Banking & Financial Services. White Paper. Fiduciary Advice: A Step toward Responsible Retirement Investment Management

Transcription

1 Banking & Financial Services White Paper Fiduciary Advice: A Step toward Responsible Retirement Investment Management

2 About the Author Shalini Joshi Shalini Joshi is a Domain Consultant with the Banking and Financial Services (BFS) business unit of Tata Consultancy Services (TCS). She has over 15 years of industry experience in the capital markets space. Joshi has worked with leading retirement services firms and multinational banks, providing 401(k) advisory to participants. She has a Bachelor's degree in Commerce (Honors) from Sri Venkateswara College, Delhi University, India, and a Master's degree in Business Administration, with a specialization in Finance and Marketing, from Jaipuria Institute of Management, Lucknow, India. She also has Series 6 and Series 63 certifications from the Financial Industry Regulatory Authority, Inc. (FINRA), USA.

3 Abstract In February 2015, the US government directed the Department of Labor (DOL) to propose a rule that will require retirement advisors to abide by a 'fiduciary' standard putting their clients' interests above their own profits.¹ Thus far, people have sought retirement investment advice from professional pension managers. However, these days more and more people are shifting from traditional defined benefit plans to self-directed, defined contribution plans. The role of retirement investment 'experts' has therefore become even more important because people need the 'correct' advice on how to manage their 401 (k) and IRA plans. Existing retirement advisory rules allow investment advisors to put their interests ahead of their clients' retirement security, which is not a desirable scenario. Under the current Employment Retirement Income Security Act (ERISA) and tax rules, both rollovers and IRAs do not receive fiduciary protection. With $7.2 trillion invested in IRAs and more than $5.3 trillion in 401(k) type plans², retirement advisory rules need to be improved to protect the interests of individual investors and extend them maximum benefit. This paper discusses the key aspects of DOL's proposed regulation for fiduciary advice and the resultant impact on financial institutions. We have outlined the key features of the proposed rule and highlighted some technology areas that financial institutions need to focus on, to ensure adherence to the new requirements. [1] United States Department Of Labor, Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year, accessed January 8, 2016, [2] United States Department of Labor, The Committee for the Fiduciary Standard (July 2015), accessed January 8, 2016,

4 Contents Introduction 5 Key Aspects of the Proposed Fiduciary Rule 5 Impact of the Proposed Regulation on Retirement Investment Industry 8 Beneficial impacts 8 Adverse impacts 8 Business Implications for Various Stakeholders 9 What Aspects Financial Firms Will Need to Focus On 9 Conclusion 10

5 Introduction Despite notable changes in the retirement landscape, with people moving from defined benefit plans to defined contribution plans, the retirement advisory rules haven't been altered much over the last four decades. These rules have more or less been devoid of 'fiduciary' responsibility, which has allowed advisors extending retirement advice prioritize their profits over the retiree's benefit. In view of this anomaly, the Department of Labor (DOL) in the US proposed a rule in February 2015, under which, retirement investment advisors will be mandated to abide by fiduciary standards when dealing with plan investors and Individual Retirement Account (IRA) investors. This will help limit or mitigate the conflicts of interest, protect investors from backdoor payments and hidden fees in retirement investment advice, and improve retirement security. Financial institutions like wealth management firms and brokerage advisory groups will all come under the purview of this proposed rule, so that instances of misselling can be significantly reduced and retirees' hard earned money stays safe. Regulatory authorities in other countries have established similar rules in the past. In 2012, the Australian Government enacted the Future of Financial Advice (FOFA) reforms to mitigate conflicts of interest and ban advisor commissions. Likewise, in 2013, UK's Financial Services Authority (FSR) introduced the Retail Distribution Review (RDR) which echoes DOL's proposed rule on fiduciary advice. RDR put a ban on commissions for sale of investment products. An adverse impact of the RDR that almost immediately became visible was the 'advice gap' investors with less wealth found it difficult to get investment related advice. Times seem to have changed since today there is a willingness among advisory firms to adopt such rules in the interest of the greater common good. How the DOL's proposed fiduciary standard fares in the longer run, remains to be seen. Key Aspects of the Proposed Fiduciary Rule Some key aspects of the proposed fiduciary standard are listed below: Fiduciary advice definition extended to include retirement investment advisors: The gaps in the existing DOL rules and the definition of retirement investment advice result in middle class households in the US, especially IRA owners, getting exposed to investment advice that may not be in their best interest. Under DOL's proposed rule, any individual providing retirement advice either to a 401 (k) participant, a 401 (k) plan sponsor, or an IRA investor, will have to comply with fiduciary standards. This means, the adviser will need to provide impartial advice in the client's best interest, and cannot accept any payments that amount to conflicts of interest. Commissions will be prohibited under this new norm. The DOL has listed some exemptions to the rule. Two prominent ones are: n Best Interest Contract (BIC) exemption: This will allow financial institutions dealing in mutual funds, insurance products, annuity products, and equities to continue to receive commissions if they comply with specific disclosure requirements. Of these, the point of sale disclosure requirement is likely to be the toughest to meet because it will amount to heavy costs and long turnaround times for financial institutions. Firms will need to disclose the total cost of each new investment prior to executing it for retirement investors. Only if the client is comfortable with the proposition, the transaction will be confirmed. This process will be time-consuming, and in case the deal doesn't get through, will lead to monetary losses for the investor. 5

