One of the most disputed policy initiatives of the Obama administration was the Department of Labor’s fiduciary rule, which subjects brokers and other financial professionals managing retirement accounts to a fiduciary duty to avoid conflicts and act in the best interest of investors. Functionally, the rule mandates a drastic change to how brokers are compensated. The rule has been enormously controversial, garnering thousands of comments, subjected to days of hearings, and spawning hundreds of pages of news articles and commentaries. The Trump administration has halted enforcement of the rule for 18 months to review its effects, and its future remains uncertain, though further action by the DOL and SEC is likely. Despite its importance, the fiduciary rule has received relatively little academic attention. In a new paper, The Fiduciary Rule Controversy and the Future of Investment Advice, I argue that the rule, while well-intended, risks leaving some investors worse off.
The fiduciary rule addresses a real problem: A substantial academic literature suggests that broker-sold mutual funds perform worse than other funds, creating a drag on investors’ retirement accounts. Because brokers are compensated via sales commissions, which vary across funds, brokers are motivated to push low-quality, high-cost investments so long as the investments also carry high commissions. Absent a fiduciary duty to their clients, brokers are free to recommend funds that are not unsuitable, given the investors’ risk profile.
The rule treats brokers and other professionals who advise investors in IRA and 401(k) plans as fiduciaries. The most important effect of the rule is to restrict the receipt of commission compensation by brokers managing retirement accounts. This is a dramatic intervention into current revenue models for many financial advisers. To address concerns that this change could be too disruptive, the fiduciary rule was proposed alongside the Best Interest Contract (BIC) exemption, which permits brokers to receive commissions, provided they satisfy a number of substantive requirements and contractually agree to act in their clients’ best interest.
Will the fiduciary rule leave investors better off? The answer is less clear than one might think. The academic literature provides damning evidence of the deleterious effects of conflicted, commission-based advice. But, from a policy perspective, that’s not the whole story. The academic literature compares the performance of mutual funds sold through conflicted and unconflicted channels without observing the costs of the conflicted and unconflicted advice that lead to investors holding those funds. What matters to consumers is not just the performance of their mutual funds, but their net returns, after accounting for the total cost of investing, including whatever professional advice they require. Conflicted advice may lead to inferior investment choices, but it may also be cheaper. Sound policy needs to be based on netting out both effects.
Simple calculations, calibrated using numbers from the DOL’s Regulatory Impact Analysis for the rule, show that the all-in cost of conflicted advice—including the associated underperformance—is only modestly higher than the typical cost of unconflicted advice from financial advisors already subject to a fiduciary duty. The total cost of conflicted advice—including the associated underperformance—and fiduciary advice, which typically comes at a higher price, are nearly the same. Shifting investors toward fee-based fiduciary financial advice may well increase total costs for some of them, even if they end up with better portfolios. More importantly, the calculations show that, if conflicts of interest could be managed and the underperformance eliminated, commission compensation may be cheaper on an all-in basis for many investors.
This puts pressure on the BIC exemption, which is specifically aimed at reducing conflicts of interest while permitting commission-based advice. If successful, this could save investors a considerable amount of money, but the fiduciary rule otherwise carries a substantial risk of increasing costs. Indeed, the Regulatory Impact Analysis for the rule effectively assumes that it will work through the BIC exemption by holding the direct costs of advice constant while eliminating the impact of conflicts of interest on returns. The success of the fiduciary rule is therefore critically dependent on the efficacy of the BIC exemption.
Unfortunately, the BIC exemption has two design flaws that may limit its success. First, the BIC exemption conflates two separate concepts from the academic literature: the collective underperformance of broker-sold funds relative to other funds and the underperformance of high-commission funds relative to low-commission funds. The DOL has encouraged firms to equalize sales load—the commissions paid to brokers—across funds to reduce conflicts of interest, but funds with equalized loads are still load funds, which collectively underperform. As a result, the BIC exemption might not eliminate underperformance. Second, the BIC exemption effectively creates a private right of action for fiduciary breaches in commission-based IRA accounts using the BIC exemption, but not in IRA accounts that charge a flat management fee. Whatever the costs or benefits of a private right of action for fiduciary breaches in general, attaching such a right to commission-based compensation, but not fee-based compensation, creates a strong disincentive to use the former. This is a problem, because the entire premise of the BIC exemption is that consumers may benefit from commission compensation if the conflicts of interest can be managed.
In principle, these flaws are fixable. The SEC could act to give brokers flexibility in attaching uniform sales commissions to no-load funds, truly leveling the playing field. The DOL has a number of policy levers to address the discontinuity in liability created by the BIC exemption. Such adjustments could make the fiduciary rule more effective. But policymakers would do well to focus on the demand side of the retirement advice problem. Professional advice is expensive, and policy changes that reduce the need for that advice by streamlining retirement savings promise more dramatic savings for investors than do policies that attempt to tweak how that advice is paid for.
This post comes to us from Professor Quinn Curtis at the University of Virginia School of Law. It is based on his recent article, “The Fiduciary Rule Controversy and the Future of Investment Advice,” available here.