Case 3:16-cv-01476-M Document 53-2 Filed 07/18/16 Page 1 ...

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mailto:[email protected]



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www.ici.org/pdf/rpt_15_ira_traditional.pdf

https://institutional.vanguard.com/iam/pdf/HAS15.pdf

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10 1868 0.006 -11.395 0.010 1.000 -11.395 1.308 -10.087 0.190 -10.648 -18.818

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services and advice to corporations, institutions and individuals. It has developed an employee code of conduct that stresses the primacy of client interests over those of the company or individual employees, and has articulated four “Core Values” that guide our business approach, the first of which is “Putting Clients First.”2

Morgan Stanley’s wealth management division, Morgan Stanley Wealth Management

(“Wealth Management”), has approximately 16,000 financial advisers throughout the United States servicing approximately 6.6 million wealth management accounts with over $2 trillion in client assets. Wealth Management provides services to individual retirement accounts (“IRAs”) and qualified retirement plan accounts through both brokerage accounts with transaction based pricing (e.g., commissions, selling concessions), and investment advisory accounts where customers pay an annual fee based on the value of the assets in the account. Where we act as a broker, in addition to transaction execution, we also offer investor education, research and personalized information about financial products and services through our financial advisers.

Morgan Stanley’s institutional securities business segment provides financial services to a diverse group of corporate and other institutional clients globally, primarily through wholly owned subsidiaries, and also conducts sales and trading activities worldwide, as principal and agent, and provides related financing services on behalf of institutional investors. Morgan Stanley’s investment management business segment offers products and strategies to institutional investors worldwide, including corporations, pension plans, endowments, foundations, sovereign wealth funds, insurance companies and banks through a broad range of pooled vehicles and separate accounts.

II. Summary

Morgan Stanley is comprehensively regulated under the federal securities laws, including

examination and oversight by the U.S. Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”). Whether acting in a brokerage or advisory capacity, Morgan Stanley must observe high standards of commercial honor and just and equitable principles of trade. In accordance with these regulations and our Core Values, Morgan Stanley supports the development of a uniform “best interests” of the customer standard applicable to all personalized advice about securities to retail customers, regardless of account type. By introducing an additional standard of care applicable only to retirement accounts, the Proposal will add to consumer confusion and result in regulatory and operational inefficiencies.

Morgan Stanley respectfully believes that a new, uniform fiduciary standard, promulgated

by the SEC, is the most comprehensive way to enhance consumer protection across all retail account types. If the Department adopts its Fiduciary Proposal before the SEC takes action, it will

Management”) is registered as a broker-dealer and investment adviser with the SEC and a member of FINRA and the NYSE. Morgan Stanley & Co. LLC is registered as a broker-dealer with the SEC, a member of FINRA and the NYSE, and registered as a futures commission merchant with the CFTC. 2 The remaining Core Values are “Doing the Right Thing,” “Leading with Exceptional Ideas,” and “Giving Back.”

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exacerbate the current lack of uniformity in fiduciary standards. 3 Thus, Morgan Stanley respectfully asserts that any Fiduciary Proposal await (and be consistent with) prospective SEC rule making.

Morgan Stanley strongly agrees with the Department that retirement investors should have

access to transparent and unbiased investment information. However, in its current form, the Department’s Fiduciary Proposal will curtail access to many beneficial services and products available to retail retirement investors. That is because, if the Proposal is adopted as written, firms and their representatives will become fiduciaries for virtually any retirement plan or IRA investment service and will be required to either: (1) comply with a Best Interest Contract (“BIC”) Exemption, which we believe is unworkable and which unduly restricts the universe of permissible investments (and is not currently available for many retirement plans), or (2) curtail investment information provided through existing retirement plan and IRA brokerage options. Of course, under the Proposal retirement savers and sponsors of retirement plans could still access advice by enrolling in fee based advisory programs that do not rely on the BIC, but these types of programs may not be appropriate or cost effective for all consumers. Retirement savers should not lose the choice of accessing some level of personalized information and guidance at no additional cost when paying transaction fees in a traditional brokerage account as a result of the Proposal.

If the Department proceeds with the Proposal before SEC rule making, the following clarifications and adjustments are critical to make the Proposal practically and operationally workable, preserving consumer choice and achieving the consumer protection goals that both Morgan Stanley and the Department share. As we detail below in the body of this letter, those needed changes include:

• Extending the applicability date of the final rule. Even working diligently, firms will need more than eight months from the issuance of the final rule to implement the extensive systems, procedural, and contractual changes necessary to comply with the Proposal. We therefore request extension of the applicability date until 24 months following the publication of the final rule.

• Revisions to the BIC Exemption to make it truly “principles based,” which include: (1) clarifying how and when firms and financial advisers may receive differential compensation, (2) adopting a feasible disclosure scheme that provides meaningful information at the most appropriate time, and which does not result in retirement clients getting less timely trade execution than other clients, (3) allowing a full range of permissible “Assets,” and (4) clarifying and tailoring the contractual requirements of the BIC so that contracts do not have to be entered into before any recommendations occur and so that the warranties do not create excessive litigation risk. Without meaningful changes to the BIC Exemption, retirement savers will have significantly limited access to the

3 In the IRA market alone, the Department’s Fiduciary Proposal could affect more than 34 million individual accounts holding over $7.4 trillion dollars. Most consumers who maintain both retirement and non-retirement accounts will not want to restrict the IRA portion of their assets to a limited product or service set (such as an advisory flat fee model, significantly limited brokerage products and services, or potentially receiving no investment guidance at all).

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transaction based model of obtaining investment education and assistance that many consumers currently utilize.

• Changes to the definition of a fiduciary to ensure that routine sales interactions (including

responding to Requests For Proposals) and the provision of basic investment-related information do not transform a financial institution into a fiduciary, necessitating fundamental changes to, and placing limitations on, the ability to provide beneficial information, products and services. We have proposed an alternative facts and circumstances test that focuses on the reasonable belief of the advice recipient. Alternatively, we have suggested specific language changes that include eliminating the “specifically directed to” provision and introducing the concept that the advice recipient must reasonably rely on a recommendation. In short, in whatever approach is adopted, the factual context should indicate a fiduciary relationship rather than a sales relationship.

• Providing a new “carve-out” for rollover discussions that complies with FINRA Notice 13-45. Notice 13-45 imposes a framework to ensure that rollover discussions are fair, balanced and not misleading while at the same time preserving consumers’ access to information to assist them in making informed choices. In the absence of such a carve-out, the BIC Exemption should be revised to address the full array of rollover advice (in particular, its application to distribution advice and selecting the rollover vehicle).

• Revisions to the Principal Transaction Exemption to allow firms to better provide liquidity to consumers, which is especially important during market downturns and periods of market volatility. These revisions include: (1) expanding the exemption to cover additional types of debt and some equities, (2) eliminating the requirement for two price quotes, and (3) eliminating or clarifying certain terms and conditions (e.g., “moderate credit risk” and “sufficiently liquid”).

• An expanded counterparty carve-out (the “seller’s exception”) that allows financial institutions to market services and provide investment information to all markets – large employers, small employers, participants in 401(k) plans, and IRAs.

• A modification to both the BIC and Principal Transaction Exemptions which allows a financial institution to rely on the Exemptions for so long as they act in “good faith and with reasonable diligence” in their compliance efforts and mitigate any compliance errors within a reasonable period upon discovery. This standard was adopted by the Department’s 408b-2 regulation, and should similarly apply here in light of the Proposal’s complexity and compliance requirements.

These and additional recommended changes to the Proposal are set forth in detail in the

remainder of this letter. Implementing these critical changes to the Proposal will not undermine the Department’s stated goals, but will instead ensure that retirement investors have continued access to beneficial investment information. We appreciate the opportunity to provide comments on the Proposal and look forward to a constructive dialogue with the Department to ensure that retirement savers are protected from conflicts of interest and continue to have access to quality investment assistance and advice.

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III. The Department Should Refine Its Proposed Definition of Fiduciary

We believe that the Department’s proposed definition of fiduciary is overly broad and

should be replaced with a facts and circumstances “reasonable belief” standard as described below, which will allow for consumer access to basic information and allow financial advisers to educate, inform and sell products and services. If the Department does not adopt this proposed alternative approach, we believe the changes set forth below (which introduce the concept of “reasonable reliance”) must be made to the Department’s functional definition in order to protect valid educational, marketing and sales activities.

Under the Proposal, virtually any conversation or written correspondence with a current or

prospective client about an investment, a distribution or rollover, or the hiring of an investment adviser or manager, could be a fiduciary act since the communication needs only to be “specifically directed” to the individual and does not need to be tailored to their particular needs. Routinely, such conversations will include general ideas, hypotheticals, suggestions or proposals, and there could be some basic understanding that the information may be considered by the client or prospect. However, these basic interactions are all that is needed to become a fiduciary under the Department’s Proposal – regardless of whether the educational or sales-related information serves as a material basis for the consumer’s decision or is in any way individualized to their circumstances.

The implications of this broadened definition are sweeping. Because the BIC Exemption

may be unworkable to avoid otherwise prohibited transactions, this broadened definition threatens to deprive consumers, particularly IRA holders, of basic information or drive them into programs and fee structures that may not be appropriate for their investment needs if firms limit or stop providing brokerage services. Some examples of valid, routine activities of financial institutions and advisers which we are concerned could be deemed to be fiduciary activities under the Proposal include:

• Ordinary communications involving any kind of discussion, comparison or identification

of available investment options, strategies, advisers or managers. For example, a financial adviser communicating with a prospective client could become a fiduciary by making suggestions about or comparisons between alternative advisory account programs offered by Morgan Stanley.

• The simple act of distributing research reports that analyze particular securities to a large group of clients or potential clients might be a fiduciary action since it could be viewed as “specifically directed to” the consumer.

• Presenting a sample 401(k) investment option menu in connection with an RFP response for retirement plan services.

• Responding to a plan participant’s questions about which available investment options under their 401(k) plan fit in a particular asset class.

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In each case, it is unlikely that a client would be willing to enter into a contract before receiving such basic information. We are particularly concerned that, as noted above, even if financial institutions were to limit their retirement account offerings to only asset based fee advisory programs (that do not require an exemption because conflicts are eliminated through offsets or fee credits), merely suggesting those programs to a prospect or existing brokerage client could be deemed to be fiduciary advice for which no practical sales exemption is available. None of the preceding activities are fiduciary activities under current law, and revisions should be made to the Proposal in order to clearly permit these activities and communications to continue, as they provide important and necessary information to consumers.

Furthermore, the broad coverage of the Proposal is particularly troublesome in the institutional space. Under the Proposal many ordinary course investment discussions could be viewed as “recommendations” and thus as investment advice, such that even discussions with the sophisticated asset manager of a large plan (which is already protected by ERISA’s rigorous fiduciary regime) may need to comply with a carve-out to avoid fiduciary status. Morgan Stanley points to the Department’s statement set forth in the Fact Sheet accompanying the Fiduciary Proposal that additional protections are not needed for large plans “managed by financial experts who are themselves fiduciaries” and are “under a duty to look out for the participants’ best interests.” Moreover, the Department acknowledges that such fiduciaries already understand “that if a broker promotes a product, the broker may be trying to sell them something rather than provide advice in their best interest.” Accordingly, the Department’s own view appears to be that the Proposal should not consider such transactions fiduciary investment advice. Rather, conversations with such large plans should be presumed not to be investment advice without regard to any carve-out.

To best address these concerns about the breadth of the definition, the Department should refine the Proposal to allow for consumer access to basic information and allow financial advisers to educate, inform and sell products and services. Specifically, we suggest that the Department delete the currently proposed functional test found in 29 CFR 2510.3-21(a)(2)(ii) and replace it with the following –

(ii) Renders the advice in a manner where the advice recipient reasonably believes that such person is acting in their best interest in providing such advice and is not acting in an educational, marketing or sales capacity. This determination is based on the relevant facts and circumstances. Under this clause, relevant factors include the individualized nature of the advice provided, the reliance placed on it by the advice recipient and any disclosures provided to the advice recipient; however, no single factor shall be determinative.

This approach addresses the Department’s key concerns about potential gaps under the current regulation’s 5-part test. Under this test, a person could still be a fiduciary even if they disclaimed fiduciary status, but then acted in a way to create consumer reliance (e.g., provided individualized and specific recommendations). It would also cover service providers that make important, personalized, “one time” recommendations. But this approach would protect valid educational, marketing and sales activities. In addition, adopting this approach would still require a seller’s carve-out since the carve-out provides a clear exception from fiduciary status and this test would still be appropriately factual.

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If the Department does not adopt the alternative approach suggested above, then the necessary changes to the proposed functional definition of fiduciary include: (1) eliminating the “specifically directed to” prong of the investment advice definition, or, alternatively, limiting its application to communications directed to a specific client so as not to pick up general communications (e.g., research, market reports and other materials sent to a large client base), and (2) adding a requirement that the advice given be “reasonably relied on” by the consumer or a “material” factor in the consumer’s investment decision rather than information simply provided “for consideration.” Thus, 29 C.F.R. 2510.3-21(a)(2)(ii) would be revised as follows:

Renders the advice pursuant to a mutual written or verbal agreement, arrangement or understanding that the advice is individualized to, or that such advice is specifically directed to, the advice recipient for consideration and is reasonably relied on or material in making investment or management decisions with respect to securities or other property.

In addition, the Department should eliminate the valuation prong of the “covered advice” portion of the definition, which is overreaching because it does not even require that a recommendation or call to action be made. The Department has already explicitly carved out ESOP valuations from this prong, and it is our understanding that ESOPs were the Department’s primary concern behind making valuations into “investment advice” in the first instance. It is unnecessary to make an unspecified group of benign valuation activities fiduciary actions under the Proposal. At the very least, if this prong is retained, then the Department should provide specific examples in the definition of what it considers to be the abusive valuation practices at which this prong is directed.

Finally, in response to the Department’s request for comments, Morgan Stanley would

support using FINRA’s definition of “recommendation” and its related interpretations, provided that in any final rule the Department clarify that the term is not applied in a way that is broader than the current application by FINRA.

IV. The Department Should Clarify and Expand the Carve-outs from its

Definition of Fiduciary

Because of the broad definition of fiduciary, even if that definition is modified as described above, it is also crucial that the carve-outs be expanded to apply more broadly and to provide specific relief for services to small employers and to IRAs. This would be consistent with the Department’s original 2010 proposed fiduciary definition.

A. Counterparties Carve-out

Limiting the counterparty carve-out to ERISA plans with more than 100 employees or

fiduciaries that manage more than $100 million in employee benefit plan assets is arbitrary and will chill the communication of important basic investment information and valid sales activities to small employer plans and IRAs. The Department has cited no evidence that small employers and the participants in their plans (many maintained by the professional firms of doctors, lawyers, accountants, or consultants) or IRA holders are uniformly unsophisticated and unable to evaluate and consent to sales activities. In fact, it is contradictory to assume that such consumers will be

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able to digest and understand the voluminous disclosures required under the Department’s BIC Exemption, but will be unable to understand a simple disclosure which explicitly discloses in plain English that with respect to a particular transaction, the adviser is merely acting as a seller of products or services, and not as a fiduciary.

The carve-out should be extended and made available to additional parties under a wider variety of circumstances. Specific recommendations include:

• The counterparty carve-out should be extended to sales to smaller ERISA plans and to

IRAs. This is particularly crucial for small employers since there is effectively no small employer defined contribution plan relief under the BIC Exemption (i.e., the BIC only covers plan sponsors of non-participant-directed plans with fewer than 100 participants). In the event the Department is reluctant to broadly extend the counterparty carve-out to all ERISA plans and IRAs, there should be, at a minimum, a carve-out for larger IRAs similar to the “accredited investor” standard widely used in the financial services industry, and defined under the federal securities laws. Under the federal securities laws, securities may not be offered or sold unless registered with the SEC or exempted from registration. Certain securities offerings that are exempt from registration (e.g., most alternative investments) may only be offered to investors who are accredited investors. The primary purpose of the accredited investor standard is to protect potential investors from risk by identifying investors that have sufficient financial sophistication and resources to understand and bear the risks associated with more complex or risky investments. Customers that meet this high standard, which include high-net-worth individuals and large companies, are given special status under the securities laws. Such sophisticated investors should be able to purchase the same assets in their IRAs as they are able to purchase in their non-retirement accounts. Finally, another alternative would be to permit the extension of the counterparty carve-out to smaller plans and IRAs if such clients receive an alert similar to that described in the Preamble to the BIC Exemption as a “cigarette warning”-style disclosure.

• The Department should clarify that the counterparty carve-out applies to the provision of all services (the ambiguity is created by the fact that the carve-out focuses on transactions, such as sales, purchases, loans and contracts, rather than straightforward services arrangements).

• The representations under the carve-out should be required prior to the time the transaction occurs, not prior to the time a recommendation is made. This is in line with current practice under FINRA and SEC guidance, and we believe comports with the way in which clients prefer to do business (e.g., a number of conversations may take place, and then the client decides to go ahead with a particular transaction, such that requiring the representations before each recommendation would be unwieldy).

• Some investment transactions take place over a period of time. To simplify the carve-out, any requirements regarding representations relating to the number of participants and assets under management should be met prior to the initial transaction and such obligations should not be continuous in nature.

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• The $100 million assets under management standard should be revised to include any type of assets under management, rather than be limited to only employee benefit plan assets, and lowered to $85 million (the Department’s dollar threshold under its QPAM Exemption, which is widely utilized with clients with which the counterparty carve-out may also be used).

• The counterparty carve-out should apply to referral programs. Many financial institutions have programs that provide compensation to professionals (e.g., lawyers or accountants) for referrals (as regulated by SEC Rule 206(4)-3). Under these programs, an estate planning lawyer might refer their client to a financial institution for investment services or advice relating to their IRA and other non-retirement assets. Under the Proposal, such referrals would likely be considered fiduciary advice because they could be construed to be a recommendation of an investment adviser or manager. Yet the referral would not be subject to the counterparty carve-out because IRAs are not included. These referral programs are beneficial to consumers as they involve recommendations by the consumer’s other trusted professionals. Furthermore, they are already regulated by the SEC, which requires extensive conflict disclosures to the consumer, but would not be covered by the counterparty carve-out, as currently contemplated.

B. Swap Transaction Carve-out

This carve-out does not sufficiently cover the entities that play a role in bilateral and cleared swap transactions such as clearing brokers, IRAs and commingled vehicles (e.g., bank collective trusts or hedge funds holding ERISA plan assets). Additionally, the carve-out conflicts with recently issued guidance (Advisory Opinion 2013-01A), where the Department indicated that clearing brokers would not be deemed fiduciaries to the extent they exercised certain close-out rights (provided the underlying transaction was governed by an applicable prohibited transaction exemption). Accordingly, Morgan Stanley asks that the Department expand the swap transaction carve-out to cover IRAs, pooled funds that hold plan assets, and clearing firms. These expansions will better capture the scope of participants currently entering into such transactions and prevent service disruption.

C. Platform Carve-out

The courts have recognized that constructing and offering an investment product with

investment options is not a fiduciary act, and we believe the Department should do the same.4 Indeed, no financial firm could establish a fiduciary relationship to an ERISA plan or IRA when it constructs its products and platforms – there is no relationship with any plan or IRA at that time. Creating an “exception” to the definition of investment advice for “platforms” is an indirect way for the Department to suggest that merely constructing and offering a platform to defined

4 See Hecker v. Deere & Company, 556 F.3d 575 (7th Cir. 2009) (Fidelity not a fiduciary where it merely “played a role” in the choice of investment options and plan sponsor retained ultimate authority over which options to include); Leimkuehler v. American United Life Insurance Co., 2013 WL 1591450 (7th Cir. 2013) (standing alone, insurer’s act of selecting funds and share classes for inclusion in investment options menu was not a “functional fiduciary” act where provider never exercised right to make substitutions in a way that could give rise to a claim).

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contribution plans is fiduciary in nature and requires a carve-out. Even more troubling is that the platform carve-out is not applicable to IRAs or self-directed brokerage accounts offered to qualified retirement plans. This creates a negative implication that the mere offering of an IRA or self-directed brokerage account whereby consumers can invest in a range of common investments is somehow a fiduciary function.

As a result, the platform exception should be significantly reformulated and revised to

cover additional commonplace circumstances as follows:

• The Department should make clear that it interprets the definition of fiduciary such that offering a platform of investments to consumers does not constitute a fiduciary act at all. This would mean that the Department would clarify in the Preamble to the final rule that the construction of platforms, and their offering to the public, is not investment advice and therefore does not need a “carve-out” from the definition of advice. This interpretive guidance should be extended to IRAs and self-directed brokerage accounts, many of which offer nearly limitless investment opportunities.

• If the Department retains the carve-out approach, then IRA and self-directed brokerage account platforms must be included in the carve-out. If not, then it could be impossible for financial institutions to avoid fiduciary status for IRAs and self-directed brokerage accounts even if they offer non-fiduciary “self-directed/execution only” IRAs/accounts (i.e., if any limits are placed on the available universe of investment options, a platform may be created).

Without relief on this fundamental issue, IRA and qualified retirement plan clients may have no brokerage services available to them.

D. Selection and Monitoring Carve-out

Morgan Stanley believes that the Proposal must allow for the provision to plan fiduciaries

of a sample 401(k) line-up and educational information about investment selection. Thus, we recommend that the Department clarify that the presentation of 401(k) line-ups and related education is covered by this carve-out where criteria for identifying funds is specified by the plan fiduciary, regardless of who provides the 401(k) line-up and information or whether it is offered in connection with making a platform available.

Wealth Management acts as broker of record on many plans which have assets held on a

third party’s platform, and Wealth Management financial advisers may provide education at both the participant and plan sponsor level. Unless the carve-out is clarified and is applicable to such “broker of record” situations, plan fiduciaries using Wealth Management as the broker of record will not be able to seek basic investment education relating to the identification of investment products that meet objective criteria or the provision of objective financial data and comparisons to independent benchmarks. This would disadvantage small employers which are particularly in need of investment information and assistance, and in turn disadvantage their plan’s participants who may not have an appropriately constructed fund line-up.

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Finally, this carve-out should be expanded to IRAs as otherwise individual consumers will similarly be denied basic investment information such as the ability to have a platform provider identify available investment products that meet consumer provided selection criteria.

E. Valuation and Reporting Carve-out

If the proposed prong of the basic definition which makes valuations into fiduciary advice

is not eliminated as requested above, this carve-out should be clarified and expanded such that any regularly provided account statement, or statement provided in connection with a distribution, is not investment advice regardless of whether it is required by law. In many instances valuations are provided for other client service oriented reasons, such as through a financial planning tool or on statements which are not specifically produced as required by law. Rendering such statements of value as fiduciary in nature seems unnecessary and will reduce the usefulness of such tools to clients, without a significant benefit. Clients should be more concerned about the values provided for reporting purposes, and the Internal Revenue Service (“IRS”) is already charged with monitoring the behavior of firms in connection with required reporting, and has a panoply of recently revised rules (i.e., the IRS’ “hard to value asset” revisions to its Form 5498 and 1099-R reports) designed to detect and prevent deficiencies in this area.

F. Education Carve-out

Morgan Stanley appreciates that the Department has proposed to formally extend the

participant education “safe harbor” set forth in Interpretive Bulletin (“IB”) 96-1 to IRAs. However, we are concerned that the new limitation on identifying investment options that fit into asset classes will restrict the flow of other factual information that is vitally important to consumers.

For example, as proposed, a call center conversation could not even identify to the

participant which funds offered under a 401(k) plan fit any particular asset class. Providing asset classes without examples, or requiring participants to navigate the internet alone for additional information, will not help participants. This basic information should be available so consumers can construct a diversified portfolio. Absent this information, the utility of any educational materials provided would depend in large part on the individual’s degree of investment sophistication. This limitation on identifying investment options also conflicts with the Preamble to the Proposal where the Department cites the need for investor help as a cause for its revisiting its regulatory definition. The current “safe harbor” under IB 96-1 has operated well for nearly 20 years, connecting participants with the practical information most individual retirement investors seek, without the need to bring a relationship to a full stop in order to insert the contract and disclosure regime proposed by the BIC Exemption.

A further unintended consequence will be the inability of firms to provide any specific

investment solutions with respect to lifetime income options. The Department is making efforts to promote lifetime income options for defined contribution plans, but under the Proposal financial advisers would have no ability to suggest appropriate annuities or other payout strategies without becoming fiduciaries to plans and having to rely on the complex and costly BIC Exemption, which

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many advisers will avoid unless it is revised. This will frustrate the very behavior that the Department wishes to promote.

G. Add a Rollover Carve-out

The Department should also encourage robust distribution and rollover education and

information and should provide greater clarity defining the line between distribution and rollover education and distribution and rollover advice. Therefore, Morgan Stanley strongly recommends that the Department enact a workable rollover sale “safe harbor” based upon FINRA Regulatory Notice 13-45.

Specifically, where a firm follows the principles of Notice 13-45, that discussion should be

covered by the education carve-out. The FINRA notice imposes a standard of care on rollover discussions to ensure that rollover discussions are fair, balanced and not misleading. As Notice 13-45 acknowledges, although IRAs may entail higher fees, there are other reasons why they are desirable to individuals including the services, investments and control they offer. In addition, many individuals simply do not want to be connected to their former employer, or to take the chance that if that employer goes out of business the plan will be abandoned and the individual will lose the ability to access their retirement savings when they need them. As a result, opening an IRA may be in the best interest of the participant, despite a potential increase in cost, but firms may be unable to provide rollover assistance as any resulting compensation would constitute a prohibited transaction. Absent such a “safe harbor” from fiduciary status, firms will be forced to try to comply with the BIC Exemption, which currently does not provide a workable framework for rollover discussions (in particular, because many of these discussions take place with individuals who are not yet clients of the firm, and thus entering into a contract before discussions commence is not feasible).

Without a rollover carve-out, firms may no longer be able to provide important information

to individuals at a crucial juncture in their retirement savings efforts (i.e., upon retirement or other termination of employment), and this lack of information could lead to increased “leakage” from the tax-qualified retirement system. The marketing of retirement account products (both IRAs and qualified retirement plan self-directed brokerage accounts) and rollovers into retirement accounts, and the proactive education that financial advisers provide about their benefits, acts to counter the impulse of individuals to take and spend their retirement savings. This impulse can be especially pronounced in connection with changing or losing one’s job. Unfortunately, and to the detriment of America’s retirement saving and in consequence its future retirees, unless they receive more clarity defining the line between education and recommendation, firms may have to curtail their activities in this area.

V. The Department Should Revise the Best Interest Contract Exemption

Morgan Stanley agrees with the Department that the BIC Exemption should be a

“principles based” exemption that preserves consumer access to existing investment services and “broadly permit[s] firms to continue common fee and compensation practices, as long as they are willing to adhere to basic standards aimed at ensuring that their advice is in the best interest of their customers.” Indeed, Morgan Stanley would support a truly “principles based,” workable BIC

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Exemption that: (1) establishes broad consumer protections, including enhanced disclosure and a “Best Interest” standard applicable to IRAs, (2) mitigates conflicts of interest when advice is provided, (3) permits the receipt of a range of direct and indirect compensation, but does not require “fee leveling” at the Adviser or firm level, and (4) preserves consumer choice by covering transactions involving a wide range of “Assets.”

However, as currently proposed, certain requirements and conditions of the BIC

Exemption render it practically and operationally unworkable and are inconsistent with a “principles based” approach. Importantly, among other issues noted below, the Department should clarify that no “wet” signature is needed on contracts under the BIC Exemption for existing clients (i.e., firms can re-paper existing client relationships via negative consent), and should revise the Exemption so it only requires two parties to the contract, not three. Furthermore, changes must occur with respect to the disclosure regime, which currently includes a point of purchase disclosure requirement that will hinder client execution and will be extremely difficult if not impossible to implement, and which departs from the Department’s more workable disclosure precedents (e.g., under section 408(b)(2)). Moreover, unless substantially clarified, the BIC Exemption could result in Financial Institutions having to completely revise their compensation structures to ensure the fee neutrality of the individual Adviser. True Adviser level fee neutrality and the reformulation of the “reasonable compensation” standard may require fundamental changes in the compensation structure of many financial products firms offer, some of which are controlled by independent third party product issuers. We are also concerned that the mandated contractual warranties expose firms to significant new litigation risks and are duplicative and unnecessary as part of a Best Interest standard of care.

Finally, Morgan Stanley believes that the BIC Exemption and Principal Transaction

Exemption must be modified so that Financial Institutions can rely on the Exemptions for so long as they act in “good faith and with reasonable diligence” in their compliance efforts and correct any errors within a reasonable time period after detection. Given the complexity of the Exemptions and time frame for implementation, a good faith compliance standard coupled with the ability to cure defects upon knowledge of those defects is needed. This concept of good faith compliance is found in several Department precedents including regulations for the very recently finalized service provider exemption and participant disclosure regulation, and the insurance company general account regulation. See 29 C.F.R. § 2550.408b-2(c)(1)(iv)(F)(2), 29 C.F.R. § 2550.408b-2(c)(1)(vii), 29 C.F.R. § 2550.404a-5(b)(1), and 29 C.F.R. § 2550.401c-1(i)(5). Expecting perfect compliance with such complex conditions is unrealistic and should be tempered by good faith and cure provisions that encourage firms to use the BIC Exemption and Principal Transaction Exemption.

In the absence of changes to address these issues, Financial Institutions will not be able to rely on the BIC Exemption. As a result, many IRA owners and plan participants may end up being denied access to meaningful investment information they have until now received through their brokerage relationship (and only being offered a truly self-directed IRA or retirement plan account or paying for advice through a fee based advisory relationship). The result will be less information, more cost for certain consumers, and a contraction of the broker-dealer business model, all of which runs counter to the intent of Congress as reflected in Dodd-Frank.

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A. Written Contract – Making Compliance with the BIC Workable The Department should provide guidance that encourages compliance with the BIC

Exemption by facilitating the ability of Financial Institutions to come into compliance. This will benefit consumers. Required changes include:

• The Department should confirm that the BIC Exemption itself does not require a new physical “wet” signature of the client to bring pre-existing account contracts into compliance. It should be up to the Financial Institution to determine how its existing contracts can be modified to create an enforceable obligation between the parties, and if such a binding obligation can be done by “notice” and negative consent to a current client then it should be permitted. The new contractual provisions and warranties all flow to the benefit of the client. Thus, it would actually harm consumers if their firms had to “chase them down” and obtain their fresh signatures before they were able to avail themselves of the protections of the BIC Exemption.

• Currently, client agreements are entered into by the client and the Financial Institution – Advisers do not sign these agreements. Where a Financial Institution is the provider of the product or service (either on its own or through a representative), only the Financial Institution needs to be a party. Requiring the Adviser to sign as a party will unnecessarily complicate account opening for clients, and will create disruptions in client service upon an Adviser’s termination of employment and where a new Adviser serves the same client. This problem will be exacerbated by the common industry practice of having teams of financial advisers service the same consumer. Clearly, the Financial Institution’s signature is all that is needed to establish liability for both the firm and its Advisers. As a result, the Department should eliminate the need for the Adviser to sign new or existing contracts. (For independent brokers, the opposite should be true – just the Adviser should sign without the Financial Institution.) A way to address this practical issue in a way that should work for all types of relationships is to merely require the employer service provider to be a party to the contract.

• The timing of the contract requirement must be revised. As proposed, the BIC Exemption requires contracts to be executed before any advice is given. It is not practical or feasible for a financial adviser to persuade a customer to sign a contract before the client knows what they might be buying. Instead, contracts should be executed before transactions are entered into and can apply retroactively to the time of advice similar to existing suitability standards. This is the timing requirement included in the Department’s proposed Principal Transaction Exemption, and we urge the Department to include it here.

• The prohibition on contract provisions that limit liability should not extend to limitations on punitive or consequential damages. Such limits preserve the consumer’s right to be fully compensated for actual losses. Limitations on liability caused by third party acts or omissions should also be permitted. Firms should only be responsible for the losses they cause.

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These changes are necessary in order for the BIC Exemption to be a workable solution. Without these changes, the IRA marketplace (and small employer participant-directed plan marketplace) will be limited to a “one size fits all” solution that unnecessarily deprives the consumer of the ability to pay for brokerage services on a transaction by transaction basis.

B. Written Contract and Warranties – Eliminating or Paring Back Warranties

The BIC Exemption’s requirement that specific provisions be included in a written

agreement between the Retirement Investor, Adviser and Financial Institution makes the Exemption unworkable and must be modified. Chief among the required provisions are that the contract include a fiduciary acknowledgement and an agreement to follow the BIC Exemption’s Impartial Conduct Standards – which include the Best Interest standard, reasonable compensation and an obligation not to mislead the Retirement Investor. In addition, the contract must include warranties that the Adviser and Financial Institution will comply with law, have policies and procedures designed to identify and mitigate conflicts of interest, and not have compensation programs that “would tend” to encourage Advisers to make recommendations that are not in the Best Interest of the Retirement Investor. Finally, the contract must disclose Material Conflicts of Interest.

The Department notes that the written contract requirement “is the cornerstone of the

proposed exemption” and that it creates an enforcement scheme for both ERISA plans and IRAs. The BIC Exemption bolsters this notion by prohibiting certain types of contractual provisions that could relieve the Adviser and Financial Institution from liability and limiting class actions in court.

The written contract requirements simply go too far and must be pared back substantially

in order for the BIC Exemption to be workable. Our comments are as follows5:

• No written contract Impartial Conduct Standard (i.e., the Best Interest, reasonable compensation, no misleading statements requirements) is necessary or appropriate for ERISA plans. ERISA already imposes a statutory fiduciary duty standard on Advisers. A contractual Impartial Conduct Standard will create a duplicative standard of care that will expose service providers to state and federal claims over the very same conduct – a result that ERISA’s exclusive remedy scheme is designed to avoid.

• For IRAs, the Impartial Conduct Standards should be revised and limited to a Best Interest standard – the reasonable compensation and misleading statements provisions should be dropped because they are already covered by a Best Interest standard. No Adviser could act in the Best Interest of the client yet recommend investments that are too costly or lie or mislead the consumer, but it is possible that arbitrators and courts will seek to widen the already broad duties the Best Interest standard entails. Thus, we are concerned that these provisions could lead to additional allegations by plaintiff’s lawyers when all that should matter is whether the Adviser acted in the Best Interest of the client.

5 These comments should be read to apply to the Department’s proposed amendments to PTEs 75-1, 77-4, 84-24 and 86-128, which are being amended to include Impartial Conduct Standards.

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• Material Conflicts of Interest should be disclosed to consumers, but in a separate document rather than the contract. Otherwise, the contract will have to be updated frequently as products and services made available to the ERISA plans and IRAs are revised.

• The warranty provisions should be eliminated as they create the risk of wasteful litigation. Indeed, a Financial Institution could have well-trained and supervised Advisers acting in the Best Interest of their clients, but the firm would be exposed to class action claims if every aspect of the Department’s detailed policy and procedural requirements are not met. We think a true “principles based” exemption should focus on protecting consumers by requiring Best Interest conduct by the Adviser, but it should not involve a redundant “belts and suspenders” approach that results in unnecessary litigation exposure.

• In no event should these requirements be couched as contractual warranties – essentially a guarantee of perfect compliance. It would be more appropriate to recast the warranties as general exemption conditions and not actionable contract provisions.

• If retained as contractual requirements, the Department should modify the “warranty” requirement to a “good faith representation” requirement. As noted, this is the same approach that the Department adopted in its substantially less complex 408b-2 and other regulations.

C. Fee Neutrality for Advisers

Fee neutrality should not be imposed upon Advisers. The warranty requirements and

related Preamble discussion of appropriate Adviser compensation models suggest that the Best Interest standard could require that Financial Institutions compensate individual Advisers equivalently regardless of the products and services in which the client invests (“fee neutrality”). Indeed, each of the five examples highlighted in the Preamble describe examples of compensation structures where the individual financial adviser has no meaningful financial conflict of interest with the plan or IRA. In addition, the warranty condition itself prohibits any “different compensation or other actions or incentives to the extent they would tend to encourage individual Advisers to make recommendations that are not in the Best Interest of the Retirement Investor.” See 80 Fed. Reg. 21971(emphasis added).

Virtually any program of compensation that varies at all by type of investment could tend

to create adverse incentives.6 For example, many Advisers in the industry earn a flat percentage of the compensable revenue that the Adviser generates, regardless of the product sold or its affiliation with the Adviser’s Financial Institution (referred to as a “neutral compensation grid”). However, different products generate different amounts of compensable and non-compensable revenue to

6 Indeed, the Department recognized in commenting on the level fee requirement that applies to individual advisers under the section 408(b)(14), saying that “almost every form of remuneration that takes into account the investments selected by participants and beneficiaries would likely violate the fee-leveling requirement...” Participant Investment Advice Final Regulation and Class Exemption, 74 F.R. 3822, 3826 (January 21, 2009).

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the firm. Financial Institutions like Morgan Stanley employ measures to manage conflicts associated with such inherent differences in compensation by product, including sales practice surveillance and supervision, fee caps and client disclosure. Even with rigorous controls, however, virtually every broker-dealer’s current compensation model would be prohibited under a broad reading of this standard, which is clearly at odds with the Department’s stated goal of “proposing a set of exemptions that flexibly accommodates a wide range of current business practices” that “permit firms to continue common fee and compensation practices.” See 80 Fed. Reg. at 21929.

Importantly, the Department has previously recognized that Advisers are able to

accommodate conflicts of interest while acting in a prudent fiduciary capacity and should continue to do so. For example:

The investment advice provider does not recommend investment options that may generate for the fiduciary adviser or any employee, agent or registered representative, or any affiliate thereof, or any person with a material affiliation or material contractual relationship with the foregoing, greater income than other options of the same asset class, unless the adviser prudently concludes that the recommendation is in the best interest of the participant or beneficiary....

See Participant Investment Advice Proposed Regulation 73 F.R. 49896, 49930 (Aug. 22, 2008).

Furthermore, FINRA has closely scrutinized the compliance regimes of broker-dealers and recently published best practices for identifying, mitigating and managing conflicts of interest. Broker-dealers with compliance programs following this framework should meet the requirements of any truly “principles based” exemption. More specifically, in order to better understand how firms manage conflicts of interest, as well as to identify potential problem areas and effective practices to manage conflicts, in July 2012 FINRA began a review of conflicts of interest management practices at a number of firms (including Wealth Management). The Department’s Preamble statements on this aspect of the BIC Exemption appear to be informed by the FINRA report which was the result of that review, FINRA’s October 2013 Report on Conflicts of Interest (the “Conflicts Report”).

In the Conflicts Report, FINRA set forth its observations regarding firms’ approaches to identifying and managing conflicts of interest in three areas: (1) enterprise-level frameworks to identify and manage conflicts of interest; (2) approaches to handling conflicts of interest in manufacturing and distributing new financial products, and; (3) approaches to compensating their associated persons, particularly those acting as brokers for private clients. Specifically regarding compensation practices, FINRA noted the following effective practices to address compensation-related conflicts of interest:

• firms avoid creating thresholds in their compensation structures that enable financial advisers to increase their compensation disproportionately through an incremental increase in sales;

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• firms’ supervisory programs include specialized measures to assess whether financial advisers’ recommendations may be influenced by thresholds in a firm’s compensation structure;

• firms minimize compensation incentives for financial advisers to favor one type of product over another;

• for comparable products, firms refrain from providing higher compensation, or providing other rewards, for the sale of proprietary products or products from providers with which the firm has entered into revenue sharing agreements;

• firms monitor the suitability of financial advisers’ recommendations around key liquidity events in an investor’s lifecycle where the impact of those recommendations may be particularly significant (e.g., investor rolls over his pension or 401(k)), and;

• firms adjust compensation for employees who do not properly manage conflicts of interest.

Significantly, FINRA noted its expectation that firms should consider the practices described in the Conflicts Report and implement strong conflicts management frameworks. FINRA further noted that, given the pervasiveness of conflicts of interest and the potential for customer harm, it will continue to assess firms’ conflicts of interest management practices and the effectiveness of those practices in protecting customers’ interests (in this regard, FINRA included conflicts of interest in its 2015 Regulatory and Examination Priorities Letter). Finally, and perhaps most significantly, FINRA noted that if firms do not make adequate progress on conflicts of interest management, it will evaluate potential rulemaking in this area.

Wealth Management’s own compliance program includes many of the effective practices cited in the Conflicts Report. Extensive enterprise-level programs are in place to review new investment products for potential conflicts prior to distribution. Moreover, Wealth Management has compensation and supervisory controls in place for financial advisers that identify and mitigate key conflicts of interest. These compensation and supervisory controls are subject to review by FINRA, and to the extent that FINRA finds any deficiencies, they are noted and remediated as necessary.

The Department should clarify in the final BIC Exemption that enterprise-wide programs that effectively mitigate conflicts of interest, like Wealth Management’s, meet the requirements of the Exemption. Absent this essential clarification, the BIC Exemption will force broker-dealers into a “one size fits all” business model that in turn will limit the guidance and options available to clients, as further described above.

D. Fee Neutrality for Financial Institutions

The Department should clarify that reasonable compensation does not require the receipt of level compensation, including mutual-fund related compensation, at the Financial Institution level. If identical fee arrangements are required across thousands of mutual fund complexes and other investments, the BIC Exemption will be unworkable for this reason alone. Moreover, the Department should clarify this point explicitly so that firms are universally on notice of the BIC Exemption’s requirements.

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The BIC Exemption as drafted appears to allow Financial Institutions to receive varying

levels of compensation for different investments. This is demonstrated by the fact that the proposed Exemption includes no conditions or warranties mandating level fees at the firm level. The Department makes its intent particularly clear in the Preamble to the BIC Exemption where the Department specifically notes –

The Best Interest Contract Exemption … would provide prohibited transaction relief for the receipt … of a wide variety of compensation forms as a result of investment advice provided to the Retirement Investors. … The types of compensation payments contemplated by this proposed exemption include commissions paid directly by the plan or IRA, as well as commissions, trailing commissions, sales loads, 12b-1 fees, and revenue sharing payments provided by either the investment providers or other third parties to Advisers and Financial Institutions. The exemption also would cover other compensation received by the Adviser, Financial Institution or their Affiliates or Related Entities as a result of an investment by a plan … or IRA, such as investment management fees or administrative services fees from an investment vehicle…. 80 Fed. Reg. at 21966-67.

Notwithstanding the clarity of the Preamble, however, we are concerned that the

Department (or a court or arbitrator) may construe the “reasonable compensation” requirement included in the Best Interest standard (see Section II(c)(2)) to require consistency in the fees that mutual fund companies and other third parties pay firms. We note that the section only requires that the total compensation received by the Financial Institution be reasonable in relation to the total services provided to the plan or IRA. This should not be deemed to mandate identical fee relationships between Financial Institutions and the thousands of mutual fund companies and other third party investment providers. Fees differ for a range of reasons, including the types of services the Financial Institution provides to the fund complex, and the relative market power of the parties to the agreements. It is critical that the reasonableness of compensation be defined as a market based fee in total. This is, of course, consistent with the Department’s own prior guidance, and that of the courts. See Information Letter to John DiVincenzo (Dec. 9, 1986); Adv. Op. 2002-08A (selection of service provider involves assessment of quality of services, reasonableness of charges in light of services provided, and cost of comparable services in the market); McLaughlin v. Bendersky, 705 F. Supp. 417, 421 (N.D. Ill. 1989) (service provider's costs and profits are irrelevant to determining whether compensation is reasonable).

E. Disclosure

Morgan Stanley strongly agrees that delivering understandable and timely investment

information about fees and potential conflicts of interest is an appropriate requirement of fiduciaries relying on the BIC Exemption. However, as proposed, the BIC Exemption would establish an overly complicated and costly point of purchase and annual disclosure regime, along with continuous website disclosure, that cannot be implemented by the proposed eight month Applicability Date. Instead, the disclosure requirements should be revised to a pre-transaction

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“cigarette warning” and a direction to additional disclosures that build off of the requirements of the Department’s existing regulations under section 408(b)(2).

Under the current Proposal, firms must provide a detailed written disclosure to the

Retirement Investor prior to the execution of each recommended purchase of an allowable “Asset” (a “pre-purchase disclosure”). The disclosure must contain the all-in cost and anticipated future costs of recommended Assets in a chart. This chart would include the “total cost” to the Retirement Investor for 1-, 5- and 10- year periods expressed as a dollar amount, assuming an investment of the dollar amount recommended by the Adviser, and reasonable assumptions about investment performance, which must be disclosed. Additionally, a webpage must disclose the direct and indirect material compensation payable to the Adviser, Financial Institution and any Affiliate for services provided in connection with each Asset (or, if uniform across a class of Assets, the class of Assets) that a Retirement Investor is able to purchase, hold, or sell through the Adviser or Financial Institution, and that a Retirement Investor has purchased, held, or sold within the last 365 days, the source of the compensation, and how the compensation varies within and among Asset classes. Finally, the Financial Institution must also provide an additional comprehensive annual disclosure report detailing the client’s annual fees and direct and indirect expenses, and the firm’s and the Adviser’s direct and indirect compensation.

The information required is so complex that it will likely confuse rather than inform

consumers, and the requirement of trade by trade pre-purchase written disclosures may delay execution of clients’ transactions.

1. The key difficulties with the Pre-Purchase Disclosures:

• The written pre-purchase disclosure requirements are operationally complex, costly, and

may materially disadvantage those retirement consumers who cannot transact until their receipt. A majority of Wealth Management’s retirement clients have not authorized Wealth Management to deliver documents to them electronically via email and still choose to receive disclosure documents and account statements by mail. The requirement to disclose transaction-specific information pre-purchase may prevent clients from executing their transactions at the price that they intend. It could also potentially even restrict them from purchasing the securities that they want, if there is delay caused by the requirement to deliver the written disclosure before accepting the client’s order. It should be noted that over the past ten years, on average, the S&P 500 moved by more than 1% in a single day over 65 days within each calendar year. Furthermore, by the time such a detailed, client-specific pre-purchase disclosure is able to be prepared in accordance with the BIC’s current content requirements, the Asset’s total cost may have changed, requiring new disclosures, and this could, in its circularity, cause us to simply be unable to execute transactions in certain securities. Finally, clients may receive the disclosures when they are no longer in a position to review or respond to them – and thus they may miss out on the desired opportunity. In this regard, mutual funds are just one example to demonstrate the challenges in complying with the current pre-purchase disclosure requirements. For mutual funds, the price of the security is not known at the time an order is placed. Rather, the fund is priced

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at the end of the day and all orders received prior to market close receive the ending day prices. At the time that at an order is entered, the client may be making a new purchase of a specific amount (in which case all that is unknown is the number of shares that the amount represents) or could be selling shares and using the proceeds to make a new purchase (in which case the sales proceeds and the new purchase amount are not known until the close of business). Because of this uncertainty, it is unworkable to provide the detailed transaction-specific pre-purchase disclosure. In addition, most firms’ current systems for delivery of transaction-specific disclosures (e.g., confirmation statements, prospectuses) are triggered based on a transaction being entered and executed in the firm’s order entry system. As such, firms would need to design and build entirely new systems to trigger the delivery of a paper or electronic disclosure at a point prior to when an order is entered or processed.

• The 1-, 5- and 10-year cost information requirement that is based on rate of return assumptions is also unworkable and in many cases unnecessary as drafted. Return assumptions will need to be made for every single mutual fund, equity security, debt security, and other Asset. Every Financial Institution may come up with different return assumptions – making cost comparisons across firms impossible and possibly misleading. Furthermore, it is unnecessary to require such projections for stocks, bonds, ETFs and other investments that only generate transaction based, and not trailing, compensation. Moreover, this requirement is also problematic where we act as broker of record with respect to a retirement plan held at a third party provider, as plan size and investment make up will vary over time, and there is no way to meaningfully predict those changes.

• Finally, the disclosure regime’s emphasis on cost may lead consumers to make decisions on that basis alone. While important, cost is certainly not the only component of what makes an investment appropriate for a particular client. This focus, especially when complicated by the previous point regarding return assumptions, renders the current pre-purchase disclosure requirement imprudent.

2. Suggested revisions for the Pre-Purchase Disclosures: • The pre-purchase and website disclosure requirements should be revised to a

pre-transaction disclosure that builds off of the requirements of the Department’s regulations under section 408(b)(2). A section 408(b)(2) regime would fully inform consumers of the services provided and potential conflicts, and would disclose direct and indirect compensation, including the identity of the payer of indirect compensation and the amount (or formula or estimate) of the indirect compensation.7 Morgan Stanley would

7 Additionally, if private placement investments are permitted under the BIC Exemption, the Department should allow firms to provide the disclosure information regarding private placements to customers as part of an offering. Public websites are not an option for private placements because general solicitations are generally not permitted for these types of investments under the securities laws. Instead, customers should receive the necessary disclosures along with the offering materials for any particular private placement in advance of the client’s commitment to purchase the private placement.

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support the Department should it choose to move, as contemplated in the Preamble, to a “cigarette warning”-style approach to the pre-purchase disclosure. In addition to the language proposed in the Preamble (80 Fed. Reg. at 21974), the disclosure could specifically refer clients to a website disclosure that tracks the requirements of the regulations under section 408(b)(2). Morgan Stanley believes that firms could implement policies and procedures to ensure that each client is directed and given time to review the information on the website prior to the execution of the client’s first transaction with the firm, and through our monthly and quarterly statements, or other written communications, be reminded that the information is available for review and that the client should contact their Financial Institution or Adviser for more information.

• In the alternative, the Department should consider working with the industry to create a

static disclosure piece which describes the various asset classes available in retirement accounts, and addresses the issues which the Department believes the public does not understand (e.g., the ongoing revenue streams received in connection with mutual fund sales). Firms could then tailor this piece to their business models and ensure delivery at the onset of a client relationship and on an ongoing basis.

3. Suggestions for the Annual Disclosure Requirement: • Given existing required disclosures to clients about their investment costs and expenses

(e.g. client confirmations, mutual fund share class disclosures, prospectuses etc.), coupled with the enhanced pre-transaction disclosures recommended herein, the BIC’s annual disclosure requirement is duplicative. The annual disclosure requirement should either be eliminated or pared back substantially.

• It is unworkable in many instances to produce the required client-specific fee information using exact dollar amounts by investment, and the split in compensation between the individual Adviser and Wealth Management is simply not currently systemically available on an account by account basis. An alternative may be to provide the type of information found on a Form 5500 Schedule C to IRA clients who otherwise do not receive such reports. Schedule C requires reporting of "indirect" compensation received by plan service providers, in addition to the "direct" compensation paid to the service provider by the plan. For this purpose, "indirect compensation" includes any compensation received by a service provider from sources other than directly from the plan or plan sponsor "in connection with services rendered to the plan during the plan year or the person's position with the plan." Some examples of reportable indirect compensation described by the instructions to Schedule C include fees and expense reimbursement payments received by a person from "investment funds," finder's fees, float revenue, brokerage commissions, soft dollars, other transaction based fees received in connection with transactions or services involving the plan, and "non-monetary" compensation such as gifts and meals.

• If the annual disclosures are not eliminated then the annual disclosure requirement should not apply to any investments to which the Financial Institution or an Adviser has not served as a fiduciary. In this regard, it currently appears that the disclosure requirements of the BIC Exemption would apply to all assets in a particular IRA, regardless of whether the

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Financial Institution or an Adviser provides advice on those assets or whether those assets were brought by the client from another firm to the Financial Institution. Furthermore, in no event should exact dollar amounts be required to be disclosed for specific investments where the Financial Institution is compensated through an asset based fee. Finally, the Department should clarify that any pre-purchase or annual required disclosures only apply to compensation earned by the Financial Institution, its Advisers and its Affiliates, as opposed to any party receiving compensation in connection with a particular investment.

F. Scope of the BIC

There are critical revisions and clarifications to the scope of transactions covered by the BIC necessary to “preserve broker-dealer business models” consistent with the Department’s stated intent. Changes are needed to accommodate fulsome consumer choice in the type of investments available and to cover recommendations in connection with investment or distribution strategies. In the absence of such changes to its scope, firms may be unable to comply with the BIC Exemption even if the Department adopts other suggested modifications (e.g., to the BIC’s disclosure requirements).

Issues relating to the scope which need to be addressed include:

1. Covered Assets, Activities & Compensation:

• The BIC Exemption should not be limited to certain approved “Assets.” Such limitation needlessly restricts consumer investment choice and is unnecessary given the other comprehensive consumer protections contained in the Exemption. The Department should consider substituting its often used phrase “securities or other property” for the term “Asset.” Under the current Proposal, many investments that are utilized by consumers are not included in the list of permitted Assets. These include alternative investments (e.g., hedge funds and private equity funds), options, municipal bonds, structured products, futures contracts, precious metals, and foreign equities, foreign bonds and foreign currencies. Furthermore, the treatment of UITs, a common retirement account investment, seems unclear. Yet, the Department has consistently eschewed a “government approved list” of investments and under its recognition of modern portfolio theory, the Department has acknowledged that there is and can be a role for derivatives and other forms of sophisticated investments.8 Furthermore, the Department’s approved list of Assets cannot possibly keep up with the evolution of investment options (e.g., what happens when the “next ETF” or other “next generation” product comes along and is not a permissible “Asset”?). So long as a Best Interest standard, coupled with a reasonable enforcement and

8 IRAs are prohibited from investing in any work of art, rug or antique, metal or gem, stamp, most coins, and any alcoholic beverage under the Internal Revenue Code section 408(m). However, in general the Department has embraced modern portfolio theory, which holds that individual investments will not be considered per se prudent or imprudent, but will be evaluated in light of the whole portfolio of investments that the plan holds. See e.g., Preamble to Reg. 2550.404a-1 at 44 F.R. 37255 (June 26, 1979). Indeed, the Department has acknowledged the role that derivatives may play in a plan’s investment. See Adv. Op. 2013-01A. Defining approved Assets using a narrow list of “common” investments is a departure from the Department’s guidance and would even be a departure from the Code’s prohibited investment list.

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oversight scheme, is in place, no restrictions should be placed on what assets are covered by the BIC. Investors should be able to construct retirement portfolios that contain a diverse range of assets if they are appropriate and in the best interests of the particular client, and the exclusion of certain investments could result in unnecessarily disadvantaging retirement accounts.9 Moreover, an unintended result of this restrictive definition is that consumers may indirectly invest in assets that would otherwise be excluded under the definition (e.g., derivatives) by investing through a permissible mutual fund or ETF wrapper, which will increase the consumer’s cost of these strategies (i.e., it would be cheaper to do this directly but they are being forced to do so indirectly at a higher cost as they have to pay for the wrapper).

• The BIC Exemption also needs to be clear that it covers the fees for services that are

collateral to the investment advice provided pursuant to the Exemption (e.g., recordkeeping, custody, account maintenance).

• The BIC should be available for “riskless principal” transactions, which are functionally

similar to agency transactions.

2. Covered Parties:

• Often plan sponsors are not the ones making investment decisions. Therefore, the BIC Exemption should be clarified to cover advice directed to all fiduciaries of covered plans, such as trustees and investment committees for example, and not just plan sponsors.

• The BIC Exemption should also be available for advice to sponsors and fiduciaries

(including trustees) of small and large employer participant-directed plans. Including advice to small employer participant-directed plans in the BIC is crucial since they currently are also not eligible for the counterparty carve-out. As proposed, small employers have essentially been “carved-out” of the opportunity to receive both sales pitches and investment selection assistance. As noted above with respect to platform investment selection and monitoring, the negative impact on clients will be especially pronounced for “held-away” business (i.e., where Wealth Management is the broker of record with respect to plan assets which are held on another financial institution’s investment platform).

• We also recommend that the BIC Exemption be expanded to cover large plan sponsors of

over 100 participants to avoid a bifurcated compliance model. Otherwise firms will be vulnerable to “foot faults” and operational difficulties in monitoring whether the plan participant number fluctuates over or under 100 participants.

3. Recommendation of Strategies:

9 For example, alternative investments are often incorporated into an investor’s portfolio as a diversification and risk management strategy because they can help lessen the correlation of a traditional portfolio to the stock market, potentially reducing the effects of market volatility.

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• The application of the BIC Exemption to distribution and rollover conversations should be clarified. It appears that once amounts are rolled into an IRA, a firm can rely on the Exemption to apply to the Adviser’s recommendations on how to invest amounts rolled over. However, the BIC should be clarified to state that if its terms are followed it can also apply to the distribution advice itself and the advice on where the rollover should go (e.g., an IRA offered by the firm). As noted with respect to the rule itself, it seems unlikely that individuals will want to sign a contract prior to receiving that preliminary advice, and thus without relief, both within and outside of the BIC context, individuals may no longer be able to receive guidance with respect to a crucial rollover decision.

• The BIC or other appropriate exemption should be clarified to allow for the

recommendation of Advisers and managers. Recommending an Adviser or a discretionary manager – including the Adviser’s own firm – is investment advice under the Proposal and thus would seemingly require either the counterparty carve-out or reliance on the BIC Exemption. In the context of sales presentations, this appears to contradict the Department’s regulations at 29 CRF 2550.408b-2(f), examples (1), (3) and (4). If the person making the recommendation receives a fee (e.g., a portion of a wrap fee) then that person likely needs exemptive relief. However, a recommendation of a manager or Adviser should necessarily be subject to different disclosures and reporting than the recommendation of the purchase of a security or property under the BIC, and should not require the prior execution of a contract. The “cigarette warning”-style approach described in the Preamble, in combination with an explicit disclosure that the Adviser receives compensation in connection with the recommendation of a manager or Adviser, should suffice to inform and protect consumers (both inside and outside of the BIC Exemption). No annual reporting would be necessary or useful to the consumer.

4. Clarification of Application to Discrete Activities:

• The BIC Exemption should be clarified to make clear that where the Financial Institution

and Adviser do not provide advice, and merely carry out a direction from the client, compliance with the BIC Exemption is unnecessary. In other words, that the BIC need not be relied upon to execute a client’s self-directed purchase or sale transaction within an account which would otherwise be “BIC compliant,” or to implement a client’s independent decision to open an account. All of the conditions of the BIC Exemption should be revised accordingly (e.g., clarifying that the warranty, disclosure and data retention requirements do not apply to transactions in Assets where the Financial Institution or Adviser did not provide advice). Otherwise, clients may be forced to open up additional “execution only” accounts, potentially at additional cost (e.g., account maintenance fees).

• The BIC Exemption similarly needs to clarify whether and to what extent one time investment advice requires a Financial Institution to engage in ongoing compliance with the BIC Exemption. In our view, a simple account opening disclosure and a Best Interest standard should be sufficient for such limited engagements, even if the underlying investment pays the firm an ongoing fee for investment management or distribution.

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G. Disclosure to the Department and Recordkeeping Morgan Stanley does not object to the general requirement to maintain data necessary to

demonstrate compliance with the BIC Exemption. However, Morgan Stanley strongly feels that no trade secret or proprietary business information should be available to the Department in order to document Exemption compliance. Typically this information must undergo legal review and could be subject to protections that ensure its non-disclosure to the public. As such, we recommend that this provision be clarified such that no trade secret or proprietary information is required to be maintained or disclosed to the Department under this section.

H. Data Request Available to the Department

We respectfully submit that the requirements of Section IX – Data Request (i.e., to create

and maintain Inflow, Outflow, Holdings and Returns information) are burdensome and unnecessary given the other protections afforded by the BIC Exemption, including the contractual obligations, Impartial Conduct Standards, warranties and the resulting private rights of action; the provision of meaningful disclosures directly to the Retirement Investor; and the requirements of Section V - Disclosure to the Department and Recordkeeping, which provides an abundance of information for the Department to monitor compliance. Therefore, we request the elimination of this section of the BIC Exemption. I. Pre-Existing Transactions Exemption

Morgan Stanley strongly objects to imposing conditions on continued relief for

investments that occurred prior to the applicability of the new Proposal; in particular, the condition that no advice be given after the Applicability Date on assets purchased prior to the Applicability Date. If the original transaction was not prohibited, there should be no ongoing conditions imposed. In fact, by requiring that no additional advice be given, the Financial Institution would not be acting in an investment advice fiduciary capacity and would not need to rely on the Exemption. Furthermore, requiring that no advice be given will harm consumers as they will lose access to the investment-related information provided via their brokerage relationship and force the consumer to choose a new, potentially more costly, advisory relationship if they need assistance with their plan and/or IRA accounts. This was not the bargain when they began their relationship with the Financial Institution and it should not be forced upon them now.

In addition to permitting advice, no restrictions on assets (i.e., no “Asset” limitation)

should be imposed for pre-existing assets. Otherwise, non-conforming assets must be removed from the account prior to the Applicability Date. This may not be possible without the client providing written consent and may not be feasible without causing the client to incur a loss. As a result, we believe that such subset of assets must be subject to the proposed grandfathering suggested above (i.e., they remain subject to the rules in effect prior to the Applicability Date).

Finally, we ask that the Department clarify that firms do not need to rely on the

Pre-Existing Transactions Exemption if they provided no advice or recommendations with respect to pre-existing assets. No conditions should be imposed on assets currently held by a Financial Institution if it was directed to acquire such assets for our client, or the assets transferred in from

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another firm (i.e., we provided no advice or recommendations on the appropriateness of those assets), but those assets are held in an account which would otherwise comply with the BIC Exemption.

In sum, we believe that all assets purchased prior to the Applicability Date of the regulation

should be subject to the rules in effect before the Applicability Date. If these modifications are not made, then we request that transitional relief be granted to liquidate pre-existing positions for cash without the advice related to such liquidation requiring compliance with all of the contract and disclosure conditions of the BIC Exemption. At the very least this transitional relief must be available for liquidation of investments that do not meet the definition of Assets under the BIC Exemption.

VI. The Principal Transaction Exemption for Debt Securities Should be Expanded

Morgan Stanley supports the creation of a principal trading exemption. As discussed

below, being able to conduct principal transactions in a timely and cost effective manner provides important liquidity benefits to our customers – benefits that are especially critical in market downturns. We are concerned that if the BIC Exemption is not made workable many IRA and qualified retirement plan clients will move away from transaction based brokerage accounts to advisory programs where as a practical matter firms would not be able to provide advice or recommendations on principal transactions. Even if, as a threshold matter, the BIC Exemption is reformed, we are concerned that the proposed Exemption for Principal Transactions in Certain Debt Securities (the “Principal Transaction Exemption” or “Exemption”) is not workable as a result of the limited scope of the Exemption and the conditions it imposes on Financial Institutions. As a result, Retirement Investors would have diminished access to products, liquidity, and competitive pricing, ultimately harming the very Retirement Investors the Department is seeking to protect. We urge the Department to expand the scope of the Exemption to additional securities and to modify key conditions that make the Exemption as proposed unworkable. In doing so, we urge the Department to consider the critical liquidity role that Financial Institutions play in the marketplace, and the comprehensive existing SEC, FINRA and MSRB rules that govern these transactions.

As a starting point, the Principal Transaction Exemption only applies to a limited list of

products, which we believe will either preclude Retirement Investors from purchases and sales of numerous non-exempted securities altogether, or force these investors to transact in such securities in a more expensive and less efficient manner. With respect to those limited products currently permitted under the Exemption, Financial Institutions may be unable to continue to purchase or sell those products on a principal basis since the conditions imposed render the Exemption practically unworkable. These products may not be available to Retirement Investors through other market makers or participants at competitive prices or at all, which could materially impair liquidity for investors when seeking to buy or sell securities. In addition, the Principal Transaction Exemption is not drafted to fit into the existing regulatory and interpretive framework, which already imposes investor protection rules and policies related to pricing, execution and suitability of transactions that apply when Financial Institutions like Morgan Stanley act as principal or provide investment assistance. Rather, the proposed Exemption would subject Financial

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Institutions to inconsistent and incompatible regulatory standards, some of which are impossible to comply with for the reasons discussed below.

