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Pay Attention to the Computer Models

by Lee Kowarski

With the Department of Labor's new rules about objective investment advice looming, many articles are suggesting that advisors are likely to move even further towards fee-based services. While the long-term trend towards fee-based advice is undeniable (our latest FA Vision survey found that financial intermediaries already receive 51.6% of their compensation from fee-based services and this figure jumps to 61.8% for Traditional Wirehouse reps and 78.7% for Independent RIAs), I think that it is wrong to assume that the DoL regs will completely exclude dual registrants from giving advice on 401(k) plans and IRAs.

The new regulations require that an advisor either (a) give advice and be paid on a level-fee basis, meaning that the fees don't change based on the investments in an account, or (b) that they give advice generated by a computer model that is certified as objective. Most of the attention has skipped over this "computer model" part. While the DoL is still looking for comments on the final rules, it is important to be aware of the wording around computer models and what will allow them to be certified as "unbiased":

...a computer model shall be designed and operated to avoid investment recommendations that inappropriately distinguish among investment options within a single asset class on the basis of a factor that cannot confidently be expected to persist in the future. While some differences between investment options within a single asset class, such as differences in fees and expenses or management style, are likely to persist in the future and therefore to constitute appropriate criteria for asset allocation, other differences, such as differences in historical performance, are less likely to persist and therefore less likely to constitute appropriate criteria for asset allocation. Asset classes, in contrast, can more often be distinguished from one another on the basis of differences in their historical risk and return characteristics.

If the current wording holds up, with its strong language against basing computer recommendations too heavily on historical performance, computer models may push investors towards index funds because of their generally lower fees. It will be critical for firms that wish to play in the 401(k) and IRA markets (which is probably every firm) to keep a close eye on how the regulations evolve and to consider how their fund lineup will best be able to fit within an objective computer model.