The Department of Labor's (DOL) regulatory package, commonly referred to as the “fiduciary rule,” has far-reaching implications for the mutual fund industry and the transfer agents that serve that industry. This article explores potential impacts of the rule on the Mutual Fund Industry.
In April 2016, the United States Department of Labor (DOL) released a regulatory package that expanded the definition of the term fiduciary and redefined who was considered an investment advice fiduciary. Included in the package was a Conflict of Interest Rule for retirement investment advice, two new prohibited transaction exemptions, as well as amendments to existing prohibited transaction exemptions under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code. The DOL’s regulatory package, commonly referred to as the “fiduciary rule”, has far-reaching implications for the mutual fund industry and the transfer agents that serve that industry. More recently, there has been speculation that, under the Trump Administration, this rule may be delayed, amended, or repealed. This remains an uncertainty which complicates the planning and implementation of measures designed to support compliance with the rule.
The rule was designed to bring broker-dealers, insurance providers and other investment advisory firms that were not previously subject to ERISA or the Internal Revenue Code’s self-dealing prohibited transaction rules and impartial conduct standards, into the fiduciary fold. It also expanded the types of retirement accounts that would be governed under the rule to include individual retirement accounts (IRAs), Health Savings Accounts (HSAs) and Coverdell Education Savings Accounts (Coverdell ESAs).
Unless action is taken by the GOP-led government to delay the rule, effective April 10, 2017 (the “effective date”), an advisor will not be able to sell an investment product and receive commission, or other conflicted compensation, without entering into a Best Interest Contract (BIC) with the retirement investor. To receive commissions the advisor must act in a fiduciary manner, abide by the conditions of the BIC, acknowledge their fiduciary status, disclose conflicts of interest and ensure product picks are in-line with “reasonable compensation” requirements.
In most cases, the rule does not directly create new compliance requirements for mutual funds and their transfer agents, because funds and transfer agents do not provide the kinds of advice that are covered by the rule. However, the indirect impact of the rule will likely have a significant effect on mutual funds and their transfer agents, as they seek to accommodate mutual fund intermediaries, such as financial advisors, who are directly impacted by the rule. At this point, the industry is still developing responses to the rule, and common industry practices have yet to emerge. Nevertheless, there are a number of issues that the industry has identified, for which mutual funds will turn to their transfer agents to develop solutions. These issues include orphaned accounts, grandfathered accounts, and new mutual fund product features.
In the mutual funds industry, a shareholder account is termed to be “orphaned” when the shareholder’s financial advisor discontinues his or her relationship with the shareholder, and makes arrangements for the shareholder’s account to be held directly at the fund. After being orphaned, the shareholder is left without a financial advisor and places trades directly with the fund’s transfer agent.
The industry anticipates that there will be a significant population of orphaned accounts as a result of the rule. This is because financial advisors, faced with the heightened legal risks and costs associated with the rule will deem certain shareholder accounts, particularly those with small balances, to be unprofitable or otherwise undesirable.
At this point, the industry has formed working groups to try to arrive at common industry practices for handling the transfer of such accounts from the financial advisor to the mutual fund’s transfer agent. While orphaning processes already exist, these processes do not currently accommodate large numbers of accounts, such as may be encountered in response to the rule. In addition to working out the mechanics of larger volume transfers, the industry is working on identifying potential compliance issues associated with mass-orphaning of accounts. These issues include whether the accounts are dormant for escheatment purposes, and whether the date of last contact can be provided by the delivering financial advisor.
The rule contains a grandfathering provision that allows an advisor to continue to receive additional or subsequent compensation based on investments that were made prior to the effective date. However, additional advice provided to the retirement plan investor must be satisfied by the BIC contract requirements.
The industry has concerns about the grandfathering status an account may have if the shareholder places a trade directly with the transfer agent. These types of direct trades are not uncommon, particularly during tax filing season. Intermediaries have voiced concerns that, by the shareholder placing a trade directly with the fund’s transfer agent, the account would no longer be grandfathered and the compliance obligations imposed by the rule would be triggered. In response to these concerns, intermediaries have expressed differing views on how mutual fund transfer agents should handle these direct transactions. Some intermediaries have opined that transfer agents should reject the shareholder’s transaction, while others have expressed that they would prefer the transfer agent to hold the transaction and seek instruction from the intermediary. While everyone (the shareholders, intermediaries, and mutual fund transfer agents) would benefit from a common, consistent approach to these transactions, such a solution remains elusive at this time.
New Product Features
Under the BIC contract an advisor can only receive “reasonable compensation” for their investment advice. The industry is struggling with the term “reasonable” given that standardized fee benchmarks do not currently exist. In addition, differential compensation, as defined in Section II(d)(3) of the Best Interest Contract, is permissible as long it is based on “neutral factors” tied to differences in the services respect to the different types of investments, as opposed to the differences in the amounts of third party payments received in connection with a particular investment recommendation. Firms are finding it difficult to quantify the applicability of neutral factors across a multitude of investment products.
In response to this requirement, some intermediaries are evaluating the compensation that they receive from funds and fund classes to which they have directed their shareholders’ investments. For example, some intermediaries have expressed that the commission levels in some funds’ A (front-load commission) classes would be too high once the rule becomes effective. In response, they have placed inquiries with these funds if the funds would consider opening new A classes with lower front load commission levels. Funds, on the other hand, are faced with multiple requests from different intermediaries, each asking for different commission schedules. Given fixed costs associated with managing a fund class, mutual funds are faced with the conundrum of accommodating these diverse requests while maintaining profitable fund classes. To assist them, mutual funds are turning to their transfer agents to determine how transfer agents might be able to support different intermediary compensation features that the funds might offer.
The items described above are but some of the issues that the intermediary and mutual funds communities are grappling with. In addition to these issues there may well be significant migration of assets between funds, and between funds and exchange traded funds (ETFs).
Amidst all of the uncertainties that this rule has brought, one thing seems certain: absent intervention by the Federal government, mutual funds and their transfer agents will be faced with significant challenges in their efforts to accommodate the compliance needs of the intermediary community.
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Vice President, Transfer Agent Regulatory Management, BNY Mellon Asset Servicing
Charles S. Hawkins is a Vice President in the Transfer Agent Regulatory Management Department at BNY Mellon’s asset servicing group which is responsible for coordinating the delivery of regulatory services to transfer agency clients. Mr. Hawkins’s responsibilities include the design and implementation of compliance solutions for new or amended regulations.View Profile