In a comment letter to the SEC, Morningstar’s Aron Szapiro explores what changes the fiduciary rule has had on the asset management industry and what the SEC can do to help investors.
Although most of the attention around the future of the fiduciary rule has centered around what changes the Department of Labor might make, the SEC could also play a crucial role. Since 2010, the commission has had the authority to create a "uniform advice standard" which could apply to both retirement and nonretirement accounts. While we don't expect the SEC to promulgate a rule imminently, the DOL has pledged to work closely with the SEC on any modifications to the fiduciary rule.
New SEC Chair Jay Clayton has started the process of examining this issue by asking for responses to a series of questions about rules governing how broker/dealers and registered investment advisors can give advice. Morningstar took the opportunity to share our views on the best path forward in a letter submitted to the chair this week. The text of the letter is below and a PDF version is available here.
Dear Chairman Clayton:
Morningstar, Inc. appreciates the opportunity to comment on standards of conduct for investment advisors and broker-dealers. Morningstar, Inc. is a leading provider of independent investment research, and our mission is to create products that help investors reach their financial goals. Because we offer an extensive line of products for individual investors, professional financial advisors, and institutional clients, we have a broad view on the rule and its possible effect on the financial advice retirement investors will receive.
A Disclosure-Based Approach Is Insufficient
Morningstar believes that investors' confusion about standards of conduct applicable to different kinds of relationships is likely to continue for some time, and disclosures alone will not clarify those standards for many investors. Most investors are not very experienced and probably would not invest in the absence of the defined-contribution system. For example, from our examination of the 2013 Survey of Consumer Finance, we noted that that 76% of investors invest exclusively in tax-privileged retirement plans, and these investors often do not understand fundamental investing concepts such as the importance of taking risk for long-term investing.
Further, even among experienced investors who hold investments outside of retirement accounts, most investors do not understand the distinctions between broker-dealers and Registered Investment Advisors and the conflicts of interest some financial advisors may have when recommending investments. There has also been a good deal of coverage of the recent Department of Labor "Fiduciary Rule," mostly reporting that financial advisors are now acting in the best interests of their clients, even if they were not before. Further changes in the standards would likely further confuse investors, who have absorbed the news about the Fiduciary Rule.
New, Innovative Share Classes Created in Response to the Rule Could Improve Investors' Outcomes
In general, we believe the early evidence suggests the Fiduciary Rule will be positive for ordinary retirement investors, in part because the rule will reduce conflicted advice. For their part, asset managers appear to be responding to the rule by offering new share classes that should reduce conflicted advice. In the long term, we expect further innovation in share classes to provide more flexibility to advisors and better outcomes for investors. We also expect distributors to rationalize their investment lineups in response to the rule. (We have attached a recently released white paper, "Early Evidence from the Department of Labor Conflict of Interest Rule: New Share Classes Should Reduce Conflicted Advice, Likely Improving Outcomes for Investors," which provides our analysis of these share class trends.)
In particular, the Fiduciary Rule will reduce the current variation in A share sales loads. Such loads create an incentive for advisors to choose funds that might not be in an investor's best interest, but new share classes could reduce this risk. For example, with an A share, an advisor might receive a higher commission from an emerging-markets bond fund from one family rather than a lower-risk short-term bond fund from another, even if an investor would be better off with the lower-risk fund. In fact, Morningstar's database reveals a standard deviation of 1.08% on the 4.85% maximum average load. Using T shares with the same commission structure across all eligible funds, the advisor is more likely to choose the one that is best from a pure investment perspective. However, although T shares reduce conflicts in recommending a fund vis-à-vis A shares, the load still could give incentive to advisors to recommend moving money from one fund to another to collect a commission.