The Department of Labor’s proposed fiduciary rule, which isdesigned to remove conflicts of interests from advisors to IRAs andmost of the country’s 401(k) plans, actually creates a new conflictof interest, according to one analyst.

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Aside from the proposal’s explicit carve-outs, such as the bestinterest contract exemption, seller’s carve out and education carveout, the proposal suggests the DOL is considering another fiduciaryexemption.

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The “low-fee”exemption, a concept introduced deeper into theproposal’s lengthy layout, would exempt advisors from fiduciaryobligations when they recommend cheaper investments to plansponsors and investors.

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The idea’s presumption is that investments with low-feestructures, like passively managed mutual funds, are inherentlyconflict-free. Because they are cheaper, advisors make less moneyon them, and therefore they are in the best interest ofparticipants and retirementsavers.

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Bob Collie, chief research strategist for institutionalinvesting in the Americas at Russell Investments, has a problemwith that reasoning.

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A low-fee exemption would create a safe harbor for what he callsa “favored category” by the DOL, which, as he writes in the mostrecent post on the Russell’s fiduciary matters blog, comprisesproducts that are likely to be passively managed.

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That would incentivize advisors to recommend passively managedinvestments, which Collie thinks could be its own conflict ofinterest.

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“The conflict in this case is not based on direct monetaryincentive, but on a legal incentive (i.e. exemption from thefiduciary rule), but it’s still a conflict of interest,” writesCollie.

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That potential for conflict could result in peril to definedcontribution investors.

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Collie points to defined benefit plans for explanation as towhy. Because defined benefit plans’ investment costs andperformance directly impact a sponsor’s funding requirements,sponsors of DB plans are incentivized to invest in the mostconceivably efficient way.

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And while those sponsors certainly access passively managedfunds, they do not do so exclusively.

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In fact, defined benefit plans tend to deploy moreactively managed investments than defined contribution plans,according to Collie.

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The reason? Fiduciaries to 401(k) plans want to reduce the riskof lawsuits.

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In other words, the choice to use passively managed funds may bea decision made in the sponsor’s best interest, not theparticipants’.

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That thinking clearly runs afoul of the Employee RetirementIncome Security Act, which leaves no ambiguity as to whoseinterests sponsors must serve.

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Collie speculates that the potential for a low-fee exemption isdriven by the thinking that passively managed investments arealways better for participants.

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But that’s not always true, thinks Collie.

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“Although passive investment is generally cheap — and it’soften an appropriate route — it’s not always agood way to go,” wrote Collie (emphases his).

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He points to the example of broad market fixed income funds,which can include thousands of securities, many of themilliquid.

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Those that are passively managed often don’t include independentcredit analysis of the underlying investments, which drives theircost down, said Collie.

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That also explains, in part, why sponsors of defined benefit plans don’t favorpassively managed fixed income funds.

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“Few corporate DB plans — even those who lean heavily on passivestrategies in their equity portfolios — invest passively in fixedincome,” explained Collie.

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“That’s why the idea of a low-fee exemption seems to us to beout of place in a regulation intended to make sure that eachproduct is given fair and equal consideration, and to removeincentives from advisors that might bias their recommendations,” hesaid.

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“The suitability of passive products needs to be judged usingthe same standards as for other products,” added Collie.

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