Set forth below are Morgan Stanley’s recommended revisions to the Principal Transaction

Exemption. We believe that these changes will serve the best interests of Retirement Investors and the marketplace at large. We begin by providing you with some background information on the role Morgan Stanley plays as liquidity provider to the fixed income markets, generally, and Retirement Investors, specifically. In this context, we discuss the consequences of restricting the role of a liquidity provider, which will result from the Proposal. Next, we outline the various FINRA and MSRB rules on transaction execution, pricing and suitability that comprise the existing regulatory framework governing Financial Institutions. It is against this background that we set forth our recommendations for revisions to the Principal Transaction Exemption.

A. Impact on Investor Liquidity

We respectfully do not believe the Principal Transaction Exemption adequately accounts

for how the fixed income marketplace operates, with a substantial number of debt cusips often traded by a relatively small number of Financial Institutions. One should not assume that Retirement Investors can turn to third party financial institutions to purchase or sell their securities. These other firms may be unable to provide liquidity on favorable pricing terms or at all if, for example, the firm does not make markets in the security in question or is facing balance sheet or risk constraints. As a result, like other investors, Retirement Investors often rely on their broker-dealer to be willing and able to purchase or sell securities when the investor needs or wants to transact, and in particular in times of distress or when illiquid securities are involved.

Morgan Stanley, acting through its Wealth Management and institutional securities

businesses, is one of the largest firms participating in the fixed income markets across product types and market conditions and routinely trades fixed income securities acting as a principal with its clients. These principal trades include trades with its Retirement Investors for which it is not a fiduciary. The ability of Retirement Investors to access liquidity on both the bid and offer side of the market is particularly critical in periods of market distress, dislocation or increased volatility. This is true now more than ever as market participants’ balance sheets are constrained due to regulatory considerations and the cost of regulatory capital, with the result being diminished liquidity across product types in what was already a less liquid market (i.e., compared to equities). If Morgan Stanley and other liquidity providers are effectively compelled to act only in an agency capacity as a result of the Proposal, then investors may be unable to liquidate their positions in a declining market – the time most critical to them – or if they are able to do so, it may be delayed and at considerably worse execution quality.

As a result, if Morgan Stanley becomes a fiduciary to almost all of these investors - as

could be the case under the Proposal - then the Principal Transaction Exemption must be expanded and simplified so as to allow Retirement Investors continued access to products and liquidity at competitive pricing.

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B. The Existing Regulatory Regime Governing Broker-Dealer Pricing, Execution and Suitability is Robust

When considering the Principal Transaction Exemption, specifically the proposed new

pricing standards,10 it is important to take into account the fact that the fairness of broker-dealer pricing of securities, including fixed income securities, is highly regulated by FINRA and the MSRB.11 Under the current regulatory and interpretive framework, broker-dealers are subject to best execution and fair pricing standards under various FINRA and MSRB rules. FINRA Rule 5310 (best execution), for instance, imposes an obligation on broker-dealers to use reasonable diligence to ascertain the best market for a subject security (excluding municipal securities) so that the resultant price to the customer in the transaction is as favorable as possible under prevailing market conditions. Further, FINRA Rule 2121 imposes a fair pricing obligation on broker-dealers in connection with transactions effected on a principal basis and restricts the amount of mark-up or mark-down a broker-dealer may charge from the prevailing market price. With respect to municipal securities, MSRB Rule G-18 (effective December 7, 2015) will subject broker-dealers to best execution obligations similar to those under FINRA Rule 5310. MSRB’s best execution rule will be in addition to MSRB’s fair pricing rule (MSRB Rule G-30), which requires broker-dealers to exercise diligence in establishing the market value of the security and the reasonableness of the compensation received in the transaction (such FINRA and MSRB rules and interpretive guidance thereunder concerning fair pricing, mark-ups/mark-downs and best execution are collectively referred to herein as “Pricing and Execution Rules”).

Firms like Morgan Stanley are required to have robust controls and policies and procedures

to ensure compliance with applicable Pricing and Execution Rules. Among other controls, Morgan Stanley has developed a series of reports that compare its fixed income executions against third party executions reported through FINRA’s online reporting system, Trade Reporting and Compliance Engine (“TRACE”) or MSRB’s Real Time Transaction Reporting System (“RTRS”), as well as Morgan Stanley’s own executions with other parties. These reviews are performed by Wealth Management’s Risk Department, which is independent from the business. Wealth Management will adjust trade prices if such reports identify trade executions that do not comply with Pricing and Execution Rules or otherwise satisfy the firm’s pricing policies and controls. The Wealth Management Best Execution Committee provides additional oversight, examining quality of execution, among other responsibilities, in light of regulatory obligations. The Compliance unit monitors the performance of certain oversight reviews. Finally, FINRA actively surveils reported executions for compliance with the applicable Pricing and Execution Rules and brings actions to enforce such Rules. Moreover, investors have access to reported trade prices on TRACE and MSRB’s Electronic Municipal Market Access System (“EMMA”) as an additional layer of protection and transparency against which their executions may be validated.

10 See Section II(c) (2), “The Adviser and Financial Institution will not enter into a Principal Transaction…if the purchase or sales price of the Debt Security (including the mark-up or mark-down) is unreasonable under the circumstances” and Section III(d), Pricing. 11 While municipal securities do not provide tax benefits to retirement accounts, in certain market conditions they may be an appropriate investment. Moreover, certain municipal securities are taxable and are likely to be purchased by retirement accounts.

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In addition, it is important to note that FINRA and MSRB impose suitability obligations on broker-dealers when recommending securities (see FINRA Rule 2111 and MSRB Rule G-19, collectively, “Suitability Rules”). Firms maintain policies and procedures to comply with Suitability Rules and often utilize additional controls, such as minimum eligibility rules or maximum concentration requirements tailored to individual investors’ risk tolerance and investment objectives, as part of the financial adviser’s suitability review and determination. Among the policies maintained by Wealth Management is a policy that prescribes which investors can be solicited to purchase which corporate and municipal instruments and in what concentration levels. The policy establishes categories of instruments largely based on credit ratings and sets client eligibility guidelines for each category according to the investors’ risk profile.

The Fair Pricing and Execution Rules and the Suitability Rules are part of a

well-established regulatory framework that serves to protect investors, including Retirement Investors. On this basis, Morgan Stanley believes that the Department should consider the standards from the Fair Pricing and Execution Rules and the Suitability Rules when establishing the contours of the Principal Transaction Exemption in lieu of new and potentially conflicting standards or substantial limitations on status quo principal trading. C. Recommended Revisions to the Principal Trading Exemption

In light of both the nature and function of the fixed income markets, as well as the equity markets, and the substantial existing regulatory controls on pricing, execution and suitability discussed above, the following changes should be made to the Principal Transaction Exemption in order to preserve Retirement Investor access to liquidity and quality executions in financial instruments in which these accounts have traditionally invested.

• The types of fixed income products available under the Exemption should be expanded to

include high yield debt, convertible bonds, securities issued by non-U.S. entities (including, without limitation, emerging market and foreign currency denominated securities), securities whose issuers are not organized as corporations, and instruments that are exempt from registration under the Securities Act of 1933 (the “Act”) such as certificates of deposit, commercial paper, bank notes issued under Section 3(a)(2) of the Act and municipal securities. In addition, Financial Institutions should be permitted to execute principal transactions in securities issued by affiliates. Morgan Stanley sees no basis for limiting access to principal transactions to the limited class of debt securities set forth in the Exemption and contends that existing regulatory requirements protect Retirement Investors as they protect other non-Retirement Investors transacting in these securities. For those fixed income products not covered by the Principal Transaction Exemption, Retirement Investors may receive inferior pricing or may be unable to transact in the products since Morgan Stanley’s prices cannot be made available alongside third party prices, if any.

• The conditions relating to “moderate credit risk” and “sufficiently liquid” are ambiguous terms that should be eliminated since the Principal Transaction Exemption imposes a broad Best Interest standard of conduct and remedial scheme for IRAs. Investors should not be precluded from holding higher credit risk or less liquid products in retirement accounts

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where such products are appropriate for the investor. Excluding these securities from the Principal Transaction Exemption harms Retirement Investors by eliminating competitive prices and a source of liquidity from major market participants, thereby reducing competition and increasing the likelihood of poor execution quality for Retirement Investors, or by rendering such instruments completely unavailable. As noted above, principal transactions in these securities remain subject to applicable Pricing and Execution Rules, as well as Suitability Rules and controls which are tailored to investor risk tolerance and investment objectives. These rules and controls should be adequate to protect Retirement Investors in the same way they protect non-Retirement Investors.

• The Principal Transaction Exemption should be expanded to include equities and preferred securities that are included within the scope of Regulation NMS promulgated by the SEC. These are the most liquid and transparent of markets where registered market makers are required to provide continuous two-sided quotes, markets are fully consolidated enabling a national best bid and offer (“NBBO”) for each security to be calculated and disseminated, trades are reported and compensation disclosed. Execution quality is readily discernable and enforced. Trade executions are compared to the NBBO and those executions at prices inferior to the NBBO are reviewed and adjusted when appropriate. As with fixed income securities, orders in equities and preferred securities are subject to regular and rigorous reviews by the Wealth Management Best Execution Committee. Furthermore, market centers are required by Regulation NMS to publicly and regularly disclose prescribed information related to execution quality and each broker-dealer is required to disclose prescribed information related to its order routing practices. See 17 CFR 242.605 and 606. While much trading in the equity markets is done on an agency basis, broker-dealers and their affiliates should not be precluded from acting as principal where doing so would satisfy the firm’s obligations under applicable Pricing and Execution Rules that adequately protect Retirement Investors.

• The pricing standard under the Principal Transaction Exemption should be aligned with the

applicable Pricing and Execution Rules. Specifically, Financial Institutions should be required to use reasonable diligence to ascertain the best market for the subject security so that the resultant price to the customer in the transaction is as favorable as possible under prevailing market conditions. As mentioned above, firms have rigorous controls in place to meet their obligations under applicable Pricing and Execution Rules, and imposing a new standard under the Exemption would create confusion and impose significant costs without attendant benefits due to the adequacy of existing requirements and controls.

• Firms should not be required, and may not be able, to provide additional information related to the amount of mark-up or mark-down beyond disclosures required by applicable securities rules. The mark-up or mark-down on a transaction includes not only the financial adviser’s compensation (e.g., sales credit) but also any spread that may have been charged or, for inventory positions, any profit or loss incurred, by the trading desk. While the sales credit component is known, the calculation of any desk profit or loss on the trade is not readily determinable, for example, because securities in inventory may have been acquired at different times with different cost bases, or the position may be hedged along with many other positions such that the hedge cost allocable to the particular position is not

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readily known. Moreover, depending on how it is calculated, the amount of any mark-up or mark-down can change between the time of the Exemption’s required disclosure and the time of execution based on changes in the prevailing market price. Making matters more challenging, there is no NBBO or exchange marketplace for fixed income securities as exists for equity securities, and therefore, broker-dealers cannot look to a single established price that can be used to calculate a firm’s mark-up or mark-down on any given trade. Accordingly, should the Department proceed with some requirement to disclose mark-up or mark-down, firms would need considerable guidance on methodology given the complexity around making such calculations. Finally, any disclosures prescribed by the Department could conflict with disclosures required by applicable SEC, FINRA and MSRB rules and proposals.12

• The requirement that two other counterparties provide pricing is not workable and should be eliminated. The two-quote requirement is inconsistent with current market structure and applicable FINRA requirements, which instead impose a more flexible diligence standard. Firms may not be able to obtain two quality quotes, but may, for example, be able to establish the prevailing market value of the security by reference to similar securities or financial benchmarks. Given the substantial number of fixed income cusips, it is not always the case that there are multiple market makers. For example, an investor may hold an illiquid security which only Morgan Stanley may stand to purchase. In that instance, there may not be two available quotes. In situations where a firm can obtain two quotations, there is no assurance that the quotes will be at reasonable levels, as could be the case if the quote provider is not a market maker. Quotes could be “throw away” (or worse predatory) and offer little value and should not be considered in the pricing of a security. Moreover, firms like Wealth Management operate “open architecture” platforms where offerings from third parties are displayed in a “stack” along with Wealth Management’s internal prices for viewing by its financial advisers and traders who execute at the level representing the best execution. Traders also have access to prices through alternative trading systems or “ATS’s” and other electronic communication networks or “ECN’s” in order to perform diligence necessary to establish the price of the securities in trades with its customers. Furthermore, absent a centralized platform across firms to review quotes, imposing a requirement on each Financial Institution to obtain and review two quotes is impracticable at best and will delay or prevent execution. As a result, the two-quote requirement may adversely affect the price at which the security can be purchased and lead to a circularity with respect to disclosures (as described above with respect to the BIC Exemption), increase costs, and narrow the universe of securities for which the Principal Transaction Exemption is available.

• Syndicate transactions should be permitted under the Principal Transaction Exemption. Syndicate offerings are heavily regulated and utilize robust offering documents which disclose the compensation to the underwriter and the features and risks of the security, among other items. Further, fixed price offerings have the added benefit of uniform pricing across all investors. Finally, these securities may be more expensive or unavailable

12 We note that both FINRA and the MSRB have proposed rules that would require additional confirmation disclosure of the price differential between “paired trades.” See FINRA Notice 14-52 and MSRB Regulatory Notice 2014-20.

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in the secondary market, so retirement account clients may be disadvantaged by not receiving access to primary market offerings.

• The exemption requires that the contract affirmatively state that the Adviser and Financial

Institution are fiduciaries “with respect to any investment recommendation to the Retirement Investor regarding Principal Transactions.” We recommend that the Department clarify that Advisers and Financial Institutions are required to affirmatively agree that they are fiduciaries only with respect to: 1) those recommendations which render an Adviser and Financial Institution a fiduciary under the Proposal; and 2) the transactions that are subject to the fiduciary recommendation and not any other transactions of the investor.

Morgan Stanley urges the Department to adopt the above-listed suggestions in amending

the Principal Transaction Exemption, which is unworkable as proposed and operates to the detriment of the very investors it is designed to protect. In doing so, the Department should look to the existing regulatory and interpretive framework around pricing, execution and suitability of transactions in setting standards that are compatible and not in conflict with the current state of operations in the marketplace. Unless changes are made to address these issues as well as those issues discussed above, Financial Institutions will not be able to avail themselves of this exemption for the benefit of their retirement account clients. This will result in Retirement Investors having diminished or no access to the products or liquidity to which they are accustomed today. As a consequence of the Proposal, Retirement Investors will be forced to purchase and sell fixed income and other products outside of the Principal Transaction Exemption on what may well be a more expensive or limited agency basis or through a self-directed brokerage account where they cannot receive investment assistance from a financial adviser.

VII. Potential Streamlined Exemption Should be Approached Cautiously Morgan Stanley believes that the Department’s focus should be to make the Proposal

workable rather than adding another exemption at this time. The Department sought comments on whether it should propose a streamlined exemption for certain “high quality,” low fee investment products. The Department did not propose any specific approach because of their acknowledged difficulty in designing the exemption.

Although additional exemptive relief for low cost products may have some appeal and role

in the marketplace, we are concerned that such an exemption might restrict consumer choice. Firms may seek to rely on a less complex and costly exemption rather than comply with the BIC Exemption even though many consumers may prefer to be in potentially more expensive actively managed mutual funds that could have returns that exceed benchmark for passively managed or index offerings that might fit the exemption. It is well established that cost is not the sole criteria when investing and higher costs can be offset by the opportunity for greater returns, credit quality, and other relevant factors. See 29 C.F.R. § 2550.404a-1(b); Braden v. Wal Mart Stores, Inc., 588 F.3d 585, 596, n.7 (8th Cir. 2009) (acknowledging that higher fee funds could be chosen for “higher return, lower financial risk, more services offered, or greater management flexibility” and holding a fiduciary would not breach its duties simply because “cheaper investment alternatives exist in the marketplace”); Hecker v. Deere & Co., 556 F.3d 575, 586 (7th Cir. 2009) (“[N]othing

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in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).”). In any event, at this time Morgan Stanley believes that the Department’s priority should be to work with the industry to make the Proposal workable.

VIII. Coverage of Insurance Products Under Multiple Exemptions

The Proposal will make it difficult for consumers to access beneficial insurance products.

Historically, financial advisers have been able to offer fixed and variable annuities to ERISA plans and IRA holders without the risk of being a fiduciary. Under the Proposal, firms would have to rely on multiple exemptions that will significantly raise compliance burdens and costs. Coverage for sales will vary depending upon both the type of product and the type of purchaser. For example, the sale of registered insurance products (i.e., variable annuities) to IRAs would be covered only by the BIC Exemption, but sales of similar products to fiduciaries of small employer participant-directed plans would not be covered by the BIC Exemption, and would be covered only under Class Prohibited Transaction Exemption 84-24, which, under the Proposal would be amended to include a new Best Interest standard.

While most of the issues outlined earlier in this letter apply equally to annuities, there are

unique complexities associated with complying with the proposed BIC Exemption for annuity sales. These complexities will discourage financial advisers from offering insurance products, including products that have beneficial features such as lifetime income features – a policy goal that the Department is seeking to promote. Specific concerns relating to annuity sales include:

• Complying with the requirements to disclose acquisition, ongoing and disposition costs at the time of a sales presentation will be impractical. Annuities are sold with a myriad of optional riders and features with varying costs and benefits (including lifetime income options offered with variable annuities). It will be impossible to provide cost disclosures for every combination of the underlying funds and for each optional feature across the wide range of annuities offered through Financial Institutions. The result will be fewer products and less consumer choice as distributors of insurance products necessarily will be forced to severely limit their offerings. Furthermore, overemphasizing the legitimate cost of lifetime income guarantees could cause consumers to devalue the obvious benefits of these products.

• Many of the data elements that the Proposal will require broker-dealers to collect and disclose are not standardized among insurance companies or the DTCC. Despite numerous efforts among broker-dealers, insurance companies and the DTCC since 2007 to establish an industry data utility to collect and disseminate uniform, up to date variable annuity information—those efforts have failed because of difficulties and insurmountable hurdles in obtaining accurate data on older products, rapid innovation of new products and a lack of common/uniform technology. Without this functionality, firms such as Wealth Management will not be able to comply with the data request requirements of the BIC Exemption.

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• There are a number of product features that are unique to annuities such as the ability to internally transfer investment sub-account allocations from one sub-account to another, and the ability to make additional payments to an annuity after the initial sale. The Proposal would present difficult, if not impossible, operational obstacles to the continued utilization of these features which have been standard product features in the annuity industry for decades.

• The Department should also clarify that the Proposal does not apply to a client continuing to hold an annuity issued prior to the availability of the BIC in a brokerage IRA or other retirement account. Although numerous transitional issues have been noted above, the problems for annuities are more pronounced as these assets by their nature more often require ongoing guidance after their purchase, whether for the reallocation of underlying investments or the exercise of rights available under the contract that arise after issuance.

Generally speaking, without substantial changes to the BIC Exemption, annuities that offer

the promise of lifetime income protection will simply not be available to IRAs since they would not be sold through the BIC Exemption and could not be offered on either a purely self-directed basis or through an advisory program. Wealth Management does not believe that variable annuities could or should be offered on a completely self-directed basis given the complexity of the products and the consumer’s need for education and assistance. Indeed, consumers who have no access to guidance concerning their annuity may elect to surrender it in favor of another arrangement, potentially triggering surrender changes that impact their retirement savings.

Furthermore, Wealth Management and many other firms currently do not offer variable annuities through advisory programs because the annuity products generally are offered on a commission basis and do not have an appropriate share class for use with fee based advisory programs. In fact, the few annuity products that have been designed for use with fee based advisory programs are designed for tax efficiency rather than for guaranteed income and may not generally be appropriate for tax-favored accounts like IRAs. The current universe of annuities designed for use with fee based advisory programs generally do not offer robust optional benefit features and guarantees that support lifetime income as are available through traditional commission based accounts.

Therefore, legacy variable annuity products should continue to be covered by Class Prohibited Transaction Exemption 84-24.

IX. Conclusion

Morgan Stanley appreciates the opportunity to comment on the Department’s

Proposal. Our firm’s Core Values embrace putting clients first. We believe that the Department and Morgan Stanley share many common goals, and that a “best interest” standard should govern our relationships with retail consumers, including retirement investors. We also support clear and understandable disclosure, and strong controls and systems to identify and manage potential conflicts of interest.

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1

Submitted electronically: [email protected]; [email protected] July 21, 2015 Office of Regulations and Interpretations Employee Benefits Security Administration Attn: Conflict of Interest Rule – Retirement Investment Advice Room N-5655 U.S. Department of Labor 200 Constitution Avenue NW Washington, DC 20210 RE: RIN 1210-AB32 – Definition of the Term “Fiduciary”; Conflict of Interest

Rule – Retirement Advice; Proposed Rule ZRIN 1210-ZA25 – Proposed Best Interest Contract Exemption; Proposed

Amendment to and Proposed Partial Revocation of Prohibited Transaction Exemption 84-24 for Certain Transactions Involving Insurance Agents and Brokers, Pension Consultants, Insurance Companies and Investment Company Principal Underwriters

Dear Sir or Madam, On behalf of NAFA, the National Association for Fixed Annuities, I write today with respect to the Department of Labor’s proposed Conflicts of Interest rule, defining who is a “fiduciary” in regard to providing retirement investment advice, as well as the proposed new Best Interest Contract Exemption and the amended Prohibited Transaction Exemption 84-24 (collectively, the “Proposed Rule”). Founded in 1998, NAFA is an advocacy trade association, exclusively dedicated to educate and inform state and federal regulators, legislators, industry personnel, media, and consumers about the value of fixed annuities and their benefits to Americans in financial and retirement planning. NAFA’s membership includes insurance companies, independent marketing organizations, and individual producers, representing every aspect of the fixed annuity marketplace and covering 85% of fixed annuities sold by independent agents, advisors, and brokers. NAFA is pleased to have the opportunity to comment on the Proposed Rule and generally supports the Department’s efforts to provide enhanced protections for consumers in the retirement marketplace.

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2

However, as currently drafted, the Proposed Rule requires significant refinements to ensure that Americans continue to have access to fixed annuities and to the financial professionals who provide the education and services necessary to service their clients. This is especially true for consumers who have investable assets of less than $250,000. At a time when a huge retirement savings gap exists, compounded by the fact that Americans are living longer, regulatory efforts must not hinder the principal-protected savings and lifetime income options uniquely provided by fixed annuities. The Department appropriately recognizes that non-security annuities – in other words, fixed annuities – are insurance products and asks in its preamble to the Proposed Rule whether the line between insurance and annuity products that are securities and those that are not has been correctly drawn.1 NAFA appreciates the opportunity to answer the Department’s invitation to comment on the disclosure requirements and other applicable standards governing fixed annuities, the distribution methods and channels applicable to fixed annuities, the common structure of insurance agencies, and the applicability of the Best Interest standard to fixed annuities. However, NAFA contends that fixed annuities are different from securities investments, and we believe the Proposed Rule must not be written so broadly that it has an adverse effect on insured retirement savings and on the insurance professionals who provide consumers with education and retirement advice on fixed annuity products. The first section of this Comment letter provides an overview of the insurance product and fixed annuities marketplace and discusses why it is entirely appropriate and correct to treat those transactions differently under any proposed expansion of the fiduciary standard. The second section addresses some of NAFA’s general concerns with the Proposed Rule as currently drafted, particularly what we believe will be the unintended consequence of limiting consumer choice and access to retirement advice and products. The third section provides comments on the base Conflicts of Interest Rule, specifically addressing our concerns regarding the definition of the term “fiduciary,” as well as the investment education carve-out and seller’s exception.

1 Proposed Best Interest Contract Exemption, 80 Fed. Reg. 21975

App. 859


3

The fourth section of this letter addresses the amendments to PTE 84-24 and discusses aspects of this exemption that we believe require additional clarification and/or modification.

I. Overview of the Fixed Annuity Insurance Marketplace

A. Fixed Annuities are insurance products, not investments, and should be treated differently under any amended fiduciary standard

First and foremost, fixed annuities are insurance products, not investments. This has been clear under both state and federal law for decades and was clarified under the Dodd-Frank Act.2 As an insurance product, fixed annuities are regulated by an effective, robust, and time-tested state-based regulatory and compliance framework. State laws govern the organization and licensing of insurance companies, and state insurance departments oversee insurance company operations and agents’ sales activities. Fixed annuity contracts and amendments must be filed with, and approved by, each state in which contracts are sold. Moreover, as an insurance product, fixed annuities are insurance contracts and offer the insurance guarantees of (1) predictable income the owner cannot outlive, (2) protection from investment and market risk, and (3) minimum interest earnings in every economic climate. Further, unlike securities investments, the sales transaction – the fixed annuity contract – is made between the consumer and the insurance company, and all payments made for the purchase of the fixed annuity contract are paid to the insurance company, not the agent or advisor. These payments are not offset by payment of commissions, but are credited into the consumer’s account. The agent does not retain any type of control over the funds. Key distinctions about fixed annuities include: All fixed annuities satisfying state standard non-forfeiture laws (“SNFL”)

requirements are considered insurance products and are not considered to be securities.3

2 The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, H.R. 4173. 3 Generally speaking, the Standard Nonforfeiture Law requires that an individual deferred annuity contract provide the contract holder with a paid-up annuity or cash surrender benefits of a minimum amount, if the contract holder surrenders the policy prior to its maturity date. The nonforfeiture

App. 860


4

Fixed annuities satisfying standard state non-forfeiture laws must follow state-mandated reserving, guaranteed annuitization payout requirements and disclosure laws.

In all fixed annuity contracts, the insurance company provides contractual guarantees that a minimum SNFL value will accrue, as well as guarantees protecting the contract owner from market downturns. The insurance company retains the market risk.

A fixed annuity contract owner does not have a separate account, and interest is paid from the insurance company’s general funds.

Insurance products like fixed annuities have no downside market risk and provide state-mandated guarantees to the consumer that investment products cannot provide due to their inherent risk factors. Hence, state regulation already provides a high level of consumer protection and, as will be discussed below, impose standards on insurance agents that the fixed annuity is suitable for the consumer. Thus, NAFA agrees the Department has appropriately categorized fixed annuities as covered transaction eligible for an exemption under PTE 84-24.

B. Insurance Agents who sell fixed annuities are subject to

rigorous and comprehensive licensing requirements. The bar to become a licensed insurance agent is significant. Insurance agents are bound to act in accordance with the common law requirements of agency and must pass tests of both competency and character before they are granted a state license.4 Insurance agents need to be licensed in each state in which they operate. Only state-licensed life insurance agents may sell fixed annuity contracts. After an agent has secured a license from the state, he or she must find an insurance company that will appoint or contract with them, and permit them to act as their selling agent. Insurance carriers review each and every application for appointment, and it’s not unusual for an agent to be denied the opportunity to contract with that

amount is a state-mandated portion of the deferred annuity’s paid premium, minus any previous withdrawals and certain charges, accumulated at interest rate minimums regulated by statute. 4 To use the State of Missouri as an example, an individual may be refused a license – or may have his or her license revoked, suspended or not renewed – if the individual has been convicted of a crime involving moral turpitude or if the individual has used fraudulent, coercive, or dishonest practices or demonstrated untrustworthiness or financial irresponsibility in the conduct of business in the state or elsewhere—note that the latter may be a disqualifier even without a criminal conviction. Missouri Rev. Stat., Chapter 375, Provisions Applicable to All Insurance Companies, §375,141(6), (10) (2014), http://www.moga.mo.gov/mostatutes/chapters/chapText375.html.

App. 861


http://www.moga.mo.gov/mostatutes/chapters/chapText375.html

5

carrier. This review process occurs each time the agent applies for appointment with a new or additional insurance company. Once licensed and appointed, and before an insurance agent may sell a fixed annuity, he or she must complete, in addition to the regular and ongoing insurance continuing education requirements, insurer-provided product-specific education to ensure the agent’s compliance with the insurer’s standards for product training, as well as a one-time, 4-credit annuity suitability training course. The suitability training course includes information regarding the types and various classifications of annuities; the uses of annuities; appropriate sales practices, replacement, and disclosure requirements; how product-specific annuity contract provisions affect consumers; the identification of parties to an annuity; and the application of income taxation of qualified and non-qualified annuities.

C. Insurance agents do not have continued management of or control over the consumer’s assets.

With investment advice, the consumer pays the investment advisor to manage his or her money. The consumer gives the money to the investment advisor who then places it in different investment instruments, moving the money around, reallocating it, buying and selling different assets such as stocks and bonds, all in accordance with an investment plan that the advisor has developed. For this service – to provide advice and make decisions about the assets under management – there are ongoing, usually annual, fees that an investor pays to the advisor. With a fixed annuity, however, the money is not controlled or managed by the insurance agent; the money is paid to the insurance company. A fixed annuity sale is a one-time transaction between the client and the agent. The agent does not have access to the assets used to purchase the fixed annuity and cannot alter anything in the annuity contract. If the consumer in a fixed annuity transaction is dissatisfied for any reason, he or she may first return the fixed annuity contract for a full refund during the free-look period, which typically ranges between 10 and 30 days. Outside of the free-look period, a fixed annuity consumer can submit complaints to the insurance company or to the state insurance department. If the insurance company or state insurance department finds in favor of the consumer, corrective action is taken by the insurance company to make the consumer whole.

App. 862


6

D. Fixed annuity distribution methods and channels are unique to the insurance industry.

Fixed annuities are distributed and marketed in a wide variety of different distribution models, with each and every sale complying with a robust and effective state regulatory compliance framework. There are many different types of salespersons who distribute fixed annuities. Some of these insurance agents operate as “career agents” of carriers, “captive agents” of a carrier, “independent agents” for one or several carriers, employees of carriers or distribution firms, and the like. Some of these agents work directly with carriers, while others may be required by contract or practice to sell only certain types of fixed annuities. Fixed annuities may be distributed through bank, wire house, broker-dealer, captive, independent, or other sales channels. In some cases, the consumer may contract directly with the insurance carrier without working with an insurance agent. In some instances, the insurance agent selling a fixed annuity may have a securities license and be subject to certain rules and requirements of their broker-dealer for which they are affiliated. Some of these broker-dealers may supervise the sale of certain types of fixed annuities, while others treat insurance sales as outside business activity. Registered Investment Advisor (“RIA”) firms and Investment Advisory Representatives (“IARs”) of RIAs may too also have varying oversight rules of fixed annuity sales. While there is a wide array of distribution methods, what is clear is that every salesperson selling fixed annuities must comply with all applicable state insurance regulatory requirements. All states have comprehensive rules and regulations that govern the sales practices, disclosure, training, conduct, and consumer protection standards that ensure fixed annuities are marketed, sold, and distributed to consumers with fairness, transparency, and recourse in mind. This robust state-based insurance regulatory system has been developed over the past hundred years and has proven to work very effectively. Moreover, state laws and regulations, as well as the insurance agent contracts that carriers require insurance agents to execute, make clear that these salespersons are agents of the carriers.

E. Current disclosure requirements for fixed annuities are comprehensive, provide meaningful information to consumers, and are sufficient to protect consumers’ financial interests.

App. 863


7

In the preamble to the Proposed Rule,5 the Departments invites specific comment on the current disclosure requirements applicable to insurance and annuity contracts that are not securities and asks whether the proposed transaction disclosure requirements can be revised for non-security annuities in such a way to provide meaningful information to consumers. As the following discussion demonstrates, fixed annuities are already subject to comprehensive disclosure requirements and do not warrant additional federal disclosures other than the ones specifically recommended herein.

State insurance departments regulate the sales practices for fixed annuities and include robust regulations related to required disclosure information. States require that a written disclosure statement be provided to the purchaser of a fixed annuity contract at the point of sale to both protect consumers and foster consumer education. The majority of states have adopted the National Association of Insurance Commissioners (NAIC) Annuity Disclosure Model Regulation. In addition, the NAIC updated its Annuity Buyer’s Guide in 2013, which is included as part of the Model Regulation’s disclosure requirements.6 At a minimum, the Model Regulation requires that the following information is included in the disclosure document:

(1) The generic name of the contract, the company product name, if different, and form number, and the fact that it is an annuity;

(2) The insurer’s legal name, physical address, website address, and telephone number;

(3) A description of the contract and its benefits, emphasizing its long-term nature, including examples where appropriate: (a) The guaranteed and non-guaranteed elements of the contract, and their limitations, if any, including for fixed indexed annuities, the elements used to determine the index-based interest, such as the participation rates, caps or spread, and an explanation of how they operate; (b) An explanation of the initial crediting rate, or for fixed

5 80 FR 21975. 6 The states that have not yet adopted the revised model disclosure regulation do, however, have state insurance regulations concerning annuity disclosure requirements; moreover, insurance companies that operate on a nationwide basis have adopted internal policies and protocols that meet or exceed the state or model requirements and apply them in all states.

App. 864


8

indexed annuities, an explanation of how the index-based interest is determined, specifying any bonus or introductory portion, the duration of the rate and the fact that rates may change from time to time and are not guaranteed; (c) Periodic income options both on a guaranteed and non-guaranteed basis; (d) Any value reductions caused by withdrawals from or surrender of the contract; (e) How values in the contract can be accessed; (f) The death benefit, if available and how it will be calculated; (g) A summary of the federal tax status of the contract and any penalties applicable on withdrawal of values from the contract; and (h) Impact of any rider, such as a long-term care rider.

(4) Specific dollar amount or percentage charges and fees shall be listed with an explanation of how they apply; and

(5) Information about the current guaranteed rate or indexed crediting rate formula, if applicable, for new contracts that contain a clear notice that the rate is subject to change.

In addition to requiring a product-specific disclosure statement, as previously noted, the disclosure requirements include the delivery of a free Annuity Buyer’s Guide that must be provided no later than five days after receipt of the annuity contract application. The NAIC created the Annuity Buyer’s Guide in collaboration with the insurance industry and consumer groups.

F. Beyond disclosure requirements, additional state-based laws and rules impose a comprehensive and effective regulatory system over fixed annuities.

In addition to the Annuity Disclosure Model Regulation, state insurance departments have adopted comprehensive regulations related to the sale of fixed annuities. Insurance companies have, in turn, implemented policies to carry out these rules and objectives. They include the following:

1. Suitability in Annuity Transactions Model Regulation

Originally adopted in 2003 as the Senior Protection in Annuity Transactions Model Regulation, the Suitability Model Regulation now applies to all fixed annuity transactions, regardless of the age of the purchaser. It establishes a system for state regulators and insurance carriers to supervise recommendations to purchase

App. 865


9

annuities and sets forth standards and procedures for fixed annuity transactions so that the insurance needs and financial objectives of consumers at the time of the transaction are appropriately addressed. The Suitability Model Regulation was most recently updated in 2010, imposing more extensive suitability standards on the sale of fixed annuities, clarifying that the insurance company is responsible for ensuring compliance with the suitability standards, including the review of all recommendations prior to the issuance of a contract, and requiring insurance agents to undergo mandatory product-specific training as well as general suitability training before making any fixed annuity recommendation. In fact, these enhanced suitability requirements were codified in the Dodd-Frank Act of 2010,7 requiring the adoption of suitability standards that are modeled after the most-recent NAIC Suitability Model Regulation by the state in which the insurance annuities are sold or by the insurer issuing the contract. Currently 35 states, plus the District of Columbia, have adopted the 2010 version of the Suitability Model, with three additional states in the process of its adoption. Moreover, insurance companies that operate on a nationwide basis have adopted practices and protocols that meet or exceed the standards set forth in the 2010 model.

2. Insurance and Annuity Replacement Model Regulation

The purpose of this NAIC model law is to regulate the activities of insurers and producers with respect to the replacement of existing life insurance and annuities, by establishing minimum standards of conduct to be observed in replacement or financed purchase transactions. The regulation ensures that those who decide to purchase a replacement annuity receive the information necessary to make an informed purchase decision.

3. Advertisements of Life Insurance and Annuities Model Regulation This regulation establishes minimum standards and guidelines to assure a full and truthful disclosure to the public of all material and relevant information in the advertising of life insurance and annuity products.

4. State “Free Look” (or Right to Return) Requirements Most states require that insurance annuity contracts include a “free look” or “right to return” provision, allowing annuity contract purchasers the right to cancel their

7 The Harkin Amendment was added to the Dodd-Frank Act, H.R. 4173, as section 989G, and is codified as a note to 15 U.S.C. §77c(a)(8).

App. 866


10

contract within a certain number of days of the contract’s delivery – typically between 10 – 30 days. In fact, the Annuity Buyer’s Guide calls particular attention to this feature, as follows: When You Receive Your Annuity Contract When you receive your annuity contract, carefully review it. Be sure it

matches your understanding. Also, read the disclosure or prospectus and other materials from the insurance company. Ask your annuity salesperson to explain anything you don’t understand. In many states, a law gives you a set number of days (usually 10 to 30 days) to change your mind about buying an annuity after you receive it. This often is called a free look or right to return period. Your contract and disclosure and prospectus should prominently state your free look period. If you decide during that time that you don’t want the annuity, you can contact the insurance company and return the contract. Depending on the state, you’ll get back all of your money or your current account value.

5. Use of Senior Specific Certifications and Professional Designations in the

Sale of Life Insurance and Annuities Model Regulation While this model regulation is targeted squarely at protecting senior consumers, it sets forth standards to protect all consumers from misleading and fraudulent marketing practices with respect to the use of senior-specific certifications and professional designations in the solicitation, sale or purchase of, or advice made in connection with, a life insurance or fixed annuity product.

6. State Insurance Unfair Trade Practice Laws The NAIC’s Unfair Trade Practices Act provides the framework to regulate trade practices in the business of insurance by defining and prohibiting a broad range of conduct and practices that constitute unfair methods of competition or unfair or deceptive activities or practices. This Model Act was most recently revised in 2008, and most states have adopted this Act or similar regulations. Adoption of the Act grants broad powers to State Insurance Commissioners to examine and investigate the affairs of every person or insurer in the state to determine if the person or insurer is engaged in any unfair trade practices.

7. Market Conduct Exams

All state departments of insurance have the regulatory authority to investigate carriers and insurance agents to ensure compliance with applicable laws and regulations. State departments of insurance will each examine its domestic carriers on a regular basis. More than 40 state departments of insurance, working in conjunction with the NAIC, will annually collect compliance related data from all

App. 867


11

carriers via the Market Conduct Annual Statement. This data is utilized to identify “outliers” and address potential issues through a market conduct exam or targeted exam regarding specific issues. We include here links to the following documents discussed in this Section:

NAIC Annuity Disclosure Model Regulation (MDL-245)

NAIC Suitability in Annuity Transactions Model Regulation (MDL-278)

NAIC Standard Nonforfeiture Law for Individual Deferred Annuities (MDL-805)

NAIC Life Insurance and Annuities Replacement Model Regulation (MDL-613)

NAIC Advertisements of Life Insurance and Annuities Model Regulation (MDL-

570)

NAIC Annuity Buyer’s Guide – Fixed Deferred

NAIC Use of Senior Specific Certifications and Professional Designations in the

Sale of Life Insurance and Annuities Model Regulation (MDL-278)

NAIC Unfair Trade Practices Act (MDL-880)

G. The protections provided by the state regulatory

structure has resulted in a very low number of consumer complaints for fixed annuities.

The state-based regulatory structure governing the manufacture, distribution, and sale of fixed annuity products is effective as demonstrated by the minimal number of consumer complaints. In fact, in 2014 consumer complaints involving securities and advisors represented over 97% of combined annuity and securities complaints – but only .03% of total complaints were lodged by owners of fixed annuities.8 This low number of complaints involving fixed annuities demonstrates the effectiveness of the state-based regulatory structure.

8 Data Sources: FINRA: http://www.finra.org/newsroom/statistics; NAIC: https://eapps.naic.org/documents/cis_aggregate_complaints_by_coverage_types.pdf; SEC: http://www.sec.gov/news/data.htm; NASAA: http://www.nasaa.org/regulatory-activity/enforcement-legal-activity/enforcement-statistics/ (*NASAA only has compiled complaints for 2013)

App. 868


www.naic.org/store/free/MDL-245.pdf







www.naic.org/documents/prod_serv_consumer_anb_le_2013.pdf




http://www.finra.org/newsroom/statistics

https://eapps.naic.org/documents/cis_aggregate_complaints_by_coverage_types.pdf

http://www.sec.gov/news/data.htm

http://www.nasaa.org/regulatory-activity/enforcement-legal-activity/enforcement-statistics/

http://www.nasaa.org/regulatory-activity/enforcement-legal-activity/enforcement-statistics/

12

As the preceding discussion demonstrates, the current state-based regulatory oversight of fixed annuity transactions is most effective in protecting consumers’ financial interests when they purchase these contracts. State Insurance Departments oversee all aspects of the transaction: from the development and approval of each fixed annuity product sold in the state to the operations and compliance protocols of the insurance companies to the licensure and sales activities of the individual agents. In each instance, the objective is to protect the financial interests of the fixed annuity purchaser. In all practicalities, this comprehensive regulatory scheme serves the best interest of the consumer.

II. While NAFA appreciates the Department’s efforts to provide enhanced protections for retirement investors, the Proposed Rule would cause tremendous disruption in the distribution and sale of fixed annuities, disproportionately impacting lower- and middle-income consumers.

A. A fiduciary-only standard, without workable exceptions, will ultimately harm the consumers it was intended to protect.

77

431

508

2802

5014

9693

17509

NAIC FIAs

NAIC OtherAnnuities

NAIC All Annuities

FINRA

SEC (top 10)

NASAA

Total Securities

2014 Consumer Complaints

App. 869


13

As NAFA understands the Proposed Rule, the Proposed Rule is premised on the assumption that a commission-based payment model creates an inherent, de facto conflict of interest that works to the detriment of consumers. Consequently, the Proposed Rule disallows commission-based compensation for all qualified accounts unless the transaction was permitted under a Prohibited Transaction Exemption (“PTE”). The Department creates a paradigm whereby only fee-based compensation could avoid the conflict of interest. NAFA disagrees with this assumption. While fee-based advice may be appropriate for some consumers, it does not follow that a one-size-fits-all prescriptive payment model is appropriate for all consumers or retirement products. More than 80% of fee-based advisors define their core market as clients with a minimum of $250,000 of investable assets.9 The real world consumer marketplace reality is that requiring a fiduciary-only standard discriminates against lower and middle income savers because they do not have sufficient assets to be accepted as clients by the vast majority of fee-based advisors. The bulk of middle and mass market financial assets are in qualified accounts where the median value of an IRA account is $34,000, and the median value of a 401(k) plan account is $30,000.10

Even if fee-based advisors were encouraged to drop their minimum asset requirements and accept consumers with investable assets of $100,000, this would still mean that a majority of retirement savers, particularly minority Americans, would have insufficient assets to meet the minimum requirement and would be

9 Mary Beth Franklin, Financial Planning for the Middle Class, Kiplinger (online) August 2011, available at http://www.kiplinger.com/article/retirement/T023-C000-S002-financial-planning-for-the-middle-class.html 10 U.S. Census Survey of Income Program and Participation, 2011, available at http://www.census.gov/people/wealth/files/Wealth_Tables_2011.xlsx.

$184,725

$39,423$64,978

$139,762

$45,274 $41,834

Non-Minority African-American HispanicSource: Source: U.S. Census Bureau, Survey of Income and Program Participation, 2011

Mean Account Value

IRA 401(k) % Thrift

App. 870


http://www.kiplinger.com/article/retirement/T023-C000-S002-financial-planning-for-the-middle-class.html

http://www.kiplinger.com/article/retirement/T023-C000-S002-financial-planning-for-the-middle-class.html

http://www.census.gov/people/wealth/files/Wealth_Tables_2011.xlsx

14

unable to receive personal, individualized professional financial and retirement assistance. Even if fee-based advisors eliminated a minimum asset requirement, few middle- or lower-income consumers could afford the fees the advisor would necessarily charge to cover their operating expenses. A fiduciary-only rule without workable, common sense carve-outs effectively creates two classes of retirement consumers: the affluent who have sufficient assets to justify the time and fees of the advisor and the much larger mass market who will be unable to obtain in-person professional financial and retirement advice. Moreover, it would relegate many Americans to robo-advisors or internet-based sales, which would deny them in-person education on the importance of saving for retirement.

B. The fee-compensation model can create higher costs to consumers than under the commission-based compensation model.

In a 2014 survey of 55 Washington, D.C. area advisory firms, the median fee-based advisor minimum required assets under management was $1,000,000. Although ten of the surveyed advisory firms said they did not have a minimum asset requirement, the minimum annual fees listed for those firms ranged from $3,000 to $9,000. For a consumer with just $60,000 of investable assets, those first year fees would be the equivalent of 5% to 15% of his or her assets. 11 By contrast, the typical minimum payment required to purchase a fixed annuity ranges from $5,000 to $25,000 – and is often less for a qualified account. Importantly, fixed annuity agents can and do provide the same professional service for all their consumers, whether the annuity purchase payment is $5,000 or $500,000. When a fee-only advisor accepts smaller accounts, the annual fee is often at least 2% of the assets year after year after year. If we use a hypothetical consumer with $100,000 of investable assets, it is demonstrable that over time the consumer will pay more in fees to the investment advisor than the insurance company would pay in commissions to an insurance agent. For this example, we will assume that the yield is 3% and that the timeframe is 5 years.

11 http://www.washingtonian.com/articles/work-education/top-money-advisors-2014-fee-only-financial-planners/index.php

App. 871


http://www.washingtonian.com/articles/work-education/top-money-advisors-2014-fee-only-financial-planners/index.php

http://www.washingtonian.com/articles/work-education/top-money-advisors-2014-fee-only-financial-planners/index.php

15

Under the fee-based advisor alternative, the total advisor fees would be $10,190. However, that same consumer could purchase a fixed annuity for $100,000 from an insurance company. The entire purchase payment would earn interest under the contract, and no funds would be deducted to pay the agent’s commission. The insurance company would make a one-time payment to the insurance agent of $2,400.12 Thus, the consumer has paid nothing directly to the agent, and yet his or her annuity contract’s value will grow based on the full premium payment. In the fee-based model, the consumer’s investment is reduced over time by $10,190. Often the justification for a fee-based, fiduciary-only standard is that it is less expensive for the consumer than is a commission-based compensation model. Although that may be true for consumers with substantial financial assets, it is not necessarily true for the majority of consumers. Over time, the upfront commission paid by the insurance company to the agent is less than the ongoing, annual, cumulative fees paid to the investment advisor, who is managing the investment account.

III. The Proposed Rule’s significant expansion of what

constitutes investment advice, thereby triggering fiduciary status, is overly broad.

While NAFA supports the Department’s efforts to study and propose reasonable rules that can provide new consumer protection standards to better protect the financial interests of consumers, the changes to the definition of “fiduciary” as set forth in the Proposed Rule needs modification in order to preserve consumer access to financial professionals, to maintain broad choice in retirement savings products, and to ensure compliance certainty for product providers and financial professionals.

A. The definition of “fiduciary” should require a mutual

understanding that the advice is individualized to the consumer and will serve as a primary basis for the investment decision.

The current definition of “investment advice” (and thus the trigger for fiduciary obligations) under ERISA section 3(21)(A)(ii)13 requires that the investment advice 12 Per annuityratewatch.com, 6/26/2014, examining 37 multiple-year guarantee annuity policies with a 5-year rate guarantee. 13 See 29 CFR §2510.3-21.

App. 872


16

rendered to the plan is provided on a regular basis pursuant to a mutual agreement, arrangement, or understanding, written or otherwise, between the person rendering the advice and the plan and that such advice serves as the primary basis for investment decisions with respect to plan assets. (Emphasis added.) The Proposed Rule, in addition to expanding the definition to include investment advice to IRAs and IRA owners, eliminates the requirements that the advice is rendered on a regular basis and that the advice serves as the primary basis for the investment decisions with respect to the plan. It would also no longer require a mutual understanding between the parties, but would rather capture advice that is “individualized to” or “directed to” the advice recipient “for consideration” in making investments decisions with respect to the plan or IRA. NAFA does not disagree with the notion that a one-time rendering of investment advice might create a fiduciary relationship, so we do not object to the removal of the “regular basis” element from the current definition. However, we believe it would serve the best interests of the advice recipient if the person rendering the investment advice were able to define, through disclosure, the scope of the fiduciary duty as to its duration – whether ongoing, one-time, or limited in time relative to the particular plan or IRA investment transaction. Our greater concerns with the proposed changes to the definition are the removal of the requirement that the agreement, arrangement or understanding be mutual and the elimination of the primary basis element such that the advice recipient need only consider the rendered advice in making plan or IRA investment decisions. Additionally, we are concerned that the inclusion of the term “directed to” will capture under the fiduciary standard communications that are more generalized in nature, such as marketing and advertising materials. Additionally, the Proposed Rule needs clarification that it is the individual person who renders the investment advice who becomes the fiduciary to the plan or IRA, not the company whose products they recommend. Consistent with the American Council for Life Insurers’ position, NAFA believes that fiduciary obligations arise where the relationship between the financial professional and the consumer creates an expectation of trust. The investment advice industry has long functioned under the premise that “investment advice” that creates a trusted relationship between the financial professional and an investor must be customized and deemed suitable for and based on the needs of the specific investor.

App. 873


17

The Department’s decision to capture communications that are merely “directed to” the advice recipient upends traditional passive marketing activity that is often the primary way by which investors become aware of their product and service options. In effect, the inclusion of communications that are merely “directed to” a potential consumer creates a presumption that the communication is investment advice , thus triggering a fiduciary relationship, a relationship which neither party intended, expected or agreed to. Further, the lack of clarity within the rule will have a chilling effect on all types of marketing activity, because the line between traditional marketing and fiduciary investment advice cannot be determined in advance with any degree of certainty. Accordingly, NAFA suggests that the base definition of “fiduciary” under the Proposed Rule be revised as follows:

§ 2510.3-21 Definition of “Fiduciary.” (a) Investment advice. For purposes of section 3(21)(A)(ii) of the Employee Retirement Income Security Act of 1974 (Act) and section 4975(e)(3)(B) of the Internal Revenue Code (Code), except as provided in paragraph (b) of this section, an individual person renders investment advice with respect to moneys or other property of a plan or IRA described in paragraph (f)(2) of this section if— (1) Such person provides, directly to a plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner the following types of investment advice, whether one time or ongoing, in exchange for a fee or other compensation, whether direct or indirect: (i) A recommendation as to the advisability of acquiring, holding, disposing or exchanging investments securities or other property, including a recommendation to take a distribution of benefits (other than a distribution required by the plan or the Code) or a recommendation as to the investments of securities or other property to be rolled over or otherwise distributed from the plan or IRA; (ii) A recommendation as to the discretionary management of investments by a party other than the party making the recommendation securities or other property, including recommendations as to the management of investments securities or other property to be rolled over or otherwise distributed from the plan or IRA; (iii) An appraisal, fairness opinion, or similar statement whether verbal or written concerning the value of investments securities or other property if provided in connection with a specific transaction or

App. 874


18

transactions involving the acquisition, disposition, or exchange, of such investments securities or other property by the plan or IRA; (iv) A recommendation of a person who is also going to receive a fee or other compensation for providing any of the types of advice described in paragraphs (i) through (iii); and (2) Such person, either directly or indirectly (e.g., through or together with any affiliate),— (i) Represents or acknowledges that it is acting as a fiduciary within the meaning of the Act with respect to the investment advice described in paragraph (a)(1) of this section; or

(ii) Renders the investment advice pursuant to a written or verbal agreement, arrangement, or understanding that the advice is individualized or that such advice is specifically directed to, the advice recipient for consideration in making investment or management decisions with respect to securities or other property of the plan or IRA. to meet the specific investment goals of the investor, and is provided at the request of the investor pursuant to the agreement, arrangement, or understanding.

B. Agents must be able to sell fixed annuity products under

the “seller’s carve-out” without triggering fiduciary status.

As noted in Section I above, fixed annuity contracts are very different than securities products. With fixed annuities, consumers are not purchasing an investment that can be bought and sold in a bid market; they are entering into a legal contract with an insurance company. Insurance agents cannot make any alterations to the terms, benefits, or commitments of the fixed annuity contract; in fact, they are prohibited from making any changes. They may not negotiate benefits on behalf of the annuity client, nor can they sell the contract to another party. Rather, insurance agents consider the annuity products that are available to sell from the insurance company or companies and make recommendations to their clients and prospective clients about the fixed annuity product contract options that would best serve the client’s financial objectives. As such, the sale of an insurance product by an insurance agent is not fiduciary in nature and should not trigger fiduciary obligations. The Department has recognized this distinction when it distinguishes “incidental advice as part of an arm’s length transaction with no expectation of trust or acting in the customer’s best interest,

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from those instances of advice where customers may be expecting unbiased investment advice that is in their best interest.”14 In a fixed annuity sales transaction, the contract purchaser understands that he or she is purchasing a proprietary insurance product and that the insurance agent represents the insurance company that designed the product. Moreover, the purchaser understands that the agent is not providing (and in fact cannot provide) impartial investment advice comparing the fixed annuity product against a universe of annuity products or investment products unavailable to the agent—but, rather, the agent is describing the value and benefits of the proposed fixed annuity product as part of the sales transaction. NAFA believes that fixed annuity purchasers fully understand this agency relationship, but would nonetheless support reasonable disclosures or agreements that make clear that the insurance agent represents the insurance company and is selling only products then available to the agent. Moreover, insurance agents selling fixed annuities deal directly with individual consumers and small plans. The Proposed Rule’s carve-out for sellers is limited to transactions with large plans with either greater than 100,000 beneficiaries or with assets greater than $100 million. Given that there is no market risk to the consumer or plan purchasing an insurance product, the robust state insurance regulatory regime governing the transaction and the agent, including disclosures, NAFA recommends that the seller’s carve-out under section 2510.3-21(b)(4) be expanded to state that the mere “selling” of non-security insurance products to a plan or IRA by a person does not constitute fiduciary investment advice as long as the proper state-mandated insurance and other appropriate sales disclosures are provided, and that the exclusion is not limited by the asset size or number of participants in the plan.

C. The narrowly-drawn education carve-out will result in consumers not having sufficient information to make informed retirement decisions.

NAFA believes it is essential that the Department maintain the important distinction between non-fiduciary investment education and fiduciary investment advice. The Proposed Rule would radically change the way insurance agents communicate with their clients who are looking for sound and helpful retirement education. As 14 80 FR 21941.

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NAFA understands the Proposed Rule, fiduciary obligations would be triggered at the first instance an insurance agent provides education material to a prospective client on a particular or specific annuity product to consider in a plan or IRA investment or distribution option. Additionally, any discussions about distributions and rollovers would be considered investment advice and, therefore, fiduciary in nature. A narrow investment education carve-out would render these essential communications as little more than abstractions. Insurance agents must introduce clients to fixed annuities, help them understand the value proposition they provide in retirement planning, and educate them on the variety of annuities and their corresponding features. The investment education carve-out under section 2510.3-21(b)(6) must make it clear that non-fiduciary education includes discussions about annuities generally, as well as discussions about particular product features that address concerns regarding liquidity, inflation, premature death, etc., including models generated with regard to such features. Purely informational discussions about annuities or distributions should not create a fiduciary relationship. The intense educational component of a fixed annuity sale is unique to this product. Moreover, the Proposed Rule should clarify that fixed annuity advertising and marketing materials and illustrations that conform to state insurance laws and regulations should not be considered investment advice and should fall under the Rule’s investment education carve-out. Industry has been able to operate well under the Department’s guidance on educational investment advice provided in Interpretive Bulletin 96-1. We strongly recommend that the proposed investment education carve-out be replaced with language that incorporates the guidance provided in IB 96-1.

IV. NAFA agrees that PTE 84-24 is the appropriate

regulatory exemption for fixed annuities; however, the amended exemption requires further refinements to assist insurance companies and agents with their compliance duties and to protect the interests of retirees.

As stated previously, NAFA applauds the Department for recognizing the distinction between securities and insurance products. We agree with the

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Department that PTE 84-24 is the appropriate exemption to use for non-security annuity contracts (i.e., fixed annuities) when the insurance agent is acting as a fiduciary.15 To confirm our understanding of the amendments to the exemption and to ensure that consumers of all investable asset size have continued choice and access to insurance retirement advisors, NAFA seeks clarification regarding the applicability and scope of PTE 84-24. NAFA urges the Department to continue its long-time support of a regulatory exemption to support the efforts of life insurance companies, their partners in the fixed annuity distribution channels, and the individual insurance agents to offer everyday Americans access to products that provide a stream of retirement income that they will not outlive. In that spirit, NAFA offers the following comments on proposed amended PTE 84-24:

A. Section I. Covered Transactions – Scope of the Exemptions.

The current proposal should better clarify those annuity contracts that are intended to be outside of PTE 84-24. NAFA seeks clarification from the Department that the intent is to disallow from this exemption (in addition to mutual fund shares) annuity products that are registered under federal securities law.

B. Section II. Impartial Conduct Standards – Best Interest.

Under Section II(a), the Impartial Conduct Standards are satisfied as it pertains to the sale of insurance products only when the insurance agent or insurance company

15 NAFA notes that the Department invites public input regarding whether the conditions of the proposed Best Interest Contract (BIC) Exemption, other than the disclosure conditions, would be inapplicable to non-security annuities. (80 FR 21975.) Again, NAFA agrees that to the extent that an insurance agent may be acting as a fiduciary in relation to a plan or IRA transaction, PTE 84-24 is the appropriate exemption. Nevertheless, we would comment that the conditions of the BIC Exemption (BICE) are completely inapplicable to the sale of fixed annuities and would impose onerous and, frankly, unworkable conditions on the sale of these insurance products. In particular, we want to highlight the following points: the pre-recommendation contract requirement under BICE is entirely impractical in an insurance sales transaction. Requiring the insurance agent to warrant that he or she has complied with all applicable federal and state laws regarding the rendering of investment advice, places the insurance-only agent in an untenable position: insurance agents may not, under state or federal law, render investment advice as they are not securities registered. Should an insurance-only agent warrant that she or she is in compliance with all applicable securities laws, the agent would be in violation of both insurance and securities regulations and would be exposed to administrative and legal action.

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(a) acts in the “Best Interest” of the plan or IRA with respect to the assets involved in the transaction and (b) does not make misleading statements nor fail to disclose a “Material Conflict of Interest.”16 ‘Best Interest’ is later defined in the amended PTE as acting “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the investment objectives, risk tolerance, financial circumstances and needs of the plan or IRA, without regard to the financial or other interests of the fiduciary, any affiliate, or other party.”17 (Emphasis added.) ‘Material Conflict of Interest’ is later defined as existing “when a person has a financial interest that could affect the exercise of its best judgment as a fiduciary in rendering advice to a plan or IRA.”18 (Emphasis added.) NAFA is concerned with the breadth and ambiguity of the definitions of both “Material Conflict of Interest” and “Best Interest” under the proposed new Impartial Conduct Standards, and with their uncertain application to the insurance company that the agent may represent. Insurance agents and the companies for which they sell insurance products all have a financial interest in making a fixed annuity sale. Consumers understand that insurance agents receive compensation and that annuity providers must make money to stay in business in order to satisfy the insurance guarantees promised to the consumer. Without greater clarity it is conceivable that the payment of any commission would create – even with proper disclosure – a material conflict of interest under the proposed definition, inviting confusion and legal exposure as a violation of the Impartial Conduct Standards. Moreover, the rule is unclear whether the Impartial Conduct Standards under Section II apply to the insurance company that issued the insurance product or annuity purchased with plan assets. Only the agent deals directly with the retirement investor and is the person who provides the investment advice that triggered the fiduciary duty in the first place. Thus, NAFA recommends clarifying the rule so that it is clear the impartial conduct standards apply only on the individual person who directly and personally provides investment advice to the Retirement Investor.

16 80 FR 22018. 17 80 FR 22020. 18 Ibid.

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C. Section II. Impartial Conduct Standards – Assets Involved in the Transaction.

Unlike securities representatives, fixed annuity agents have a limited and defined array of products that they may recommend for purchase to a consumer. As discussed previously, insurance agents can only offer fixed annuity products that are available to them to sell from the insurance companies with which they have a contractual/agency relationship. NAFA seeks clarification that when the assets involved in the transaction are fixed annuities, the Best Interest standard is met as long as the insurance agent considers all of the fixed annuity products that such agent is authorized by one or more insurance company to sell at the time the recommendation is made and acts in accordance with all applicable laws and regulations, including state insurance suitability requirements.

D. Section III. General Conditions – Reasonable Compensation.

Section III(c)(2) states that the combined total of all fees, Insurance Commission, and other consideration received by the insurance agent … or insurance company may not be in excess of “reasonable compensation.” 19 Section VI(f) further defines ‘Insurance Commission’ as “a sales commission paid by the insurance company or an Affiliate to the insurance agent … for the service of effecting the purchase or sale of an insurance or annuity contract, including renewal fees and trailer, but not revenue sharing payments, administrative fees or marketing payments, or payments from parties other than the insurance company or its Affiliates.”20 NAFA believes that the term “reasonable compensation” needs to be clarified further and suggests that, as it pertains to Insurance Commissions, the determination as to whether compensation is “reasonable” should be fact-specific to the writing agent. In other words, the reasonable compensation would be based on the array of fixed annuity products and associated product specific commission arrangements available from the company or companies with whom the agent has an appointment or agent contract at the time of sale.

19 80 FR 22019. 20 80 FR 22020.

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Additionally, because it is difficult, if not impossible in practical terms, to determine the ultimate “compensation” to the issuing insurance company on the sale of a fixed annuity, the reasonable compensation analysis should be focused exclusively on the compensation received by the writing agent.

E. Section IV. Conditions for Transactions Described in Section (1)(a)(1) through (4).

Section IV(b)(1)(B) – As part of the required written disclosures with respect to the execution of the transaction, the Insurance Commission paid by the insurance company to the agent … in connection with the purchase of the recommended contract must be disclosed. NAFA seeks clarification that the disclosure is the sales commission paid by the insurance company to the writing agent for effecting the purchase of the fixed annuity contract. Section IV(b)(2) – The Proposed Rule would require that the independent fiduciary acknowledge in writing receipt of the required disclosure information with respect to the transaction, as well as written approval on behalf of the plan [or IRA]. The marketplace reality is that parties who one would normally consider to be independent fiduciaries are not readily available in IRA transactions. Therefore, NAFA seeks clarification that the independent fiduciary is the IRA owner or plan recipient or beneficiary. Section IV(d)(2) – With respect to repeated disclosure requirements for the purchase of subsequent or additional insurance or annuity contracts, Section IV(d)(2) states that written disclosures need not be repeated where the subsequent contract being recommended for purchase is not “materially different” from that for which the initial disclosures were obtained. NAFA seeks clarification regarding how the Department will define and apply the term “materially different.” Accordingly, NAFA proposes the following changes to the proposed amended PTE 84-24: Revise Section I(a)(4) as follows:

(4) The purchase, with plan assets, of an insurance or annuity contract from an insurance company and the resulting receipt of compensation by the insurance company in connection with the purchase of the insurance or annuity contract.

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Revise Section I(b) as follows:

The exemptions set forth in Section I(a) do not apply to the purchase by an Individual Retirement Account as defined in Section VI, of (1) a variable annuity contract or other annuity contract that is a security registered under federal securities laws, or (2) mutual fund shares.

