Should Advisors Ditch Their Broker-Dealers In Light Of DoL Fiduciary?

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone! Welcome to Office Hours with Michael Kitces!

For our topic today... I want to talk about the Department of Labor's fiduciary rule, specifically as it relates working under a broker-dealer.

I'm here at the airport, traveling to the FPA Dallas Fort Worth chapter for their big annual symposium event, which is going on today and tomorrow. And I was actually speaking this morning for a large broker-dealer event, as they're trying to get a better understanding of the prospective future of the broker-dealer model, what it will mean to work under a broker-dealer platform in the future, and more generally how we are going to structure our advisory businesses in the future.

In fact, this is one of the most common questions I'm getting these days, around all the Department of Labor fiduciary discussion:

"If commissions are going away with the DoL fiduciary rules, and I'm with a broker-dealer so I can earn commissions, then is it time for me to ditch my broker-dealer?"

I want to tackle this question head-on.

DoL Fiduciary Doesn't Actually Ban Commissions

First, I think we have to frame what the DoL fiduciary rule actually says.

In recent years, new fiduciary rules have been implemented in several other countries around the world. The UK implemented reforms called "RDR" and banned investment commissions. Australia did it as well, with what was called their Future of Financial Advice (FOFA) Reforms, and also banned commissions. But the Department of Labor rule does not actually ban commissions.

The new DoL rule does apply new scrutiny to commissions. It says if you want to still earn commissions, you have to sign a Best Interests Contract (BIC) with your clients that acknowledges you're a fiduciary. In addition, you have to adhere to what are called impartial conduct standards, which means you must give advice in the best interests of the client, for reasonable compensation, in a manner that doesn't mislead them about what they're buying and what you're being compensated for.

But commissions will actually still be permitted under the new rules, and that's an important thing to understand. The size of front-end commissions might come down a little. I think you'll see slightly smaller upfront commissions and a little bit more in trails. But commissions are not banned. Again though, if you want to earn commissions, you'll have to go through this whole best-interest contract structure.

And following the Best Interests Contract requirements isn't only about the advisor. The DoL also created new requirements for the broker-dealer. They have to create their own policies and procedures to substantiate that advisors will be giving best-interest advice, and that they haven't created an environment that's going to cause conflicted advice that leads to conflicted outcomes that are not in the best interest of the client. Broker-dealers, or really any financial institution that goes through this, will also have a lot of new disclosure requirements that they have to deal with.

Simplified Broker-Dealer Compliance As A Level Fee Fiduciary

So broker-dealers are at their own crossroads about how to handle the new DoL rules. Part of the decision-making challenge for broker-dealers is there's an expedited version of this best-interest contract rule, and it's called the "level fee fiduciary" alternative.

In order to qualify for this, as the name implies, you have to get only level fees, which basically means AUM fees or flat fees like a retainer fee or an hourly fee; some fee that does not go up or down based on where you steer the client. The whole point of this is that if you could recommend from higher compensation, high-commission products or lower compensation, lower-commission products, that's a conflict of interest that requires additional scrutiny and oversight (or in some cases may be banned altogether if there's also discretion). But if everything you do gives you the same level compensation, and the choice of whether they invest in A or B or C doesn't change your compensation, that's a level fee environment.

Notably, it doesn't appear it's even necessary to be solely clients paying the fees, as long as the total compensation is level. So this could even be level fees because you use C-share mutual funds for everything, and they all pay the same 1% 12b-1 fee. Technically it's a commission from the company. But if it's level across all the investments that you offer your clients, this is still a valid way to navigate the best-interest standard as a level fee fiduciary.

Now even as a level fee fiduciary, you still have to acknowledge you're a fiduciary. You still have to follow the impartial conduct standards that you're going to give best-interest advice for reasonable compensation and done in a manner that is not misleading. But for those who operate under level fee fiduciary standard, all the policies and procedures requirements that financial institutions have to create to oversee this advice process aren't applicable, which is a huge compliance relief.

In essence, the presumption is that if you're going to give conflicted advice, you need policies and procedures to manage it. If you just give level fee advice, the conflicts of interest are mitigated enough by the fact that you don't have as many conflicts of interest when compensation is level, that any institution that wants to follow this will have much easier compliance obligations, reduced policies and procedures rules, and reduced disclosure requirements.

The reason why that's significant is, from the broker-dealer perspective, it means broker-dealers are at a crossroads about what they want to be in the future. And I think what you're going to see in the coming year are three different types of broker-dealer environments that will emerge out of this DoL fiduciary rule.

