Fiduciary Rule Blog Posts

Found 14 relevant result(s)

Mitigating Conflicts of Interest - Part 4

Mitigating Conflicts Through Technology

The SEC’s proposed Regulation Best Interest seeks to impose a duty on brokers to mitigate certain conflicts of interest. This series of articles will explore the various ways firms can effectively mitigate or eliminate conflicts of interest.

Part 1 – Introduction

Part 2 – Level fee

Part 3 – This Mistake Cost Merrill $9 Million

Last week, the SEC adopted Regulation Best Interest (“Reg BI”) which established a new standard of conduct for broker-dealers in retail relationships as well as other interpretive guidance related to the standard of conduct required of investment advisers under the Advisers Act.

The proponents of Reg BI appear to outweigh its detractors because the regulation is workable for b/d’s and doesn’t necessitate the type of wholesale business changes that a regulation like this could have, or as the advisory community thinks it should have, or that the now vacated DoL fiduciary rule would have. The regulation does put mandates on firms to put in place processes and procedures to comply with Reg BI, specifically to identify and mitigate conflicts of interest.

Much of the heavy lifting around Reg BI compliance will be accomplished through technology but most of what I’ve heard regarding technology has been centered around record-keeping to support disclosure or surveillance to identify conflicts. However, the real power of this technology is not to identify conflicts of interest or mitigate them. The power of the technology is its ability to eliminate conflicts of interest, and with that comes a beautiful degree of freedom and power; let me explain.

For some time, the use of technology has been relied upon in the ERISA space to eliminate conflicts of interest in the form of a computer (don’t call me a robo) model. A computer model that uses generally accepted investment theory to make impartial recommendations, without human intervention as to the final result, has been found to eliminate conflicts of interest and protect the fiduciary advisor and plan from a prohibited transaction.

SunAmerica Advisory Opinion -  In 2001, the DoL issued its SunAmerica advisory opinion which stated a fiduciary advisor can use a computer model developed by an independent financial expert to implement model asset allocation portfolios (offered on both a discretionary and non-discretionary basis), and that increased compensation to the fiduciary that resulted from the model asset allocation portfolio would not be a prohibited transaction under ERISA §406(b)(1) or (3). The reasoning and crucial take away is that if the model is recommending the asset allocation portfolios and is developed by an independent financial expert, the fiduciary would not be using any of the authority, control, or responsibility which makes that person a fiduciary to cause the plan to pay additional fees to fiduciary. The key was the relationship between the fiduciary advisor and the developer of the model (independent financial expert). There were many parameters outlined in the opinion that led to an inference of independence as between the fiduciary and expert. Some of these factors include the control and discretion of expert, lack of any affiliation between fiduciary advisor and expert, financial arrangements between the fiduciary advisor and expert, and proportion of expert’s revenue derived from fiduciary advisor. 

The Pension Protection Act, ERISA §408(g) and IRC 4975(f)(8) – The Pension Protection Act gave rise to a new prohibited transaction exemption in the spirit of SunAmerica, which leaned on the existence of a computer model to eliminate conflicts of interest. In almost identical regulations, ERISA §408(g) and IRC §4975(f)(8) allow  the developer and fiduciary to be affiliated or even the same entity, but require the model to be certified by an independent financial expert. This exemption allows the fiduciary advisor to recommend through the computer model proprietary products and products that pay the fiduciary advisor a commission.

So why am I talking so much about ERISA prohibited transactions when Reg BI has nothing to do with ERISA? It’s because an arrangement that passes muster under ERISA’s strict fiduciary prohibitions will most certainly pass muster under Reg BI. And by the way, a new fiduciary rule from the DoL is coming down the pike and while nobody expects it to be as disruptive as its predecessor, it could give brokers a reason to want to take on the fiduciary role. Technology that eliminates conflicts of interest means brokers can take on the fiduciary role with the plan and keep their indirect compensation with no prohibited transaction.

Firms should look to leverage technology to execute their investment process in a repeatable, documented, reliable, un-conflicted manner.  Doing so will allow brokers to service clients unfettered, at the highest standard of care, and with current compensation structures intact.



Cory Clark is Chief Marketing Officer at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices. Cory is also a practicing attorney licensed in Massachusetts. He resides near Boston with his wife and 3 children.

These articles are provided for general information only, and do not constitute legal advice, and cannot be used or substituted for legal advice.

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This Mistake Cost Merrill $9 Million: Mitigating Conflicts of Interest (Part 3)

The SEC’s proposed Regulation Best Interest seeks to impose a duty on brokers to mitigate certain conflicts of interest. This series of articles will explore the various ways firms can effectively mitigate or eliminate conflicts of interest.

Part 1 – Introduction

Part 2 – Level fee

Mitigating Conflicts of Interest – Part 3: Controlling Conflict-Inciting Information 

On August 20th the SEC imposed sanctions on Merrill Lynch related to its handling of a conflict of interest, which cost the firm nearly $9M. Apparently it could have cost much more because this was an offer submitted by Merrill, which was accepted by the SEC.  I thought this might be a good opportunity to step out of the abstract discussion of conflicts and look at a real world scenario that played out over 5 years ago.  In a somewhat overly simplistic summary, it went a little something like this.

Merrill had a Due Diligence Committee responsible for recommending to the Governance Committee what managers and products would be part of a particular set of platforms. The Committee recommended terminating a manager on the platform who was a Merrill subsidiary (“Subsidiary”) and who also had a strong business relationship with BoA.  Subsidiary learned of the upcoming termination prematurely and a “plan of action” was put in place involving members of both Subsidiary and Merrill. This led to a string of events, with the crescendo being an email by an Officer of Subsidiary to a Merrill employee responsible for writing up the Governance Committee meeting agenda which read:

“It was recently communicated to us that the proposal to terminate will not be part of tomorrow’s Governance Committee agenda and [the U.S. Subsidiary] will be afforded an extension of time to further and fully demonstrate our commitment and capabilities in the SMA space…. As it stands now, this news is so new that it may be filtering through your organization, down to the key players in Due Diligence [and other areas, including the product group] but I wanted to inform you directly.”

The Subsidiary’s termination decision was put on hold and Subsidiary ultimately remained on the platform. 

This scenario is not hard to imagine and none of the actors behaved in a way that shocks the conscious (although the email was a little shady). In conversations with Merrill, Subsidiary executives expressed their appreciation for the due diligence team’s autonomy and presented legitimate concerns about the fairness of the termination. For example the due diligence committee often conducted on-site due diligence reviews before terminating a manager, but did not do so in this instance.  The main thrust of Subsidiary’s plea to have the termination put on hold was the fact that such an on-site review was not conducted. And while hindsight is 20/20, it’s interesting to note that the Subsidiary’s new management team did in fact perform well over the relevant period, in fact better than the would-be replacement. As innocent as these actions may have seemed, if not for the outside influence that was exerted on the Due Diligence and Governance Committee, the manager would have been terminated. The Committee did not prove to have the autonomy that was described in Merrill’s ADV and on which investors relied.

The SEC sanctioned Merrill for violating the anti-fraud provision of the Advisor’s Act as well as failing to implement policies and procedures reasonably designed to prevent violations of the Act. But where did Merrill go wrong, what policies and procedures did it fail to implement and what can we learn from this?  To answer this question we need to identify the point in time within these events where policies and procedures could have made the most difference. I would suggest that the only time that a policy could prevent this conflict with reasonable certainty is at the very beginning, BEFORE Subsidiary had any reason to adopt a “plan of action.”

