Relief on implementation timeline but still lots to be done by April 2017

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1 Yesterday the Department of Labor (DOL) released its final Conflict of Interest ( Fiduciary ) Rule. The Rule and related Prohibited Transaction Exemptions (PTEs) are substantial documents - in part due to the volume of background provided by the DOL on their deliberations around the range of comments received during the proposed rule s notice period. We are still poring over and reflecting on the Rule provisions and will continue to do so in the days and weeks ahead. In addition, we will be engaging heavily with other industry participants to exchange perspectives on impacts. In the meantime, we wanted to provide you with our preliminary reactions and early hypotheses as to the implications of the final versus proposed Rule (issued April 20, 2015). Relief on implementation timeline but still lots to be done by April 2017 In the original proposal, the Rule and PTEs were to become fully operational early in 2017 just 8 months after publication. Implementation of the final Rule will now be phased as follows: The change in fiduciary definition will go live as of April 10, Advice on qualified business sold from that point forward will be subject to the new fiduciary standard. Advisors will be required to provide best interest advice, to ensure that their compensation on qualified sales is reasonable, and to provide certain point of sale disclosures to customers. Financial institutions will need to have and disclose Conflict of Interest policies and procedures. However, there will be a transition period between April 10, 2017 and January 1, 2018 during which the DOL will defer the requirement to execute a Best Interest Contract to continue to receive commissions. In effect, advisors will continue to be able to receive prohibited compensation (assuming it meets the reasonable bar and does not conflict their advice) on new sales during that period provided disclosures are met. Bottom line: the new timeline appears much more achievable than that originally proposed. Much work remains to be done over what is still a short time-horizon given the scale of the changes involved. In particular, for advisors, new Best Interest models, product shelf changes, compliance procedures, and compensation model changes will have to be in place by April Similarly, manufacturers will need to have product changes available in time to meet that timeframe. However, rollout of the BIC contract and any transition away from commission models can occur between April and year-end more gradually than originally proposed. Big Relief on Grandfathering The Final Rule provides significant (and unexpected to many firms) relief around the treatment of in-force business much of which was sold into commission-based models - by expanding the options to continue receipt of compensation, in two forms: Exemptions for pre-existing transactions: Advisors can continue to receive commissions on existing business, without executing the BIC, while making recommendations to hold an investment or change certain fund allocations (e.g., within a variable annuity or fund family). Advisors will, however, become fiduciaries on this grandfathered business so will need to adhere to a best-interest standard and all that entails Oliver Wyman, Inc. (DE)

2 Page 2 Negative consent for existing business: Where a firm or advisor wishes to execute the BIC on existing business, they can do so via negative consent - significantly reducing the operational complexities of executing a written contact across thousands (in some cases millions) of existing clients and the compliance challenges of ensuring advice does not occur prior to its execution Bottom line: These provisions will broaden the options available to advisory firms to address in-force business and should limit the degree to which firms orphan policies and accounts. They will come as a big relief to product manufacturers who were, up to now, anticipating a wave of changes across their in force books. We are unclear as yet on the likely consequences for advisor and policyholder behavior on in force variable annuity books which can have material economic consequences. Even under the grandfathering provisions, advisors receiving trail commissions on these books will become fiduciaries which should heighten their level of care. We have already begun to see advisors think about how VAs and other insurance products will be considered in the context of more sophisticated best interest advice frameworks from next year onwards. Best Interest Contract Workability Improved But Still Challenging It has been very clear from our conversations with advisors that the BICE construct as proposed was perceived as both difficult from a practical workability standpoint and, in some cases, infeasible from a risk management perspective. The Final Rule addresses some of the original concerns raised regarding the BICE as follows: Existing business: Allows negative consent for roll-out of the BIC to in force books Contract execution: Clarifies that the contract can be executed at point of sale, who the required parties need to be, and that a single BIC will cover multiple instances of advice provision Disclosures and reporting: Significantly reduces the information disclosure aspects of the contract (no 1-, 5- and 10-year cost projections, more moderate website requirements) Liability: Allows inclusion of a provision to waive punitive damages However, the Rule continues to prohibit inclusion of any provision which would disqualify the investor from participation in a class action viewed by some firms as a non-starter, and still has a lot of teeth in terms of the warranties and disclosures required. Bottom line: we think the workability of the BICE has been improved. The question remains as to whether the package overall now is sufficiently acceptable that those advisory firms who were unwilling to go through the BICE under the proposed structure will reconsider. As a result, we still expect to see a significant shift to fee-for-service models going forward but may see a more moderate or less rapid shift than would have been the case if the Rule had been finalized as originally proposed.

