Complying with the DOL Fiduciary Rule

The challenges for a prudent process

ffective April 10, 2017, the Department of Labor’s Fiduciary Rule (DOL Rule) will impose a “best interest” standard on advisors and firms making investment recommendations to qualified retirement accounts in the US. The DOL Rule aligns the definition of “best interest” to that of a

"fiduciary" under the Employment Retirement Income Security Act (ERISA). The DOL 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:

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

3Complying with the DOL Fiduciary Rule: The challenges for a prudent process || Complying with the DOL Fiduciary Rule: The challenges for a prudent process2

Formalize the investment advice processThe 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.

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.

1 2

1

2

3

4

Analyze the product menuEqually 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.

This article was originally published on November 30, 2016 in LifeHealthPro. On February 3, 2017, President Trump signed an Executive Order directing the Department of Labor to review and carry out an “economic and legal analysis” on the Fiduciary Rule (DOL Rule) and its impact. As a result, it’s unclear whether the DOL Rule will become applicable on April 10, 2017 as originally published. Regardless, we believe the themes discussed in this article will continue to be relevant. Please check the EY DOL Website – http://www.ey.com/us/en/industries/financial-services/insurance/ey-us-department-of-labors-proposed-fiduciary-rule – for updates.

DOL Leadership Team

Authors

Ranjit Jaswal Principal Insurance Ernst & Young LLP ranjit.jaswal1@ey.com +1 212 773 5839

Michael Patterson Principal Financial Advisory Services Ernst & Young LLP michael.patterson@ey.com +1 212 773 2824

Daniel Bender Executive Director Wealth and Asset Management Ernst & Young LLP daniel.bender@ey.com +1 617 425 7301

Nancy Reich Executive Director Banking Capital Markets Ernst & Young LLP nancy.reich@ey.com +1 212 773 0300

Contacts

Justin Singer Senior Manager Ernst & Young LLP justin.singer@ey.com +1 704 350 9154

Eric Wolfe Manager Ernst & Young LLP eric.wolfe@ey.com +1 212 773 6587

Ben Yahr Senior Manager Ernst & Young LLP ben.yahr@ey.com +1 215 841 0577

Jill Peckingham Senior Manager Ernst & Young LLP jill.peckingham@ey.com +1 650 802 4787

5Complying with the DOL Fiduciary Rule: The challenges for a prudent process |4

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.

| Complying with the DOL Fiduciary Rule: The challenges for a prudent process

3 4 Enhance supervisory process to identify new risksMonitoring 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.

Capture and maintain the appropriate informationThe 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

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.

EY | Assurance | Tax | Transactions | AdvisoryAbout EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

How EY’s Global Wealth & Asset Management Sector can help your business The global wealth and asset management sector has rebounded from the global financial crisis to face a rapidly evolving regulatory environment and changing client base. Organizations are keenly focused on efficiently adapting to change, managing complex risks and growth in an increasingly crowded field. EY’s Global Wealth & Asset Management Sector brings together a worldwide team of professionals to help you succeed — a team with deep experience in providing assurance, tax, transaction and advisory services. The Sector team works to anticipate market trends, identify their implications and develop points of view on relevant sector issues. Working together, we can help you meet your goals and compete more effectively.

© 2016 EYGM Limited All Rights Reserved.

1611-2112975 SCORE No: 03911-161US

ED None

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.