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DOL Conflict of Interest Final Ruling: Radically Changing the Mutual Fund Ecosystem In April 2016, the Department of Labor introduced its Final Conflict of Interest Ruling, the first major change to ERISA legislation since 1975. Below are four of the most significant changes affecting mutual fund companies and the broker dealer advisers. First, the DOL reversed its earlier position exempting IRA rollovers from fiduciary advice standards. The new ruling treats paid advice with respect to distributions and rollovers as fiduciary advice and will impact almost $2.4 trillion between 2016 and 2020. Financial institutions that are “level-fee fiduciaries” will be required to make disclosures of their fiduciary status to retirement investors, and document the reasons for the recommendation of a rollover from an ERISA plan to an IRA, from another IRA or from a commission-based account to a fee-based account. Secondly, the ruling greatly expands the number of advisers considered to be fiduciaries by tightening guidelines. Now, anyone paid to advise 401k/IRA or IRA rollovers will be held to the fiduciary standard, which means they must put their client’s interest ahead of their own. Broker dealers formerly governed by the suitability standard of care will be held to the more stringent fiduciary standard of care. Third, the DOL strongly advocates for level-fee compensation programs that reduce the incentives for conflicted advice. However, the legislation does include a Best Interest Contract Exemption, which allows firms to continue using commission based compensation programs provided they meet specific conditions intended to insure the firm and its advisers act in the best interest of their client. Finally, the Best Interest Contract Exemption provides that contracts with retirement investors may require pre-dispute binding arbitration of individual disputes with the adviser or financial institution. The contract, however, must preserve the retirement investor’s right to bring or participate in a class action or other representative action in court in such a dispute. The DOL Arguments Are Flawed The Department’s ruling may be well intentioned, but the arguments upon which the legislation is based are quite flawed and unjustly punish broker sold mutual funds. Below are just a few of the key shortcomings.

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§  The most significant failure is the DOL’s core argument. It highlights a few legitimate sales abuses that should be and have been prosecuted by the SEC under existing federal law. The ruling goes on to imply the harmful issues are systemic, but provides no government numbers to actually quantify the scope of the problem. The Department then switches gears and uses the average fee differential between broker dealer sold mutual funds and no-load mutual funds to redefine and quantify the problem. The DOL uses the incendiary, misleading terms “conflict” and “harm” hundreds of times throughout the report to portray the broker dealer distribution/service model as villainous. The agency ignores the higher costs of the personalized distribution/service model and the fact that investors freely choose to work with advisers versus impersonal no-load funds.

§  The Department relies on dated studies, skewed almost exclusively toward large cap US equities, to determine simple average fee differentials between broker sold funds and no-load funds. It dismisses meaningful more up to date data from the ICI showing smaller fee and performance differentials that are more representative of actual broker dealer sales.

§  The DOL excludes from its analysis the rapid growth of index ETFs within broker dealer discretionary advisory accounts; a trend that has been driving down fees and embracing fiduciary responsibilities for over 10 years.

§  The ruling obsessively focuses on low fees and index performance throughout the report at the expense of the more relevant after-fee performance. The implication is that fees will supersede all other important factors when determining fiduciary/best interest advice.

§  The Department recognizes American’s desperate need for professional retirement help. It recognizes a study showing investors are happy with their advisers, but then goes out of its way to portray the investor’s choice of using advisers as financial ignorance. The DOL suggests over and over again that investors are victims incapable of making intelligent decisions. It virtually dismisses personal service, education, asset allocation, risk management or retirement planning as meaningful services provided by advisers in exchange for a higher fee.

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Impact on Asset Management Firms The mutual fund, exchange traded fund and annuity industries will bear the brunt of the ruling initially, but soon SMAs and traditional brokerage accounts will be affected as fiduciary practices and standards take hold throughout broker dealer firms. A few of the most important trends resulting from the legislation will be: §  The rapid growth of low cost index ETFs within broker dealer fiduciary

accounts will accelerate. The combination of the two are a tailor made solution for the legislation.

§  The growth of consistently high performing active mutual funds will rapidly accelerate. Advisers will flock to funds that compare favorably to index funds and jettison perennially weak funds that represent possible legal liabilities.

§  Fee-based advisory accounts, both discretionary and non-discretionary, will

grow more rapidly in response to a view that level-fee commissions generally reduce conflicts of interest as well as potential legal liabilities.

§  The industry will dramatically increase its focus on performance after fees. Advisers will demand literature for their files that will justify their recommendation to use a fund and that will stand up to fiduciary scrutiny.

§  Average active mutual fund performance will improve significantly relative to index funds. The elimination of 12b-1 fees and lower management fees dramatically reduces drag on their performance.

§  The DOL ruling will accelerate the current trend toward lower fees. A combination of market forces and increased regulatory scrutiny will force mutual fund companies and annuity firms to lower fees.

§  Lower fees and increased focus on performance will radically change mutual fund economics and ignite a new round of mergers and acquisitions.

§  Broker dealer shelf space will shrink. Long-standing relationships that allowed marginal performing funds a home will be usurped by concerns over fees, performance and potential legal liabilities.

The conflict of interest ruling and its failed argument may be challenged in the courts, but it has set the industry on a radical course that is unlikely to change any time soon.

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