Journal of Financial Planning: August 2016
Although much of the news following the announcement of the Department of Labor’s Conflict of Interest Final Rule has focused on the adviser component of the equation, another component that deserves discussion is the impact the fiduciary rule may have on financial product providers.
While many industry prognosticators indicate that the insurance industry will experience changes as a result of this new rule, what might one expect its effect to be on the mutual fund industry?
Although the fiduciary rule does allow advisers to receive commission-based compensation and/or indirect income by way of revenue-sharing provisions allowed through certain mutual fund share classes, there’s some question as to how long that will be the case. Direct compensation seems to be the direction the industry is headed, and indirect forms of compensation could be challenged in the future. Inevitably, mutual fund complexes would have to change how they compensate certain third-party distribution and marketing service providers.
The Future of 12b-1 Fees
Let’s take a look at the most common form of indirect compensation through mutual funds, the 12b-1 fee, which was created through the auspices of the Investment Company Act of 1940. The 12b-1 application provided a way for mutual fund companies to compensate a third party for performing tangible service functions that they otherwise would be delivering themselves.
Essentially, 12b-1 compensation can be established by an agreement that includes a listing of the services to be delivered by the subcontractor to the mutual fund, the cost for those services, and a monitoring mechanism to be used to demonstrate that the third party has met the terms of the service agreement under which he or she is being compensated.
The component of having a mechanism that demonstrates that the third party has clearly met the terms of the service agreement is where the mutual fund industry may run into a problem.
Commission-based advisers have played an integral role in attracting assets into actively traded mutual funds, and over the years they have been compensated by mutual funds for their efforts (12b-1 fees can range from 0.25 percent to 1.00 percent of market value of the assets). However, mutual funds may not have a way to effectively monitor whether or not the adviser has met the terms of the service agreement.
Another issue lies in the plethora of share classes in the mutual fund world that have been primarily created as an accommodation that offers advisers a variety of methods in which they can be paid. This multitude of share classes brings more complexity to the relationship between services being provided and adviser compensation for performing those services.
Revenue Sharing
Another area that may be impacted by the DOL’s fiduciary rule is revenue sharing to compensate third parties that are performing administrative duties on behalf of the mutual fund complex. This can include independent record keepers and third-party administrators who handle the complex back-office functions critical to ERISA plans.
As in the case of 12b-1 fee compensation, there will typically be an underlying contractual agreement outlining the services and fees associated with the administrative/operational service functions being performed. As a general rule, these third-party entities will incorporate any indirect compensation they receive into their fee schedule and credit these payments as an offset to the fee they would normally be charging the plan.
Remember however, that when mutual funds are paying third parties through a revenue-sharing class tied to one or more of their funds, those fees are being deducted from the fund’s gross performance and may not be transparent. Deducting non-transparent third-party payouts from a mutual fund potentially represents another drain on fund performance. Due to the lack of transparency, the plan participant may end up being charged fees at the expense of fund performance, which is further exacerbated if the mutual fund is not performing well when compared to other like funds in their peer group.
For a retirement plan participant, years of fund underperformance coupled with being subjected to potentially high service fees can take a big chunk out of an employee’s long-term retirement savings.
IRA Inclusion
Perhaps the most significant game changer for mutual fund companies is the inclusion of individual retirement accounts (IRAs) under the DOL’s fiduciary rule. According to the 2016 Investment Company Fact Book, at the end of 2015, IRAs and defined contribution (DC) plans had collectively invested $7.1 trillion in mutual funds. Roughly 40 million households, or more than three out of every 10 households in the U.S., owned at least one type of IRA as of mid-2015, according to the Investment Company Institute.
Under DOL governance requiring advisers to take on a fiduciary role when servicing those IRA accounts, if for no other reason than the vastness of the IRA marketplace, mutual funds will be compelled to pay closer attention to how they package and price their investment products. Initially, advisers will be able to engage in selling mutual funds that offer trail commissions, and those who do so will be required to file for a Best Interest Contract Exemption (BICE) with the DOL attesting to the fact that the use of this type of investment is indeed in the best interests of their client.
The BICE option for advisers who wish to receive variable compensation is something we will learn more about over the next few months. One might consider whether, at some point, all fiduciaries might be obligated to run their business on a levelized fee-only basis. If that becomes the case, the future of 12b-1 fee arrangements could come into question. The elimination of indirect fee compensation could create a domino effect on the pricing scheme for ERISA plans. For example, if a plan was employing revenue sharing as a means to cover their custody and trading expenses and that form of payment disappeared, those expenses would still remain and have to be covered in some other fashion.
Beyond the changes the DOL’s fiduciary rule is expected to bring to the mutual fund industry, emerging competition in the form of managed accounts and greater use of exchange-traded funds (ETFs) in ERISA plans represent substantive competition to mutual funds. Transparent and potentially lower fees embodied in those investment vehicles seem to correspond with the mandates of the DOL to promote full fee disclosure and a reasonable alignment between the services being rendered and the fees being charged for those services.
Does all of this suggest that mutual funds will suffer a death blow? Probably not, although we might witness a measurable shift in market share between product and service lines over the next few years. Open architecture for plans will remain, and mutual funds will continue to sate the appetite of many plan participants.
On the heels of the DOL’s fiduciary rule, other regulators, including the Securities and Exchange Commission, may issue their own set of guidelines. The big question is: will the financial services industry go along with bifurcated standards whereby some advisers and firms will be held to a lesser duty of determining “suitability,” while others are required to place their clients’ interests ahead of their own? The answer to that question will largely dictate the shape of the mutual fund industry in the years to come.
Thomas P. Coté is senior vice president for retirement plan solutions at EQIS, a San Rafael, California-based asset management firm.