The ABCs (and T's and Z's) of the new fiduciary rule

Adoption of the fiduciary rule, requiring advisers to act in retirement savers' interest, includes some new terminology.

  • By Daisey Maxey,
  • The Wall Street Journal
  • Fiduciary Responsibilities
  • Saving for Retirement
  • Mutual Funds
  • Fiduciary Responsibilities
  • Saving for Retirement
  • Mutual Funds
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The Labor Department's new "fiduciary" rule is meant to protect retirement savers from conflicted investment advice, by requiring that a financial adviser put the client's interest first.

But it can't protect them from this side effect: a raft of new terminology and mutual-fund share classes to decipher.

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Mutual-fund companies have been introducing an alphabet soup of share classes or expanding the use of existing share classes to help financial advisers comply with the landmark rule. So, this is a good time to sort out the related terminology, old and new, and the share classes such as A, R, T, Z and "clean shares," that are growing up around the rule or being disrupted by it.

Fiduciary: Let's start with the key word in all this. The fiduciary standard requires that a financial adviser put the client's best interest first. The new rule, which began to take effect June 9, requires that financial advisers who make recommendations on tax-advantaged retirement savings—such as 401(k) plans, individual retirement accounts and health savings accounts—act in their clients' best interests. It aims to reduce conflicts of interest that could impact an estimated $3 trillion in retirement assets.

Before the rule was implemented, many brokers advised retirement savers under a "suitability" standard, which required that they recommend products that were suitable for a particular client, but not necessarily in the client's best interest. In addition, an adviser was previously considered a fiduciary only if he gave regular investment advice to an investor, and if there was a mutual understanding between the adviser and the investor that the adviser was offering individualized advice.

Under the fiduciary rule, a much broader group of advisers, including many brokers who previously advised retirement investors under a suitability standard, are obligated to act as fiduciaries, says Fred Reish, a partner in the employee benefits and executive compensation practice group at law firm Drinker Biddle & Reath LLP. Any adviser who makes an investment recommendation on assets in a tax-advantaged retirement plan specifically directed to the individual retirement account owner, plan participant or plan fiduciary is considered a fiduciary. That adviser must put the investors' interest above his own and engage in a prudent process to analyze the investors' needs and make a recommendation at the level of a knowledgeable person.

It is likely to result in advisers paying more attention to the cost of investment products and the quality of investment managers, he says.

Level-fee fiduciary: Financial advisers who receive level fees charge a set percentage of a client's assets under management a year or a set fee that doesn't vary based on the adviser's recommendations. That is in contrast to those who charge commissions that vary based on their recommendations, such as for stock trades or mutual fund sales, or who receive similar types of compensation from a third party, such as a mutual-fund company.

The fiduciary rule may encourage advisers to take only level fees because it offers streamlined compliance obligations for those who do. To qualify as a pure "level-fee fiduciary" under the rule, an adviser and any affiliates or related parties may receive only level fees for offering advice or investment management to a retirement plan or IRA. Broker-dealers or registered investment advisers who accept varying compensation will have to comply with more stringent procedures and disclosure requirements under some circumstances when offering advice to IRA clients or to tax-advantaged retirement plans.

Investors working with advisers who accept varying compensation will receive more disclosures because such compensation creates conflicts of interests so there is more to disclose, says Michael Kitces, a partner and director of wealth management at Pinnacle Advisory Group Inc.

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Until Jan. 1, however, there is a transitionary exemption under which advisers—regardless of the type of compensation they receive—may opt to operate. Advisers must operate in the clients' best interest, accept only reasonable compensation and make no materially misleading statements. But under this transitionary exemption, advisers aren't required to make certain disclosures or execute a contractual fiduciary agreement with IRA investors which is enforceable under state law, as they will have to after Dec. 31 if they accept varying compensation.

12B-1 fees: Not a new term, but part of the new rule. Many mutual funds subtract 12b-1 fees from their assets to compensate brokers or other distributors. These fees, which pay for marketing and various shareholder services, often go unnoticed by investors. But at 0.25% to 1% of a client's assets in a fund annually, they can take a toll on a portfolio.

The fees have been in decline over the years, and the fiduciary rule will accelerate that trend. Now when an adviser operating under the fiduciary rule wants to recommend a fund that includes a share class that charges 12b-1 fees to investors, many advisers will likely conclude that they should choose the share class without the 12b-1 fee.

"That obligation never existed before for any IRA, so it's an immense, dominant pressure that will probably make most 12b-1 fees in IRAs vanish in the next few years," says Mr. Kitces.

Class A shares: Mutual-fund companies offer different types of fund shares, which each carry different fees. Investors who purchase Class A shares of a fund through a broker typically pay a sales charge ranging from 2.25% to 5.75% of the assets they're investing, according to Morningstar Inc. It is a payment that is often overlooked by investors because it's bundled in with cost of the fund's management, and is passed on to the distributor by the fund company.

Some mutual-fund experts speculate that Class A shares and some other older fund share types will decline in popularity—and may die out—under the fiduciary rule as fund companies develop shares with lower fees and shares that don't include any fees to compensate distributors.

"Is the A share dead? That is pretty likely," says Paul Ellenbogen, head of global regulatory solutions at Morningstar Inc.

Class T shares: Class T shares (the T is for "transaction") aim to help remove the temptation for advisers to recommend a higher-cost fund over a less-expensive option. These new shares feature uniform sales charges across all fund categories. No difference in price offers no financial incentive to push one fund over another.

Target-date funds for retirement savers

Not all are the same: underlying portfolios can differ as well as their stock-bond mix.

T shares would typically charge a 2.5% load, or sales fee, when purchased and a 12b-1 fee of 0.25% to pay for distribution or other expenses, according to Morningstar. The front-end load may decline for larger purchases.

At least 123 T share classes have already been launched, and more are on the way, according to Morningstar.

Clean shares: Some investment professionals consider new "clean shares" the wave of the future. These shares charge only the fee to manage and operate a mutual fund, and don't include payments to distributors, such as the broker-dealers and retirement-plan platforms that sell the funds.

Investors who buy clean shares will likely pay 60% to 70% less to buy a fund, says Mr. Ellenbogen. But investors will have to pay separately for any advice they receive from a broker so it doesn't necessarily mean they'll pay less overall. The new shares could help advisers and brokers comply with the fiduciary rule in two ways, Morningstar says. Firms that wish to qualify as "level-fee" fiduciaries must strip out third-party payments of any kind, which clean shares do, and firms that wish to continue receiving sales fees, or commissions, could sell clean shares, then set their own commissions that are the same across products.

Clean shares will also magically boost the performance of the average actively managed mutual fund, says Mr. Kitces. That is because mutual funds currently have to report their performance net of commissions and broker compensation. As broker-dealers shift to being compensated by commissions outside of the funds, "the mutual fund itself will no longer have to count the broker's compensation against their own performance," he says.

Clean shares carry different monikers: American Funds, a subsidiary of Capital Group, began this year offering F3 shares, which charge no fees to pay distributors, and Janus Capital Group , now Janus Henderson Group , filed in January to offer Z shares, which are also free of any fees to distributors.

Rather than creating new shares, some fund companies are simply expanding the creation of Class R shares. Those shares were previously available only through employer-sponsored retirement plans, such as 401(k)s, and are usually a fund company's lowest-priced share class.

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