New DOL Fiduciary Rule A Dangerous Step For Institutional Investors

On April 6, 2016, the Department of Labor (DOL), in a final rule issuance, determined pension plan investment advisers will now be held to a fiduciary standard in every investment advising situation, completing a nearly six year process and expanding the reach of the fiduciary standard to pension plan advisers. While the rule will not take effect until April 10, 2017, the majority of investment advisers providing advice to pension plans will need to consider the new rule and its impact on their business models and investment strategies going forward. In a $12 trillion industry, pension plan investment advisers have their work cut out for them over the next few months to move from a suitability standard of advising to a fiduciary standard.

The DOL’s rule comes at a time when discussions about fiduciary standards have been very much in vogue; in fact, the Securities and Exchange Commission (SEC) was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act to create a new rule with a similar impact. The SEC, though, has delayed its rule, providing the DOL an opportunity to step in and set a new standard for pension plan advisers.

Part of the stated motivation for shifting pension plan investment advice to a fiduciary standard hinges on a White House study that found investors on average spend in excess of $17 billion annually in investment management fees. Shifting to a fiduciary standard and requiring investment advisers to advise in a pension plan’s best interest in every investment advising decision rather than providing just suitable investment advice purports to stop advisers from supposedly putting their own interests (earning high commissions and fees) over their clients’ interests (getting the best investment advice at the lowest cost).

Another concern the White House, SEC, and now DOL share is that investment advisers will not advise in a pension plan’s best interest in every transaction. Their collective solution is to require pension plan investment advisers to be held to a fiduciary standard in every investment advising situation. On its face, a fiduciary standard for pension plan investment advisers is appropriate: with billions of dollars of working Americans’ retirement money being managed, pension plan investment advisers have an awesome responsibility that could have unfathomably bad consequences if they mismanage those funds. In return for managing a pension plan’s assets, investment advisers have been compensated well; a little too well in the White House’s opinion. The questions that naturally arise when contemplating investment adviser compensation are whether the $17 billion in fees pension plans pay annually are reasonable, what value pension plans receive for these fees, and whether a shift to a fiduciary standard will actually reduce the fees pensions pay for investment advice.

The short answer is that the fees investment advisers receive in exchange for their services to pension plans are considered reasonable by their investors. With massive amounts of capital to manage, pension plans are highly sought-after clients for investment advisers, who compete fiercely to earn pension business. The best way to differentiate from other investment advisers within an adviser’s control is setting a fair fee structure, so it stands to reason that fees for investment advice to pension plans have to be reasonable, or advisers will be weeded out by plans unwilling to pay too high of a fee. Advisers provide significant value to pensions in exchange for these fees, including strategic advising on investment opportunities, pension plan portfolio diversification, and asset growth that helps a pension plan better meet its goals of protecting working people’s retirement funds and helping the pension protect itself against the near-unlimited liability it could face should it fail to responsibly manage its funds. The fees advisers receive are a necessary part of investing, so the DOL should really be concerned about what value pension plans get in exchange for the advisory fees they pay.

Investment advisers may provide great value to pension plans, but that value may be hard to differentiate from others seeking to do the same now that advisers’ strategies are restricted to only being in a clients’ best interest every time they provide advice. Forcing advisers to manage pension plan assets with an inherently short-term focus prevents advisers from looking ahead and making decisions that right now may not be in a plan’s absolute best interest, but may be in the plan’s best interest in the long run. A short-term focus necessarily yields only short-term results and could leave significant long-term potential value unrealized.

Further, a shift to a fiduciary standard may make pension plan investment advisers’ value addition more difficult by reducing the options pension plan investors have to choose from when investing. Requiring all investment advice to a pension plan to be given as a fiduciary will likely restrict advising strategies and force managers to be more alike than they otherwise would want to be relative to their peers. This limitation and homogeneity among advisers will consequently reduce pension plan portfolios’ diversification opportunities.

When investing, investors like pension plans strive to create a diverse portfolio, with some investments in that portfolio exposed to greater levels of risk (and inherently, greater return) than others. Risk is derived from all sorts of factors, one of which includes what an investment adviser managing an investment may do in the course of managing it; some investments are safer than others, and investors are generally amenable to having at least some risk in their portfolios. Forcing a pension plan’s entire slate of assets managed by investment advisers to be managed at a fiduciary standard may cut down on some of the risk a plan’s investments may be exposed to, but it also caps what return those investments can realize over their timelines and restricts the diversity of a portfolio altogether. The suitability standard, the standard being replaced by the DOL’s rule, allowed more flexibility to advisers and gave pension plans a better opportunity to diversify their portfolios. Now that this diversification potential is going away, investing pension plans and investment advisers will need to scramble to find new ways to diversity plans to reach their goals.

Fundamentally, the DOL’s rule seems to create more problems for pension plan investors and investment advisers alike, and ignores the current state of the industry’s regulatory landscape. When one considers how highly regulated investment advising already is by entities like the SEC, as well as by federal and state laws and a number of other regulatory bodies, it become readily apparent that investors’ investments are under constant surveillance. In addition to major regulatory considerations, many managers already make a fiduciary strategy available to investors, so a plan has the option to request its investment be managed at a heightened standard if that suits its portfolio strategy. Investment advising is a dynamic industry with many customizable features in place at investors’ disposal, yet the DOL seems to believe this is not enough as evidenced by the new standard it is implementing.

Pension plan investment advisers presently still have some managerial flexibility under the present suitability standard, offering significant upsides to interested pension plan investors. But now, forcing advisers to all adhere to a fiduciary standard any time they manage a pension plan’s investment will completely undermine these upsides and very likely could stunt investment creativity and with it, the full amount of returns an investing pension plan can realize. The DOL’s rule kills a main driver in pension plan portfolio diversification, at a time when investment advisers had already created options that are now requirements under the rule. Simply, the rule does not add the value it claims to in the pension plan investment industry.

Restricting investment advisers’ investment opportunities could have wider-reaching impact on U.S. capital markets as well. If investment advisers cannot operate in their full range of desired investment opportunities, especially with the large pension plan accounts, U.S. capital markets’ liquidity presently derived in part from the investments advisers make or advise on may dry up. Less liquid or illiquid markets make investing in these markets more difficult, and in many cases, less attractive; mandating a fiduciary standard for major investable assets makes this market threat a very real possibility with wide-reaching negative impacts.

At its core, the DOL’s rule fails to bring at least the same value relative to the problems it creates, and it has the potential to negatively impact pension plan investors in a big way. The fees the White House and DOL claim will be reduced by this new standard are still going to exist; now, though, advisers may actually be restricted from offering as much value as they do currently in exchange for these fees because their investment advice will be restricted by the fiduciary standard. With pension plan investment advisers held to a fiduciary standard rather than a suitability standard, strategy differentiation and the portfolio diversification this offers pension plans will be much more difficult to achieve. Further, the investment adviser standard shift will have market impacts beyond just what advice advisers can offer pensions, especially with respect to market liquidity. While the rule is here to stay, the DOL needs to take a good look at what it has caused, and the SEC should take heed in its impending rule proposal as well. Implementing rules with this little apparent foresight that encourage shortsightedness is bad policy, and creating more rules like this has the potential to cause substantial damage to the investment industry as a whole.

Author’s Note: I consulted frequently with my dad, David Young, while writing this post. David has over 30 years of experience in the financial services industry. Dad, thank you for all your help. 

Zack Young is a third year JD/MBA candidate at Wake Forest University. He has undergraduate degrees in Political Science and Philosophy from Marquette University. Zack’s goal is to practice as an investment management attorney upon graduation.