The DOL Fiduciary Rule - Using Income Discovery s Analytical Tools to Help Demonstrate Procedural Prudence

Transcription

1 The DOL Fiduciary Rule - Using Income Discovery s Analytical Tools to Help Demonstrate Procedural Prudence May 4, 2016

2 Overview of the New Fiduciary Rule Is Covered Investment Advice Being Provided? On April 6, 2016, the Department of Labor published final Conflict of Interest regulations with the goal of eliminating potential conflicts of interest between investment advisors and the clients they serve. The rule defines who is a fiduciary investment advisor, while two accompanying exemptions contain additional steps certain broker-dealers and insurance agents can take in order to continue to receive common forms of compensation if they become fiduciaries under the new rule. The final Fiduciary Rule describes the kinds of communications that are considered to be Investment Advice covered by the rule, with the core question being whether an investment recommendation has been made to the recipient of the communication for a fee or other compensation. The recipient of the recommendation may be a retirement plan, plan participant, beneficiary, an IRA or an IRA owner. The reach of the term recommendation is very broad, and includes recommendations regarding buying; holding; selling assets from retirement accounts or IRAs; how the funds should be managed; and recommendations with respect to rollovers, transfers and distributions from plans and IRAs. The final rule also includes a number of categories of communications that would not rise to the level of a recommendation and, as a result, would not constitute a fiduciary investment advice communication. See the regulations for more information. In summary, the definition and scope of coverage of fiduciary advice is broad, covering most types of advice sessions advisors have with investors. The Fiduciary Standard of Care Briefly summarized, the prohibited transaction rules in ERISA and the Internal Revenue Code protect plan participants by imposing trust law standards of care and undivided loyalty on fiduciaries. Advisors are expected to provide prudent advice that is in the customer s best interest, avoid misleading statements, and receive no more than reasonable compensation. As a result of the rule, many advisors and entities will find that, as fiduciaries, they are now subject to the prohibited transaction restrictions of ERISA and the Internal Revenue Code. Without an exemption, becoming a fiduciary sales@

3 would prohibit many of the compensation arrangements currently used by institutions and advisors. Two exemptions were created to address potential conflict-of-interestrelated transactions which would otherwise be prohibited: 2. The Best Interest Contract Exemption The Best Interest Contract Exemption ( BICE ) provides an exemption from the prohibited transaction provisions by requiring institutions, brokerdealers and advisors to acknowledge their fiduciary status and adhere to new Impartial Conduct Standards. Among the requirements, the institution and advisor must: Give advice that is in the Retirement Investor s Best Interest, described as prudent advice that is based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to financial or other interests of the Advisor, Financial Institution, or their Affiliates, Related Entities or other parties ; Charge no more than reasonable compensation; and Make no misleading statements about investment transactions, compensation, and conflicts of interest Additional requirements include implementing policies prudently designed to prevent violations of the Impartial Conduct Standards; refraining from the use of incentives for advisors to act contrary to the customer s best interest; and fairly disclosing fees, compensation and material conflicts of interest are contained in the BICE exemption. Prohibited Transaction Exemption (PTE) PTE as amended, preserves the availability of an exemption for the receipt of commissions by insurance agents, insurance brokers and pension consultants, in connection with the recommendation that plans or IRAs purchase insurance contracts and certain types of annuity contracts defined in the exemption as Fixed Rate Annuity Contracts and insurance. The revised PTE provides a streamlined exemption for relatively straightforward guaranteed lifetime income products (e.g. immediate and deferred income annuities), while transferring coverage of variable annuity contracts, indexed annuity contracts, and similar annuity contracts, to the Best Interest Contract Exemption. As amended, the exemption requires fiduciaries engaging in these transactions to adhere to certain Impartial Conduct Standards, including acting in the best interest of the plans and IRAs when providing advice. sales@

4 3. Getting to the Heart of the Rules and Exemptions The consistent theme occurring throughout the preamble and rules contained in the Conflict of Interest regulation and accompanying exemptions is that advisors making advice recommendations must take a principles-based approach when dealing in matters involving their clients retirement savings. Well established principles of prudence, loyalty, care, due diligence (commonly found in trust law) require the advisor to put the best interest of the client first when it comes to making important investment and retirement income planning decisions. Practices and procedures should be maintained to ensure all material facts, alternatives and options are considered before recommendations are made to the client. The term procedural prudence can be used to describe actions that should be taken to provide the level of skill and care required of the fiduciary. One challenge facing advisors seeking to exercise diligence and prudence in evaluating investment strategies for their clients is finding product-agnostic tools that can be used to generate and compare client-specific retirement income planning scenarios, e.g., comparing the purchase of annuity against not doing so. Further, client-specific variables such as life expectancy assumptions, risk profile, earnings, retirement income and legacy preferences add to the complexity of the analysis. Advisors who incorporate tools capable of analyzing multiple scenarios and generic product combinations should be in a better position to demonstrate procedural prudence by showing that appropriate consideration is being given to a wide range of retirement income planning scenarios and product combinations. Use Income Discovery to Demonstrate Recommendations are in the Client's Best Interest This section delves into specific situations to highlight how Income Discovery can help the advisor demonstrate compliance with the new requirements. Whether advice is provided to an investor under a level fee fiduciary arrangement or is subject to more expansive Best Interest Contract Exemption rules recently enacted, Income Discovery helps institutions and their advisors exercise care and demonstrate diligence and compliance to impartial conduct standards by providing side-by-side illustrations and alternatives using different combinations of resources, product types, and withdrawal strategies. Leading up to, and during retirement, investors face many puzzling decisions related to sequencing cash flow to meet expenses in retirement. sales@