Revise Section II, as follows:

If the insurance agent or broker, pension consultant, insurance company or investment company Principal Underwriter is a fiduciary within the meaning of ERISA section 3(21)(A)(ii) or Code section 4975(e)(3)(B) with respect to the assets involved in the transaction and provides investment advice directly and personally to the Retirement Advisor, the following conditions must be satisfied with respect to the transaction to the extent they are applicable to the fiduciary's actions:

Revise Section VI(b) as follows:

(b) The insurance agent or broker, pension consultant, insurance company or investment company Principal Underwriter that is a fiduciary acts in the “Best Interest” of the plan or IRA is when the fiduciary acts either with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the investment objectives, risk tolerance, financial circumstances and needs of the plan or IRA or when providing advice that satisfies state suitability standards for insurance products without regard to, and places the interests of the Retirement Investor before the financial or other interests of the fiduciary, any affiliate or other party.

Revise Section VI(h) as follows:

(h) A “Material Conflict of Interest” exists when a person has a material financial interest that could places the person’s own financial interest before that of the Retirement Investor and thereby affects the exercise of its best judgment as a fiduciary in rendering advice to a plan or IRA.

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V. Conclusion The Department has clearly devoted a great deal of time and effort in drafting the Proposed Rule, and NAFA commends those efforts. However, we firmly believe that the Proposed Rule as currently written, while well intentioned, will result in diminished access to financial and retirement advice and products, particularly for low- and medium-balance retirement savers and particularly for insurance products such as fixed annuity contracts. NAFA respectfully requests the Department to consider and implement the changes and revisions suggested in this letter, which we believe will result in greater clarity and understanding for the industry, while ensuring that the financial interests and goals of retirement consumers are fully met. Without these proposed changes, it would be impossible to meet all the requirements set forth by the Proposed Rule. Again, on behalf of NAFA and its members, I want to thank you for the opportunity to submit these comments. We hope they will help the Department understand why the Proposed Rule should be amended as we have requested. Please do not hesitate to contact me if you would like additional information or further clarification. Sincerely, Charles “Chip” Anderson NAFA Executive Director

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NASAA

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC. 750 First Street N.E., Suite 1140

Washington, D.C. 20002 202/737-0900

Fax: 202/783-3571 www.nasaa.org

President: William Beatty (Washington) Secretary: Kathryn Daniels (Ontario) Directors: Joseph P. Borg (Alabama) President-Elect: Judith M. Shaw (Maine) Treasurer: Michael Rothman (Minnesota) Melanie Senter Lubin (Maryland) Past-President: Andrea Seidt (Ohio) Ombudsman: Keith Woodwell (Utah) John Morgan (Texas) Executive Director: Joseph Brady Gerald Rome (Colorado)

July 21, 2015 Via email to [email protected] Phyllis C. Borzi Office of Regulations & Interpretations Employee Benefits Security Administration Attn: Conflicts of Interest Rule Room N-5655 U.S. Department of Labor 200 Constitution Avenue Washington, DC 20210 Re: RIN 1210-AB32 – Definition of the Term “Fiduciary” – Conflicts of Interest Rule –

Retirement Investment Advice, and related proposals published on April 20, 2015 in Volume 80 of the Federal Register.

Dear Ms. Borzi,

The North American Securities Administrators Association, Inc. (“NASAA”)1 welcomes the opportunity to comment on the Department of Labor (“the Department”) Employee Benefits Securities Administration’s (“EBSA”) proposed rulemaking defining the term “fiduciary”2 “(the “fiduciary duty proposal”) and related proposed rulemaking initiatives published alongside the fiduciary duty proposal, including the Best Interest Contract Exemptions3 (“BIC proposal”) and Prohibited Transaction Exemption (PTE) 84-244 (“variable annuities proposal,” collectively, “the EBSA proposal” or “the proposal” or “the proposed rule”).

The NASAA membership includes all U.S. state securities regulators. U.S. state securities regulators have long-standing experience in applying the fiduciary standard of care in investment adviser oversight. To this end, NASAA offers the enclosed comments to inform this important EBSA regulatory initiative as applied to retirement accounts, which will serve to further protect retirement investors, as identified by the proposal. In parallel, NASAA continues to advocate for extending the fiduciary duty standard of care currently applicable to investment

1 NASAA is the association of the 67 state, provincial, and territorial securities regulatory agencies of the United States, Canada, and Mexico. NASAA serves as the forum for these regulators to work with each other in an effort to protect investors at the grassroots level and to promote fair and open capital markets. 2 80 Fed. Reg. 21928 (April 20, 2015). 3 80 Fed. Reg. 21960 (April 20, 2015). 4 80 Fed. Reg. 22010 (April 20, 2015).

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advisers to broker-dealers, as provided in Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”).5 While the EBSA proposal is a rulemaking initiative distinct from any U.S. Securities and Exchange Commission (“SEC”), rulemaking under its Dodd-Frank Act Section 913 authority, NASAA emphasizes the importance of continuing to raise the standard of care available to investors through multiple initiatives. Any progress towards an increased duty of care that addresses the problems associated with the significant conflicts of interest present in today’s marketplace is a productive step in the right direction.

By broadening the definition of investment advice and who is a fiduciary, the EBSA

proposal would significantly raise the standard of care available to investors in retirement plans, or retirement investors. Specifically, the proposal would treat those who provide investment advice or recommendations to an employee benefit plan, plan fiduciary, plan participant or beneficiary, individual retirement account (“IRA”) or IRA owners as fiduciaries under the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code (“the Code”). NASAA supports the proposed definition of investment advice also extending to IRAs. IRAs, a widely used retirement tool today, had only just begun to exist in 1975 when the Department promulgated the existing ERISA fiduciary duty regulations, and therefore were likely not considered extensively as part of the 1975 rulemaking. NASAA notes the proposed definition of fiduciary will extend to IRAs as a result of the parallel structure between Title I of ERISA and Section 4975(e)(3)(B) of the Code. However, the remedies under each regulatory framework differ, despite the parallel structure. While the ERISA Title I provisions generally authorize recovery of losses and imposition of civil penalties, the Code can only impose excise taxes on persons engaging in the prohibited transactions. As outlined below, explicitly preserving remedies available under state securities laws would enhance this unavoidable discrepancy between remedies available to IRAs under the Code in comparison to Title I plans.

NASAA appreciates that the new general definition of investment advice avoids many of

the weaknesses of the current EBSA framework. Such weaknesses include the narrow definition and applicability of the framework. NASAA supports the proposal’s goal to avoid sweeping in relationships that are not appropriately regarded as fiduciary in nature and that the Department does not believe Congress intended to cover as fiduciary relationships. NASAA also supports the Department’s inclusion of new exemptions designed to preserve certain transaction-based compensation models as part of its proposal, including the BIC proposal and the proposed amendments to existing exemptions to ensure workability. To contribute to the workability of the proposed rule, NASAA offers below a few suggestions to enhance the proposal while continuing to protect investors and preserving the remedies available to investors outside of binding arbitration.

5 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

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The Importance of a Fiduciary Duty of Care

The proposal is a positive step towards raising the standard of care for retirement accounts, though NASAA notes the importance of raising the standard of care for investors on all accounts, not solely retirement accounts. The proposal would ensure that many broker-dealer relationships currently governed by the suitability standard would become retirement accounts under the proposal and, therefore, subject to a conduct standard meant to prohibit conflicts of interest. The proposal is appropriate considering the evolution of retirement accounts since 1974 as well as ERISA’s scope and intent. ERISA is a comprehensive statute and the broad public interest in ERISA-covered plans is reflected in ERISA’s imposition of stringent fiduciary responsibilities on parties engaging in important plan activities, as well as in the tax-favored status of plan assets and investments.

NASAA has also long advocated for a true, undiluted, fiduciary duty standard applicable

to broker-dealers when providing investment advice to customers. An important benefit of a fiduciary duty regime for investors in general is that the fiduciary duty standard is not exclusively a conflicts disclosure regime, but one where the provider of advice must act in the best interest of the investor. While disclosing and managing conflicts of interest is a component of fiduciary duty, a true fiduciary duty standard also contemplates conflicts that cannot be disclosed and are therefore prohibited. To this end, NASAA has continued to emphasize that certain significant conflicts of interest must be prohibited, rather than allowed through disclosure. To the extent that the Department’s rulemaking will inform other regulatory initiatives to raise the standard of care available to investors, NASAA is pleased that the Department has designed a rule that is meant to preserve certain traditional compensation models while significantly narrowing the exemptions to ensure the protection of investors.

NASAA also appreciates that the Department has coordinated with the SEC, and would

encourage continued consultation with the SEC and state securities regulators. Continued coordination serves to minimize any confusion that may result on behalf of either investors or industry members as the rule is implemented. To this end, NASAA has also sent a comment letter to the SEC noting the importance of coordinating with the Department to ensure that the standard of care available to investors is a fiduciary standard for retirement accounts, but also for non-retirement accounts at broker-dealers. The SEC, under the grant of authority of Section 913 of the Dodd-Frank Act, has the discretion to ensure that the standard of care that broker-dealers owe to customers be raised to a fiduciary standard on all account relationships, with very limited carve-outs for commissions and principal transactions. SEC rulemaking can and should occur in close coordination with the Department’s rulemaking, though regulatory harmony should not delay either the Department’s or the SEC’s rulemaking.

Extending Fiduciary Duty to IRAs Will Result in Greater Investor Protection

The proposal’s extension of the fiduciary duty standard to IRAs would provide significant and much needed protection to retirement investors. The Department’s reliance on economic evidence supporting a finding of the negative impact of conflicts of interest on

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retirement investment outcomes demonstrates the need for the rule under consideration. The Department cites to substantial failures in the market for retirement advice, noting that IRA holders receive conflicted advice and can expect the investments to underperform by an average of 100 basis points per year over the next 20 years. The proposal seeks to remedy this adverse impact on the performance of IRAs with investments from a wide range of products. Products held in IRAs can include mutual funds, insurance products, exchange traded funds (ETFs), individual stocks and bonds, and other products which are all sold by agents and brokers.

Rollovers and account transfers are an area where state securities regulators routinely see abuse, such as in cases where an investor is advised to liquidate a well-balanced portfolio in exchange for an over-concentration in a high-fee product. That same fact pattern can occur in IRA rollovers. Furthermore, even if a specific IRA rollover may be an adequate transaction for the investor, it may not be the transaction in the investor’s best interest. Therefore, NASAA is supportive of the greater breadth of application of fiduciary duty that the proposed rule can afford, as long as remedies available under the state securities laws are explicitly preserved under the proposal. State securities regulators have active enforcement programs that contribute to investor protection and would supplement the few remedies available to IRA holders under the Code, particularly in contrast with the remedies available to Title I plans.

State securities enforcement programs address both registered and unregistered activities. In its most recent report on state securities enforcement activities, NASAA reported that investigations conducted by state securities regulators led to nearly 2,200 enforcement actions across 51 jurisdictions, including administrative, civil, and criminal actions against 3006 respondents or defendants.6 Those actions targeted both registered and unregistered activity and resulted in state securities regulators levying $71 million in fines and penalties and the ordering of $616 million in restitution to investors.7 State securities regulators also took steps to deny licenses to bad actors and imposed restrictions on the activities of licensees with significant disclosure history. As noted in the most recent report on state securities enforcement activities, a total of 169 licenses were denied due to state action, a 36 percent increase in denials over last year.8 In addition, 394 licenses were conditioned, a 48 percent increase over last year.9

Adoption of the Proposal Should Include Explicit Acknowledgment of the ERISA Savings Clause for State Securities Laws and Enforcement The proposal notes that enforcement of the fiduciary standard varies depending on the type of plan. Specifically, the remedies for IRA plans are limited to excise tax remedies and contractual remedies under the BIC. Therefore, it remains important that state securities regulators maintain their authority to pursue a registered person who may have engaged in violative conduct involving an IRA or other transaction covered by ERISA fiduciary duty. We 6 See NASAA 2014 Enforcement Report available at http://www.nasaa.org/wp-content/uploads/2011/08/2014-Enforcement-Report-on-2013-Data_110414.pdf. 7 Id. 8 Id. 9 Id.

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urge the Department to include language in its final rule that explicitly acknowledges that state securities laws are not superseded or preempted in any way and remain subject to the ERISA Section 514(b)(2)(A) savings clause.10

Explicit acknowledgement of the savings clause ensures that state enforcement actions can supplement the current remedies under ERISA and the Code, which vary by type of plan. Participants in plans covered by Title I of ERISA have a statutory right of action to bring suit against fiduciaries under ERISA for violation of the prohibited transactions. In contrast, while the proposal includes IRAs in terms of extending fiduciary duty to IRAs, the sole statutory sanction available under the Code is an excise tax enforced by the Internal Revenue Service. The proposal bolsters these remedies for IRA owners through the addition of contractual remedies for transactions that include use of the BIC exemption. The proposal essentially empowers enforcement of the BIC exemption through the retirement investor, noting “the Department intends that all the contractual obligations (the Impartial Conduct Standards and the warranties) will be actionable by IRA owners.”11 While NASAA supports empowering the retirement investor, state securities regulators know from long-standing experience and active enforcement programs that deterrence and enforcement of remedies cannot rest on investors alone.

The ERISA “pre-emption clause” (Section 514(a))12 provides that ERISA supersedes all

state laws insofar as they “relate to any employee benefit plan,” but acknowledges the importance of certain state laws through ERISA's “saving clause” (Section 514(b)(2)(A))13 that excepts from the pre-emption clause any state law that “regulates insurance, banking, or securities.” As the proposal represents a significant regulatory shift, explicit acknowledgement that state securities laws are not superseded in any way and remain subject to the ERISA Section 514(b)(2)(A) savings clause is an important and clear indication of the Department’s support for state securities regulators’ mission to protect investors who may have engaged in ERISA-covered transactions, such as becoming IRA owners. Adoption of the Proposal Should Prohibit Pre-Dispute Binding Arbitration Agreements NASAA urges the Department to revise the proposal’s endorsement that institutions entering into agreements with retirement investors would be able to include pre-dispute binding arbitration agreements with respect to individual contract claims.14 We appreciate and agree with the Department’s position that waivers for class actions should not be part of the 10 29 U.S.C. 1144(b)(2)(A). 11 BIC proposal, 80 Fed. Reg. at 21972. 12 29 U.S.C. 1144(a). 13 29 U.S.C. 1144(b)(2)(A). 14 BIC proposal, 80 Fed. Reg. at 21973:

As proposed, this section would not affect the ability of a Financial Institution or Adviser, and a Retirement Investor, to enter into a pre-dispute binding arbitration agreement with respect to individual contract claims. The Department expects that most individual arbitration claims under this exemption will be subject to FINRA’s arbitration procedures and consumer protections.

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agreements, but remain concerned that the regulation would allow the use of binding pre-dispute arbitration provisions for individual claims. Prohibiting binding, or mandatory, pre-dispute arbitration clauses would ensure retirement investors’ access to the courts, provide an important measure of investor protection, and uphold the original purpose of the Federal Arbitration Act (“FAA”). If the Department declines prohibiting pre-dispute binding arbitration agreements, NASAA urges that the Department consider revising its assent to such agreements by including in the adopting release a discussion on these agreements’ inherent conflict with investor choice of forum and protection.

The FAA was enacted in 1925 to honor agreements to arbitrate between mutually consenting parties. The “principal purpose” of the FAA was to “require courts to enforce privately negotiated agreements to arbitration, like other contracts, in accordance with their terms.”15 Form contracts or “contracts of adhesion” where one party offers terms on a non-negotiated, “take-it-or-leave-it” basis are contrary to the intended purpose of the FAA. Unfortunately, these types of agreements are an endemic part of brokerage “form” contracts between institutions and investors, requiring investors to agree, in advance of any dispute, to mandatory arbitration. NASAA has a long-standing position opposing such mandatory pre-dispute arbitration agreements and has supported the Arbitration Fairness Act of 201316 and the Investor Choice Act,17 as well as other efforts to curtail these agreements. Investors should not be forced into an arbitration forum, but rather should have a choice of forum, whether arbitration or the traditional court system.

NASAA notes that Congress recognized the potential harm to investors raised by

mandatory pre-dispute arbitration agreements when it enacted Section 921 of the Dodd-Frank Act. Section 921 provides the SEC with the authority to prohibit or impose limitations on the use of mandatory pre-dispute arbitration clauses in broker-dealer and investment adviser customer contracts. It is unfortunate that the SEC has not yet exercised this authority, but in light of the importance of coordination between the Department and the SEC, the Department could take an important step towards investor protection by opposing mandatory pre-dispute arbitration agreements as part of the BIC proposal’s requirements for contracts with retirement investors.

Additional Comments Regarding the Proposal

In addition to the above comments regarding some of the larger policy aspects of the proposal, NASAA offers the following comments to enhance the proposal’s application and workability.

Explicit retroactive application of the BIC’s fiduciary obligations once the written contract is

signed. The BIC proposal notes that the contract is the cornerstone of the proposed 15 Volt Info. Scis., Inc. v. Bd. of Trs. of Leland Stanford Junior Univ., 489 U.S. 468, 478 (1989). 16 See Letter from NASAA to Representative Hank Johnson (May 20, 2013), available at http://www.nasaa.org/wp-content/uploads/2011/07/NASAA-Letter-Supporting-AFA-Rep-H-Johnson-May-2013.pdf. 17 See Letter from NASAA to Senator Al Franken (May 20, 2013), available at http://www.nasaa.org/wp-content/uploads/2011/07/NASAA-Letter-Supporting-AFA-Sen-A-Franken-May-2013.pdf.

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exemption but, as it is a written contract, it will be signed after the relationship with the Adviser and Financial Institution has begun. Account opening is a crucial time to ensure that the investor understands the relationship, the type of account, and the long term strategy. Here, a retirement investor may receive advice about the various types of retirement accounts, including differences between these accounts with regard to commissions, tax consequences, and fee structure. Retroactive application of the fiduciary standard prior to the written contract being ratified would be analogous to the attorney-client confidentiality and privilege rules in the majority of states, where discussions leading up to the decision of a client to retain an attorney are nevertheless covered by obligations of confidentiality and privilege. The BIC proposal should be revised to note that the provisions of the written contract cover the relationship with the retirement investor retroactively.

Investment and retirement education. NASAA appreciates that the fiduciary duty proposal includes a carve-out for the provision of investment education information and materials. NASAA especially appreciates the proposal’s equal application of this carve-out to information provided to plan fiduciaries as well as information provided to plan participants and beneficiaries and IRA owners, including equal application to participant-directed and other plans. While this type of investment and retirement education is important for investors, this type of education differs from the unbiased investor education that federal and state securities regulators provide. Therefore, while it is appropriate for the Department to provide guidance on what constitutes education in comparison to advice, allowing some specificity within educational materials may provide a service to retirement investors. Such specificity should be balanced, however, with requiring materials to prominently note that they are part of the marketing process of a plan and could present biases or conflicts.

Narrow exemptions. NASAA supports the general narrowing of exemptions contemplated in

the proposal, including the amendment in the variable annuities proposal that would revoke relief for insurance agents, insurance brokers, and pension consultants to receive a commission in connection with the purchase by IRAs of variable annuity contracts and other annuity contracts that are securities under federal securities laws. Revoking this exemption through application of the BIC exemption provides an important measure of investor protection. NASAA has identified problems in the sale of variable annuities as a persistent threat to all retail investors.18 The regulatory and investor protection issues surrounding variable annuities have been documented over the years in regulatory warnings, governmental enforcement actions, private lawsuits, and media accounts.19 The problematic sales practices surrounding variable annuities include: (1) misrepresentations about the annuities’ liquidity; (2) unsuitable sales to customers for whom a variable annuity’s long

18 See NASAA Enforcement Report (Oct. 2012), available at http://www.nasaa.org/wp-content/uploads/2012/10/2012-Enforcement-Report-on-2011-Data.pdf; see also NASAA Enforcement Report (Oct. 2011), available at http://www.nasaa.org/wp-content/uploads/2011/08/2010-Enforcement-Report.pdf. 19 See Comment Letter from Karen Tyler, NASAA President and North Dakota Securities Commissioner regarding the SEC’s Proposed Rule That Would Subject Certain Equity-Indexed Annuities to Regulation Under the Federal Securities Laws (Sept. 10, 2008), available at http://www.nasaa.org/wp-content/uploads/2011/07/29-NASAA_Comment_Letter_on_SEC_Proposed_Rule_151A.pdf.

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timeline is inappropriate; (3) lack of disclosures about steep surrender charges; (4) lack of disclosures about commission structures; and (5) lack of choices for customers, as firms usually sell only a limited number of variable annuity products. Several state securities regulators have brought enforcement actions involving the offer and sale of variable annuities.

In closing, NASAA reiterates its support towards the Department’s important goal of enhancing the standard of care available to retirement investors, including those who invest through IRAs. The proposal is an important step in raising the standard of care available to retirement investors and paves the way for additional regulatory initiatives to raise the standard of care for investors in general. NASAA particularly urges the Department to explicitly preserve remedies available under state securities laws, as they would serve to enhance the more limited remedies available under ERISA and the Code. NASAA is also pleased to have an opportunity to comment on other aspects of the proposal, such as arbitration agreements and investment education.

Should you have any questions regarding the comments in this letter, please do not

hesitate to contact Joseph Brady, NASAA’s Executive Director, at [email protected], or A.Valerie Mirko, NASAA’s Deputy General Counsel, at [email protected], or 202-737-0900.

Sincerely yours, William Beatty NASAA President Washington Securities Administrator

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Via Electronic Mail to [email protected] Office of Regulations and Interpretations Employee Benefits Security Administration U.S. Department of Labor 200 Constitution Avenue, NW Washington, DC 20210 Re: Conflicts of Interest Proposed Rule Definition of the Term “Fiduciary”; Conflict of Interest Rule – Retirement Investment

Advice (RIN 1210-AB32) Proposed Best Interest Contract Exemption (ZRIN: 1210-ZA25) Proposed Amendments to Various Exemptions (ZRIN: 1210-ZA25)

Ladies and Gentlemen:

PFS Investments Inc. (“PFSI”), a registered broker-dealer and an indirect wholly-owned subsidiary of Primerica, Inc. (“Primerica”), is pleased to submit this comment on the proposed Conflicts of Interest Rule (“Proposed Rule” or “Proposal”) that would more broadly define the term “fiduciary” under Internal Revenue Code (“IRC”) section 4975. We appreciate the opportunity to share our thoughts regarding this critical rule-making. We focus our comments on the Proposed Rule’s impact on the middle-income savers and investors who we have diligently and successfully served for over 30 years.

PFSI respectfully submits that the Proposed Rule will cause significant harm to middle-income individuals and families by restricting their ability to save for retirement through Individual Retirement Accounts (“IRAs”). In the Proposed Rule, the U.S. Department of Labor (the “Department”) has greatly expanded the definition of fiduciary such that nearly every conversation a financial professional has with a potential retirement saver will be construed as fiduciary advice. Accordingly, transactions effected in connection with a financial professional’s assistance will be subject to reversal and penalties under the prohibited transaction rules unless it falls within a prohibited transaction exemption. We acknowledge the Department’s statement that it has sought to craft an exemption that allows the continuation of the very popular brokerage-based IRA, designated by the Department as the Best Interest Contract Exemption (“BIC Exemption”). Regrettably, we find the BIC Exemption to be unworkable. In short, the requirements of the BIC Exemption are so complex and burdensome that it is not administratively or operationally feasible. We believe the Proposed Rule will still require broker-dealers to fundamentally restructure their IRA businesses, resulting in higher minimum

Karen L. Sukin EVP and Deputy General Counsel Primerica, Inc. General Counsel PFS Investments, Inc. Member FINRA 1 Primerica Parkway Duluth, Georgia 30099-0001 (470) 564-6580 Phone (470) 564- 7174 Fax

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account balances beyond the reach of millions of middle-income households, reduced access to financial professionals, reduced investor choices, and ultimately, lost opportunities to accumulate meaningful retirement savings on a tax-deferred basis for millions of hard-working Americans in the middle-income market.

In Section I of this letter, we introduce Primerica as a company. We discuss how we help

middle-income families save for retirement and the importance of our face-to-face services in encouraging these savings. In Section II, we address the over-breadth of the proposed fiduciary definition. In this discussion, we request the retention of key elements of the current definition, such as the requirement of “mutual understanding” by the client and the financial professional that the relationship is a fiduciary one. We further request that the definition include a meaningful “seller’s exception” for retail investors, and that the exception for investment education be broadened rather than narrowed. In Section III, we discuss our concern that the BIC Exemption is unworkable as written, and suggest specific changes that could potentially make the BIC Exemption operational. In Section IV, we briefly address the faulty legal basis of the Proposal. Finally, in Section V, we summarize our recommendations with respect to the Proposal. I. Who We Are and How We Help Middle-Income Families

A. How Primerica Reaches Middle-Income Households Primerica is a leading distributor of basic savings and investment products to

middle-income households throughout the United States. Our typical clients are middle-income consumers, defined by us as households with an annual income of $30,000 to $100,000, a category that represents approximately 50% of all U.S. households. As is widely known, the smaller-sized transactions typical of middle-income consumers have induced most financial services companies to focus on more affluent consumers and abandon the middle-income market. Primerica’s business model, however, is designed to allow us to provide exceptional service to the middle-income market, and to do so in a sustainable manner. All PFSI representatives are independent contractors, hold the necessary Financial Industry Regulatory Authority (“FINRA”) and state registrations, and are compensated by commissions resulting from product sales. Our business model allows our representatives to concentrate on the smaller-sized transactions typical of middle-income consumers and provides clients access to personal services that would usually not be available to middle-income investors with smaller account balances.1

Primerica has limited its offering of investment products to those that are most

appropriate for our middle-income clients. Through PFSI, our affiliated broker-dealer, we offer open-end mutual funds and variable annuities, all from well-known and respected companies, as well as many different savings vehicles, including taxable accounts, IRAs, and college savings plans. Our platform includes off-the-shelf products, with commissions on par with those paid to other product distributors.

1 We will open an IRA account for an individual with as little as $250 to invest, or for $50 per month.

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Likewise, our investment education and philosophy is geared toward our middle-income clients, who oftentimes are new or less experienced investors. In that regard, we produce easy to understand educational pieces teaching fundamental investing concepts. In our educational outreach efforts, we often partner with our product providers.2 Our primary investing principle, which is consistent throughout our educational pieces, is the long-term benefit of dollar-cost averaging through systematic investing into a diversified investment portfolio. To help our clients adopt this approach, our affiliated shareholder servicing entity, Primerica Shareholder Services (“PSS”), facilitates periodic investments (monthly or quarterly) into mutual fund accounts by processing electronic bank drafts against client checking accounts for five platform fund families.3 In addition to the advantages of dollar-cost averaging and diversification, PFSI emphasizes the benefits of asset allocation, which spreads investment dollars across different asset classes in an effort to reduce risk and increase returns. By any measure, PSS has been highly successful in aiding Americans to save; it currently handles transactions for over 1.2 million client accounts, and was recently awarded the 2014 DALBAR Service Award4 for exemplary client service for the twelfth consecutive year.5

At Primerica, our representatives reflect and serve the communities in which they live. Accordingly, they are well-acquainted with the financial challenges facing the middle-income market. The diversity of our sales force reflects the make-up of the middle-income market and continues to be a primary strength of our company. There is no doubt that our representatives are a big reason for our success, as well as the success of many middle-income American families in starting to save for their retirement and future.

B. Our Focus on Saving for Retirement

Our investing products and principles fit hand-in-glove with the primary financial need of most middle-income Americans, which is the need to establish a long-term savings plan for retirement. In response to this need, Primerica and its representatives have made providing retirement savings education and information a priority. Over our history, we have produced and distributed hundreds of thousands of educational brochures that discuss saving for retirement.6

2 See, e.g., Legg Mason’s Discover the 3D’s of Investing, available at www.leggmason.com (click on US Investors/Products & Insight; then Literature; then ClearBridge Appreciation Fund).

3 The five fund families available on the PSS platform are American Century, Franklin Templeton, Invesco Funds, Legg Mason and Pioneer Investments.

4 DALBAR, Inc. is the financial community’s leading independent expert for evaluating, auditing and rating business practices, customer performance, product quality and service.

5 See www.dalbar.com/AwardsRankings/AwardHistory. As a service provider to the five mutual fund companies on our platform, PSS receives recordkeeping and shareholder servicing fees from those companies (or their affiliates). This is a common arrangement in the mutual fund industry. In essence, these five fund companies are paying PSS to perform services for shareholders that they, or their affiliates, would otherwise have to perform.

6 For example, some of the current retirement brochures are identified as follows: Investing at Retirement; Asset Management; IRAs; Power of Dollar-Cost Averaging; Invest for Success; and ABC’s – The Basics of Investing.

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We introduce clients to fundamental retirement savings concepts, such as the difference between expected retirement age and life expectancy, the “Rule of 72” which produces the years required to double one’s investment based on an assumed rate of return, and how inflation and rate of return affect a long-term savings plan. As a result of our efforts to educate American families about the need to save for retirement, and to provide beneficial, cost-effective retirement solutions, in just about any given year more than half of all accounts opened by PFSI are IRAs.

C. The Real Issue for Middle-Income Americans Is the Lack of Retirement Savings, Not Conflicts

Our experience in serving middle-income Americans has shown us that the real issue for this group of investors is not that their retirement accounts are negatively affected by conflicts, but rather that far too many of them have simply failed to take the steps necessary to accumulate meaningful retirement savings. This lack of retirement savings is borne out by the research. The Survey of Consumer Finances (the “SCF”) is conducted by the Federal Reserve Board every three years and is a leading source of data on American’s wealth. It provides detailed information on the incidence of retirement plan ownership by American families, and categorizes the results by different criteria, one of which is family income. In its analysis of the results of the 2013 SCF, the Employee Benefit Research Institute (the “EBRI”) finds that participation in an employment-based retirement plan (either a defined benefit or defined contribution plan) is strongly linked to family income.7 According to the EBRI’s report, in 2013 the SCF shows that 67.1% of all families with an income of $100,000 or more had someone participating in a plan at a current job. But in middle-income America, with incomes below $100,000, participation is significantly lower; in 2013, just 53.5% of families with incomes ranging from $50,000 to $99,999 had a participant in a plan. In the $25,000 to $49,999 income range, participation is even lower; in 2013, the number of families with a participant in a plan at a current job was just 25.8%.8 What these results show is that for whatever reason, the middle-income market is currently participating far less in employer-sponsored retirement plans than the more affluent market.9 Also, the SCF takes a more inclusive look at retirement plan ownership by measuring the percentage of all families with a participant in an employer-based plan or an IRA or Keogh plan. A wide variance in participation remains. In 2013, for families with incomes of $100,000 or more, fully 93.0% had a participant in one of these plans. But for families with incomes of $50,000 to $99,999, participation drops to 81.8%, and for incomes of $25,000 to $49,999,

7 See Craig Copeland, Individual Account Retirement Plans: An Analysis of the 2013 Survey of Consumer Finances, EBRI Issue Brief, no. 406, November 2014, available at www.ebri.org.

8 Id. at 7 (Figure 2). 9 This negative trend is an ominous sign for retirement savings in the middle-income market, Oliver Wyman recently found that 84% of more than 4,300 retail investors surveyed only began saving for retirement via a workplace retirement plan. See Oliver Wyman, The Role of Financial Advisors in the US Retirement Market, Key Findings (July 6, 2015), at 5.

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participation drops to a lowly 58.9%.10 Lack of participation is particularly acute in the lower income range, where more than 4 out of 10 families have no retirement account or savings. Finally, the EBRI report allows further insight by reviewing the SCF data on total average retirement portfolio account balance for families in any plan or IRA. The SCF categorizes all families into five net worth percentiles. Again, the average retirement account balances drop off considerably in the lower three net worth percentiles. These balances are $69,144 for the 50-74.9% percentile, $18,543 for 25-49.9%, and only $10,458 for families with a net worth in the bottom 25%.11 This data confirms that retirement savings is heavily skewed to higher net worth families, and that everybody else needs to save more. Those families with a net worth in the bottom 50%, which would be most middle-income families, are in real trouble. The EBRI report confirms that, for middle-income Americans, the lack of retirement savings is a serious problem. The real issues that the Department and the Administration should be focused on are Americans’ lack of retirement savings and poor financial literacy. In fact, because the Proposal will make retirement information and advice harder to obtain for middle-income Americans, it will, unfortunately, make a bad situation worse. For us, the Proposal will make it more difficult for our representatives – who are on the frontlines and living in these most affected communities – to continue to effectively educate middle-income families on the benefit of retirement savings.

D. Middle-Income Families Need Help to Understand the Need to Save for Retirement

In the New York Times bestselling book “Nudge,”12 behavioral economist Richard Thaler and law professor Cass Sunstein draw from behavioral science research to propose ways that sensible “choice architecture” (the context in which people make decisions) can successfully “nudge”13 people toward better decisions, without giving up their freedom of choice. One of the societal problems they examine is saving for retirement, and the choices that participants make, or fail to make, inside of employer based retirement plans. In so doing, the authors provide their insights into why saving for retirement is such a challenge for many people:

The standard economic theory of saving for retirement is both elegant and simple. People are assumed to calculate how much they are going to earn over the rest of their lifetime, figure out how much they will need when they retire, and then save up just enough to enjoy a comfortable retirement without sacrificing too much while they are still working.

10 See Copeland, supra note 7, at 10 (Figure 5) 11 Id. at 11 (Figure 6). 12 Thaler, Richard H. and Sunstein, Cass R., “Nudge: Improving Decisions About Health, Wealth, and Happiness” (Penguin Books; Revised & Expanded edition, 2009 ) (All cites are to the paperback edition).

13 The authors define a nudge as “any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.” Id. at 6.

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As a guideline for how to think sensibly about saving, this theory is excellent, but as an approach to how people actually behave, the theory runs into two serious problems. First, it assumes that people are capable of solving a complicated mathematical problem in order to figure out how much to save. Without good computer software, even a trained economist would find this problem daunting. The truth is that we know few economists (and no lawyers) who have made a serious attempt at doing it (even with software). The second problem with the theory is that it assumes that people have enough willpower to implement the relevant plan. Under the standard theory, flashy sports cars or nice vacations never distract people from their project of saving for a condo in Florida. In short, the standard theory is about Econs [previously described as the “textbook picture of human beings offered by economists”, that “think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi”14], not Humans [real people that “have trouble with long division if they don’t have a calculator, sometimes forget their spouse’s birthday, and have a hangover on New Year’s Day”15].16

We agree with the authors’ opinion that the decision to save for retirement is one where most people need help to do the right thing. They explain that the act of saving for retirement tests one’s self-control, and that “self-control issues often arise when choices and their consequences are separated in time.”17 This seems particularly relevant, as when a 37-year-old parent opts to put off saving for retirement, a decision that will not have consequences for 20 or 30 years, in order to buy a new car, a choice that generates immediate gratification. Finally, the authors posit that it is particularly hard for people to make good decisions when they have trouble translating the choices they face into terms that they can easily understand.18

Thaler and Sunstein conclude that saving for retirement is, for most people, a hard choice, and that people need a “nudge,” or help, to do the right thing. We completely agree, especially for people in the middle-income market, where the decision to allocate a portion of limited resources to savings often means passing on some other purchase or activity. We believe that it is our representatives, empowered with our educational materials and ability to successfully service small balance accounts, who are this “nudge” or help for many American families. This Proposal may severely limit our ability to continue to provide this valuable personal service or function.

14 Id. at 6.

15 Id. at 6.

16 Id. at 106.

17 Id. at 75.

18 Id. at 74.

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E. People that Use Financial Professionals Report Better Results in Retirement

Savings In May of this year, the LIMRA Secure Retirement Institute published the results of its 2014 Consumer Survey.19 The results show that “advisors” (defined as paid financial professionals, such as brokers, financial planners, or advisors) add significant value to the clients they serve by encouraging them “to save holistically”, including for retirement. For nearly every identified savings goal surveyed (except vacation), LIMRA found that “advisors’ clients are significantly more likely to save on a regular basis compared with people who don’t consult advisors.”20 Specifically with respect to retirement, LIMRA found that people who work with advisors (as broadly defined) are more than twice as likely (54% with advisors, as opposed to 26% without) to save for retirement on a regular basis (outside of the workplace) than people who do not work with advisors.21 With respect to pre-retirees (ages 55 to 70), LIMRA found that those that use advisors are more likely to have performed key planning activities than pre-retirees who do not use advisors; these activities include: calculation of the amount of assets they will have available for retirement (58% with advisors, as opposed to 30% without), determination of their income in retirement (56% as opposed to 39%), determination of their retirement expenses (52% as opposed to 32%), estimation of how many years their assets will last in retirement (50% as opposed to 23%), and identification of the activities they plan to engage in and their likely costs (42% as opposed to 24%). Finally, in an earlier survey, LIMRA found that pre-retirees that use advisors consider themselves significantly better prepared for retirement than those who do not consult an advisor.22 Another recent study conducted by consulting firm Oliver Wyman, attached as Appendix 1, confirms that financial representatives add substantial value to their client’s financial, and retirement, well-being.23 The study focused on the role of financial representatives in the U.S. retirement system, and primarily drew upon proprietary surveys of more than 4,300 retail investors (the “Retail Investor Retirement Survey”) and analysis of two datasets from IXI Services, a division of Equifax.24 Based on the Retail Investor Retirement Survey, the study found that on average, individuals that use a financial representative have more assets than

19 See Matters of Fact: Consumers, Advisors and Retirement Decisions (and Results); LIMRA Secure Retirement Institute (May 2015), available at http://www.limra.com/.

20 Id. at 6. The identified savings goals were as follows: retirement (outside of the workplace), education, specific one-time large purchase (other than home), home purchase, vacation or travel, unexpected expenses/rainy day fund, home improvement, medical costs, and taxes.

21 Id. at 6.

22 See Advisor Perspectives on Retirement Planning, LIMRA Secure Retirement Institute (2012).

23 Oliver Wyman states that it “was engaged to perform a rigorous investigation of the role of financial advisors in the US retirement market, and quantify differences in investing behavior and outcomes between advised and non-advised individuals.” Oliver Wyman, The Role of Financial Advisors in the US Retirement Market, at iii.

24 See id. at iii-iv (About This Report).

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non-advised individuals across all the age and income levels examined. For example, concerning individuals with $100,000 or less in annual income (i.e., middle-income individuals), Oliver Wyman found that advised individuals have a minimum of 38% more assets than non-advised individuals.25 Moreover, with respect to individuals in or approaching retirement, the differences in assets are even more significant. On average, advised individuals ages 55 to 64 had 51% more assets than non-advised individuals, and those 65 and older had 113% more assets (i.e., more than double) than the non-advised.26 These are meaningful differences in assets for middle-income individuals that use advisors, which should translate into significant improvements in their retirement living.27 Oliver Wyman’s analysis of the IXI dataset, representing approximately 20% of U.S. consumer-invested assets, substantiated its findings from the retirement survey. With respect to middle-income savers ($100,000 or less in annual income), Oliver Wyman found that on average, individuals who employ the services of an investment professional, like a broker, have had “at least 50% more” in total invested assets than others since at least 2006, the first year of the dataset.28 This advantage in total invested assets rose throughout the 2009 recession and its immediate aftermath, and remained at “more than 200% more” in total invested assets from 2011 through 2013, the last year of the dataset. When looking only at IRA assets, Oliver Wyman found similar results. From 2006 to 2008, IRAs of advised individuals had, on average, approximately “40% more assets” than the IRAs of the non-advised.29 During the 2009 recession and its immediate aftermath, this advantage rose sharply to “more than 50% more” in IRA assets for the advised for 2010 through 2013. Also, Oliver Wyman analyzed total IRA assets by age group in 2013, and found that for individuals with $100,000 or less in annual income, those with advisors had higher IRA assets in all age brackets, ranging from a low of 39% more IRA assets in the 18-to-34 age bracket, to a high of 87% more IRA assets in the 55-to-64 age bracket.30 Clearly, the sharp rise in the advantage of advised individuals in both total invested assets and IRA assets during the 2009 recession and its immediate aftermath is a testament to the benefit of receiving the assistance of a financial representative during a period of extreme market turmoil. Finally, Oliver Wyman also found that advised individuals more often displayed investing practices “commonly associated with long term investing success,” which included having more diversified portfolios, staying invested in the market by holding significantly less cash, taking fewer premature cash distributions, and rebalancing their investments to a desired

25 Id. at 16.

26 Id. at 16.

27 The study states that their findings hold true, even when excluding survey respondents who anticipate receiving retirement income from either an inheritance or trust fund.

28 Oliver Wyman, The Role of Financial Advisors in the US Retirement Market, at 17.

29 Id. at 17.

30 Id. at 24.

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asset allocation more frequently.31 Again, we believe that the Proposal will harm middle-income savers by unnecessarily disrupting the relationship between the client and her chosen financial professional.

II. The Proposed Rule Will Significantly Disrupt Retirement Savings for Middle-Income

Americans

Based on our vast experience with working with middle-income American families and the research cited above, we are deeply concerned that the Proposed Rule will have the unintended effect of depriving middle-income consumers of desperately-needed retirement guidance from SEC- and FINRA- regulated financial professionals. We anticipate the result will be an industry-wide movement to further abandon the middle-market and focus on affluent clients. The “haves” will be afforded personal services, while the “have-nots” will be left without personal assistance to fend for themselves online, or will be steered away from tax-advantaged IRAs entirely.

We do not say this lightly. Since the Proposed Rule was first released, PFSI has spent significant effort parsing the rule and determining how the Proposal would impel us to modify our operations. Given the Department’s stated intent to preserve business models and provide flexible “principles-based” guidance, we were initially hopeful. However, we regrettably conclude that the BIC Exemption – the way that the Department seeks to preserve the commission-based brokerage model for retirement accounts – requires such significant people, process and technology changes, not to mention increased exposure to litigation risks, that in the end, it does not appear to be operationally practical or feasible to implement. The Proposal will harm the very consumers it was intended to protect.

If the Department’s Proposal is finalized as proposed, “Main Street” consumers – young

families saving what they can each month – will be separated from their chosen financial professional and lose access to the commission-based brokerage model that has served them so well. They are likely to be limited to investing in taxable accounts, or be left with no in-person financial professional to encourage (or “nudge”) them to save at all. For those with more to invest, the choice likely will be limited to more costly advisory services.32 For these reasons, we urge the Department to withdraw the Proposed Rule. We believe the Proposal is unnecessary and that the Department has failed to clearly establish how the Proposal addresses the real retirement savings issues confronting America: lack of financial literacy and will to save for retirement. If the Department nevertheless continues with this Proposal, we urge the Department to take its time to reconsider how the Proposal will affect the average saver. Substantial revisions are necessary to preserve choice and access to financial and

31 Id. at 2.

32 Garber, Steven, Burke, Jeremy, Hung, Angela, and Talley, Eric, Potential Economic Effects on Individual Retirement Account Markets and Investors of DOL’s Proposed Rule Concerning the Definition of a “Fiduciary,” Rand Corporation, Rand Labor and Population, RR-1009-DOL, February 2015, prepared for the Department of Labor, at 18 (“The number of professional advisers needed to serve the IRA market would be expected to decrease as a result of adopting the rule to the extent that broker-dealers exit the IRA market or take steps to reduce their IRA-related advisory activities.”).

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investment services for middle-income Americans. To get these revisions right will require more time than the Department has proposed to provide for a final rule to become effective and applicable. Specifically, the Department should revise the proposed definition of fiduciary investment advice to: (1) retain key elements of the current five-factor fiduciary definition, including the mutual understanding element which is critical to allowing clients and their representatives to define their financial services relationship; (2) provide for a meaningful “seller’s exception” for retail investors; and (3) preserve investment education by broadening, not narrowing, the education exception.

A. The Proposed Definition of Fiduciary Is Too Broad

The Proposed Rule greatly expands the scope of who is a fiduciary and when fiduciary status begins and ends. To do so, it eliminates the current “five-part test,” and instead introduces vague and novel terminology that could have the result of imposing fiduciary status on almost every conversation that a representative may have with a potential client. For example, the Proposal removes the fundamental requirement that advice be provided pursuant to a “mutual understanding”. The proposed removal of mutuality as a necessary condition to establish a fiduciary relationship is alarming. Without that element, under the Proposed Rule fiduciary status could ensue even when there is no agreement, indication, or intention by either party at the time that the representative will act as a fiduciary. There is risk that an “understanding” that is not “mutual” can be unilaterally asserted after the fact, leaving no way for a representative to prove the contrary. The Proposal also eliminates the requirement that the advice be “individualized”. The Proposal instead requires only that the advice be “directed to” a client “for [the client’s] consideration”. Yet, “directed to” could encompass nearly any communication received by an investor, including forms of targeted and public advertising. The Department has offered no guidance in this regard. Further, “for consideration” could include information that is not relied upon in making an investment decision. The proposed definition also lacks specificity regarding when the fiduciary relationship begins and ends. As a result, the Proposal will likely have a chilling effect on valuable, non-fiduciary communications with clients. It is well understood that fiduciary status brings with it significant duties and responsibilities as well as significant liability and risk, including harsh penalties for prohibited transactions. Moreover, though not currently subject to a fiduciary standard of care under the IRC, fiduciaries to IRAs are subject to high standards of care under securities and banking laws and regulations, as well as state laws. Breaches of these standards can result in regulatory penalties and state law claims. Firms and their representatives who become fiduciaries under the Proposed Rule and who seek to rely upon the proposed BIC Exemption would face even broader liability than the Department seems to appreciate. They would be required to adhere to the BIC Exemption’s contractual best interest standard of care, and the Department seeks to give investors a non-waivable right to bring class action claims in court based on breaches of this standard, as well as strict liability under the prohibited transaction rules. Of course, any firm that assumes fiduciary liability and risk will face increased compliance and other costs with respect to its fiduciary services. These costs will ultimately be reflected in how firms structure their business models to mitigate risks, and is likely to affect the types of clients the firm serves, and

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the firm’s compensation and fee arrangements. It is also likely that these costs will be passed on to consumers. Because of these high duties and significant risks, we believe that fiduciary duties should not be imposed unless the representative and the investor specifically agree to a fiduciary relationship, and that a representative and an investor should also be able to agree to limit the scope of that relationship.

RECOMMENDATION: The proposed definition of fiduciary investment advice should be narrowed to make it clear that fiduciary status is based upon a mutual understanding or agreement, and that advice is individualized and intended for the recipient’s material consideration.

B. The Seller’s Exception Should Be Available to Retail Investors We agree with the Department’s statements that the current financial marketplace is complex, and that retirement investors, particularly middle-income investors, need help navigating the many choices they must make to achieve better retirement outcomes. But we submit that the Proposal will have an effect that is the opposite of the Department’s stated intentions. The Department should not upend the right of middle-income Americans to choose the representative they desire to work with and the level of service they want. Absent a fiduciary definition that clearly allows clients and their representatives to choose whether or not to enter into a fiduciary relationship, the Proposed Rule should allow for a “seller’s exception” that extends to all Americans. A person should not be considered to be an investment advice fiduciary when the client understands, or reasonably should understand, that the person is acting as a sales representative and not as a fiduciary. In short, as under current law, retail investors should be trusted to understand the difference between sales activity and fiduciary investment advice. The distinction between sales pitches and fiduciary investment advice is long-standing, and has been recognized by both the Department and the courts.33 For example, in Farm King

33 See Farm King Supply, Inc. v. Edward D. Jones & Co., 884 F.2d 288 (7th Cir. 1989); see also Leimkuehler v. Am. United Life Ins. Co., 713 F.3d 905, 911-12 (7th Cir. 2013) (confirming that, standing alone, selecting both funds and their share classes for a menu of investment options offered to 401(k) plan customers does not transform a provider of annuities into a functional fiduciary under ERISA); Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009) (citing Farm King and finding that “merely playing a role or furnishing professional advice” in the selection of funds is not enough to transform a company into a fiduciary), reh’g denied, 569 F.3d 708 (7th Cir. 2009), cert. denied, No. 09-447 (Jan. 19, 2010); Am. Fed’n of Unions, Local 102 v. Equitable Life Assurance Soc’y, 841 F.2d 658 (5th Cir. 1988) (noting that simply urging the purchase of products does not make an insurance company an ERISA fiduciary with respect to those products); Golden Star, Inc. v. Mass Mut. Life Ins. Co., 3:11-cv-30235-PBS (D. Mass. May 20, 2014) (while service provider had reserved the right to delete or substitute the mutual funds offered to the plan without either providing any notice of changes or opportunity to reject them, or allowing the plan to engage a different service provider in the event of a rejection, it had never exercised that authority or acted in any way other than in a ministerial fashion with respect to the plan menu, so it was not a fiduciary on this basis); Santomenno v. John Hancock Life Ins. Co. (U.S.A.), 56 Employee Ben. Cas. 1131 (D.N.J. 2013) (holding that a plan service provider was not an ERISA fiduciary with respect to its fees because it “negotiated its service provider fees at arm’s length” and because the fees were fully disclosed; nor was the service provider a fiduciary with respect to its selection of a particular fund that paid revenue sharing as an investment option because the service provider did not have the ultimate authority over which investments were included in the plan); Zang v. Paychex, Inc., 728 F.

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Supply, Inc. v. Edward Jones, the Seventh Circuit considered a client’s “agreement” with a broker-dealer to listen to the broker-dealer’s “sales pitch” and, if the client liked the pitch, to purchase from among the suggested investments. The court observed that the broker-dealer offered the plan individualized solicitations “much the same way a car dealer solicits particularized interest in its inventory,” and concluded that there was no basis to conclude that the broker-dealer’s activities would have resulted in fiduciary status. This distinction makes sense, and should continue to apply under the Proposed Rule. Though the Department appears to have recognized the distinction in its proposed carve-out for sales to certain institutional investors, it seems that the Proposed Rule would not allow sales and marketing communications – even communications that a new or inexperienced investor would construe as sales pitches rather than impartial advice – to continue to be provided to middle-income investors on a non-fiduciary basis. We strongly urge the Department to fully recognize the broad application of the long-standing, common-sense distinction between sales activity and fiduciary investment advice by inserting a broadly applicable “seller’s exception” into the Proposal. The exception should require that the seller provide, at the point of sale, a clear, plain English written disclosure which explains: (i) the services to be provided and the compensation to be received in exchange for those services; (ii) that the representative is selling or marketing products or services, and is not acting in a fiduciary capacity, or offering impartial advice; and (iii) any material conflicts the seller and its financial institution may have, including the receipt of higher compensation for selling certain products or services. The primary benefit of a seller’s exception is that it preserves freedom of choice for retirement investors. Instead of being forced into a situation where the options are only higher-cost fiduciary advice or do-it-yourself options, middle-income investors would be able to receive non-fiduciary information if they felt it useful for learning about available products and services. In spite of the Department’s focus on a few unscrupulous financial representatives, the truth is that millions of middle-income Americans like their current representatives, have benefited from their relationships with them, and want to keep these existing non-fiduciary brokerage relationships. In addition, inserting a “seller’s exception” that removes sales activity from the definition of fiduciary would preserve the services provided by the traditional brokerage model that has evolved under the federal securities laws. As such, it would more closely align the rule with Congressional intent to preserve the traditional brokerage model, as expressed in Section 913 of the Wall Street Reform and Consumer Protection Act (Pub. L. 111-203, H.R. 4173 (the “Dodd Frank Act”), where Congress considered, but rejected, repealing the broker-dealer exemption in

Supp. 2d 261, 270 (W.D.N.Y. 2010) (citing Hecker and holding that a plan service provider that offered a menu of investment options to a 401(k) plan was not a fiduciary, where the parties’ contract required the service provider to give the plan notice of, and an opportunity to reject, any changes to the menu); Columbia Air Services Inc. v. Fidelity Mgt. Trust Co., 2008 U.S. Dist. LEXIS 76999 (D. Mass. Sept. 30, 2008) (citing Hecker and following its analysis); Dupree v. The Prudential Ins. Co. of Am., WL 2263892 (S.D. Fla. 2007) (finding “it is well settled” that an insurer is not a plan fiduciary when it sells insurance products and services to a plan, even when it otherwise performs fiduciary functions for the same plan, and that insurers are free to contract with their plan customers on an arm’s-length basis that does not implicate ERISA’s fiduciary standards); Fechter v. Connecticut Gen. Life Ins. Co., 800 F. Supp. 182 (E.D. Pa. 1992) (noting that courts refuse to impose fiduciary obligations on insurance companies who merely sell their products or services to pension plans, unless the insurer assumes decision-making control over the administration or disposition of plan assets, and that simply urging the purchase of its products does not make a company an ERISA fiduciary for those products).

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the Investment Advisers Act of 1940 (“Advisers Act”), as a way to impose a higher standard of care on broker-dealers. As the Honorable Barney Frank explained in his letter to the Chairman of the SEC, Congress intended that any new standard “recognize and appropriately adapt to the differences between broker-dealers and registered investment advisers.”34 Because the Proposal could broadly impose fiduciary status on broker-dealers and effectively bar them from receiving commissions with respect to retirement accounts, unless the Department inserts a broad-based “sellers exception”, the Proposed Rule does not appear to conform to Congressional intent. It is well known that middle-income savers rely heavily on traditional brokerage relationships for help with investments and retirement savings. In its April 2011 study of the impact of the Department’s 2010 proposal on IRA consumers, Oliver Wyman found that 98% of IRA investors with less than $25,000 were in brokerage relationships, and that 7.2 million retail brokerage IRAs did not have sufficient assets to qualify for an advisory account at any firm in the study.35 It is highly likely that the vast majority of these 7.2 million accounts belonged to middle-income investors. We find nothing in the current Proposal to alleviate the disruption that Oliver Wyman predicted would befall these IRA investors if they are cut off from their existing brokerage relationships. As a result, though unintended, it is predictable that the disruption caused by implementation of the Proposal, which does not provide a workable mechanism by which traditional brokers can continue to provide services to IRAs, will fall primarily on middle-income Americans.36

34 See Letter from the Honorable Barney Frank, Ranking Member of the U.S. House of Representatives Financial Services Committee, to SEC Chairman Mary L. Shapiro, dated May 31, 2011.

35 Oliver Wyman, Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on IRA Consumers (April 12, 2011), at 2, 16.

36 We note that the SEC took a similar approach that acknowledged the investor’s ability to understand the differences between a brokerage account and an advisory account when it adopted Rule 202(a)(11)-1 under the Advisers Act. That rule, which was later vacated by the D.C. Circuit Court of Appeals on other grounds, allowed broker-dealers to make available fee-based brokerage accounts without subjecting them to the Advisers Act. See Certain Broker-Dealers Deemed Not to Be Investment Advisers, Exchange Act Release No. 51523, Investment Advisers Act Release No. 2376 (Apr. 12, 2005), 70 Fed. Reg. 20424 (Apr. 19, 2005); see also Fin. Planning Ass’n v. SEC, 482 F.3d 481, 488, 493 (D.C. Cir. 2007) (holding that the SEC exceeded its authority in promulgating the final rule by relying on Section 202(a)(11)(F) of the Advisers Act (now 202(a)(11)(H)) to establish a new, broader exemption for broker-dealers). Among other things, broker-dealers relying on the rule were required to include the following prominent statement in advertisements and account agreements: “Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.” In a subsequent no-action letter, the SEC staff contemplated and provided a process for shifting from an advisory relationship to a brokerage relationship, stating that where a dually registered broker-dealer/investment adviser seeks to terminate an advisory relationship and assume a brokerage relationship, “[d]isclosure by a broker to a customer should be sufficient to enable the client to reasonably understand that the broker-dealer/investment adviser is removing itself from a position of trust and confidence with its client.” See Securities Industry Ass’n, SEC Staff No-Action Letter (pub. avail. Dec. 16, 2005).

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RECOMMENDATION: The Department should provide a meaningful seller’s carve-out for retail investors that preserves their access to non-fiduciary investment assistance and the commission-based brokerage model.

C. The Education Exception Is Too Narrow

1. Identifying Investment Options Given the breadth of the proposed fiduciary investment advice definition, the Proposal’s investment education carve-out would be one of the few avenues for conveying critical information about investing to middle-income investors without subjecting the provider of such valuable education and assistance to the fiduciary prohibited transaction rules. Though the Department explains that it has based the carve-out on its current guidance under Interpretive Bulletin 96-1, and has made certain clarifications to that guidance, the carve-out’s restriction on identifying specific investment options severely hampers its usefulness. Our representatives help middle-income investors navigate the complex landscape of investment alternatives. They do this by providing education about saving and investing techniques that the client can implement without devoting significant time to complicated research. They educate middle-income families about the general financial and investment concepts cited in the carve-out, and empower them with investment tools that are generally consistent with the carve-out’s contemplated requirements. In our experience, this education leads to increased savings and investment decisions that are better-suited to meeting the goals of those investors. The Department’s narrowed carve-out would prevent us from providing our clients with the investment education that would allow them to identify the investment options available that can be used to implement the carve-out’s general investment concepts, asset allocation models, and interactive investment materials. We are concerned that the end result will be missed investment opportunities, investment decisions that are not consistent with the education provided, and in the worst case, reduced retirement savings for middle-income Americans, who cannot afford and may not be eligible for full-service investment advisory programs. Thus, we ask the Department to permit financial professionals to continue to identify specific investment options, so long as the information is provided in a non-discriminatory and objective manner, and is accompanied with a robust disclosure about the availability of similar products on other platforms. RECOMMENDATION: The Department should provide an investment education exception that permits us to identify specific products so that we can provide useable and meaningful education and assistance.

2. Education with Respect to Rollover and Distribution Decisions The education carve-out also should clarify when and how information can be provided about rollovers and plan distributions, confirming that our representatives will not be deemed to be fiduciaries (under ERISA or Section 4975 of the IRC) solely as a result of providing

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information about factors the client should consider in making decisions about rollovers as discussed in FINRA Notice 13-45. Under the Department’s broad construct of “fiduciary,” nearly all conversations about rollovers and distributions could be viewed as fiduciary investment advice, including discussions about rollovers from a plan to an IRA and between IRAs, as well as conversations with plan participants about the availability of rollover services or regarding help setting up an IRA. As a result, we are concerned that many representatives will be reluctant to discuss options and considerations with investors absent a clearer carve-out for education about rollovers and distributions. Studies show that if employees lose access to retirement assistance at employment termination, they often are likely to cash out some or all of their retirement savings. A 2014 study by Quantria Strategies, LLC estimated that the loss of rollover assistance at job termination could lead to increased cash-outs of $20-32 billion annually.37 Under the Proposal, fiduciary investment advice would include recommendations with respect to rollovers and plan distributions among the categories of covered recommendations, reversing the Department’s prior guidance in Advisory Opinion 2005-23A (the “Deseret Letter”) that such recommendations, absent other factors, would not be fiduciary investment advice. We believe the Deseret Letter is correct under the plain terms of ERISA and established principles of the law of trusts. As the Department knows, many firms have relied on the Department’s guidance in the Deseret Letter in structuring their services to investors who are eligible for a plan distribution. Investors themselves benefit significantly from these services. For all of these reasons, the Department should not reverse the position set forth in the Deseret Letter. If the Department does not change the Proposal in this regard, then it must allow us to continue to provide meaningful educational assistance to families who are faced with important and complex decisions about what to do when they are separating from their employer or are otherwise eligible for a distribution. Specifically, the Department should provide clear guidance regarding the types of information that can be provided as investment education that does not implicate fiduciary status. We specifically ask the Department to confirm that financial professionals can provide rollover and distribution education in accordance with FINRA’s guidance distinguishing recommendations from investment education, and discuss the factors raised in FINRA Notice 13-45 without being deemed to be a fiduciary, so long as the financial professional clearly notifies the participant that the professional is not acting as a fiduciary, or a representative or agent, of the plan. RECOMMENDATION: The Department should clarify the investment education exception by specifically incorporating FINRA guidance distinguishing recommendations from investment education in the context of rollovers and distributions. III. The Exemptions Do Not Address the Actual Issues Facing Middle-Income Families

with Respect to Their Retirement Savings

37 Quantria Strategies, LLC, Access to Call Centers and Broker Dealers and Their Effects on Retirement Savings, April 9, 2014.

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As written, the Proposed Rule is a marked departure from existing law. With such a broad and ambiguous definition of fiduciary investment advice, and without meaningful carve-outs for sales and education activities directed to retail investors, financial institutions are likely to limit the options and assistance available to middle-market retirement savers. Further, without substantive coordination with the legal standards of other agencies, the Proposal risks cutting off opportunities for tax-deferred savings, effectively restricting a substantial portion of the population to saving in taxable accounts. This is particularly true with respect to smaller accounts, where the risk of triggering fiduciary status will outweigh the potential reward. Again, the result will be a two-tiered system of services: those available for the “haves” and self-help options for the “have-nots,” namely young families and lower-wealth individuals who most need guidance and encouragement to save.

A. The BIC Exemption Is Not Workable as Written

We draw this conclusion first and foremost because the Department’s expanded definition of “fiduciary” makes prohibited transaction relief necessary to continue to effectively serve IRAs, and because the relief the Department has drafted for commission-based brokerage services to IRAs – the BIC Exemption – is not workable. As a starting point, we agree with the Department that firms and their representatives should always act in their clients’ best interests. In fact, we believe that acting in the clients’ best interests is critical to our business’s long-term success. When our clients can see that they are on the path towards achieving their retirement and other goals, they are more likely to return to us and our representatives, and are more likely to refer their friends and family members to us. The growth and success of our investment business is closely tied to our clients’ growth and success, and our clients’ growth and success depends upon us acting in their best interests. Though we agree with the best interest standard in principle, the BIC Exemption includes prescriptive conditions that fall short of the Department’s stated intent to adopt a flexible, principles-based approach.38 From start to finish, the BIC Exemption disrupts the personal relationships that we and our representatives have worked hard to develop with our clients, and it fails to offer certainty that the commission model can be preserved, even in a significantly altered, more costly, and less effective form. In operating our business, “certainty” with respect to regulatory compliance matters is critical, because a failure to satisfy the BIC Exemption may result in steep costs to correct prohibited transactions. It may also lead to consumer and class action lawsuits. This is the case even when there has been no client harm or loss. Critically, the technical implementation of the BIC Exemption promises to be a substantial burden, and likely will cause a significant disruption of services to our clients with few added benefits in the way of investor protections.

38 Definition of “Fiduciary”; Conflict of Interest Rule-Retirement Investment Advice; Proposed Rule (Fiduciary Proposal), 80 Fed. Reg. 21,928, et seq., at 21,929 (proposed Apr. 20, 2015) (stating that the Department “sought to preserve beneficial business models for delivery of investment advice . . . that would broadly permit firms to continue common fee and compensation practices, as long as they are willing to adhere to basic standards aimed at ensuring that their advice is in the best interest of their customers.” (emphasis added)).

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We are not alone in our observations. The feasibility of the BIC Exemption has been analyzed and will be commented on by others. The difficulty, cost, risk and uncertainty the BIC Exemption imposes likely will cause those firms serving middle-income clients to limit brokerage services and move accounts with higher account balances to advisory services. Millions of existing small-balance IRA owners are likely to lose access to the financial professional of their choice, or any financial professional at all. The majority of others will face higher costs as their accounts shift to advisory accounts, will experience lower savings rates as they increasingly cash out of 401(k)s due to lack of guidance, and will carry excess portfolio risk due to less diversification and less frequent re-balancing.39 According to one study,

Conservative estimates of the combined reduction in retirement assets attributable to the unintended consequences of the re-proposed regulations suggest that the regulations could result in losses of retirement savings of $68-$80 billion each year.40

The consequence will be negative to “Main Street” retirement savers, particularly to long-term buy-and-hold retirement investors and those with smaller accounts. Our comments on the BIC Exemption follow below and are focused on identifying the specific conditions that prevent it from providing meaningful relief from prohibited transactions. In each section, we recommend changes to the BIC Exemption that cumulatively may improve its feasibility.