Our cognitive biases as humans can make ethical decision-making very difficult because we identify and analyze facts in a self-serving manner to rationalize why a particular action is allowed or justified. In a competitive corporate environment, these physiological factors make it extremely difficult for a firm’s policies and procedures to stop these human behaviors. In this case, once the horse was out of the barn, reeling her back in was next to impossible. The only way to keep the horse in the barn was by preventing the horse from knowing it should leave the barn. Subsidiary should never have known it was on the chopping block.

In this case, the horse was let out of the barn when an operational employee from Merrill contacted the soon-to-be terminated Subsidiary to get started on all the legwork that would have to be performed to actually remove Subsidiary from the platform.  Usually, a Merrill employee would notify the third party manager after the termination decision had been made by the Governance Committee. However, as the SEC keenly pointed out, no written policy or procedure governed this process.

Had the operational employee at Merrill either not possessed the information about Subsidiary’s termination or had he been trained on a policy to keep such information strictly confidential, Subsidiary would have had no reason to act in a conflicting manner until it was too late to do anything about the termination. The Committee would have acted with the autonomy that it represented to its investors in its ADV and that was required to avoid a conflict of interest. I’d be willing to bet that Merrill at this very moment has extensive policies and procedures governing the confidentiality of Due Diligence Committee recommendations, particularly with respect to the managers who have been recommended for termination.

When designing your policies and procedures, first think about the types of information that could trigger interested parties to act in a manner that conflicts with client interests. Seek to limit the number of people who have access to such information to only those who need to know. Once you have effectively limited the number of people with such information, policies and procedures must put a gag order on such information (both internally and externally) until the passing of a certain event. Had this firewall of information been in place, Merrill would be $9 million richer and I would be writing this article about something else.


                Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds his Juris Doctor from New England Law |Boston where he graduated Cum Laude and holds a Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.

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Mitigating Conflicts of Interest - Part 2

In Part 1 of this series on mitigating conflicts of interest, I discussed the SEC’s proposed Regulation Best Interest and the potential significance of the mitigation requirements for financial incentives.  The mitigation requirement would appear to be one area where broker/dealers and their reps could be responsible for some significant changes.

When tackling conflicts of interest, it’s helpful to look to a place where disclosure has never been a sufficient remedy; employer-sponsored retirement plans. ERISA is perhaps the strictest regulatory regime related to financial services and under ERISA, an advisor’s conflict of interest is always a prohibited transaction (subject numerous potential exemptions).  Even those not familiar with ERISA parlance can surmise that a prohibited transaction is bad news. However, there are two well established methods of avoiding prohibited transactions in ERISA that serve as a good starting point to neutralizing conflicts of interest in the broker community. Those two methods are (1) fee leveling and (2) the use of a computer model. Fee leveling is the subject of this Part 2 article. Subsequent parts to this series will discuss the use of computer models and other financial technology as a means for elimination and mitigation of conflicts.  

Fee leveling is not the same as fee-only and does not require a shift to a wholly new business model; it simply implies an offsetting arrangement to avoid variable compensation. The distinction between fee leveling and fee-only is an important one.  First, shifting to a model where fees are deducted directly from the client’s account could be disruptive to some client relationships.  Second, shifting to a truly fee based compensation structure and no longer relying on commissions, markups, and markdowns would constitute “special compensation,” in which case the broker may magically morph into an investment adviser with respect to that client.

Regulators have been consistent that when compensation cannot be increased by the advisor, there is no conflict of interest. The Department of Labor stated in a landmark advisory opinion known as the Frost Letter that when fees are passed through to the investor, the advisor is not being benefited. Congress would later codify the concept of level fee in the Pension Protection Act when it created a new level fee exemption for advisors under ERISA §408(g). The SEC specifically mentioned the option of an offsetting arrangement in its Regulation Best Interest proposal.

Fee leveling does more than mitigate conflicts of interest, it eliminates them. Firms should explore the possibility of eliminating some conflicts altogether because in some cases it may be the only appropriate action. The SEC noted that the nature of the conflict, its inherent lack of transparency involved, and the level of sophistication of a particular investor are all factors which may lead to a determination that disclosure and mitigation are insufficient. In these cases, elimination will be the firm’s only viable option. Nonetheless, fee leveling will often be over and above what is required to mitigate a financial incentive, but serves as a preemptive strike against the continuous cost of procedures designed to police lingering incentives. It may pay long term to simply cut the head off the snake and eliminate financial incentive completely through fee leveling or other methods.


     Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds a law degree from New England Law |Boston where he graduated Cum Laude and earned his Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.

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Mitigating Conflicts of Interest – Part 1

In the wake of the Fiduciary Rule’s slow and painful extinction, a new regulatory initiative has emerged front and center, albeit with much less angst and trepidation attached. The SEC's proposed Regulation Best Interest; what one might consider the Commission’s bite at the “fiduciary rule” apple, was released for public comment last spring. The initial reaction to Regulation Best Interest for many was “nothing to see here.” It was difficult to discern how this regulation materially differed from existing regulations and it certainly had far less bite than its Department of Labor predecessor. What Regulation Best Interest does do is mark an apparent shift on the part of the SEC from a scheme of disclosure to a scheme of mitigation and this philosophical change should not be taken lightly.

Regulation Best Interest carves out a distinction between conflicts of interest generally and those arising from financial incentives (it’s safe to say that we care most about the financial incentives). It then imposes a duty on the broker/dealer to identify, disclose, and mitigate the financial incentives. This represents a significant change for brokers who previously relied on disclosure to properly receive compensation that amounts to financial incentives. Adopting policies and procedures to mitigate financial incentives will certainly prove to be more vexing, involve many more moving parts, and cost much more money than putting words on a page. The good news is that at the very same time, changes in the industry are giving B/D firms and their reps more viable options for mitigating conflicts.

 These series of articles will explore various questions emanating from the proposed Regulation Best Interest with a focus on the policies and procedures that are available to properly mitigate financial incentives. The next two articles will look at two prominent methods for conflict mitigation used today: fee levelizing and computer models.

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The 5th Circuit decision to vacate the DoL Fiduciary Rule (“Rule”) creates a dilemma for the Robo Advice arrangements that depend on the relief granted by that Rule.

Rolling back the Rule means that regulations revert to the 1975 rules[1]. Applying 1975 rules make virtually all Robo advisors to IRAs and defined contribution plans into fiduciaries, without the benefit of an exemption (since the Best Interest Contract Exemption also goes away).

It would appear that institutions that have created/acquired Robos will be unable to use these automated solutions for IRAs or DC Plans, without some additional exemption being created for them.

Presumably, the roll back would include the “no enforcement policy[2]”. Without that policy, Robos may not be permitted to operate.

Financial institutions and advisors must therefore make changes necessary to qualify for an existing exemption or seek a private exemption.

[1] In 1975, the Department issued a regulation, at 29 CFR 2510.3-21(c), defining the circumstances under which a person is treated as providing “investment advice” to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA (the “1975 regulation”), and the Department of the Treasury issued a virtually identical regulation under the Code.[15The regulation narrowed the scope of the statutory definition of fiduciary investment advice by creating a five-part test that must be satisfied before a person can be treated as rendering investment advice for a fee. Under the regulation, for advice to constitute “investment advice,” an adviser who is not a fiduciary under another provision of the statute must—(1) render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property (2) on a regular basis (3) pursuant to a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary that (4) the advice will serve as a primary basis for investment decisions with respect to plan assets, and that (5) the advice will be individualized based on the particular needs of the plan or IRA. The regulation provides that an adviser is a fiduciary with respect to any particular instance of advice only if he or she meets each and every element of the five-part test with respect to the particular advice recipient or plan at issue.

[2] FAB 2017-01…during the phased implementation period ending on January 1, 2018, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions, or treat those fiduciaries as being in violation of the fiduciary duty rule and exemptions.

