Fiduciary Rule Myths

MYTH:  “Advisors must recommend the lowest cost investment.”

This post discusses what broker-dealers and their advisors need to do to manage the risks in providing investment recommendations to plans and IRAs. In order to manage those risks, though, broker-dealers and advisors need to understand what the rules require. To do that, we need to debunk some “myths” about the rules.

As a reminder, the DOL fiduciary rule is in full effect. Some, but not all, of the provisions of the applicable prohibited transaction exemptions — particularly the Best Interest Contract Exemption (or BICE) — are not. However, broker-dealers and their advisors who work with plans and IRAs need to comply with the BICE conditions that are in effect … including the requirement to adhere to the Impartial Conduct Standards.

This leads to Myth No. 1: “Advisors must recommend the lowest-cost investment.” This isn’t true. The Impartial Conduct Standards have three requirements:

  • The compensation to the broker-dealer and advisor must be reasonable.
  • Recommendations must be in the best interest of the customer (that is, prudent, taking into account relevant information about the customer, and putting the customer’s interests above those of the broker-dealer and the advisor).
  • Communications with the customer may not be misleading.

Nowhere in these Standards is there an explicit requirement to recommend the “lowest cost” investments. Some may argue that the best interest standard or the reasonable compensation standard imposes that requirement; however, the DOL has specifically rejected that argument. In its discussion of the exemption when it was first released, the DOL said:

“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” [81 Fed. Reg. 21002, at page 21030 (April 8, 2016)]

In other words, while cost is a relevant factor that needs to be taken into account, it isn’t the only one.

The Impartial Conduct Standards say that a firm and its advisor’s financial interest in a transaction must be subordinate to the interests of the customer. Inherent in that, but separately stated, is the requirement that the compensation for both the broker-dealer and the advisor must be reasonable. In many investments, such as mutual funds, compensation is built into the expense ratio. In making a recommendation, an advisor needs to assess both the investment cost and the reasonableness of the compensation. In a sense, where compensation is embedded in the investment product, the compensation should be deducted from the expense ratio and evaluated for reasonableness. Then the remaining, or “net,” expense ratio should be evaluated as the cost of the investment.

Note that we said that an advisor needs to assess cost and compensation in making a recommendation. While the evaluation of the investment cost is part of the best interest standard of care, the reasonableness of compensation is a prohibited transaction issue. Under the prohibited transaction rules, the burden of showing that the exemption is available — that all of the conditions have been satisfied — falls on the broker-dealer, not the customer. As a result, the broker-dealer must be able to prove that the compensation is reasonable. One source of “evidence” would be data from credible benchmarking services.

Keep in mind that, while compensation must be reasonable, it is a myth that the Impartial Conduct Standards require a “lowest cost” recommendation. Instead, the requirement is that the costs be prudently considered in light of the value of the investment.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

About the Author: Fred Reish

Fred Reish represents clients in fiduciary issues, prohibited transactions, tax-qualification and Department of Labor, Securities and Exchange Commission and FINRA examinations of retirement plans and IRA issues.

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