6 The BIC exemption doesn't apply to investments in alternative assets like real estate, hedge funds, and private equity funds. Additionally, it doesn't come into play while offering advice to sponsors of small 401k plans (with 100 or less participants or under $ 100 million in plan assets). n Principal Transaction Exemption (PTE): This permits a financial institution to purchase or sell certain debt securities (out of the firm's inventory) on behalf of the retirement account. To avail this exemption, firms need to prepare a pre-transaction statement for investors. This statement should include price quotes from similar debt securities from two non-affiliated market participants. Rollover and distribution recommendations to be considered as fiduciary investment advice: Under the current retirement guidelines, advice regarding IRA investments can at times be unfavorable for the investors. Hundreds of billions of dollars are rolled over from plans to IRAs every year. Consumers are vulnerable to bad advice regarding rollovers because they represent such a large portion of their savings. Families with IRAs would save more than $40 billion over ten years if the proposed rule is adopted. Providing retirement education does not amount to fiduciary advice: Providing general education to retirement investors on their savings does not trigger fiduciary duties. Education could consist of suggesting appropriate asset allocation based on the investor's age, income, and other parameters, Suggestions on specific stocks, bonds, or funds that may constitute the mix should be avoided. Order-taking is not a fiduciary activity: Situations where a customer calls a broker and tells him exactly what to buy or sell without asking for advice will not constitute investment advice. In these scenarios, the broker will have no fiduciary responsibility to the client. The proposal was published by the DOL on April 20, 2015, and was open to comment until September 24, Based on feedback from all stakeholders, the DOL will develop and release the final rule. There has been no timeframe indicated for this exercise. 6

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8 Impact of the Proposed Regulation on Retirement Investment Industry If the proposed regulation from DOL becomes the law of the land, American citizens planning for retirement will face both beneficial and adverse impacts. Beneficial impacts The new proposal will level the playing field, which means independent advisors who put their clients' interests first will not be squeezed out of the market at the hands of those who don't. Individual investors will become more responsible, taking important investment decisions related to their 401(k) and IRA accounts into their own hands. IRA investors will gain from the extension of fiduciary standards to advice on their retirement investment. This alone will save billions of dollars for middle class households in the US. The new proposal is expected to deliver additional investor gains that will far exceed any additional compliance costs that the financial firm may incur. These costs could be related to the revamp of IT applications and personnel training. Additionally, it will promote healthy competition in the investment advice market. IRA investors will get impartial and more transparent advice, making the market more efficient. Adverse impacts The DOL's fiduciary standard rule will reduce investors' access to retirement savings options. Since the incentive to promote certain products and make considerable commissions will no longer be there, advisors might not be willing to invest time and effort in the clients they deem as non-profitable. Due to this rule, millions will not qualify for an advisory account and will therefore no longer be able to receive investment services from a professional broker. Moreover, when employees change jobs and roll over to IRAs, they may not be able to get advice on how to I nvest their money since financial advisors will see little incentive in catering to these investors as mis-selling will be curbed. Currently, every financial institution has elaborate marketing material that contains information about its investment products. With the fiduciary standard coming into effect, firms might need to tone down such communication since it could be seen as an attempt to sell one's own products and not present the investor with an unbiased view of all available products in the market. Small corporates will have to adhere to stringent regulations while offering retirement plans to their employees. This may deter them from offering retirement plans because they may be unable to get advice with respect to plan investment options. This could reduce the number of plans that are initiated, as well as lead to the termination of existing plans. Hence, these employees may have to look outside of their organizations to buy retirement plans, which may be more expensive. 8