On March 28, 2017, the Treasury Department and the IRS issued IRS Announcement 2017-4 stating that the IRS will not apply § 4975 (which provides excise taxes relating to prohibited transactions) and related reporting obligations with respect to any transaction or agreement to which the Labor Department’s temporary enforcement policy described in FAB 2017-01, or other subsequent related enforcement guidance, would apply. The Treasury Department and the IRS have confirmed that, for purposes of applying IRS Announcement 2017-4, this FAB 2017-02 constitutes “other subsequent related enforcement guidance.”

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Confused By the Clarity
The State of the Fiduciary Rule

It is certainly clear that the DoL Fiduciary Rule (“Rule”) will materially change the investment business over the next ten years but what is unclear to me is what those changes will be. As I read and hear definitive statements about what will and will not happen, I fail to understand how so many informed people could possibly be so confident about so many things.

This article is about the state of affairs and why I am so confused by the clarity others have expressed.

There are four major centers of influence that will define the final Rule.

There is the current administration that will dictate what administrative actions or inactions will be taken by the DoL, SEC, IRS, Department of Justice, etc. But the composition of these areas of current administration could change as other administration areas have.

In 2020 the entire administration could change. A likely delay of the Rule’s implementation for more years could herald another administration that could either be much more supportive or much less supportive of the Rule.

The courts have supported the Rule thus far but there is the very real possibility that higher courts could strike down the Best Interest Contract Exemption (“BICE”) contained in the Rule.

A least likely influence is that the Congress will find common ground to halt or modify the Rule.

Despite all these centers of influence in play, there are certain aspects of the Rule that are already in place and “Cast in Stone” so that changing them is almost out of the question. There are other aspects that are simply “Unknowable” at this point since the relevant centers of influence have not weighed in on them. There are also aspects of the Rule that are not yet in effect but are “Likely to be Implemented”. Then there are those that are “Unlikely to Remain” as part of a final Rule.

The most important aspects of the Rule have been put into these categories to help explain my confusion, and maybe yours.

Cast in Stone

The aspects of the Rule that have already been implemented are by far the most difficult to change or to reverse. These include the aspects that were implemented on or before June 9th, 2017:

  • The Definition of the Term “Fiduciary”; Conflict of Interest Rule-Retirement Investment Advice. This revised definition specifies who is a fiduciary, what Fiduciary Acts (See Appendix) are and what constitutes a breach (Conflicts of Interest1).

    The activities that are now “Cast in Stone” as Fiduciary Acts as of June 9th 2017 are summarized in the following table:

    Checklist of Ten Types of Recommendations Defined as Fiduciary Acts
    1The advisability of acquiring, holding, disposing of, or exchanging securities or other investment property
    2Investment policies or strategies
    3Portfolio composition
    4Selection of other persons to provide investment advice
    5Investment management services
    6Selection of investment account arrangements (e.g., brokerage versus advisory)
    7Other management of securities or investment property
    8Whether, in what amount and in what form rollovers, transfers, or distributions from a plan or IRA should be made
    9To what destination should a rollover, transfer, or distribution from the plan or IRA be made
    10How securities or other investment property should be invested after being rolled over, transferred, or distributed from the plan or IRA

    The most far reaching impact of the June 9th Fiduciary Acts are probably the effects on rollovers. As it stands today, a rollover is required to be in a client’s best interest but meeting such a standard is not a familiar process and BICE provides guidance only for level fee arrangements. It is therefore necessary to create a process to show that a client’s best interests are served by the rollover. This may be challenging when the cost of the rollover alternative is substantially higher than the cost of not rolling over.
  • Once defined as a Fiduciary Act, standards must be maintained that comport with the universally accepted Prudent Expert Rule2.
  • Furthermore, retirement regulations prohibit all conflicts of interests unless the prohibition is waived by an exemption, for which specific conditions must be met.
  • Laws and regulations that remain unchanged such as statutory exemptions defined in the Pension Protection Act of 2006 (408g exemption). These exemptions have the full force and power of being derived through the constitutional process of making laws.


A number of material questions have been raised but not yet answered about the survivability of the Best Interest Contract Exemption. These aspects are generally the consequences of the regulatory process, actions taken and promises made. By describing the answers to these questions as “Unknowable” it also means that there is a reasonable likelihood for those answers to either favor or oppose the BICE:

  • What aspects of the Rule will the courts ultimately uphold and which will be struck down?
  • What enforcement will be in place when the No Enforcement Policy3for various aspects of the Rule eventually expires?
  • What the consequences will be of failing to meet the “Working Diligently” requirement of the No Enforcement Policy?
  • Will plaintiffs and courts recognize the No Enforcement policy or will private action be based on regulations already passed and thereby limiting the usefulness of this policy?
  • Will the SEC make changes based on the Dodd-Frank Act4, and will they augment, replace or contradict the DoL Fiduciary Rule?
  • How will arbitration panels act until all exemptions are fully implemented?
  • What are the final exemptions and what conditions will be required for each?
  • Who will be in charge of the DoL Fiduciary Rule at the EBSA (department previously headed by the architect of the Rule, Phyllis Borzi)?

Likely to be Implemented

Certain aspects of the Rule are likely since they are favored by the current administration. They are likely only if the Rule is fully implemented during the tenure of this administration as it is composed today. If not fully implemented, changes in department heads can reverse the likelihood:

  • The No Enforcement Policy of selected provisions, subject to “Working Diligently” to comply with the best interest requirement, reasonable compensation and misleading statement aspects of the existing Rule
  • Some form of additional exemptions that waives prohibitions to conflicts of interest
  • Compensation through existing arrangements, subject to conditions that are yet to be defined
  • Other alternatives to BICE that are better aligned with certain business models

Unlikely to Remain

Elimination or changes to the following aspects of BICE have been promised or implied by the current administration. Full implementation of final exemptions must take place under the current administration for these to be eliminated or changed:

  • Right to class action for all retirement investors
  • Required warrantees and supporting procedures
  • Disclosure requirements as defined in the current version of BICE
  • Limitations on compensation for pre-existing and future business
  • Written contract requirement


Faced with these uncertainties, what would a prudent expert do? I don’t know, but here is what I advise:

  • Stop trying to find the right answer… no one knows

The best answer is:

  • Limit expenditures to aspects that are “Cast in Stone”
  • Hedge against the “Unknowable” aspects with contingency plans
  • Assess progress with aspects that are “Likely to be Implemented” and make any improvements that represent minimal disruption and cost
  • Stop all spending on aspects that are “Unlikely to Remain”
  • Pay attention to all aspects and keep them all in focus, not just those that are in the latest headline, tweet or study.

Frequently Asked Questions

This report puts a wide range of issues into perspective and raises a number of questions. This section is intended to give more depth to several of these issues and answer questions that may have been raised.

What aspects of the Rule were “Set in Stone” on June 9th, 2017?

  • In its announcement on April 4th, 2017 of a 60-day extension of the applicability dates of the fiduciary rule and related exemptions, the DoL noted regarding the revised June 9th date…

    “The fiduciary definition in the Fiduciary Rule published on April 8, 2016, and impartial conduct standards in these exemptions, are applicable on June 9, while compliance with the remaining conditions in these exemptions, such as requirements to make specific written disclosures and representations of fiduciary compliance in communications with investors, is not required until Jan. 1, 2018.”

    “Under the terms of the extension, advisers to retirement investors will be treated as fiduciaries and have an obligation to give advice that adheres to “impartial conduct standards” beginning on June 9 rather than on April 10, 2017, as originally scheduled. These fiduciary standards require advisers to adhere to a best interest standard when making investment recommendations, charge no more than reasonable compensation for their services and refrain from making misleading statements”.


