The Fiduciary Rule: Mistaken Beliefs (#3)
This is my 78th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.
The fiduciary regulation has been in effect since June of last year — a period of over six months. As you might expect, we are seeing mistakes and misunderstandings about activities that can result in fiduciary status for advisors. This article covers one of those.
The myth for this Angles is that broker-dealers and RIAs, and their advisors, must only recommend the lowest cost investments, for example, mutual funds with the lowest expense ratios. That is not correct.
In fact, the DOL has explained that:
“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” [81 Fed. Reg. 21002, at page 21030 (April 8, 2016)]
As indicated in that quote, and as explained elsewhere by the Department of Labor and several courts, an advisor’s fiduciary responsibility is to recommend investments with reasonable expenses . . . or, in a more specific context, to recommend mutual funds with expense ratios within the range of reasonableness for the particular plan and the type of fund.
For advisors with broker-dealers, the expense ratio of mutual funds typically includes a cost component and a compensation component (that is, compensation for the advisor). Assume, for example, that the expense ratio of a mutual fund is 100 basis points and that it includes a 12b-1 fee of 25 basis points. Viewed in terms of cost and compensation, the true cost of the mutual fund is 75 basis points and the cost of the advisor’s compensation is 25 basis points. In order to perform a proper analysis of cost of the investment, that distinction must be made.
Once the “true cost” is determined, that should be used as the expense ratio of the mutual fund for purpose of the fiduciary analysis of whether the cost of the investment is reasonable. (Note that, the reasonableness of the cost of an investment is a fiduciary issue measured by the best interest standard of care; however, the reasonableness of the compensation of the firm and the advisor is a prohibited transaction issue.)
A second step in the fiduciary analysis of cost is the determination of whether or not the appropriate share class is being recommended (including, for example, whether waivers are available). Generally speaking, the lowest cost available share class should be recommended. However, keep in mind that I am referring to the lowest “net cost” share class. In other words, the advisor’s compensation (for example, the 12b-1 fee) should be deducted to determine the true cost and then should be compared to the net cost of the other share classes of the same mutual fund.
Once an investment’s cost has been appropriately determined, and the appropriate share class has been determined, that information should be compared to similar data for other mutual funds in the same investment category. Again, though, the requirement is not that the lowest-cost investment be recommended. Instead, it is that the cost be reasonable relative to the value provided. On a practical level, that means that there is a range of reasonableness for a given type of investment. The risk is in recommending an investment that is clearly more expensive than what is typically charged for that type of investment.
Since a broker-dealer, RIA and advisor are fiduciaries for this purpose, the process used for the selection of investments and the determination of the reasonableness of cost should produce documentation that can be retained and retrieved. In other words, firms and advisors should be in a position to prove that they engaged in a prudent process.
The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.
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