On Wednesday, April 6, 2016, the United States Department of Labor (the “DOL”) released the final version of its rule imposing a “best interest” fiduciary standard on financial professionals who provide retirement savings advice.1 The DOL release is massive in scope, and we expect to issue subsequent Alerts addressing various aspects of the new rule. However, our initial observation is that the DOL rule is particularly significant because of its focus on lowest-cost investment options and conflicts disclosures. We believe this focus will have a significant impact on the manner in which firms address compliance and supervision, not only for retirement accounts, but also for non-qualified accounts.

The DOL rule attempts to accommodate both fee-based and commission-based models by imposing a “best interest” standard for all retirement accounts. To accommodate commission-based models, the DOL rule further requires extensive disclosures in the form of a “Best Interest Contract.” Although the exact contours of the required disclosures will evolve over time, the DOL has made clear that conflicts of interest and costs will be key components.

The DOL’s emphasis on cost disclosures is consistent with the recent regulatory focus on costs by the Securities and Exchange Commission (“SEC”)2 and Financial Industry Regulatory Authority (“FINRA”).3 Recently, both the SEC and FINRA have focused on the importance of making investment recommendations which consider the lowest-cost option available to an investor.

In particular, the DOL appears focused on an analysis of a product’s costs as reflective of whether an advisor’s recommendation comports with the “best interest” of the investor. Such a focus on costs could effectively limit investment options for retirement investors under the guise of trying to protect those investors.

The sale of alternative investments, proprietary products and variable annuities, as just a few examples, highlight the problem of focusing on “lowest-cost” as indicative of the best interests of the investor. These types of products often have imbedded costs such that it is more difficult to assess compliance with a “lowest-cost” option. As a result, the new rule creates additional challenges in the sale of such products in retirement accounts. Obviously, with respect to these products, firms will have to consider the degree to which they will need to enhance their analysis of relative investment performance in order to justify the additional costs which may be associated with such investments. Moreover, we recognize that some firms may simply decline to permit advisors to sell these types of products to retirement accounts.

While the initial rule proposal contemplated limitations on the types of investments that could be recommended to retirement investors, the final rule does not delineate “permitted” assets.4 Fortunately, the final rule rejected express prohibitions on the sale of certain illiquid investments, such as non-traded real estate investment trusts, hedge funds and private equity funds. While the DOL might argue that elimination of a list of specifically prohibited products addresses any concern about limiting investor options, concerns remain regarding the circumstances in which purchases of these products will actually be deemed acceptable.

The new rule may increase the pressure for firms to migrate commission-based retirement accounts onto a fee-based platform. Of course, for smaller retirement investors, such a percentage-of-assets based fee may not make financial sense or may create concerns about reverse churning in small accounts with little activity, resulting in firms either no longer accepting such clients or assigning them to a call center. In this regard, we agree with many commentators who are concerned that the rule will negatively impact smaller investors.

Implications for Non-Qualified Accounts

We believe the new rule also has potential implications for the handling of non-qualified accounts. Firms will face the common situation of a client having both a retirement account and a non-qualified account. Under the current regulatory regime, two standards will apply, creating the potential for client confusion and increased uncertainty in the arbitration and litigation sphere. Also, the possibility exists that the DOL standard will serve as a driver for new suitability and disclosure standards for non-qualified accounts. Further complicating matters is the pending implementation of the fiduciary standard under Dodd-Frank. In the near term we believe it is important for firms to consider additional disclosures for non-qualified accounts which clearly delineate the differing standards and regulatory requirements applicable to retirement and non-qualified accounts. In short, the DOL rule is likely to pose significant challenges for firms across the entire spectrum of their brokerage and advisory platforms.

Anticipating the difficulties in implementation and application such as those identified above, and in response to comments and criticism of the proposed rule, the DOL extended the implementation period from what was initially contemplated. The final rule adopts a phased-in approach that requires firms to be compliant on several broader provisions by April 2017 and fully compliant by January 1, 2018 – all well beyond the term of the current administration. For example, the BIC exemption requirements will not go into effect until January 1, 2018.