What does “Working Diligently” actually entail?

  • In its Field assistance Bulletin No. 2017-02 (“FAB 2017-02”) the DoL announced its No Enforcement Policy and that “fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions” would be granted relief.

    The April 4th announcement made reference to what was expected during the “transition period”. Fiduciaries need to “adhere only to the impartial conduct standards (including the best interest standard), as conditions of the exemptions during the transition period”

    There is no further guidance as to what must be done or shown to establish that the promised relief would be granted. This makes relief uncertain, considering that the DoL has also announced that the referenced exemptions are subject to change and new exemptions could be added.

    A reasonable response of FAB 2017-02 would be to assess and then assume the most likely conclusion. Any evidence of work done to comply with the current version of BICE should be well documented in the event that relief is withheld at a future date.

What will happen to the BICE changes that have already been developed?

  • Changes fall into one or more of four broad categories that have different dispositions.

    • Improve Business: Improvements may include lower costs, automation, marketing advantage and intangibles.
    • Commitments Made: Reversing public statements and promises made to clients could have serious negative effects. Efforts need to be made to minimize any potential harm.
    • High Cost of Reverting: New practices and systems that have already been implemented may involve high risk, disruption and expenditure to undo. It is possible to seek efficiencies that reduce the burdens without reverting to the previous practices and systems.
    • High Cost of Continuing: In cases where significant future costs or risks are anticipated, the decision to abort is clear, given the enormous instability that has evolved.

    Separating changes into these four categories can lead to a clear course of action.

What aspects of the Rule are covered by the No Enforcement Policy?

  • In its FAB 2017-03, the DoL promises relief for violation of BICE, Principal Transaction Exemption or limitations on the use of Arbitration.

    “…the Department of Labor will not pursue a claim against any fiduciary based on failure to satisfy the BIC Exemption or the Principal Transactions Exemption, or treat any fiduciary as being in violation of either of these exemptions, if the sole failure of the fiduciary to comply with either the BIC Exemption or the Principal Transactions Exemption, is a failure to comply with the Arbitration Limitation in Section II(f)(2) and/or Section II(g)(5) of the exemptions.”


Why is further delay likely?

  • As long as supporters and opponents of the Rule see a reasonable path to achieving their conflicting goals, it will be difficult to avoid further delays. The precedent having been set, both supporters and opponents will demand a postponement of any aspect with which they disagree. Denial of a delay at this point would produce an outcry that would force the delay.

What forms of compensation are affected by the Rule?

  • Any compensation that is paid by, reduces the retirement investor holdings or influence the advice that is given is covered by the Rule. This includes all fees, expenses, commissions, salaries, incentives and non-cash compensation received by the person who performs a Fiduciary Act.

What court cases are pending that can materially change the future of the Rule?

  • The National Association for Fixed Annuities vs. DOL and Secretary Thomas Perez: The DoL rule’s definition of reasonable compensation is too vague, and the inclusion of fixed-indexed annuities in the BICE is “arbitrary and capricious” and “contrary to law.”

    U.S. Chamber of Commerce vs. DOL and Secretary Thomas Perez: The DoL has “improperly exceeded” its authority by creating this rule, is in violation of ERISA and other rules, and that it has “unlawfully created a private right of action.”

    The American Council of Life Insurers/National Association of Insurance and Financial Advisors vs. DOL and Secretary Thomas Perez: The DoL rule “unlawfully and arbitrarily imposes fiduciary duties on commercial sales relationships and communications that are not fiduciary in nature.”

    Indexed Annuity Leadership Council vs. DOL and Secretary Thomas Perez: The fiduciary rule and the BICE are “arbitrary and capricious” and exceed the DoL’s statutory authority.

    Market Synergy Group vs. DOL and Secretary Thomas Perez and Assistant Secretary Phyllis Borzi: The DoL rule inflicts “severe and irreparable harm” and its actions “violate applicable law and procedure.”

    Thrivent Financial for Lutherans vs. Acosta: The DoL exceeded its statutory authority by attempting, with its new fiduciary rule, to force all disputes into federal court rather than allowing for alternative dispute resolution methods.

What is the greatest effect that BICE will have on the industry?

  • If BICE survives, it will transform the way pricing is done. The combination of fiduciary risk, best interest requirement, compensation limitations and the burden of disclosures will eventually outweigh the convenience of bundling advisor compensation with other associated products and services.

    Advisors will demand a dizzying array of prices to fit each situation encountered. What is even more complex are the changes that follow as clients naturally begin to act like consumers and demand discounts and price reductions. All this will make it impractical for product and service providers to manage. Distributors will be forced to step in and manage the pricing.

    Distributor control of pricing will ultimately change the way business is conducted and transform the relationship of manufacturers and distributors as distributors create higher markups and lower core product pricing.

Will there ever be strong enforcement of BICE?

  • Very likely. The new definition gives a concrete basis to prosecute so regulators expect to see increased enforcement from private sources. Courts and arbitration panels will render judgement on losses where a fiduciary breach can be shown.

    This form of enforcement can be expected to remain dormant until there is a major market correction.

How do you explain what is going on to a client?

  • The government seeks to oversee the advisor/client relationship and there is a struggle going on between the pro-government and free market factions.

    Pro-government factions seek to have legal contracts, identical methods, controlled compensation, warrantees, and extensive public disclosures.

    The free market factions seek to rely on the self-interest of clients and advisors to maintain a fair and orderly process.


Fiduciaries and Fiduciary Acts

The definition that went into full effect on June 9th, 2017 revised ERISA 3(21):

  1. Such person provides to a plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner the following types of advice for a fee or other compensation, direct or indirect:
    1. A recommendation as to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, or a recommendation as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
    2. A recommendation as to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., brokerage versus advisory); or recommendations with respect to rollovers, transfers, or distributions from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer, or distribution should be made;

1 According to the Department of Labor, “Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers’ interests and often create strong incentives to steer customers into particular investment products.

2 Fiduciaries must act in the interests of clients with the care, skill, prudence and diligence under the prevailing circumstances that a prudent expert acting in a like capacity and familiar with such matters would act.

3 On May 2nd, 2017 the DoL issued Field assistance Bulletin No. 2017-02 which in essences states that, “…during the phased implementation period ending on January 1, 2018, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions, or treat those fiduciaries as being in violation of the fiduciary duty rule and exemptions.” The DoL goes on to say “This Bulletin is an expression of EBSA’s temporary enforcement policy; and it does not address the rights or obligations of other parties.” Revisions that extend this policy to July 1st, 2019 are being considered.

4 Section 913 of the Dodd Frank Act empowers the SEC to make new rules to harmonize advisor regulations.

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Fiduciary Rule: Enforcement by No Enforcement

If you thought the Fiduciary Rule was mind boggling, the latest DoL policy directive takes contradictions to new levels.

First, the facts.

The DoL has confirmed that the Fiduciary Rule will take effect on June 9th, 2017 (“Transition Period”). But the enforcement of the Rule (See FAB 2017-02) and several of the exemptions will not be applicable until after a review ordered by President Trump. This final portion of the rule is scheduled for January 1st, 2018 and is likely to be changed from what is on the books today.

The promise of no enforcement does come with strings attached and offers only limited protection until the final portion of the Rule becomes applicable.

The first “string” is that new business must comply with three of the provisions of the BIC exemptions. All new business must meet the standard of being in the client’s best interest, compensation must not be above a reasonable level and there can be no material misleading statements. While it is not necessary to prove compliance, doing nothing is an enormous risk.

The second “string” is that compensation from existing accounts must not be above a reasonable level. It is necessary to test if the compensation from existing accounts is reasonable.