9 Business Implications for Various Stakeholders If the proposed regulation comes into force and fiduciary advice becomes the norm, all the stakeholders involved in retirement investment are bound to be impacted. Let's see how. Retirement advisors and consultants: Since retirement advisors will have to abide by the fiduciary rule, they may not be interested in providing guidance to less wealthy investors. Unlike earlier times, they won't be able to place their interests above the client's, which will amount to limited economical gains. Institutional plan providers: Businesses offering plans like 401(k) to their employees relied on market forecasts by advisors they partnered with. With the proposed rule, such information will be limited and businesses will need to seek the support of fiduciary advisors and managers to look after separate accounts of their employees, who may not be interested in working with small clients. These increased costs may force small businesses to opt out of offering retirement solutions to their employees rather than comply with increased regulations. Individual IRA investors: With the fiduciary standard extended to IRAs, individuals will benefit from advisories without any conflict of interest. They will get full risk and benefit information to enable them to choose the best investment scheme suited to their requirements. What Aspects Financial Firms Will Need to Focus On The Financial institutions will need to revisit their current business and operating models in order to remain competitive when the proposed rule comes into effect. For instance, firms planning to avail the BIC exemption will need to adopt a fee based compensation model rather than existing commission based model. Since this exemption requires numerous disclosures, organizations will need to deploy comprehensive fee calculation mechanisms to produce accurate and timely pre- and post-sale customer disclosures. This in turn means that technology will play a crucial role since most financial institutions do not have all fee and cost related information in a centrally located database. Secondly, trading systems will have to be updated to block certain products that are not allowed under the BIC exemption. Financial institutions will need to adopt ways to notify clients in real time. They will therefore need to move from the existing postal mail based communication system to the ones based on s. This will reduce the time it takes to get customer consent. The flip side of this system could be that older investors may find it a bit cumbersome. Hence, adequate training of advisors and education of investors will be of vital importance once the guidelines are implemented. We believe that technology service providers and fintech companies will have a large role to play in this regard. They could be involved in creating simple and intuitive IT systems and mobile apps to cater to financial firms and retirees alike. Robo-advisors could also come in handy tool for investors who wish to seek advice on their retirement assets but don't have the willingness or the time to engage with investment advisors. Several banks have built inhouse robo-advisor platforms, and some have partnered with fintechs in this regard. 9

10 Conclusion Due to take effect any time now, DOL's new proposal on fiduciary investment advice would foster additional investor gains which will far exceed the additional compliance costs. Currently at the discussion and feedback stage, the rule will soon go on to become the law of the land. The new rule is sure to foster healthy innovation in the retirement funds market and improve the way retirement investment advisors communicate with their clients. To meet the requirements of this new rule, financial firms will turn to newer, more efficient business models that will rely heavily on technology to generate quality advice for investors. Robo-advisors that are already gaining market share are set to gain further momentum. In effect, the new rule will bring the long ignored field of retirement investment under the umbrella of advanced technology systems, thus opening up a plethora of opportunities for technology firms and service providers. 10

11 About TCS' Banking and Financial Services Business Unit With over four decades of experience in partnering with the world's leading banks and financial institutions, TCS offers a comprehensive portfolio of domain-focused processes, frameworks, and solutions that empower organizations to respond to market changes quickly, manage customer relationships profitably, and stay ahead of competition. Our offerings combine customizable solution accelerators with expertise gained from engaging with global banks, regulatory and development institutions, and diversified and specialty financial institutions. TCS helps leading organizations achieve key operational and strategic objectives across retail and corporate banking, capital markets, market infrastructure, cards, risk management, and treasury. TCS has been ranked #1 in the 2015 FinTech Rankings Top 100 of global technology providers to the financial services industry, by both, FinTech Forward (a collaboration of American Banker and BAI) and IDC Financial Insights. TCS has also been recognized as a 'Leader' and a 'Star Performer' in Everest Group's 2015 PEAK Matrix report for Capital Markets Application Outsourcing (AO), as well as a 'Leader' in the 2015 PEAK Matrix report for Banking Application Outsourcing (AO). Contact Visit TCS Banking and Financial Services unit page for more information bfs.marketing@tcs.com Blog: Drive Governance Subscribe to TCS White Papers TCS.com RSS: Feedburner: About Tata Consultancy Services (TCS) Tata Consultancy Services is an IT services, consulting and business solutions organization that delivers real results to global business, ensuring a level of certainty no other firm can match. TCS offers a consulting-led, integrated portfolio of IT and IT-enabled infrastructure, engineering and TM assurance services. This is delivered through its unique Global Network Delivery Model, recognized as the benchmark of excellence in software development. A part of the Tata Group, India s largest industrial conglomerate, TCS has a global footprint and is listed on the National Stock Exchange and Bombay Stock Exchange in India. For more information, visit us at IT Services Business Solutions Consulting All content / information present here is the exclusive property of Tata Consultancy Services Limited (TCS). The content / information contained here is correct at the time of publishing. No material from here may be copied, modified, reproduced, republished, uploaded, transmitted, posted or distributed in any form without prior written permission from TCS. Unauthorized use of the content / information appearing here may violate copyright, trademark and other applicable laws, and could result in criminal or civil penalties. Copyright 2016 Tata Consultancy Services Limited TCS Design Services I M I 02 I 16