Exclusive Interview with Ron Rhoades: Revenue Sharing – Two Hats are Worse than One
From time to time, FiduciaryNews.com makes an effort to go beyond the quotes and sit down with thought leaders in the fiduciary arena in hopes of getting them to share some of their deeper thoughts with our readers. This week we’ve been fortunate to catch up with Ron A. Rhoades, JD, CFP®, who shared the podium with our own Chief Contributing Editor at an FPA Ethics Symposium in Buffalo, NY last fall.
Dr. Rhoades is an Assistant Professor and Program Chair for the Financial Planning Program at Alfred State College, Alfred, New York. He is also President of ScholarFi Inc., a fee-only RIA firm. Dr. Rhoades has written extensively on the fiduciary obligations of investment and financial advisors. He was the recipient of the 2011 Tamar Frankel Fiduciary of the Year Award, for “changing the nature of the fiduciary debate in Washington.” He also was named one of the Top 25 Most Influential Persons in the advisory profession by Investment Advisor magazine for 2011. Ron currently serves on the National Board of NAPFA. Dr. Rhoades is the author of several books, and many published articles, and frequently contributes to comment letters to government agencies on issues affecting investment adviser compliance and fiduciary duties.
FN: Ron, first off, congratulations on your award. It’s an honor to have this opportunity to talk to you on the topic of fiduciary liability and conflicts of interest. Let’s start with revenue sharing, the popular industry practice where mutual funds pay the fees of broker-dealers, recordkeepers and other service providers in lieu of the plan sponsor paying those fees. Can you share with our readers your thoughts on revenue sharing, why it’s a problem and how it can increase fiduciary liability for the plan sponsor?
Dr. Rhoades: The largest problem with revenue sharing payments, from the standpoint of the plan sponsor, is that they can vary the compensation paid to the investment adviser. The amount of revenue sharing varies from fund company to fund company, and it can also vary based upon either the new assets brought by the broker-dealer to the fund or the assets maintained in the fund, or both. This leads to an inherent conflict of interest – so severe that a true fiduciary cannot effectively manage the conflict. In essence, the fiduciary advisor could receive greater compensation by recommending one fund over another. Essentially, the broker-dealer would be wearing two hats – a circumstance the “sole interests” ERISA fiduciary standard and the prohibited transaction rules (as originally written, without exemptions) were designed to avoid.
FN: You bring up a good point when you say “as originally written.” The reality is the DOL has now carved out exemptions to the prohibited transaction rules all trustees must abide by. Short of re-establishing a pure fiduciary standard and reinstate these prohibitions, how can plan sponsors best maintain the fiduciary premise in the current regulatory environment?
Dr. Rhoades: In a true fiduciary environment, the compensation of the advisor is established in advance of any recommendations. This insures the compensation of the fiduciary will not vary based upon the recommendations made. The fiduciary acts as the sole representative of the plan sponsor, and is prohibited from wearing two hats. If compensation of any form is then received by the fiduciary from anyone other than the client, then that compensation so received should be credited (in full) against the fiduciary’s agreed-upon fee.
FN: OK, that’s how to deal with the current regulatory environment. But we all know the DOL wants to broaden the definition of “Fiduciary” under ERISA. Do you think this new DOL proposal will fix the current problem?
Dr. Rhoades: While the plain language of ERISA adopts the “sole interests” fiduciary standard – a tougher standard than the “best interests” standard applicable to registered investment advisers – and hence outlaws conflicts of interest, the DOL has provided numerous exemptions from the definition of fiduciary. Hopefully the new rulemaking in this area will rectify this situation, with very few exemptions and with a full implementation of the “sole interests” fiduciary standard of conduct.
FN: Of course, some rather large and entrenched players in the financial services industry have fought the DOL, as well as the SEC, on the issue of the fiduciary standard. Even politicians, many who have expressed concerns about regulations hampering business in a slow economy, have asked the regulators to restrain themselves. Do you believe it’s possible for regulators to create a fiduciary framework consistent with the traditional duties of fiduciaries (i.e., the “fiduciary standard”) that allows existing business models to continue?
Dr. Rhoades: There have been numerous calls by the broker-dealer industry for the DOL to adopt a “compensation-neutral” or “business model-neutral” fiduciary scheme. In reality, however, fiduciary standards act as a restraint on various forms of conduct, and compel certain other types of actions (e.g., extensive due diligence on both overall investment strategy and investment product selection). Hopefully the DOL will force the securities industry to adapt to the fiduciary standard of conduct – it can so adapt, by changing its compensation practices and eliminating revenue-sharing arrangements. Hopefully the fiduciary standard of conduct will not be diminished by seeking to adapt it to the business practices of an industry which remains largely composed of “manufacturer’s representatives.” Many a jurist has warned that, in the end, a true fiduciary cannot wear two hats.