3 Page 3 Fixed Index Annuities Through The Best Interest Contract; Exemption Not Available for Non-registered Advisors In the proposed rule, the DOL provided prohibited transaction exemption (PTE) as a route to receive commission on insurance products, with the exception of variable annuities. The lesser liability risk and reporting requirements associated with PTE favor products available under this exemption relative to those offer only under the BICE. The Final Rule limits the use of PTE to only fixed rate annuity contracts moving both Fixed Indexed Annuities (FIAs) and many group annuity contracts (GACs) to the BICE. This shift is particularly meaningful for non-registered advisors selling insurance products that would not have had to rely on the BICE under the proposed rule but will under the final. This issue is exacerbated by the fact that these advisors have been explicitly excluded by the DOL from the definition of a Financial Institution under the BICE. Only banks, savings associations, insurance companies, and firms which are registered as investment advisors under the Investment Advisors Act of 1940 qualify. While the Department has added an avenue for firms to apply for individual exemption, it seems unlikely that this will be provided in most cases. It seems, therefore, that an agent will only be able to sell an FIA going forward if they either register under the 1940 Act, make the sale on a fee-for-service basis, or find a suitable third party willing to act as the sponsoring Financial Institution. We find the last of these solutions difficult to envisage at this point given the degree of control required by an Institution in order to be able to satisfy the required provisions of the BICE. Bottom line: this shift will cause a scramble for many IMOs, PPGAs, and other nonregistered advisors whose DOL planning efforts thus far did not contemplate use of the BICE, as well as FIA manufacturers who will now need to provide significant information to these firms to support disclosure and reporting requirements. It could also hamper the FIA market more broadly as advisory firms who seek to or are required to limit their product shelf to annuity products eligible for PTE no longer carry FIAs. No Relief for Captive Distribution The question of how proprietary product sales would be impacted by the new standard has been a very lively topic of discussion with the industry looking for increased clarity regarding rule and exemption applicability. The Final Rule restructures the section of the BICE dealing with these sales. The DOL, however, in its comments points out its core concerns about proprietary products The condition in Section IV(b)(3) reflects the Departments deep and continuing concern regarding the Financial Institutions own conflicts of interest in limiting products available for investment recommendations. 1 So, while the Final Rule is recast to talk explicitly about proprietary product sales (Section IV is now headed Proprietary Products and Third Party Payments rather than the former Range of Investment Options heading), the end result is not much relief i.e. where a Financial Institution limits an Advisors investment recommendation wholly or partly to Proprietary 1 Best Interest Contract Exemption at page 190

4 Page 4 Products or to investments which generate Third Party Payments, it may rely on the BICE for receipt of reasonable commission by the advisor only where: It clearly and prominently and with significant specificity informs the investor of the use of the relevant products and the limitations placed on the universe of investments available as a result It provides pre-transaction disclosures regarding fees and compensation to the investor and informs them in writing of any material conflicts of interest in relation to the transaction The financial institution documents in writing the limitation of the available universe of investments, any material conflicts of interest, any services it will provide to the investor in exchange for any third party payments, that compensation being received is reasonable, and its determination that any limitations will not cause an imprudent investment recommendation The financial institution adopts, monitors, implements, and adheres to policies and procedures and incentive practices designed to ensure its advisors adhere to a best interest standard and does not use quotas, appraisals, performance standards, bonuses, contests, special awards, differential compensation or other actions or incentives that would reasonably be expected to subordinate the interests of the investor to the advisor s own Bottom line: this topic will continue to be a very sensitive issue to navigate. While the standard allows for proprietary product sales, it is clear that the bar is high and exposure potentially greater than for corresponding third party products. Operationalizing the policies and procedures and monitoring processes to support governance of the Best Interest requirement will be critical and will break new ground for example, what is a reasonable benchmark for proprietary sales volumes by advisory and across the firm within a product category before a red flag needs to be raised from a monitoring standpoint? Where will incentive structures need to change and how? No Real Change to Challenges of Advice vs Education The Rule as proposed limited the range of activities classified as education - raising concerns amongst many commentators that these restrictions would limit the availability of investment education by placing too strict of constraints on call center representatives, onsite plan representatives, and other parties who assist plan participants and IRA owners today. By the DOL s own statement, the substance of the Rule is largely unchanged from the proposal: While the pre-amble to the Final Rule provides additional clarity around the activities that will and will not qualify for the education carve-out including explicit language to allow a discussion of the need for guaranteed income the substance of the carve-out remains largely unchanged The only substantive expansion explicitly allows the identification of specific investment alternatives through the use of an asset allocation model based on the available line-up with an employer-sponsored plan. While a modest change, it will enable plan participants to

5 Page 5 receive tangible education without an advisor assuming fiduciary status. This provision, however, does not apply for IRA customers. In addition to the education carve-out, the Final Rule explicitly excludes general communication from what constitutes an investment recommendation; this provision captures any communication that a reasonable investor would not view as an investment recommendation, such as general marketing materials and speeches. Bottom line: better but still a lot of changes required to remediate call center and other customer facing staff interactions. Continued Challenges in Provision of Advice to Small Plans The Rule requires significant changes to the manner in which advisors and product manufacturers support small employer-sponsored plans by defining many of the activities conducted by both plan advisors and product manufacturers as fiduciary advice. The Final Rule introduces several changes to requirements supporting these plans and the avenues for advisors to receive compensation: Significantly reduces the number of plans eligible for a carve-out by replacing the Seller s Carve-out (applicable to plans with 100+ participants) with an alternative provision limited to only independent fiduciaries managing $50 MM or more in assets Expands the BICE to encompass plan fiduciaries managing up to $50 MM in assets, providing a route to receive commissions for small plans Removes group annuity contracts from PTE 84-24, forcing advisors to operate under the BICE to receive commission for these products, and eliminating their favored status relative to other plan types (e.g., mutual fund platforms) Bottom line: while the changes provide clear relief to small plan advisors by offering a path to continue accepting commissions on all plan types, they also increase the implementation burden on both advisors and plan providers to meet the BICE requirements and limit the ability of product manufacturers to offer services to mid-sized plans. Similar to the trends anticipated in the retail market, these heighten requirements may restrict the availability of advice to small and micro plans.

6 Page 6 This note is based on our preliminary interpretation of the rule and is subject to change. This note is not intended as nor does it constitute legal advice and should not be acted on as such. It does not represent a legal opinion on the rule provisions but is intended as a preliminary view on likely business consequences. Detailed legal analysis and advice will be required.