Beyond Risk Tolerance: The New Fiduciary Rule For Advisors And Retirement Planning

by: Michael Lonier


New DOL regs require advisors' recommendations for retirement money to be in the client’s best interest based on the client’s complete financial circumstances, not just their investments accounts.

Under the new fiduciary regs, the advisor’s role shifts from salesperson to financial planner; those who excel at planning will distinguish themselves in serving their clients well.

Recommendations must be based on the goals, risk tolerance, financial circumstances, and needs of the client -- essentially requiring a comprehensive financial plan, not just a risk tolerance quiz.

The New Fiduciary Rule for Retirement Financial Recommendations

The new ERISA regs mandating a fiduciary standard for advisors who make recommendations to clients for retirement plans and accounts -- including rollovers from 401(k)s to IRAs -- was front and center at the Retirement Income Industry Association (RIIA) summer conference at Salem State in Salem, MA this past week.

Briefly, the regs require advisors to make any recommendations for retirement money to be in the client's best interest and based on the client's complete financial circumstances, not just their investment account. These regs will begin to go into effect in April 2017, and will apply to existing as well as new advisory arrangements, so there will be significant changes coming for those who work with advisors over the next nine months.

The game changes almost totally for the bulk of advisors, from independents to those who work at big firms, shifting the advisory business away from commissions and third party fees and incentives, disclosed or undisclosed, and variable compensation schemes ("fee-based") to what will likely become fee-only compensation favoring retainer arrangements or a menu of flat fees.

There will, of course, be a back door of sorts, the "best interest contract exemption" (BICE) that requires an advisor whose compensation does vary by the amount or type of investment the advisor recommends to adhere to a strict and openly disclosed supervisory process. No doubt, those who use BICE will find some way to make it sound as if the BICE is a good thing for the client, not a work-around for the advisory firm (cue soothing music with voice over: "If you grow, we grow.").

Beyond compensation, and more importantly for the client, the regs will start a movement away from the limited existing risk tolerance questionnaires towards a more comprehensive analysis of the client's full financial situation, from a short quiz to a financial plan. This is a sea change, since the risk tolerance quiz was designed to provide a "suitability" safe harbor for the stock broker to sell securities to a client without considering much more than investment total return and how the client felt about losing money the day he or she answered the questions.

Under the new fiduciary regs, the advisor's role shifts from salesperson to financial planner. Those who excel at planning will distinguish themselves in serving their clients well. And clients, especially those primarily interested in retirement planning, will be much better served than under the old suitability regime.

Previously, the client's best interest was often secondary -- if considered at all -- to the advisor's goal of capturing the client's accounts, resulting in higher advisory fees. This was especially the case with so-called "money in motion" where the advisor would recommend a rollover from the client's 401(k) to the advisor-managed IRA, without considering whether the client needed to make at least some safe investments like CDs, Treasury bond ladders, or income annuities to protect the household lifestyle.

Beyond Risk Tolerance Quizzes
At the RIIA conference, I gave a short talk on the limitations of risk tolerance and risk tolerance questionnaires (RTQs) for determining how much market risk a client should take. The bulk of advisors today use simple ten-question quizzes to determine whether a client should have a conservative, moderately conservative, moderate, moderately aggressive or aggressive portfolio allocation of stocks and bond funds. The whole process provides almost no mathematical justification for that allocation.

A simple (and admittedly simplistic!) analogy points to the shortcomings of this approach. Imagine going to the doctor, answering a dozen questions about how you feel about your health, and the doctor then prescribing treatment based on your answers. "Mr. Smith, you are moderately unhealthy, so take these three pills every day," or "you are aggressively unhealthy, take these five or six pills."

Any of us would reject this method in an instant. Answering questions -- getting a medical history and patient input -- is an important part of a diagnosis, but it's not enough to create a sound treatment plan. Similarly, a risk tolerance questionnaire may provide some indication of a client's attitude towards risk, but it ignores the client's larger financial circumstances, their household balance sheet, and the specific risks the household faces in retirement. You wouldn't risk a major operation based on being judged moderately unhealthy from answering a few questions. Why would you risk your lifelong retirement savings on a similarly incomplete and superficial information-gathering method?

The new fiduciary rules for retirement plans and accounts stipulate that in order to serve the best interest of the client, the advisor's recommendations must be based on the goals, risk tolerance, financial circumstances, and needs of the client. Essentially this requires the advisor to create a comprehensive financial plan -- not give a simple quiz about market risk. A financial plan looks at all the risks that impact the household, the various strategies to mitigate those risks, and other opportunities for enhancing and protecting the client's retirement goals. These include longevity risk, liquidity risk (having enough ready cash), portfolio risk, inflation/deflation risk, regulatory risk, healthcare and long-term-care expense risk, life shocks, estate planning and legacy goals, tax optimization, current and future earnings, and Social Security and pension benefits planning and co-ordination.

The comprehensive analysis of the client's complete financial situation can be mathematically summarized in the household balance sheet. The balance sheet shows the current value of investable savings and the present value of all future earnings and Social Security and pension benefits on the asset side, and the present value of all future expenses on the liabilities side.

The balance sheet gives us the Floor, the amount of savings needed to cover all future household liabilities after subtracting the present value of earnings, Social Security and pension benefits, and any other income. This is the amount the client needs to hedge against market and inflation risk in a risk-free, inflation-adjusted Floor portfolio.

The amount of savings in excess of the Floor that is not needed to cover liabilities is the risk capacity found on the balance sheet. Risk capacity is based on the simple math of the household balance sheet, not on a short quiz about the client's feelings about risk.

We call the risk capacity on the balance sheet Upside. Upside is the amount of savings that can be exposed to market risk in an Upside portfolio for long-term growth without jeopardizing the household lifestyle. Once the Floor and Upside values are determined on the balance sheet, we can allocate the client's resources to the four risk management portfolios based on those values which are the core of a comprehensive retirement plan -- Upside, Floor, Longevity, and Reserves.

These four portfolios allocate client resources based on the household risk exposures identified on the household balance sheet -- not on the vagaries of a risk tolerance quiz. This approach is the foundation of a sound, fiduciary method that meets the best interest requirements of the new ERISA retirement plan regs based on a comprehensive plan that accounts for the client's complete financial circumstances.

And most importantly, this process provides the retirement client with the sound framework for a successful retirement outcome based on the client's own balance sheet, not on the uncertain expectations of market returns and potentially disastrous allocations of market risk divorced from the client's own risk capacity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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