The investment advice regulation for 401(k) plans recently released by the Labor Department offers more than proposed guidelines for making advice available to retirement plan participants: It provides clear evidence of why the growing regulatory crackdown on conflicts of interest will radically change the people, products and processes associated with providing investment advice.
In effect, the Labor Department's new regulation says that there is a right way to provide advice, and there is the way that isn't particularly easy or satisfying for either the recipients or the providers of advice.
The right way is quite straightforward and requires very little ink in the proposed regulation. It is the conflict-free “level-fee” approach.
To understand why this approach is so simple, one needs only to recognize that the central objective of the regulation is “to create a new statutory exemption from the prohibited-transaction rules to expand the availability of investment advice to participants in 401(k)-type plans and individual retirement accounts.”
If the fees paid to advisers didn't vary based upon the investments recommended, no transactions would be prohibited because of the way the adviser is compensated.
The other way to provide advice without crossing the line is what I call the “artificial intelligence” approach. Under this version, advice must be formulated by a computer model that has been certified as unbiased.
The unbiased computer model serves as the mechanism to divorce the fiduciary adviser from the decision making. This approach is necessary to manage the inherent conflict of interest that exists if the fiduciary adviser's compensation varies based upon the investments selected by the participant.
In this case, participants get “personalized” investment advice from a computer, even if there is a person tasked with delivering the results.
Impersonal “personalized” advice is only one drawback of the artificial intelligence approach. Another is the problem of deciding how the computer should be programmed to provide sound advice.
The proposed regulation opens this can of worms by posing 17 questions for public comment for the purpose of deciding how specific the final rules should be in prescribing factors to be built into or excluded from the computer model. Among these questions: Which investment theories are generally accepted as effective and appropriate for decision making? Is past performance an appropriate due-diligence criteria?
These practical questions are complex and contentious when considered in the context of whether a computer can be an effective substitute for human judgment.
But that isn't the only reason why the Labor Department is asking these questions; it also is because conflicts of interest are involved.
If the compensation of fiduciary advisers and their affiliates isn't level, a computer model can be rigged to favor higher-paying investment options based upon skillful and devious programming. The mere existence of conflicts of interest makes detailed specifications for the computer model a virtual necessity.
Finally, there are the game-changing disclosure requirements of the new regulation.
The Labor Department provided a model Fiduciary Advisor Disclosure to accompany its proposal.
It includes numerous paragraphs to be included “if applicable,” pertaining to sources of additional or non-level compensation by the fiduciary adviser and by affiliates of the fiduciary adviser. It also addresses additional compensation opportunities for the fiduciary adviser and affiliates if rollovers are recommended from the plan.
The result of greater transparency is to link more numerous conflicts of interest directly to more onerous disclosures.
So what big message is the Labor Department signaling in the proposed participant advice regulations?
First, if you expect to be in the business of giving investment advice, you should get up to speed on what it means to be a fiduciary and start shifting your practices to meet fiduciary obligations. Regardless of what happens legislatively in financial regulatory reform, the fiduciary trend is unstoppable.
Second, compensation to advisers must, sooner or later, be separated from the financial products that they recommend. Those who are fighting to keep the compensation element of 12(b)-1 fees and other forms of revenue sharing are going to find the inherent conflicts of interest to be impractical to manage and uncompetitive in a more-transparent marketplace.
The fiduciary standard is the practical, logical and desirable choice for relationships based upon trust.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
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