The DOL Rule: Tension at the heart of the fiduciary standard

Although the recent election result has created some doubt over its future, the DOL’s conflict of interest rule is currently scheduled to go into effect early next year. For advisors dealing with individual investors, the rule represents a significant change. The side of our business that works with these advisors asked me to share some thoughts on what the rule might mean, based on my personal experience from working on the institutional side of the investment world. Here’s what I said.

A new rule—but not a new standard

Although the Department of Labor’s (DOL) new conflict of interest rule extends the application of the fiduciary standard to a whole new group of people, it’s not a new standard. It’s been a feature, for example, of the world of large institutional investment programs in the U.S. for some time.

I’ve been working in that world for decades, advising large institutions on investment strategy for more than 20 years. So, for those who’ve just been brought into the world of the Employee Retirement Income Security Act (ERISA) and fiduciary standards and who wonder what it all really means, here’s a personal perspective on what to expect.

To be trusted, start by deserving that trust

Judging by the resistance to the rule from many in the industry, you might think that the fiduciary standard is nothing but bad news for those it applies to. So let me start with a positive. What I do like about the fiduciary standard is its clear insistence on acting in the client’s best interest and meeting a duty of care1. As professionals, that’s what we should all aspire to.

I don’t want there to be an incentive for me—or my competitors—to adopt practices that take advantage of clients. I want to succeed by helping my clients succeed, not by finding ways to transfer their wealth into my pocket or by hiding sources of revenue. The financial services industry needs to be trusted by those it serves, and that begins by deserving that trust.

Principles vs. rules: the tension at the heart of the standard

On the other hand, translating good principles into practical courses of action can be really tough.

The duty of care and the duty of loyalty are principles. Good regulation must start with principles, but it cannot end there. Many fiduciaries today are on the defensive, some reaching the point where they feel that no matter what they do, there is a danger that somebody may feel it is worth taking them to court. So having a way to demonstrate that they have done what is required of them can become as important as actually doing it. When this happens it becomes unreasonable, and potentially even unworkable, to ask them to operate by principles alone, without specific guidance.

Specific guidance may come in the form of safe harbors (for example: qualified default investment alternatives, or QDIAs) or the outcome of court rulings. A softer form of specific guidance can come in the form of common practice. These specific practices become, in effect, rules that supplement the principles from which they were derived.

You might imagine that, in time, the practices that are deemed to satisfy the fiduciary standard would have become clear and well–established. But sadly there is no sign of that having happened. The courts continue to be kept busy by what I have heard referred to as a “robust plaintiff’s bar” (an expression loosely translatable as: a lot of class–action lawyers).

So the rules accumulate. In my experience, as that happens, the focus inevitably moves away from serving the client’s interest to checking the right boxes, things being done from a motivation of satisfying lawyers, rather than achieving the best outcome for the client – the very opposite of what the principles intended.

And if fiduciaries focus on following prescriptive rules, then their decisions can only be as good as the rules themselves, rules that are reactive in nature, constantly trailing changing circumstances, and potentially even acting as a barrier to the evolution of best practices. As a UK regulator put it “a large volume of detailed, prescriptive and highly complex rules can divert attention towards adhering to the letter, rather than the purpose of our regulatory standards.”2

This is the tension that lies at the heart of the fiduciary standard, the difficult balancing act between principles and rules. With principles alone, fiduciaries cannot be sure they have done what is required of them; but move too far toward rules, and clients’ interests may become secondary. As the application of the fiduciary standard widens, I don’t expect that tension to go away.

Next steps for fiduciaries to consider

In the meanwhile, I suggest that fiduciaries ensure there’s a solid governance process in place, focused on serving the best interest of clients. That process may include, for example, steps to monitor investments, document decisions that are taken and partner with experts when help is needed. In today’s environment, such steps are more important than ever.

This content first appeared on the Russell Investments corporate blog on November 21, 2016.

1Source: Cornell University Law School. Legal Information Institute. July 2016.
2“Principles-based regulation: Focusing on the outcomes that matter.” The Financial Services Authority, April 2007, p6.