1. Written Contract Will Preclude Reliance on BIC Exemption

a) Timing Is Too Disruptive The BIC Exemption requires that the financial institution, representative, or retirement investor execute a contract before the representative dispenses recommendations. Given the breadth of communications that the Proposed Rule covers as “fiduciary” advice, this requirement makes it imperative that the contract be signed at the very outset of a potential client relationship. Requiring a potential client to execute a formal agreement so early in a putative relationship will likely have a chilling effect on middle-income investors who are already understandably overwhelmed about saving for retirement. In our experience, prospective clients want to get to know our representatives, probe their financial knowledge, discuss financial goals and generally learn about potential savings plans before deciding to invest. Forcing a prospective client to sign a contract before he or she gets to know our representative and our business will be off-putting and disconcerting. A premature agreement is more likely to make prospective clients anxious about the obligations that they taking on by executing the document, rather than give comfort to them about their rights and

39 Oliver Wyman, The Role of Financial Advisors in the US Retirement Market, at 3.

40 Quantria Strategies, LLC, Unintended Consequences: Potential of the DOL Regulations to Reduce Financial Advice and Erode Retirement Readiness (July 20, 2015), at 29.

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protections. Undoubtedly, some prospective clients will choose not to go forward at all. As we have discussed, this would have the effect of curtailing retirement savings. We request instead that the Department require the agreement to be signed at account opening, after a prospective client has decided to engage with the firm and the representative. We base the foregoing observations on our and our representatives’ decades of experience working with middle-income and new savers, through which we have developed an informed understanding of the types of demands on clients that are likely to cause them to retreat from retaining a firm’s services. The process also inflicts significant added cost, as we undoubtedly will be executing contracts with persons who never become clients. These added costs are likely to result in increased costs for those who do become clients. RECOMMENDATION: The BIC Exemption contract should not be imposed until account opening.

b) Requiring Representative to Sign Creates Uncertainty The obligation to have both the financial institution and the representative execute the agreement is also troublesome. If a representative ceases working with us and some of his or her clients would like to continue as clients of another one of our representatives, the client would be required to execute a new agreement with the new representative before proceeding under the BIC Exemption. In the interim period, we would be unable to provide retirement investment services without risking the loss of the BIC Exemption’s protection. Likewise, the Proposal does not clarify whether, in situations where multiple representatives participate in client services, the client will need to sign an agreement with each representative. It seems that under the Proposal, if the contracted representative is not available, a recommendation or transaction cannot be made. The inconvenience would be hard to explain, would be frustrating to clients, and could prevent best execution. These ambiguities and similar other difficulties should be addressed and resolved. The Department should expressly permit satisfaction of the BIC Exemption contract requirement via an enforceable agreement between the firm and the investor only, which is distributed to the client without “wet signatures” of the firm, the representative or the client. RECOMMENDATION: The BIC Exemption contract should not require “wet signatures” or that individual representatives be parties to the contract.

c) Contractual Assumption of Fiduciary Status Under the proposed regulatory language of the BIC Exemption, the firm and the representative must affirmatively state in a contract that they are fiduciaries with respect to any investment recommendations made to the investor. Yet, it is not clear as drafted whether this requirement is intended to apply with respect to a single recommendation, to the account, or to the investor. Guidance here is needed; without it, we are left uncertain as to whether the requirement mandates an ongoing or long-term advisory relationship. Similarly, it is unclear whether contractual assumption of fiduciary status at point-of-sale effectively imposes an ongoing obligation to provide “best interest” advice, such as account re-balancing, or otherwise to monitor the account. Likewise, it is unclear how or whether the contract can specify the time

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at which the fiduciary relationship would terminate. While the Department may have intended flexibility, given the lack of clarity we must consider how the plaintiff’s bar and courts will interpret this duty. RECOMMENDATION: The BIC Exemption should expressly permit a firm and its representatives to contractually agree to be a fiduciary solely with respect to a transaction without an ongoing fiduciary obligation to monitor the account.

2. Transition Rule for Existing Clients Is Too Restrictive

The BIC Exemption provides limited transition relief for existing clients for trail commissions and other compensation in connection with advice that occurred prior to the applicability date of the Proposed Rule. However, the conditions of the BIC Exemption must be satisfied before a firm or its representative makes a buy, hold or sale recommendation to an existing client. The effect is that all current IRA and plan clients would need to execute a contract for the exemption to be available to future transactions. For example, if an existing account holder were to contact their representative on a “bearish” day in the markets inclined to sell and minimize losses, the representative would have to decline to provide assistance until a contract is signed. Historically, financial representatives have played a critical role in this circumstance, serving to calm nervous investors and help them to avoid selling at market lows. Studies show that unsophisticated investors in particular benefit from this professional help.41 To prevent such “no-service” conversations, firms can be expected to pro-actively send their existing clients a letter just prior to the rule’s implementation stating that the Department’s rule prevents the firm and its agents from helping the client with his or her IRA unless and until a new contract is in place. Operationally, this would require us to mail or electronically distribute these new agreements to our more than 1.2 million existing IRA clients and then track and document the signed and returned agreements. Most importantly, most clients will not understand why we are asking them to sign a new contract agreement with us so they can continue to receive services that they already have chosen to receive and that we have already been providing. Moreover, we would need to develop systems to record whether the BIC Exemption contract was executed and returned, and systems to retain copies of the executed BIC Exemption contract to be able to prove compliance with the BIC Exemption. All of this will come at a cost in terms of both time and money, which likely would ultimately be passed on to clients. Countless conversations will be deflected and transactions derailed during the process. While the transition rule allows for compensation received pursuant to an agreement or arrangement entered into prior to the applicability date of the Proposal, the Department should eliminate ambiguity by clarifying that pre-arranged transactions with respect to existing IRA accounts, such as established arrangements for regular deposits to IRA accounts, which are not dependent on new advice, are provided the transitional relief. Further, we request that rather than simply providing “transitional relief,” the Department grandfather existing clients in a meaningful way. Specifically, firms should be permitted to continue providing assistance under

41 Garber, Burke, Hung, and Talley, Potential Economic Effects on Individual Retirement Account Markets and Investors of DOL’s Proposed Rule Concerning the Definition of a “Fiduciary”, at 23.

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current rules with respect to all retirement accounts opened prior to the implementation date of the final rule. RECOMMENDATION: Existing accounts and all prospective transactions within them should be grandfathered under the current definition of “fiduciary investment advice” rather than transitioned to the BIC Exemption.

3. Impartial Conduct Standards and Warranties Create Untenable Uncertainty and Risk with Respect to Common Business Models

As a condition of the BIC Exemption, firms must contractually agree to provide investment advice that reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise, based upon the investment objectives, risk tolerance, financial circumstances, and needs of the retirement investor, without regard to the financial or other interests of the adviser, financial institution or any of their affiliates or any other party (the “Impartial Conduct Standards”).42 In addition, firms must warrant that they have adopted “policies and procedures reasonably designed to mitigate the impact of material conflicts of interest . . . and ensure that individual Advisers adhere to the Impartial Conduct Standards.”43 The Proposed Rule further requires the firm and the representative to agree and warrant that each will not recommend any assets for purchase if the total amount of compensation anticipated to be received by the representative, the financial institution, and their affiliates and any related entities in connection with the purchase, sale or holding of the asset will exceed “reasonable compensation in relation to the total services provided” to the retirement investor. Among the serious concerns we have, the Impartial Conduct Standards and the “total compensation” condition impose strict liability dependent upon a subjective, facts-and-circumstances analysis. Though a firm might conclude that its practices satisfy the Impartial Conduct Standards, a litigant could claim the contrary after the fact. Thus, firms will not know with any degree of certainty whether its policies and compensation practices effectively satisfy the exemption, absent a final adjudication of the issue by a court or the Internal Revenue Service years later. There is a significant difference between (i) requiring that the firm to contractually agree to provide its services in conformance with the Impartial Conduct Standards and (ii) requiring actual compliance with the subjective standard, as a condition of the BIC Exemption. With respect to the former, a breach would provide the client a contractual right to sue for damages based on the loss caused by the firm and its representative’s acts or omissions. The latter would expose the firm to strict liability for a prohibited transaction regardless of whether there was even a loss. For this reason, we request that the Department require that the firm contractually agree to provide its services pursuant to the Impartial Conduct Standards, but not require actual adherence to the Impartial Conduct Standards as the condition of the BIC Exemption.

42 80 Fed. Reg. at 21,987.

43 Id. at 21,970.

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We note that similar risks are managed in the context of ERISA section 404, where remedies are generally balanced against the severity of the infraction; they are not managed under the strict liability prohibited transaction rules. This is because the penalties for engaging in a non-exempt prohibited transaction are severe, and may include undoing the transaction, forfeiture of all compensation, disgorgement of any profits and payment of excise taxes of 15% to 100% of the amount “involved” in the transaction. Additionally, as discussed in Section V below, the Proposal creates a private right of action that likely goes beyond the authority of the Department. RECOMMENDATION: The Department should eliminate the warranty requirements from the BIC Exemption, and should not require actual adherence to the Impartial Conduct Standards as a condition of the BIC Exemption.

4. Lack of Clarity of Terms Means High Risk of Prohibited Transactions

a) Best Interests Standard’s “Without Regard” to Firm’s or Representative’s Interests

As cited above, the Impartial Conduct Standards require firms and their representatives to act “without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.” In the preamble to the Proposal, the Department makes clear its view that this standard is based on ERISA’s duty of loyalty, which requires fiduciaries to act “solely in the interests” of the plan and its participants, and that the Department expects this standard to be interpreted in light of the judicial experience with ERISA’s fiduciary standards.44 This duty has been strictly interpreted to require fiduciaries to act with “complete and undivided loyalty to the beneficiaries of the trust”, and with an “eye single to the interests of the participants and beneficiaries.”45 Effectively, the Department has turned the ERISA prudence and loyalty standards into a prohibited transaction applicable to IRAs, and at the same time has made that standard enforceable by IRA owners in state court. We do not believe that Congress intended a breach of the duty of prudence to violate the prohibited transaction provisions of ERISA and the IRC. Adding to this, the requirement that advice be given “without regard” to the financial interests of the representative may make the standard impossible to satisfy. The “without regard” language may have the effect of limiting the representative to recommending nothing but the lowest fee investment. Should the representative be so restricted, the representative will remain at litigation risk, as the lowest-fee option is not necessarily the choice that is best-suited to the investor. The “without regard to” language also extends to the “other interests” of “any other party”. Neither of these terms is explained and no limits are set. Once again, these

44 29 U.S.C. § 1104(a)(1).

45 See Donovan v. Bierwirth, 680 F.2d 263, 3 EBC 1417 (2d Cir. 1982); Freund v. Marshall & Ilsley Bank, 485 F. Supp. 629, 1 EBC 1898 (W.D. Wis. 1979).

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ambiguities are primed to prevent a firm and its representatives from obtaining certainty that they can satisfy the conditions of the BIC Exemption. RECOMMENDATION: The “best interest” language should adhere to the FINRA formulation – the financial professional should provide recommendations that are in the “best interest of his client and put his client’s interest before his own;46 the “without regard” and other extraneous language should be deleted.

b) Reasonable Compensation “In Relation to the Total Services” The Impartial Conduct Standards require that no recommendation be made if the “total amount of compensation anticipated to be received” by the representative, firm, its affiliates and related entities will “exceed reasonable compensation in relation to the total services they provide” to the investor. No guidance is provided as to how to make the comparison between compensation and “total services,” nor is there guidance to be drawn from other sources. Until now, neither ERISA nor any regulator has required that compensation be justified in relation to the specific services provided to a client or account. Because this new construct is unexplained and untested by the courts, and because failure to satisfy its precepts would mean that transactions would be reversed and that excise taxes could apply, it presents unmanageable risk. Adding further confusion, a “reasonable compensation” requirement appears twice in different forms in the Proposed Rule. In addition to being included in the Impartial Conduct Standards, Section IV(b)(2) provides that any compensation received in connection with any buy, sale or hold recommendation be “reasonable in relation to the value of the specific services provided to the Retirement Investor in exchange for the payments and not in excess of the services’ fair market value.” The Department provides no guidance as to how to apply the requirement that compensation be no more than “fair market value” for the services. Some of the fees that we collect support our overhead and administrative costs of doing business and are not directly tied to a specific account or transaction. It is not clear whether this mandate would require us to trace every dollar earned with respect to these costs of doing business to a particular account, or to a transaction, in order to document reasonableness or fair market value. It is also unclear whether the required market comparison means that the BIC Exemption cannot be satisfied by any means other than level fees. This uncertainty increases the risk that a court may interpret the “fair market value” standard to mean that a fee differential could not be justified for different assets classes that are similarly serviced. Similarly, it is unclear whether the language used to describe “reasonable compensation” requires a representative to recommend only those funds with the lowest revenue share or other third-party payments, on the grounds that a higher-fee fund would provide unreasonable benefit to the firm or representative. As noted above, this interpretation would make the Proposal impossible to satisfy, as the lowest-cost investment is not always in the client’s best interest.

46 See, e.g., FINRA Regulatory Notice 12-25, Q1 at 3 (May 2012) (citing FINRA rules that adhere to this

formulation).

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By requiring compliance with this standard as a condition of the prohibited transaction exemption, the Department may have undermined its effort to preserve existing business models. To achieve its stated objective, the Department should revise the BIC Exemption to include a single condition regarding reasonable compensation, and to use the same, well-understood standard that applies under IRC section 4975(c)(2). Specifically, no more than reasonable compensation may be paid for the services provided to the investor. RECOMMENDATION: Reasonable compensation should be defined in standard terms; the “total compensation” and “reasonable in relation to value” language should be deleted.

c) “Neutral Factors” to Justify Differential Compensation

Layering on to its vague “reasonable compensation” language, the BIC Exemption requires firms and representatives to warrant that their compensation practices will not “tend to encourage” violations of a best interest standard. Again, in spite of the Department’s stated intention to preserve current business models, the BIC’s cumulative effect may be to force firms to eliminate any differential compensation or third-party compensation arrangements.

The Department suggests five examples that it claims provide support for variable compensation structures. However, none is practicable to implement. Two of the examples are level-fee structures, and one requires independent computer models. Notably, despite querying others in the industry, we are aware of no company that offers a 408(g) computer model advice arrangement. We believe that is because 408(g) arrangements are impractical, which in turn reflects that it is error for the Department to base the rule in part upon projections about computer-based tools that do not currently exist and have not been shown to be feasible. The fourth option is a compensation system based on “neutral factors,” such as the time and effort involved in selling a product, and the fifth suggests arrangements designed to “align the interests” of the representative with the interests of the investor. Though the fourth and fifth options ostensibly permit variable compensation, it is unclear how either could be implemented in a way that would give the firm any certainty that its practices comply with the exemption. Specifically, it is unclear how fee differences could be supported by “neutral factors” or under what circumstances the representative’s interests could align with those of his or her client. With respect to the former, a firm has no ability to control what the Department, or state courts, may consider to be a “neutral factor”, particularly when prices are set by third-party manufacturers based upon market factors. We find it unlikely that a firm would offer an advice arrangement in reliance on the exemption, such as a commission schedule that differs between mutual funds and annuities, in the absence of certainty that its variable pricing meets the neutrality requirement. With respect to the second, no guidance is provided as to how a firm is to align the representative’s interests with those of the investor where fee differences exist. It is also unclear, from a compliance perspective, how either of these standards could be administered and supervised in practice. Without this certainty, the liability risks and the prohibited transaction penalties for failure to comply are too great for a firm to proceed under the BIC Exemption. We request that the Department provide clarification and guidance, including a meaningful example, regarding how and under what circumstances a firm and its representatives can receive variable compensation under the BIC Exemption. We request that the Department

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clarify that variable commission-based fee arrangements are permitted, so long as the firm discloses the compensation to be received and any material conflicts of interest, and receives no more than reasonable compensation. Adopting alternate methods of compensation, such as those included in the Department’s five examples, would require a complete structural overhaul of the forms in which retirement assets are commonly distributed to consumers. At least with respect to mutual funds and variable annuities, most broker-dealers do not themselves set the price of the third-party products they sell, nor do they have the negotiating power to require the providers to uniformly price their products. In any event, we question whether an effort to level fees would pass anti-trust scrutiny. Regardless, the Department’s five suggestions would ultimately lead to inferior models of delivering investment advice, particularly to middle-income investors who have smaller accounts and trade infrequently.47 RECOMMENDATION: The Proposed Rule should be revised to expressly allow for differential compensation among products and asset classes; the “tend to encourage” language should be deleted.

5. Disclosure Obligations

In addition to the contract requirements, the BIC Exemption imposes no less than three new onerous investor and public disclosure obligations. These disclosure requirements will not only burden the industry with added costs and compliance risks, but will also overwhelm and confuse clients with yet more documents and information to review and digest, while providing few benefits over the disclosures already required to be provided under the federal securities laws, state insurance regulations, and other applicable rules.

a) Point-of-Sale Disclosures Are Potentially Harmful to Client

Decisions First, prior to an investor’s purchase of a recommended asset, the representative must

provide the investor a detailed chart setting out the “total cost” of the proposed investment over periods of one, five and ten years in actual dollar amounts. The “total cost” for each recommended asset must include its acquisition cost such as loads, commissions, mark-ups and account opening fees, ongoing fees and expenses such as mutual fund expenses, and disposition costs such as surrender charges and back-end loads. All of this will require forward-looking assumptions about holding periods and the investment’s performance. While we understand that

47 See, e.g., Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers, at 152 (Jan. 2011), available at https://www.sec.gov/news/studies/2011/913studyfinal.pdf (stating that investors may face increased costs if the broker-dealer exclusion were eliminated, such as where commission-based accounts would incur lower costs compared to fee-based account due to infrequent trading); NASD Notice to Members 03-68, Fee-Based Compensation (Nov. 2003) (reminding members that fee-based accounts must be appropriate for customers, considering among other things the cost of the account compared to alternative fee structures available, such as commission-based accounts); Report of the Committee on Compensation Practices (Apr. 10, 1995), available at https://www.sec.gov/news/studies/bkrcomp.txt (noting commenters’ views that fee-based accounts can pose higher costs for small and low-activity accounts).

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the Department intends for this disclosure to clarify costs for the client prior to his or her investment, it will instead inject unnecessary complexity and slow transactions. Further, effective investment conversations often result in multiple proposals reflecting the iterative nature of good dialogue. A broker-dealer will need to provide a new chart with respect to each potential asset a client may want to consider. Much of this “total cost” data is actually held by their third-party product providers, and there may be a cost to the broker-dealer associated with developing each chart. Given that each client is likely to consider multiple investments, compilation of this information multiple times with respect to each ultimate transaction will be expensive and will also delay transactions. The resultant increase in transaction costs per investor will generally be passed on to clients, and may ultimately have the effect of shutting out small transactions from access to IRAs.

As importantly, we also are concerned that the upfront disclosure is likely to overwhelm

the investor by focusing too much attention on costs and expense. In almost every case, stocks that are highly correlated to the market’s movements will look less expensive than a more stable asset such as a bond fund. The primary focus of an investment decision should instead be on the particular asset’s risk and return (net of expenses) profile and likelihood to achieve the investment goal. Moreover, the “total cost” information is likely to be overwhelming in respect of the summary prospectus, insurance disclosure, and other documents already required to be furnished to investors, all of which display fee and expense information. The new upfront disclosure is at odd with these, particularly where other regulators, for good reason, do not allow forward-looking estimates of performance.

Finally, as with other BIC requirements, we are concerned because the disclosure

requirement is rife with ambiguities. For example, no guidance is provided as to what a firm is to do when the precise investment amount is not known, such as in the course of a rollover. Similarly, because the information required to be disclosed is held by third parties that may change pricing at any time, and because these disclosures must be produced in real time at any time a representative proposes an investment to a client, this disclosure will be impossible to perfect, and the Proposal builds in no margin for error or correction regime (other than a prohibited transaction).

RECOMMENDATION: The required point-of-sale disclosure should be a concise and easy-to-read document that presents in a standardized, rather than individualized, format solely that information required in a summary prospectus expressed as percentages and should include a mechanism to correct inadvertent or de minimis errors without penalty.

b) Annual Disclosures Will Not Aid Investors

Second, a new annual disclosure must be made to investors, within 45 days after the end

of each year. The annual disclosure must include a list identifying each asset purchased or sold during the applicable year and the price at which it was purchased or sold. It must also include a statement of the total dollar amount of all fees and expenses paid by the investor or the IRA, directly and indirectly, with respect to each asset, as well as a statement of the total dollar amount of all compensation received by the representative and the firm, directly or indirectly, from any party as a result of each asset. The Department provides no guidance as to what is

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meant by “directly or indirectly,” nor does it explain the need for the very short time of 45 days allowed for firms to compile the required information.

Our concerns about this annual disclosure requirement are numerous. First, the account

transaction list duplicates information that is already reported to clients by the account custodian under SEC and FINRA rules, and the Department did not align the timing of this disclosure with the timing of SEC- and FINRA- mandated disclosures. Second, other information now required to be disclosed annually, such as fees and expenses attributable to each transaction, is duplicative of information the client has received at point-of-sale. And like the point-of-sale disclosure, such information should be standardized and permitted to be provided by way of percentage costs rather than individualized total dollar costs. Third, some information required to be reported by the firm is in fact held by the product manufacturer. Distributor broker-dealers simply do not have the required data. For example, most broker-dealers will not know the total dollar amount that an IRA paid to a third-party annuity company over the applicable period. Finally, while the fees and expenses are relevant to an investor, the share of those fees that the firm or the representative is being paid is not.

Like the upfront disclosure, the proposed annual disclosure is more likely to overwhelm

than aid our clients. We do not believe the information would provide significant meaningful information to investors beyond what is currently provided on trade confirmations, account statements, and other disclosures. Because these information reports have not previously been required by any regulator, aggregating the data and presenting the reports will require an expensive systems build-out to be able to track each individual representative’s compensation with respect to each particular client’s accounts. Further, much of the required information will be costly to acquire, as it is held by third-party intermediaries. The exemption provides no guidance or safe harbor to apply in a situation where required information cannot be obtained in a timely manner from the relevant intermediary, even though a failure to make a timely disclosure would technically cause the firm to fail to qualify for the BIC Exemption. As a result, like the upfront disclosure, the excessive costs and risks of compliance likely will drive firms upscale.

RECOMMENDATION: The annual disclosure is duplicative of the point-of-sale disclosure and other disclosures made by product manufacturers and custodians under SEC and FINRA rules. It should be removed as a condition of the exemption.

c) Web Page Disclosures Will Cause Firms to Avoid Reliance on BIC

Exemption Finally, the Proposed Rule requires a financial institution availing itself of the BIC

Exemption to maintain a web page in machine-readable format showing all “direct and indirect” compensation payable to the representative, firm, or other affiliate, with respect to each asset that an investor is able to purchase, hold or sell through the representative and that has been purchased, held or sold in the last year, along with the source of the compensation and how it varies within and among assets. This requirement seems to include every insurance company separate account, every mutual fund by share class, and every annuity contract. It would require, according to the preamble (though unclear from the proposed regulation itself), a quarterly

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review of product and fee changes. Moreover, the website would make publically available personal information about representatives’ compensation, which could conflict with state law privacy obligations. It likewise would make publicly available privately held competitive information, the disclosure of which would conflict with contractual obligations to third parties.

This massive web-based disclosure undertaking would be very difficult and costly for us

to develop, implement and administer. It is highly unlikely that we could build out the technology in the eight months the Department has allowed for implementation. Nor do we believe that it will provide any value to members of the public, beyond providing an avenue for plaintiff’s lawyers to make uninformed comparisons of fee practices between companies. We also have concerns that this information would be used to make unwarranted critiques of individual representatives, which likely would be based solely upon portfolio returns without regard to all of the factors that appropriately go into selection of a portfolio, or that investors are free to decline to follow with regard to their representative’s recommendations. Moreover, we are deeply concerned that data mining companies will be able to extract proprietary information about our strategies that could unjustifiably hamper our competitive position in the market for financial services.

Again, notwithstanding the impracticality and cost, failure to satisfy any aspect of this

website disclosure requirement, like each of the other BIC Exemption requirements, would trigger a wave of prohibited transactions. The resultant risk of strict liability penalties and participant lawsuits likely will cause firms to restructure the modes in which they sell IRAs and qualified plans to the public so as not to be subject to the need to satisfy the BIC Exemption.

RECOMMENDATION: Because the web page disclosure on its own will preclude the use of the BIC Exemption, it should be removed as a condition of the exemption. To the extent a firm is willing to attempt to comply with the BIC Exemption despite this requirement, the Department must allow more than eight months for development and implementation of a system to satisfy this disclosure requirement, and must include a mechanism to correct inadvertent or de minimis errors without penalty.

6. Department’s Data Request and Recordkeeping Obligations

Adding to the burden, the BIC Exemption requires firms to store and maintain, for six

years, a host of information that is subject to the request of the Department. This information includes: the identity and quantity of each asset purchased, sold or held; the aggregate dollar amount invested or received and the cost to the investor for each asset bought or sold; the cost incurred by the investor with respect to each asset; all revenue received by the firm and its affiliates with respect to each asset; the identity of each revenue source and the reason for payment; and at the investor or account level, the identity of the representative along with the quarterly value of the portfolio and inflow and outflows of cash with respect to the portfolio. The firm is further required to maintain records demonstrating that the conditions of the BIC Exemption have been satisfied. Each firm must be prepared to make this information available to the Department within six months from the date of a request. Further, the firm must make its records unconditionally available to investors and other members of the public for examination.

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Finally, the Department makes these detailed recordkeeping requirements a condition of satisfying the BIC Exemption, without any relief for inadvertent errors.

We do not understand the need to provide this data to the Department with regard to IRA

accounts over which it has no enforcement authority. By extending a form of audit authority to members of the public, the Department has effectively delegated enforcement to the plaintiff’s bar. The Department fails to address the very serious privacy and security risks that acquisition, maintenance and distribution of such detailed personal financial information entails. Moreover, we do not have a system today that is capable of collecting, organizing or maintaining this massive volume of information. Nor should we be expected to have such a system, as this volume of information has never before been required, nor are we in possession of all of the required data. We expect that building such a system would take far more time – several years – and would be at a far greater cost than projected by the Department. We do not see any benefit to consumers from this requirement.

RECOMMENDATION: Records should not be required to be publicly disclosed, and these onerous recordkeeping requirements should not be a condition of relief with regard to the BIC Exemption.

7. Class Action Waiver

The BIC Exemption prohibits the contract from containing a provision whereby the investor “waives or qualifies its right to bring or participate in a class action or other representative action in court” against the representative or its firm.

The requirement to contractually warrant compliance with the Impartial Conduct Standards, the publication of the broker-dealers compensation grids in machine-readable format on a public website, and the prohibition against a class action waiver, taken together, seem designed to invite class action enforcement, in the form of breach of contract claims, against broker-dealers that have taken advantage of the BIC Exemption to maintain differential compensation they believe is justified based on neutral factors. Unfortunately, we believe that trial lawyers will simply mine the website to identify differential compensation structures, and then file class action “strike suits” alleging breach of the warranty that compensation practices do not “tend to encourage individual Advisers to make recommendations that are not in the Best Interest of the Retirement Investor.” Even if a firms has reasonable arguments to substantiate its differential compensation, due to the enormous costs of protracted litigation, the pressure to settle these cases, rather than to incur the cost to fight and prevail, will be enormous. We believe that this reason alone is sufficient to deter most firms from attempting to operate the under BIC Exemption.

Although we focus in the body of this letter on the practical ramifications of the Proposal

on our industry and our clients, rather than on the scope of the Department’s authority and conflicting law, we note that the Department lacks the authority to ban class action waivers in connection with arbitration agreements. This point is further addressed in the legal memorandum prepared by Gibson, Dunn and Crutcher that is attached as Appendix 6.

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RECOMMENDATION: The Department should not, and lacks authority to, ban waivers in connection with arbitration agreements.

8. Applicability Date Is Far Too Short

As drafted, the Proposal allows firms eight months from the final rule date to implementation to make the operational, supervisory, technological and structural changes it requires. This period is far too short. As discussed below, implementation of the rule and the BIC Exemption would be extremely time-consuming and costly. Eight months is simply not enough time to accomplish the wholesale restructuring of our business models that the Proposed Rule would require.

RECOMMENDATION: The applicability date should be lengthened to three years from eight months.

B. Costs of Compliance with the BIC Exemption Make Serving Small Accounts

Impracticable

The Rule’s many requirements would command substantial time and resources to develop and implement. For example, the BIC Exemption would require firms to build and test a public website that needs to be updated and tested quarterly. Moreover, contracts would have to be prepared for new and existing clients, new systems would have to be developed and integrated (in some cases with third parties) to create and manage new disclosures, and compliance policies and procedures would need to be updated. At our firm alone, over 80,000 U.S. representatives would need to be trained to comply with the Proposal. We expect the increased costs associated with compliance with the BIC Exemption to have a direct impact on our ability to provide IRAs for the smaller investments that are typical of many of our clients.

To assist in our understanding of the operational impact and cost of complying with the

Proposed Rule and its exemptions, Primerica participated in an industry working group of over forty financial institutions impacted by the Proposal. The group, which was organized by Deloitte & Touche LLP (“Deloitte”), produced the report attached here as Appendix 2. The working group firms were asked to analyze the systems and process changes they would make to comply with the Proposal, and also to assess the resources required to make these changes. Without a doubt, there was agreement that firms would need to make “substantial investments and transformations to business, compliance and operational frameworks.” 48 The firms also recognized that the Proposed Rule would require a considerable overhaul to existing systems impacting controls, supervision, surveillance, data collection and data management. As the Proposal affects only retirement accounts, firms would need to bifurcate their field and back office systems and processes, as well as supervisory and marketing materials, to accommodate differing regulatory requirements for retirement and non-retirement accounts. In many cases, the group recognized that technology solutions to capture some of the required data do not currently

48 Deloitte & Touche LLP, Report on the Anticipated Operational Impacts to Broker-Dealers of the Department of Labor’s Proposed Conflicts of Interest Rule Package (July 17, 2015), at 14, available at http://www.sifma.org/workarea/downloadasset.aspx?id=8589955444.

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exist, and would require effort and time to develop. Likewise, technology to document, substantiate, retain and maintain a fiduciary standard and reliance on the exemption would have to be developed, as it does not currently exist.

Below is an exhibit from the Deloitte report illustrating the operational impact of areas

where build-out of systems, processes, controls and oversight are required to meet the BIC Exemption disclosure requirements.49

Potential Impacts (May Not Be All-Inclusive)

System Build to Collect

Conversion to Dollar Amount

Implementation of Process

Implementation of Controls

Implementation of Oversight

Pote

ntia

l Req

uire

d D

ata

Poin

ts

Disclosures

Initi

al

Tran

sact

ion

Dis

clos

ure Acquisition Costs of Transaction X X X

Ongoing Costs of Product X X X X X Disposition Costs for 1-, 5- and 10-year Periods X X X X X Reasonable Assumptions about Investment Performance X X X X X

Ann

ual D

iscl

osur

e

List of Assets Bought and Sold During the Year (Along with Sales Price) X X X X X

Total Dollar Amount of Direct Fees Paid by the Investor with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Indirect Fees Paid by the Investor with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Expenses Paid by the Investor with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Direct Compensation Received by the Investment Professional with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Indirect Compensation Received by the Investment Professional with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Direct Compensation Received by the Financial Services Firm with Respect to Assets Bought, Sold and Held

X X X X X

Total Dollar Amount of Indirect Compensation Received by the Financial Services Firm with Respect to Assets Bought, Sold and Held

X X X X X

Web

page

Direct Compensation Payable to the Investment Professional for Assets Bought, Sold and Held by an Investor in the Last 365 Days

X X X X

Indirect Compensation Payable to the Investment Professional for Assets Bought, Sold and Held by an Investor in the Last 365 Days

X X X X

Direct Compensation payable to the Financial Services Firm for Assets Bought, Sold and Held by an Investor in the Last 365 Days

X X X X

Indirect Compensation Payable to the Financial Services Firm for Assets Bought, Sold and Held by an Investor in the Last 365 Days

X X X X

Direct Compensation Payable to Any Affiliates for Assets Bought, sold and Held by an Investor in the Last 365 Days

X X X X

Indirect Compensation Payable to Any Affiliates for Assets Bought, Sold and Held by an Investor in the Last 365 Days

X X X X

Variations in Compensation Within and Among Assets X X X X

Recordkeeping

Intention to Rely on Exemption X X X X Inflows X X X X Outflows X X X X Holdings X X X X Returns X X X X Substantiation that Conditions of the Exemption Were Met X X X X

49 Deloitte, Figure 2.4, at 19.

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Without a clear understanding of the operational, systems and technological changes that the rule would require, the Department estimated that start-up compliance costs for a large broker-dealer would be a mere $5 million. This estimate is off the mark. Deloitte surveyed a diverse mix of firms and grouped them based on net capital. Deloitte reports the firm’s estimated start-up and ongoing maintenance costs of compliance with the rule as follows:50

Firm Size

Number of Firms in

Industry per DoL

Mean Start-Up

Costs Per Firm

Mean Ongoing Costs Per Firm

Large 42 $34,257,289 $8,757,222 Clearing $24,217,800 $5,265,000 Self-Clearing $37,125,714 $9,755,000 Medium 137 $18,862,337 $4,032,935 Clearing $33,516,685 $4,254,676 Self-Clearing $15,198,750 $3,977,500 Small 2,440 $ 5,563,804 $4,255,210 Introducing $ 7,220,706 $6,132,815 Self-Clearing $ 2,250,000 $ 500,000

Using the Department’s own estimate of the number of large, medium and small firms,

the start-up costs for large firms across the industry will be $1.4 billion. The start-up costs for medium and small firms will be $2.5 billion and $13 billion, respectively, for a total of approximately $17 billion. Ongoing compliance costs for the industry as a whole are projected to be approximately $11 billion annually. The Department has vastly understated the cost of compliance.

Moreover, the sums reported above are direct costs of the proposal. Attached as

Appendix 3 is a report by Compass Lexecon regarding the costs benefit analysis performed by the Department. Compass Lexecon determined that the Department’s economic analysis of the Proposed Rule “grossly overstates the benefits it purports to measure”.51 It further concluded that the Department failed to properly analyze the unintended consequences of the Proposal that can serve to substantially increase costs, thus rendering the Department’s conclusions as to the costs of the Proposal to be fatally flawed. The authors state:

With respect to the potential costs, the DOL’s analysis relies upon a

number of vague and unsupported assumptions which call into question its reliability. For example, the DOL only offers a dollar cost estimate relating to the most obvious categories of direct costs. The DOL routinely speculates that its

50 Deloitte, Figure 1.10 at 15.

51 Compass Lexecon, An Evaluation of the Department’ Impact Analysis of Proposed Rules Relating to Investment Advisor Fiduciary Status (July 20, 2015), at ¶ 2.

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estimate is likely overstated but ignores or dismisses additional costs associated with many possible unintended consequences of the proposed amendments. Examples of unintended consequences include the possibility of higher investor paid fees and lower overall savings by IRA investors. 52

Importantly, the authors note that the Department failed to acknowledge that the costs imposed on advisers and advisory firms operating in the industry will likely be passed on to investors in the form of higher fees. For example, the authors state that these higher costs can lead firms to exit certain segments of the industry, leading to weakening competition that could otherwise drive down fees. As there likely will be less competition for IRA investors with account balances below $25,000, fees to these customers may increase.53 Likewise, the Department too readily dismisses the potential for reduced savings in tax-preferred IRAs. Compass Lexecon concludes:

Though lengthy, the DOL’s “Regulatory Impact Analysis” provides no reliable estimates of the costs and benefits of the proposed amendments, and as a consequence, does not justify the costs likely to be incurred by market participants (including IRA investors). Among other limitations in the DOL’s benefits analysis, it improperly applies the results of the academic literature upon which it relies and, as a consequence, likely grossly overstates the benefits of the proposed amendments. The DOL’s cost estimate is reminiscent of the old joke about the drunkard who looks for his lost keys under the streetlamp because that’s where the light is. The DOL only attempts to quantify the most obvious and direct costs of the proposed amendments, while dismissing or overlooking a wide range of potential unintended consequences that could dramatically increase the costs. The history of regulation provides strong reason to be skeptical of the DOL’s assumption that the proposed amendments would have no costly unintended consequences.54

Equally troubling is a report prepared by NERA Economic Consulting (“NERA”), attached as Appendix 3, which draws a direct link between the excessive costs of compliance with the Proposal and the ability of firms to make IRAs available to small-dollar investors. NERA reviewed account level data of over 69,000 IRA accounts from six firms, ranging from 2012 through the first quarter of 2015. From this data, they determined that 40.49% of the accounts could not be maintained under the Proposed Rule. As a result, NERA stated that, based upon a “conservative estimate” of the minimum balance for advisory accounts being $25,000:

If we were to take at face value the DOL’s methodology in the 2011 cost-benefit analysis discussed above, the new fiduciary standard would cause a loss of

52 Compass Lexecon, Comment to the Department of Labor on a Proposed Rule Regarding the Fiduciary Status Under ERISA (July 20, 2015), at ¶ 5.

53 Id. at ¶ 32.

54 Id. at ¶ 49.

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access to professional advice for 40.49% of retirement account holders. This would result in an aggregate cost of $114 billion x 40.49% or about $46 billion per year.55

(Emphasis added.) NERA additionally identifies the costs of investors losing access to advice, largely as set forth in a 2011 study by the SEC staff (the “SEC 913 study”). In particular, NERA notes that brokers are expected to convert existing accounts from commission-based accounts to fee-based accounts in order to respond to the new requirements placed on commission-based accounts. The likely impact would be higher costs to investors who buy and hold. Likewise, broker-dealers may unbundle their services and provide them separately through affiliates or third parties, generating additional administrative costs. The primary concern, as expressed by the SEC 913 study, is that the cost and availability to retail investors of accounts, products, services and relationships with broker-dealers “could inadvertently be eliminated or impeded.”56

This high cost of compliance will have far broader consequences, by affecting the decisions firms make in responding to the Proposal. As a simple example, if a firm is anticipating the cost per retirement account to increase by a significant dollar amount, it is within reason that the firm will set account minimums to preclude accounts that would no longer be profitable or direct low-dollar investments to taxable accounts. Equally likely, firms will pass these very real costs on to clients. In some cases, firms may choose to exit the retirement market. In each case, the increased cost can be expected to be felt most severely by middle-income consumers where margins are lowest.

C. Self-Help Online Investment Options Will Not Offset the Harm of the Proposed

Rule to Middle-Market Investors

Many of the middle-income families we serve are prompted to save because we encourage or “nudge” them. As noted, we believe that our representatives are an integral part of clients achieving their retirement objectives, through face-to-face education and assistance and access to an appropriate range of reasonably-priced products with transparent fee structures. Without this sort of personal interaction, many of our clients are likely to forgo saving at all. If cut off from responsible, well-equipped financial professionals, even those who have the confidence to go it alone would be left vulnerable to the temptations inherent to human nature: chasing returns and attempting to time the market, and moving resources to inappropriate, low-risk, low-yield assets (i.e., savings accounts) even with many years to go until retirement. Nonetheless, this benefit – and the potential loss to middle-income savers from lack of personal assistance – is ignored by the Department in its analysis of the costs and benefits of its Proposed Rule.

55 NERA, Comment on the Department of Labor Proposal and Regulatory Impact Analysis (July 20, 2015), at 17.

56 Id. at 28.

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In fact, the Department at times has responded to the Proposed Rule’s potential to

decrease access to help for lower-wealth households by suggesting that self-help online investment tools may even be preferable.57 However, these self-help alternatives are not the solution. Studies consistently confirm that the percent of workers and retirees comfortable obtaining assistance from financial professionals online is quite low. In its 2012 study, the EBRI put this figure at just 10 percent.58 In a similar 2015 study, the EBRI reported that the majority of workers (74%) are not interested in obtaining investment education online.59 Likewise, a recent Gallup Poll found that less than one in three is very comfortable using online technology for investing.60 Even younger generations with greater familiarity with technology strongly prefer personal interactions when it comes to retirement investing. According to a recent survey performed by Greenwald and Associates (“Greenwald”), more than twice as many younger workers want traditional, in-person education.61 Greenwald likewise asserted that in-person education boosts savings.62 Further, a self-help or robo-solution will not provide post-transaction assistance in the same way that an individual financial professional can.

Equally troubling, nearly 20% of U.S. adults, or nearly 60 million Americans, remain without access to online investment options, as internet adoption has leveled off in recent years.63 These are predominantly lower-wealth families, minorities and English-as-a-second-language individuals, yielding some disturbing differences among internet users that should be concerning to policymakers. Internet usage by Hispanic and African-American households still lags behind

57 InvestmentNews; DOL Secretary Perez touts Wealthfront as a paragon of low-cost, fiduciary advice, June 22, 2015. (“When he appeared at a June 17 congressional hearing, Mr. Perez mentioned Wealthfront, an online investment adviser, at least three times. A day later, he tweeted a photo of himself and Wealthfront Chief Executive Adam Nash at the Wealthfront office.”)

58 EBRI 2012 Retirement Confidence Survey, available at http://www.ebri.org/pdf/surveys/rcs/ 2012/EBRI_IB_03-2012_No369_RCS.pdf (“[J]ust 10 percent of [workers and retirees] say they are comfortable obtaining advice from financial professionals online.”), at 1 (last bullet point).

59 EBRI 2015 Retirement Confidence Survey, available at http://www.ebri.com/pdf/surveys/rcs/ 2015/EBRI_IB_413_Apr15_RCS-2015.pdf (“While just 4 percent of workers report being very interested in obtaining investment education and advice online, 22 percent say they are somewhat interested. Nevertheless, the majority of workers are not too (26 percent) or not at all (48 percent) interested.”), at 24.

60 Gallup Poll, “U.S. Investors Opt for Human Over Online Financial Advice: Just one in three are very comfortable using online technology for investing,” available at http://www.gallup.com/poll/174851/investors-opt-human-online-financial-advice.aspx.

61 Matthew Greenwald Survey, “Younger Workers Want In-person Education,” available at http://www.benefitnews.com/news/retirement/younger-workers-want-in-person-education-2746146-1.html (“Despite their familiarity with technology, the Generation X and Generation Y populations prefer traditional means when it comes to retirement education.”).

62 Id.

63 “The 60 million Americans who don’t use the Internet, in six charts,” available at https://www.washingtonpost.com/blogs/the-switch/wp/2013/08/19/the-60-million-americans-who-dont-use-the-internet-in-six-charts/.

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white and Asian households.64 There is also a notable geographic gap among rural versus urban households, and there are more non-users in the Southeast. Expectedly, household wealth is directly linked to usage. Up to 40% of Americans do not have broadband at home,65 presumably where self-help investing is most likely to occur. This potential financial advice wealth-gap has not gone unnoticed. During the recent House Education and Workforce Committee hearing entitled “Restricting Access to Financial Advice: Evaluating the Costs and Consequences for Working Families and Retirees,” Rep. Federica Wilson (D-Fla.) expressed her concern, stating: “Technology is very intimidating to many people in our communities. For people who don’t have access to technology, it is intimidating. So let’s . . . make sure that we don’t eliminate them from the equation because we thrust them into a pit that they don’t quite understand.” 66 Also notable is that many of the current online investment providers either require investment minimums that are not attainable for many first-time savers, or offer only discretionary services, or both. Of similar concern are the minimalistic gating questions posed by the online providers. The providers’ technology takes responses to these questions to compute specific investments for the clients. For example, Wealthfront asks five questions: (1) “What is your current age?”; (2) “What is your annual after-tax income?”; (3) “What is the total value of your cash and liquid investments?”; (4) “When deciding how to invest your money, which do you care about – maximizing gains, minimizing losses, or both equally?”; and (5) “The global stock market is often volatile. If your entire investment portfolio lost 10% of its value in a month during a market decline, what would you do – sell all of your investments, sell some, keep all, or buy more?” Absent from these are questions regarding short-term liquidity needs, life-cycle events, employment, short- and long-term goals, need for qualified retirement savings vs. taxable investments, and a host of others personal to each family. First, in our experience, our clients – often first-time savers – would be stymied by some of these questions. Second, we are puzzled why the Department seems to believe computer-generated decisions calculated from such a generic questionnaire to be de facto in a consumer’s “best interests”.

Even more alarming, families seeking self-help advice are susceptible to being misdirected to “bad advice”. A simple search for investment help online can easily lead to internet message board commenters and affinity fraudsters enticing middle-income Americans to cash out their savings and invest in speculative, undiversified ventures without raising the issues of tax penalties and lost tax-advantages, and recklessly suggesting returns that would persuade an overwhelmed investor to disregard tax considerations in any event. Many American families are

64 Pew 2012 Research Report “Digital Differences,” available at http://www.pewinternet.org/2012/04/13/digital-differences (“ 20% of U.S. Adults Do Not Use the Internet… Senior citizens, Spanish-speaking adults, the disabled, the less educated, and lower earners are among the least likely to go online. 40% of Americans do not have broadband access at home.”).

65 Id.

66 House Education and Workforce Committee hearing entitled “Restricting Access to Financial Advice: Evaluating the Costs and Consequences for Working Families and Retirees” (June 17, 2015), Final Transcript, Panel 1 at 42.

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rightly overwhelmed by the mass of “investment information” on the internet, and many are paralyzed to act on their own.

We fervently believe that while technological models are well-designed to augment the

sales process (calculators, Monte Carlo simulators, etc.) and to suit the needs of some, it is imprudent to believe that they will provide the “band-aid” required to stop the leakage caused by a Proposed Rule that has the effect of cutting off personal service to small accounts.

D. The Proposed Rule Will Effectively Result in a Tax on the Middle Class As indicated by NERA, a likely outcome of the Proposed Rule is that nearly half of middle-income consumers – those with amounts to invest below advisory account minimums – will be left with limited options to save in an IRA.67 For many families this may result in decisions to spend rather than save. As noted above, for those who choose saving, only a tenth can be expected to use online investment options. The others may forgo the tax benefits available to IRAs and instead invest through taxable accounts in order to continue their relationship with their chosen financial professional. Obviously, this would be to their detriment, and contrary to Congressional intent of encouraging retirement savings. In order to understand the effect of such leakage away from IRAs and into taxable savings vehicles, Compass Lexecon was asked to measure the impact on accounts with balances below $25,000, a conservative minimum account balance for advisory accounts. The Compass Lexecon report is attached as Appendix 5. As explained in detail in their letter, Compass Lexecon quantified the loss to investors who would have opened IRAs but, as a consequence of the Proposal, instead open taxable savings accounts. In the analysis, Compass Lexecon looked at median taxpayers ranging in age from 30 to 45 years when they make their initial investment and modeled representative annual or biannual contributions until retirement. This age range and the contribution amounts are based upon EBRI reports of average annual IRA contributions and fairly represent the demographic age at which our clients commonly begin their IRAs with us. Compass Lexecon concluded that the loss associated with moving from an IRA to a taxable savings account is large. In the median case of a 30-year-old investor who starts an IRA and contributes annually, Compass Lexecon determined:

“The median outcome of our model for this investor involves an effective average tax rate on savings (relative to a totally untaxed account) of 23.8 percent for a Roth IRA and 15.0 percent for a traditional IRA, whereas the effective average tax rate on savings for the same investor making the same investment, but in a taxable savings account, is 38.7 percent. In other words, the taxpayer in this case would see his effective tax rate rise by 62.6 percent relative to a Roth IRA, and 158.0 percent relative to a traditional IRA if the DOL’s proposed amendments caused him to open a taxable savings account.”68

67 NERA, Comment on the Department of Labor Proposal and Regulatory Impact Analysis, at 28.

68 Compass Lexecon, Tax Consequences to Investors Resulting from Proposed Rules Relating to Investment Adviser Fiduciary Status (July 20, 2015), at ¶ 5.

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The Compass Lexecon report goes on further to conclude that while the Proposal’s impact varies across investors who start saving at different ages:

“The median effective tax increase due to the DOL’s proposed amendments varies across investors who start saving at different ages, but in any case, the tax increases remain very substantial, with the median never below 32.9 percent. Therefore, to the extent that the DOL’s proposed amendments lead a substantial number of investors to open taxable savings accounts instead of IRAs, the amendments would in essence constitute a sizable tax increase on many Americans’ retirement savings.”69

Compass Lexecon put this anticipated higher effective tax rate in perspective by estimating the number of years of retirement that an investor can fund at a desired level of annual retirement income. They estimated that the tax impact would reduce the number of years funded at retirement by about 2.7 years or 4.3 years, relative to a Roth IRA or a traditional IRA, respectively. This can be a meaningful difference for our clients. Additionally, Compass Lexecon roughly calculated that over the potentially 7.0 million existing households with IRAs under $25,000, the effective tax increase could result in a total reduction in retirement savings of between $147 billion and $372 billion. 70 Compass Lexecon acknowledges that while account values diminish substantially for investors who either wait until later ages to begin an account or who do not contribute every year, IRAs still have substantial tax benefits in all cases, not surprisingly.

E. Fiduciary Definition Is Not Uniform Across Regulators We are also concerned that the Department’s lack of substantive coordination with the regulators that have overseen the financial industry for decades (and, in some cases, a century or more) will result in fiduciary standards that are far from uniform, and that will only increase investor complexity and hamper efficient and successful financial planning and implementation of investment objectives. The input of these regulators (including the SEC, FINRA, and the federal banking regulators, among others) would help the Department gain a fuller understanding of the financial services industry, its products, the conflicts firms and financial professionals face, and how these conflicts may be best addressed to protect investors, while minimizing complications and inefficiency. Over many more than forty years, these regulators (checked by federal court litigations) have developed clear fiduciary standards that are rooted in common law principles, but also are adapted to particular financial services’ business models. The extensive learning of these regulators, as well as the SEC’s current initiative to adopt uniform standards under Section 913 of the Dodd Frank Act, should inform and guide the Department’s approaches to fiduciary standards in the Proposal. This is critical to minimize complexity and inefficiencies and to help ensure that investors can meet their retirement goals. We also note that the

69 Id. at ¶ 6.

70 Id. at ¶ 8.

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Department is required to consider the cost of cumulative regulation when issuing its own regulations to ensure that they impose the least burden on society, consistent with the regulation’s objectives.71

F. The Proposed Amendments to PTE 84-24 Will Have the Effect of Denying

Important Annuity Products to Consumers

The Department’s public statements regarding the Proposed Rule seem unduly focused upon whether variable annuities are appropriate for retirement investors.72 Specifically, the Department has suggested that variable annuity fees are too high relative to mutual fund fees. The Department’s statements ignore that variable annuities typically come with benefits in addition to investment returns, and so it is not appropriate to compare them to mutual funds. For example, variable annuities may have both living and enhanced death benefits. These lifetime benefits are often critical to protecting the best interests of retirement investors.

The Department has proposed certain changes to the current class exemption covering

sales of insurance products – Prohibited Transaction Exemption 84-24 (“PTE 84-24”). Specifically, the Department’s Proposal excludes sales of variable annuities to IRA clients from coverage, and substantially limits relief for traditional forms of compensation from sales of variable annuities heavily relied upon by the industry, which could effectively restrict the sale of fixed and variable annuities entirely. In addition, the Department’s proposed amendments do not provide grandfather protection for existing contracts that currently rely on PTE 84-24.

We understand that the Department has proposed that sales of variable annuities to IRA

clients would be covered under the BIC Exemption, as opposed to PTE 84-24. As proposed, the BIC Exemption does not provide a practical pathway for firms to offer variable annuities if they also offer any other products, such as mutual funds, under the Impartial Conduct Standards, which may be read to prohibit non-level compensation. As discussed, the Impartial Conduct Standards seems to require level fees across product lines with the exception that variations may be justified based on “neutral factors.” As the Department is aware, variable annuities, like most products, are priced based on market factors. Are market factors “neutral”? The risk is too great. The unintended consequence may be the elimination of these investment options for retirement investors.

We see no reason for the Department to modify current relief under PTE 84-24. We urge

the Department not to amend or partially revoke PTE 84-24. The Department should further study the use of annuities and their benefits to particular investors, and should properly measure the costs and benefits of disallowing traditional forms of compensation associated with annuities before amending the definition of “commissions” and effectively banning the sale of variable annuities to IRAs. Moreover, because the Department has also proposed to require firms and financial professionals to act in their clients’ best interests, it would seem unnecessary to exclude sales of variable annuities from relief under PTE 84-24. Finally, our concerns about how it is

71 See also Exec. Order No. 13563, Improving Regulation and Regulatory Review (2011).

72 See House Education and Workforce Committee hearing transcript, supra at note 66, at 8.

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generally not feasible to satisfy the BIC Exemption’s conditions, particularly the Impartial Conduct Standards, would apply equally to sales of annuities.

RECOMMENDATION: PTE 84-24 should not be amended or revised.

IV. Legal Basis for the Proposed Rule and Exemptions

While we appreciate the Department’s interest in protecting consumers’ retirement

savings and its role with respect to ERISA plans, we respectfully submit that the Proposed Rule and accompanying exemptions exceed the Department’s regulatory authority.

We retained the law firm of Gibson Dunn & Crutcher LLP to address the legal basis for the Department’s Proposed Rule. Attached as Appendix 6 is a comment letter setting forth a legal analysis of the Proposed Rule (“Gibson Dunn Comment”). In summary, the Department’s Proposal will not withstand legal scrutiny for several reasons. First, the Department’s definition of “fiduciary” is vastly overbroad and impermissible, and conflicts with the plain statutory text, the common law of trusts, and the language of the Advisers Act that Congress drew upon in codifying ERISA’s definition of investment fiduciary. Second, the Department exceeds its authority in regulating the activity of broker-dealers with respect to IRAs. The Proposed Rule and BIC Exemption also exceed the Department’s regulatory authority by attempting to create an enforcement scheme over IRAs. For these and other reasons, the Proposed Rule is improper and should be withdrawn.

V. Recommendations The Department has stated its intention to preserve the existing revenue streams associated with commission-based accounts predominately used by IRA investors. Our comments are intended to help the Department understand that the Proposal fails because of its overly broad expansion of the definition of fiduciary, and the enormous complexity and burden of the BIC Exemption that was intended to preserve commission-based brokerage services. If the Proposal is finalized in its current form, companies like ours will have no choice but to restructure their businesses so as to avoid a need to rely on the BIC Exemption. This will likely result in an increased focus on serving affluent clients at the expense of middle –income savers. To the extent firms do provide services that fall under the BIC Exemption, they are likely to establish parameters for non-taxableaccounts, which will have the effect of cutting off small investors from valuable retirement services and passing on the higher costs of compliance to consumers. We therefore urge the Department to withdraw the Proposed Rule. If the Department nonetheless continues to believe that an expanded definition of “fiduciary” is necessary, we think it is critical that the Proposal be substantially revised. Specifically, and to summarize our recommendations above, an operational Proposal would allow for the following:

A definition of “fiduciary investment advice” that is narrowed to make it clear that fiduciary status is based upon a mutual understanding or agreement that advice is individualized to the advice recipient, and is intended for the recipient’s material

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consideration.

A meaningful seller’s carve-out for retail investors that preserves their access to non-fiduciary investment assistance and the commission-based brokerage model.

An investment education carve-out that:

o Permits specific products to be identified so that useable and meaningful education and assistance can be provided to retail investors.

o Incorporates FINRA guidance distinguishing recommendations from investment education within the context of rollovers and distributions.

A workable exemption that preserves investor access to traditional commission-based brokerage services by:

o Not requiring a contract until an account opening. o Not requiring “wet signatures” or that individual representatives be parties to the

contract. o Expressly permitting a firm and its representatives to contractually agree to be a

fiduciary, solely with respect to a transaction, without an ongoing fiduciary obligation to the client or the account.

o Grandfathering existing accounts and all prospective transactions within them under the current definition of “fiduciary investment advice” rather than transitioning them to the exemption.

o Eliminating the warranty requirements, and not requiring actual adherence to the Impartial Conduct Standards as a condition of the exemption.

o Providing for a “best interest” standard that adheres to the FINRA formulation: the financial professional should provide recommendations that are in the “best interests” of the client and put the client’s interest before his or her own.

o Defining reasonable compensation in standard terms; the “total compensation” and “reasonable in relation to value” language should be deleted.

o Expressly permitting differential compensation among products and asset classes. o Requiring a concise and easy-to-read, point-of-sale disclosure that presents, in a

standardized rather than individualized format, solely the information required in a summary prospectus.

o Eliminating the annual, website, and data record keeping requirements. o Permitting parties to waive class actions in connection with arbitration

agreements.

PTE 84-24 should not be amended or revised.

An extension of the applicability date to three years after the publication of a final rule. If combined with a narrower definition of “fiduciary investment advice,” a seller’s exception to the fiduciary advice definition that applies to retail investors (provided that adequate disclosures about the nature of the communications and products are made) and a broader exception to the fiduciary advice definition for investor education (including rollover education, provided the conditions of FINRA Notice 13-45 are met), a new best interest contract exemption

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Page 1

APPENDICES

1. Oliver Wyman, The Role of Financial Advisors in the US Retirement Market (July 10, 2015)

2. Deloitte & Touche LLP, Report on the Anticipated Operational Impacts

to Broker-Dealers of the Department of Labor’s Proposed Conflicts of Interest Rule (July 17, 2015)

3. Compass Lexecon, An Evaluation of the Department’ Impact Analysis

of Proposed Rules Relating to Financial Representative Fiduciary Status (July 20, 2015)

4. NERA Economic Consulting, Comment on the Department of Labor

Proposal and Regulatory Impact Analysis (July 17, 2015) 5. Compass Lexecon, Tax Consequences to Investors Resulting from

Proposed Rules Relating to Financial Representative Fiduciary Status (July 20, 2015)

6. Comment Letter of Gibson Dunn & Crutcher LLP (July 20, 2015) 7. Comment Letter of Daniel Campagna 8. Comment Letter Joan Jones-White 9. Comment Letter Sarah Manley 10. Comment Letter Alex Franki 11. Comment Letter Thomas R. Pool 12. Comment Letter of Rita Huckle 13. Comment Letter of Shelly Rosen 14. Comment Letter of Jodie Orel

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APPENDIX 1

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The role of financial advisors in the US retirement market JULY 10, 2015

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ii

Contents

Contents ii

About this report iii

Executive summary 1

Key findings 5

I. Role of financial advisors in the defined contribution plan market 8

II. Role of financial advisors in helping individuals save for retirement 16

Appendix I. 41

Appendix II. 43

Report qualifications/assumptions and limiting conditions 45

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iii

About this report There has been substantial public debate recently about the value of financial advice and the importance of financial advisors. Many people continue to believe financial advisors perform a critical service helping individuals and small businesses successfully navigate complex financial challenges. Others have sought to portray financial advisors as self-interested salesmen and saleswomen, who provide conflicted advice to sell high cost products. Against this background, Oliver Wyman was engaged to perform a rigorous investigation of the role of financial advisors in the US retirement market, and quantify differences in investing behavior and outcomes between advised and non-advised individuals.

In this report, Oliver Wyman focuses on understanding the impact of financial advisors on individuals saving for retirement and small businesses setting up and maintaining a workplace sponsored retirement plan. Through a combination of proprietary research with individuals and small businesses and analysis of unparalleled datasets from IXI (a division of Equifax), we found that advised individuals and small businesses are better off in many of the ways that matter most for superior investing outcomes.

The benefits financial advisors provide are now at risk. On April 14, 2015, the Department of Labor issued its Conflict of Interest rule proposal, a replacement for the Definition of the Term “Fiduciary” rule proposal withdrawn in September 2011. The new Conflict of Interest Rule proposal, like its predecessor, would greatly expand the range of conditions under which an individual who provides investment services would be subject to ERISA fiduciary rules. The new proposal goes further in some respects. It explicitly defines promotional services provided to IRA account holders and small businesses as advice subject to ERISA fiduciary rules. While many stakeholders are analyzing the technical details and implications, this study considers the impact on individuals and small businesses that use financial advisors. We conclude that the newly proposed rule, while well intended, would have significant negative consequences for many retail investors if implemented with regard to the availability and cost of retirement savings help and support.

Further details on our research sources and methodology

1. Proprietary research, including two surveys of 4,393 retail investors and 1,216 small businesses;

2. Two datasets provided by IXI Services representing approximately 20% ($5.6 Trillion in 2013) of U.S. consumer invested assets on a household level and approximately 30% ($9.7 Trillion in 2013) of U.S. consumer invested assets on

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iv

3. an account level, respectively. This data is broken into different types of investment holdings for specific age, income and wealth segments as well as between individuals with, and without, a financial advisor;

4. Widely available secondary data sources.

Analyses based on data from the Oliver Wyman Retail Investor Retirement Survey and IXI invested assets datasets have been controlled for factors such as income, age, and assets to ensure they are representative of particular segments of the US retail investor population. In addition, responses from the retail investor survey were further scaled based on the 2013 Federal Reserve Survey of Consumer Finances to produce a representative sample of US retail investors. Unless indicated otherwise, small businesses are defined as businesses with established payroll and up to 100 employees. For additional information regarding our approach and market research, please refer to the methodology section of this document contained in the appendices.

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v

Table of Figures

Figure 1: US personal investable assets and retirement assets 8 Figure 2: Active retirement plan participants 9 Figure 3: Defined contribution assets by plan type (2013 YE) 10 Figure 4: Workplace retirement plan access and participation among private sector workers, W-2

adjusted rates, by firm size (2013) 11 Figure 5: Prevalence of different advisor types among small businesses 12 Figure 6: Value of advice attributed to advisors in choosing to set up a retirement plan 13 Figure 7: Plan formation rates by size of firm and advisor status 14 Figure 8: Frequency of referral to service provider(s), by advisor 15 Figure 9: Total asset levels across relationship status, age, and income 16 Figure 10: Ratio of average asset holdings for advised and non-advised investors 17 Figure 11: Households’ primary reasons for saving 18 Figure 12: Financial advisor services valued by investors 19 Figure 13: Availability and usage of in-plan support options (for respondents with a defined

contribution plan) 21 Figure 14: Primary reason for most recent rollover among those choosing to roll over assets 22 Figure 15: Retirement plan ownership among investors 23 Figure 16: IRA ownership and assets (2013) – Income: $0-100K, Wealth: $0-100K 24 Figure 17: Comparison of return by portfolio composition 25 Figure 18: Assets and IRA asset class mix for households with and without a financial advisor 27 Figure 19: Assets and IRA asset class mix – Age: 45-54, Income: $0-100K, Wealth: $0-100K 28 Figure 20: Assets and IRA product mix for households with and without a financial advisor 29 Figure 21: Assets and IRA product mix – Age: 45-54, Income: $0-100K, Wealth: $0-100K 30 Figure 22: Percent of assets held in cash or cash equivalents outside of workplace retirement

plans 31 Figure 23: Cash holdings as a percent of account assets for advised and non-advised investors 32 Figure 24: Cash holdings as a percent of total account assets for investors with and without a

financial advisor – Segment with <$100K in wealth and income 33 Figure 25: Percentage of individuals taking cash distributions by age and plan type 35 Figure 26: Worked example comparing a cash distribution with an IRA rollover- Illustrative 35 Figure 27: Rebalancing frequency outside of DC plans 37 Figure 28: Example retirement assets by year at median income, 3% contribution rate, and 6%

growth 44

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1

Executive summary Oliver Wyman’s study of the role of financial advisors in the US retirement system draws upon proprietary surveys of more than 4,300 retail investors and 1,200 small businesses, datasets from IXI Services (a division of Equifax), representing approximately 20% of U.S. consumer invested assets on a household level and approximately 30% of U.S. consumer invested assets on an account level, to provide a unique window into the value financial advisors provide to small businesses and retail investors for their retirement savings and investments needs.

With fewer individuals covered by corporate pension plans and the future of social security uncertain1, individuals are increasingly responsible for providing for their own retirement. Workplace-sponsored defined contribution (DC) plans offer significant tax and other advantages to foster increased retirement savings. Indeed, 84% of individuals began saving for retirement via a workplace retirement plan.2 When available, they are often the primary vehicle for personal retirement savings. However, over 19 million people who work for businesses with fewer than 50 employees do not currently have access to a workplace retirement plan.

