Michael Wong, CFA, CPA, is a senior equity analyst for Morningstar covering investment banks and brokerages.
The delay to the rule was largely expected, as President Trump directed the Department of Labor to restudy the effects of the rule. Additionally, extra time would be needed by financial services companies to implement the requirements of the rule if the Department of Labor decided to make material modifications.
The majority of the implementation costs of the rule have probably already been incurred, and the three major trends that the fiduciary rule accelerates (increased use of passive investment products, fee-based accounts, and digital advice) are still firmly in place, so we are maintaining our fair value estimates and moat ratings for the affected investment management and other financial services companies that we cover.
We see two areas that are likely to receive quite a bit of attention in regard to potential modifications. The first is how the best interest contract exemption, or BICE, exposes companies to class-action lawsuits. We previously estimated that use of the BICE could lead to class-action lawsuit settlements of $70 million-$150 million annually. The second area is related to increased interest in “clean” mutual fund share classes that are stripped of many opaque fees. Clean share classes may become a component of the final rule, just like how the initially proposed rule had conceptualized a “high-quality, low-fee” investment product exemption. However, we believe that it’s important for the Department of Labor to prudently define how clean shares are to ensure that they’re in accordance with the principles of the rule, such as reducing conflicts of interest and transparency.
It’s good to remember that the first phase of the fiduciary rule began in June, with those providing advice on retirement assets being considered fiduciaries with a responsibility to comply with the Department of Labor’s impartial conduct standards. There are three parts to the impartial conduct standards; advice should be in the best interest of the retirement investor. This means that the advisor adheres to a professional standard of care and puts the interests of the client before his or her own financial interest; the advisor charges no more than reasonable compensation; and the advisor doesn’t make misleading statements. The Department of Labor’s definition of who is a fiduciary and the impartial conduct standards, even without the other sections of the rule that are delayed, seem to be propelling companies toward improved practices.
Evidence continues to accumulate that the financial services industry is moving toward more fiduciarylike obligations and processes. While many countries, such as the United Kingdom and Australia, have adopted fiduciary standards, the state of Nevada recently moved forward and created its own fiduciary rule that applies to broker/dealers. Other states may follow in Nevada’s footsteps, especially given the relatively long delay until the second phase of the Department of Labor’s rule.
Financial services companies have also already implemented changes that better align their financial advisors’ interests with clients, and that could actually make their firms more profitable. For example, they’ve transitioned to share classes without commission trails in their fee-based accounts, increased due diligence on financial products, and stopped offering some financial products where it would be difficult to substantiate that the advisor was acting with the client’s best interest in mind. Wealth management firms have also made changes to their compensation and hiring practices, such as reducing the size of hiring incentives and bonus payout criteria, and have developed more digital advice capabilities that can improve advisor efficiency. While it would probably be an unwise move for financial services companies to whipsaw their improved practices, causing confusion to both their employees and clients, we can imagine that regulators will still put in place guardrails to ensure that the industry continues down the fiduciary path.
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