The third “string” is that advisors and firms must be able to show that they are working diligently and in good faith to comply with the new Rule. It becomes essential to show progress or readiness during the Transition Period.

The protections offered by the DoL no-enforcement policy extends to the IRS but does not address the rights or obligations of other parties. Other parties include other regulators and clients who have the right to sue if they should lose money and find non-compliance!

Now, what it means.

Starting on June 9th, firms and advisors will be at risk for doing nothing. Action is required to move in the direction of compliance with the new Rule.

It is also far from certain what the new rule will be. Compliance must be based on the current version of the Rule and adaptations made if the Rule changes. While it is unlikely that the June 9th regulations will change materially, it is very likely that the delayed portions will be revised.

The January 1st date is also subject to change, so the Transition Period could go on for an extended period, increasing the odds of a market crash or other events that lead to lawsuits.

And finally, how to avoid trouble.

The looming question is what actions make the most sense for firms to take leading up to June 9th and immediately thereafter. The following list of actions are prudent because they demonstrate working diligently, are low cost and least likely to be changed as well as offer the best protection from threats outside the DoL and IRS:

  • Get trained on fiduciary practices that apply to the business that are designated as“fiduciary” by the June 9th applicability. A certification will show that that work was done and the threat of litigation is minimized by learning what prudent fiduciary practices are.
  • Develop new templates that permit advisors to accurately discover what client’s best interests are
  • Write procedures that adapt the business to fiduciary practices
  • Begin the process of changing practices to meet the fiduciary standard.
  • Test the reasonableness of compensation for existing clients and make the necessary changes that justify the compensation.
  • Notify clients of changes that affect them.
  • Consider using an exemption other than those outlined in the Fiduciary Rule. Alternatives include using a certified computer model (“408(g)”), a fee leveling arrangement (“408(g)”)under the Pension Protection Act or a non-conflicted business model.

These actions should be examined and those that are feasible should be adopted as soon as possible.

Test your knowledge of the June 9th rules… take the free test here!

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Bark Without Bite

The recent turmoil about the DoL Fiduciary Rule is unlikely to change anything in the short term. Long term changes will require a Herculean effort! In fact, additional exemptions are more likely than revisions of the current rule. There are four obstacles to changing the applicability date of April 10 or making other amendments before that time:

  • The Administrative Procedure Act (“APA”) requires a 90 day notice and comment period before the Trump Administration can make such changes… unless a major flaw is discovered in the regulation.
  • Three of the most conservative courts have considered every conceivable flaw and found none…. very unlikely that some new flaw will be discovered that was not uncovered in any of the lawsuits filed to date.
  • Another court (probably an appellate court) could delay the applicability date… very unlikely to occur before April 10, even with the support of the White House.
  • Congress could act to waive the 90 day requirement of the APA… but this would unleash a political firestorm and Democrats would certainly obstruct such a Bill until after April 10.

These obstacles lead to the inevitable conclusion that the April 10 applicability date is not changing.

What to do?

If plans to comply are underway, the smart course is to continue and show that there was a best effort made should the deadline be missed. If there has been no demonstrable progress to date, the reasonable course is to start immediately with the exemption that is the fastest to implement. For most circumstances this is using a level fee arrangement under the Best Interest Contract Exemption or conduct a 408(g) Audit established by the Pension Protection Act.

The greatest and most time sensitive exposure for those who adopt the Best Interest Contract Exemption are any existing clients who may be paying excessive fees. This is a liability because excessive fees disqualifies these clients from the protection of the Pre-existing Account exemption (Grandfathering). As a result, a prohibited transaction is created by simply failing to act.

Advisors must therefore act to develop evidence that demonstrates compliance with Grandfathering requirements. This involves a process of defining the services, costs and other factors to explain the level of compensation. Clients that pay excessive compensation must be dealt with immediately.

For more information on compensation requirements visit Compliance Compensation at

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The 21st century has seen an escalation in the focus on retirement adviser compensation coming from a plethora of lawsuits, new laws from Congress, Regulatory action and even the President promising to cut $17 billion from adviser’s pay.

This unprecedented activity has led many to conclude that compensation will be cut. The basis for all this activity is the firm belief that advisers are excessively compensated for the work they do. Such a belief may have been fueled by the high profile case of Bernie Madoff. 

While it is entirely possible that unreasonable and excessive compensation exists, it is unreasonable to expect that such excesses are widespread.

Unfortunately the hunt for unreasonable compensation is being fueled by advisers and advisory firms that fail to see the threat to their own existence. Instead many carry out this destructive behavior by lowering their own compensation in an imprudent effort to avoid possible penalties.

This paper is intended to inform and to limit the damage to advisers who perform at a high level for reasonable compensation.

Supporting this initiative to limit the damage to good advisers, is the unanimous 2010 Supreme Court decision that stipulates that reasonable compensation must be based on factors of value described in the Gartenberg Standard.

The Gartenberg Standard incorporates the varied relationships and arrangements that exist between advisers and clients,developed from decades of understanding client needs and situations and molded into a framework of regulation and enforcement.

The Court warned about the use of benchmarks to compare advisers, limiting such tools to “arm’s length benchmarks” that include only those arrangements derived from arm’s length bargaining. The Court ordered that even “arm’s length benchmarks” were unnecessary and only ancillary to the other Gartenberg factors.

BICE II(c)(2) The recommended transaction will not cause the Financial Institution, Adviser or their Affiliates or Related Entities to receive, directly or indirectly, compensation for their services that is in excess of reasonable compensation within the meaning of ERISA section 408(b)(2) and Code section 4975(d)(2).
ERISA 408(g)(1)(b)(3) (B) Any investment advice takes into account investment management and other fees and expenses attendant to the recommended investments;

ERISA 408(b)(2)(c)(1) (i) General. No contract or arrangement for services between a covered plan and a covered service provider, nor any extension or renewal, is reasonable within the meaning of section 408(b)(2) of the Act and paragraph (a)(2) of this section unless the requirements of this paragraph (c)(1) are satisfied.


The 21st century ushered in a witch hunt to find and punish advisers who take unfair advantage of consumers by charging unreasonable compensation. After three decades of largely failed efforts at pursuing fees charged by institutions, attention has turned to advisers.

There has been a history of success in reducing adviser compensation in the late 20th century. Of particular note are:

  • Deregulation of brokerage commissions 
  • The demise of contractual plans by requiring refunding of commission advances 
  • Cutting sales charges from 8.5% to 5% by the action of the self regulatory organization 
  • Reduction in retirement plan charges by the competitive onslaught of mutual funds 
  • Introduction of expense criteria in investment policy statements

Advisers are today faced with threats to retirement business from four directions:

  • Litigation from Retirement Investors 
  • Limitations of the Best Interest Contract Exemption (“BICE”)
  • Reasonableness requirements of the Pension Protection Act Exemption 408(g)
  • Fee Disclosure Regulation (ERISA 408(b)(2)

All of these seek to eradicate unreasonable fees, but it is the Supreme Court that provided the guidance of what a reasonable fee should be. It is up to the investment adviser community to adopt an appropriate standard of reasonableness that complies with this guidance.

Determining what is and is not reasonable for clients whose wealth ranges a thousand fold in a mosaic of relationships, services, products and compensation systems is complex. As the Court affirmed, simple comparisons of what others charge “are problematic because [they] may not be the product of negotiations conducted at arm's length”.

Assessment of reasonableness involves consideration of a host of factors that may be relevant to one situation but immaterial in another.

Answering these threats requires a course of action that recognizes and enhances the value that advisers provide so as to limit the exposure to massive compensation cuts.