FN: Well, we’ve been talking pretty theoretically up to this point. That’s the professor side of you. Speaking of two hats, let me allow you to don your other hat and speak to the practical side of things. Many plan sponsors would rather focus on improving their business and don’t have a lot of time set aside to address issues important to their 401k. They would rest comfortably, though, if an expert such as yourself gave a few quick-and-easy rules of thumb to abide. With that in mind, what advice would give 401k plan sponsors that they could act upon right now?
Dr. Rhoades: Plan sponsors should not wait for the DOL to act. The DOL’s rules do not necessarily provide “safe harbors” for plan sponsors. Hence, I would advise plan sponsors to avoid any revenue-sharing arrangements, of any type, between the advisors and other vendors of the plan. This includes not only payment for shelf space, but also soft dollar compensation and other “back-channel” payments. Establish the compensation of the investment adviser in advance – before any investment recommendations are made – either as a flat fee, hourly fee, or percentage of assets (or some combination thereof). If revenue-sharing payments are in place, demand that they be credited, in full, against any fees paid to the broker-dealer firm acting as the fiduciary to the plan.
FN: Moving from the issue of revenue sharing, let’s talk about 12b-1 fees. If revenue sharing is sort of a back-door way for plan vendors to “hide” compensation, then 12b-1 fees are the front door. There’s no question there are much broader concern with 12b-1 fees. Indeed, for a time it appeared the SEC was on the verge of outlawing them. Recent studies by the ICI show the use of 12b-1 fees has tailed off considerably among 401k plans. Still, some plans continue to offer funds with 12b-1 fees. Do you have any straight-forward rules plan sponsors should adopt regarding 12b-1 fees?
Dr. Rhoades: If 12b-1 fees exist and are paid out to the broker-dealer firm, those should be credited (in full) against the amount of the agreed-upon compensation with the broker-dealer firm. If 12b-1 fees exist and are not fully paid out to broker-dealer firm (to be credited), then the plan sponsor should avoid the fund. There is no reason to pay 12b-1 fees to a mutual fund, which 12b-1 fees were originally designed to assist in the retail marketing of a fund, where there is no benefit to the plan sponsor.
FN: Wow, you’re pretty blunt. But that’s probably the kind of advice 401k plan sponsors most desire. Are there any other skeletons hiding in the conflict-of-interest closets plan sponsors need to be aware of?
Dr. Rhoades: In addition, if the broker-dealer is chosen by a fund company to execute a large amount of trades for the fund (which can be, even without payment of soft dollar compensation, a questionable practice, given the outlawing of directed brokerage and the rise of electronic trading platforms at very low fees), this is a “red flag” that highlights the need for greater scrutiny as to whether the investment adviser is truly acting on behalf of the plan sponsor, and not their own. Is directed brokerage, which was outlawed by the SEC several years ago, still a problem? A simple statistical analysis of the relationships between many mutual fund complexes and broker-dealer firms, relative to those of other fund complexes, would show that directed brokerage remains an insidious problem in many segments of the broker-dealer industry.
FN: That’s one many plan sponsors have probably never even heard of. It might be enough to have them question their existing relationships. With that in mind, what guidelines do you suggest 401k plan sponsors should require of their investment adviser?
Dr. Rhoades: When selecting an investment adviser, plan sponsors should focus on: (1) the amount of compensation paid to the investment adviser – because fees directly impact participants’ returns; (2) the quality of adherence to the duty of due care by the adviser – as to due diligence in overall investment strategies utilized, plus individual fund due diligence; (3) whether the investment adviser possesses any limits as to the funds which could be offered (because why would an plan sponsor choose an investment adviser who cannot recommend the entire universe of mutual funds and ETFs – including the very best offerings out there – to execute the strategies adopted); and (4) expertise on all matters relating to the selection of other vendors, the education of plan participants, and the fiduciary duties of plan sponsors. A failing in any one of these areas could subject the plan sponsor to unintended consequences – including potential liability for breach of the plan sponsor’s own fiduciary obligations.
FN: Ron, as always, it’s been a pleasure speaking with you. As expected, you’ve given FiduciaryNews.com readers several important points to ponder. Thanks and good luck on your continued efforts to promote all things fiduciary!
Dr. Rhoades: Hope this helps. Good to hear from you. Thank you.