating more on understanding and solving client needs.
Capture and maintain the appropriate information
The data needed at each stage in the customer life cycle has increased significantly. While many attributes related to a client profile are already captured, they are often stored in paper files in remote locations and manually maintained and/or re-keyed into various applications.
Under the DOL Rule, firms will need the ability to access and update this information in real time, leaving some firms to look to their customer relationship management (CRM) system as a possible data collection and maintenance solution. Further, as a firm fulfills its fiduciary duty, it will need the ability to connect client conversations, particularly those covering investment recommendations, to its CRM system, product master and account master. In addition to the client-level information, firms will need the following data to support their best interest sales process:
- Product data such as features, performance and fees
- Peer group analysis on compensation
- Industry data aggregators for plan costs, advisory program fees and brokerage platform costs
- Academic research to discover new advice strategies
- Supervisory findings
Keeping a close eye on compliance must be a top priority so firms can identify new risks. (Photo: iStock)
Enhance supervisory process to identify new risks
Monitoring compliance with the DOL rule is a top priority for financial institutions. The largest firms are trying to make compliance as efficient as possible at the enterprise level.
Firms adopting a more prescriptive advice approach and a focused product menu will be able to rely on their existing framework with modest enhancement. Firms that are allowing more advisor freedom will need to consider adopting new technology and analytical tools to monitor advisor performance and to identify outlying behaviors and supervisory red flags.
Firms will focus on a range of indicators, including:
- Sales history by product type, fund families and other factors
- Assets under management by product type
- Sales practices, including outlying behaviors such as churning
- Compliance with firm policy such as form completion, customer signatures or branch manager approval
Firms will use analysis to determine the need for case reviews and audits vs. further product education or process training. Advisors should recognize that monitoring is likely to increase, and additional training may be mandatory.
The bottom line: Thoughtfully designing a prudent process will create opportunity
The DOL rule’s best interest standard is principle-based, and therefore open to interpretation. Designing a robust process so that advisors act prudently is challenging, and firms will design approaches to suit their distribution networks, product portfolios and client bases.
Determining the right balance of prescription and flexibility is critical to demonstrating compliance and seizing the associated business opportunities. Firms that take a strategic approach to designing a prudent process will create more value for their customers and be in a better position to compete in the marketplace.
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