DOL's Fiduciary Rule May Lead to Retirement Product Changes

The Department of Labor’s (DOL’s) proposed conflict-of-interest rule (fiduciary rule) will force a period of product and platform innovation in the United States, according to Cerulli Associates.

Cerulli anticipates large broker/dealers (B/Ds) will use developing technology to serve smaller accounts on a flat-fee basis, and insurance companies will be forced to lower variable annuity expenses and commissions to be in line with other financial products.

The DOL’s proposal creates a new type of prohibited transaction exemption, referred to as the best interest contract exemption (BIC), which is a contract that the investment advice provider must present to a potential client in the case that the adviser will have an opportunity to earn a variable commission or fee in servicing that client. Specifically, Cerulli notes in its first quarter 2016 issue of The Cerulli Edge – Retirement Edition, the financial institution must disclose any variable compensation that the adviser receives for the advice and any resultant product sales, whether by the adviser or a colleague in the firm, along with comparative examples of compensation they would have received for other products.

Cerulli anticipates there will be unexpected changes to the retirement and wealth management industries and, to a degree, this cultural evolution is what the proposed rule is hoping to affect. According to Cerulli, in a speech at the Brookings Institution, Secretary of Labor Thomas Perez said, “I believe, in fact, that the new rule will be a catalyst for further innovation in the industry, as more firms devise new tools and strategies—assisted by modern software and new technology-based tools—to accommodate even those with only a few thousand dollars to invest.”

The continuing move to robo-advisers will be a result of the DOL’s proposed rule, Cerulli believes. These platforms offer scalable trading technology, algorithmic portfolio construction, and heavy use of low-cost exchange-traded funds (ETFs). “Digital adviser technology may provide a scalable solution for B/Ds to work with low balances in individual retirement accounts on a flat-fee and a fiduciary basis,” Cerulli says in its report.

Cerulli says the fee and compensation disclosure requirements of the BIC will cause insurance companies to re-evaluate annuity pricing. It expects there will be a short-term hit to variable annuity sales as B/Ds grapple to comply with the requirements of the DOL rule.

Cerulli anticipates two primary evolutions to annuity pricing: First, pricing products for inclusion on fee-based managed account programs, and second, adjusting expenses and commissions to be more in line with mutual funds.

The crux of the challenge for insurance companies is that annuities must compete against other financial products on their value to the consumer and not compensation to the adviser. Insurance companies have been competing with each other over features and benefits. Cerulli believes this focus on product features has kept annuities from experiencing the same growth as other financial products, such as mutual funds or ETFs. “The conflict-of-interest rule may ultimately be a wake-up call for the insurance industry to evolve the way it does business,” Cerulli says.

However, while the proposed rule is a major event, Cerulli says its true effects may not be immediately felt, noting that Employee Retirement Income Security Act (ERISA) section 408(b)(2) and 404(a)(5) rules enforcing mandatory fee disclosure for retirement plans were hailed as a game-changer for the industry, but the first wave of fee disclosure mailings “was largely met with crickets.”

But, the retirement plan industry matured during succeeding years as plan sponsors benchmarked costs, interest grew in low-cost passive investments, and specialized consultants increased their control. “It may be that implementation of the DOL rule is a short-term non-event, but the effects will continue to creep into the retirement industry,” Cerulli says.

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