The Level Fee Fiduciary Broker-Dealer Without Upfront Commissions

The first type of broker-dealer in the future will be the "level fee fiduciary broker-dealer". The level fee fiduciary broker-dealer is, frankly, a really big change from the traditional broker-dealer model, because in order to qualify for level fee, not only does the client have to pay level across all the options, but the financial institution has to earn level compensation across all the options. So back-end overrides wouldn't be allowed. Revenue sharing wouldn't be allowed. Shelf space agreements would be problematic. Broker-dealers will be under significant pressure to completely restructure their business models to facilitate this.

I suspect the way you'll see it play out is that broker-dealers will create what I call the sandbox of investment options for their advisors. They'll say "All right, advisors. Here's a whole bunch of choices you can select from the sandbox. All of these have level compensation across them. As long as you choose anything in this little sandbox of choices, you're okay. You're a level fee fiduciary, and we're a level fee broker-dealer because we've designed the sandbox to all be level fee compensation. Off you go on your merry way."

The caveat to this environment is that you'll only be able to use the stuff in the sandbox. Actually, let's call it the toolbox. You'll only be able to use the tools in the toolbox, and nothing else. In turn, one of the ways that level fee fiduciary broker-dealers will probably differentiate in the future is the depth of their toolbox, how many choices they give you in that level fee toolbox that you can use.

The Full-BIC Broker-Dealer That Pays Commissions

The second kind of DoL broker-dealers will be the ones that go with the full Best Interest Contract (BIC) Exemption.

The good news is that they'll have a broader suite of products. They might include some proprietary products. They'll offer products that pay at least some commissions; again, probably not huge upfront commissions, but they can have at least some commission products.

So these "full-BIC" broker-dealers will have a wider range of products, including some that pay commissions. But now they have additional conflicts of interest that are introduced. So they'll have to go through the full best-interest contract exemption, which basically means more compliance policies and procedures for the firm, and the broker is going to feel the broker-dealer parent company overseeing them more, trying to enforce these policies and procedures, to make sure that the advice is not conflicted advice.

And that will be the trade-off. The full best-interest contract broker-dealers will include commissions and proprietary products, but as the broker, you'll feel more compliance oversight pressure coming down on you about how you're using that wider range of products, and how you're implementing them for clients.

The After-Tax Only Broker-Dealer Can Avoid DoL Fiduciary Altogether!

The third type of broker-dealer I think you'll see in the future is what I call the "after-tax-only broker-dealer", or the "non-qualified-only broker-dealer".

Because the reality is the Department of Labor fiduciary rules only apply to retirement accounts and retirement investors. Which means one way that a broker-dealer can manage the DoL fiduciary rules is to just commit to not touch retirement dollars, and then they're not subject to the DoL fiduciary rules at all.

That means their brokers cannot give advice on retirement rollovers, nor anything relating to retirement accounts. They would have to just work with after-tax brokerage accounts, non-qualified dollars. So you can sell non-traded REITs. You can offer non-qualified variable or equity-indexed annuities. You can do all these products, even with substantial commissions, and face no DoL scrutiny at all... as long as you only sell into non-qualified (i.e., taxable) accounts and don't touch retirement accounts.

Do You Need To Change Broker-Dealers Now?

So getting back to our question of:

"Do I need to change broker-dealers, or ditch my current broker-dealer, given DoL Fiduciary rules coming in 2017?"

First of all, you're going have to wait and see what your broker-dealer decides it wants to be in the future, and how they choose to handle this DoL rule transition? Are they going to be a level fee fiduciary broker-dealer? Are they going to be a full best-interest contract broker-dealer? Are they gonna be a non-qualified-only broker dealer?

Notably, it's the broker-dealer that gets to choose, because technically the best-interest contract will be signed between the client and the financial institution. So it's the broker-dealer's backside on the line, and that means they're the ones who choose whether they want to comply with being level fee fiduciary B/Ds, full best-interest contract B/Ds, or non-qualified-only B/Ds.

And broker-dealers basically have six months to decide their path. It's actually 11 months before the rules take effect in April of 2017. But realistically, broker-dealers are going to have to decide by the end of the year, because when they go through all of their annual updates with their brokers, discuss potential changes to the grid, and all the other things that broker-dealers do to adjust compensation every year, they'll need to communicate their DoL fiduciary path, and the related compliance obligations that will be rolling out in 2017.

Will You Be A Level-Fee Fiduciary Or Still Receive Commissions?

