Now that the Department of Labor has offered extended guidance on its fiduciary rule, wirehouses, regional broker-dealers, independent BDs and other regulated entities will need to revise their payout grids, with the very real possibility that advisers will see their compensation drop.
"Advisers hate when there's comp changes, and this could have a big change. If you're taking out retroactivity you're going to have to go to a completely alternative approach or restructure the numbers," says industry consultant Andrew Tasnady.
In the section dealing with compensation in the department's recently released frequently-asked-questions guidelines, the regulator is putting industry firms on notice that it expects them to overhaul their compensation policies to guard against conflicted advice in the retirement space.
But by attempting to put equalize fees in an area as widely divergent as mutual funds, and by directing firms essentially to cut out retroactive compensation, the Labor Department is setting the stage for a significant disruption in adviser compensation, according to Andrew Tasnady, managing director of Tasnady Associates, an industry consulting firm specializing in broker compensation.
"There's a lot of grids that would need to be restructured," Tasnady says. "Advisers hate when there's comp changes, and this could have a big change. If you're taking out retroactivity you're going to have to go to a completely alternative approach or restructure the numbers."
"It does have a big impact on the grid design."
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COMP "BLOW UP"
One of the enduring industry gripes with the Department of Labor's fiduciary rule has been that in seeking to crack down on conflicted retirement advice it would blow up the preferred compensation structures and business models in the wirehouse and broker-dealer sector.
In question nine of the DoL's FAQs, regulators offer detailed guidance on compensation, indicating that the pay grids that are a staple of the wirehouse world can endure, provided firms and advisers meet other baseline fiduciary requirements.
"Question nine, at least on its face, permits the use of grids -- as long as firms and advisers make recommendations that continue to be in the best interest of their clients and the amounts are reasonable," says Howard Diamond, chief operating officer and general counsel at Diamond Consultants, an adviser recruiting and consulting firm based in Morristown, N.J.
The DoL tees up the issue in the section discussing quotas, bonuses and other forms of compensation that could sway advisers to make investment recommendations not in their clients' best interest and are prohibited under the so-called best interest contract exemption. But does that provision of the rule also ban volume-based commissions such as those that are found in an escalating payout grid?
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"Financial institutions may use such payment structures," the department explains, "if they are not intended or reasonably expected to cause advisers to make recommendations that are not in the best interest of retirement investors and they do not cause advisers to violate the reasonable compensation standard."
Therefore, the DoL is urging firms to "take special care in developing and monitoring compensation systems to ensure that they do not run counter to the fundamental obligation to provide advice that is in the customer's best interest."
A spokeswoman for Morgan Stanley declined to comment. Spokespersons for Wells Fargo and Edward Jones said their firms were still reviewing the potential changes. Other firm spokespersons were not immediately available.
A HARD LOOK
So for firms that intend to operate under the BIC exemption and continue to offer escalating compensation, the Labor Department is recommending they take a hard look at their payout grids to root out conflicts that could incentivize advisers to put their own interests ahead of their clients'. The DoL's guidance specifically directs firms to "avoid transmitting firm-level conflicts to the adviser" as they retool their compensation structures.
"If, for example, different mutual fund complexes pay different commission rates to the firm, the grid cannot pass along this conflict of interest to advisers by paying the adviser more for the higher commission funds and less for the lower commission funds," the DoL says. "Such an approach would incentivize the adviser to recommend investments based on their profitability to the firm, rather than their value to the investor."
The department goes on to suggest that firms could mitigate those types of conflicts by keying "compensable revenue" to broad investment categories grouped where compensation is based on neutral factors that do not take into account how much the firm stands to make by steering clients into a particular retirement product.
"The touchstone is always to avoid structures that misalign the financial interests of the adviser with the interests of the retirement investor," the department says.
William Nelson, public policy counsel at the CFP Board, which has advocated for stronger fiduciary regulations, hailed the Labor Department's focus on firms' compensation policies, including the stipulation that compensation grids should not offer advisers steep increases for meeting a certain productivity threshold.
"[U]nder some firms' current payout grids, advisers can more than double their compensation by opting for a more aggressive asset allocation," Nelson says. "This situation -- where the compensation varies substantially [and] where the time invested and level of analysis provided does not vary at all -- would be prohibited under the rule."
TWO TIER COMP OPTION
Diamond points out that advisers should remember that the Department of Labor's jurisdiction in the fiduciary space only concerns retirement advice, suggesting that firms consider a two-tiered compensation system that would limit the impact of the regulation only to accounts held by clients who receive retirement advice.
"The [DoL] cannot and should not be permitted to dictate how firms and advisors deal with non-retirement based accounts," he says. "I think that perhaps a pragmatic and reasonable type of solution that could be fashioned would be a dual-grid system -- one grid that strictly comports to the compensable revenue and neutral factors, etc. that are outlined in the FAQ, and a second that is similar to the current grid for non-DoL oversight accounts."
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"There are ways to potentially be cute with it. You could potentially cut out retirement business from the back-end bonuses," says an ex-Merrill Lynch executive who works in the independent space. "Cute doesn't usually work when it comes to regulators."
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But the DoL's guidance hints that regulators will be looking closely at how those grids for retirement advice are structured, and warns firms that "modest or gradual increases are less likely to create impermissible incentives than grids characterized by large increases."
Additionally, the Labor Department is urging firms that use grids with tiered payouts to monitor those programs closely, both to guard against conflicts of interest in the grids themselves and to ensure that advisers working under incentive programs make recommendations that are in the best interests of their clients.
DEFENSIVE STAND
As the rule becomes the law of the land next April, the greater concern for wirehouses and brokers might not be the challenge of complying with the regulation, but of establishing a defensible position that could withstand potential legal challenges brought by aggrieved clients who could argue that an adviser was making recommendations based on compensation incentives after an investment went south.
"Firms can tone down the extent to which they use incentives, but there are still incentives," Tasnady says.
"In my mind, if there's any incentive, someone can make a claim that there's a potential for biased advice. So while the DoL suggestions and rules and guidelines reduce that potential amount of bias, it doesn't eliminate it," he says. "The risk is it's really an unknown."
