In late October, the DOL announced the Retirement Security Rule, which expands the definition of an investment advice fiduciary under ERISA and amends several prohibited transaction exemptions. This initiative bolsters the Biden administration’s drive to protect retirement investors during a time of unprecedented need for transparent and trusted advice.
Many of the key provisions of the new Rule revive ideas first presented in the 2016 Fiduciary Rule, which was ultimately vacated by the Fifth Circuit in 2018. However, this new version is framed to be narrower in scope to avoid the same outcome while still providing meaningful updates to the rules originally introduced in 1975. Despite the proposed adjustments likely producing better outcomes for retirement investors through improved advice and lower fees, there will almost certainly be legal challenges from myriad parties who are currently suggesting the new Rule is still excessively broad.
Closing Gaps to Address Conflicts of Interest
At its core, the proposed 2023 Rule addresses conflicts of interest, which have been a focus area for several regulatory bodies over the years. The DOL’s proposal defines the conditions under which someone making direct or indirect investment recommendations needs to meet fiduciary standards.
While most advisors are likely doing the right thing, conflicted advice is nonetheless estimated to cost retirees tens of billions of dollars each year. In particular, the negative impact of moving retirement investors out of low cost, well-diversified portfolios into higher cost options can sometimes be drastic.
The new Rule expands the requirement for advisors to meet a higher standard and duty of care in a wider range of scenarios, while also closing several notable gaps that allowed some advisors to put their own interests ahead of those of their client. To address these concerns, the DOL proposal hits three main areas that it is important advisors be aware of.
First and foremost, it strengthens requirements around product recommendations so that any suggested investment product must be in the savers’ best interest. Some products, such as fixed annuities, real estate, and certain banking products currently fall outside the authority of the Securities and Exchange Commission under Regulation Best Interest (Reg BI). There are also certain investment advice providers that are not covered by Reg BI or fiduciary obligations within the Advisers Act.
In addition, the proposal includes advice on rolling assets out of employer-sponsored plans such as a 401(k), as one-off advice like this is generally exempt from existing fiduciary rules but could have significant impact on client outcomes. Bringing this under the fiduciary umbrella should lead to advice that helps the investor make the best decision for them instead of the advisor’s bottom line.
However, it could reintroduce difficulties, also highlighted in review of the 2016 attempt, where investment professionals would need to present the costs of the various recommended options where fee information may not be readily available. This would likely add costly manual activities for firms providing advice and could disrupt the rollover process for retirement investors.
Finally, the new Rule covers advice to plans and plan fiduciaries about what investments to make available as options in 401(k) plans and other employer-sponsored plans. This is particularly relevant on the back of the SECURE Act 2.0, which encourages firms to offer employer sponsored retirement plans. Many have likely never acted as a plan sponsor before and could rely heavily on advice when constructing them. Requiring fiduciary care for sponsors should help employee outcomes by reducing fees and offering more choices for diversification.
If the DOL’s proposal becomes binding in its current form, there will be several key areas of consideration.
Updated Compliance Regiments. Firms will need updated compliance regiments – and/or employ new technology solutions – on a transaction-by-transaction basis, along with updated exemptions handling to account for the new rules. This may also require additional full-time employees to meet enhanced documentation processes. There is an advantage for larger players to absorb the changes, risks, and costs of compliance, which could contribute to further industry consolidation.
Moreover, steps should be taken in preparation for change implementation:
- Select strategies that ensure compliance while also creating process continuity and minimizing negative impacts to the financial advisor and their interactions with clients; and
- Identify the proposal’s most challenging aspects early to help focus planning efforts well in advance.
Product Reconciliations Across Complementary Rules and Regulations. Firms should reconcile product sets that do not fall under Reg BI and align them with other rules and regulations, such as the SECURE Act 2.0, which included updated mandates around certain products in retirement accounts. It is surprising to see how similar products have very different regulatory requirements and governing rules.
For instance, an assessment is particularly essential to fixed and fixed indexed annuities, which, unlike variable and some indexed annuities, are not considered securities and are governed by a patchwork of state laws. Any review should also include analysis of commissions received by the firm and comparisons in performance to similar, less costly options.
Changing Client Engagement Practices. Firms should rethink how they engage certain clients in light of the associated risks arising under the new standards. For instance, current rules treat plan sponsors as sophisticated investors, which does not always accurately reflect their level of financial acumen. Picking less optimal investments can have a significant impact on returns over time, and potentially serious implications for those recommending them. An extreme example is the events leading up to the 2008 financial crisis: pension funds holding AAA rated residential mortgage-backed securities (MBS) – which they had been advised were safe investments – suffered heavy losses when the sub-prime mortgage crisis blew up.
Why Getting it Right is Crucial
At the end of June 2023, the US Defined Contribution (DC) market represented a $10.2 trillion industry, up from $6.5 trillion at the time of the 2016 proposal. Demographics also tell an important story. Baby boomers control approximately 50% of the wealth in the US (approximately $78 trillion) and are quickly approaching retirement age, and 100% of them will be aged 65 or over by 2030.
They are followed closely by Generation X, who control the next biggest piece of US wealth at 29.5% (approximately $46 trillion) and who will be reaching the age of 65 between 2030 and 2045.5 Continued growth in DC markets, coupled with evolving demographic changes, are set to trigger a pivot from asset growth to asset preservation and income generation as well as an unprecedented amount of retirement plan rollovers.
Concurrently, a shift from brokerage to advisory relationships is already underway for qualified and retirement assets that will only further accelerate with an implementation of the proposed rules, which suggests strong near-term and long-term demand for trustworthy and retirement-focused financial guidance.
While the DOL is likely to modify aspects of the proposed Rule, it will still lead to significant changes in how wealth managers and financial markets operate within the retirement space. Firms that recognize both the challenges and opportunities are starting to aggressively evaluate their strategic response along with the implications on their current operating and business models to ensure they preserve clients and revenue.
Matthew Berkowitz is US Wealth & Asset Management Strategy Practice Lead and Justin Handley is a Senior Consultant, both at Capco.