We found that financial advisors are often a key advisor to small businesses, helping business owners through the process of setting up a defined contribution plan for their employees. When a financial advisor is involved, small businesses with 10-49 employees are 50% more likely to set up a workplace retirement plan. In addition, micro businesses (1–9 employees) that work with a financial advisor are nearly twice as likely to set up a plan.

Recognizing the growing importance of workplace DC plans, there have recently been a number of innovations that have doubtlessly improved the retirement outcomes for millions of people, including automatic enrollment and rebalancing features, better default investment options and in-plan advice. Yet, in spite of these improvements, many individuals continue to under-save (the average default contribution rate for plans with automatic enrollment is 3.4%3 vs. the 6-10% recommended by many experts).

Many people are uncomfortable tackling retirement savings on their own. By one measure, 58% of households with under $100,000 in investable assets, and 75% of households with over $100,000 in investable assets solicit professional financial advice4. 1 Social Security Administration, (http://www.ssa.gov/policy/docs/ssb/v70n3/v70n3p111.html): “Benefits are now

expected to be payable in full on a timely basis until 2037, when the trust fund reserves are projected to become exhausted…[at that point] continuing taxes are expected to be enough to pay 76 percent of scheduled benefits.”

2 Oliver Wyman Retail Investor Retirement Survey 2014 3 Center for Retirement Research at Boston College, ‘How Does 401(K) Auto-Enrollment Relate To The Employer

Match And Total Compensation?’, (http://crr.bc.edu/wp-content/uploads/2013/10/IB_13-14.pdf), October 2013 4 2013 Survey of Consumer Finances

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2

Advised individuals place the largest value on financial advisors’ support for financial planning, monitoring and providing trusted advice for their holistic financial needs.

In this regard, we found that many investors prefer to seek help from financial advisors outside their workplace in part to receive holistic advice on their assets. When changing jobs, individuals often choose to roll over assets into an IRA, primarily to consolidate assets and avoid leaving assets with a former employer. Just 29% of individuals own 401(k) plans exclusively, while nearly two-thirds hold assets outside their workplace in combination with an IRA or alone in one or more IRAs.

How well are financial advisors doing their job? On average, we found that individuals with a financial advisor have more wealth than non-advised individuals across all age and income levels studied. For example, we found that advised individuals aged 35-54 years making less than $100K per year had 51% more assets than similar non-advised investors. These are typical middle-class households in the middle of their accumulation years. Moreover, advised individuals are better investors across many key dimensions commonly associated with long term investing success. Specifically, we found that compared with individuals without a financial advisor, advised individuals

Own more diversified investment portfolios

Stay invested in the market by holding less cash and cash equivalents

Take fewer premature cash distributions; and

Re-balance their portfolios with greater frequency to stay in line with their investment objectives and risk tolerance.

The benefits financial advisors provide to their clients are now at risk. On April 14, 2015, the Department of Labor issued its Conflict of Interest rule proposal, a replacement for the Definition of the Term “Fiduciary” rule proposal withdrawn in September 2011. In our 20115 study reviewing the impact of the previously proposed rule, we concluded that the Department of Labor’s proposed rule change was motivated by a laudable objective: to ensure a high standard of care for retirement plan participants and account holders with regard to the receipt of services and investment guidance, amid an increasingly complex financial marketplace. However, we found the proposed rule proposal was likely to have serious negative and unintended effects on the very individuals the change was supposed to help. Many stakeholders are now analyzing the technical details of the newly proposed rule, and there is growing concern that the proposal would again result in unintended

5 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on IRA

Consumers’, 2011

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3

consequences, including limiting the ability of financial services firms and individual financial advisors to offer services to individual IRA holders and small businesses, as well as increasing investor costs due to new expenses associated with implementing the rule and transitioning many clients to a higher cost advisory model. With regard to the impact on individuals, regrettably we reach the same overall conclusion as in the prior study. The proposed rule change is likely to have significant consequences that will adversely impact individual investors saving for retirement. For example, because the rule as proposed will take away the assistance small businesses most value, fewer new plans will be established and more plans will likely close6. This would directly impact the 19 MM individuals who work for small businesses with fewer than 50 employees, who do not currently have access to a workplace retirement plan and reduce the likelihood of their gaining access to a retirement plan in the future. In the case of IRAs, if the rule is implemented as proposed7

Millions of existing small balance IRA owners are likely to lose access to the financial advisor of their choice or any financial advisor at all

The majority of others will face higher costs when providers shift brokerage accounts to advisory accounts

Individuals without the help and support of financial advisors are less likely to open an IRA, leading to increased cash-outs when changing jobs and lower savings rates compared with advised individuals8

Unadvised individuals are likely to carry excess portfolio risk due to less diversification and less frequent re-balancing.

* * *

6 The new rule proposal explicitly excludes small businesses with fewer than 100 employees with employee-directed

plans from the prohibited transaction exemption, otherwise made available to larger plans. This will force financial advisors to limit the services they currently provide to such small businesses in connection with establishing and maintaining retirement plans.

7 See Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on IRA Consumers’, 2011

8 Prior guidance from the DOL “held that recommendations to a plan participant to take an otherwise permissible distribution, even combined with a recommendation as to how to invest distributed funds, is not fiduciary investment advice.” K&L Gates, DOL Re-Proposes Rule to make Brokers, Others, ERISA Fiduciaries (Apr. 27, 2015), http://www.klgates.com/dol-re-proposes-rule-to-make-brokers-others-erisa-fiduciaries-04-27-2015.

App. 942


4

Retirement is too important to get wrong. We encourage key stakeholders from the financial services industry and regulators to join together to find workable solutions that preserve individuals’ access to help and support from a financial advisor of their choice as well as the business model and fee structure that best meet their needs.

App. 943


5

Key findings

Workplace sponsored defined contribution plans are critical retirement savings vehicles

84% of individuals began saving for retirement via a workplace retirement plan9

Workplace sponsored defined contribution plans represent the primary or only retirement vehicle for 67% of individuals who save for retirement with a tax-advantaged retirement plan10

Financial advisors help individuals that work for small businesses gain access to workplace retirement plans

19 million individuals who work for small businesses with fewer than 50 employees do not currently have access to a workplace sponsored retirement plan

Small businesses that work with a financial advisor are 50% more likely to set up a retirement plan (and micro business with 1-9 employees are almost twice as likely)

The majority of retail investors seek financial advice – many want personalized services from a professional financial advisor outside their workplace for financial planning and holistic advice and support on all their investment holdings

58% of households with under $100,000 in investable assets, and 75% of those with over $100,000 in investable assets solicit professional financial advice

Individuals most value financial advisors for support with financial planning, monitoring and trusted advice for their holistic financial needs

Many individuals currently have access to help and advice on their plan assets through workplace retirement plans; those that use it save 43% more on average. However, fewer than half of workplace retirement plan participants currently use in-plan advice features

9 Oliver Wyman Retail Investor Retirement Survey 2014 10 Oliver Wyman Retail Investor Retirement Survey 2014

App. 944


6

Two-thirds of investors have retirement savings outside of employer-sponsored retirement plans, and many seek advice and support from a professional advisor outside their workplace for all of their investment holdings

Advised investors have more assets than those without a financial advisor

We found that advised individuals have a minimum of 25% more assets than non-advised individuals

In the case of individuals aged 35-54 years with $100,000 or less in annual income, advised individuals have an average of 51% more assets than non-advised individuals

Individuals with a financial advisor are better long term investors

Advised investors have more diversified portfolios -- own twice as many asset classes, have more balanced portfolio asset allocations and use more packaged products for equity exposure compared with non-advised investors

Advised investors stay more invested in the market – Advised individuals hold less cash in their investment accounts (36%-57% less than non-advised individuals for similar age and wealth cohorts)

Advised investors re-balance more frequently, and are 42% more likely to re-balance their portfolios at least every two years

The Department of Labor’s proposed Conflict of Interest rule would likely reduce retirement savings

As proposed, financial advisors would be forced to stop providing workplace retirement plan set-up and support services to small businesses, due to the lack of an exception that would allow providers to market to self-directed plans with fewer than 100 participants, which will likely result in many small businesses closing existing plans or not establishing new plans due to the additional administrative burden

Individuals with small balance accounts that are below standard advisory account minimums are likely to lose access to retirement help and support with selecting appropriate products as a result of providers shifting accounts from brokerage to fee-based advisory accounts. In our prior study, we estimated that 7 MM current IRAs would not qualify for an advisory account due to low balances11

11 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on

IRA Consumers’, 2011

App. 945


7

Almost all retail investors face increased costs (73% to 196% on average) from providers shifting clients to a fee-based advisory model. In our 2011 study, we found nearly 90% of the 23 MM IRAs analyzed were held in brokerage accounts 12

When changing jobs, individuals will be less likely to open an IRA to manage their plan savings, leading to lower savings rates and increased cash-outs13. In our 2011 study, we found that as many as 360,000 fewer IRAs would be opened every year

Unadvised individuals will likely carry excess portfolio risk due to less diversification and less frequent re-balancing compared with advised individuals

12 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on

IRA Consumers’, 2011 13 Prior guidance from the DOL “held that recommendations to a plan participant to take an otherwise permissible

distribution, even combined with a recommendation as to how to invest distributed funds, is not fiduciary investment advice.” K&L Gates, DOL Re-Proposes Rule to make Brokers, Others, ERISA Fiduciaries (Apr. 27, 2015), http://www.klgates.com/dol-re-proposes-rule-to-make-brokers-others-erisa-fiduciaries-04-27-2015.

App. 946


8

I. Role of financial advisors in the defined contribution plan market

Two-thirds of retirement assets are held in workplace retirement plans

At an estimated $26.9 TN, US retirement savings represent over half of total personal investable assets. Of this amount, workplace sponsored retirement plans such as defined benefit (DB) and defined contribution (DC) plans constitute approximately two-thirds of retirement assets, while the remaining one-third is held in IRAs and annuities (Figure 1).

Figure 1: US personal investable assets and retirement assets14

Individuals are increasingly responsible for saving for their own retirement

Nearly five times as many individuals are active participants in DC plans as compared to DB plans as of 2012 (75.4 million vs. 15.7 million). 15,16 Moreover, as Figure 2 shows, 14 Federal Flow of Funds L.116, B.100: Includes financial assets and defined benefit assets; excludes agency and

GSE backed securities, other loans and advances, mortgages, consumer credit (student loans), pension entitlements and equity in non-corporate business Federal Flow of Funds L.116: Retirement assets include household retirement assets

15 Private Pension Plan Bulletin Historical Tables and Graphs, U.S. Department of Labor, Employee Benefits Security Administration, December 2014

16 Note: Aggregation methodologies were changed in 2004 and 2009, generating anomalies for those years

U.S. retirement assets by plan type2014 Q2, US$ TN

U.S. personal investable assets2014 Q2, US$ TN

13.4

3.5

7.7

3.1

0

5

10

15

20

25

30

35

40

45

50

$ (T

N)

Defined benefit plans

Corporate equities

Deposits

Credit market instruments

Mutual fund shares

Other

2014 Q2

48.7

11.1

9.9

7.2

DB plans

DC plans

IRAs

Annuities

2014 Q2

26.9

11.1

6.2

2.4

Approximately 55% of $48.7 TN

App. 947


9

the long-term trend continues to favor DC plans. As a result, the level of retirement assets available to individuals is now dependent upon a number of factors both within and outside their control, including employment status, personal contribution rate, the availability of employer matching contributions, investments selected and market performance.

Figure 2: Active retirement plan participants (see footnotes 8,9)

Within the broad category of defined contribution plans, there are a number of different vehicles such as 401(k), 403(b), 401(a), 457 and profit sharing plans with different features to suit the needs of a wide range of business plan sponsors and individuals. As illustrated in Figure 3, the most popular vehicle by share of assets is the 401(k).

05

101520

2530354045505560

65707580

Defined contribution

Defined benefit

2010

Year

Part

icip

ants

(MM

)

2005200019951990198519801975

App. 948


10

Figure 3: Defined contribution assets by plan type (2013 YE)17

Based on our retail investor survey, we found that workplace retirement plans are vital for individuals to start saving for retirement – 84% of respondents began saving for retirement via a workplace retirement plan.

More than 80% of retail investors surveyed began saving for retirement through workplace retirement plans

17 Pensions & Investments Research Center: (http://researchcenter.pionline.com/rankings/dc-money-

manager/plantype/2014?limit=213)

11%

2%

15%

401(k)

1%

Profit sharing plan

403(b)

65%

457

6%

Other

401(a)

App. 949


11

As of 2013, approximately 75 million, or 70% of the 107.0 million full-time and part-time US private sector workers, had access to a workplace retirement plan, and 60 million, or 56% of 107.0 million, chose to participate. Of the 32 million private sector workers without access, nearly two-thirds, or 19 million, are employed by small businesses with fewer than 50 employees (Figure 4).18

Figure 4: Workplace retirement plan access and participation among private sector workers, W-2 adjusted rates, by firm size (2013)

18The number of employees by firm size is based on Investment Company Institute tabulations of the US Census’

Current Population survey (www.ici.org/info/per20-06_data.xls). We use W-2 adjusted self-reported access and participation rates, as compiled by Dushi, Iams, and Lichtenstein (‘Assessment of Retirement Plan Coverage by Firm Size Using W-2 Tax Records’, Social Security Administration, 2011, http://www.ssa.gov/policy/docs/ssb/v71n2/v71n2p53.pdf). This study accounts for under- and over-reporting of plan participation by using individual tax filings to identify tax-deferred contributions, and avoids the issues of double-counting of individuals active in more than one plan and non-active participants in plans with short-form filings associated with available DOL data.

10%

16%

16%

0% 40% 60% 100%80%20%

55%

100 or moreemployees 16%

35%

Percentage of employees

30%

Fewer than 50employees

54%50 to 99employees

68%

No plan available Plan available but don’t participate Plan available and participate

Number of employees

(MM)

Number of employees with out access to a

plan (MM)

34.1 19.1

9.1 2.8

63.8 10.2

TOTAL 107.0 32.0

App. 950


12

Our research provides interesting insights into reasons for the lower availability rates of workplace retirement plans among small businesses. When asked to select their reasons for not offering a plan, we found that cost (47% of small business survey respondents), prioritization of other employee benefits (24%) and significant use of temporary labor (20%) were the most commonly cited barriers to DC plan formation.

Barriers to small business plan formation include cost, prioritization of other benefits and temporary labor

In contrast to large businesses that often employ investment consultants to assist internal governance committees with managing a DC plan, small businesses typically rely on a circle of trusted advisors. We found small businesses most commonly seek advice from a range of providers including accountants, attorneys, retail banks, insurance firms, financial advisors, and outsourced service providers. Figure 5 shows the prevalence of these advisors among small businesses.

Figure 5: Prevalence of different advisor types among small businesses19

19 Oliver Wyman Small Business Retirement Survey 2014, Respondents were asked to select all of the advisors that

they consult in the management of their business, hence the sum is greater than 100%. Participants were asked to select from the following options: outside accountant (CPA), outsourced service, financial advisor (e.g. Merrill Lynch, Morgan Stanley, Independent financial professional), asset management firms (e.g. Vanguard, T. Rowe Price), attorney, retail bank (other than private banks and brokerages within banks, e.g. JPMorgan Chase, Bank of America, HSBC, Citibank), investment consultants (e.g. Aon Hewitt, Mercer), insurance firms (e.g. Aetna, Nationwide), and none (I am solely responsible for all business decisions).

0

10%

70%

60%

50%

40%

30%

20%

80%75%

63%

47%

Insurance firms

Retail bankAttorneyOutside accountant

Advisor

41%

Perc

ent o

f bus

ines

ses

Investment consultants

45%

Asset management

firms

Outsourced service

providers

Financial advisor

6%9%

38%

App. 951


13

Financial advisors help small businesses set up workplace retirement plans

Small businesses use advisors for a range of services for their DC plans, which vary from plan to plan and from advisor to advisor. Examples of typical services include:

Development of an investment policy statement covering aspects such as plan objectives, investment philosophy and risk appetite

Plan design consulting (e.g. choice of funds, use of auto-enrollment, QDIA, auto-escalation, and employer matching program), and selection of a record-keeper

Participant education and support (e.g. general help and support around plan participation, contribution rates and investment options, investment planning and IRA rollovers).

Small businesses perceive financial advisors to be most helpful with respect to guidance on retirement plan setup and administration. We asked survey respondents to allocate 100 points among their different advisors based upon the value they assigned to their help and support in choosing to set up a workplace retirement plan. As shown in Figure 6, this statement holds true across all types of advisors and business sizes with small businesses allocating between 30% and 36% of value to financial advisors.

Figure 6: Value of advice attributed to advisors in choosing to set up a retirement plan20

20 Oliver Wyman Small Business Retirement Survey 2014, Respondents were asked to allocate 100 points across all

their advisors in terms of their contribution to the business setting up a workplace retirement plan; presented values are calculated as the average score per advisor type.

5%

6%

7%

8%

21%

12%

36%

6% 12%

5%

7%

8%

15%

4%

16%

33%

13%

5%

10%

8% 14%

5%

15%

30%

Asset management firmsInvestment consultantsOutside accountant

Financial advisor Insurance firmsRetail bankOutsourced service providers

Attorney

1–9 employees 10–49 employees 50–100 employees

App. 952


14

Small businesses with financial advisors are 50% more likely to set up a retirement plan overall and micro businesses with financial advisors are nearly twice as likely to set up a plan

We found that 41% of small businesses with 100 or fewer employees work with a financial advisor, and that these firms are significantly more likely to set up a retirement plan. Specifically, businesses with 1–9 employees with a financial advisor are almost twice as likely to set up a retirement plan as are businesses without financial advisors (51% vs. 26%). Businesses with 10–49 employees with a financial advisor are 48% more likely (77% vs. 52%) and businesses between 50 and 100 employees are 19% more likely (89% vs. 75%) to set up a plan. These differences are illustrated in Figure 7 below. Additionally, micro businesses (1-9 employees) with financial advisors are 18% more likely to offer employer matching with a financial advisor (85%) than without (72%).

Figure 7: Plan formation rates by size of firm and advisor status21

21 Oliver Wyman Small Business Retirement Survey 2014

51%

77%

89%

69%

26%

52%

75%

46%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1-9 10-49 50-100 Overall

Perc

ent o

f bus

ines

ses

offe

ring

retir

emen

t pla

n

Number of employees

FA Non-FA

36% 63% 80% 56%Overall plan rate

App. 953


15

Financial advisors play a key role in referring small businesses to service providers, such as plan administrators/ recordkeepers and fiduciary service providers

As Figure 8 shows, a majority of small businesses, ranging from 55%–62% depending on size, found their workplace retirement plan provider via a referral from a trusted advisor. Financial advisors and accountants were the most common referral sources on a relative basis, with financial advisors cited between 33–45% of the time22, depending on company size.

Figure 8: Frequency of referral to service provider(s), by advisor23

22 Raw results are normalized to account for relative frequencies of different advisors. For example, in the 1-9

business segment, financial advisors provide 41% of all referrals on an unadjusted basis. We weighted this figure by the prevalence of financial advisor relationships among these businesses (i.e. 38%) and re-scaled all advisor scores to total 100%. This approach yields relative referral rates by removing skews associated with advisor prevalence.

23 Oliver Wyman Small Business Retirement Survey 2014

10%22%

6%

62%

9%16%

21%

55%

10%12%

19%

59%

Other

Independent research

Referral from similar business

Referral from trusted advisor

32%

19%20%

23%

11% 6%18%

5%

0% 10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

50-100

42%

10%

4%

10-49

38%Perc

enta

ge o

f ref

erra

ls

Firm size

5%

1-9

52%

5% 0%

Investment ConsultantAsset ManagerOther

Financial advisorOutside AccountantAttorney

App. 954


16

II. Role of financial advisors in helping individuals save for retirement

In our Retail Investor Retirement Survey, advised investors had a minimum of 25% more assets than non-advised individuals, depending on age and income levels

A key finding of our research is that individuals with a financial advisor have more assets than non-advised individuals across age, income, and wealth segments, as shown in Figure 9.

Figure 9: Total asset levels across relationship status, age, and income24

This finding holds true even when excluding survey respondents who anticipate receiving retirement income from either an inheritance or trust fund.

24 Oliver Wyman Retail Investor Retirement Survey 2014

517

297

204

81

243

196

148

43

0

50

100

150

200

250

300

350

400

450

500

550

Age Group

55-6418-34 65+35-54

Aver

age

hous

ehol

d as

sets

($K

)

With FA Without FA

<=$100K in annual income

1,345

820

486

203

892

577

388

115

0

100

200

300

400

500

600

700

800

900

1,000

1,100

1,200

1,300

1,400

Age Group

55-6418-34 65+35-54

Aver

age

hous

ehol

d as

sets

($K

)

With FA Without FA

>$100K and <=$250K in annual income

+51%+42%+25%+76%+113%+51%+38%+86%

% Increased assets of advised households

A B C D A B C D

% Increased assets of advised households

A

B

C

D

A

B

C

D

App. 955


17

Our analysis of the IXI data, representing ~20% of U.S consumer invested assets, further substantiates and expands on this finding. We found that individuals with a financial advisor have larger account balances (including IRA assets) across age, income and wealth levels. Specifically, in 2013, 98% of accounts examined for advised individuals reflected ≥10% more investment assets compared to those of non-advised individuals controlling for age, wealth, and income. Moreover, 90% of accounts reflected ≥25% more investment assets among advised accounts.

This finding holds true across multiple time periods for specific wealth and income cohorts. Figure 10 illustrates this point for all segments as well as the segment with annual income and wealth below $100,000.

Figure 10: Ratio of average asset holdings for advised and non-advised investors25

As described in detail below, our research finds that individuals with a financial advisor are better investors across many dimensions commonly associated with long term investing success.

Advised individuals are better long term investors

Key elements of a robust long-term investing program typically include:

A. Developing and maintaining a personalized financial plan

25 IXI account-level time series dataset of U.S. Consumer Invested Assets; Oliver Wyman Analysis

Recession and

immediate aftermath

Recession and

immediate aftermath

Total AUM measured in 2013:

$9.7 TR

0%

50%

100%

150%

200%

250%

2006 2007 2008 2009 2010 2011 2012 2013

Advi

sed

/ non

-adv

ised

acc

ount

ass

ets

YearSegment: <$100K wealth, income Overall

Total IRA holdings measured in 2013:

$3.1 TR

0%

50%

100%

150%

200%

250%

2006 2007 2008 2009 2010 2011 2012 2013

Advi

sed

/ non

-adv

ised

IRA

asse

ts

Year

Segment: <$100K wealth, income Overall

Total assets IRA assets

App. 956


18

B. Commitment to regular saving and investment C. Constructing and maintaining a well-diversified portfolio of appropriate

investment products D. Staying invested in the market E. Periodically re-balancing investment holdings to restore desired asset allocation

and risk levels We found that financial advisors play an important role in helping individuals adopt each of these investing practices commonly associated with better investing outcomes.

A. Developing and maintaining a personalized financial plan

Individual investors’ savings goals include liquidity, education and retirement, but their primary focus varies with life stage

Individuals have a range of different investment goals. As indicated in Figure 11, investors’ most common investing objectives are ensuring sufficient liquidity; saving for retirement; and funding education or a large purchase, such as a home.

Figure 11: Households’ primary reasons for saving26

The primary reasons for saving often vary significantly with life stage, however. In a recent survey, the Investment Company Institute (ICI) found that Households with a head of household younger than 35 primarily save for liquidity purposes (39%), whereas

26 Investment Company Institute, The Success of the U.S. Retirement System, Figure 1

(http://www.ici.org/pdf/ppr_12_success_retirement.pdf)

4%

8%

23%

35%

Other

Cannot or do not save

Education, home, or large purchase

Liquidity (cash on hand, emergencies, unexpected needs)

Retirement30%

App. 957


19

those in which the head of household is between 50 and 64 years old, are focused on retirement savings (48%).

58-75% of non-retired households seek professional financial advice, depending on wealth, and most value personalized financial planning, investment monitoring and holistic advice

Many Americans are uncomfortable with investing on their own, and consult with a financial advisor to assist with achieving their goals. By one measure, 58% of households with under $100,000 in investable assets, and 75% of non-retired households with over $100,000 in investable assets, solicit professional financial advice27.

In our research, individuals most value the following services from their financial advisor: personalized financial planning, ongoing monitoring of investments and trusted advice for all their personal financial affairs (Figure 12).

Figure 12: Financial advisor services valued by investors28

27 2013 Survey of Consumer Finances 28 Oliver Wyman Retail Investor Retirement Survey 2014

27

22

21

14

12

3

0 10 20 30

Average score out of 100

Individuals mostly value personalized and holistic financial advice

Financial planning to achieve your personal

financial goals

Ongoing monitoring of your personal investments

Trusted advice for all of your personal financial affairs

Investment expertise for making individual purchases

or sales of securities

Access to high-quality financial products

Trusted advice for helping manage your small business

Serv

ice

App. 958


20

Against investor demand for holistic advice, we observe different help and support models available within workplace retirement plans and outside plans. In-plan help and advice is often well suited for individuals whose workplace plan represents their primary investment savings, while outside plan advice is a better fit for individuals with multiple investment accounts seeking advice and guidance on all investment holdings.

The majority of DC plans now offer a variety of educational materials, tools and advice options to enable individuals to make informed investment decisions. Educational materials and automated financial tools are the most widely available as well as the most used features as shown in Figure 13. In our research, in-plan advice had a positive impact on participant behavior for those who used it. We found participants who made use of at least one type of support contributed an average of 2.0 percentage points29 more of their salary to a DC plan (6.7% vs. 4.7%) – an increase of 43%. When done in younger working years, this difference could mean a substantial difference in asset accumulation at retirement.

Participants who use in-plan advice features save 43% more, on average

We also found that fewer than half of plan participants currently use in-plan advice features. While 82% of individuals have access to an investment advisor on the phone and 64% have the ability to meet with a financial advisor in-person, utilization of these services is low. Of the individuals that participated in our survey, just 25% consulted with an advisor on the phone and 25% met with a financial advisor in-person.


App. 959


21

Figure 13: Availability and usage of in-plan support options (for respondents with a defined contribution plan)

In-plan advice models are often more limited in scope compared with external advisory offerings

A number of financial firms operating in a brokerage model have forged partnerships with in-plan advice providers such as Financial Engines, Morningstar and Wilshire Associates, instead of establishing a relationship with their financial advisory businesses, to provide basic help and advice to plan participants on current plan holdings and investment options.30,31,32 Due to legal constraints, this form of advice is generally limited to plan assets, which does not meet the full needs of individuals that hold assets in multiple DC plans and other brokerage and/or advisory accounts.

30 Financial Engines, 2012 Annual Report (http://phx.corporate-

ir.net/External.File?item=UGFyZW50SUQ9MTc3OTk4fENoaWxkSUQ9LTF8VHlwZT0z&t=1) 31 Morningstar, 2012 Annual Report, (http://corporate.morningstar.com/us/documents/PR/2012-Morningstar-Annual-

Report.pdf) 32 Wilshire Associates, Retirement Managed Accounts, (http://www.wilshire.com/funds-management/our-

solutions/retirement-managed-accounts)

91%

82%

64%

93%

59%

25% 25%

61%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Automated financial tools,available online

Investment advisor,available on the phone

Investment advisor,available in-person

Educational materials

Avai

labi

lity

of o

ptio

n

Support Option

Available Used

App. 960


22

Individuals elect IRA rollovers for many reasons including asset consolidation, increased investment options and access to a different financial services provider

Many individuals prefer to access financial help and support outside of their DC plans and choose to rollover their DC plan assets to an IRA when changing employers. According to a 2014 ICI report, “The Role of IRAs in US Household Saving for Retirement”, more than 41 million US households hold an IRA of some type. In addition, as shown in Figure 14, ICI further found that nearly half of all rollover decisions were motivated by a desire to consolidate assets and avoid leaving assets with the former employer.

Figure 14: Primary reason for most recent rollover among those choosing to roll over assets33

Only 29% of workplace plan participants use DC plans exclusively for retirement savings; nearly two-thirds use a combination of DC plans and IRAs or IRAs only34

As demonstrated by the distribution of retirement plans within our sample of investors (Figure 15), 44% of individuals utilize both DC plans and IRAs in order to take advantage of the benefits of each type of account. As noted previously, IRAs offer

33 Investment Company Institute, The Role of IRAs in U.S. Households’ Saving for Retirement, 2014

(http://www.ici.org/pdf/per21-01.pdf) Other includes ‘Were told by a financial advisor to roll over assets’, ‘Wanted to keep assets with the same provider’, ‘Thought it was easier to roll over assets to an IRA’, and ‘Wanted the same investments as former employer’s plan’.


19%

7%

9%

24%

Other

Wanted to use a different financial services provider

17%

Wanted to preserve tax treatment of the savings

Wanted more investment options

24%

Did not want to leave assets with the former employer

Wanted to consolidate assets

App. 961


23

access to holistic help and support, a wider selection or financial products, and greater control. In comparison, DC plans have a higher limit for tax-deferred annual savings (e.g. $18,000 for 401(k)s vs. $5,500 for IRAs, excluding catch up contributions) and employer matching contributions (where available), making them attractive vehicles for new retirement contributions.

Figure 15: Retirement plan ownership among investors35

B. Commitment to regular saving and investment

Individuals with a financial advisor are more likely to own an IRA, have greater IRA assets and save more of their income in 401(k) plans

Individuals with a financial advisor are more likely to have an IRA. In 2013, 99.8% of households examined belonged to an age / income / wealth segment in which advised households were ≥10% more likely to have an IRA compared to non-advised households (and 87% of households belonged to segments in which advised households were ≥25% more likely to have an IRA).

Additionally, 94% of households examined belonged to an age / income / wealth segment in which advised households held ≥25% more IRA assets compared to non-advised households. Our findings for IRA ownership and asset levels hold true across income, age, and wealth segments. For example, Figure 16 shows IRA ownership and 35 Oliver Wyman Retail Investor Retirement Survey 2014, includes only those with retirement or investment accounts

5%3%

29%

44%

None

IRA only18%

DC only

Both

Other

App. 962


24

assets for advised and non-advised households within different age groups for the cohort with $0-100K in annual income and wealth, respectively. In this cohort, increased IRA ownership ranges from 41% higher for households with accounts registered to individuals 65 and older to 68% higher for those in the 35-44 age group. IRA asset levels for the $0-100K annual income and wealth cohort ranges from 39% higher for households with accounts registered to individuals aged 18-34 to 87% more for those aged 55-64.

Figure 16: IRA ownership and assets (2013) – Income: $0-100K, Wealth: $0-100K 36

These results are consistent with a recent Natixis survey, where individuals with a financial advisor were found to hold more assets in their 401(k) across age and income segments, compared with non-advised investors. The Natixis survey also found that individuals with a financial advisor contributed an average of 1-2% more of their pre-tax salary to their 401(k) across age and income segments.37

36 IXI household-level dataset of U.S. Consumer Invested Assets; Oliver Wyman Analysis 37 Saving is Not Enough: Liabilities, shortfalls and the need for active participation in 401(k) plans; Natixis Global

Asset Management, August 2014 – online survey of 899 participants (427 with FA, 472 without FA) across age and groups

$50

$40

$30

$20

$10

$0

Aver

age

Hou

seho

ld IR

A H

oldi

ngs

($K

)

Age Group

65+

27

49

55-64

24

44

45-54

20

33

35-44

15

24

18-34

913

Without FAWith FA

47%

59%56%

51%

41%

33%38%

34%31%

25%

60%

50%

40%

30%

20%

10%

0%

% o

f hou

seho

lds

with

IRA

Age Group

65+55-6445-5435-4418-34

+41%+56%+65%+68%+64%+83%+87%+66%+55%+39%

% Increased assets of advised households % Increased IRA ownership of advised households

A

B

C

D

E

A B C D E

A

BC

D

E

A B C D E

App. 963


25

C. Constructing and maintaining a well-diversified portfolio of appropriate investment products

The benefits of portfolio diversification are well documented. Figure 17 shows how a diversified balanced index outperformed the S&P 500 by an average of 1.7 percentage points annually (11.2% vs. 9.5%) over a long time period (1965-2012) spanning multiple business cycles.

Figure 17: Comparison of return by portfolio composition38

Individuals with a financial advisor exhibit more diversified investment portfolios compared to non-advised individuals across a number of dimensions

Portfolio diversification refers to the practice of mitigating investment risk by investing in a variety of un-correlated products. There are a number of ways to assess portfolio diversification. We have attempted to assess relative portfolio diversification between advised and non-advised individuals with respect to several basic measures.

1. The number of asset classes within the portfolio – The correlation between investments in different asset classes is typically lower than that between investments in the same asset class. Thus, the more distinct asset classes in an investor’s portfolio the more diversified the portfolio, on average.

2. The ratio of equities to fixed income – This is a basic measure of portfolio risk with a higher concentration in equities typically signaling a riskier portfolio. A “60/40” portfolio consisting of 60% equity and 40% fixed income is widely recognized as a balanced portfolio that provides capital appreciation and income while limiting volatility and potential loss of capital. A substantial overweighting of

38 DFA Returns 2.0

Portfolio Mix 1965-1981 1982-1999 2000-9/2012 Total Period

S&P 500 Index +6.3% +18.5% +1.7% +9.5%

Cash +6.7% +6.2% +2.2% +5.3%

Diversified Balanced Index +9.9% +15.1% +7.4% +11.2%

App. 964


26

equities or fixed income could indicate a misalignment between intended and actual risk-taking.

3. The use of packaged products vs. individual securities – Packaged products like mutual funds are typically composed of many securities, and have lower non-systematic risk (i.e. individual company risk exposure) than an equivalent investment in a smaller number of individual securities. As a result, investment strategies employing packaged products tend to be more diversified than strategies that rely only on individual securities.

Based on each of these three measures of diversification, we found individuals with a financial advisor have more diversified portfolios than individuals without a financial advisor.

1. Number of asset classes within the portfolio – Individuals with a financial advisor own twice as many asset classes as non-advised individuals

In a 2010 study, Charles Schwab found that financial advisors help clients achieve greater investment diversification, and that the average investor receiving professional advice invests in over four more asset classes than an investor who does not (e.g. more than 8 versus 3.7)39.

2. Ratio of equities to fixed income -- Advised individuals have more balanced portfolios than non-advised investors, and hold, on average, more than 20% less equities and nearly twice as much fixed income

Individuals with a financial advisor have more balanced portfolios with less equity exposure and higher fixed income allocations than non-advised individuals. As shown in Figure 18, advised individuals held 17 percentage points (more than 20%) less equity than non-advised individuals, as well as nearly twice as much fixed income exposure (25% vs. 13% as a percent of the total portfolio). IRA holdings show a similar, finding where the difference in equity exposure is 8 percentage points (or 10%) less of an allocation for advised individuals vs. those without a financial advisor. By contrast, fixed income exposure is 38% higher for advised vs. non-advised individuals.

39 Charles Schwab, ‘Advice Matters: New Charles Schwab Study Demonstrates Positive Impact of Professional

Advice on 401(k) Investor Behavior’, (http://pressroom.aboutschwab.com/press-release/schwab-corporate-retirement-services-news/advice-matters-new-charles-schwab-study-demo)

App. 965


27

Figure 18: Assets and IRA asset class mix for households with and without a financial advisor40

The finding of more balanced portfolios among advised individuals persists when controlling for age, income, and wealth, as 72% of households belong to a segment in which advised households hold more than 20% less of their assets in equities41. By way of further example, Figure 19 shows the same analysis of the segment aged 45-54 with less than $100,000 in annual income and total wealth, respectively. In this case, the difference in equity exposure is 76% vs. 85% of total assets for advised vs. non-advised individuals. Additionally, advised individuals hold more than twice as much fixed income as a percent of total assets, and 1.5 times as much in IRAs.

40 IXI household-level dataset of U.S. Consumer Invested Assets; Oliver Wyman Analysis; percentages may not add

up to 100% due to rounding 41 Measured as a percentage of the total portfolio assets

13%

25%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Without FA

12%

63%Asse

t Cla

ss a

s %

of A

UM

With FA

8%

80%

OtherFixed incomeEquities

13%

18%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Asse

t Cla

ss a

s %

of I

RA

71%

Without FA

8%

79%

With FA

11%

6 : 1 3 : 1 6 : 1 4 : 1

Equity : Fixed income ratio Equity : Fixed income ratio

App. 966


28

Figure 19: Assets and IRA asset class mix – Age: 45-54, Income: $0-100K, Wealth: $0-100K42

3. Use of packaged products vs. individual securities – Non-advised individuals hold 70% more of their equities exposure in individual securities compared to advised individuals

Finally, individuals with a financial advisor hold more of their equity exposure in packaged products compared to individuals without a financial advisor. Figure 20 shows individuals with a financial advisor hold approximately equal proportions of their equity exposure in packaged products and individual securities. By contrast, investors without a financial advisor hold 1.7 times as much of their equity exposure in individual securities, on average. The mix of IRA holdings again reflects this trend.

42 IXI household-level dataset of U.S. Consumer Invested Assets; Oliver Wyman Analysis

6%14%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

With FA

85%

9%

76%

Without FA

Asse

t Cla

ss a

s %

of A

UM

10%

8% 12%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Asse

t Cla

ss a

s %

of I

RA

With FAWithout FA

83%

9%

81%

7%

13 : 1 6 : 1 10 : 1 7 : 1

Equity : Fixed income ratio Equity : Fixed income ratio

OtherEquities Fixed income

App. 967


29

Figure 20: Assets and IRA product mix for households with and without a financial advisor43

These trends hold true when controlling for age, income, and wealth. Figure 21 shows the findings for one particular segment (i.e. the cohort aged 45-54 with less than $100,000 in annual income and total wealth, respectively), where the comparison is even more stark. In this case, non-advised individuals hold more than four times as much of their portfolios in individual equity securities vs. equity packaged products.

In the cohort aged 45-54 with less than $100,000 in annual income and wealth, non-advised individuals hold four times more equity exposure through individual securities compared with advised investors


up to 100% due to rounding of values

7%

13%

5%12%

8% 9%

3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

With FA

Asse

t Cla

ss a

s %

of A

UM

31%

32%

Without FA

53%

26%

0.5 : 1 1 : 1 1 : 1 2 : 1

Packaged product : Individual security Packaged product : Individual Security

OtherIndividual securities - Fixed incomeIndividual securities - Equities

Packaged product - Variable annuitiesPackaged product - Fixed incomePackaged product - Equities

10%

14%

4%

8% 8%

4%

2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

39%

40%

Asse

t Cla

ss a

s %

of I

RA

With FA

21%

50%

Without FA

App. 968


30

Figure 21: Assets and IRA product mix – Age: 45-54, Income: $0-100K, Wealth: $0-100K44

D. Staying invested in the market

Individuals with a financial advisor hold smaller cash balances – ranging from 36%-57% less than non-advised individuals for similar age and wealth cohorts

In our Retail Investor Retirement Survey, we found that individuals with financial advisors hold a smaller percentage of their non-retirement assets in cash equivalents. As shown below in Figure 22, this finding holds true across all asset and age stratums45. As cash equivalent holdings have lower real returns, individuals may potentially achieve higher long-term returns by limiting their allocation to cash.


up to 100% due to rounding of values 45 The differences observed in cash holdings between advised and non-advised households was significant at a 95%

confidence level for all segments except the group aged 65 or older with $250K-$ 1MM in assets

12%

9% 7%

6%

3%

1%1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Asse

t Cla

ss a

s %

of A

UM

With FA

12%

64%

Without FA

52%

33%

8%

11%

9% 5%

2%

1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

With FA

8%

73%

Without FA

34%

49%As

set C

lass

as

% o

f IR

A

1 : 1 4 : 1 1 : 1 6 : 1

Packaged product : Individual security Packaged product : Individual Security

OtherIndividual securities - Fixed incomeIndividual securities - Equities

Packaged product - Variable annuitiesPackaged product - Fixed incomePackaged product - Equities

App. 969


31

Figure 22: Percent of assets held in cash or cash equivalents outside of workplace retirement plans46

Again, the IXI data supports and expands upon this finding, which holds true over time for both total assets as well as retirement assets in IRA accounts across income, wealth, and age segments analyzed. For example in 2013, nearly 99% of advised households held 25% or more less cash and/or cash equivalents as a percentage of their portfolio compared to non-advised.47

Figure 23 depicts this trend for the overall population analyzed.

46 Oliver Wyman Retail Investor Retirement Survey 47 IXI account-level time series dataset of U.S. Consumer Invested Assets; Oliver Wyman Analysis

0

5

10

15

20

25

30

35

% o

f ass

ets

in c

ash

or c

ash

equi

vale

nts

Age Group

65+

29%

13%

55-64

31%

15%

35-54

30%

13%

18-34

33%

18%

Without FAWith FA

<=$100K in assets

1211

1416

1820

22

28

0

5

10

15

20

25

30

35

Age Group

65+55-6435-5418-34

Without FAWith FA

>$100K and <=$250K in assets

(55%)(52%)(57%)(45%)

% Less cash held by advised households

A B C D A B C D

% Less cash held by advised households

A

BC D A

B

C D

(33%)(45%)(36%)(43%)

App. 970


Figure 2investor

Analysisadvised (48% les(Figure 2

48 IXI acco

3: Cash hors48

s of the seginvestors h

ss), during 24).

unt-level time s

ldings as a

gment with lheld substa(44% less)

series dataset o

percent of

less than $antially less

and after t

of U.S. Consum

account as

100K in wecash as a he financia

mer Invested A

ssets for ad

ealth and inportion of to

al crisis (60%

Assets; Oliver W

vised and n

come similotal accoun% by the en

Wyman Analys

non-advised

arly shows nt assets bend of 2013)

is

32

d

that efore ).

App. 971


33

Figure 24: Cash holdings as a percent of total account assets for investors with and without a financial advisor – Segment with <$100K in wealth and income49

The finding of persistently lower cash allocations for advised investors provides strong evidence that financial advisors help individuals enter and stay invested in the market across market cycles leading, on average and over time, to better investing outcomes.

Excess cash holdings represent a drag on investment performance. However, pre-mature withdrawal of retirement account assets is an even costlier investing behavior that reduces principal and the potential benefit of compounded returns.

49 IXI account-level time series dataset of U.S; Morningstar, Oliver Wyman Analysis

0%

30%

60%

90%

120%

150%

2006 2007 2008 2009 2010 2011 2012 2013

w/o FA w/ FA

Average cash holdings (% of account assets))

Precrisis

Peak crisis

Post crisis+2

Post crisis+5

w/o FA 23% 34% 23% 23%

w/ FA 12% 19% 12% 9%

Relative change in cash holdings(indexed, 2006 = 100%)

Pre-financial crisis investors without a financial advisor held nearly 2X as much cash as advised investors

A

By 2010, cash allocations for both types of investors had returned to pre-crisis levels

However, investors with a financial advisor held nearly 50% less cash as a percent of total investable assets

C

Both types of investors increased cash holdings during the crisis

Even after accounting for a sharp drop in equity market values, investors increased cash holdings1

B

At the end of 2013, advised investors held 25% less cash vs. pre-crisis levels, while allocations investors without an FA remained constant

At year-end 2013, non-advised investors held more than 2.5 times as much of their portfolios in cash

D

A

B

C D

1 Cash allocations could have increased without any change in investor behavior due to the large decline in equity markets. We analyzed the magnitude of the this potential effect in the following manner. Average advised investor pre-crisis (2007) allocation to equities was 60% while cash holdings represented 12% of investable assets. Assuming (1) no change in portfolio holdings, (2) only equity values changed, and (3) the equities allocation performed similarly to the S&P (as measured by SPY) during the financial crisis, the 38% drop in SPY share price in 2008 could have represented at most 3.5% of the 7% point increase cash holdings, i.e. .12/(1-(0.38*0.6))-.12. The equivalent figure for non-advised is 8%, i.e. 0.24/(1-(0.38*0.66))-0.24 of the 10% point increase in cash holdings. Since actual equity allocations dropped by only 40-45% of that predicted in (3) above, the equity market decline is estimated to account for an even smaller portion of increased account cash allocations..

App. 972


34

Financial advisors help individuals avoid premature IRA distributions - 76% of heads of households that made traditional IRA withdrawals in 2013 were retired

Tax-advantaged workplace retirement plans provide the greatest benefit when individuals start saving early and continue to save and invest throughout their working years until retirement age. According to a GAO study, “Cashouts [have] the greatest ultimate impact on participants’ retirement preparedness […] Cashouts of 401(k) accounts at job separation can result in the largest amounts of leakage and the greatest proportional loss in retirement savings.”50

Approximately 9 out of 10 (88%) IRA accounts are held in a brokerage model, where an individual has access to a range of different types of advice and support from a financial advisor.51 According to ICI, IRA holders tend to keep assets in their accounts until retirement. In 2013, 76% of households that made traditional IRA withdrawals were retired. This stands in contrast with DC plan behavior, where there is a natural triggering event when individuals terminate employment. According to a Vanguard study, 38% of individuals in their twenties took cash distributions upon leaving their employer52. Moreover, individuals aged 25-34 were more than three times as likely to take a cash distribution from a 401(k) compared to an IRA when leaving a job. Different distribution rates by age cohort and account type are illustrated in Figure 25.

50 Government Accountability Office, ‘401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage

on Workers' Retirement Savings’, August 2009 51 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on

IRA Consumers’, 2011 52 Vanguard, ‘How America Saves 2013: A report on Vanguard 2012 defined contribution plan data’, June 2013

App. 973


35

Figure 25: Percentage of individuals taking cash distributions by age and plan type53

The value of remaining invested is illustrated in a worked example, shown in Figure 26, where we contrast the potential outcomes of two scenarios. In the first scenario, an individual with a $10,000 account balance takes a cash distribution 30 years prior to retirement. Assuming an early withdrawal penalty of 10%, a federal tax rate of 15% and a state tax rate of 3%, they would have $7,200 after penalties and taxes. In the second scenario, the individual rolls the same amount of money into an IRA, achieves an average annual return of 6% and is subject to the same combined state and federal 18% tax rate at retirement. In this situation, they would have $44,280 after taxes, or approximately $24,500 in current period equivalent dollars, assuming 2% annual inflation – an amount 3.4 times greater.

Figure 26: Worked example comparing a cash distribution with an IRA rollover- Illustrative

53 Butrica, Zedlewski, Issa, ‘Understanding Early Withdrawals from Retirement Accounts’, 2010

2%

10%

8%

6%

4%

0

4.0%

Perc

ent o

f peo

ple

taki

ng a

cas

h di

strib

utio

n

3.4%

3.1%

6.6%

55-58

4.5%4.8%

45-54

4.3%

7.5%

35-44

7.4%

25-34

9.7%

3.2%

0.3%

Age

IRA401(k)

Penalty or Tax Amount

Early Withdrawal Penalty (10% of withdrawal amount)

$1,000

Required Federal tax withholding $2,000

Federal tax withholding refund you should receive

$500

State tax you will owe $300

Paid$2,800

Receieved$7,200

App. 974


36

E. Periodically rebalancing asset holdings to restore desired asset allocation and risk levels – Individuals with financial advisors are 44% more likely to re-balance their portfolios at least every two years

Portfolio re-balancing is an important risk mitigation tool. For example, if an investor’s portfolio is valued at $100,000, divided equally between equities and fixed income, and the equities portion increases in value by 25% while fixed income increases by a more modest 5%, the overall portfolio value increases to $115,000. In this case, the equities allocation increases from 50% to 54% of the portfolio value, while the fixed income portion decreases from 50% to 46%. Regular re-balancing restores asset allocations to target levels to reflect investors’ risk return objectives. In our research, individuals with financial advisors rebalanced their portfolios more often than non-advised individuals. 65% of advised individuals re-balanced at least every two years, compared with 45% for non-advised individuals (a difference of 44%). This is illustrated in Figure 27.

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Ass

et V

alue

Years invested

Total assets of ~$54,000 at retirement

App. 975


37

Figure 27: Rebalancing frequency outside of DC plans54

* * *

Returning to the original question of the value of a financial advisor, the majority of individuals across wealth and age segments, as well as many small businesses, seek professional financial advice, and value their FA as a trusted advisor. We found substantial evidence that advised individuals are more sophisticated and diligent long term investors who achieve better investing outcomes.

The benefits financial advisors provide are now at risk. On April 14, 2015, the Department of Labor issued its Conflict of Interest rule proposal, a replacement for the

54 Oliver Wyman Retail Investor Retirement Survey 2014: A KS test is significant at a 95% confidence level

9%

13%

14%

19%

31%

26%34%

5%

3%

2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Perc

ent o

f res

pond

ents

Relationship Status

With FA

14%

Without FA

31%

Less frequently than every 10 years

Annually or more frequently

Every 3-5 yearsEvery 1-2 years

Every 6-10 years

Never

App. 976


38

Definition of the term “fiduciary” rule proposal withdrawn in September 2011. 55 In our 2011 study reviewing the impact of the previously proposed rule, we concluded that the Department of Labor’s proposed rule change was motivated by a laudable objective: to ensure a high standard of care toward retirement plan participants and account holders with regard to the receipt of services and investment guidance, amid an increasingly complex financial marketplace. However, we found the proposed rule was likely to have serious negative and unintended effects on the very individuals the change was supposed to help. Many stakeholders are now analyzing the technical details of the newly proposed rule, and there is growing consensus on the implications for financial services providers with regard to the prohibited transaction exemptions newly proposed, modified or absent from the proposed rule. However, with regard to the impact on individuals, regrettably we reach the same overall conclusion as in the prior study. The proposed rule change will likely have significant consequences that will adversely impact individual investors’ ability to save for retirement.

As proposed, financial advisors would be forced to withdraw workplace retirement plan set-up and support services from small businesses, due to the lack of an exception allowing providers to market to plans with fewer than 100 participants that are self-directed –many small businesses are likely to close or not open plans due to the additional administrative burden as a result. This would directly impact the 19 MM individuals who work for small businesses with fewer than 50 employees, who do not currently have access to a workplace retirement plan by reducing the likelihood these individuals will gain access to a plan in the future

Individuals with small balance accounts are likely to lose access to retirement help and support with selecting appropriate products. We previously estimated that 7 MM current IRAs would not qualify for an advisory account due to low balances56

Almost all retail investors would face increased costs (73% to 196% on average) from providers shifting clients to a fee-based advisory model. In our 2011 study, we found nearly 90% of the 23 MM IRAs analyzed were held in brokerage accounts 57

55 Definition of the Term “Fiduciary”; Conflict of Interest Rule – Retirement Investment Advice, 80 Fed. Reg. 21928,

pp. 21927-21960 (proposed Apr. 20, 2015) 56 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on

IRA Consumers’, 2011 57 Oliver Wyman, ‘Assessment of the Impact of the Department of Labor’s Proposed “Fiduciary” Definition Rule on

IRA Consumers’, 2011

App. 977


39

Individuals are less likely to open an IRA, leading to lower savings rates and increased cash-outs when changing jobs58

Unadvised individuals are likely to carry excess portfolio risk due to less diversification and less frequent re-balancing compared with advised individuals

* * *

Retirement is too important to get wrong 59. We encourage key stakeholders from the financial services industry and regulators to join together to find workable solutions that preserve individuals’ access to help and support from a financial advisor of their choosing as well as the business model and fees that best meet their needs.

58 Prior guidance from the DOL “held that recommendations to a plan participant to take an otherwise permissible

distribution, even combined with a recommendation as to how to invest distributed funds, is not fiduciary investment advice.” K&L Gates, DOL Re-Proposes Rule to make Brokers, Others, ERISA Fiduciaries (Apr. 27, 2015), http://www.klgates.com/dol-re-proposes-rule-to-make-brokers-others-erisa-fiduciaries-04-27-2015.

59 [C]onstraints on the availability of investment services that could result from the DOL’s reproposal, particularly for smaller plans or individual retirement investors, can undermine the retirement system in various ways.” Sutherland, Legal Alert: DOL Reproposes Expanded ERISA Fiduciary Definition and Revised Complex of Exemptions (Apr. 21, 2015), http://www.sutherland.com/NewsCommentary/Legal-Alerts/172823/Legal-Alert-DOL-Reproposes-Expanded-ERISA-Fiduciary-Definition-and-Revised-Complex-of-Exemptions.

App. 978


40

Survey methodology

Our small business survey had 1,216 valid complete responses by owners and HR decision makers of payroll-based businesses with between 1 and 100 employees. We employed a stratified sampling approach designed to control for the size of the business and ensure that a sufficient number of businesses were recorded that did and did not consult with financial advisors. Furthermore, we selected three company size cohorts for analysis, namely 1–9, 10–49, and 50–100 employees, based the alignment of these segments with data available on employee retirement plan access for comparison purposes. This design allowed us to isolate the impact that financial advisors have upon small businesses. Where appropriate, we report conclusions that are statistically significant at a 95% confidence level using standard methods of statistical inference.

Our retail investor survey had 4,393 valid complete responses by non-retired individuals with investments or retirement accounts. Responses were excluded from respondents who, at the time of the survey, were: under age 18; retired; not at least partially responsible for financial decision making; and non-investors, meaning they did not have at least one investment or retirement account. In addition, we excluded incomplete responses and those completed in less than 1/3 of the median time to ensure a robust data set. Any figures that we report describe this specific sub-population.

Our stratified sampling approach in this case controlled for age and income as well as the presence of a financial advisor. In designing the sample this way, we strove to control for the effects that age and income have upon investment decisions and retirement planning. However, as our sample does not match the composition of the overall population, we utilize scale factors in our analysis to correct for respondent bias, by underweighting sample responses that are overrepresented relative to the population and vice-versa. Although we sampled based upon age, income and the presence of a financial advisor, we scale our sample to the population using age, assets, and the presence of a financial advisor, as the distribution of household assets is better documented in secondary sources than the distribution of personal income. We obtained the population distribution of household age and assets for FA advised and non-FA advised households from the survey of Consumer Finances, a triennial cross-sectional survey of US families conducted by the Federal Reserve. We utilized the 2013 survey data. We report conclusions that are statistically significant at a 95% confidence level.

App. 979


41

Appendix I.

Methodology for analysis of U.S. retail investor assets

Our analysis leveraged IXI Services data containing segment-level detail on U.S. consumer invested assets. Segments were defined by specific age tiers (five), income tiers (eleven), wealth tiers (seven), advisor relationship type (Full Service Brokerage vs. Discount Brokerage) and year. For the purposes of this report, we refer to the Full Service Brokerage relationship as “with financial advisor” and the Discount Brokerage relationship as “without financial advisor.”

IXI data contained information on total segment:

Assets and IRA holdings

Asset class distribution

Number of households / accounts

We used two datasets from IXI, which were distinct in the following ways:

Dataset name 1. Household Point-In-Time 2. Account Time Series Time period 2012-2013 2006-2013 Count type Households60 Accounts 2013 Assets $5.6 TR $9.7 TR 2013 Population 21 MM households 71 MM accounts Segment criteria Only households with recorded

age, income and wealth segment Includes accounts with no recorded age

While the age segment criterion was analyzed in the Account Time Series dataset, it was ultimately eliminated to capture a broader representation of US invested assets. This is due to a data limitation whereby only 60% of accounts were associated with a specific age. All findings in this study were confirmed across all age, wealth, income, and time segments in both the Household Point-In-Time and Account Time Series datasets unless indicated otherwise.

Findings were generated by comparing the segment-level averages of the various metrics listed above between the Full Service and Discount Brokerage populations. In drawing conclusions from this granular segment-level comparison, we disregarded segments with fewer than 500 households (Household Point-In-Time) or 500 accounts

60 IXI could only aggregate account holdings from a single household within a given institution and could not aggregate households’ holdings across institutions

App. 980


42

(Account Time Series) to eliminate segments with insufficient data points. This resulted in the exclusion of 0.01%-0.04% of the population.

App. 981


43

Appendix II.

Automated solutions to address inertia in retirement plans do not guarantee optimal retirement outcomes

It has been well-documented that retirement outcomes are significantly impacted by the status quo bias that leads DC plan participants to prefer their current state both in terms of non-participation and nature of participation61. This not only affects contribution rates but also asset allocations, both with respect to rebalancing and following a risk allocation glide path to match investor risk profiles at various ages.

Standard default contribution rates do not appear to generate sufficient asset levels for retirement.

Automatic features can impact participant behavior, a notable example being auto-enrollment features which have been shown to increase plan participation by 45%.65 However, while encouraging participation is certainly a step in the right direction, according to EBRI, the most common default contribution rate within a workplace retirement plan was just 3% in 201262. This falls well short of an ideal default path to encourage sufficient retirement savings, which is suggested by Prudential as, “A 5–6% default deferral rate with a 2% annual acceleration up to a cap of at least 10–12%”65. Unfortunately, only 21% of plans had an automatic escalation feature in 201363, leading us to conclude that inertia leads many participants continue to save at sub-optimal default contribution rates.

The illustrated example shown below in Figure 28 confirms that for the average individual, a 3% savings rate results in sub-optimal retirement savings. The example utilizes the median income by age according to the US Census, which assumes that an income of approximately $36,000 at age 25 grows to an income of $58,000 at age 65. In addition, we utilize a constant 3% contribution rate consistent with the most common default rate, and 6% annual returns. These assumptions lead to a total asset value of approximately ~$220,000 at age 65, which at approximately 3.8 times the illustrative ending salary falls short of industry recommendations that suggest that individuals save 8 times their ending salary64, or approximately $460,000 in this case. In order to retire

61 Overcoming Participant Inertia: Prudential Research:

(http://research.prudential.com/documents/rp/Automated_Solutions_Paper-RSWP008.pdf) 62 EBRI September 2012 notes: (http://www.ebri.org/pdf/notespdf/EBRI_Notes_09_Sept-12.HCS-AE.pdf) 63 JP Morgan Asset Management, 2013 defined contribution Plan Sponsor survey Findings: Evolving Toward Greater

Retirement Security 64 Fidelity Investments, ‘Fidelity Outlines Age-Based Savings Guidelines to Help Workers Stay on Track for

Retirement’, September 2012, (http://www.fidelity.com/inside-fidelity/employer-services/age-based-savings-guidelines)

App. 982


44

comfortably while contributing only 3%, our individual would need to work until age 77. Conversely, contributing an annual average of 6.3% would allow for retirement by age 65.

Figure 28: Example retirement assets by year at median income, 3% contribution rate, and 6% growth

$0

$50,000

$100,000

$150,000

$200,000

$250,000

25 30 35 40 45 50 55 60 65

401(

k) a

sset

s

Age

Total asset value of

~$220,000 at age 65

App. 983


45

Report qualifications/assumptions and limiting conditions Oliver Wyman shall not have any liability to any third party in respect of this report or any actions taken or decisions made as a consequence of the results, advice or recommendations set forth herein.

This report does not represent investment advice or provide an opinion regarding the fairness of any transaction to any and all parties. This report does not represent legal advice, which can only be provided by legal counsel and for which you should seek advice of counsel. The opinions expressed herein are valid only for the purpose stated herein and as of the date hereof. Information furnished by others, upon which all or portions of this report are based, is believed to be reliable but has not been verified. No warranty is given as to the accuracy of such information. Public information and industry and statistical data are from sources Oliver Wyman deems to be reliable; however, Oliver Wyman makes no representation as to the accuracy or completeness of such information and has accepted the information without further verification. No responsibility is taken for changes in market conditions or laws or regulations and no obligation is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof.

App. 984


Oliver Wyman, Inc.

Oliver Wyman 1166 Avenue of the Americas, 29th floor New York, NY 10036 Tel: 1 (212) 541-8100 Fax: 1 (212) 541-8957 www.oliverwyman.com

App. 985


APPENDIX 3

App. 986


COMMENT LETTER TO THE DEPARTMENT OF LABOR

An Evaluation of the Department’s Impact Analysis of Proposed Rules Relating to Financial Representative Fiduciary Status

COMPASS LEXECON JULY 20, 2015

App. 987


Table of Contents

I. BACKGROUND AND SUMMARY OF OPINIONS.......................................................... 1

II. THE DOL’S ANALYSIS OF PURPORTED BENEFITS IS OVERSTATED AND

UNRELIABLE ..................................................................................................................... 4

A. THE DOL MISAPPLIES FINDINGS FROM THE ACADEMIC LITERATURE ........... 5

B. THE DOL IGNORES OTHER FINDINGS FROM THE ACADEMIC LITERATURE 10

C. THE DOL ASSUMES BENEFITS IT PURPORTS TO ESTIMATE.............................. 11

D. TAKE-AWAY ON THE DOL’S PURPORTED BENEFIT ANALYSIS ....................... 13

III. THE DOL’S ANALYSIS OF PURPORTED COSTS IS LIKELY UNDERSTATED AND

UNRELIABLE ................................................................................................................... 13

A. THE DOL TOO READILY DISMISSES COSTS LIKELY TO BE INCURRED BY

MARKET PARTICIPANTS, INCLUDING THE DOL ITSELF .................................... 14

B. THE DOL IMPROPERLY DISMISSES COSTS RELATED TO OTHER

UNINTENDED CONSEQUENCES ................................................................................ 15

C. THE DOL’S COST ANALYSIS IS FLAWED IN OTHER WAYS THAT RENDER IT

UNRELIABLE. ................................................................................................................ 21

IV. CONCLUSION ................................................................................................................... 23

App. 988


1

I. BACKGROUND AND SUMMARY OF OPINIONS

1. On April 21, 2015, the Department of Labor (“DOL”) released a “Regulatory Impact

Analysis” in support of certain proposed amendments to the rules that identify when a financial

representative is deemed to be a fiduciary, as defined in the proposed regulations.1 The DOL

claimed that its proposed amendments “would deliver to IRA investors gains of between $40

billion and $44 billion over 10 years,” and that these gains “would far exceed the proposal’s

compliance costs, which are estimated to be between $2.4 billion and $5.7 billion over 10

years.”2

2. Compass Lexecon was asked by counsel for Primerica, Inc. (“Primerica”) to review the

DOL’s Regulatory Impact Analysis and to comment on whether it provides a satisfactory and

reasonable economic assessment of the likely costs and benefits associated with the proposed

amendments.3 We conclude that it does not. Specifically, we find that the DOL’s analysis

grossly overstates the benefits it purports to measure. Moreover, the DOL’s analysis likely

understates the costs of the proposed regulation by failing to properly analyze potential

unintended consequences. Thus, as a matter of economics, the DOL’s Regulatory Impact

1. Department of Labor (2015) “Fiduciary Investment Advice: Regulatory Impact Analysis,” April

14, 2015 (“DOL Impact Analysis”). 2. DOL Impact Analysis, at 8. The DOL states: “The Department expects the proposal to deliver

large gains for retirement investors. Because of data limitations of the academic literature and available evidence, only some of these gains can be quantified. Focusing only on how load shares paid to brokers affect the size of loads IRA investors holding load funds pay and the returns they achieve, the Department estimates the proposal would deliver to IRA investors gains of between $40 billion and $44 billion over 10 years and between $88 and $100 billion over 20 years.” The DOL goes on to state, “The Department nonetheless believes that these gains alone would far exceed the proposal’s compliance costs, which are estimated to be between $2.4 and $5.7 billion over t10 years, mostly reflecting the cost incurred by new fiduciary advisers to satisfy relevant PTE conditions.” Given the DOL’s focus on the $40 to $44 billion range, this comment letter also focuses its discussion relating to benefits on the DOL’s analysis of the potential benefits it expects to achieve within IRA investment in front load mutual funds. However, we note that our concern about the reliability of the DOL’s analysis showing $40 to $44 billion also apply to the DOL’s presented in Table 3.4.4-1 and Table 3.4.4-2.