2010 -JONES ET AL. v . HARRIS ASSOCIATES L. P. (a) A consensus has developed regarding the standard Gartenberg set forth over 25 years ago: The standard has been adopted by other federal courts, and the Securities and Exchange Commission’s regulations have recognized, and formalized, Gartenberglike factors.

The Guidance on Excessive Fees

In 2010 the US Supreme Court affirmed (Jones1) the historical standard for determining when investment related fees and expenses are excessive. The Court also added further guidance for lower courts to apply in judging whether compensation is excessive.

The affirmed standard are the Gartenberg Factors that require compensation be examined from multiple perspectives before a finding of excessiveness can be made, including at a minimum:

  • Services and Quality

    The nature, extent, and quality of the services to be provided by the investment adviser;

  • Adviser Performance

    the investment performance of the investment and the investment adviser;

  • Costs and Profits

    the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates;

  • Economies of Scale

    the extent to which economies of scale would be realized as the investment grows and other circumstances increase efficiency;

  • Benefit to Investor

    whether fee levels reflect these economies of scale for the benefit of investors.

2010 -JONES ET AL. v . HARRIS ASSOCIATES L. P. “The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain. If it does not, equity will set it aside.” Gartenberg’s approach fully incorporates this understanding, insisting that all relevant circumstances be taken into account and using the range of fees that might result from arm’s-length bargaining as the benchmark for reviewing challenged fees

Conclusions of the Court

In its decision, the Supreme Court pointed out that in order to be excessive:

  • “…an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining."

The Court also warned against placing too much emphasis on a comparison of one advisory fee against fees charged to others by other advisers (Statistical benchmarks). The Supreme Court wrote:

  • "These comparisons are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm's length.”
  • and
  • “Gartenberg uses the range of fees that might result from arm’s length bargaining as the benchmark for reviewing challenged fees.”

Arm's Length
adj. the description of an agreement made by two parties freely and independently of each other, and without some special relationship, such as being a relative, having another deal on the side or one party having complete control of the other. It becomes important to determine if an agreement was freely entered into to show that the price, requirements, and other conditions were fair and real. Example: if a man sells property to his son the value set may not be the true value since it may not have been an "arm's length" transaction

DoL FAB 2007-01 With regard to the prudent selection of service providers generally, the Department has indicated that a fiduciary should engage in an objective process that is designed to elicit information necessary to assess the provider’s qualifications, quality of services offered and reasonableness of fees charged for the service.

Arm’s Length Benchmarks

The Supreme Court discouraged the use of benchmarks, ascribing only marginal usefulness to “arm’s length benchmarks” that excluded many adviser arrangements in the market today. This lay to waste benchmarks that contain arrangements between parties who:

  • Are family members
  • Are employer/employee
  • Have other material business relationship(s)
  • Have controlling influence (Superior/subordinate)
  • Have a significant knowledge advantage of the market
  • Engage in bartering in which goods or services are exchanged
  • Are referred in a quid pro quo arrangement
  • Use temporary low pricing to capture market share

These exclusions make the collection and calculation of “arm’s length benchmarks” difficult, expensive and unreliable.

The process is made difficult by the need to identify only those arrangements that are arm’s length. The existence of these exclusions may only be known to the parties involved.

The process is expensive due to the slow manual process required to select the arrangements that qualify as “arm’s length”. The results are likely to be unreliable for the reliance on a manual process and the relatively small sample that can be obtained by this means.

A further consideration is that “arm’s length benchmarks” can only be applied to arm’s length arrangements.

Why Regulators Pass the Buck

In considering regulation regarding fees, regulators have had to avoid being reversed in court, and in particular by the Jones and Gartenberg precedents. Regulations have therefore stayed away from defining what compensation is reasonable and therefore not excessive

While the DoL and IRS have both expressed support for considering compensation in all vendor selection, they have generally been silent on what specific methods would be acceptable.

Endorsing benchmark comparisons would also contradict the Supreme Court decision that limits the use to “arm’s length benchmarks”.

Product Dependency

Unlike products that are generally cut from the same mold, advisers have evolved to meet a non-homogenous mix of client needs, preferences, fears and desires. Compensation for advisers based on products that are in the client’s best interest will invariably yield over-compensation in some cases and under-compensation in others.

The imbedded compensation received from product manufacturers presents a further challenge to regulators seeking to curb excessive compensation.

The first issue is jurisdictional.

A dually registered adviser may be paid by an investment manager and insurance company for products held in a combination of taxable accounts, IRAs and ERISA plans. In this case the adviser may come under the Jurisdiction of the SEC, Finra and one or more insurance commissioners. The IRA business is in the jurisdiction of the IRS and ERISA is the responsibility of the Department of Labor.
So who will be holding the adviser accountable?

The second issue is complexity.

The payment of this compensation can take very intricate routes. Starting with the client the funds may come first to a broker/dealer, a bank for certain activities, an insurance agency or a payroll provider for payroll deductions. It may then flow to a number of product providers who distribute the funds as directed, including back to the broker/dealer.
Imagine trying to follow the money!

The third issue is conflicting laws.

This entangled system is further knotted up by the growing number of laws that sometimes contradict each other. The list of these are so long it would be impractical to attempt to list them here, but consider just the categories of State and Federal laws covering securities, insurance, taxes, money movements and consumer protection.
And excessive compensation could potentially violate any of them
The Gartenberg Standard cuts across these jurisdictions, complexities and laws to provide a rational way to assess reasonableness.

Why Rely on Gartenberg

Specifics of the case is fairly narrow but the principles of the Court’s decision have wide application.
These principles can be summarized as follows:

  • The reasonableness of Adviser’s compensation cannot be determined by a single measure but require at least the five considerations embodied in the Gartenberg Standard in addition to other relevant facts.
  • The compensation received by other advisers under similar circumstances may have no bearing on the reasonableness of another for several reasons, but in particular transactions are often not “arm’s length” and involve other relationships and services.

These principles guide regulators and courts and are applicable to individual clients as well as institutions and large investment pools.

The Gartenberg Standard also addresses the variation in the portfolio mix that an adviser’s client owns. Examining each adviser recognizes the difference in time and skill required to serve very simple portfolios (say indexed mutual funds) from portfolios that are more complex (with insurance products, alternative investments, etc.) as well as every possible combination. With Gartenberg, advisers with complex client portfolios are not penalized for the time it takes to serve them.

Employing these principles provides advisers with the greatest protection since they are based on a Supreme Court decision. In the event of a charge of excessive or unreasonable compensation the adviser can answer the plaintiff or regulator with a value argument. The value provided by the adviser is represented in the Gartenberg Standard which can often be demonstrated to exceed the compensation that the adviser receives.

Operating outside of these principles exposes advisers to excessive compensation penalties, regardless of other regulatory compliance. If a client should suffer a loss, and an adviser cannot show evidence of meeting the Gartenberg Standard, it is far more likely that the adviser or firm will be forced to restore losses or worse, pay penalties.

It becomes clear that while nothing is certain, the prudent choice for advisers is to operate under the Gartenberg Standard and the opinion of the Court.

Exceptionally high service requirements.

Applying the Gartenberg Standards to Various Situations

The four examples that follow show the misleading results that can be produced by using simple peer group averages without considering the Gartenberg factors.

Example 1: Reasonable above average compensation for an IRA

  • The client is retired and has only one account with assets of $700,000 to fund retirement in addition to Social Security. Investment requirements are to hold a substantial portion of assets in the energy sector but to avoid health care. The client requires quarterly reviews to monitor the IRA portfolio and update personal preferences and risk tolerance.

    The adviser receives compensation of 95 basis points which is 50% higher than other similarly situated clients with other advisers.

    This give the misleading impression that this client is overpaying for the adviser’s services.

