In response to the Department of Labors conflict-of-interest rule aka the fiduciary rule firms in the financial services industry are rolling out two new classes for mutual fund shares: T shares and clean shares.

These new shares are designed to help advisers comply with the requirements of the fiduciary rule which will start being enforced unless something happens in the meanwhile on Jan. 1, 2018. The fiduciary rule requires, among other things, that financial advisers to put their clients best interest ahead of their own compensation when selling investments and products inside a retirement accounts such as an IRA.

Read: The fiduciary rule is about more than adviser pay. Heres why that matters

Read: 6 key points on the fiduciary rule

Read: Morningstar comment letter on COI examination

And that means financial advisers would be hard-pressed to comply with the Labor Departments (DoL) rule given that the earn commission and 12b-1 fees on the load class of shares they often sell to clients for their retirement accounts. Those would include according to the 2017 Investment Company (ICI) Fact Book:

Front-end load shares, which are predominantly Class A shares, and were the traditional way investors compensated financial professionals for assistance;

Back-end load shares, often called Class B shares, where investors pay for services provided by financial professionals through a combination of an annual 12b-1 fee and a contingent deferred sales load (CDSL); and

Level-load shares, which include Class C shares, where investors compensate financial professionals with an annual 12b-1 fee (typically 1%) and a CDSL (also typically 1%) that shareholders pay if they sell their shares within a year of purchase.

Enter T shares and clean shares

T shares (or transactional shares) will help financial advisers maintain their traditional business modelselling mutual funds on commissionwhile complying with new rules, according to a paper published by Morningstar in April. The second new share class, clean shares, could help financial services companies that wish to shift to a level fee model in which advisers compensation only comes from a level charge on a clients assets and not from any varying third-party payments.

And the early evidence is that these new share classes should reduce conflicted advice and likely improve outcomes for investors, according to the Morningstar report.

T shares eliminate some but not all conflicts

T was originally said to stand for transactional, and then later, transitional, and we think there is truth in both those claims, said Paul Ellenbogen, head of global regulatory solutions at Morningstar and co-author of the report, Early Evidence on the Department of Labor Conflict of Interest Rule.

The T share, he said, is designed to replace the A share, which had become the workhorse of retail brokerage, but has two fatal flaws in the post-DOL, or best-interest world: its load structure, and varying revenue sharing arrangements. The load structure, which can vary across funds, fund companies, and investors, creates an incentive for an adviser to choose one fund over another based on their own interest, rather than the best interest of the client, Ellenbogen said. Revenue-sharing arrangements, which are more opaque, put certain fund families ahead of others, again based on the business interests of the provider and not the financial interests of the investor.

The T shares address these two challenges, he said, by levelizing loads (generally, at 2.5%), and otherwise removing inducements to offer one fund versus another. So far, our database shows nearly 1,000 T shares registered, but only about 125 actually operating, that is, holding assets and posting a daily price, said Ellenbogen. From the perspective of a broker-dealer, T shares have some operational advantages. As with A shares, the fees charged to the investor are collected by the fund company. Then, one part the management fee is kept by the asset manager, another part generally the 12b-1 fee is paid to the distributor; and some goes to the transfer agency and the sub-transfer agent. This collection and reallocation of fees is compatible with the business models of most brokerages.

However, T shares still include inducements that make them more attractive to brokers than other investments, said Ellenbogen. Specifically, all of the other fees beyond investment management included in the expense ratio, and paid by the investor, go to pay for some elements of the brokerage business, he said. Hence, funds with these other non-management fees serve the interest of the broker but not necessarily the investor.

To be fair, Ellenbogen and his co-author, Aron Szapiro, director of policy research, noted in their paper that that the move to T shares from A shares may not only reduce what some investors pay directly for advice in the form of commissions, but could also reduce other costs of investing, including fees for asset management and other services.

They estimated a savings of 50 basis points (one-half of 1%) to investors from reduced conflicted advice. Precisely how much T shares will save investors is an open question that we will be able to address more authoritatively after we have some experience with the new regime, they wrote.

Clean designed to eliminate conflicts

Clean shares, which are coming to market slowly, are meant to eliminate conflicts of interest altogether, said Ellenbogen. In our view, a clean share has fees only for investment management, he said. The investors money goes straight to the asset manager; no fees are redistributed to the broker. Of course, there are still fees that an investor has to pay, for administration, operations, distribution, and perhaps financial advice. But with a clean share these expenses are externalized, not part of the expense ratio, but billed separately and paid directly by the investor to the service provider.

Given that, Ellenbogen said clean shares have the advantage of being lowest cost, and being directly comparable to other investment only options, such as ETFs. That said, investors still need to consider the total costs of ownership: transactions, account fees, custodial charges, and the cost of financial advice still fall to the investor, he said. While T shares offer the convenience of all-in-one pricing; clean shares enable clearer disclosure of who pays how much to whom for what.

