I have had a lot of people ask me what I thought of the DOL’s new fiduciary standard. While I think there are some good points to the new fiduciary standard, in many ways the new standard reminded me of a basic concept I learned in my first year contracts class in law school – the large print giveth, and the small print taketh away.
In this case, the overall new fiduciary standard guidelines are the large print and the Best Interests Contract Exemption, or BICE, is the small print. While I realize why BICE was added to the new law, as a former compliance director I also understand the potential consequences of the exemption, especially in regards to undermining the entire purpose of the DOL’s new fiduciary standard.
From a compliance perspective, I always had to deal with a certain few that were going to try to do whatever they wanted to do, especially if it was financially profitable for them. In some cases, they knew I was not going to approve a proposed trade or trades, so they decided at some point to just keep the applications in their desks and hope I would not find out.
What they forgot was that the compliance director gets a list of all trades and has a key to every desk in the office. The brokers I supervised also quickly learned that I brought those keys with me on my audits of external offices.
Some of the brokers I supervised hated me because of my thoroughness. Brokers know that the percentage of brokers that get caught for improper or illegal activity is very low, due both to the sheer numbers of brokers and trades. If a compliance director is not diligent in his/her supervision of their brokers, unethical brokers can make a lot more money.
So how does this apply to BICE? BICE requires that brokers and other advisers prepare and execute the contract that provides, among other things, that the broker agrees to act as a fiduciary and to put the “best interests” of customer first. Violations of the contact provides customers with a cause of action against the offending broker.
However, the benefits and protections of the BICE agreement are essentially meaningless unless a customer has the ability to detect violations of the agreement and the “best interests” rule. Needless to say, most people lack the knowledge or experience to detect such violations. So, BICE notwithstanding, unethical brokers can maintain their pre-BICE business practices.
Shifting the responsibility for enforcing the “best interests” provision of the DOL’s new fiduciary standard on to the public simply makes no sense and provides a significant loophole for unethical brokers and other financial advisers. It is clearly foreseeable that investors will simply sign whatever is given to them to sign, with little or no understanding as to the content of the document and the accompanying legal significance of same.
One of the aspects of the new DOL fiduciary standard that I did like was the recognition of the abusive marketing strategies often connected to variable annuities and fixed index annuities. By requiring such products to comply with BICE, the hope was that such abusive marketing strategies would be addressed.
Variable annuities often assess their annual M&E fees (primarily the annuity’s death benefit) on what is known as an inverse pricing platform. What this essentially means is that that the variable annuity’s annual fee is based on the accumulated value within the variable annuity rather than on the actual cost to the annuity issuer should they have to pay a death benefit to the variable annuity owner’s heirs.
Since the annuity issuer’s legal and financial obligation as to the death benefit is often limited to the annuity owner’s actual contributions, allowing the variable annuity issuer to bases fees on the accumulated value within the variable annuity ensures a windfall for the annuity issuer in most cases. Allowing a windfall to the the benefit of the annuity issuers at the expense of the annuity owner clearly is not in the “best interests” of the annuity owner and violated a basic principle of equity law – equity abhors a windfall.
Variable annuities and fixed index annuities pay large commissions. Therefor, some brokers and broker-dealers are not going to give up selling such products, BICE be damned. So given the previously mentioned low detection rate for non-compliance with both FINRA guarantees and the BICE guarantees, unethical brokers will simply say whatever they need to say in the BICE agreement and continue to do business as usual, with a wink and a nod to a weak or complicit compliance department.
This presents a perfect marketing opportunity for the prudent and proactive investment adviser. Since investment advisers are already held to a fiduciary standard, the investment adviser should stress this and help educate customers and potential clients of the chance that the guarantees of the DOL’s new fiduciary standard, especially with regard to the guarantees provided by BICE, may be largely illusory unless the customer or clients is knowledgeable enough to understand and detect violations of the fiduciary standard’s “best interest” requirement. Alerting clients and potential clients to these concerns may help develop the trust that is so crucial to forming a solid long-term adviser-client relationship.