3. A description of Compass Lexecon is contained in the Appendix.

App. 989


2

Analysis does not constitute a reliable cost-benefit analysis. Moreover, the DOL’s conclusion

that the benefits of the proposed amendments exceed the costs is not supported by reliable

economic analysis.

3. With respect to the purported benefits, the DOL’s analysis relies upon a misapplication of

findings from the academic literature and a number of vague and unsupported assumptions

which call into question its reliability. For example, the DOL estimates a purported dollar

benefit estimate relating to IRA investor holdings in front-load mutual funds. This estimate

relies critically on a result from a 2013 academic study that explored investment and

performance in mutual funds with front-end loads conducted by Christoffersen, Evans and Musto

(“CEM”).4 CEM document an empirical relation between fund flows and performance of front-

load mutual funds sold by unaffiliated brokers and the amount of excess load shared with

unaffiliated brokers. However, the DOL misapplies CEM’s findings by incorrectly attributing

fund underperformance to the total level of the of load fee shared with unaffiliated brokers as

opposed to the excess load fee shared. Moreover, the DOL goes on to also attribute

underperformance to funds sold by captive brokers, even though CEM did not find that these

funds underperformed.

4. With respect to the potential costs, the DOL’s analysis relies upon a number of vague and

unsupported assumptions that call into question its reliability. For example, the DOL only offers

a dollar cost estimate relating to the most obvious categories of direct costs. The DOL routinely

speculates that its estimate is likely overstated but ignores or dismisses additional costs

associated with many possible unintended consequences of the proposed amendments.

4. Susan E. K. Christoffersen, Richard Evans, and David K. Musto (2013) “What Do Consumers’

Fund Flows Maximize? Evidence from Their Brokers’ Incentives,” Journal of Finance 58(1):201-227.

App. 990


3

Examples of unintended consequences include the possibility of higher investor paid fees and

lower overall savings by IRA investors.

5. Overall, the DOL’s Impact Analysis does not provide the public with a reliable estimate

of the net benefit (if any) of the proposed regulatory amendments. The DOL’s misapplication of

CEM’s results leads it to overstate, likely by a large amount, the benefit (if any) of the proposed

amendments. Moreover, whereas the DOL admits that the $40 billion to $44 billion may not be

realized, it provides no reliable economic analysis to demonstrate how the proposed amendments

would eliminate or mitigate the underperformance it claims exists. The DOL’s reliance on vague

and unsupported assumptions and its failure to consider appropriately costs associated with

unintended consequences likely lead to an understatement of the true costs of the proposed

amendments.

6. A broad consensus exists among economists, including those with a variety of different

perspectives on the proper role for government regulation, that accurate cost-benefit analysis is

crucial to effective policymaking and promotes democratic ends. For example, Professor Cass

Sunstein, who until recently served as administrator of the Office of Information and Regulatory

Affairs, wrote:

Cost-benefit requirements are of course most easily justified on economic grounds, as a way of promoting economic efficiency and thus eliminating unnecessary and wasteful public and private expenditures. But cost-benefit requirements also have strong democratic justifications. Indeed, they can be understood as a way of diminishing interest-group pressures on regulation and also as a method for ensuring that the consequences of regulation are not shrouded in mystery but are instead made available for public inspection and review. Some of the strongest arguments for cost benefit requirements are not so much economic as democratic in character. 5

5. Cass R. Sunstein (1996) “The Cost-Benefit State,” University of Chicago Law School Coase-

Sandor Working Paper Series in Law & Economics, at 4. See also Kenneth J. Arrow, et al. (1996) “Benefit-Cost Analysis in Environmental, Health, and Safety Regulation: A Statement of Principles,” American Enterprise Institute, The Annapolis Center, and Resources for the Future, at 3 (“Benefit-cost analysis should play an important role in informing the decisionmaking process, even when the information on benefits, costs, or both is highly

App. 991


4

7. A failure to accurately measure costs and benefits has the potential to cause waste, to

result in misdirected resources, and to harm the basic functions of government in society.

Historically, the importance of accurate cost-benefit analysis has been most noted with respect to

environmental, health, and safety regulations, but there is today growing recognition that the

same principles apply to financial regulations. For example, Eric Posner, the Kirkland and Ellis

Distinguished Service Professor of Law and the Arthur and Esther Kane Research Chair at the

University of Chicago Law School concludes:

The importance of developing methods for benefit-cost analysis for financial regulation can scarcely be overstated. In recent years, courts have awakened to the fact that many such regulations lack a sound economic basis and have started blocking them.6

II. THE DOL’S ANALYSIS OF PURPORTED BENEFITS IS OVERSTATED AND UNRELIABLE

8. The DOL’s $40 billion to $44 billion estimate of purported benefits is overstated and

fatally flawed for at least three reasons:

The DOL misapplies findings from the academic literature in its estimate of the amount

of underperformance potentially associated with conflicted advice.

o First, the DOL incorrectly asserts that the level of underperformance associated with

purportedly conflicted advice in front-load mutual funds is proportional to the total

uncertain … The estimation of benefits and costs of a proposed regulation can provide illuminating evidence for a decision, even if precision cannot be achieved because of limitations on time, resources, or the availability of information.”) See also W. Kip Viscusi (1996) “Economic Foundations of the Current Regulatory Reform Efforts,” Journal of Economic Perspectives 10(3):119-34, at 120 (“Unless mechanisms exist for placing bounds on our risk reduction efforts, we can end up pursuing policies of diminishing marginal impact and diverting resources from more productive uses.”)

6. See, e.g., Eric Posner and E. Glen Weyl (2013) “Benefit-Cost Analysis for Financial Regulation,” American Economic Review 103(3): 393-397, at 397

App. 992


5

load that goes to the broker when the literature cited demonstrates that

underperformance (if any) is only related to the excess load that goes to the broker.

o Second, the DOL incorrectly asserts that front-load mutual funds sold by captive

brokers underperform as a result of conflicted advice when the literature cited does

not find evidence of underperformance.

The DOL ignores findings from the academic literature suggesting that underperformance

may be limited to certain investment categories (e.g., U.S. equity, bonds, foreign equities,

etc.) of mutual funds and need not be present in all mutual funds.

The DOL assumes that the proposed regulatory amendments will mitigate or eliminate

underperformance without providing any reliable economic analysis demonstrating that

such an outcome is likely.

A. THE DOL MISAPPLIES FINDINGS FROM THE ACADEMIC LITERATURE

9. The DOL performs a simulation of expected IRA-related savings amounts over the 10

year investment horizon beginning in 2017 and ending in 2026 to calculate the purported $40

billion to $44 billion in expected gains.7 Specifically, the simulation compares aggregate IRA-

related savings in front-load mutual funds under a “Baseline Scenario” without the proposed

regulatory amendments to various “Alternative Scenarios” which make different assumptions as

7. DOL Impact Analysis, at 113. The DOL also extended the analysis to 20 years, out to 2036. The

same concerns we raise below apply equally to this longer-duration estimate. The DOL also claims that there may be other benefits beyond those quantified, including “improvements in the performance of IRA investments other than mutual funds and potential reductions in excessive trading and associated transaction costs and timing errors (such as might be associated with return chasing).” Id., at 235. However, the DOL has provided no support for any of these claims, nor any quantification of the claimed benefits. As discussed below, one likely result of the proposed amendments would be to push some IRA investors into less tax-advantaged savings accounts. IRAs, unlike taxable savings accounts, impose a substantial penalty for early withdrawal, and as a consequence, investors in taxable savings accounts may have weaker incentives to resist early withdrawal. Therefore, there are plausible reasons why the proposed amendments could have the opposite effect as claimed by the DOL, namely, to incentivize early withdrawal of retirement savings, and the loss of subsequent compounding of returns.

App. 993


6

to the benefits of the regulatory amendments. The $40 billion to $44 billion in expected savings

is calculated as the difference in the predicted total IRA related savings in front-load mutual

funds between two of the Alternative Scenarios and the Baseline Scenario.

10. The difference in IRA-related savings in front-load mutual funds results from the DOL’s

assumption that investors will earn higher investment returns in the Alternative Scenarios than in

the Baseline Scenario. For example, the DOL assumes that, if the proposed amendments are

finalized, IRA investors’ front-load mutual fund holdings will experience investment returns

between 5.17 percent and 5.91 percent per annum under the Alternative Scenarios. However,

absent the regulatory amendments, the DOL assumes that IRA investors’ holdings will only

grow at rates between 5.07 percent and 5.46 percent per annum.8

11. The DOL rationalizes this difference in returns by appealing to the results from a

regression analysis published in a 2013 academic paper by CEM. Specifically, the DOL asserts:

An estimate from CEM suggests that for every 100 basis points of the load that go toward an unaffiliated broker’s load share, an IRA investor can expect to experience a decrease in performance of 49.7 basis points. For every 100 basis points of the load that go toward a captive broker’s load-share, an IRA investor can expect to experience a decrease in performance of 14.5 basis points.9

12. Next, the DOL weights the 49.7 basis points and 14.5 basis points estimates by what it

claims are the market shares of overall investment in front-load mutual funds sourced from

unaffiliated and captive brokers. The DOL concludes that each 100 basis points in the amount

of load received by a broker is associated with a weighted average reduction of 44.94 basis point

8. DOL Impact Analysis, at 105 & 113. The DOL analyzes three Alternative Scenarios. As part of

its third scenario, the DOL speculates that, as consequence of the proposed amendments, “loads paid by investors immediately fall to zero.” Id., at 104. However, the DOL immediately discounts the likelihood of this outcome, and the results of this scenario are not a part of the DOL’s conclusion that the benefits of the proposed amendments are $40 billion to $44 billion.

9. DOL Impact Analysis, at 114.

App. 994


7

in IRA returns.10 The DOL then uses this 44.94 basis point estimate as an input in its calculation

of the increase in the return performance the DOL assumes will result from the proposed

amendments. Thus, the reliability of the 44.94 basis point estimate and the implementation of

that estimate in the DOL’s benefit calculation is a critical component of the DOL’s analysis.

13. The DOL applies the 44.94 basis point estimate to its estimate of the total load that goes

toward the broker’s share to determine the amount of underperformance to be used in its

simulation study.11 Specifically, the DOL assumes that front-load mutual funds will experience

44.94 basis points in improved performance as a result of the proposed regulatory amendments

for every 100 basis points of total load that goes toward the broker. For example, in 2017, the

DOL estimates that the average total load that goes toward the broker is 134 basis points. In the

Baseline Scenario, the DOL assumes that new investment in 2017 into front-load mutual funds

will result in underperformance of 60.22 basis points – 134 basis points times 44.94 basis points

divided by 100 equals 60.22 basis points. The DOL assumes that new investments made under

the Alternative Scenarios will not experience this 60.22 basis point in underperformance because

of the proposed regulatory amendments. The DOL attributes the difference to a purported

benefit.

14. However, a review of CEM reveals that CEM’s point estimates of 49.7 and 15.4 basis

points are associated with the excess load that goes toward a broker’s load share and not the total

load that goes toward the broker’s load share.12 Excess load is defined by CEM as the load

10. DOL Impact Analysis, at 114. 11. The DOL’s estimates of the total load that goes toward the brokers share are provided in DOL

Impact Analysis, at Table 3.4.1-1 in columns (B) and (C). 12. See, for example, Christoffersen, Evans, and Musto (2013) op. cit., at 226 (Table V, entitled

“Future Returns and Excess Load Paid to Broker”). See also, for example CEM at 225 quoted herein for exposition: “Do the funds that pay brokers more subsequently perform better or worse? To address this question we run multiple regressions with the excess load paid to the broker and excess revenue sharing explaining performance over the next 12 months.”

App. 995


8

received by the broker, net of a baseline load amount for funds in the same category (e.g.,

“Equity,” or “Fixed Income”), and with similar attributes (e.g., size of total load, mutual fund

family size, or fund size).13 CEM’s focus on excess load reflects a hypothesis that a poorer-

performing fund may be able to compete by offering brokers additional load payments relative to

otherwise similar funds, not any claim that all load payments to brokers reflect lower returns.14

15. Thus, the DOL misapplies its 44.94 basis point estimate derived from CEM to its

estimate of the total load that goes toward the broker’s share as opposed to an estimate of the

excess load that goes toward the broker’s share as originally estimated by CEM. This

misapplication of CEM results in an overstatement of the purported benefits actually estimated.

To see why, consider the following example. Suppose a certain mutual fund in 2017 charges 164

basis points in a front-end load and that the fund shares 134 basis points with a broker as

estimated by the DOL.15 CEM’s regression analysis applies only to the amount of excess in load

fees shared with the broker relative to similar mutual funds. For example, if other funds similar

to the fund in question levy an average of 150 basis points in front-end load fees and pay 122

basis points to unaffiliated brokers, then the excess load shared for the fund in question (relative

to other funds) is only 12 basis points (134 basis points minus 122 basis points equals 12 basis

points of excess load shared).16 Using a proper estimate of excess load shared compared to the

total load shared results a reduction in the estimate amount of underperformance from the 60.22

13. Christoffersen, Evans, and Musto (2013), op. cit., at 216-218. 14. Indeed, CEM state “Flows and returns vary over time and across funds for many reasons, and

these reasons could also be important for broker payments. For example, flows, payments, and returns could all be higher for equity funds.” Christoffersen, Evans, and Musto (2013), op. cit., at 216.

15. This example is modeled after the DOL’s prediction that the baseline average load paid by IRA holders will be 164 basis points and the baseline average load share paid to brokers will be 134 basis points in 2017. See DOL Impact Analysis at 113.

16. For ease of exposition, we refer to the load predicted using CEM’s regression model as the average load paid by similar funds. Technically speaking, the proper implementation would be to use CEM’s regression model to fit a predicted load and then to derive the excess load by subtracting the predicted load from the actual load.

App. 996


9

basis points assumed by the DOL to only 5.39 basis points—12 basis points times 44.94 divided

by 100 equals 5.39. That is, the DOL’s misapplication overestimates the amount of

underperformance—and hence, the gains from the proposed amendments—by more than a factor

of 11 in this example.

16. Because the DOL applies the 44.94 basis point figure to the total load that goes toward

the broker, the DOL’s estimate of the improvement in return performance assumed to follow the

implementation of the proposed amendments is dramatically overstated. Moreover, the

overstatement in the improvement in return performance is roughly proportional to the estimated

dollar amount of purported benefits because the vast majority of the estimated benefits are

derived from the assumed improvement in performance.

17. While the actual overstatement of the gains from the proposed amendments would vary

from the example above depending on the amount by which a fund’s total broker load payments

constitute an excess load shared, it is guaranteed that the overstatement is large. This is because

an individual fund’s excess loads are defined relative to the total loads of other funds. Thus,

only some funds can even have excess loads, and therefore, only some funds can suffer reduced

performance as a result of the alleged conflicts of interest. However, the DOL implicitly

assumes that all front-loads experience excess loads when, as a matter of statistics, as many as

half of the funds analyzed by CEM may be expected to lack the requisite excess load.

18. Separately, the DOL also misapplies the findings of CEM in attributing a 14.5 basis point

reduction in investment performance to mutual funds that are sold by captive brokers. (As noted

above, the 14.5 basis point figure is used by the DOL as part of the calculation in deriving the

critical 44.94 basis point assumption.) While it is true that the point estimate related to captive

brokers in CEM’s regression is 14.5 basis points, this point estimate is not statistically different

App. 997


10

from zero – a finding commented on directly by CEM but ignored by the DOL.17 That is,

CEM’s results indicate that they did not find reliable statistical evidence of underperformance

within captive broker front-load funds. The DOL ignores this finding and instead simply

assumes that this underperformance exists.

19. Moreover, other evidence in CEM further demonstrates the unreliability of the DOL’s

application of the 14.5 basis points. In particular, CEM demonstrate that funds sold by captive

brokers do not exhibit increased inflows as a result of load sharing arrangements—suggesting the

conflicted advice does not play a role in investments recommended by captive brokers. In fact,

CEM report that excess load payments to captive brokers reduce fund inflows.18 The fact that

CEM do not find evidence that excess load contribute to captive broker fund inflows is entirely

inconsistent with the DOL’s assumption that load-sharing agreements in captive brokered funds

incentivize captive brokers to steer customers toward these funds.

B. THE DOL IGNORES OTHER FINDINGS FROM THE ACADEMIC LITERATURE

20. The DOL asserts that other literature is consistent with the CEM results in “direction and

magnitude” 19 but this assertion is misleading. For instance, another article cited by the DOL,20

by Bergstresser, Chalmers, and Tufano (2009) (“BCT”), concludes that while broad U.S. equity

and bond funds underperform relative to direct-marketed U.S. equity and bond funds over a

particular period of time, there is only mixed evidence of underperformance in foreign equity

17. Christoffersen, Evans, and Musto (2013) op. cit., at 228 (“the coefficient on captive brokerage is

not statistically significantly different from zero”). 18. Christoffersen, Evans, and Musto (2013), op. cit., at 220 (Table III). 19. DOL Impact Analysis, at 118. 20. DOL Impact Analysis, at 95.

App. 998


11

funds and no evidence of underperformance in money market funds.21 If the results of BCT

apply to front-load mutual funds, then a potentially large subset of front-load funds examined by

the DOL may not experience the underperformance assumed by the DOL. If so, then once again

the DOL has overestimated the prevalence of underperformance even with unaffiliated brokered

funds and by doing so, the DOL potentially further overstates the benefits of the proposed

amendments.

C. THE DOL ASSUMES BENEFITS IT PURPORTS TO ESTIMATE

21. Notwithstanding the considerations described above, which all render the DOL benefit

analysis unreliable and overstated, the critical question on the table is not analyzed by the DOL.

Namely, would the proposed amendments mitigate or eliminate the underperformance, if any,

experienced within front-load mutual funds that share excess loads with brokers? This question

is central to the issue at hand given that the vast majority of the purported gains quantified by the

DOL relating to front load mutual funds, even in the second scenario, result from an assumption

by the DOL that the amendment will increase returns in front-load mutual funds.22

22. As noted above, the benefit estimated by the DOL derives from their assumption that the

proposed regulatory amendments will mitigate or eliminate underperformance in front-load

mutual funds. Importantly, the DOL fails to provide any analysis to demonstrate how the

amendments in question will achieve this outcome. Instead, the DOL only suggests that mutual

21. Bergstresser, Chalmers, and Tufano (2009) “Assessing the Costs and Benefits of Brokers in the

Mutual Fund Industry,” Review of Financial Studies 4129–4156, at 4138-9 (Table 3) and the discussion at 4140-1. 22. DOL Impact Analysis, at 105 (“Under the second reform scenario, the effect on investment

performance constitutes approximately 90 percent of the estimated gain.”) In addition, under certain Alternative Scenarios, the DOL also assumes that IRA investors will experience the additional benefit of paying lower total loads due to the proposed amendments (DOL Impact Analysis, at 105). This claim is entirely unsupported by any reliable analysis. Notwithstanding the lack of support, the DOL assumes includes this secondary benefit in its estimate of $40 billion to $44 billion.

App. 999


12

funds will in some way be more strongly incentivized to “invest in performance” if advisers’

conflicts of interest are ameliorated.23 It is unclear what the DOL means by investing in

performance, but in any case, the DOL’s impact statement includes no analysis or any reference

to other literature demonstrating that funds do not currently attempt to maximize performance,

that they could make additional investments that would increase performance materially, or

where the money for this additional investment would come from.

23. Moreover, it is unclear whether the DOL believes that this increase in performance would

be pervasive throughout the industry, suggesting that even firms that do not underperform today

will improve in performance, or whether the increase would be limited to only those funds that

currently underperform. In the case of the former, this assumption borders on irrational. If it is

the latter, the DOL analysis fails to identify a reasonable mechanism by which current

underperforming funds will be disciplined to improve performance. While one potential form of

discipline could come from a shift in financial advisers’ tendencies to recommend

underperforming funds, this disciplining mechanism can only work if (1) IRA investors consult

with financial representatives, (2) these representatives advise them to reallocate their

investments, and (3) the investors follow that advice. However, the DOL has provided no study

documenting the frequency with which investors consult with financial professionals or the

frequency with which those professionals provide guidance that is followed.

24. Moreover, and perhaps most importantly, none of the literature cited by the DOL claims

that the proposed amendments or any similar policy would lead to higher investment returns.

Simply stated, the literature cited by the DOL does not support its speculative conclusions.

23. DOL Impact Analysis, at 115.

App. 1000


13

D. TAKE-AWAY ON THE DOL’S PURPORTED BENEFIT ANALYSIS

25. Overall, the DOL’s purported benefit analysis suffers several flaws: it misapplies

findings from the academic literature used to substantiate its claims; it ignores findings in the

literature indicating underperformance may not be as widespread as suggested by the DOL; and

it assumes the benefits it purports to estimate. Each of these flaws is critical and leads to the

conclusion that the DOL’s benefit analysis is unreliable and overstates the benefits purported to

be measured. Perhaps telling of overstatement, the DOL also repeatedly speculates that a

substantial portion of these gains, such as 75 percent or 50 percent, will be realized.24 To date,

the DOL has not provided any analysis to rule out the possibility that none of the gains it

envisions will actually be realized.25

III. THE DOL’S ANALYSIS OF PURPORTED COSTS IS LIKELY UNDERSTATED AND UNRELIABLE

26. The DOL’s $2.4 billion to $5.7 billion estimate of purported compliance costs is most

likely understated and fatally flawed for at least three reasons:

The DOL only estimates the most direct and obvious costs, while improperly dismissing

other costs likely to be incurred by market participants, including the government.

The DOL improperly dismisses costs likely to be incurred due to unintended

consequences.

The DOL routinely relies on assertions about potential cost levels when reliable data

analysis is required.

24. DOL Impact Analysis, at 8, 101-2, 106, & 216. 25. As noted previously, our concerns about the reliability of the DOL’s analysis showing $40 to $44

billion also apply to the DOL’s presented in Table 3.4.4-1 and Table 3.4.4-2.

App. 1001


14

A. THE DOL TOO READILY DISMISSES COSTS LIKELY TO BE INCURRED BY MARKET PARTICIPANTS, INCLUDING THE DOL ITSELF

27. The DOL estimates costs of the proposed amendments in four specific categories: “Firm

Costs,” “E&O Insurance,” “Switching/Training Costs,” and “Additional PTE/Exception

Costs.”26 According to the DOL, the total cost of compliance with the proposed amendments

over 10 years in these four categories is expected to be between $2.4 billion and $5.7 billion, a

range which reflects two different scenarios regarding “Firm Costs” and two different assumed

discount rates over the 10 year period.27 However, the DOL dismisses or completely ignores the

likelihood of unintended consequences from the proposed amendments that are likely to be

incurred by market participants that could substantially increase costs.

28. In describing its cost estimates, the DOL repeatedly suggests that the estimates are likely

to overstate the actual costs of the proposed amendments, but only rarely mentions any reasons

why its estimates might understate the actual costs of the proposed amendments.28 Importantly,

26. DOL Impact Analysis, at 178. 27. DOL Impact Analysis, at 178. 28. See, e.g., DOL Impact Analysis, at 157-8 (“The Department believes the higher end of the

estimated cost range represents an over-estimate, because it implicitly assumes that existing business models will change only as necessary to come into compliance, and will retain their existing market shares, when in fact new, more cost-effective business models are already gaining market share, and the new proposal is likely to encourage such market improvements … The lower end of the estimated range incorporates lower available bases, but should not be interpreted as a lower bound because it likewise neglects such ongoing market improvements and the new proposal’s positive effects thereon”); DOL Impact Analysis, at 164 (“Scenario A likely overstates the costs of the proposed regulations and exemptions by a substantial margin. Scenario B is a more reasonable estimate, but probably also overstates the costs because of the flexible standards-based approach of the Department’s new proposal, which would enable firms to comply in the most cost-effective way in light of their current practices and systems”); DOL Impact Analysis, at 166 (“As discussed above even these estimates are believed to be overestimates, possibly by a large margin”); DOL Impact Analysis, at 165 (“[U]sing the IAA ration could lead to an over-estimate of small firms costs, particularly for start-up costs”); DOL Impact Analysis, at 167 (“Subsequent year costs could be even lower as firms already conduct training of their staff”); DOL Impact Analysis, at 174 (“[S]ome of these costs would be offset by firms and individuals that would no longer be required to register as BDs or their representatives”); DOL Impact Analysis, at 215 (“Much of the estimated compliance cost is associated with satisfaction of PTE conditions. The number of advisers who will take advantage of the relevant PTEs is uncertain, however. Some advisers may find it more advantageous to simply avoid PTs. The Department has aimed to err on the side of overestimating the compliance costs”).

App. 1002


15

the DOL repeatedly dismisses other potential categories of costs likely to be incurred by firms

and employees in the industry, including those associated with call centers,29 creating or

updating contracts,30 and search and training for advisers left unemployed.31 The DOL also

dismisses any costs imposed on financial product providers32 and costs paid by the government

to implement and enforce the proposed regulations.33

B. THE DOL IMPROPERLY DISMISSES COSTS RELATED TO OTHER UNINTENDED CONSEQUENCES

29. In contrast with the DOL’s assumption of no costs for the proposed amendments beyond

those that are immediate and obvious, the academic literature on regulation demonstrates that

well-meaning regulations very frequently have important unintended consequences that lead to

additional costs (and/or reduced benefits) relative to what was expected.34 Unintended

consequences are even more likely—and potentially more costly—in the case of financial

regulation because financial markets serve as an important conduit for the efficient allocation of

resources throughout the economy, and therefore touch many other markets. As one study noted,

“The history of U.S. financial regulation, in many respects, is a history of unanticipated

29. DOL Impact Analysis, at 175. 30. DOL Impact Analysis, at 176. 31. DOL Impact Analysis, at 176, 227 32. DOL Impact Analysis, at 176-7. 33. DOL Impact Analysis, at 215. 34. Some famous examples of unintended consequences leading to additional costs in the literature

include: Richard A. Posner (1974) “The Social Costs of Monopoly and Regulation,” Journal of Political Economy 83(4):807-27; Sam Peltzman (1975) “The Effects of Automobile Safety Regulation,” Journal of Political Economy 83(4):677-726; Robert W. Crandall and John D. Graham (1989) “The Effect of Fuel Economy Standards on Automobile Safety,” Journal of Law & Economics 32(1):97-118; and John DiNardo and Thomas Lemieux (2001) “Alcohol, Marjiuana, and American Youth: The Unintended Consequences of Government Regulation,” Journal of Health Economics 20(6):991-1010.

App. 1003


16

consequences.”35 In this case, the proposed amendments would impact the provisioning of IRAs,

which the DOL projects would involve approximately $9 trillion in individual savings.36

30. An important category of potential unintended consequences for any regulation that

imposes costs on firms (as the DOL admits the proposed amendments do) is higher prices

charged to consumers by these firms and the reduced purchasing. Basic economics indicates that

any regulation that increases an industry’s costs of serving consumers will lead to higher prices

and lower output.37

31. All else equal, economic theory predicts that fees charged to investors will rise when

additional costs are imposed on firms in the industry for at least two reasons. First, the costs

imposed on advisers and advisory firms operating in the industry will be passed on (at least in

part) to investors in the form of higher fees.38 Moreover, higher costs can cause firms to exit the

industry or to exit certain segments of the industry, leading to a weakening of the competition

that otherwise would drive down fees. As a result, investors facing higher fees would, in turn,

likely invest less, or alternatively select other forms of investment that do not have these higher

costs and potentially are less tax advantaged.

32. For example, we understand that participants in this rulemaking have indicated that the

proposed regulatory amendments will cause certain firms within the industry to significantly

curtail their efforts to attract IRA investors with balances below $25,000. If so, then there would

be less competition in the industry for investors that wish to start a new IRA or roll-over another

retirement account with a balance below $25,000. In this instance, fees to these customers may

35. Charles K. Whitehead (2012) “The Goldilocks Approach: Financial Risk and Staged Regulation,”

Cornell Law Review 97:1267-1308, at 1268. 36. DOL Impact Analysis, at 115 (citing Cerulli Associates, “Retirement Markets 2014.”)

37. Hal R. Varian (2014) Intermediate Microeconomics, 9th ed., W. W. Norton & Co., at 438-9. 38. Jeremy I. Bulow and Paul Pfleiderer (1983) “A Note on the Effect of Cost Changes on Prices,”

Journal of Political Economy 91(1):182-5.

App. 1004


17

increase. Moreover, the reduction in client service could result in a reduction in the amount of

money that today’s consumers save in tax deferred IRA accounts. As noted in a separate

Compass Lexecon comment, investors that are forced to abandon IRAs as saving vehicles may

face an effective tax increase of 32.9 percent or more.39 But more generally, given the size of

total IRA investments in the U.S., even a small reduction in the total amount of IRA investment

as a consequence of higher fees has the potential to generate costs to investors that would dwarf

the DOL’s estimates of the benefits of the proposed amendments.40

33. The DOL only briefly addresses these potentially enormous costs associated with lost

savings. First, the DOL speculates that new, competitive advisory businesses may enter the

industry due to the proposed amendments, thus eliminating any lost savings.41 However, this

claim is inconsistent with commonly accepted economic theory, which teaches that increased

costs can create barriers to entry that reduce, not increase, entry by potential competitors.42 In

this context, the proposed amendments would, as the DOL admits, impose additional costs on

firms. Larger firms may be able to achieve profitability even with these new costs because of

their scale of operations. However, smaller firms may be more likely to struggle, and hence,

more likely to exit the industry. At the same time, new entrants are typically smaller firms, and

the increased costs imposed by the proposed amendments similarly affect their incentives to

39. Compass Lexecon (2015) “Comment to the Department of Labor on a Proposed Rule Regarding

Investment Adviser Fiduciary Status: Tax Consequences to IRA Investors,” July 20, 2015 at 2. 40. Even assets that remained in 401(k)s or other company plans as a consequence of higher IRA

adviser fees could reflect losses due to the proposed amendments, since academic literature indicates these accounts are often highly undiversified, whereas IRAs allow a broader range of investments, leading to greater diversification benefits. Schlomo Benartzi (2001) “Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock,” Journal of Finance 56(5):1747-64.

41. DOL Impact Analysis, at 222 & 228. 42. Dennis W. Carlton and Jeffrey M. Perloff (2005) Modern Industrial Organization, 4th ed., Pearson

Addison-Wesley, at 79-80.

App. 1005


18

enter the industry. These effects reduce competition, to the detriment of the IRA investors the

DOL seeks to protect.43

34. The DOL also suggests that any reduction in investment due to the costs imposed by the

proposed amendments might be offset by increased investment due to greater investor trust in

fiduciary advisers.44 This claim seems to reflect a notion that, while the proposed regulations

will reduce the supply of advice, they will also increase the demand for advice from investors

who recognize the better value provided by unconflicted advisers. Such a notion is at least

ironic, given that the entire rationale for the proposed amendments is that investors are currently

subject to “abuse” by apparently being too reliant on conflicted advice.45 That is, the DOL

argues the regulation is needed because investors are too reliant on their financial advisers, but at

the same time, the regulation would increase that reliance, driving investors to demand even

more advice.

35. Moreover, the DOL claims that “retail investors generally and IRA owners in particular

… cannot effectively assess the quality of the investment advice they receive or even the

investment results they achieve … Individuals over the age of 55 often ‘lack even a rudimentary

understanding of stock and bond prices, risk diversification, portfolio choice, and investment

fees.’”46 However, the DOL fails to explain why the same unsophisticated investors the DOL

43. The DOL describes at length its view that so-called “robo-advisers” will, over time, gain market

share from traditional advisory firms. The DOL notes that robo-advisers have lower costs and, at least to date, offer largely unconflicted advice. DOL Impact Analysis, at 230-1. The DOL speculates that, absent the proposed amendments, robo-advisers may become conflicted through competition with traditional advisory firms, which it claims provide more conflicted advice. Id., at 232. The DOL does not explain why the growth of these allegedly unconflicted robo-advisers does not demonstrate that market forces in the current regulatory environment serve to ameliorate conflicts of interest. Nor does the DOL explain its view that increased competition between firms in the future will reduce market efficiency, when the standard presumption in economics is that increased competition increases efficiency.

44. DOL Impact Analysis, at 222 & 228. 45. DOL Impact Analysis, at 59. 46. DOL Impact Analysis, at 59-60.

App. 1006


19

describes would nevertheless understand the implications of a complex new regulation regarding

fiduciary status, and as a consequence, seek to invest more with their advisers.

36. More generally, the DOL fails to fully consider outcomes that have occurred to date from

regulation with similar aims to the proposed amendments, such as the Retail Distribution Review

(“RDR”), which was implemented in 2013 in the United Kingdom.47 While there are a number

of differences between RDR and the proposed amendments, the available evidence to date

appears to indicate higher investment fees as a consequence of RDR and mixed results regarding

the number of advisers and regarding investors’ access to advice.48

37. In addition to the potential consequences associated with increased consumer fees and the

potential for reduced savings in tax-preferred IRAs, the DOL also does not consider at all a wide

range of other potential costs. For instance, the DOL has not fully assessed the likely changes in

the structure of payments to advisers, claiming only that an arbitrary number may switch to

asset-based fee structures.49 In some instances, a move to asset-based fee structures could lead

require investors to pay the same or more in fees as the amount of money they purported save

from avoiding underperformance.

38. Moreover, the proposed regulatory amendments may change the type of advice offered

by advisers. For example, risk-averse financial advisers may attempt to avoid any potential

liability now imposed under the fiduciary regime by only recommending lower cost and less

risky securities to investors. After all, financial advisers and their employers may bear more 47. http://www.fca.org.uk/firms/being-regulated/retail-investments/faqs [accessed July 16, 2015] 48. A study commissioned by the Financial Conduct Authority, the regulatory body that developed

RDR and enforces it, stated “The evidence currently available implies adviser charges have increased post-RDR, at least for some consumers,” and “Some firms are segmenting their client books and focusing on wealthier customers,” although the study found that this segmenting effect appears to have been relatively small to date. Europe Economics (2014) “Retail Distribution Review Post Implementation Review,” December 16, 2014, at 64 & 66. Similarly, see (stating that “Although the number of advisers has fallen, revenue from regulated businesses for financial advice firms has remained steady, at around £3.8 billion per annum, for the period from 2011 through to 2013.”) Association of Professional Financial Advisers (2014) “The Advice Market Post RDR Review,” June, at 4.

49. DOL Impact Analysis, at 173-4.

App. 1007


20

downside risk as a result of litigation (justified or unjustified) under the proposed regulatory

change. This shift in the type of investment advice may further reduce investors’ overall savings

by lowering the returns earned on dollars saved because less risky securities tend to provide

lower overall returns relative to more risky securities. For example, bonds provide lower

expected returns than do equity.

39. Economic theory predicts that financial product providers who currently rely on load-

sharing and other arrangements with advisers may also be affected. While the DOL speculates

that these firms will “invest” to generate higher returns, these providers may not be able to

generate higher returns and may be forced to spend additional funds in marketing to maintain

their profitability. These other means may be equally or more costly than the current

arrangements with advisers, and may raise other consumer protection issues.50 In any case, those

costs would likely be passed on, at least in part, to investors through higher fees.

40. Similarly, financial product providers that currently rely on load-sharing and other

arrangements to sell their products may not be able to reach economies of scale using alternative

distribution mechanisms, and as a consequence, may exit the market. If mutual funds or other

financial product providers exit the market, IRA investors may not have as many choices, which

could lead to suboptimal investment allocations.

41. Finally, academic literature on regulation also indicates that consumer-protection

measures like the proposed amendments may lull consumers into a false sense of security by the

50. Available evidence indicates that mutual fund advertising is effective in driving fund flows, but

does not signal superior fund performance. Prem C. Jain and Joanna Shuang Wu (2000) “Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows,” Journal of Finance 60(2):937-58. Hence, whatever gains investors experienced as a consequence of mitigating adviser conflicts of interest could be lost through the effects of increased advertising.

App. 1008


21

notion that government regulators are watching over them.51 As a consequence, they face

incentives to be less careful, thus offsetting in full or in part whatever benefits the regulators may

provide. In the context of the proposed amendments, investors may feel they do not need to be

as careful with their retirement savings because the government is forcing their advisers to be

more careful.

42. We do not hold a view that all of these costs are necessarily likely outcomes of the

proposed amendments. Our discussion is only meant to highlight that regulations like the

proposed amendments often create additional costs due to unintended consequences, and the

DOL’s estimates of costs have not substantively addressed the potential for such additional costs.

C. THE DOL’S COST ANALYSIS IS FLAWED IN OTHER WAYS THAT RENDER IT UNRELIABLE.

43. Even putting aside the failure to appropriately consider potential increased costs due to

unintended consequences of the proposed amendments, the DOL’s analysis of costs also suffers

from other limitations that further render it unreliable. First, the DOL repeatedly relies upon

unsupported assumptions. For instance, in analyzing the impact of the proposed amendments on

advisers’ insurance premiums, the DOL assumed a 10 percent increase due to advisers’ new

fiduciary status.52 No basis is provided for this critical assumption, even while available

evidence indicates that fiduciary status in other contexts has had large effects on the likelihood of

51. See, similarly, W. Kip Viscusi (1984) “The Lulling Effect: The Impact of Child-Resistant

Packaging on Aspirin and Analgesic Ingestions,” American Economic Review 74(2):324-7. 52. DOL Impact Analysis, at 171.

App. 1009


22

litigation,53 and litigation risk in the financial sector has been shown to have material impacts on

insurance premiums.54

44. The DOL also assumes without basis that rising insurance premiums are the only relevant

litigation costs generated by the proposed amendments. The DOL ignores the full cost of

litigation necessary to enforce regulations, including attorneys’ fees (both plaintiffs’ and

defendants’), court costs, and opportunity costs for legal resources which otherwise could be

employed in other types of cases.

45. While it may be appropriate to rely on assumptions in an economic analysis in certain

cases, those assumptions must have at least some justification or basis in order for the analysis to

be reliable. As a group of prominent economists stated in evincing principles of cost-benefit

analysis, “Quantification of benefits and costs is useful, even where there are large uncertainties

… If the decision maker wishes to introduce a ‘margin of safety’ into his decision, he should do

so explicitly. Assumptions should be stated clearly rather than hidden within the analysis.”55

46. Separately, the DOL’s cost analysis also fails to consider the consequences of the

proposed amendments for population subgroups. A careful cost-benefit analysis should analyze

not only the total costs of the regulation at issue, but also who ultimately pays those costs, and

whether such outcomes are equitable. As a prominent group of economists establishing

principles for cost-benefit analysis of regulations stated, “A good benefit-cost analysis will

identify important distributional consequences of a policy.”56

53. See, e.g., Erik J. Olson (2012) “Shareholder Class Litigation Arising from Mergers and

Acquisitions,” Association for Corporate Counsel (“Corporate directors are fiduciaries entrusted with the power and responsibility to supervise a corporation’s business affairs and obligated to act in the best interests of the corporation and its shareholders ... With rare exceptions, shareholder plaintiffs base their claims on alleged violations of these fiduciary duties.”)

54. John E. Core (2000) “The Directors’ and Officers’ Insurance Premium: An Outside Assessment of the Quality of Corporate Governance,” Journal of Law, Economics, & Organization 16(2):449-77.

55. Arrow, et al. (1996) op. cit., at 8. 56. Arrow, et al. (1996), op. cit., at 6.

App. 1010


23

47. For instance, the DOL estimates direct costs to advisery firms and certain employees who

may require additional licensure. But the DOL never considers the ultimate incidence of these

costs and their implications for different groups of stakeholders or for social equity. As noted

above, costs ostensibly imposed on firms will typically be passed on (at least in part) to

consumers. Given the DOL’s concerns regarding protection of vulnerable groups of investors,

the consequences of such an outcome for specific groups of investors would seem highly

important. It is very commonly the case that costs imposed by the government on one group are

ultimately borne by other industry participants, and economists have developed standard

approaches to estimating this “incidence” of government policy.57 However, the DOL fails to

apply these approaches.

IV. CONCLUSION

48. Though lengthy, the DOL’s “Regulatory Impact Analysis” provides no reliable estimates

of the costs and benefits of the proposed amendments, and as a consequence, does not justify the

costs likely to be incurred by market participants (including IRA investors). Among other

limitations in the DOL’s benefits analysis, it improperly applies the results of the academic

literature upon which it relies and, as a consequence, likely grossly overstates the benefits of the

proposed amendments. The DOL’s cost estimate is reminiscent of the old joke about the

drunkard who looks for his lost keys under the streetlamp because that’s where the light is. The

DOL only attempts to quantify the most obvious and direct costs of the proposed amendments,

while dismissing or overlooking a wide range of potential unintended consequences that could

dramatically increase the costs. The history of regulation provides strong reason to be skeptical

57. See, e.g., Don Fullerton and Gilbert E. Metcalf (2002) “Tax Incidence,” in Handbook of Public

Economics 4:1787-1872.

App. 1011


24

of the DOL’s assumption that the proposed amendments would have no costly unintended

consequences.

App. 1012


25

APPENDIX

Compass Lexecon is an economic consulting firm that specializes in the application of

economics to a variety of legal and regulatory issues. Compass Lexecon has a professional

staff of more than 325 individuals and fourteen offices throughout the United States, Europe

and South America. Compass Lexecon also maintains affiliations with leading academics

including several Nobel Prize winners in Economics.

Lexecon, Compass Lexecon’s predecessor firm, was founded in 1977 by, among others,

then Professor (now Judge) Richard A. Posner of the Seventh Circuit Court of Appeals.

Compass Lexecon was formed in January 2008 through the combination of Lexecon with

Competition Policy Associates, another premier economic consulting firm. Compass

Lexecon is a wholly owned subsidiary of FTI Consulting, Inc., a global business advisory

firm. Professor Daniel R. Fischel currently serves as Compass Lexecon’s Chairman and

President.

Compass Lexecon’s practice areas include antitrust, securities and financial markets,

intellectual property, accounting, valuation and financial analysis, pension economics and

policy, corporate governance, bankruptcy and financial distress, derivatives and structured

finance, class certifications and employment matters, damages calculations, business

consulting, regulatory investigations and public policy.

App. 1013


26

Compass Lexecon’s clients include the United States Department of Justice and other

agencies of the federal government, state and local governments, regulatory bodies, major

corporations, investor groups, and leading law firms across the globe.

For more information about Compass Lexecon, see its website at:

www.compasslexecon.com

App. 1014


APPENDIX 4

App. 1015


i

Comment on the Department of Labor Proposal and Regulatory Impact

Analysis

July 17, 2015

EXECUTIVE SUMMARY

NERA Economic Consulting has been retained by SIFMA to review and comment on the

U.S. Department of Labor’s (“DOL”) proposed conflict of interest rule and definition of the term

“fiduciary” under ERISA (the “proposal”), and associated Regulatory Impact Analysis (“RIA”).

The estimates in the above documents form the basis of the Department of Labor’s argument that

the proposed conflict of interest rule would provide a net “benefit” to the public.

To study these costs associated with the DOL proposal, NERA also collected account-

level data from a number of financial institutions in order to construct a representative sample of

retirement accounts. Our dataset includes tens of thousands of IRA accounts, observed over a

period from 2012 through the first quarter of 2015.

Briefly, our findings are as follows:

• The DOL proposal may effectively make the commission-based brokerage model

unworkable for investment accounts covered by ERISA due to the operational

complexity and costs of compliance that would be required under the Best Interest

Contract Exemption. Using our account-level data, we find that:

o Some commission-based accounts would become significantly more expensive

when converted to a fee-based account under the DOL proposal.

o Investors can and do select the fee model (commission vs. fee) that best suits their

own needs and trading behavior.

o A large number of accounts do not meet the minimum account balance to qualify

for an advisory account.

App. 1016


ii

o There is no evidence that commission-based accounts underperform fee-based

accounts.

• In 2011, the DOL estimated that consumers who invest without professional advice make

investment errors that collectively cost them $114 billion per year. Applying the DOL’s

own logic to the present proposal, combined with the likelihood that a large number of

investors will lose access to advice, will result in aggregate costs that may exceed the

DOL’s own estimates of the benefits of the proposal.

• The RIA produces many different numbers representing different underlying

assumptions, resulting in industry cost estimates that vary wildly from about $2 bil./year

to $50 bil./year. The range of numbers is so wide it suggests no scientific confidence in

their own methodology.

• The academic research cited in the RIA is misapplied.

o While the academic literature focuses on mutual funds, it is applied more widely

to other assets such as variable annuities in order to come up with the asset base

of $1.7 trillion in retirement assets.

o The most frequently cited paper in the RIA takes results from a statistical analysis

on certain types of funds and misapplies those results to all funds. This likely

exaggerates the importance of the findings cited by the DOL.

o The academic literature cited in the RIA does not compare the costs and benefits

of fiduciary accounts with those of brokerage accounts. Therefore, any findings

based on this research are inappropriate as a basis for the DOL proposal.

• Overall the DOL’s misapplied use of the academic literature and erroneous conclusions

on investor behaviors render their regulatory impact analysis unreliable and incomplete.

App. 1017


1

Contents

I. Costs of Impeding the Commission-Based Investment Model............................................2 A. Summary of Data .................................................................................................................2 B. Some Accounts Would Become More Expensive under the DOL Proposal .......................5 C. Account-Level Data Suggests that Investors Select the Fee Model that Best Suits

Their Own Needs and Trading Behavior .............................................................................6 D. Some Account Balances Are Too Small for RIA Accounts ................................................9 E. Commission-Based Accounts Do Not Underperform .......................................................10

II. Cost of Losing Access to Advice .......................................................................................11 A. Estimates of Number of Investors Who Will Lose Access to Advice ...............................12 B. Implications of Losing Access to Advice: Individual Investors Make Systematic

Errors When Investing on Their Own ................................................................................13 1. The disposition effect and mental heuristics ................................................................13 2. Mental heuristics disproportionately affect people with fewer savings .......................14 3. Individual investors churn............................................................................................16

C. Benefits of Financial Advisors...........................................................................................17 1. Portfolio allocations that are more diversified and closer to model portfolios ............17 2. Advisors help investors stop making investing mistakes ............................................19 3. Tax minimization .........................................................................................................19 4. Increased savings .........................................................................................................20 5. Economies of scale with respect to the cost of information ........................................21

D. The Cost of Losing Access to Professional Investment Advice ........................................22 1. Review of the SEC (2011) assessment: costs of imposing a fiduciary standard on

brokers..........................................................................................................................22 2. The DOL (2011) Federal Register Study .....................................................................25

III. The Cost of Conflicted Investment Advice .......................................................................28 A. Estimates of the Benefits of the Proposal Vary Wildly in the RIA ...................................29 B. The RIA Misapplies the Academic Literature ...................................................................31

1. The cited literature focuses on mutual funds, yet the DOL applies the results more widely ...........................................................................................................................31

2. The research cited in the RIA takes results associated with higher-than-average load funds and misapplies them to all funds. ...............................................................32

3. The academic literature cited in the RIA does not compare the costs and benefits of fiduciary accounts with those of brokerage accounts ..............................................33

Appendix: The Cost of Complying with the DOL proposal .........................................................39

App. 1018


2

I. COSTS OF IMPEDING THE COMMISSION-BASED INVESTMENT MODEL

The Department of Labor’s (“DOL”) proposed conflict of interest rule and definition of

the term “fiduciary” under ERISA (the “proposal”), and associated Regulatory Impact Analysis

(“RIA”) 1,2 have led many to conclude that the proposal would effectively make the commission-

based brokerage model unworkable for investment accounts covered by ERISA and similar

sections of the IRS code due to the operational complexity and costs of compliance that would be

required under the Best Interest Contract exemption. In this section, we use account-level data to

pursue the question of how this result would affect existing holders of commission-based

accounts.

There are at least two immediate consequences to the proposed rule change. The first is

that some commission-based accounts would become more expensive, in the sense that average

fees would increase, particularly for investors who trade infrequently. Second, advisory or “fee-

based” accounts currently have minimum balance requirements. These account balance

requirements are in place to ensure that the firm serving the client can at least break even on the

operating costs associated with administering advisory accounts. Using account-level data, we

can estimate the percentage of consumers currently in commission-based accounts who would

not meet the minimum account balance requirements and therefore lose access to professional

investment advice under the DOL proposal.

We begin with a discussion and summary of the account-level data that NERA has collected

for this study.

A. Summary of Data

The RIA itself recognizes (p. 101) “the absence of comprehensive data” with which to

conduct a complete analysis of the proposal. To address that void, we collected account-level

1 29 CFR 2509 and 2510, DOL, Definition of the Term “Fiduciary”; Conflict of Interest Rule-- Retirement Investment Advice; Proposed Rule in Federal Register Volume 80, Number 75 (Monday, April 20, 2015), Pages 21927-21960. 2 “Fiduciary Investment Advice Regulatory Impact Analysis”, Department of Labor, Available on-line at www.dol.gov/ebsa/pdf/conflictsofinterestria.pdf.

App. 1019


3

data from a number of financial institutions in order to construct a representative sample of

retirement accounts. Our dataset includes over 63,000 IRA accounts, with data ranging from

2012 through the first quarter of 2015. The investors in our dataset are distributed across a wide

range of age groups, with the bulk of IRAs held by investors aged 50 or older, as shown in

Exhibit 1.

The data we collected from the participating firms contains various types of account-level data

fields, including: balances, fees, activity, and positions. In order to conduct an analysis, we

merged the data from the various firms into one combined dataset.

Fees

Based on data received from participating firms, we classify IRAs into two broad fee-

type categories: fee-based and commission-based accounts. Fee-based accounts are charged a

fixed fee as a percentage of assets whereas commission-based accounts are charged fees based

on trading and other activity. As shown in Exhibit 2, approximately 70.6 percent of our accounts

are commission-based; the rest are fee-based.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

<22 22-29 30-39 40-49 50-59 60-69 70+

Age

Exhibit 1. Distribution of IRAs by Age

App. 1020


4

Fees include all proceeds paid by the account-holder directly to the firm, such as

management fees and trading commissions.3 They exclude, however, fees paid to third-parties

such as mutual fund managers.

The median account balance in our sample is $57,072, with the 25th and 75th percentiles

falling at $17,511 and $166,794 respectively.4 These summary statistics are shown in Table 1

below.

3 Fees exclude revenue that the firm may receive indirectly from the account-holder, such as markup/markdown

revenue or 12b-1 fees. Recognizing that such indirect revenues are not included in our fee data, we construct returns which are net of all fees, both direct and indirect. These net returns are presented in section I.E.

4 In our analyses, we exclude accounts with balances below $1,000.

29.36%

70.64%

Exhibit 2. IRA Account Structure

Fee Based

Commission Based

App. 1021


5

Table 1. Account Balances

Account Balance ($)

Mean 174,034 Median 57,072 25th Percentile 17,511 75th Percentile 166,794

B. Some Accounts Would Become More Expensive under the DOL Proposal

Our account-level dataset allows us to identify a large number of accounts as having a fee

structure which is either fee-based, or commission-based. In Exhibit 3, we present the difference

between median fee-based and commission-based account fees, as a percentage of account

balance, for various levels of account balance. The chart shows that this difference is always

greater than zero; in other words, holders of fee-based accounts pay higher fees, in percentage

terms, for all levels of account balance.

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

Med

ian

Fee

Dif

fere

nce

(%)

Account Balance ($)

Exhibit 3: Fee-Based Accounts Are More Expensive Than Commission-Based Accounts

App. 1022


6

The differences tend to be in the range of about 57 basis points (bps) for relatively small

accounts (those with balances below $25,000) up to about 1 percent for accounts with balances

from $100,000 to $250,000. This suggests that investors would pay more if moved to fee-based

accounts. Indeed, the magnitude of the increased cost is on par with the 1 percent “cost of

conflicted advice” claimed in the White House/CEA memo that preceded the DOL proposal.

The numerical results are reported in Table 2, below.

Table 2. Fees by Balance and Account Type

Median

Balance Range Fee

Based Commission

Based Difference $1,000-25,000 1.24% 0.67% 0.57%

$25,000-50,000 1.16% 0.36% 0.80% $50,000-100,000 1.20% 0.27% 0.93%

$100,000-250,000 1.25% 0.24% 1.01% $250,000-1,000,000 1.09% 0.22% 0.86%

Greater than $1,000,000 0.99% 0.12% 0.87%

C. Account-Level Data Suggests that Investors Select the Fee Model that Best

Suits Their Own Needs and Trading Behavior

In the data, one of the most striking behavioral distinctions between fee-based and

commission-based accounts is that the former tend to trade more frequently. We also calculated

investors’ aggregate trading activity by looking at both the number and dollar amount of

purchases and sales in each account.5 We measure trading activity in two ways: number of

trades and account turnover. Number of trades counts each discrete purchase and sale during the

time period. Account turnover takes the minimum of the total dollar amount purchased and the

total dollar amount sold as a percentage of the average dollar balance during the year. Summary

statistics of trading activity are presented below in Table 3.

5 Where we could not break out dividends from new investments, trades may include dividend reinvestments.

App. 1023


7

Table 3. Trading Activity

Number of Trades

Account Turnover

Mean 54 34.11% Median 16 14.79% 25th Percentile 4 4.84% 75th Percentile 56 39.31%

Exhibit 4 below shows the number of trades, or transaction frequency, of fee-based and

commission-based accounts in 2014 for various account balance levels.

In 2014, the median trade frequency in commission-based accounts was just 6 trades. By

comparison, in fee-based accounts the median trade frequency was 57 trades, with larger

accounts generally trading more frequently than smaller ones.

Thus, the data are consistent with the idea that investors who expect to trade often

rationally choose fee-based accounts whereas those that do not trade often are likely to choose

commission-based accounts.

0102030405060708090

Num

ber

of T

rade

s

Account Balance ($)

Exhibit 4: Median Number of Trades

Fee Based Commission Based

App. 1024


8

Additionally, it is worth noting that the data does not seem to show “churning,” the

needless buying and selling of securities. We see the median commission-based account had

traded 6 times in 2014. Such trading is more consistent with a buy-and-hold strategy than

churning.

The interpretation of the account-level data as being consistent with investors who trade

infrequently self-selecting into commission-based accounts is further supported by account

turnover. The median dollar-value of transactions, as a fraction of account balance, is show in

Exhibit 5 below, for various levels of account balance.

The median commission-based account across all balances only turns over 8.9 percent of

its assets annually. For fee-based accounts the median turnover is 22.1 percent.

0%

5%

10%

15%

20%

25%

30%

35%

Med

ian

Tur

nove

r (%

)

Account Balance ($)

Exhibit 5: Account Turnover

Fee Based Commission Based

App. 1025


9

D. Some Account Balances Are Too Small for RIA Accounts

As mentioned above, a primary concern with the DOL proposal is that it would make

commission-based accounts unworkable. If this turns out to be the case, investors will have to

move to fee-based accounts or lose access to professional investment advice entirely.

Using our account-level data, we can estimate the number of investors who currently have

commission-based accounts with balances below the minimum required account balance for

advisory accounts.6

The results are shown in Exhibit 6. Using the conservative minimum account balance of

$25,000, over 40% of commission-based accounts in our dataset would not be able to open fee-

based accounts. Using a $50,000 threshold, over 57% of accounts would not meet minimum

balance requirements for a fee-based account. If the effective threshold is $75,000, two-thirds of

account holders would be left without any professional investment advice.

6 An important limitation in our data is that we have collected account-level data, which may not coincide with

household-level data. We may therefore be understating the ability of some households to combine separate IRA accounts held within the same household to achieve the minimum balance requirement. This limitation also likely explains the existence of fee-based accounts smaller than $10,000 in our dataset.

40.49%

16.58%

9.59%

33.34%

Exhibit 6: Commission-Based Accounts by Account Balance

Less than $25,000

$25,000-$50,000

$50,000-$75,000

Greater than $75,000

App. 1026


10

E. Commission-Based Accounts Do Not Underperform

We calculate returns on a quarterly basis by calculating the change in account balance,

adjusting for net flows during the quarter.7 Since fees are deducted from account balances, either

directly or indirectly, returns calculated based on account balances are net of fees.

We find that the median annualized return across all accounts in our sample, over the

period from June 30, 2012 to March 31, 2015, is 10.3 percent.

In terms of differential fee structures, if investors in commission-based account are

subject to the “cost of conflicted advice”, then we would expect to see an underperformance in

terms of the returns they earn. Indeed, this is explicitly the argument made in the DOL proposal.

Over the time periods for which we have data, commission-based and fee-based accounts

exhibit similar performance, when calculated net of fees. The median differences in returns are

shown, quarter by quarter, in Table 4. As the data show, the difference in return is sometimes

positive and sometimes negative but small in magnitude. Moreover, the difference in returns is

not statistically significant.

Table 4. Fee-Based Returns Less Commission-Based Returns

Date Range Difference in Median

Quarterly Return 06/30/12-09/30/12 -0.14% 09/30/12-12/31/12 0.63% 12/31/12-03/31/13 -1.96% 03/31/13-06/30/13 -0.91% 06/30/13-09/30/13 0.62% 09/30/13-12/31/13 -0.08% 12/31/13-03/31/14 -0.44% 03/31/14-06/30/14 -0.18% 06/30/14-09/30/14 -1.04% 09/30/14-12/31/14 0.04% 12/31/14-03/31/15 0.33%

Average -0.28%

7 Net flows include cash and other transfers to and from the account that are not investment-related (i.e.:

withdrawals and contributions). Net flows were constructed to exclude fees, dividends, and interest, to the extent it was possible to identify these payments in the underlying transaction data. To eliminate the potential impact of outliers on our findings, we removed the top and bottom 1 percent of returns from our calculations (where such outliers may reflect the timing of transactions in our data, and not be reflective of actual returns).

App. 1027


11

Overall, from June 30, 2012 to March 31, 2015, the average difference (where again the

difference is the fee-based return minus the commission-based return) is -0.28 percent. Thus,

there is no support in this data for the contention that commission-based accounts underperform.8

An alternative interpretation of the finding that returns are roughly equal across the two fee

structures is that investors self-select into account types that are appropriate for them and that

this leads to equilibrium.

II. COST OF LOSING ACCESS TO ADVICE

In order to conduct a proper cost-benefit analysis, it is important to consider all of the

costs associated the proposed rule. Indeed, the DOL Regulatory Impact Analysis itself states

(p.99-100) that:

“A full accounting of a rule’s social welfare effects would encompass all of the rule’s

direct and indirect effects as would be manifest in general market equilibrium. Likewise, that

full accounting would consider pure social welfare costs – that is, reductions in economic

efficiency – which are not the same as simple compliance costs.”

The RIA goes on to recognize that (p. 100): “The quantitative focus of this analysis,

however, is on the proposal’s most direct, and directly targeted, effects: gains to retirement

investors, and compliance costs to advisers and others.”

But the DOL fails to measure one important cost—the cost of the loss of advice to

investors. In this section we partly address this shortcoming by explicitly considering the costs

that would be incurred by those consumers who completely lose access to professional

investment advice as a result of the DOL proposal.

In prior studies, the DOL itself acknowledged this cost. An October 2011 DOL cost-

benefit analysis published in the Federal Register on the “final rule” relating to the provision of

investment advice under ERISA included estimates of the costs to consumers of not having

access to advice.9 In that document, the DOL estimated that participant-directed retirement

8 The sign of the difference might be read to mean that commission-based accounts outperform fee-based accounts

in our dataset, but in fact the difference is not statistically different than zero in any of the quarters in our sample period.

9 29 CFR 2550, DOL, Investment Advice – Participants and Beneficiaries, Final Rule, October 2011.

App. 1028


12

savings account holders make investment mistakes in the absence of professional advice valued

at an aggregate of “more than $114 billion in 2010” (p.66151).

Moreover, the 2011 DOL cost-benefit analysis estimated the effects of a change in public

policy on investors’ access to professional investment advice. In particular, the DOL estimated

that the enactment of the Pension Protection Act of 2006 (P.L. 109-280, the “PPA”) increased

access to advice, and hence reduced aggregate investing errors by $7 billion to $18 billion per

year. These are extremely large numbers, and hence clearly indicate the DOL’s own estimation

of the importance to investors of access to professional advice.

A. Estimates of Number of Investors Who Will Lose Access to Advice

As discussed in section I.A above, our account-level data allows us to identify a large

number of accounts as having a fee structure which is either fee-based, or commission-based, by

account balance. For example, we noted above that 40.49 percent of the accounts that are

currently commission-based have balances below $25,000 in our sample.

If the DOL proposal were to make commission-based accounts unworkable for broker-

dealers, these accounts could no longer be maintained. Moreover, many commission-based

accounts have small balances and so would be below the minimum account balance for advisory

accounts. These investors will be left on their own with no access to professional investment

advice.

If we were to take at face value the DOL’s methodology in the 2011 cost-benefit analysis

discussed above, and assume a minimum-balance threshold of $25,000, the new fiduciary

standard would cause a loss of access to professional advice for 40.49 percent of commission-

based retirement account holders. It would take a relatively small number of such accounts to

lose advice for this to result in an aggregate cost that exceeds the $17 billion in purported

benefits claimed in the White House/CEA memo.

Moreover, this is based on a conservative estimate of the minimum balance, at only

$25,000. Even at this level, the aggregate cost could easily be on par with the DOL’s own

estimates of the “cost of conflicted advice”.

Hence, using the DOL’s own approach, the costs of the proposal likely exceed its benefits

once we account for other costs such as the cost of compliance.

App. 1029


13

B. Implications of Losing Access to Advice: Individual Investors Make

Systematic Errors When Investing on Their Own

In this section we first review the extensive academic and professional literature on the

value to investors of having access to professional investment advice. The discussion begins

with a survey of the potential pitfalls faced by many individuals who invest on their own. We

then discuss the established literature that documents ways in which the use of professional

advisors tends to lead to fewer such investment errors.

Additionally, it is worth noting that below, in section III.D, we discuss an earlier 2011

cost-benefit analysis on the Pension Protection Act of 2006 in which the DOL itself recognized

the implications of investors losing access to professional investment advice. The conclusions of

that DOL study are similar to the academic findings discussed in this section.

1. The disposition effect and mental heuristics

Ever since the seminal work of Kahneman and Tversky (1979, 1992), it has been widely

accepted that individual investors are prone to making systematic mistakes in the way they

evaluate and treat investment decisions in the presence of uncertainty.10 Indeed, Kahneman was

awarded the Nobel Prize in Economics for this work in 2002. This research agenda was typically

accompanied by experimental data, but not backed up with actual accounts and transactions of

individual investors.

In the 1990’s, however, Odean (1998) built upon the earlier literature by analyzing the

trading records of ten thousand accounts at a large nationwide discount brokerage firm. The

dataset he collected covered the period 1987 through 1993.11 The data includes an account

identifier, trade dates, the security traded, a buy-sell indicator, the quantity traded, the

commission paid and the principle amount. The study compared the selling price for each stock

sold to its average price to determine whether that stock is sold for a gain or loss. One of the

primary findings of the paper was that investors demonstrate a strong preference for realizing

winners rather than losers. This phenomenon is now widely known as the “disposition effect” for

individual investors. 10 Kahneman, D and A. Tversky (1979), “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (2): 263 and Tversky, A and D. Kahneman (1992), “Advances in prospect theory: cumulative representation of uncertainty,” Journal of Risk and Uncertainty 5 (4): 297–323. 11 Odean, T. (1998), “Are Investors Reluctant to Realize Their Losses?” Journal of Finance, 53, 1775-1798.

App. 1030


14

Since Odean (1998), the disposition effect has been confirmed by numerous studies.