I think you're going to start hearing a lot about this split as we get into the fall, and broker-dealers begin to declare which type they're going to be.

Now, from your perspective as an advisor who works under a broker-dealer, whether you want to stay or not is going to be driven by first which of these the broker-dealer chooses, and then second what you want the future of your business to be.

If you want to operate in the level fee environment, and say, "I'm just going to run my whole business model on AUM fees and retainers," that's great. But if you want to focus on being a level fee fiduciary, you probably won't want to be at a full best-interest contract broker-dealer, because it's going to feel like a lot of compliance oversight for things that don't actually apply to you because you're just doing level fees.

If, on the other hand, you want a wider range of products that can still pay commissions, or at least whatever's left of commissions, you will want a full best-interest contract broker-dealer. If your broker-dealer goes level fee fiduciary-only, you're not going to want to be there. You'll need to switch to a broker-dealer that actually does full best-interest contract, and allows you to still earn commissions.

And of course, if you want to be a holistic advisor, and your broker-dealer says, "We're just gonna do non-qualified-only and avoid the DOL," then you probably won't want to be there at all. Realistically, I suspect that any broker-dealer making a decision to go non-qualified-only is basically putting a line in the sand, saying, "We're not actually about advice. We're just about product sales." I don't know how you give advice if you're going to exclude everything that has to do with retirement accounts. But if you just want to be an intermediary that facilitates sales, you can go sell products at that broker-dealer for commissions, but only for consumers who buy with non-qualified after-tax dollars only.

Don't Make Any Broker-Dealer Changes... Yet?

So if you're an advisor thinking about whether to make a broker-dealer change, frankly, it's too soon to make a shift right now. I would not be going out and dropping your broker-dealer now.

But the decision for you, that you need to be thinking about over the next six months, is how you want your advisory firm in the future to operate. Will you be level fee fiduciary, or pursue a broader range of commission-based products, recognizing that if you choose the commission angle, you are going to face more compliance oversight, and that will be part of the trade-off in your business. In addition, you might even see lower payouts and higher costs from full-BIC commission-paying broker-dealer platforms, because it will be more expensive for them to comply with the full best-interest contract.

So you have to decide over the next six months what you want your business to be in the future. Then as we get into the end of the year, you should start to see clarity from your broker-dealer about how they're going to re-tool for the final DoL fiduciary rule, and you can decide then whether you want to be a level-fee fiduciary or not, and whether your current broker-dealer makes sense. Or if you decide on level-fee fiduciary, whether any broker-dealer make sense, or if you should just transition to being an RIA.

Conversely, if you still want to do commissions, you'll need to make sure you're at a full-BIC broker-dealer. And then you can start asking questions: "What's the compliance going look like? What are the suite of commission-paying products going to be? How is this going to impact my life as a broker on your platform?"

And if your broker-dealer decides it will be non-qualified only, you'll have to decide if you want to stay at all. Though again, I think if you're really an advisor, it means you'll have to leave and find a broker-dealer that at least facilitate the full range of advice on all types of accounts, or you're really just a product salesperson.

So that's the looming DoL fiduciary decision if you're at a broker-dealer. It will start with what do you want your business to be in the future, and then looking to your broker-dealer towards the end of the year to see what they declare they will be, and seeing if there is alignment. Does their vision of the future fit your vision of the future? If so, great. You may stay put. If their vision of the future is different than yours because they want to be full best-interest contract and you want to be a level fee fiduciary, or vice versa, then you've got a mismatch, and you may be looking at changing broker-dealers. Or, again, if you want to be a level fee fiduciary, even re-evaluating if you want to be a level fee fiduciary at a broker-dealer at all, or just be a level fee fiduciary at an RIA instead?

I hope that helps a little to think about the landscape and making decisions about broker-dealer affiliations with DoL fiduciary. The short answer is "Don't jump ship yet." Regardless of which side you're on, it probably doesn't make sense to jump ship yet. But be figuring out what you want your business to be in the future, because the decision is coming in a couple of months, where you're going have to evaluate whether you actually want to stay at your broker-dealer, given whatever it chooses.

Thanks for hanging out with Office Hours with Michael Kitces. We were a little late this week due to my travel, but we try at least for 1:00 PM East Coast Time every Tuesday. So stay tuned next week, and have a great day, everyone! Take care.

So what do you think? Are you considering whether to change broker-dealers in light of the DoL fiduciary rule? What are your concerns in thinking about the "right" broker-dealer for your firm in the future? Please share your thoughts, or ask further questions, in the comments below!