Advice worth more than the cost of the advice?

To be sure, its worth discussing the fees and commissions that come with T and clean shares. But its just, if not more important, to consider the quality of the financial advice retirement account owners receive.

The implementation of the fiduciary rule should focus on what kind of advice individuals will receive and whether it is reasonably priced, Ellenbogen and Szapiro wrote. We do not believe that fees are inherently problematic, as long as investors get advice that is worth more than the cost of the advice.

In fact, Morningstar research into the value of high-quality financial advice finds that it can improve a retirement savers financial well-being by as much as the equivalent of a 23% increase in lifetime income.

To the extent that the shift to T or clean share classes enhances fee transparency for investors by making it clear what they are paying for advice, it should encourage financial advisers to provide high-quality advice to remain competitive, Ellenbogen and Szapiro wrote. Shifting to a T share structure could potentially align advisers incentives with investors interests, particularly compared to the uneven and opaque fee structure we observe with A share classes.

In the long term, however, they wrote that clean share classes represent the best way to enhance transparency, which is why countries such as the United Kingdom and Australia have moved toward a clean share model.

Although T shares are a step in the right direction, the authors noted that the loads could induce advisers to rebalance unnecessarily. Further, they wrote that T shares impede advisers from trying innovative ways to charge for advice. Using a clean share model, advisers can align the level of advice they provide to their fee, and clients can choose how they would prefer to pay for advice: a flat dollar amount, a commission, or a level fee on assets under management, wrote Ellenbogen and Szapiro.

So, what do others say? Should investors use T or clean shares or something else in their retirement accounts if thats what their financial adviser recommends?

Well, for starters, there is much uncertainty with T shares as well as the future of the Labor Departments fiduciary rule right now, according to Avi Nachmany, an independent consultant and author of A Perspective on Mutual Fund Share Class Development.

Investors will be offered T shares in a wrap account

But assuming T and clean shares and the Labor Departments fiduciary rule are here to stay, Nachmany said its worth noting that the great majority of fund purchases today are inside some sort of asset allocation construct: a mutual fund wrap account, for instance, where there is a fee-for-service relationship, or a single balanced fund including target-date funds and their many permutations.

Given that, and given that financial advisers earn money on the wrapper fee, then actively managed mutual funds need to be entered into such wrappers at the lowest fee, said Nachmany. Thus, the shifts to lower fee classes and the early interest in clean, he said.

In other words, its likely most retirement account owners will find themselves being offered not just one clean share fund, but many clean share funds inside a mutual fund wrap account or target-date or target-risk fund.

T shares in a holding period

Its also likely that investors wont have much chance to invest in T shares. According to Nachmany, commissionable classes of shares represent less than 10% of fund transactions today. Ts are addressing the DoL conflicts, he said. But naturally until you get a critical mass of participation and DoL uncertainties settle down we are in the holding period.

Others take a different approach

While many firms are going down the T and clean shares route, some are taking a different approach to complying with the Labor Departments fiduciary rule, which among other things suggests that advisers receive levelized or standardized compensation on the products they recommend to retirement account owners.

For instance, LPL Financial announced in July plans to roll out its Mutual Fund Only (MFO) platform, a platform designed to improve the way advisers offer mutual funds in brokerage accounts with participating fund companies, according to a release.

The platform includes load-waived shares from 20 mutual-fund companies, a consistent trail commission, and free exchangeability across fund companies. According to LPL, MFO accounts will be subject to a maximum upfront commission of 3.5% and a 0.25% trail payment. Investors will be eligible for discounts based on the combined amount of brokerage assets held at LPL that are invested in MFO-eligible mutual funds.

The most unique aspect of the mutual fund only platform is the ability to exchange across funds and fund families without transaction fees, said Rob Pettman, an executive vice president with LPL Financial. This means that investors wont be charged for activities like regular rebalancing, changes to improve performance, and reallocations if their needs change or they decide to go to cash temporarily.

In addition to the cost savings for transactions, Pettman said the platform also offers quantity-based discounts, no IRA maintenance fees or ticket charges.

Finally, investors can move existing A share positions from participating companies into the account at no charge, he said. This movement adds incremental value given it expands their investment choice from one to 20 fund companies. It also does not require the use of a new share class which may result in the confusion of having different share classes of the same fund within one account.

Time to address pros and cons in public way

Other experts, meanwhile, say retirement account owners should approach T and clean shares with caution. Theres always two questions for miracle solutions, said David Snowball, publisher of Mutual Fund Observer. One, do they address the underlying forces that led to the original problem? And, two, what the likely cost of their unintended consequences? Theres so much cheerleading for the new share classes that Im not sure those questions have been much addressed, in public anyway.

The rest is here:
Are 'clean' shares best for your retirement account? - MarketWatch