Goetzmann and Massa (2004) construct a variable based on investor trades that acts as a proxy

for the representation of disposition-prone investors in the market and test how it relates to stock

returns. 12 The authors report a strong negative correlation between the disposition effect and

stock returns. Grinblatt and Han (2005) also study the disposition effect, and in particular the

tendency of investors to hold on to their losing stocks.13 They attribute this behavior to prospect

theory, or the tendency to under weigh outcomes that are merely probable in comparison to

outcomes that are obtained with certainty, and to a psychological phenomenon known as “mental

accounting”. The authors find that the tendency for households to fully sell winning stocks is

weaker for wealthy investors with diversified portfolios of individual stocks.

Franzini (2006) uses a database of mutual funds holdings to construct a measure of

reference prices for individual stock and confirms the existence of the disposition effect.14

Moreover, the author suggests that the disposition effect can induce under-reaction by individual

investors to news, leading to return predictability and post-announcement price drift. In

particular, bad news travels slowly among stocks trading at large capital losses, in turn leading to

a negative price drift, and good news travels slowly among stocks trading at large capital gains.

Nor is this literature limited to academic circles. The Morgan Stanley Consulting Group

(2014), for example, studied the various behavior biases that can impair the performance of

individual investors in managing their own portfolios.15 The authors point to “psychological

blindspots” that negatively influence investors such as overconfidence, mental accounting,

anchoring biases, framing biases and loss aversion. Their research suggests that a financial

advisor can mitigate the effects of these problems because they have a clearer understanding of

the investment process.

2. Mental heuristics disproportionately affect people with fewer savings

As argued above, the academic literature has documented evidence that individual

investors display irrational and costly investing behavior in the form of the disposition effect.

12 Goetzmann, W. and M. Massa (2004), “Disposition Matters: Volume, Volatility and Price Impact of Behavioural Bias,” Centre for Economic Policy Research, Paper No. 4814. 13 Grinblatt, Mark and Bing Han (2005), “Prospect theory, mental accounting and momentum,” Journal of Financial Economics, 78, 311-339. 14 Frazini, Andrea (2006), “The Disposition Effect and Underreaction to News,” The Journal of Finance, 61, No. 4 15 Morgan Stanley Consulting Group, “The Value of Advice,” (2014), available on-line at www.morganstanleyfa.com/public/projectfiles/thevalueofadvice.pdf

App. 1031


15

Beyond this general observation, there is also a strand of research that shows that these flaws

tend to disproportionately affect people with lower levels of wealth.

Grinblatt and Keloharju (2000) employ the central register of shareholdings for Finnish

stocks in the Finnish Central Securities Depository (FCSD), a comprehensive data source which

covers 97 percent of the total market capitalization of Finnish stocks beginning in 1995.16 The

data set reports institutional holdings and stock trades on a daily basis. The authors find that

generally the more sophisticated the investor and the greater the wealth invested in stocks, the

less contrarian (buying losing stock and selling winning stock) is the investment strategy. The

degree of contrarianism appears to be inversely related to a ranking of the sophistication of

investor types.

Dhar and Zhu (2002) analyze the trading records of a major discount brokerage house

and confirm the existence of the disposition effect.17 The paper finds empirical evidence that

wealthier and individual investors in professional occupations exhibit less disposition effect.

Trading experience also tends to reduce the disposition effect.

Calver, Campbell and Sodini (2009) study a dataset containing the disaggregated wealth

of all households in Sweden between 1999 and 2002. The authors find that contrary to rational

expectations, households are more likely to fully sell directly held stocks if those stocks have

performed well and more likely to exit direct stockholding if their stock portfolios have

performed well.18 This paper examines changes in household behavior over time, specifically

decisions to scale up or down the share of risky assets in the total portfolio, to enter or exit risky

financial markets, to full sell individual risky assets and to scale up or down the share of

individual assets in the risky portfolio. By doing so, the authors develop an adjustment model

with different target risky shares across households. The authors find that wealthy, educated

investors with better diversified portfolios tend to rebalance more actively. Specifically, the

authors point to wealth and portfolio diversification as more relevant than income in predicting

the strength of the disposition effect

16 Grinblatt, Mark and Matti Keloharju (2000), “The investment behavior and performance of various investor types: a study of Finalnd’s unique data set” Journal of Financial Economics, 55, 43-67. 17 Dhar, Ravi and Ning Zhu (2002), “Up Close and Personal: An Individual Level Analysis of the Disposition Effect,” Yale ICF Working Paper No. 02-20. 18 Calver, Laurent E. and John Y. Campbell and Paolo Sodini (2009), “Fight or Flight?” The Quarterly Journal of Economics, 124, 1.

App. 1032


16

Cerqueira Leal, Rocha Armada and Duque (2010) use a database of 1,496 trading records

of individual investors in the Portuguese stock market from January 1, 1999 to December 31,

2002, consisting of initial position, account movements, events and daily closing stock prices.19

The authors then calculate the “proportions of gains realized and the proportions of losses

realized” based on each investor’s portfolio for each day of the sampling period. The authors

find that less sophisticated investors (defined by average account value, number of shares traded

and number of trades) exhibit a stronger disposition effect.

3. Individual investors churn

Aside from the disposition effect described above, another well-known error that is

commonly observed in un-advised, self-directed, individual investors is the tendency to trade too

often, or “churn”. In a seminal paper, Barber and Odean (2000), analyze the returns earned on

common stock investment by 66,465 self-directed households. The net return earned by these

households underperforms a value-weighted market index by about 9 basis points per month (or

1.1 percent annually).20 Those that trade the most earn an annual return rate of 11.4 percent,

while the market returns 17.9 percent. The poor performance of the average household can be

traced to the costs associated with this high level of trading. The authors find a negative

correlation between trading frequency and investment returns.

Similarly, Barber, Lee, Liu and Odean (2007) use a complete trading history of all

investors in Taiwan, and document that the aggregate portfolio of individual investors suffers an

annual penalty of 3.8 percentage points.21 These losses virtually all come from aggressive

trading. In contrast, institutional investors enjoy an annual performance boost of 1.5 percentage

points--even after commission and transaction taxes. Foreign institutional investors garner

nearly half of the institutional profits. The author points out that investors who are saving to meet

long term goals would benefit from effective guidance regarding best investment practices.

19 Cerqueira Leal, Cristiana and Manuel J. Rocha Armada, and Joao C. Duque (2010), “Are All Individual Investors Equally Prone to the Disposition Effect All The Time? New Evidence from a Small Market,” Frontiers in Finance and Economics, 7, No. 2, 38-68. 20 Barber, M. Brad and Terrance Odean (2000), “Trading is Hazardous to Your Wealth: The Common Stock Investment

Performance of Individual Investors” The Journal of Finance, 60, No. 2. 21 Barber, Brad M., Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean (2007) “Just How Much Do Individual Investors Lose by Trading?” AFA 2006 Boston Meetings Paper.

App. 1033


17

C. Benefits of Financial Advisors

Having established that individual investors are prone to making systematic mistakes in

their investing due to behavioral biases, it is natural to ask whether such errors are reduced, on

average, by having access to professional advice. The answer, unsurprisingly, tends to be “yes”

in the by extensive academic and professional literature.

1. Portfolio allocations that are more diversified and closer to model portfolios

Bluethgen, Gintschel, Hackethal and Mueller (2008) examine a dataset of 12,000 German

bank accounts, categorizing bank customers as “advised customers” or “self-directed”, and find

that financial advice enhances portfolio diversification, and makes investor portfolios more

congruent with predefined model portfolios.22 While the bank in the study derived more revenues

from advised clients, the advised clients’ portfolios also resembled more closely the optimal

portfolios prescribed by financial theory. The authors conclude that financial advisory service

has a “significant impact on household investment behavior.”

Gerhardt and Hackethal (2009) collect a data set on 65,000 private investors and analyzed

the portfolio composition and trading behavior of more than 14,000 persons and note that there

are clearly positive effects to working with an advisor.23 These benefits include: less speculative

trading and a more diversified portfolio.

A study commissioned by the Investment Funds Institute of Canada (2010) analyzed a

longitudinal database with Canadian households’ financial behaviors and attitudes.24 The study

isolated 3200 households and broke the sample into two groups – those who had an advisor in

both years and those who did not have an advisor in either year. The authors found that

households that received investment advice had substantially higher investable assets that non-

advised households, controlling for age and income level. Additionally, investors without advice

save less, utilize tax-advantaged savings opportunities less, and invest in securities with less

opportunity for future investment growth than their advised counterparts.

22 Bluethgen, Ralph, Andreas Gintschel, Andreas Hackethal, and Armin Mueller (2008), “Financial Advice and Individual Investors' Portfolios.” 23 Gerhardt, Ralf and Andreas Hackethal (2009), “The Influence of Financial Advisors on Household portfolios: A study on Private Investors switching to Financial Advice,” February 14, 2009. 24 The Investment Funds Institute of Canada (2010), “The Value of Advice Report,” available on-line at

www.ific.ca/wp-content/uploads/2010/07/IFIC-Value-of-Advice-Report-2010-July-2010.pdf/4001/

App. 1034


18

A paper by the Investment Funds Institute of Canada (2012) stresses the importance of

the CIRANO 2012 research, as well as citing papers from Australia and the United States.25

Summarizing the existing literature, the paper notes that research proves that advice has a

positive and significant impact on wealth accumulation, leads to better long term investment

strategies and benefits the wider macroeconomy.

Kramer (2012) compares portfolios of advised and self-directed Dutch individual

investors to investigate whether financial advisers add value to individual investors’ portfolios.26

The author finds that advised portfolios are more diversified and perform better than self-

directed portfolios, thus reducing avoidable risk. The author (at least partly) attributes the

reduction of idiosyncratic risk observed in advised portfolios to advisory intervention

In a widely-cited paper, Kinniry, Jaconetti, DiJoseph and Zilbering (2014), argue that

through suitable asset allocation using broadly diversified funds/ETFs, cost effective

implementation, rebalancing, behavioral coaching, asset location, spending strategy, and total-

return versus income investing strategies, advisors can potentially add about 3 percent in net

returns to investors.27 For some investors, the value of working with an advisor is peace of mind.

The value of an advisor for investors “without the time, willingness, or ability to confidently

handle their financial matters” should not be ignored by “the inability to objectively quantify it.”

The authors argue that value added cannot be analyzed as an annual figure because “the most

significant opportunities to add value occur during periods of market duress or euphoria when

clients are tempted to abandon their well-thought-out investment plan.”

Mardsen, Zick and Mayer (2011) argue that working with an advisor is related to several

important financial planning activities including goal setting, calculation of retirement needs,

retirement account diversification, use of supplemental retirement accounts, accumulation of

emergency funds, positive behavioral responses to the recent economic crisis and retirement

confidence.28

25 The Investment Funds Institute of Canada (2012), “The Value of Advice Report,” available on-line at www.ific.ca/wp-content/uploads/2013/02/IFIC-Value-of-Advice-Report-2012.pdf/1650 / 26 Kramer, Marc M. (2012), “Financial Advice and Individual Investor Portfolio Performance,” Financial Management, 41, No. 2, 395-428. 27 Kinniry, Francis M., Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zilbering (2014), “Putting a value on your value: Quantifying Vanguard advisor’s Alpha,” The Vanguard Group. 28 Mardsen, Mitchell, Cathleen D. Zick, and Robert N. Mayer (2011), “The Value of Seeking Financial Advice,” Journal of Family and Economic Issues, 32, No. 4, 625-643.

App. 1035


19

Winchester, Huston and Finke (2011) collect data containing 3,022 respondents with at

least $50,000 in annual income.29 These individuals also had equity holdings that they could

control or direct during market downturns. The authors used “investor prudence” as the

dependent variable and noted whether the individuals rebalanced their portfolio over a market

decline. The authors find that investors who use a financial advisor are about one-and-a half

times more likely to adhere to long-term investment decisions. Moreover, investors with a

written financial plan are almost twice as likely to make optimal long term financial decisions.

2. Advisors help investors stop making investing mistakes

Shapira and Venezia (2001) argue that professionally-managed accounts experienced

better roundtrip performance than those administered independently.30 The authors find that the

disposition effect, or the tendency of investors to sell shares whose price has increased, while

keeping assets that have dropped in value, is significantly weaker for professional investors. This

indicates that professional training and experience reduces judgmental biases, even though it

cannot eliminate them. The authors point to this as an advantage in enlisting professional advice.

Maymin and Fisher (2011) used data from a boutique investment management firm,

Gertstein Fisher.31 The data includes all account and household information, client introduction

history, notes, and portfolio allocations and performances since 1993. The authors test five

predictions by analyzing the contacts actually recorded between clients and the manager in the

data set. The authors conclude that the advisor’s role in helping investors stay disciplined and on

plan in the face of market volatility, including dissuading them from excessive trading, is one

that is highly valued by the individual investor.

3. Tax minimization

Horn, Meyer and Hackethal (2009) use transaction data from a German bank from 1999-

2008, to study a natural experiment of the introduction of a withholding tax in Germany in order

to see how private investors react to changes in taxation.32 The authors conclude that financial

29 Winchester, Danielle D., Sandra J. Huston, and Michael S. Finke (2011), “Investor Prudence and the Role of Financial Advice,” Journal of Financial Service, 65, No. 4, 43-51. 30 Shapira, Zur and Itzhak Venezia (2001). Patterns of Behavior of Professionally Managed and Independent Investors, Journal of Banking and Finance, 25, No. 8, 1573-587. 31 Maymin, Philip Z. and Gregg S. Fisher (2011), “Preventing Emotional Investing: An Added Value of an Investment Advisor.” The Journal of Wealth Management, 13, No. 4. 32 Horn, Lutz, Steffen Meyer and Andreas Hackethal (2009), “Smart Investing and the Role of Financial Advice – Evidence from a natural Experiment Using Data Around a Tax Law Change,” Working Paper Series.

App. 1036


20

advisors help people make smarter investment decisions because of their financial sophistication

and experience in tax-related investment decisions.

Martin and Finke (2012) uses both the 2004 and the 2008 waves of the National

Longitudinal Survey of Youth to estimate the impact of financial advice on retirement savings

and the change in accumulated retirement wealth between 2004-2008.33 The authors compare the

effectiveness of creating one’s own retirement plan versus using a professional advisor. The

authors find that the use of a comprehensive financial professional overwhelmingly increases the

likelihood that households will go through the process of calculating retirement needs.

Respondents who rely on an advisor to help plan for retirement are more likely to own tax-

advantaged accounts. Authors conclude that planning, with the help of a comprehensive advisor,

improves retirement outcomes.

4. Increased savings

Montmarquette and Nathalie (2015) used Ipsos Reid collected data in the form of a 45-

question internet survey from 18,333 Canadian Households.34 The data were filtered to produce a

high quality sample of 3,610 households. After splitting up the data into “advised households”

and “non-advised households” the authors used econometric modelling in order to isolate the

benefits of advisors in the accumulation of wealth.

Econometric results show that participants retaining the services of a financial advisor for

more than 15 years have about 174 percent more financial assets (in other words, 2.73 times the

level of assets) than non-advised respondents. The authors conclude that a highly plausible

explanation for this finding comes from the greater savings and improved asset selection that is

associated with having a financial advisor. Those investors who have advice are more likely to

trust financial advisors, associate satisfaction with financial advisors and have confidence in

financial advisors.

Similarly, in a KPMG Econtech (2009) paper based on the results of a regression analysis

from an economy-wide model, the authors conclude that an individual who has a financial

planner is estimated to save $2,457 more in a year compared to similar individuals without 33 Martin, T. K. and Michael S. Finke (2012), “Planning for Retirement,” (December 31, 2012), available at SSRN: papers.ssrn.com/sol3/papers.cfm?abstract_id=2195138 34 Montmarquette and Nathalie Viennot-Briot (2015), “The Value of Advice,” Annals of Economics and Finance, 16-1, 69-94. This paper was also published as Montmarquette and Veinnot-Briot (2012), “Econometric Models on the Value of Advice of a Financial Advisor,” at the Centre interuniversitaire de recherché en enalyse des des organisations.

App. 1037


21

financial advisors/planners.35 Investors with a financial planner have greater savings and

investment balances than those who do not.

A study by Standard Life (2012) based on collected data from the UK, reports that the

current average pension pot for consumers who have been advised on their retirement planning is

£74,554.30, nearly double that of those not seeking advice.36 Those who have taken advice put

nearly a third more a month into their pension plan. On investments, people with an adviser save

for longer and contribute more, leading to an average investment value which is over £40,000

higher than the average for those who haven’t sought advice.

Lastly, Antunes, Macdonald and Stewart (2014) construct a hypothetical scenario using

collected survey data that included age, average savings, average income and the presence of an

advisor.37 After collecting the data, the authors assume that 10 percent of the income of non-

advised savers is now saved at the higher rate of those who do receive financial advice in order

to capture the increased savings level that is correlated with having an advisor. This paper then

applied the percentage difference between this savings rate and the baseline savings rate to the

Conference Board of Canada’s long term national forecasting model to quantify the economic

impact of the increased savings in the long run. On top of positively impacting an investor’s

savings rate, the presence of an advisor was also shown to boost real GDP, turn consumer

expenditures positive and raise the aggregate household savings rate.

5. Economies of scale with respect to the cost of information

In a highly-regarded paper by Stoughton, Wu and Zechner (2010), the authors create a

model with three classes of agents: the active portfolio manager, the set of financial advisers and

the pool of investors in the economy.38 The authors first derive an equilibrium assuming that

financial advisers are independent and must charge their investors their full costs in order to

break even and allow portfolio manager to provide payments to the adviser. Then, the authors

run the model to solve for the optimal amount of rebates preferred by the portfolio manager and

35 “Value Proposition of Financial Advisory Networks” (2009), KPMG Econtech.

www.fsc.org.au/downloads/uploaded/2009_1105_KPMGEcontech(FinalReport)_7d94.pdf 36 Standard Life (2012), “Value of Advice Report,” available on-line at www.unbiased.co.uk/Value-of-Advice-Report-2012.pdf 37 Antunes, Pedro, Alicia Macdonald and Matthew Stewart (2014), “Boosting Retirement Readiness and the Economy Through Financial Advice,” The Conference Board of Canada. 38 Stoughton, Neal M., Youchang Wu, and Josef Zechner (2010), “Intermediated Investment Management,” Journal of Finance, 66, No. 3. 947-980.

App. 1038


22

the impact on management fees, fund sizes and flows. Finally, the paper derives the equilibrium

without an adviser and compares all the scenarios. The authors find that financial advisers

facilitate the participation of small investors in actively managed portfolios by economizing on

information costs.

It is also interesting to note that the DOL itself wrote, in a 2011 cost benefit analysis of

the final rule on investment advice under ERISA39 (p. 66156) that “The Department therefore

expects this final rule to produce cost savings by harnessing economies of scale and by reducing

compliance burdens.” “For example, an adviser employed by an asset manager can share the

manager’s research instead of buying or producing such research independently.”

D. The Cost of Losing Access to Professional Investment Advice

While the 2015 DOL regulatory impact analysis (RIA) ignored the costs of investors

losing access to advice, the 2011 SEC staff’s 913 study as well as the 2011 DOL cost-benefit

analysis, both mentioned above, both discussed the costs of investors not having access to

advice.

We note that the DOL’s 2010 proposal differs from the current one in some of its details.

However, both proposals raise the same troubling implications for current investors in

commission-based accounts by increasing the complexity and compliance costs associated with

offering that fee structure to customers.

1. Review of the SEC (2011) assessment: costs of imposing a fiduciary standard on

brokers

As mentioned above, the SEC staff undertook a study in 2011 designed to evaluate the

effectiveness of existing regulatory standards for investment advisers and brokers. The study

was mandated under Section 913 of Title IX of the Dodd-Frank Act and analyzed some of the

potential costs associated with changes to the current regulatory framework (see p.143-165),

including imposition of a fiduciary standard on brokers.

In this section we review the discussion in SEC (2011) regarding the potential costs and

expenses to retail customers, and the potential impact on the profitability of their investment

39 See footnote 10.

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23

decisions, including access to the range of products and services offered by broker-dealers,

resulting from imposing on broker-dealers the fiduciary standard associated with the Investment

Advisers Act of 1940.

The primary concern mentioned in SEC (2011) is with respect to the cost and availability

to retail investors of accounts, products, services, and relationships with broker-dealers, which

could inadvertently be eliminated or impeded (for example, through higher costs to brokers being

passed on to investors).40

In general imposition of a new regulatory standard of conduct on broker-dealers has the

potential for additional costs on broker-dealers, which would be passed on to the customers at

least in part, according to the standard economic theory of “effective incidence”. That theory

simply states that it is likely that at least some portion of the regulatory costs imposed by the

government is ultimately passed on to the public.41 In turn, costs passed on to retail investors

would have the effect of eroding the profitability of their investments.

The net cost impact on retail customers would likely depend on a complex interplay of

various factors, such as investor wealth, investor willingness to pay additional fees, and size of

the particular broker-dealers in question as well as the competitive landscape. To take an extreme

example, in relation to the UK experience, the FSA found42 that smaller firms and firms with less

revenue were more likely to either exit the market or alter the types of services provided, in

response to new government regulations.

The following discussion presents some further detail on specific concerns discussed in

SEC (2011).

a. Brokers may deregister and register as investment advisers and, in the

process, convert their brokerage accounts into advisory accounts subject to

advisory fees.

One concern expressed in SEC (2011) associated with the imposition of a fiduciary

standard is the possibility that brokers would convert existing accounts from commission-based

40 See p. 155-159. 41 See, for example, Mukherjee, S. (2002), Modern Economic Theory, at p.833. 42 Oxera, Retail Distribution Review Proposals: Impact on Market Structure and Competition, prepared for the Financial Services Authority, Mar. 2010

App. 1040


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accounts to fee-based accounts, in order to respond to new requirements placed on those account.

The ultimate cost impact of this would depend on the actual fees and commissions, the relative

extent to which the accounts in question had been actively trading, and any increased costs

associated with providing advice for a fee.43

Additionally, there could also be “fee layering” (whereby fees are charged based both on

the value of the assets as well as account fees such as administrative and custodial fees),

especially for less actively traded accounts.44

An Oliver Wyman/SIFMA 2010 study45 notes that there are significant cost differences

between broker-dealer and advisory accounts, and if a change in the regulatory regime has the

effect of pushing more clients toward the higher-cost model then this could be a suboptimal

outcome for those investors. They estimate cumulative returns to retail customers with $200,000

in assets would be reduced by $20,000 over the next 20 years in such a scenario.

The 2011 SEC study states on p.162 that: “One possible way that costs could increase is

if broker-dealers whose customers want advice and who currently provide the full range of

brokerage services…for a single commission (or mark-up) and perhaps minor account level fees,

simply converted these accounts to investment adviser status and cease to provide execution

services to retail investors who sought advice. If that were the case, custody costs to the retail

investors would be higher. Advice costs charged, at least initially upon conversion (and absent

the investor researching competitors’ prices), would also be higher for those investors who buy

and hold, because either an hourly or asset-based fee would likely exceed the current

commission or mark-up on a retail trade.”

The 2011 SEC study goes on to note: “In sum, to the extent that broker-dealers respond

to a new standard by choosing from among a range of business models, such as converting

brokerage accounts to advisory accounts, or converting them from commission-based to fee-

based accounts, certain costs might be incurred and ultimately passed on to retail investors in the

43 See p. 155-159. 44 See p. 172 45 Oliver Wyman, Securities Industry and Financial Markets Association, Standard of Care Harmonization: Impact Assessment for SEC, Oct. 2010.

App. 1041


25

form of higher fees or lost access to services and products. Any increase in costs to retail

investors detracts from the profitability of their investments.”46

b. Broker-dealers may unbundle their services and provide them separately

through affiliates or third parties.

The SEC (2011) study notes that broker-dealers might choose to unbundle their services

and provide some of the component services through third parties.47 A brokerage relationship

involves various component functions: finding customers; providing advice to those customers;

executing orders; clearance and settlement services; custodial services; and recordkeeping

services, such as trade confirmations and account statements.

SEC (2011) argues that costs to broker-dealers are likely to depend on whether these

services were provided by one firm or whether they were divided among affiliates. For example,

a broker can self-clear securities transactions or contract with a third-party clearing broker to

clear transactions. A broker can act as custodian for securities itself or contract with a third party

such as a bank.

Brokers could decide to divide some or all of these functions. As noted in SEC (2011), to

the extent broker-dealers may transfer accounts or personnel to affiliates, this may generate

additional administrative costs.

2. The DOL (2011) Federal Register Study

While the most recent 2015 DOL RIA did not provide estimates of the cost to investors

of losing professional investment advice, an earlier DOL (EBSA) study in 2011, previously

cited, did in fact do so. The 2011 DOL Federal Register article published the final rule relating

to the provision of professional investment advice to plans and beneficiaries of IRAs, under

ERISA.

The 2011 DOL publication explicitly argues that participants in participant-directed

retirement savings accounts make mistakes. In particular, the study notes (p.66151) that:

46 See p. 162. 47 See p. 164, 173.

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26

“such mistakes and consequent losses historically can be attributed at least in part to

provisions of the Employee Retirement Income Security Act of 1974 that effectively preclude a

variety of arrangements whereby financial professionals might otherwise provide retirement

plan participants with expert investment advice. Specifically, these ‘prohibited transaction’

provisions of section 406 of ERISA and section 4975 of the Internal Revenue Code prohibit

fiduciaries from dealing with DC plan or IRA assets in ways that advance their own interests.”

The DOL estimates this error rate costs an aggregate of “more than $114 billion in 2010”

(p.66151). The study goes on to say (p. 66159) that: “The Department is highly confident in its

conclusion that investment errors are common and often large, producing large avoidable losses

(including foregone earnings) for participants. It is also confident that participants can reduce

errors substantially by obtaining and following good advice. While the precise magnitude of the

errors and potential reductions therein are uncertain, there is ample evidence that that magnitude

is large.”

The DOL then argued that the PPA, by permitting a broader array of investment advice

under ERISA, decreased the amount of errors made by investors. For example, the study states

(p.66152): “the Department believes this final regulation will provide important benefits to

society by extending quality, expert investment advice to more participants, leading them to

make fewer investment mistakes. The Department believes that participants, after having

received such advice, may pay lower fees and expenses, engage in less excessive or poorly timed

trading, more adequately diversify their portfolios and thereby assume less uncompensated risk,

achieve a more optimal level of compensated risk, and/or pay less excess taxes.”

The DOL estimated that the reduction in investment errors due to the expansion of

availability of investment advice would amount to between $7 billion and $18 billion annually,

or approximately 6 percent to 16 percent of the $114 billion total in investment errors made per

year.48 At the upper range these numbers are as large as the supposed cost of conflicted advice

that the DOL Fiduciary Standard is designed to alleviate.

48 The DOL stated that it based its estimates on the retirement assets in DC plans and Individual Retirement Accounts reported by the Federal Reserve Board’s Flow of Funds Accounts (Mar. 2011), at www.federalreserve.gov/releases/z1/Current/. The study also refers the reader to earlier DOL studies including 74 FR No 164 (Aug. 22, 2008), 74 FR No 12 (Jan. 21, 2009), and 75 FR No 40 (Mar. 2, 2010).

App. 1043


27

The investment mistakes discussed in the 2011 RIA are grounded in the behavioral

finance literature, which we have discussed in detail above. For example, the DOL stated (p.

66153) that “in practice many investors do not optimize their investments, at least not in

accordance with generally accepted financial theories. Some investors fail to exhibit clear, fixed

and rational preferences for risk and return. Some base their decisions on flawed information or

reasoning. For example some investors appear to anchor decisions inappropriately to plan

features or to mental accounts or frames, or to rely excessively on past performance measures or

peer examples. Some investors suffer from overconfidence, myopia, or simple inertia.”

The study then goes on to focus on five types of investment mistakes:

a) Fees and Expenses. The DOL stated that it believes that (p. 66153) “there is a strong

possibility that at least some participants, especially IRA beneficiaries, pay inefficiently

high investment prices.” However, it is not clear what empirical evidence the DOL used

as its basis for this statement.

b) Poor Trading Strategies. The study cited churning, failure to rebalance, attempts to time

the market, and chasing past returns as examples of strategies that tend to underperform.

c) Inadequate Diversification. The DOL claims that DC plan participants sometimes

concentrate their assets excessively in stock of their employer, as well as being under-

invested in international equity or debt.

d) Inappropriate Risk. The study notes that investors may construct portfolios that are too

risky or too safe, given their preferences.

e) Excess Taxes. The DOL study mused that some households appear to follow sub-optimal

strategies with respect to minimizing taxes, such as not placing taxable bonds in tax-

deferred accounts. However, the DOL also stated that (p. 66154) “the Department

currently has no basis to estimate the magnitude of excess taxes that might derive from

participants’ investment mistakes.”

Despite the rather lengthy description of the above types of investment errors, the DOL did not

use data from actual investor-held accounts to estimate the magnitude of the associated losses.

Instead, they made a variety of assumptions, summarized as follows:

App. 1044


28

1) The DOL assumed that approximately 40 percent of DC plan sponsors provided access to

investment advice before the PPA.49 After enactment of the PPA, they assumed this

percentage increased to between 56 and 69 percent.

2) They assumed that about 25 percent of plan participants that are offered advice use the

advice (both pre-PPA and post-PPA). For IRAs, they assumed that 33 percent used

advice pre-PPA, and between 50 percent and 80 percent post-PPA.50,51

3) Investors who received advice make mistakes about half as often as those who are

unadvised (they also consider other fractions).

Finally, the above assumptions are combined with the previously mentioned assumption that

aggregate investment errors cost consumers about $114 billion per year to arrive at the final

estimates of between $7 billion to $18 billion per year from having increased access to

professional investment advice.

Taking the DOL’s methodology and results at face value, by their own calculations the

loss of access to advice, by even a small fraction of investors, would result in investment errors

so large as to be of the same magnitude as the problem that the DOL is purportedly trying to

solve—the “cost of conflicted advice,” by the DOL’s own reckoning, is on par with the losses

that would be incurred by a government policy that curtails the availability of professional

investment advice.

III. THE COST OF CONFLICTED INVESTMENT ADVICE

We begin with a review of the claims of harm associated with purportedly conflicted

investment advice, as put forth in White House memo entitled “The Effects of Conflicted

Investment Advice on Retirement Savings” (“WH/CEA memo”) published in February 2015 and

the Department of Labor’s (DOL) proposed conflict of interest rule and definition of the term

49 The DOL attributed these numbers at least partly to surveys including Hewitt Associates LLC, Survey Findings: Hot Topics in Retirement, 2007 (2007); Profit Sharing/401(k) Council of America, 50th Annual Survey of Profit Sharing and 401(k) Plans (2007); and Deloitte Development LLC, Annual 401(k) Benchmarking Survey, 2005/2006 Edition (2006). 50 These are based on Employee Benefit Research Institute, 2007 Retirement Confidence Survey, Wave XVII, Posted Questionnaire (Jan. 2007); Hewitt Associates LLC, Survey Findings: Hot Topics in Retirement, 2007 (2007); Profit Sharing/401(k) Council of America, 50th Annual Survey of Profit Sharing and 401(k) Plans (2007); and Deloitte Development LLC, Annual 401(k) Benchmarking Survey, 2005/2006 Edition (2006). 51 It is interesting to note that the DOL assumed that “a large majority of IRA beneficiaries who invest in mutual funds purchase them via such professionals.”

App. 1045


29

“fiduciary” under ERISA (the “proposal”), and associated Regulatory Impact Analysis

(“RIA”). 52,53

The estimates in these documents form the basis of the Department of Labor’s argument

that the proposed conflict of interest rule would “benefit” the public. The Regulatory Impact

Analysis in particular purports to quantify these benefits in dollar terms. As shown in detail in

the next section, however, the RIA fails to do so. The RIA produces many different numbers

representing different underlying assumptions, and results in estimates that vary wildly over an

incredible set of values. This range of numbers is so wide as to suggest no scientific confidence

in the DOL’s methodology. As a result, the estimates in the RIA provide little confidence as to

the actual benefits, if any, arising from the DOL’s proposal.

A. Estimates of the Benefits of the Proposal Vary Wildly in the RIA

In the WH/CEA memo entitled “The Effects of Conflicted Investment Advice on

Retirement Savings” published in February 2015, the authors estimated that a baseline aggregate

cost to consumers from purportedly conflicted advice is about $17 billion per year. They

calculated this number as one percent times the total number of mutual funds and variable

annuities in IRAs. The one-percent factor came from their assessment of an average of estimates

produced by various academic papers using differing methodologies and datasets.

However, this number does not appear in the subsequent DOL Regulatory Impact

Analysis published two months later in April 2015. Instead, the RIA provides many different

numbers, all generated by different sets of assumptions.

Table 5 summarizes the various estimates of the cost of purportedly conflicted advice that

appeared in the RIA. A review of the table indicates an astounding range of different estimates.

On the low end, there is mention in three separate places in the RIA (p. 8, p. 102, and p. 106) of

an estimated cost from $20 billion to $22 billion over a ten year horizon. These numbers appear

to come from an analysis that assumes the new DOL rules will eliminate 50 percent of

52 29 CFR 2509 and 2510, DOL, Definition of the Term ``Fiduciary''; Conflict of Interest Rule-- Retirement Investment Advice; Proposed Rule in Federal Register Volume 80, Number 75 (Monday, April 20, 2015), Pages 21927-21960. 53 “Fiduciary Investment Advice Regulatory Impact Analysis”, Department of Labor, Available on-line at http://www.dol.gov/ebsa/pdf/conflictsofinterestria.pdf.

App. 1046


30

underperformance due to front-end-load sharing, and that this is the only effect considered.

These numbers equate to between $2 billion to $2.2 billion per year (setting aside discount rates

and any growth in the asset base over time), which are about 13 percent of the WH/CEA memo’s

$17 billion per year estimate.

On the high range, the RIA states on p. 7 and p. 98 that the costs of conflicted advice

could be “nearly $1 trillion” over a horizon of 20 years. This is consistent with approximately

$50b in costs per year (again, setting aside discount rates, compounding of returns and other

dynamic assumptions the DOL may have made). The estimate seems to come from an analysis

in which it is assumed that investors lose 200 basis points (two percentage points) of annualized

return per year due to “conflicted advice,” instead of the 100 bps (one percentage point) assumed

in the WH/CEA memo. It is not clear where the 200 bps number comes from. Nor is it clear

why this number is so large, given that simply doubling the 100 bps number should

approximately double the estimate from $17 billion per year to $34 billion per year. Presumably,

the DOL increased the number from $34 billion to $50 billion by apparently compounding

returns over time, but the RIA does not specify this in enough detail to be certain.

One reason for the incredible range in aggregate estimates is that the RIA numbers vary

in terms of the horizon of interest (some are per year, some cover a 10-year horizon, and some

cover a 20-year horizon), assumptions made (e.g., some assume a 100 bps reduction in

investment performance, and others assume a 200 bps reduction in performance), and the

universe of assets that are considered (e.g., some consider all mutual funds held in individual

retirement accounts (“IRAs”) while others focus only on front-end load mutual funds, and so

forth).

Nevertheless, given the variety to the DOL’s own numbers, the “benefit” estimates do not

provide a credible foundation on which to base significant changes in policy and regulation. The

very wide range in the numbers suggests that the DOL itself does not have a good measure of the

dollar magnitude of purportedly conflicted advice that they seek to ameliorate.

This range of numbers is so wide as to provide no scientific confidence in the DOL’s own

methodology, and is inconsistent with a cost-benefit analysis that is concrete enough to form the

basis of a change to federal government policy.

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31

An additional problem with the “benefits” of the proposal, as presented by the DOL, is

that the academic literature on which they base their argument does not directly apply to the

question of how to best define and implement a fiduciary standard under ERISA.

B. The RIA Misapplies the Academic Literature

In this section, we discuss some important ways in which the RIA misapplies the existing

academic literature in an attempt to justify the DOL proposal.

Before discussing the methodological shortcomings, we note that much of the academic

literature which is cited by the RIA is based on data which is now dated and may no longer be

relevant. Significant changes have occurred in the past several years. Indeed, one of the most

salient recent developments is that mutual fund fees have been declining substantially, and that

has occurred independently of any explicit government driven interventions.

Over the period 1990-2013, front-end sales loads have declined by nearly 75 percent for

equity funds and hybrid funds, and even more than that for bond funds.54 The ICI argues this

decline, at least in part, may reflect the increasing role of mutual funds in helping investors save

for retirement. That is, mutual funds now often waive load fees on purchases made through

defined contribution plans, such as 401(k) plans.

Additionally, nearly all net new cash flows in recent years have accrued to no-load

mutual funds. Net flows to load mutual funds have been negative for all four years of the most

recent data.55

1. The cited literature focuses on mutual funds, yet the DOL applies the results

more widely

The academic research that serves as the basis for conflicted cost-of-advice estimates

focuses on the commissions embedded in mutual fund purchases and sales. These are typically

front-end loads, although there may be back-end loads and on-going fees such as 12b-1 fees.56 54 See Chapter 5 of the 2014 Investment Company Fact Book, Mutual Fund Expenses and Fees, available on-line

at http://www.icifactbook.org/fb_ch5.html 55 Id., in Figure 5.10.

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Yet the DOL proposal extends far beyond mutual funds. To cite one example, the

proposal ends the existing prohibited transaction exemption for variable annuities and states that

they would be able to be sold only under existing compensation structures under the Best Interest

Contract Exemption. Other assets classes, such as options on stocks, do not appear to be

permitted for sale to IRA accounts under any of the proposed exemptions.

There is no justification provided, therefore, as to why the DOL would propose making

such radical shifts to the way in which all assets are sold to IRA account holders, given that the

academic literature on which the RIA relies so heavily is almost exclusively limited to the

mutual fund literature. There is no basis in the academic literature for extrapolating conclusions

applicable to mutual funds to other investment products that may not even have front-end sales

loads.

2. The research cited in the RIA takes results associated with higher-than-average

load funds and misapplies them to all funds.

One of most heavily cited academic papers in the RIA is Christoffersen, Evans and

Musto (2013).57 It is cited dozens of times, and is one of the leading sources of the baseline

estimate of 100 bps per year in apparent “cost of conflicted advice” that the DOL claims is

suffered by investors in commission-based retirement accounts.

It is therefore important to understand the claims that actually appear in Christoffersen et

al. (2013). In particular, their study finds evidence that a subset of funds, those whose front-end

loads are higher than other funds with similar characteristics, underperformed the average return

of their fund category during the next year. In formulating much of their “cost of conflicted

advice” aggregate figures, the DOL then assumes that all IRAs invested in front-end load funds

56 The RIA attempts to portray brokers and investment advisers in the professional IRA market as charging excessive fees to investors, yet it fails to mention one of the most salient developments in recent years – namely, that mutual fund fees have been declining substantially. It is notable that this has occurred independently of any explicit government driven interventions. Investment Company Institute (ICI) expense ratio data for three broad types of mutual funds over the years 2000-2013 indicate, for example, that in 2000 equity mutual fund investors incurred average expense ratios of 99 basis points. By 2013, that number fell to 74 basis points, a decline of 25 percent. The same basic pattern is true for hybrid and bond funds. In terms of front-end sales loads, it is again the case that they have declined substantially over time with no explicit government intervention. Over the period 1990-2013, they have declined by nearly 75% for equity funds and hybrid funds, and even more than that for bond funds. Additionally, nearly all net new cash flows in recent years have accrued to no-load mutual funds. Net flows to load mutual funds have been negative for all four years of the most recent data. See Chapter 5 of the 2014 Investment Company Fact Book, Mutual Fund Expenses and Fees, available on-line at http://www.icifactbook.org/fb_ch5.html 57 Christoffersen, Susan E. K., Richard Evans, and David K. Musto (2013) “What Do Consumers’ Fund Flows Maximize?

Evidence from Their Brokers’ Incentives,” Journal of Finance, Vol. 68(1), p. 201-235.

App. 1049


33

suffer the same underperformance, thereby mistakenly applying a result from a subset of load

funds to all load funds.

The extrapolation the DOL made is analogous to the following: Suppose we conduct

medical research and find that people who consume more salt than average have a lower life

expectancy by five years, and we then conclude that eating no salt will increase the life

expectancy of everyone by five years. This is a logical fallacy. We have no evidence that people

who eat a “normal” amount of salt would benefit from reduced salt intake, and so extrapolating

to them is an error in logic.

Again, we emphasize this point because an official cost-benefit analysis needs to be

precise and free of logical fallacies. By incorrectly extrapolating from a subset of mutual funds

to all mutual funds, the DOL is effectively applying the 100 bps cost number to assets for which

it does not apply. Hence, the benefit side of the cost-benefit analysis presented in the RIA is

seriously flawed. The result is that it is impossible to conclude whether the benefits of the DOL

proposal outweigh the costs.

3. The academic literature cited in the RIA does not compare the costs and benefits

of fiduciary accounts with those of brokerage accounts

The academic literature on which the DOL relies, such as Christoffersen, Evans, and

Musto (2013), Bergstresser, Chalmers, and Tufano (2009),58 Del Guercio and Reuter (2014),59

generally compares the performance of mutual funds with loads (paid as commission to brokers)

versus mutual funds sold directly to the public.

None of these academic studies actually compares the performance of accounts with a

financial advisor who is a fiduciary to the performance of accounts with a broker or other

financial advisor that is not a fiduciary. Hence they are using results that do not address the

central question of the proposal. It is absolutely inappropriate to conclude that investors would

58 Bergstresser, Daniel, John Chalmers, and Peter Tufano (2009), “Assessing the Costs and Benefits of Brokers in the Mutual

Fund Industry”, The Review of Financial Studies, 22(10), p. 4129-4156. 59 Del Guercio, Diane and Jonathan Reuter (2014) “Mutual Fund Performance and the Incentive to Generate Alpha”, The Journal

Of Finance, Vol. 69(4), p. 1673-1704.

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34

be better off under an expanded fiduciary standard on the basis of the academic literature being

cited.

The bulk of the literature considers data at the mutual fund level and measures their loads

and performance. These can be compared to direct-to-public investments such as a “S&P 500”

index fund. The academic research generally has not undertaken a direct way of comparing how

investors would fare under a fiduciary standard in relation to a broker-based suitability model or

a self-direction model because that analysis requires account-level data from actual investors,

rather than aggregate fund-level data.60

Absent account-level data, the DOL is drawing fallacious conclusions. Even if it were

true that fund loads cause underperformance—which is not proven—there is no reason to

conclude that consumers would be better off in fiduciary advised accounts based on the evidence

cited by the DOL. Fiduciary advisors do not work for free. They must also be compensated for

their work, and in some cases they may be providing a great deal more service than a

commission-based non-fiduciary broker and may need even more compensation. If certain

investors are forced out of commission-based accounts, they may either lose access to advice

entirely, or they may switch to advisory accounts which may charge more, not less. Moreover,

this increased expense is likely to be particularly acute for low-balance and low-activity accounts

who may pay very low annual fees and loads because their portfolios tend to be static. Hence the

DOL proposal is likely to disproportionately hurt low-income Americans.

60 A small number of academic papers have looked at account-level data, but these are generally limited to extremely small

sample sets that are not in any way representative of the spectrum of American consumers. For example, Chalmers and Reuter (2014) collect account level data, but it is limited to faculty and administrators in the Oregon University’s optional retirement plan (ORP). See Chalmers, J. and J. Reuter (2014), “What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?” working paper, University of Oregon.

App. 1051


35

Table 5 The Cost of Conflicted Advice Estimated by DOL Varies Widely

Entry Page Amount Horizon Methodology Notes

(1) (2) (3) (4) (5) (6)

Estimates found in The Effects of Conflicted Investment Advice on Retirement Savings 1

1 2 $17 bil. per year 100 bps (from

academic lit) * $1.7 trillion assets in IRA funds

N/A

Estimates found in Fiduciary Investment Advice: Regulatory Impact 2

1 7 100 bps per year "Careful review" of

academic literature N/A

2 7, 98 $210 bil. 10 years Applying performance gap (100 bps based on academic lit) to the current IRA marketplace

100 bps figure is the average underperformance associated with conflicts of interest in the mutual funds segment

3 7, 98 $500 bil. 20 years See above N/A 4 7, 98 $430 bil. 10 years Applying performance

gap (200 bps based on academic lit) to the current IRA marketplace

200 bps figure is based on academic studies that suggest that the underperformance of broker-sold mutual funds may be even higher than 100 bps, possibly due to loads that are taken off the top and/or poor timing of broker sold investment

5 7, 98 "nearly" $1 tril.

20 years See above On pg. 8 the RIA also mentions that adviser conflicts "could cost IRA investors as much as $410 bil. over 10 years and $1 tril. over 20 years. The $410 bil. number seems to come from the 200 bps points, but the RIA is unclear

App. 1052


36

6 8 $410 bil. 10 years DOL estimate based on reduction in excessive trading, associated transaction costs, timing errors, improvements in performance of IRA investments other than front-load mutual funds

See above

7 8, 101 $40-44 bil. 10 years DOL estimate based of assumption that rule will eliminate 100 percent of underperformance due to variable front-end-load sharing

"Baseline scenario" where the 1975 rule remains in place. Loads projected to decrease over time at the same rate as the baseline scenario. Quantifying gains expected to accrue to IRA investments in front-end load mutual funds attributable to variations in load sharing. DOL considers this estimate "conservative". Quantified gains pertain only to 13 percent of all IRA assets that are involved in front-end-load mutual funds

8 8, 101 $88-100 bil.

20 years See above See above

9 8, 102, 106

$30-33 bil. 10 years DOL estimate based of assumption that rule will eliminate 75 percent of underperformance due to variable front-end-load sharing

The Report offers no basis for the selection of 75 percent underperformance

10 8, 102, 106

$20-22 bil. 10 years DoL estimate based of assumption that rule will eliminate 50 percent of underperformance due to variable front-end-load sharing

The Report offers no basis for the selection of 50 percent underperformance

App. 1053


37

11 105 $44.1 bil. 10 Loads decrease over time at twice the rate of the baseline scenario. Quantifying gains expected to accrue to IRA investments in front-end load mutual funds attributable to variations in load sharing and increased investment performance for broker-sold mutual funds. The DOL considers this estimate "reasonably high" Quantified gains pertain only to 13 percent of all IRA assets that are involved in front-end-load mutual funds

N/A

12 105 $99.7 bil. 20 See above N/A 13 105 $65.6 bil. 10 Represents upper limit.

Loads paid by investors immediately fall to zero Quantifying gains expected to accrue to IRA investments in front-end load mutual funds attributable to variations in load sharing and increased investment performance for broker-sold mutual funds. The DOL considers this to be an "illustration but does not expect the proposal to result" in this number. Quantified gains pertain only to 13 percent of all IRA assets that are involved in front-end-load mutual funds

N/A

14 105 $135.1 bil. 20 See above N/A 15 98 $18 bil. per year Applying performance

gap (100 bps) to the current IRA marketplace

N/A

App. 1054


38

16 98 $10 bil. per year Christoffersen, Evans, and Musto (2013) find that each 100 basis points in load sharing paid to an unaffiliated adviser reduces future returns by 50 bps and 100 bps paid to a captive broker reduces future performance by 15 bps. Authors of the RIA project these results onto the current IRA marketplace

N/A

17 98 $125 bil. 10 years See above N/A 18 98 $285 bil. 20 years See above N/A 19 98 $26 bil. per year Harm to consumers if

industry has simply shifted conflicted revenue streams, rather than reducing conflicts

This refers to a hypothetical where the industry shifts away from front-end load mutual funds into other revenue streams with conflicts of interest. Appears to be based off of Christoffersen, Evans, and Musto (2013).

20 98 $300 bil. 10 years See above See above 21 98 $700 bil. 20 years See above See above 22 101 $80 bil. 10 years Underperformance

seen by focusing only on how load shares paid to brokers affect the size of loads IRA investors holding load funds pay and the returns they achieve

The Report assesses the gains to investors attributable to the rule by specifically quantifying benefits in an area of the IRA market where the conflicts are well measured-namely front-end load mutual funds

23 101 $200 bil. 20 years See above See above Sources: 1 The Effects of Conflicted Investment Advice on Retirement Savings. The White House. February 2015 2 Fiduciary Investment Advice: Regulatory Impact Analysis. The Department of Labor

App. 1055


39

APPENDIX: THE COST OF COMPLYING WITH THE DOL PROPOSAL

The Regulatory Impact Analysis published by the DOL also reported estimates for the

costs of implementing the DOL’s new Fiduciary Standard rules. These are essentially limited to

compliance costs.

A detailed overview is presented in Table 6. Turning to the top row, compliance costs

are estimated to range from range from $240 million to $570 million per year (equivalently, $2.4

billion to $5.7 billion over a 10 year horizon, abstracting from applying discount rates, inflation

corrections or other dynamic adjustments).

Perhaps more important than the baseline numbers, however, is the incredibly complex

and opaque, ad hoc, methodology and set of assumptions which were used to formulate these

estimates.

For example, The DOL’s cost estimates for complying with the DOL’s proposed

fiduciary rule rely on data submitted by SIFMA to the SEC in 2013 (the “SIFMA Data”).61 The

SIFMA Data was collected and submitted by SIFMA to the SEC for the purpose of estimating

the costs of complying with potential SEC fiduciary rule changes under Dodd-Frank Section

913.62 Although the DOL states that “there will be substantive differences between the [DOL]’s

new proposal and exemptions and any future SEC regulation that would establish a uniform

fiduciary standard… ”, the DOL nevertheless relies on the SIFMA Data as part of the basis for

its cost estimates.63 DOL’s stated reason for doing so is that there are “some similarities

between the cost components” in the SIFMA Data and the costs that would be required to

comply with the DOL proposal.

However, the phrase “some similarities” implies there are some differences and the DOL

is, by definition, unable to address the compliance costs that may arise due to such differences in

the two regulatory regimes in question.

The SIFMA Data estimates the costs of implementing an SEC-established uniform

fiduciary standard in two parts. The first was the cost for broker-dealers to develop and maintain

61 Regulatory Impact Analysis, http://www.dol.gov/ebsa/pdf/conflictsofinterestria.pdf, at pp. 160 – 65. 62 SIFMA Comment to SEC dated July 5, 2013, http://www.sifma.org/issues/item.aspx?id=8589944317. 63 Regulatory Impact Analysis at p. 161.

App. 1056


40

a disclosure form and customer relationship guide, similar to the Form ADV Part 2A that

registered investment advisors use today.

The DOL proposal does not require a Form ADV Part 2A-type disclosure for broker-

dealers, but it would require an extensive range of new disclosure obligations that do not exist

today. These include: (i) contractual disclosures under the Best Interests Contract Exemption,

(ii) point of sale disclosure, including the total cost of the acquired asset over periods of 1, 5, and

10 years; (iii) annual fee and compensation disclosure; (iv) public website disclosure, including a

list of all direct or indirect material compensation; and (v) aggregated data regarding inflows,

outflows, holdings, and returns, including the identity and amounts of revenue received, which

DOL reserves the right to publicly disclose.

The disclosure estimates in the SIFMA Data are for broker-dealers to adopt an essentially

“known quantity” disclosure form that is used by advisors today. The disclosure estimates in the

SIFMA Data do not address any of the new disclosure obligations in the DOL proposal. Hence it

is erroneous for DOL to use SIFMA’s disclosure estimates to approximate the costs of the

extensive, new, separate and distinct, disclosures required under the DOL proposal.

The second part of the SIFMA Data is the estimated cost of implementing compliance

oversight and training programs to adapt to a new SEC standard. In providing these estimates,

SIFMA member firms were asked to make a host of assumptions. None of these assumptions,

however, include the new obligations and potential liabilities that the DOL proposal may create,

including: (i) new contractual liability under the Best Interest Contract Exemption, including

potentially significant individual and class action litigation exposure; (ii) compliance with a new

DOL exemption in order to engage in principal transactions; (iii) new restrictions on products

that may be offered and sold, and (iv) the costs of creating the new data and information that are

subject to the new disclosures outlined above.

In sum, the SIFMA Data applies to estimating the cost of a contemplated SEC fiduciary

regime, under specific assumptions that were applied to such a contemplated SEC approach. It is

not methodologically appropriate to use the SIFMA Data to estimate the cost of a separate and

distinct DOL regime, with separate and distinct requirements, obligations, liabilities, and costs.

The DOL further compounds the apparent inconsistency by relying on the SIFMA Data

and then suggesting that “the SIFMA submission significantly overestimates the costs of the new

App. 1057


41

proposal.”64 The DOL thus appears to be relying on inputs into its cost analysis that it does not

view as accurate, thereby undermining the reliability of its own methodology.

Lastly, we note that the US Chamber of Commerce submitted a comment letter to the

OMB on May 20, 2015 outlining their view that the Department of Labor vastly underestimated

the compliance costs associated with the proposed Fiduciary rule.65 Specifically, the Chamber

states (on p. 2) that real costs associated with the information collection requests alone may be

“five to ten times greater” than the DOL’s estimate of $792 million over ten years. The ten-page

letter goes on to detail the various shortcomings and implausible assumptions made by the DOL

in their calculations.

While we will not undertake to comment on the OMB letter, it does serve to emphasize

the clear shortcoming of the DOL’s estimates. Namely, they are not based on a scientific or

empirical approach and the resulting estimates may or may not be wildly inaccurate reflections

of the true costs. As a result, it would be inappropriate to include them as part of a formal

assessment of the costs and benefits of a proposed change in public policy.

64 Regulatory Impact Analysis at p. 162. 65 Available on-line at http://www.uschamber.com/sites/default/files/oira_comments.pdf.

App. 1058


42

Table 6 The Costs of Compliance Are Based on Complex and Opaque Set of Assumptions

Estimates found in Fiduciary Investment Advice: Regulatory Impact 1

Page

Source

Amount

Horizon

Notes

(1)

(2)

(3)

(4)

(5)

157 Department of Labor Estimate $2.4b-5.7 bil. 10 years Total compliance cost. Cost mostly reflects the costs incurred by new fiduciary advisers to satisfy relevant PTE conditions

162 SIFMA estimate of average start up cost to develop and implement new, comprehensive supervisory systems, procedures and training

$5 mil. one year Estimated costs that would be incurred by broker-dealers

162 SIFMA estimate of annual on-going costs

$2 mil. annual

165 DOL estimated start-up cost of compliance for medium firms based on values provided by SIFMA

$663,000 one year $5 million x (0.133). 0.133 is the estimated ratio of medium firms and large firms' cost based on figures provided for RIAs in the IAA comment letter

165 DOL estimated start-up cost of compliance for small firms based on values provided by SIFMA multiplied by DoL's ratio

$242,000 one year 5 million x (0.048). 0.048 is the estimated ratio of small firms and large firms' cost based on figures provided for RIAs in the IAA comment letter

166 DOL total estimated start-up cost of compliance in the first year

$892 mil. one year

165 DOL estimated on-going cost of compliance for medium firms

$265,000 annual $2 million x 0.133 (the IAA ratio)

165 DOL estimated on-going cost of compliance for small firms

$96,900 annual $2 million x 0.048 (the IAA ratio)

166 DOL estimated on-going cost of compliance after first year

$357 mil. annual

166 Estimated start-up cost of compliance for large firms based on values provided by the IAA

$1 mil. one year

166 DOL estimated start-up cost of compliance for medium firms based on values provided by the IAA

$145,000 one year The DoL took the ratio between the cost SIFMA and IAA provided (.2181) and derived the costs from that ratio referred to as the

App. 1059


43

"ADV ratio"

166 DOL estimated start-up cost of compliance for small firms based on values provided by the IAA

$53,000 one year SIFMA estimates multiplied by ADV ratio

166 DOL total start-up cost of compliance after first year based on IAA

$195 mil. one year See above

166 Estimated on-going cost of compliance for large firms based on values provided by the IAA

$436,000 annual See above

166 Estimated on-going cost of compliance for medium firms based on values provided by the IAA

$58,000 annual SIFMA estimates multiplied by ADV ratio

166 Estimated on-going cost of compliance for small firms based on values provided by the IAA

$21,000 annual See above

166 DOL estimated total annual ongoing costs for subsequent years based on IAA

$78 mil. annual See above

Cost of Developing and Maintaining a Disclosure Form and Customer Relationship Guide

161 SIFMA reported start-up cost for preparing a relationship guide similar to the Form ADV 2A

$2.8 mil. one year

161 SIFMA reported "low" start up cost

$1.2 mil. one year

161 SIFMA reported "high" start-up cost

$4.6 mil. one year

161 SIFMA reported average annual on-going cost

$631,000 annual

Costs Incurred by Registered Investment Advisors

166 DoL Analysis of cost for legal consultation for small firms

$3,840 one year Hourly rate of $480. 8 hours assumed

166 DoL Analysis of cost for legal consultation for medium firms

$7,680 one year Hourly rate of $480. 16 hours were assumed.

166 DoL Analysis of cost for legal consultation for large firms

$19,200 one year Hourly rate of $480. 40 hours were assumed.

167 DoL Analysis of costs of training for a large firm in the first year

$30,000 one year

167 DoL Analysis of costs of training for a large firm after the first year

$10,000 annual

167 DoL Analysis of costs of training for a medium firm in the first year

$4,000 one year

App. 1060


44

167 DoL Analysis of costs of training for a medium firm after the first year

$1,500 annual

167 DoL Analysis of costs of training for a small firm in the first year

$1,500 one year

167 DoL Analysis of costs of training for a small firm after the first year

$1,500 annual

167 Total cost to evaluate compliance with rule and provide training for a large RIA firm in the first year

$49,200 one year

167 Total cost to evaluate compliance with rule and provide training for a medium RIA firm in the first year

$11,700 one year

167 Total cost to evaluate compliance with rule and provide training for a small RIA firm in the first year

$5,300 one year

167 Total cost to evaluate compliance with rule and provide training for a large RIA firm in the subsequent years

$10,000 annual

167 Total cost to evaluate compliance with rule and provide training for a medium RIA firm in the subsequent years

$1,500 annual

167 Total cost to evaluate compliance with rule and provide training for a small RIA firm in the subsequent years

$500 annual

167 Total Cost for IRA firms in the first year

$110.8 mil, one year

167 Total Cost for IRA firms in the subsequent years

$11.9 mil. annual

Costs Incurred by Plan Service Providers

168 Start-up cost for a large firm $49,000 one year

168 Start-up cost for a medium firm $12,000 one year

168 Start-up cost for a small firm $5,000 one year

168 Aggregate start-up cost for training employees

$24.1 mil. one year

169 On-Going Costs for small firm $10,000 annual 2,275 small service providers, 437 medium service providers, 142 large service providers

169 On-Going Costs for medium firm $2,000 annual

169 On-Going Costs for large firm $1,000 annual

169 Aggregate on-going costs for training employees, yearly

$3.2 mil. annual

App. 1061


45

2,275 small service providers, 427 medium service providers, 142 large service providers

Additional Costs

171 Increased insurance premiums for consultants, firms and broker-dealer representatives

premiums for these affected service providers could be expected to increase 10 percent; average insurance premium is $3,000 per representative. Premium increase would be $300 per insured

N/A DoL estimates that 50% of the cost reflects the expenses and profits of insurance carriers, while the remainder is not a cost but a transfer in the form of compensation paid to those harmed by the insured fiduciary investment adviser

172 one year premium increase for broker dealer representatives

$87 mil. one year 290,000 broker dealers multiplied by $300

173 Cost of premiums and transfers from firms to plans or IRA investors

$63 mil. annual 418,00 BD representatives and plan service provider employees could experience a $300 increase. 50% is paid out as compensation and 50% is paid to the insuring firm

174 First year cost for each BD representative converting to RIA status

$5,600 one year 50 hours preparing for Series 65 exam (at $106.06/hour) plus additional costs

174 Total first year cost of BD to RIA conversion

$59.4 mil. one year

174 Ten year cost of BD to RIA conversion

$445 mil. ten years

177 first year cost for producing and distributing the disclosures and subsequent compliance

$77.4 mil. one year

177 on-going cost for subsequent years for producing and distributing disclosures

$29.2 mil. annual

177 first year cost of the 6.3 million disclosures required under the new Principal Transactions PTE

$57.4 mil. one year

on-going cost of the 6.3 million disclosures required under the new Principal Transactions PTE

$47.8 mil. annual

177 Disclosure requirements required by the amended PTE 86-128

$198,000 annual

177 Seller's Carve-Out disclosures $6.2 mil. annual Assumes 43,000 disclosures

App. 1062


46

178 The Platform Provider Carve-Out $39,000 annual Assumes 1,800 disclosures

178 The Investment Education Carve-Out

$121,000 annual Assumes 2,800 disclosures

178 Total exemptions and carve-outs cost in the first year

$141.5 mil. one year Assumes 92.4 million additional disclosures

178 Total exemptions and carve-outs cost in the subsequent years

$83.5 mil. annual

178 Total exemptions and carve-outs cost in 10 years

$791.8 mil. 10 years

Mentioned But Not Quantified

175 Increased traffic in Call Centers

176 Cost of creating or updating contracts

176 transitional impacts on the financial sector market

176 impact on asset providers

177 costs for complying with the new and amended PTEs

Sources 1 Fiduciary Investment Advice: Regulatory Impact Analysis. The Department of Labor

Our work in this matter is ongoing and we may update or change our opinions as we continue our review and analysis.

App. 1063


APPENDIX 5

App. 1064


COMMENT TO THE DEPARTMENT OF LABOR

Tax Consequences to Investors Resulting from Proposed Rules

Relating to Financial Representative Fiduciary Status

COMPASS LEXECON JULY 20, 2015

App. 1065


1

I. BACKGROUND AND SUMMARY OF OPINIONS

1. The Department of Labor (“DOL”) has proposed amendments to the existing rule

that defines when financial representatives are fiduciaries for purposes of ERISA and the Internal

Revenue Code, including with respect to advice provided regarding IRA assets.1 We understand

that much or all of the assistance currently provided to investors through commission-based

accounts is not currently subject to fiduciary status, but arguably would be so under the proposed

amendments.

2. We understand participants in this rulemaking have stated that, if subjected to the

changes in fiduciary status imposed by the proposed amendments, firms currently offering

commission-based IRAs will no longer find it cost-effective to offer IRAs to small account

holders, such as those with a balance below $25,000. The impact on IRAs is particularly

problematic because the IRS strictly limits annual deductions for IRA contributions. For

instance, in 2015, total contributions to all traditional and Roth IRAs cannot be more than $5,500

(or $6,500 for those 50 or older).2 As a consequence, there would be essentially no way for an

investor to start a new IRA with one of these firms, unless the investor already had more than

$25,000 in another retirement account that could be “rolled over.”3

3. We understand that the proposed amendments will only affect tax-qualified

accounts such as IRAs and Roth IRAs; the proposed amendments will not change firms’ ability

to offer commission-based taxable accounts. Obviously, taxable savings accounts lack the tax

1. 80 FR 21927 (April 20, 2015). 2. Internal Revenue Service, Publication 590-A (2014). 3. Making the maximum $5,500 contributions, and earning 10 percent returns per year, it would take

four years before a new IRA account achieved a $25,000 balance. ∑ 5,500 1.07. = $26,129. A “rollover” is a withdrawal from an existing retirement plan (such as a 401(k) or another IRA) that is reinvested within 60 days into an IRA. If reinvested into a traditional IRA, the rollover amount will generally not be taxed, although it will incur taxes at the time of retirement. Internal Revenue Service, “Rollovers of Retirement Plan and IRA Distributions,” http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Rollovers-of-Retirement-Plan-and-IRA-Distributions [accessed July 13, 2015].

App. 1066


2

advantages of IRAs. Therefore, if, as a consequence of the DOL’s proposed amendments, an

investor who would have opened an IRA instead opens a taxable savings account, the investor

will experience lower retirement savings, all else equal.

4. Compass Lexecon was asked by counsel for Primerica, Inc. (“Primerica”) to

analyze and quantify these reductions in retirement savings.4 The size of the reductions varies

depending on a number of factors about an investor and his or her investment choices, such as

the length of time the account is held and the investor’s income (and hence, his or her tax rate).