    Applying Gartenberg, the finding is that this client should be paying more:

    • The first step is to calculate what the client is actually paying the adviser:

      $700,000 X 95 bps = $6,550
    • Next is to determine the cost and profit of providing the services to this client. Adviser spends 24 hours per year servicing this client at an internal cost + profit of $350 per hour.

      $350 X 24 hours = $8,400
    • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

      Adviser performance: + 10% ($840)
      Economies of scale: +0% ($0)
      Benefits to client: +25% ($2,100)
    • Summing to a total reasonable compensation of

  • The reasonable compensation in this case is far in excess of what the adviser earns.

  • Example 2: Reasonable above average compensation for 401(k) Plan

    • This client is a 401(k) plan with $13 million and 300 participants. Participation rate is 93% of eligible employees and contributions average 7.5% of salaries. The average age of participants is 46. Plan asset allocation is rated at moderately aggressive. The adviser visits quarterly and provides regular training sessions with employees. The adviser is responsive to calls from participants 24 hours per day.

      The adviser receives a net of 40 basis points as broker of record on the plan. This is nearly double the average for plans of this size.

      Applying Gartenberg, the finding is that this client should be paying more, not less:

      • The first step is to calculate what the client is actually paying the adviser:

        $13,000,000 X 40 bps = $52,000
      • Next is to determine the cost and profit of providing the services to this client. Adviser spends 52 hours per year servicing this client at an internal cost + profit of $450 per hour. An analyst in the practice spends 45 hours per year at $150 per hour

        $450 X 52 hours = $23,400
        $150 X 45 hours = $6,750
                           Total = $30,150
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 25% ($7,538)
        Economies of scale: +0% ($0)
        Benefits to client: +50% ($15,075)
      • Summing to a total reasonable compensation of:

    • The reasonable compensation in this case is close to what the adviser earns.

  • Example 3: Unreasonable below average compensation for large client

    • This client has total assets of $47 million with the adviser that includes a $100,000 IRA on a separate platform that pays the adviser 65 basis points. This account receives no services from the adviser and is considered a “convenience” for the client.

      The average adviser compensation for IRAs of this size is 85 basis points, but this simple average does not consider the scale of the entire relationship.

      Applying Gartenberg, the finding is that this client should be paying less:

      • The first step is to calculate what the client is actually paying the adviser

        $100,000 X 65 bps = $650
      • Next is to determine the cost and profit of providing the services to this client. Adviser spends ½ hour per year discussing this account at an internal cost + profit of $350 per hour.

        $350 X ½ hour = $175
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 0% ($0)
        Economies of scale: +0% ($0)
        Benefits to client: +5% ($9)
      • Summing to a total reasonable compensation of:

  • While this scenario is not likely to be called out as a problem, it is an irritant since it technically violates the Gartenberg Standard. In reality, the adviser could simply decline this compensation.

  • Example 4: No average compensation for situation

    • This client purchased an annuity for his IRA, but seeks to surrender it now. The surrender charges are 4% of the account valued at $250,000. There are no ongoing services to this client.

      The adviser received a 5% commission at the time of the sale but will not participate in the surrender charge. The issue is, however, that the client is now paying for compensation that the adviser received two years ago. There is no available peer group average for this scenario.

      This scenario illustrates the need to consider a variety of factors when assessing the reasonableness of adviser compensation. Using Gartenberg, the adviser compensation received at the time of the sale was simply an advance. The analysis is therefore performed as if the payment and receipt occurred concurrently.

      Applying Gartenberg, the finding is that this client should be paying less:

      • The first step is to calculate what the client actually paid the adviser:

        $250,000 X 5% = $12,500
      • Next is to determine the cost and profit of providing the services to this client. Adviser spent 4 hours discussing this account at an internal cost + profit of $350 per hour

        $350 X 4 hours = $2,450
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 10% ($245)
        Economies of scale: +0% ($0)
        Benefits to client: +10% ($245)
      • Summing to a total reasonable compensation of:

  • The reasonable compensation in this case is considerably less than what the adviser earned and would be considered excessive.

What Profit is Reasonable?

One aspect of Gartenberg that has been the subject of confusion is the determination of a “reasonable profit”. The adviser’s profit is one component of compensation, but left unchecked could be excessive.

In attempting to provide some parameters, DALBAR gathered data on the pre-tax profit margins in financial services and related industries. The findings were unsurprising in that the range is close to initial estimates:

  • The average margin was 35.9%
  • The minimum was 16.1%
  • The maximum was 54.5%

Margins within these ranges are arguably reasonable and would reign in extreme cases.

How to Prove Reasonableness

Proof is having the evidence before the fact, not trying to create it afterword. There is very little credibility in trying to explain that taking home a five figure compensation was fair after a client lost $1 million.

The answer is making it undeniably clear beforehand what the pay will be and what facts were available to support your decision.

While the cost and profit factors of the Gartenberg Standard can be quantified, it is necessary to establish a credible method of weighting the other factors to establish the reasonableness of compensation.

This proof can be accomplished by estimating the time spent and allocating the cost to each client. This is a well-established practice and has been used by professionals for centuries.

The proof of reasonableness is a comparison of the compensation calculated from allocated costs and profit.

Advisers must estimate the time spent on:

  • Delivering services to the client
  • Discovery, research, analysis and monitoring required to achieve the results produced.

Economies for clients where applicable are used to reduce the allocation to those clients.

A further refinement is changing the allocation based on skill, knowledge and experience of each practitioner in a multi practitioner office

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The Department of Labor is expected to impose new regulations that require financial advisors to enter into a written contract with each client (“Fiduciary Rule”). This contract requires that the financial advisor act in the client’s best interest as well as a number of additional provisions and warranties.

There has been an unprecedented level of resistance to the Fiduciary Rule that is scheduled to take effect in the fall of 2016. Opponents argue that these regulations pose a threat to the financial services industry and its clients and that the upheaval will cause more damage than any benefit that could be derived.

There have been a series of threats to the status quo of financial advisors in last 10 years. These have had little effect on the way business is done. In spite of the potential for massive changes, financial advisors and institutions have had to do little more than make minor adjustments and add more disclosures.

Some examples of these threats to the status quo that occurred in the last decade were:

  • The pension protection act of 2006 threatened to neutralize incentives by limiting advisors to computer models or level fees. Thwarted by favorable rulemaking by regulators.

  • Dodd/Frank threatened universal fiduciary standards. Still awaiting regulatory action

  • Fee Disclosure promised radical changes in pricing by disclosing what clients were paying and what they were getting in return. Poor compliance and weak enforcement turned this tidal wave into a ripple.

  • 12b-1 repeal would prohibit the largest compensation source for financial advisors. These efforts have died on the vine.

  • Government sponsored retirement plans have been proposed to replace private sector plans. Moving at a snail’s pace, the automatic IRA is being adopted in only a few states

  • Repeal of tax advantages threaten to undermine a key benefit of retirement plans, annuities, IRAs, etc.

  • Overhaul of tax laws threaten to change the tax treatment of all investments. No overhaul has made it through the Congress.

The lesson from this past decade of threats may well be that the best bet is to sit back and do nothing, for this too shall pass.

Is the Department of Labor Fiduciary Rule any different?

While the Fiduciary Rule may suffer the same fate as previous initiatives, it may be instructive to understand how this differs from previous attempts at major changes. Here are 10 ways in which the Fiduciary Rule differs from previous proposals/changes.

  • Populace issue with a winning message… Opponents must win the argument that acting in a client’s best interest is too disruptive, too expensive, too risky and exclusionary to be a prerequisite for financial advisors.

