As the Office of Management and Budget considers a proposed 18-month delay of the fiduciary rule by the Labor Department, some in industry are holding out hope that the rule will be rescinded, if not gutted to the point of effective extinction.
Neither is likely, says Aron Szapiro, director of policy research at Morningstar.
“I’ve been saying that since last year’s election,” Szapiro told BenefitsPRO. “And I’m more confident in that belief now than ever.”
From the specificity of questions raised in Labor’s request for information in support of its review of the rule, to the tone taken by Sec. Alexander Acosta in his Wall Street Journal op-ed announcing that the rule’s impartial conduct standards would not be further delayed, Szapiro says the tea leaves are clear: Anyone expecting the rule to die a slow death is making the wrong bet.
“At this point industry is not having an argument about the need for a fiduciary standard,” he said. “We’re having an argument about enforcement.”
In the comment letter Szapiro recently penned on behalf of Morningstar, he and the firm offered substantive support for the rule alongside hard details on how to improve it.
Questions in the RFI indicate that Labor is considering new, streamlined exemptions to soften the Best Interest Contract Exemption—specifically the prohibited transaction exemption’s warranties and private right of action, which the Obama-era Labor Department designed as the rule’s enforcement levers.
Morningstar and others have said the threat of lawsuits under the BIC have been a motivating force behind industry’s efforts to comply with the rule.
Those advocating changes to the rule are targeting the private right of action. Many stakeholders have argued the provision would leave even those firms committed to giving best interest advice subject to the ambitions of the trial bar.
Consumer advocates say stripping the private right of action would leave a fickle rule in place. Without the threat of class-action lawsuits, some firms would be tempted to sidestep the best interest standard.
Morningstar thinks it has a way to appease both industry and consumer advocates.
The solution: Replace Big Law’s role as enforcer with Big Data.
“If Labor designs a new exemption to give relief from potential lawsuits, you still would need an enforcement mechanism,” said Szapiro, who added that he is suspicious of both those that see the rule as a panacea, and those that say it will price smaller investors out of the advice market.
Morningstar envisions what it calls an “auditable big-data system,” implemented by a neutral third-party, which would hold information on all of a firm’s client’s portfolios.
Each portfolio would be scored on the quality and cost of investments, the appropriateness of asset allocation relative to a specific investor’s needs, and the value and extent of personalized advice given.
By sourcing the scores from thousands of portfolios, technology could green-light when a portfolio is constructed in the best interest of a client. Moreover, the database could be applied to determine if a 401(k) rollover recommendation satisfies the fiduciary rule’s impartial conduct standards.
Szapiro said it is not Morningstar’s intention to be the independent third-party auditor, but that the firm could supply data and the methodology for scoring portfolios.
“The idea came out of what we were seeing in the marketplace anyway,” said Szapiro. “Companies are interested in leveraging technology for monitoring their recommendations.”
Morningstar thinks the data approach would provide a more uniform application of a fiduciary standard for individual clients than enforcement by private right of action.
Szapiro describes the alternative as a way to “pre-emptively prove” compliance.
“Provided there was a standard of prudence and reasonableness, a financial institution could at any time provide that its entire book of business was either compliant or being brought into compliance,” writes Szapiro in Morningstar’s comment letter.
He is hoping regulators are aware of the emerging data capabilities.
“A lot of this technology is in place,” said Szapiro. Morningstar has already developed a best-interest score card, based on the rule’s impartial conduct standards, to assist in the evaluation of rollovers.
“This doesn’t present a tech problem, but a policy problem. Labor would have to come up with a workable way to incorporate this into an exemption that satisfies the major parties. But once you have the regulation, it would only be a matter of months to stand this up.”
Easier than clean shares
Obtuse as the big-data solution may seem to the technologically challenged, Szapiro says it would be a less complicated fix to the fiduciary rule than clean shares.
A handful of firms have filed new clean share mutual fund classes with the Securities and Exchange Commission.
Clean shares allow money managers to strip distribution fees, which have been traditionally used to compensate brokers and advisors, from the expense ratio of a fund.
With a clean share, brokers and advisors attach their own advisory charges on top of expense ratios. Potential conflicts in fund selection are neutered because different clean shares would not have variable advisor compensation embedded in the funds.
But the Labor Department will have to clearly define what constitutes a clean share if it intends to write a new exemption based on their use, said Szapiro.
Client memorandums from law firm K&L Gates have interpreted an SEC determination letter to mean clean shares can include Sub Transfer Agent fees, which are embedded costs paid to fund distributors to record keep investments.
Morningstar adamantly opposes the notion that clean shares can include Sub TA fees and still be clean.
“There is a real dispute going on over clean shares and sub TA fees,” said Szapiro.
In stripping 12b-1 fees, clean shares address conflicts at the advisor level. But sub TA fees create a conflict at the distributing firm level, says Szapiro.
Szapiro calls sub TA fees the elephant in the room. Labor is definitely getting input from some stakeholders saying the fees should be allowed in clean shares, he says
Morningstar’s bottom line: if Labor allows clean shares to carry sub TA fees, they would be leaving the door open to conflicted advice.
“Once you strip out loads and 12b-1 fees, the problem of sub TA fees is exacerbated,” added Szapiro. ““We would be taking a step back if Labor allows clean shares to include sub TA fees.”