W. Scott Simon
Registered representatives–stockbrokers–legally are agents of broker/dealers. In the insurance field, sales representatives–insurance agents–legally are agents of insurance companies.
Under principal/agency law, agents owe the fiduciary duty of loyalty to their principals. Satisfaction of this duty must come first and foremost before any duties that stockbrokers or insurance agents may owe to their clients. In effect, this means that stockbrokers and insurance agents are required by law to maximize the revenue of their principals–whether or not doing so comes at the expense of clients.
This legal requirement that the interests of one’s principal must come before those of one’s clients clashes directly with the legal requirement that the interests of one’s clients must come before those of fiduciaries such as registered investment advisors subject to the Investment Advisers Act of 1940. This has always been ground zero–the precise point where the rubber meets the road–in the fiduciary wars of the last decade.
Any efforts to “harmonize” the fiduciary standard of conduct between those who must legally place the interests of their principals above those of their clients–stockbrokers and insurance agents–and those who are legally required to place the interests of their clients before their own–fiduciary registered investment advisors–are therefore doomed from the start. That’s why all such efforts to date have failed as the revolving chairs at the U.S. Securities and Exchange Commission continue to “study” this “important issue.”
Should some sort of a “harmonized” fiduciary standard of conduct ever be adopted–which likely would be spearheaded by the SEC–then, by definition, that standard would necessarily fall short of the basic duty required of a fiduciary found in the common law of trusts: placing their clients’ interests ahead of their own. You just cannot fit a square peg in a round hole.
I’d like to share a few thoughts on topics that may not be deserving of coverage on their own, but still deserve to be addressed.
The DOL Rule in 31 Words
I have rarely cited other articles in my column. But one by Bob Veres, “My Journey Toward a Better, Simpler Fiduciary Rule,” caught my eye. Veres is a 30-year observer of and participant in the financial planning and investment advisory fields.
Veres set out to pare down the 2,000-plus pages (including the Best Interest Contract Exemption) of the U.S. Department of Labor’s fiduciary rule to its bare essentials. He achieved that goal in only 47 words:
“Any individual or organization providing financial or investment advice for compensation in regards to an IRA rollover must adhere to the same standards of care that are required of individuals or organizations that provide financial or investment advice to qualified plans under the ERISA rules and guidelines.”
What’s even more remarkable is that, after consulting with several industry thought leaders (Kate McBride, Skip Schweiss, Ron Rhoades and Dan Moisand), Veres was able to knock off an additional one third of the words from his initial definition to produce this polished jewel:
“The ERISA statute and fiduciary standards currently governing qualified plans now apply to advice relating to IRA accounts, including advice regarding rolling over a person’s retirement plan balance to an IRA.”
There you have it, folks: 31 simple words to replace more than 2,000 pages of lawyer-speak.
Of course, advisors, some anyway, would vehemently object to this rendering of the DOL’s fiduciary rule, as they have to the actual DOL fiduciary rule. In particular, they have registered great displeasure that the DOL would move into the highly profitable area that they long assumed was free of its reach: their IRA rollover business.
It seems clear, as noted, that the DOL is on firm legal footing in its seeming “invasion” of the IRA marketplace. Under ERISA, IRAs are not employer-sponsored “plans” and so any broker/dealers or RIAs that provide services to IRAs are not subject to ERISA’s fiduciary duties or prohibited transaction rules. However, IRAs are “plans” for purposes of the prohibited transaction rules in the Internal Revenue Code which includes a definition of “fiduciary” that closely tracks that found in ERISA. (See IRC section 4975.)
So even though IRAs and other non-ERISA plans are not subject to ERISA, an Executive Order issued by President Jimmy Carter in 1978 transferred from the IRS to the DOL rule-making authority over the fiduciary status and prohibited transaction provisions of IRC section 4975 that correspond to those in ERISA. (See Reorg. Plan No. 4 of 1978, § 102(a) (43 FR 47713, October 17, 1978 and confirmed by statute in P.L. 98-532 (1984).) It is this authority, granted nearly 40 years ago, that allows the DOL to bring IRAs under its purview.
The irony, then, is that while the DOL has no power to enforce any penalties against those advisors who engage in prohibited transactions when rendering investment advice to IRA owners, the IRS does have that power. And the IRS could exercise it by imposing excise taxes on advisors who engage in a prohibited transaction by, for example, earning more than “reasonable” compensation from an IRA owner. (See IRC section 4975(d)(2).)
But the IRS has chosen not to enforce any such penalties against offending advisors. Because of this non-enforcement, the IRS has, by default, allowed advisors rendering advice to IRA owners to be governed by the suitability standard instead of the fiduciary standard. The issuance of the conflict of interest rule now subjects such advisors to the more stringent fiduciary standard and some of them are none too happy about that.
Determining What ‘Reasonable’ Expenses Are
Section 404(a)(1)(A) of the Employee Retirement Income Security Act of 1974, which sets forth the fiduciary duty of loyalty, provides that a “fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan.”
This review of ERISA’s fiduciary duty of loyalty–which includes its great sole interest and exclusive purpose rules–reminds advisors that ERISA doesn’t require expenses and costs to be the lowest, or even low, in any particular case, but to be reasonable.
The notion of “reasonableness” in this context (as in any other context) can only be judged by tying expenses and costs to the products and services which are provided in exchange. When that comparison is made intelligently with full understanding of both sides of the bargain, it’s possible to determine whether value is present. If value is found, then the expenses and costs of the products and services offered are therefore reasonable.
The problem with many fiduciary/investment committees, even at companies sponsoring multibillion dollar 401(k) plans, is that there are no records of anyone undertaking an analysis of reasonableness. Instead, fiduciary/investment committees too often acquiesce to what non-fiduciary salespersons at providers are peddling.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.