  • High visibility… Repeated demands of the President and active involvement of Congressional Leaders with associated media coverage continues to make consumers aware of the planned regulation.

  • High awareness of how previous changes failed to materialize… The administration and regulators are keenly aware of the ways that previous attempts to change have been thwarted and have implemented tactics to overcome them.

  • No fear of reprisal from disapproving Congress… Unlike any time in recent history, the current administration has shown disdain for the Congress after suffering no reprisals for standing against Congress in the past.

  • No action required from Congress for adoption… The Fiduciary Rule is a regulatory change that requires no action from Congress to take effect. While Congress could vote to stop the Fiduciary Rule, there is little chance such an action would survive a certain presidential veto.

  • Low interest in campaign support from the financial sector (AKA Wall Street)… The current administration appears to have little interest in support from the financial sector and has been unwilling to negotiate.

  • Enforcement not dependent on regulatory inspection… The Fiduciary Rule is embodied in a written contract that permits any client to take action against financial advisor or institution, needing only to prove a breach of contract.

  • Explicit agreement required of each client… Clients play an active role since each will be required to sign a best interest contract, thus opening the door for clients to review the arrangement with their attorneys.

  • Risk of non-compliance… Clients may have to be reimbursed for market losses. The exposure exists for losses if the protection of the contract is not in place.

  • Liability for failure to comply increases over time… The likelihood of a loss occurring increases with the time of the exposure since the period over which the loss is calculated could be any period.

Is it really different this time? “What if I do nothing?”

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The Broker/Dealer business model was created to distribute products to investors but has now incorporated the delivery of investment advice. When viewed as an investment advice business the inherent conflicts of interest has alarmed regulators and consumer advocates and driven the regulatory changes we see today. Michael Kitces offers some thoughts on how this incompatibility can be resolved, but “something’s gotta give!”

Mr. Kitces’ position is supported by DALBAR products such as the 408(g) Model Certification that separates the personality driven business of relationship management from the scientific probabilities of asset allocation and investment selection. The 408(g) Fee Leveling eliminates the conflicts of interest with an audit that complies with DoL and IRS regulations..

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If the goal of compliance practices is to keep advisors out of trouble, the job just got a lot harder. As firms seek a course of action after the Fiduciary Rule, the problem of compliance becomes exponentially more difficult. Compliance based on processing orders is not remotely capable of protecting anyone from what happens before the order is even received. Complex pre-order procedures and practices may go unsupervised without rethinking how compliance is achieved. Michael Kitces shares his views on the inadequacy of compliance that exists today...

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More Work and Less Pay

New Federal regulations change what financial advisors do and how they do it as well as the amount of compensation they receive. These regulations apply to advisors who offer investment advice to IRAs, retirement plans or participants. The effects will also be felt by clients, providers they use and affiliated firms.

Under current rules, most financial advisors are paid by investments to find good deals for clients. The advisor’s business is sustained by offering investments that perform well for clients. Advisors who offer bad investments lose clients and are out of business in a short time.

Regulators have decided that this type of arrangement represents a conflict of interest and have established new rules to end these practices. Under the new rules the advisor’s job is no longer finding good deals and payment is no longer for making investments.

Under the new rules, the financial advisor’s job is to provide defined services to clients and receive payment that is in line with those services, which must be in the client’s best interest. On the surface this appears quite reasonable but further examination shows the challenges that the change creates.

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Computer Model Certification


The Fiduciary Rules go into effect April 10, 2017 and must be fully operational by January 1, 2018. These applicability dates set the timelines for decisions, preparation and implementation of alternatives to comply with these regulations.

The Conflict of Interest Rules (“COIR”) replace the 1975 definition of what constitutes a fiduciary for ERISA plans and IRAs. The effect of COIR is to transform currently permitted practices into prohibited fiduciary acts.

Institutions and individuals must cease these prohibited fiduciary acts or use an exemption to legitimize these activities.

The Chosen Exemption

Among the exemptions is the provision in the 2006 Pension Protection Act that exempts advice delivery by a certified computer model from prohibited conflicts of interest (408(g)). The use of 408(g) has certain advantages when business circumstances permit its use and the requirements are achievable. Advantages can include:

  • Overcome conflicts of interest and differential compensation from related businesses

  • A superior solution for investors

  • Lower risk for the fiduciary

  • Lower cost to implement, operate and to maintain

  • Shorter time to market

  • Scalable to handle high volumes

Flexibility to make changes and adapt to new investment types and practices

DALBAR Qualifications

Under 408(g) Computer Models can only be certified by an eligible investment expert, with the appropriate technical training or experience and proficiency to analyze, determine and certify, in a manner consistent with the regulation. DALBAR has met these qualifications and has been performing certifications since the inception of the regulation in 2009.



The certification attests to five dimensions:

  • Regulatory Compliance
  • Capabilities, strengths and weaknesses
  • Performance
  • Consistency with offers and agreements
  • Reasonableness and cost


In addition to compliance with securities laws the computer model may be certified as compliant with regulations as they apply to:

  • ERISA Plans

  • Managed account QDIAs

  • IRAs


Capabilities are evaluated in three areas:

  • Discovery… information gathered about the client and defaults used when information is not available

  • Interpretation… how client information is applied

  • Investments… universe of investments available


Historical Results:

  • Participation in up markets

  • Capital preservation in down markets


Consistency of communication and model results:

  • Contracts, descriptions, brochures and other materials

  • Appropriateness for audience and expected knowledge to meet the requirement: “Calculated to be understood”

  • Tests run with multiple scenarios


Reasonableness is an overall evaluation of all observations taken together in relation to the cost to users of the mode




  • Application with attachments received in good order

Pre-Qualification Review

  • Review materials for disqualifiers and terminate engagement if uncorrectable

Additional Disclosures

  • Determine and request any additional materials

Investment Theory Evaluation

  • Determine if exception procedures will be required

Performance Record

  • Examine samples in up and down markets Cost Evaluation

  • Determine if direct and indirect cost to the client is reasonable

Regulatory Checklist

  • Review items specifically suggested by DoL

Model Tests

  • Test models and communication for consistency

Management Letter

  • Review any exceptions or deficiencies and determine if resolution is feasible


  • Issue certification, good for one year from date of issue


Additional Support

DALBAR offers a number of services to enhance the utility of the computer model and the effects of the Fiduciary Rule on the use of the model as an alternative to the Best Interest Contract Exemption. These services are separately purchased and are not included in the certification.

Upgrade Analysis

Current implementations of the computer model are examined for possible violations of the new Conflict of Interest Rules, Areas of concentration include handling of rollovers and potentially conflicting exemption requirements.

Pre-Certification Review

DALBAR will perform a subset of the certification process before changes are made to comply with 408(g). In this way, findings from the pre-certification can be incorporated add to or reduce the changes being made. The cost of pre-certification lowers the cost of the actual certification.

Usability Analysis

The usability is based on criteria for a particular target audience. The access to, use of, exception conditions and the follow through are evaluated.

Contact Center Monitoring

Contact center representatives who use the certified computer model must comply with the requirements of 408(g). The contact center monitoring adds a level of oversight of the required practices and is evidence of “best efforts” in the event of a failure to comply or litigation.


Consulting engagements may cover planning, diagnosis, cost/benefits, research and other services that utilize DALBAR’s expertise, knowledge of the market, practices and regulations.


Cory Clark (617) 624-7156

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About Lou Harvey

Louis S. Harvey
President & CEO

Founder and leader of DALBAR, Lou Harvey is relentless in the search for the forces that are shaping the world of financial services today, tomorrow and for years hence. Using Dalbar’s research capabilities, Lou Harvey seeks insights from inside and outside the industry to understand and anticipate changes in customers’ needs and the ways products are distributed.