As a consequence, for this study, we considered a range of possible values for these parameters.

5. Nevertheless, as a general matter, we conclude that, for most investors, the loss

associated with opening a taxable savings account instead of an IRA would be large. For

example, consider a 30-year-old investor who starts a new IRA, expects to hold it 35 years until

retirement, and contributes 4.5 percent of his income annually. The median outcome of our

model for this investor involves an effective average tax rate on savings (relative to a totally

untaxed account) of 23.8 percent for a Roth IRA and 15.0 percent for a traditional IRA, whereas

the effective average tax rate on savings for the same investor making the same investment, but

in a taxable savings account, is 38.7 percent. In other words, the taxpayer in this case would see

his effective tax rate rise by 62.6 percent relative to a Roth IRA, and 158.0 percent relative to a

traditional IRA if the DOL’s proposed amendments caused him to open a taxable savings

account.

6. The median effective tax increase due to the DOL’s proposed amendments varies

across investors who start saving at different ages, but in any case, the tax increases remain very

substantial, with the median never below 32.9 percent. Therefore, to the extent that the DOL’s

4. Appendix A includes a brief description of Compass Lexecon. Appendix B includes a list of

materials relied upon in the preparation of this comment.

App. 1067


3

proposed amendments lead a substantial number of investors to open taxable savings accounts

instead of IRAs, the amendments would in essence constitute a sizable tax increase on many

Americans’ retirement savings.

7. To put these effective tax increases into perspective, we estimated their effect on

the number of years of retirement an investor can fund at a desired level of annual retirement

income. As an example, consider again the 30-year-old new IRA investor described above who

can fund annual retirement income equal to 60 percent of his expected final pre-retirement

income. We estimate that the effective tax increase to this investor from opening a taxable

account reduces the number of retirement years funded at this level by about 2.7 years or 4.3

years, relative to if he had opened a Roth IRA or a traditional IRA, respectively. For someone

who expects 20 total retirement years, these reductions reflect between a 13.5 percent (Roth

IRA) and 21.4 percent (traditional IRA) reduction in financially-secure retirement years.

8. These examples above are illustrative, but this type of effective tax increase

potentially affects any future investor who seeks to start an IRA with a commission-based

professional through contributions or through a relatively small rollover. Available evidence

indicates that there are around 7.0 million existing households with these types of IRAs. If 7.0

million future households experience the effective tax increases we estimate in our model, the

total reduction in retirement savings would be between $147 billion and $372 billion. This is a

rough estimate of the potential impact, and, to the extent some investors do not switch to taxable

accounts as a consequence of the proposed amendments, the actual impact may be lower. But in

any case, this calculation illustrates that the proposed amendments may have very substantial

costs which nevertheless do not appear to have been considered in the DOL’s cost-benefit study.

App. 1068


4

9. For our model, we considered investors with typical values of key parameters,

such as income and asset allocations. Section II below describes in detail the assumptions about

these and other parameters.

10. Section III describes in detail how the model was run. In brief, the model

calculates effective tax rates for three different possible savings vehicles: a traditional IRA, a

Roth IRA, and a taxable savings account, based on the after-tax value of each at the time of

retirement, relative to the value of a hypothetical fully untaxed account. The three types of

accounts are assumed to include the same assets, which provide the same fundamental returns;

nevertheless, the three types of accounts grow at different rates due to different tax treatments.

11. Future returns to IRA assets are obviously not known in advance. To estimate

effective tax rates, we perform what is known as a “Monte Carlo” model. First, we draw a set of

returns at random for each year until retirement based on the historical distribution of returns to

different types of assets. We then calculate the resulting effective tax rates for each type of

account based on the results of the model using these randomly-drawn returns. We then repeat

the entire process 10,000 times. This allows us to report the median effective tax rates, as well

as other statistics, such as the 95th percentile.

12. Section IV reports the resulting effective tax rates and the potential tax impacts of

the DOL’s proposed amendments for investors starting accounts at various ages and with various

income levels. Section IV also describes in more detail the calculations noted above regarding

the effect on the number of secure retirement years and the total potential tax impact on U.S.

investors.

App. 1069


5

II. DESCRIPTION OF MODEL

13. We first describe the key parameters of the model, including the investor’s age,

income, tax rates, annual size and frequency of contributions to savings, and asset allocations.

We then describe how investment returns are calculated each year.

A. Investor Characteristics

14. We considered an investor who plans to retire at age 65. In order to understand

the impact of the DOL’s proposed amendments on different types of investors, we considered

investors who begin a new retirement savings account today at ages ranging between 30 and 45.

15. Available evidence indicates that IRA investors have somewhat higher income

than the average household. According to a recent large survey, the median household income

of a household that contributed to an IRA in 2013 was $87,500 for traditional IRAs, and $95,000

for Roth IRAs.5 An average of these two is $91,250. The same survey indicates a median age of

45 years for a household head contributing to an IRA.6 By contrast, U.S. Census data indicates

that in 2013, median household income for a household with a 45-year-old head-of-household

was $66,057.7 Therefore, the typical IRA-contributing household has an income level

approximately 38 percent higher than the median U.S. household of the same age.8

16. For our model, we assumed that a typical investor’s household income when

starting an IRA would be approximately 38 percent above the median U.S. household income for

5. Sarah Holden and Daniel Schrass (2015) “Appendix: Additional Data on IRA Ownership in

2014,” ICI Research Perspective 21(1A), at 11. 6. The median age of the household solo or co-decisionmaker for saving and investing was 47 years

for a traditional IRA and 43 years for a Roth IRA. Id., at 11. 7. Median household income for a household with a 35-44 year-old head-of-household was $64,973,

and the similar figure for households with a 45-54 year-old head-of-household was $67,141. $66,057 is the average of these two figures. U.S. Census Historical Income Table H.10, http://www.census.gov/hhes/www/income/data/historical/household/index.html [accessed July 7, 2015].

8. $91,250 / $66,057 = 1.38.

App. 1070


6

individuals of the same age. For example, at age 30, household income of $72,729 is 38 percent

above the median household income,9 and at age 45, $91,159 is 38 percent above the median.10

In 2011, these incomes would correspond to approximately the 70th percentile of U.S. household

income for each age.11

17. We also allow the investor’s income to increase over the period of the investment

in the model. This happens for three reasons. First, incomes rise with age due to increased

human capital accumulation and other effects. The U.S. Census data on household income

described above indicates an average 1.3 percent higher household income per year of age in

2013.12 Second, our model is based on nominal dollars, and there is likely to be at least a

moderate amount of inflation in the future. The most recent long-term forecast for annual

growth in inflation from the Philadelphia Federal Reserve’s “Survey of Professional Forecasters”

is 2.14 percent.13 Third, median household incomes have historically grown faster than inflation.

Between 1980 and 2013, median real household income for all U.S. households experienced a

compound annual growth rate of 0.26 percent in constant dollars.14 Combining these three

effects, we assumed annual income growth for the investor of 3.70 percent until retirement at age

65 ( = 1.30 percent + 2.14 percent + 0.26 percent).

9. In 2013, median household income for households with head-of-household aged 24-34 years was

$52,702. Id. $72,729 = $52,702 x 1.38. 10. In 2013, median household incomes for households with head-of-household aged 35-44 years and

45-54 years were $64,973 and $67,141, respectively. Id. $91,159 = (($64,973 + $67,141) / 2) x 1.38. 11. U.S. Census Bureau, 2011 Annual Social and Economic (ASEC) Supplement, HINC-02, Total All

Races, http://www.census.gov/hhes/www/cpstables/032012/hhinc/hinc02_000.htm [accessed July 17, 2015]. 12. Median household income for households with head-of-household aged 15-24 was $34,311, and

the similar figure for households with head-of-household aged 55-64 was $57,538. U.S. Census Historical Income Table H.10, op. cit. 1.30 percent = (57,538 / 34,311)(1/(59.5 – 19.5)) -1.

13. https://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/2015/survq215 [accessed July 7, 2015].

14. In 2013 dollars, median household income was $51,939 in 2013, and $47,668 in 1980. U.S. Census Historical Income Table H.10, op. cit. 0.26 percent = (51,939 / 47,668)(1/(2013 – 1980)) -1.

App. 1071


7

18. Upon retirement, we assumed a reduction in income of 40 percent, relative to

income in the prior year (in other words, an income replacement rate of 60 percent). This is

consistent with findings in the academic literature,15 as well as recent data from the Social

Security Administration.16

19. Federal income tax rates ranging between 10 percent and 39.6 percent were

applied in each year based on the current marginal tax rates applicable to a married jointly-filing

household with taxable income calculated as described above. The threshold incomes defining

each income tax bracket are assumed to increase annually by 2.14 percent from their current

(2015) levels based on the long-term forecasts published by the Philadelphia Federal Reserve

described above. The current capital gains tax rates that correspond to each income tax bracket

are assumed to maintain that same relationship in the future.17 For investors with income above

$250,000, the recently implemented Net Investment Income Tax of 3.8 percent was also

applied.18

20. As noted above, the median household income of an investor contributing to a

traditional IRA is $87,500, and the median age of the head-of-household for traditional IRA

contributors is 47.19 The average annual contribution to a traditional IRA for a contributing

15. See, e.g., B. Douglas Bernheim, Jonathan Skinner, and Steven Weinberg (1997) “What Accounts

for the Variation in Retirement Wealth Among U.S. Households?” NBER Working Paper 6227, at 53 (indicating median income replacement rate of 0.60).

16. Andrew G. Biggs and Glenn R. Springstead (2008) “Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income,” Social Security Bulletin 68(2), at Table 3 (indicating replacement rate relative to final earnings of 69 percent for households in the 3rd highest quintile, and 52 percent for households in the 4th highest quintile).

17. For taxpayers in the 10 or 15 percent income tax bracket, the capital gains tax rate is 0 percent. For taxpayers in the 25, 28, 33, or 35 percent income tax bracket, the capital gains tax rate is 15 percent. For taxpayers in the 39.6 percent income tax bracket, the capital gains tax rate is 20 percent. Internal Revenue Service, “Publication 17 (2014),” at Chapter 16.

18. By law, the $250,000 threshold is not adjusted for inflation. See http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs [accessed July 10, 2015].

19. Holden and Schrass (2015) op. cit.

App. 1072


8

household with head-of-household between 45 and 49 is $3,975.20 This therefore corresponds to

approximately 4.5 percent of household income. Hence, we assume that investors make a

contribution to retirement savings equal to 4.5 percent of income (on a pre-tax basis), unless the

contribution is limited, as described below. (Of course, investors may contribute additional

amounts to other forms of retirement savings outside our model, such as company plans.)

21. Current contribution limits to an IRA are $5,500 per year ($6,500 for investors

age 50 or above).21 By statute, these limits increase according to a formula relating to the

inflation rate, and we applied this formula to project contribution limits in each year over the

period of investment until retirement.22 If an investor’s contribution of 4.5 percent of income

exceeds these limits in any year, we assumed the investor contributed only the limited amount.

In order to maintain comparability, we assumed the same limited contribution, whether the

investment was made in an IRA or a taxable savings account.

22. Available evidence indicates that many investors who own IRA accounts

nevertheless do not contribute to them every year.23 Therefore, in our model we considered two

possibilities for the investor: (a) contribute the amount described above every year, or (b)

contribute the amount described above every other year.

20. Craig Copeland (2014) “Individual Retirement Account Balances, Contributions, and Rollovers,

2013; With Longitudinal Results 2010-2013: The EBRI IRA Database,” Employee Benefit Research Institute Issue Brief 414, at 17 (Figure 16).

21. Internal Revenue Service, “Retirement Topics – IRA Contribution Limits,” http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits [accessed July 7, 2015].

22. The contribution limit for investors under age 50 is calculated as $5,000, multiplied by the ratio of the CPI for the relevant year and the CPI for 2007. 26 USC §§219(b)(D) & 1(f)(3). The contribution limit for investors age 50 and above is $1,000 higher than the limit for younger investors. 26 USC §§219(b)(B).

23. Craig Copeland (2014) “Individual Retirement Account Balances, Contributions, and Rollovers, 2013; With Longitudinal Results 2010-2013: The EBRI IRA Database,” Employee Benefit Research Institute Issue Brief 414, at 1.

App. 1073


9

23. A recent survey indicates the typical asset allocation held in IRAs, by the age of

the account owner.24 While essentially any asset can be held in an IRA, the bulk of assets are

equities, bonds, and money / cash.25 For instance, the typical IRA held by a 25-44 year-old

contained 66.3 percent equity, 12.9 percent bonds, 13.9 percent money, and 6.9 percent other

assets. For each age group, we allocated the “other” assets evenly across the equity, bonds, and

money categories, and then linearly extrapolated these asset allocations reported for age groups

to individual ages. We assume that the investor holds these age-specific allocations in their

retirement savings, rebalancing annually.26

B. Investment Returns

24. For each year until retirement, the model requires a set of four investment returns:

(a) equity appreciation; (b) dividends; (c) bond interest; and (d) bond appreciation. As proxies

for the equity appreciation and dividend returns, we calculated these returns for the S&P500 over

the past 38 years.27 As proxies for the bond yield and appreciation, we calculated these returns

for the Barclay’s U.S. Aggregate Bond Index, also over the past 38 years.28 These returns are

gross of commissions paid to brokers or other fees, which will vary depending on the specific

asset an investor purchases, but because these commissions and fees would be paid in either an

24. Craig Copeland (2014) “IRA Asset Allocation, 2012, and Longitudinal Results, 2010 – 2012,”

Employee Benefit Research Institute Notes 35(10), at 8. 25. Other assets account for between 5.7 and 11.1 percent of assets, depending on the age of the

account holder. Id. 26. Given the assumed annual contributions, as well as dividend, interest, and capital gains

distributions (as described below), we assumed this rebalancing could be made without selling any current holdings (and thus potentially triggering capital gains tax liability).

27. Both returns are calculated, assuming reinvestment (of capital gains or dividends, respectively). The mean annual S&P total return (including price appreciation and dividends) over this period is 12.6 percent, with a16.7 percent standard deviation. The mean annual dividend return over this period is 2.8 percent, with a 1.3 percent standard deviation.

28. The mean annual Barclay’s Aggregate Bond Index total return (including coupons and price appreciation) over this period is 7.9 percent, with a 6.9 percent standard deviation. The mean annual coupon return over this period is 7.4 percent, with a 3.1 percent standard deviation.

App. 1074


10

IRA or a taxable savings account, a comparison of the value of the two accounts will likely not

suffer a material bias due to this omission.

25. For each year until retirement in our model, we selected at random (with

replacement) one year from the past 38 years, and applied the four historical returns from that

selected year. Given the asset allocation described above, we can, for each year until retirement,

calculate the gain in the value of the account. We assume that all dividends and interest are

reinvested in the account. We also assume that a share of the equity portion of the portfolio is

distributed each year as (long-term) realized capital gains, but then reinvested. Over the last five

years, the three largest U.S. load-bearing equity-only mutual funds distributed an average of 2.2

percent of fund value as long-term capital gains,29 so we assume 2.2 percent of the equity held in

the account is distributed as realized capital gains each year (and then reinvested).

III. MODEL OPERATION

26. At the beginning of each year, the investor makes her annual contribution and

draws a set of equity and bond returns, as described above. For a taxable savings account or a

Roth IRA, the annual contribution is made using after-tax dollars (i.e., the contribution is

reduced by the contemporaneous marginal tax rate), while for a traditional IRA, the annual

contribution is made using pre-tax dollars.30 The portfolio then grows during the year according

to the returns drawn, and at the end of the year, the investor pays any taxes due before the start of

the next year. In the case of IRAs, no taxes are paid at the end of each year. In the case of a

29. According to Morningstar, the three largest equity-only load-bearing mutual funds are AGTHX,

AIVSX, and CWGIX. The calculation was performed over the years 2010 – 2014. None of these funds distributed short-term capital gains in any of these years.

30. In the case of a traditional IRA, the deduction that allows the contribution to be made in pre-tax dollars may not be realized until the end of the year, but we assume the deduction is available at the beginning of the year.

App. 1075


11

taxable savings account, ordinary income taxes are paid each year on interest and dividends

received that year, and long-term capital gains taxes are paid on capital gains distributions. After

taxes, the remaining interest, dividends, and capital gains are reinvested in the account.31

27. At age 65, the investor retires and we value the account at that point. For a Roth

IRA, no taxes are due on withdrawal. For a traditional IRA, taxes are paid on the full amount of

the account at the point of retirement, based on the marginal income tax rate applicable in

retirement, calculated as described above (40 percent below the last working year income). For a

taxable savings account, taxes are paid at retirement on the gain in the account, relative to the

cost basis, based on the long-term capital gains tax rate applicable in retirement, calculated as

described above. The cost basis each year is calculated as the annual contributions made to the

account, plus reinvested interest, dividends, and realized capital gains (net of taxes). The cost

basis at retirement is the sum of the cost basis calculated each year.

28. The values at retirement of the various accounts, and hence, the effective tax

rates, depend on the investment returns experienced each year. As noted above, these are a

random draw from historical returns. Hence, the results will differ in any given run of the model.

We ran a Monte Carlo simulation of the model with 10,000 iterations.32

31. We do not allow for loss “harvesting” in the case of a taxable savings account, in which investors

strategically realize capital losses on certain assets to offset any gains they may have. Some evidence indicates that such harvesting can, if performed rigorously, increase the value of a portfolio materially. Robert D. Arnott, Andrew L. Berkin, and Jia Ye (2001) “Loss Harvesting: What’s It Worth to the Taxable Investor?” First Quadrant Perspective, No. 1, at 13 (“We have simulated returns for 500 assets over 25 years to examine the benefits of loss harvesting for taxable portfolios … Even after liquidation, net of all deferred taxes, this advantage is still an impressive 14%.”) However, available evidence indicates that few investors actually realize gains through such a strategy. Brad M. Barber and Terrance Odean (2003) “Are individual investors tax savvy? Evidence from retail and discount brokerage accounts,” Journal of Public Economics 88:419-42, at 440 (“both discount and retail households have a strong preference for realizing gains, rather than losses, in their taxable accounts.”)

32. See William H. Greene (2012) Econometric Analysis (7th ed.), Prentice Hall, at 615-7. Ten thousand iterations is relatively large compared with other Monte Carlo studies of tax behavior. See, e.g., Robert D. Arnott, Andrew L. Berkin, and Jia Ye (2001) op. cit., at 6 (indicating 500 simulations).

App. 1076


12

IV. RESULTS

A. Effective Tax Rates

29. Exhibit A summarizes the results of eight specifications of the model,

corresponding to different ages at account inception and different contribution frequencies. The

results of each specification are based on a separate set of 10,000 runs of the model. In the first

specification, an investor who starts contributing at age 30 makes a contribution to the account

every year. In the second model, the same investor makes a contribution only every other year.

The remaining specifications increase the investor’s age at account inception in five-year

increments up to age 45. In each specification, we report the after-tax value at retirement of four

types of accounts that differ only in their tax treatment: a completely untaxed account (for

reference), a traditional IRA, a Roth IRA, and a taxable savings account. We report the median

value for each of these (across all 10,000 runs), as well as the 5th and 95th percentiles.

30. For an investor who begins an account at age 30 and contributes every year, the

median traditional IRA at retirement after taxes is worth $1,021,747, with a 5th to 95th percentile

range of $498,220 to $2,102,672 (these figures are in nominal 2050 dollars, when the investor in

question retires). The median Roth IRA is worth $916,524, with a 5th to 95th percentile range of

$444,695 to $1,891,507. The median taxable savings account is worth $736,068, with a 5th to

95th percentile range of $364,754 to $1,495,796. This demonstrates the substantial tax savings

generated by IRAs, relative to taxable savings accounts. Unsurprisingly, Exhibit A also shows

that all account values diminish substantially for investors who either wait until later ages to

begin an account or who do not contribute every year; nevertheless, IRAs still have substantial

tax benefits in all cases. (In part, the decline in value for investors who start accounts at later

ages is due to the fact that the account values are calculated in nominal dollars at the time of

App. 1077


13

retirement. Thus, the results for a 45-year-old investor are denominated in nominal 2035 dollars,

whereas the results for a 30-year-old investor are denominated in nominal 2050 dollars.)

31. We also report in Exhibit A the median, 5th, and 95th percentiles of the effective

tax rates on each of the IRAs and the taxable savings account. The effective tax rate is

calculated separately in each of the 10,000 runs of the model, based on the difference between

the value of the IRA or taxable savings account, and the value of the completely untaxed

account. For instance, if in a particular run, a completely untaxed account would be worth

$500,000 in retirement, and an otherwise equivalent taxable savings account is only worth

$350,000, then the effective tax rate is 30 percent ( = $150,000 / $500,000). (The median, 5th,

and 95th percentile tax rate may not correspond to the same run of the model as the median, 5th,

and 95th percentile account value; hence, the tax rates in Exhibit A cannot necessarily be

calculated directly using the account values reported in Exhibit A.)

32. For an investor who begins an account at age 30 and invests every year, the

median effective tax rate for a traditional IRA is 15.0 percent, a Roth IRA is 23.8 percent, and a

taxable savings account is 38.7 percent. The traditional IRA tax rate is based entirely on the tax

bracket at retirement, while the Roth IRA tax rate reflects the various tax brackets throughout the

working life. If the investor is in the same tax bracket at retirement as throughout his working

life, then a Roth IRA and a traditional IRA have the same value at retirement. If the investor is

in a lower tax bracket in retirement than during the working life, then the traditional IRA will

have a higher value at retirement than a Roth IRA, and vice-versa if the investor is in a higher tax

bracket at retirement. For the taxable account, taxes are paid both during the working life and at

retirement, so the effective tax rate we calculate reflects both.

33. While contributing only every other year substantially diminishes the value of any

account at retirement, it has little impact on the effective tax rates. The age at which the investor

App. 1078


14

begins contributing can affect the effective tax rates on each type of account. This reflects

investors’ movements between various tax brackets during the working life and at retirement.

Investors’ incomes rise over time, but the tax bracket thresholds also rise, although at a different

rate. For this reason, investors of different ages today may end up retiring in different tax

brackets.

34. Exhibit A also reports the lost retirement savings for an investor who opens a

taxable savings account instead of an IRA. For an investor who begins an account at age 30 and

contributes every year, the median loss is $179,541 relative to a Roth IRA, and $286,046 relative

to a traditional IRA (again, these figures are in nominal 2050 dollars). The loss is so much larger

for a traditional IRA because, in foregoing a traditional IRA, the investor in this case loses the

advantage granted by his lower tax bracket in retirement. However, that additional advantage of

traditional IRAs does not apply to all investors of different ages in our model, because, even

assuming retirement income is 60 percent of pre-retirement income, some investors may

nevertheless end up retiring in the same tax bracket as they spent most or all of their working

life. In addition, starting to save at a later age (or contributing only every other year) reduces the

loss from opening a taxable savings account instead of an IRA simply because the accounts are

worth less.

35. The last statistic in Exhibit A is the effective tax increase in percent imposed by

placing IRA investors into taxable savings accounts. For instance, if, in a particular run of the

model, the effective tax rate on an IRA is 25 percent, and the effective tax rate on a taxable

savings account is 35 percent, then the effective tax increase on retirement savings is 40 percent (

= 10 percent / 25 percent). For an investor who begins an account at age 30 and contributes

every year, the median effective tax increase in moving from a Roth IRA to a taxable account is

62.6 percent; the equivalent figure for a traditional IRA is 158.0 percent. Again, the tax increase

App. 1079


15

imposed on a traditional IRA holder is larger because, in addition to the tax benefits of IRAs

generally, the investor also loses the benefit of paying taxes at the lower rate applicable during

retirement. The 5th-to-95th percentile of the tax rate increase is 52.6 percent to 72.0 percent for

the Roth IRA, and 145.8 percent to 169.1 percent for the traditional IRA, indicating that in all or

nearly all cases, the investor would be expected to suffer a substantial tax increase.

36. Contributing only every other year has little effect on these effective tax increase

estimates. The effective tax increases do depend to some degree on the age at which the investor

begins the accounts, but the median tax increase is never less than 32.9 percent at any age, and

even at the 5th percentile, the tax increases for investors of different ages are at or above 28

percent. Hence, investors of all types are very likely to experience a substantial tax increase if,

as a consequence of the DOL’s proposed amendments, they open taxable accounts instead of

IRAs.

37. One factor not incorporated into our model is the penalty for early withdrawal

imposed on IRAs. Investors always face the temptation to raid retirement savings in response to

financial shocks and other needs.33 For IRAs, the law imposes a 10 percent additional tax on

early distributions from both traditional and Roth IRAs in most cases.34 No such additional tax

applies to taxable accounts. This difference in incentives may make it more likely that investors

maintain their savings in IRAs, relative to taxable accounts. If so, then the difference in account

balances between IRAs and taxable accounts at the time of retirement will be even larger than we

estimate in our model.

33. Gene Amromin and Paul Smith (2003) “What Explains Early Withdrawals from Retirement

Accounts? Evidence from a Panel of Taxpayers,” National Tax Journal 56(3):595-612. 34. Internal Revenue Service, “Topic 557,” http://www.irs.gov/taxtopics/tc557.html [accessed July

15, 2015].

App. 1080


16

38. While, as noted above, the typical IRA investor has household income higher than

the U.S. median, IRAs are nevertheless popular investments for households of all income levels.

In order to better understand the effects of placing IRA investors into taxable savings accounts,

we therefore also ran variants of the model, assuming different household income levels for the

investor. For illustrative purposes, we focused on the specification of the model in which the

investor begins an account at age 30 and contributes every year. As discussed above, we

estimate the median household income of such an investor at age 30 as $72,729. In Exhibit B,

we also ran the model assuming the investor’s household income at age 30 was either higher or

lower than this value by 10 percent or 25 percent, producing a range between $54,547 and

$90,911. In 2011, this range of household incomes would encompass approximately the 54th

percentile up to the 80th percentile of the distribution of the household incomes of 30-year-olds in

the U.S.35

39. As in Exhibit A, we report in Exhibit B the median, 5th, and 95th percentiles of

account values, effective tax rates, lost retirement income, and effective tax increases when

opening a taxable savings account instead of an IRA. Exhibit B shows that higher income

households have higher account values at retirement, since they are able to contribute more to

their accounts each year. Effective tax rates on all accounts also generally rise with income,

consistent with the progressive tax structure. Placing higher income IRA investors into taxable

savings accounts sometimes involves larger tax increases and sometimes involves lower tax

increases, relative to lower income investors, due to the different tax brackets during the working

career and retirement for households of different incomes. At all income levels considered,

however, the median tax increase for an investor who would have opened a Roth IRA but instead

35. U.S. Census Bureau, 2011 Annual Social and Economic (ASEC) Supplement, HINC-02, Total All

Races.

App. 1081


17

opens a taxable account is greater than 62 percent, and the median tax increase for an investor

who would have opened a traditional IRA but instead opens a taxable account is greater than 73

percent. Thus, investors with a wide range of incomes would experience substantial losses if the

DOL’s proposed amendments reduced their access to IRAs.

B. Implications for Retirement Security

40. The effective tax increases calculated above are clearly substantial, but in order to

make these results concrete, we examined the impact these tax increases would have on

investors’ retirement security. To illustrate, we considered the effect for investors initiating

accounts at age 30, as described above, and contributing annually throughout the working life.

Immediately before retirement (i.e., in 2049, at age 64), the investor’s household income is

$250,141 (in nominal 2049 dollars, not current dollars). As noted above, the typical retirement

income replacement rate, relative to pre-retirement income, is about 60 percent, so suppose this

investor was able to maintain retirement income at about $150,085 (again, in nominal 2049

dollars).36

41. In Appendix C, we use the Social Security Administration’s benefit formula to

project the annual Social Security payment this investor would receive at the time of retirement

in 2050 as $83,291. This means that the investor’s savings must cover the remaining $66,794

each year.37 In Exhibit A above, we estimated median account values at retirement for the

investor of $916,524 for a Roth IRA, $1,021,747 for a traditional IRA, and $736,068 for a

taxable savings account. Of course, investors may also have other assets that they can use to

fund their retirement, but these figures indicate that an investor can fund her retirement at the

36. $150,085 = $250,141 x 60 percent. 37. $66,794 = $150,085 - $83,291.

App. 1082


18

desired level for approximately 13.7 years with a Roth IRA, 15.3 years with a traditional IRA,

and 11.0 years with a taxable savings account.38

42. This means that if, as a consequence of the DOL’s proposed amendments, an

investor opens a taxable savings account instead of an IRA, they would lose approximately 2.7

years of fully-funded retirement based on a Roth IRA, and approximately 4.3 years based on a

traditional IRA. For an investor who expects roughly 20 years of retirement, this reflects a 13.5

percent or 21.4 percent reduction in fully-funded retirement, respectively.

C. Aggregate Tax Increase Estimates

43. Finally, we also estimated the potential overall dollar impact to U.S. investors

from the effective tax increases calculated above. Our calculation necessarily is a rough

estimate, and relies on several assumptions for which there is some uncertainty. The actual

impact may be larger or smaller than we calculate here. Nevertheless, this illustrates that the

total impact may be very large if investors open taxable accounts instead of IRAs as a

consequence of the proposed amendments. It must therefore be seriously considered in any

reasonable cost-benefit analysis of the proposed amendments.

44. The DOL has indicated that in 2013, 34 million U.S. households had IRAs, and

41 percent of IRA-owning households reported holding IRAs at brokerages.39 This implies there

are approximately 14.0 million U.S. households with brokerage IRAs. As noted above, we

understand that, as a consequence of the proposed amendments, many of the firms offering these

38. We ignore additional investment returns after retirement for these calculations. This is appropriate

if investors switch to less risky assets that provide expected returns that do not exceed inflation by much. If investors are able to maintain returns above inflation during retirement, then these accounts can fund more years of retirement at the desired level, and the differences between the accounts in the number of years funded will be higher. This is one reason why the results presented here may be conservative.

39. Department of Labor (2015) “Fiduciary Investment Advice: Regulatory Impact Analysis,” at 52 & 53.

App. 1083


19

accounts have indicated they will restrict the availability of new IRAs with balances less than

$25,000. Therefore, the proposed amendments have the potential to affect all households that

(absent the amendments) would have started brokerage IRAs either from a contribution or a

rollover of less than $25,000.

45. The DOL has claimed that approximately half of all existing IRAs include no

rollover funds.40 Moreover, many IRAs initiated with rollover funds were likely started with less

than $25,000. Indeed, the median traditional IRA rollover amount was only $22,840 in 2012.41

To be conservative, we assume that only half of the 14.0 million U.S. households with brokerage

IRAs started those accounts with a contribution or a rollover less than $25,000.

46. Available data indicates that the average value (in 2013 dollars) of an IRA held by

a 65-year-old investor is $188,976.42 This reflects all IRAs, not only brokerage IRAs, but we are

not aware of any available data providing information on average balances at age 65 among only

brokerage IRAs. If the average balance for the 7.0 million households calculated above was

$188,976 (in 2013 dollars) at the time these households retire, then these accounts would be

worth, in total, $1,323 billion upon retirement.

47. We do not know whether the proposed amendments will affect these 7.0 million

households who hold existing IRAs, but even if their access to existing IRAs is not affected,

these households will, over time, be replaced with new households who may be affected if their

ability to start new IRAs is impaired. The median results of the model for all ages of investors

(as reported in Exhibit A) indicate that, at the time of retirement, taxable saving accounts have a

40. Id., at 54. 41. Investment Company Institute (2014) “The IRA Investor Profile: Traditional IRA Investors’

Activity, 2007 - 2012,” at 36. 42. Craig Copeland (2014) “Individual Retirement Account Balances, Contributions, and Rollovers,

2013; With Longitudinal Results 2010-2013: The EBRI IRA Database,” Employee Benefit Research Institute Issue Brief 414, at 9 (indicating average IRA balance of $165,139 for individuals 60-64 and $212,812 for individuals 65-70; the average of these two figures is $188,976).

App. 1084


20

value that is between 11.1 percent and 21.9 percent lower than Roth IRAs, and between 18.2

percent and 28.1 percent lower than traditional IRAs. This provides a range of the potential

effect on savings at the time of retirement if investors forego IRAs for taxable accounts.

48. Applying this range to the estimated $1,323 billion in IRA savings at the time of

retirement for 7.0 million future households similar to those existing today, the potential investor

losses due to a regulation that moves these households into taxable accounts would be between

147 billion and 372 billion.

49. These losses would be spread out over many years, of course, as some of the 7.0

million households in question would likely not retire until well into the future. Moreover, it is

possible some of these households could avoid or mitigate the impact of the effective tax

increases we calculate by finding other ways to invest in IRAs, such as through non-commission-

based accounts or by putting off starting an IRA until a later age when greater rollover assets

may be available to them. (Of course, these alternative options may involve costs as well.)

Nevertheless, these figures do illustrate that the potential total impact to U.S. savers of any

regulation that restricts access to IRAs may be very large and must be at least considered in any

reasonable cost-benefit analysis of such a regulation.

App. 1085


Exhibit ASummary of Model Estimates of Tax Impact of Placing IRA Investors Into Taxable Accounts

Untaxed1Traditional

IRA Roth IRATaxable Account

Traditional IRA

Roth IRA

Taxable Account

Relative to Traditional IRA

Relative to Roth IRA



Median Values (50th Percentile)30 Annual $1,202,055 $1,021,747 $916,524 $736,068 15.0% 23.8% 38.7% $286,046 $179,541 158.0% 62.6%30 Biennial $623,203 $529,723 $475,040 $380,843 15.0% 23.8% 38.8% $149,021 $93,930 158.9% 63.0%35 Annual $816,199 $612,149 $612,149 $480,709 25.0% 25.0% 41.0% $131,057 $131,057 64.0% 64.0%35 Biennial $418,982 $314,237 $314,237 $245,492 25.0% 25.0% 41.3% $68,425 $68,425 65.3% 65.3%40 Annual $530,698 $398,024 $398,024 $325,439 25.0% 25.0% 38.7% $72,553 $72,553 54.7% 54.7%40 Biennial $277,475 $208,106 $208,106 $169,772 25.0% 25.0% 38.8% $38,339 $38,339 55.1% 55.1%45 Annual $306,697 $260,693 $230,023 $204,503 15.0% 25.0% 33.2% $55,907 $25,202 121.5% 32.9%45 Biennial $157,224 $133,640 $117,918 $104,386 15.0% 25.0% 33.5% $29,197 $13,433 123.6% 34.2%

5th Percentile Values (95% of Outcomes Involve Larger Values)30 Annual $586,141 $498,220 $444,695 $364,754 15.0% 23.3% 36.9% $131,965 $77,816 145.8% 52.6%30 Biennial $302,958 $257,514 $229,727 $188,380 15.0% 23.3% 37.0% $68,584 $40,494 146.3% 52.9%35 Annual $418,407 $313,805 $313,805 $265,144 25.0% 25.0% 36.6% $48,499 $48,499 46.5% 46.5%35 Biennial $211,518 $158,639 $158,639 $133,429 25.0% 25.0% 37.0% $25,402 $25,402 47.9% 47.9%40 Annual $300,127 $225,095 $225,095 $196,335 25.0% 25.0% 34.6% $28,909 $28,909 38.3% 38.3%40 Biennial $156,689 $117,517 $117,517 $102,111 25.0% 25.0% 34.6% $15,158 $15,158 38.6% 38.6%45 Annual $185,452 $157,635 $139,089 $124,898 15.0% 25.0% 32.0% $32,883 $14,066 113.5% 28.1%45 Biennial $93,845 $79,768 $70,384 $62,662 15.0% 25.0% 32.3% $16,863 $7,424 115.5% 29.3%

95th Percentile Values (95% of Outcomes Involve Smaller Values)30 Annual $2,473,732 $2,102,672 $1,891,507 $1,495,796 15.0% 24.3% 40.4% $606,129 $398,323 169.1% 72.0%30 Biennial $1,289,872 $1,096,391 $986,903 $778,113 15.0% 24.3% 40.5% $318,622 $209,811 170.2% 72.7%35 Annual $1,534,900 $1,151,175 $1,151,175 $865,575 25.0% 25.0% 43.7% $285,561 $285,561 74.9% 74.9%35 Biennial $796,981 $597,736 $597,736 $447,234 25.0% 25.0% 44.0% $150,603 $150,603 76.1% 76.1%40 Annual $927,703 $695,777 $695,777 $546,565 25.0% 25.0% 41.3% $151,255 $151,255 65.3% 65.3%40 Biennial $488,306 $366,230 $366,230 $285,822 25.0% 25.0% 41.5% $80,123 $80,123 65.9% 65.9%45 Annual $496,239 $421,803 $372,179 $329,396 15.0% 25.0% 34.5% $92,870 $43,711 130.0% 38.0%45 Biennial $258,089 $219,375 $193,566 $170,684 15.0% 25.0% 34.8% $48,972 $23,497 132.1% 39.3%

Note: See text for assumptions regarding income at inception, income growth rate, inflation rate, investment returns, and other parameters.1. Untaxed account value is reported in order to identify effective tax rates.

3. Lost retirement savings is difference in dollar value between taxable account and specified IRA account at time of retirement.

2. Effective tax rate is loss in specified account value, relative to untaxed account, at time of retirement. For instance, if an untaxed account would be worth $1,000,000, and an IRA or taxable account would be worth $800,000, then the effective tax rate is 20%.

4. Effective tax increase is percentage increase in effective tax rate between taxable account and specified IRA. For instance, if the effective tax rate on a taxable account is 35 percent and the effective tax rate on an IRA is 25 percent, then the effective tax increase is 40% ((35% - 25%) / 25%).

Effective Tax Increase From

Taxable Acct.4Account Value at Retirement

(Nominal $ at Time of Retirement)

Effective Tax Rate on Retirement

Savings2Age at

Account Inception

Contribution Frequency

Lost Retirement Savings From

Taxable Acct.3

App. 1086


Exhibit BSummary of Model Estimates of Tax Impact of Placing IRA Investors Into Taxable Accounts

30-Year-Old Account Holder Making Annual ContributionsVarious Initial Income Levels

Untaxed1Traditional

IRA Roth IRATaxable Account

Traditional IRA Roth IRA

Taxable Account





$54,547 $901,545 $766,314 $748,296 $631,862 15.0% 17.1% 30.0% $135,149 $116,292 99.8% 75.3%$65,456 $1,081,848 $919,571 $861,046 $698,208 15.0% 20.5% 35.5% $222,911 $162,351 136.6% 72.9%$72,729 $1,202,055 $1,021,747 $916,524 $736,068 15.0% 23.8% 38.7% $286,046 $179,541 158.0% 62.6%$80,002 $1,322,262 $991,697 $991,697 $748,521 25.0% 25.0% 43.4% $243,303 $243,303 73.4% 73.4%$90,911 $1,495,024 $1,121,268 $1,126,455 $847,465 25.0% 24.6% 43.3% $273,541 $279,053 73.1% 75.7%

5th Percentile Values (95% of Outcomes Involve Larger Values)$54,547 $439,608 $373,667 $359,700 $307,331 15.0% 16.2% 28.6% $65,817 $51,680 91.0% 61.5%$65,456 $527,526 $448,397 $413,849 $341,857 15.0% 19.3% 34.1% $105,480 $70,444 127.5% 58.6%$72,729 $586,141 $498,220 $444,695 $364,754 15.0% 23.3% 36.9% $131,965 $77,816 145.8% 52.6%$80,002 $644,756 $483,567 $483,567 $393,465 25.0% 25.0% 38.9% $89,977 $89,977 55.7% 55.7%$90,911 $725,301 $543,976 $549,053 $445,299 25.0% 24.3% 38.6% $98,726 $103,331 54.3% 58.6%

95th Percentile Values (95% of Outcomes Involve Smaller Values)$54,547 $1,855,308 $1,577,011 $1,550,245 $1,300,330 15.0% 18.4% 31.3% $276,875 $253,013 108.5% 88.0%$65,456 $2,226,355 $1,892,402 $1,788,560 $1,434,272 15.0% 22.0% 36.9% $460,337 $360,193 145.8% 86.8%$72,729 $2,473,732 $2,102,672 $1,891,507 $1,495,796 15.0% 24.3% 40.4% $606,129 $398,323 169.1% 72.0%$80,002 $2,721,109 $2,040,831 $2,040,831 $1,468,177 25.0% 25.0% 46.1% $569,552 $569,552 84.5% 84.5%$90,911 $3,082,532 $2,311,899 $2,318,621 $1,663,083 25.0% 24.8% 46.2% $646,241 $652,563 84.6% 86.2%

Note: See text for assumptions regarding income at inception, income growth rate, inflation rate, investment returns, and other parameters.1. Untaxed account value is reported in order to identify effective tax rates.

3. Lost retirement savings is difference in dollar value between taxable account and specified IRA account at time of retirement.

2. Effective tax rate is loss in specified account value, relative to untaxed account, at time of retirement. For instance, if an untaxed account would be worth $1,000,000, and an IRA or taxable account would be worth $800,000, then the effective tax rate is 20%.

4. Effective tax increase is percentage increase in effective tax rate between taxable account and specified IRA. For instance, if the effective tax rate on a taxable account is 35 percent and the effective tax rate on an IRA is 25 percent, then the effective tax increase is 40% ((35% - 25%) / 25%).

Median Values (50th Percentile)

Household Income at

Age 30

Account Value at Retirement (Nominal $ at Time of Retirement)

Effective Tax Rate on Retirement

Savings2

Lost Retirement Savings From

Taxable Acct.3

Effective Tax Increase From

Taxable Acct.4

App. 1087


1

Appendix A: About Compass Lexecon Compass Lexecon is an economic consulting firm that specializes in the application of

economics to a variety of legal and regulatory issues. Compass Lexecon has a professional staff of more than 325 individuals and fourteen offices throughout the United States, Europe and South America. Compass Lexecon also maintains affiliations with leading academics including several Nobel Prize winners in Economics.

Lexecon, Compass Lexecon’s predecessor firm, was founded in 1977 by, among others,

then Professor (now Judge) Richard A. Posner of the Seventh Circuit Court of Appeals. Compass Lexecon was formed in January 2008 through the combination of Lexecon with Competition Policy Associates, another premier economic consulting firm. Compass Lexecon is a wholly owned subsidiary of FTI Consulting, Inc., a global business advisory firm. Professor Daniel R. Fischel currently serves as Compass Lexecon’s Chairman and President.

Compass Lexecon’s practice areas include antitrust, securities and financial markets,

intellectual property, accounting, valuation and financial analysis, pension economics and policy, corporate governance, bankruptcy and financial distress, derivatives and structured finance, class certifications and employment matters, damages calculations, business consulting, regulatory investigations and public policy.

Compass Lexecon’s clients include the United States Department of Justice and other

agencies of the federal government, state and local governments, regulatory bodies, major corporations, investor groups, and leading law firms across the globe.

For more information about Compass Lexecon, see its website at:

www.compasslexecon.com

App. 1088


1

Appendix B: Materials Relied Upon Public Documents 80 FR 21927 (April 20, 2015) Internal Revenue Service, Publication 590-A (2014) Internal Revenue Service, Publication 17 (2014) U.S. Census Bureau, 2011 Annual Social and Economic (ASEC) Supplement, HINC-02, Total All Races 26 U.S.C. § 219 : US Code - Section 219: Retirement savings Department of Labor (2015) “Fiduciary Investment Advice: Regulatory Impact Analysis” Articles & Books: Sarah Holden and Daniel Schrass (2015) “Appendix: Additional Data on IRA Ownership in 2014,” ICI Research Perspective 21(1A) B. Douglas Bernheim, Jonathan Skinner, and Steven Weinberg (1997) “What Accounts for the Variation in Retirement Wealth Among U.S. Households?” NBER Working Paper 6227 Andrew G. Biggs and Glenn R. Springstead (2008) “Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income,” Social Security Bulletin 68(2) Craig Copeland (2014) “Individual Retirement Account Balances, Contributions, and Rollovers, 2013; With Longitudinal Results 2010-2013: The EBRI IRA Database,” Employee Benefit Research Institute Issue Brief 414, May 2015 Craig Copeland (2014) “IRA Asset Allocation, 2012, and Longitudinal Results, 2010 – 2012,” Employee Benefit Research Institute Notes 35 Robert D. Arnott, Andrew L. Berkin, and Jia Ye (2001) “Loss Harvesting: What’s It Worth to the Taxable Investor?” First Quadrant Perspective, No. 1. Brad M. Barber and Terrance Odean (2003) “Are individual investors tax savvy? Evidence from retail and discount brokerage accounts,” Journal of Public Economics 88 William H. Greene (2012) Econometric Analysis (7th ed.), Prentice Hall Gene Amromin and Paul Smith (2003) “What Explains Early Withdrawals from Retirement Accounts? Evidence from a Panel of Taxpayers,” National Tax Journal 56(3)

App. 1089


2

Investment Company Institute (2014) “The IRA Investor Profile: Traditional IRA Investors’ Activity, 2007 - 2012” Websites: U.S. Census Bureau, 2011 Annual Social and Economic (ASEC) Supplement, HINC-02, Total All Races, http://www.census.gov/hhes/www/cpstables/032012/hhinc/hinc02_000.htm [accessed July 17, 2015]. U.S. Census Historical Income Table H.10, http://www.census.gov/hhes/www/income/data/historical/household/index.html [accessed July 7, 2015] https://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/2015/survq215 [accessed July 7, 2015] http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs [accessed July 10, 2015] Internal Revenue Service, “Retirement Topics – IRA Contribution Limits,” http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits [accessed July 7, 2015] http://www.ssa.gov/oact/cola/cbbdet.html [accessed July 17, 2015]. http://www.ssa.gov/oact/TR/TRassum.html [accessed July 17, 2015]. http://www.ssa.gov/oact/cola/piaformula.html

App. 1090


1

Appendix C: Estimated Social Security Payments

1. We estimated the annual Social Security payout for a 30-year-old in 2015 who

retires in 2050. As noted above, we assumed household income at age 30 of $72,729, and

increased this income by approximately 4.5 percent per year until age 65.1 We indexed these

earnings to the investor’s age 60 year (i.e., 2045, two years before retirement eligibility)

according the Social Security Administration’s most recent projections for the National Average

Wage Index (NAWI).2 These are reported in the table below. The Average Indexed Monthly

Earnings (AIME) is the sum of these indexed earnings over the entire 35 year period, divided by

420 months during that period.3 This value is $18,527.

2. The Primary Insurance Amount (PIA) is calculated as a function of two “bend

points” that serve to graduate Social Security benefits for high-income households. These bend

points can be calculated based on future values of NAWI, projected as described above, and are

reported for each year in the table below. The table indicates that, in the investor’s age 62 year

(the first year of retirement eligibility), the two bend points are projected to be B1 = $2,876 and

B2 = $17,334.

3. If B1 and B2 are the two bend points, then the PIA is equal to 0.9 x B1 + 0.32 x

(B2 – B1) + 0.15 x (AIME – B2).4 At age 62, the PIA for this investor is projected to be $7,394.

This value is then increased between ages 62 and 65 at the projected future COLA of 2.7

percent.5 A 30-year-old investor today was born in 1985. Therefore, under current regulations,

1. The assumed incomes are always below the Contribution and Benefit Base that constitutes the

maximum annual earnings relevant for the calculation of Social Security benefits. http://www.ssa.gov/oact/cola/cbbdet.html [accessed July 17, 2015].

2. http://www.ssa.gov/oact/TR/TRassum.html [accessed July 17, 2015]. Earnings after age 60 are not indexed.

3. We assume all of the investor’s highest 35 years of earnings take place after age 30. 4. http://www.ssa.gov/oact/cola/piaformula.html [accessed July 17, 2015]. 5. Id.

App. 1091


2

if this investor retires at age 65, he receives a monthly Social Security benefit equal to 86.67

percent of the COLA-adjusted PIA, or $6,941. On an annual basis, this is $83,291.6

6. $83,291 = $6,941 x 12.

App. 1092


3

Indexed Earnings and Bend Points for Social Security Benefit Calculation

Year Age

Assumed Household

Income1

Projected NAWI Growth

Rate2 Projected

NAWI3

Index Earnings to

Age 60 Year4

Projected Bend Point

15 Projected

Bend Point 25 2013 28 1.8% $44,888 2014 29 3.7% $46,549 2015 30 $72,729 4.9% $48,830 $232,700 $826 $4,980 2016 31 $75,420 5.0% $51,271 $229,818 $857 $5,164 2017 32 $78,211 4.9% $53,784 $227,189 $899 $5,418 2018 33 $81,104 4.7% $56,312 $225,020 $944 $5,688 2019 34 $84,105 4.3% $58,733 $223,725 $990 $5,967 2020 35 $87,217 4.1% $61,141 $222,865 $1,036 $6,248 2021 36 $90,444 4.1% $63,648 $222,009 $1,081 $6,516 2022 37 $93,791 4.0% $66,194 $221,369 $1,125 $6,783 2023 38 $97,261 3.9% $68,775 $220,943 $1,171 $7,062 2024 39 $100,859 3.8% $71,389 $220,730 $1,218 $7,344 2025 40 $104,591 3.8% $74,101 $220,517 $1,266 $7,630 2026 41 $108,461 3.8% $76,917 $220,305 $1,314 $7,920 2027 42 $112,474 3.8% $79,840 $220,092 $1,364 $8,221 2028 43 $116,636 3.8% $82,874 $219,880 $1,416 $8,534 2029 44 $120,951 3.8% $86,023 $219,669 $1,470 $8,858 2030 45 $125,426 3.8% $89,292 $219,457 $1,525 $9,195 2031 46 $130,067 3.8% $92,685 $219,245 $1,583 $9,544 2032 47 $134,880 3.8% $96,207 $219,034 $1,644 $9,907 2033 48 $139,870 3.8% $99,863 $218,823 $1,706 $10,283 2034 49 $145,045 3.8% $103,658 $218,612 $1,771 $10,674 2035 50 $150,412 3.8% $107,597 $218,402 $1,838 $11,080 2036 51 $155,977 3.8% $111,686 $218,191 $1,908 $11,501 2037 52 $161,748 3.8% $115,930 $217,981 $1,980 $11,938 2038 53 $167,733 3.8% $120,335 $217,771 $2,056 $12,391 2039 54 $173,939 3.8% $124,908 $217,561 $2,134 $12,862 2040 55 $180,375 3.8% $129,654 $217,352 $2,215 $13,351 2041 56 $187,049 3.8% $134,581 $217,142 $2,299 $13,858 2042 57 $193,970 3.8% $139,695 $216,933 $2,386 $14,385 2043 58 $201,147 3.8% $145,004 $216,724 $2,477 $14,931 2044 59 $208,589 3.8% $150,514 $216,515 $2,571 $15,499 2045 60 $216,307 3.8% $156,233 $216,307 $2,669 $16,088 2046 61 $224,310 3.8% $162,170 $224,310 $2,770 $16,699 2047 62 $232,610 3.8% $168,333 $232,610 $2,876 $17,334 2048 63 $241,216 3.8% $174,729 $241,216 $2,985 $17,992 2049 64 $250,141 3.8% $181,369 $250,141 $3,098 $18,676

1. As described above, income is based on typical IRA investor income at age 30, and increased at approximately 4.5 percent per year.

2. Source: http://www.ssa.gov/oact/TR/TRassum.html.

3. Calculated as prior year NAWI, increased at projected growth rate. 4. Calculated as Household Income x (Specified Year NAWI / NAWI in 2045), and equal to Household Income after 2045. 5. Calculated as $180 x (NAWI from 2 years prior / $9,779.44). See http://www.ssa.gov/oact/cola/piaformula.html. 6. Calculated as $1,085 x (NAWI from 2 years prior / $9779.44). See http://www.ssa.gov/oact/cola/piaformula.html.

App. 1093


APPENDIX 6

App. 1094


GIBBON DUNN

July 20, 2015

VIA ELECTRONIC MAIL

Office of Regulation and InterpretationsOffice of Exemption DeterminationsEmployee Benefits Security AdministrationU.S. Department of Labor200 Constitution Ave., NWWashington, DC 20210

Re: Definition of the Term "Fiduciary"; Conflict of Interest Rule—Retirement

Investment Advice (RIN 1210-AB32);Proposed Best Interest Contract Exemption (ZRIN 1210-ZA25~

To the Office of Regulation and Interpretations:

Gibson, Dunn & Crutcher LLP

1050 Connecticut Avenue, N.W.Washington, D.C. 20036-5306Tel 202.955.8500

www.gibsondunn.com

Eugene ScaliaDirect. +1 202,955.8206Fax: +1 [email protected]

I write to comment on the rules proposed by the Employee Benefits Security

Administration to broaden the definition of "fiduciary" under ERISA and the Internal

Revenue Code, and to institute "best interest contract" requirements for financial

representatives falling within this new definition. The purpose of this comment is to address

certain legal flaws in the rulemakings and proposed rules.

The Department states that "changes in the marketplace" and its "experience" with

the current definition of fiduciary have caused it to propose a new regulatory framework for

broker-dealers and IRAs. Definition of the Term "Fiduciary"; Conflict of Interest Rule—

Retirement Investment Advice, 80 Fed. Reg. 21,928, 21,932 (Apr. 20, 2015) (to be codified

at 29 C.F.R. pts. 2509, 2510). The DOL also asserts that broker-dealers labor under conflicts

of interest that cause them to act contrary to their client's interests, which warrants a

regulatory response by the Department. Id. at 21,934.

The Department's assertion that "conflicted investment advice" by broker-dealers has

resulted in substantial investment underperformance might—if accurate—be reason to call

on Congress to enact corrective legislation. Indeed, Congress has already acted in the area

by authorizing the Securities and Exchange Commission to establish a fiduciary standard of

conduct for brokers and dealers consistent with the standard applicable to investment

advisers under the Investment Advisers Act of 1940 ("IAA" or the "Advisers Act"). Dodd-

Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203,

§ 913(g), 124 Stat. 1376, 1828 (2010). But the Department's perceptions ofbroker-dealers

Beijing •Brussels •Century City •Dallas •Denver •Dubai •Hong Kong •London •Los Angeles •Munich

New York •Orange County •Palo Alto •Paris •San Francisco •Sao Paulo •Singapore •Washington, D.C. App. 1095


GIBBON DUNN

July 20, 2015Page 2

and investment performance do not empower it to radically rewrite its long-standing

definition of "fiduciary investment advice" in a manner that conflicts with ERISA's plain

statutory language, its common law roots, and the framework established by Congress for the

regulation ofbroker-dealers and investment advisers. Nor do the Department's policy views

authorize it to deploy its exemptive authority to construct a whole new regulatory and

enforcement regime for IRAs and broker-dealers.

For at least two overarching reasons, therefore, the Department's expansive new

regulatory program is legally flawed.

First, the Department's proposed interpretation of "fiduciary" is vastly overbroad and

impermissible. In enacting ERISA's fiduciary definition, Congress drew upon principles of

trust law and the law governing investment advisers and broker-dealers that must be

considered in interpreting the statute today. See Corning Glass Works v. Brennan, 417 U.S.

188, 201 (1974); Blitz v. Donovan, 740 F.2d 1241, 1245 (D.C. Cir. 1984). Under trust law, a

fiduciary relationship arises in the context of a relationship of special "trust and confidence"

between the parties. The DOL proposal, however, would deem persons to be fiduciaries

where those hallmarks of a fiduciary relationship are absent, for example, when making a

recommendation regarding a single transaction. See 80 Fed. Reg. at 21,934. Further,

ERISA's reference to "render[ing] investment advice for a fee or other compensation"

incorporates terminology in the IAA, which—in accordance with the industry understanding

and practice when the IAA was enacted—excludes broker-dealers executing sales from the

definition of "investment adviser." That is because the payment to broker-dealers is

principally for the product acquired or sold, not the advice. That limitation is incorporated in

ERISA: The phrase "render[ing] investment advice for a fee" by its terms means that the

payment is principally made for the investment advice provided, and not for execution of a

financial transaction or the sale of a financial product.

Second, the Department lacks the authority~to establish new standards and a

regulatory and enforcement program for broker-dealers. In the Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), Congress committed the

authority to establish uniform fiduciary duty standards for broker-dealers and investment

advisers to the SEC—the agency that has long held principal regulatory responsibility in that

area—and only after the Commission completed a study on the effects of any such standards.

DOL may not front-run the Commission by crafting its own new standards and enforcement

program, and certainly may not do so by bootstrapping its authority to interpret "fiduciary"

into a sweeping new regulatory program replete with private rights of action and mandatory

class actions.

App. 1096


GIBBON DUNN

July 20, 201 sPage 3

DISCUSSION

I. The Department's Definition Of "Fiduciary" Is Vastly Overbroad And

Impermissible.

The Department has proposed a definition of "fiduciary" so broad that it must be

accompanied by seven carve-outs and six prohibited transaction exemptions to limit the

scope of even a small portion of the vast new regulatory regime it would establish over

broker-dealers and the IRA market. A regulatory definition that cannot function or be

harmonized with generations of practice unless it is re-worked through a dizzying array of

carve-outs and exemptions is, axiomatically, a definition that does not faithfully interpret the

words Congress wrote.

ERISA does not allow for this expansive new definition. Indeed, as discussed below,

its plain text precludes it.

A. The Proposed Definition Conflicts With ERISA's Plain Text.

ERISA is a "comprehensive and reticulated statute," Nachman Corp. v. PBGC, 446

U.S. 359, 361 (1980), and its definition of "fiduciary" is no different. Under ERISA,

[A] person is a fiduciary with respect to a plan to the extent (i) he exercises

any discretionary authority or discretionary control respecting management of

such plan or exercises any authority or control respecting management or

disposition of its assets, (ii) he renders investment advice for a fee or other

compensation, direct or indirect, with respect to any moneys or other property

of such plan, or has any authority or responsibility to do so, or (iii) he has anydiscretionary authority or discretionary responsibility in the administration of

such plan.

29 U.S.C. § 1002(21)(A) (emphasis added).

Congress did not develop this provision in a vacuum, but drew from existing law.

See, e.g., Firestone Tire &Rubber Co. v. Bruck, 489 U.S. 101, 110-11 (1989). That included

the law of trusts and the law embodied in, and developed under, the IAA. See infra pp. 4-6.

1 For simplicity, this comment refers to the proposed rule's interpretation of ERISA's

definition of "fiduciary," but the discussion applies equally to the Code's definition of

"fiduciary," which is identical as relevant here.

App. 1097


GIBBON DUNN

July 20, 2015Page 4

In interpreting the definition of "fiduciary," therefore, both the common law of trusts and the

IAA must be consulted, since it is presumed that "Congress is knowledgeable about existing

law pertinent to the legislation it enacts." Goodyear Atomic Corp. v. Miller, 486 U.S. 174,

185 (1988).

1. A fundamental principle of trust law is that a "fiduciary" relationship arises only

under certain circumstances, specifically, where "special intimacy or ...trust and

confidence" exists between the parties. Bogert's Trusts &Trustees § 481; see also Black's

Law Dictionary 753 (rev. 4th ed. 1951) (defining "fiduciary" based on the "trust and

confidence involved" in the relationship). For example, at the time of ERISA's enactment,

courts had held relationships such as physician-patient or director-corporation stockholder to

be fiduciary based on the particularly close and trusting relationship between the parties.

See, e.g., Twin-Lick Oil Co. v. Marbury, 91 U.S. 587, 588 (1876) (recognizing that "a

director of a joint-stock corporation occupies [a] fiduciaxy relationship] [and] his dealings

with the subject-matter of his trust or agency, and with the beneficiary or party whose

interest is confided to his care" are protected by courts); Hammonds v. Aetna Cas. &Sur.

Co., 237 F. Supp. 96, 102 (N.D. Ohio 1965) (deeming physician a "fiduciary" to his patient

where patient "entrusted" information to the doctor).

Relationships lacking that special degree of "trust and confidence"—such as

everyday business interactions—are not fiduciary. The court in In re Codman, 284 F. 273,

274 (D. Mass. 1922), for example, rejected the contention that "the relation of the broker to

his margin customers is a fiduciary or trust relation," describing it instead as a "debtor and

creditor" relationship. And in Robinson v. Merrill Lynch, Pierce, Fenner &Smith, Inc., 337

F. Supp. 107, 113-14 (N.D. Ala. 1971), the court concluded that a broker "had no fiduciary

relationship to the plaintiff' where he was merely "executing the plaintiff's orders on an

open market."

These principles were well established by the time of ERISA's enactment and were

incorporated into ERISA. See Bruch, 489 U.S. at 110-11. As the report of the House of

Representatives stated in setting out ERISA's definition of the term, "[a] fiduciary is one

who occupies a position of confidence or trust." H.R. Rep. No. 93-533, at 11 (1973); see

also id. ("The fiduciary responsibility section, in essence, codifies and makes applicable to

these fiduciaries certain principles developed in the evolution of the law of trusts."). Onewho does not occupy that position of heightened trust and confidence cannot be considered a

fiduciary under ERISA.

2. The law of trusts is not the only body of law that informs the meaning of

"fiduciary" in ERISA. So, too, does the law embodied in, and developed under, the IAA. In

the investment-advice prong of ERISA's definition of fiduciary, Congress used the phrase

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"renders investment advice for a fee or other compensation." That language reflects

terminology in the IAA, which for decades had held a central place in the regulation of

investment advisers, and which defines "investment adviser" as a person who ̀for

compensation ... advis[esJ others ... as to the value of securities or as to the advisability of

investing in, purchasing, or selling securities." 15 U.S.C. § 80b-2(a)(11) (emphasis added).

The language and history of the Advisers Act is informative of ERISA's meaning in

two ways. First, by the time of ERISA's enactment, investment advisers were widely

understood to be fiduciaries—and the reason they were fiduciaries was that they had a

closer, deeper relationship with their clients than did other financial professionals. Thus, the

Supreme Court wrote in 1963 that the Advisers Act "reflects a congressional recognition of

the delicate fiduciary nature of an investment advisory relationship"; therefore, "Congress

recognized the investment adviser to be" "a fiduciary." SEC v. Capital Gains Research

Bureau, Inc., 375 U.S. 180, 191, 194-95 (1963). In reaching this conclusion, the Court relied

on legislative history that recognized the "personalized character of the services of

investment advisers," id. at 191, and cited congressional testimony that characterizedinvestment advisers as having relationships of "trust and confidence with their clients," id. at

190 (internal quotation marks omitted). The Court cited this legislative history two decades

later in reiterating the fiduciary "character" of the investment-adviser relationship. Lowe v.

SEC, 472 U.S. 181, 190 (1985). Being an investment adviser, the Court said, is a "personal-

service profession [which] depends for its success upon a close personal and confidential

relationship between the investment-counsel firm and its client. It requires frequent and

personal contact of a professional nature between [the advisers] and [their] clients." Id, at

195 (emphases altered and internal quotation marks omitted).

Second and related, when investment advisers were being described by the Court as

having the sort of "close and personal" relationship with clients—characterized by "frequent

and personal contact"—that rose to the level of a fiduciary relationship, the Court was not

considering investment advisers in isolation, but rather in contrast with other financial

professionals whose relationships did not rise to the same level, namely, broker-dealers.

Thus, the Advisers Act included acarve-out which clarified that "investment adviser" did not

include "any broker or dealer" who provided advice that was "solely incidental to the

conduct of his business as a broker or dealer and who receives no special compensation

therefor." 15 U.S.C. § 80b-2(a)(11)(C).

This exemption from the definition of investment adviser was not introduced by the

IAA, the D.C. Circuit has explained, but "reflected [a] distinction" then existing between the

"two general forms of compensation" that financial professionals received in connection with

offering investment assistance. Fin. Planning Assn v. SEC, 482 F.3d 481, 485 (D.C. Cir.

2007). "Some [representatives] charged only ...commissions (earning a certain amount for

App. 1099