5 Consider: Implications of different Social Security election strategies on portfolio longevity, survivor benefits for a spouse, and taxes paid over time Purchase of annuities by type and the timing of annuitization into one s lifestream of income or the invocation of a lifetime rider to retain control of the assets and obtain longevity protection Tax-type account to use for an annuity purchase Impact of income taxes on different withdrawal strategies Ordering of withdrawals and asset sales by asset type and tax wrapper qualified retirement plan, IRA, non-qualified, annuity, Roth, etc. In a paper in the Journal of Financial Planning 1, Income Discovery s founder proposed an analysis framework consisting of multiple risk-reward metrics to compare various retirement income strategies and using computing power to find an optimum strategy. The framework was further enhanced based on behavioral finance research the rationale is described in an article 2. Using the framework metrics, a sample side-by-side comparison for a case analysis using Income Discovery s tools is provided below to illustrate how the recommendation will improve a client s outcome in retirement, and is in the client s best interest. 4. Plan: Client Desired Plan: Max Confidence Shortfall 471/1000 Shortfall 148/1000 Unfunded $590,261 cumulative over 15 years Avg. Legacy Income Strategies $58,556 Lisa & Peter Social Security Age claimed Unfunded $160,843 cumulative over 15 years Avg. Legacy Income Strategies Social Security Age claimed $285,280 Peter Lisa Conservative Inflation Protected Conservative Inflation Protected Annuity Additionally, Income Discovery is designed to find a better combination of annuities, investments, and Social Security claiming strategy for the client s unique situation. It is primarily built to support pre-retirees and retirees, but the analytical engine can also be used for people many years away from retirement. 1 Journal of Financial Planning paper link: 2 Behavioral Finance improved analysis framework article link: sales@

6 5. Annuities Annuity sales in a retirement plan, irrespective of whether initiated by insurance agents, Broker-Dealer representatives or investment advisor representatives, are covered under the new rule. Income Discovery can help advisors meet their obligation to provide impartial judgment, care and diligence by illustrating how one or more annuities can help improve the outcome for clients in retirement. The client can be shown alternative plans containing no annuities, followed by illustrations comparing different combinations of annuities to demonstrate how adding annuities to the retirement income plan changes various risk-reward metrics for retirement. Variable, Indexed and Similar Annuities New Purchases If a fiduciary collects variable compensation from the sale of variable or indexed annuities, then the new Best Interest Contract Exemption rules ( BICE ) impose a new set of disclosures and standards. Income Discovery s client report can demonstrate how variable and indexed annuities can be used to address specific retirement income needs and objectives, based on the client s time horizon, risk tolerance and stated preferences. Each type of annuity can be analyzed in combination with other resources (Social Security, nonqualified accounts, IRAs, qualified plan assets) in order to help identify the most suitable type of annuity and method of annuitizing (amount and timing) that will meet the client s needs. Fixed Rate Annuities New Purchases Though BICE doesn t apply to fixed rate annuities described in Prohibited Transaction Exemption as recently amended, the exemption requires fiduciaries engaging in these transactions to adhere to certain Impartial Conduct Standards including acting in the best interest of the plans and IRAs when providing advice. Income Discovery can help fiduciaries meet the requirement to act in the best interest of the investor by demonstrating how these types of annuities can be aligned with other resources to meet the cash flow requirements and retirement income objectives of the client and provide better outcome, as measured by various risk-reward metrics. Combination of Annuities Moreover, although Income Discovery can be used to demonstrate an income strategy using one type of annuity product versus the other, a common practice among product manufacturers and distributors, such analysis ignores the fact that a combination of annuities may be better for the client. The optimization process of Income Discovery will evaluate all sales@

7 possible combinations, within the user-given constraint of maximum annuity purchase, of annuities to find the optimal mix. 6. It is not choosing between fixed, variable, and indexed, but rather finding the best combination for each client. Timing of Annuitization for Existing Annuities Purchase Account for Annuities Investment Accounts Consider an investor who has saved into an annuity product in a retirement plan and who, at retirement, is exploring the right time to annuitize the balance into a lifestream of income, or to invoke the lifetime rider. Although it is not clear at the early stage of interpretation of the rule whether such are fiduciary recommendations, Income Discovery is fully prepared to support justification for such recommendations too. In the advanced mode of Income Discovery, the advisor can explore the purchase of the recommended annuity in a taxable account or a retirement plan and demonstrate which option will provide a better outcome in retirement, considering taxes, required minimum distributions and other personal factors. It is important to recognize that such recommendations are not research based on a hypothetical retiree, but have to be based on the unique tax situation, asset mix, preferences for varying expenses in retirement and Social Security claiming strategy for the client. That is precisely what Income Discovery s toolset helps accomplish! Many recommendations in retirement accounts - e.g., rollover into IRA from an ERISA plan, or move from commission to fee-based account, or proprietary product sales require adherence to the new Best Interest Contract Exemption rules. Income Discovery can produce a comparison report of alternatives in each situation illustrating (e.g., how managed account services in IRA can improve the outcome in retirement compared to unmanaged investments in an ERISA plan.) Withdrawal Order Further guidance from the DOL will help determine whether the recommendation on the order of withdrawal from retirement plans and taxable accounts during retirement is a fiduciary recommendation. Financial institutions can provide such a justification using Income Discovery s toolset and thus be prepared for compliance. sales@

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