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With a divided U.S. Congress and a pro-Wall Street agenda at the U.S. Securities and Exchange Commission (SEC) and U.S. Department of Labor, little hope exists in 2020 for meaningful regulatory enhancements that would benefit consumers. Still, foundations for reform can be laid in the halls of Congress. And a few of the states will continue their efforts to step into the void, especially in applying fiduciary duties to brokers.
Here’s my “wish list” for reforms in 2020, acknowledging that some of these actions may take years, or even decades, to accomplish.
Product provider-paid fees disappear
No sales loads. No contingent-deferred sales charges. No 12b-1 fees. No payment for shelf space. No insurance company or mutual fund sponsorship of educational seminars, for either financial advisors or their clients.
Why such a draconian step? It’s simple. The elimination of product-provided compensation is the best, and perhaps the only way, to successfully meet the fiduciary standard of conduct. In particular, it meets the “no conflict” and “no profit” rules embodied within the fiduciary duty of loyalty. These are tough rules that require informed consent of the client even after full disclosure (remembering that no client can consent to be harmed), followed by the test that the transaction is substantively fair to the client. Compensation to a financial advisor, by anyone other than the client, creates conflicts of interest that cannot be mitigated simply by mere disclosure.
This does not mean that commissions would disappear. In essence, a financial advisor could still charge 5.75% (or more, or less, subject to the fiduciary requirement that compensation be reasonable), but the “commission” must be fully transparent and deducted directly by the advisor from the client’s funds. This enables advisors to “levelize” their compensation for smaller accounts. It is similar to charging a fixed fee (which varies by the amount of assets invested) for advice on a particular transaction.
Soft dollars – payments by asset managers to brokerage firms for “research” (that is rarely used and vastly overpriced) – also fall by the wayside. This requires action by the U.S. Congress.
Custodians get paid for trade execution and custodial services directly
If you think commission-free equity trades are “free” equity trades, you have not paid attention to the payment for the order-flow regime. Market makers take part of the revenues derived from bid-ask spreads to pay the brokerage firms representing the seller and the buyer of the stock shares. This arrangement casts doubt on the ability of any brokerage firm to truly effect “best execution” during trading. With the elimination of payment for order flow, brokerage commissions for equity trades would return; however, bid-ask spreads would decline, and the competitive marketplace would keep transparent brokerage commissions at reasonable levels.
In addition, custodians would be required to sweep cash into third-party money market (or FDIC-insured high-yield checking) accounts. Investors would receive higher returns on their cash holdings, and conflicts of interest arising from greater asset allocations to cash (driven by the additional revenue generated thereby) would disappear.
At the same time, the services provided by custodians to investment advisers would be priced, and billed, separately. Some custodians might choose to provide a broad array of services, including software solutions, to investment advisers, and charge higher fees for the same. Others would confine themselves to providing trading platforms, client statements, tax basis tracking, and other “core” custodial services for lower fees. Menus of services would appear from which advisers might choose. Custodians could become the largest distributors of software solutions and other services to investment advisers.
A bona fide fiduciary interpretation is adopted by the SEC
In 2019, the SEC substantially weakened the fiduciary standard with its interpretation of the fiduciary standard in the Investment Adviser Act of 1940.
The SEC does not embrace the concept that the fiduciary duty of loyalty requires fiduciaries – stewards of their client’s assets – to eschew additional compensation beyond that agreed to with the client. For example, the receipt of 12b-1 fees by dual registrants is permitted by the SEC, as long as disclosures are adequate. A true fiduciary standard recognizes that the presence of 12b-1 fees drives product fees higher, and acknowledges the substantial body of academic research concluding that, on average, higher fees for similar investment products result in lower returns for investors.
Regulation of brokers, certain insurance agents, trust officers and RIAs is replaced with a new regime
Functional regulation of personal financial advisors (PFAs) is adopted.
All PFAs must disclose whether the account(s) they provide advice upon will be governed by the prudent investor rule (PIR) and its strict requirements to minimize idiosyncratic risk and to not waste clients’ assets. Clients may “opt out” of the PIR following full disclosure of the risks undertaken.
All PFAs must disclose the type of advice provided:
- “Independent advice” results when the PFA possesses access to a very broad range of investment securities and solutions for the client, no proprietary products are provided, and no compensation is paid to the PFA (or his/her firm or affiliates) from any insurance or investment product provider. No incentives can exist to recommend one product over another.
- “No advice” results when no financial products are recommended to the client. Information may be gathered to satisfy internal documentation for suitability or similar requirements. Communications to potential customers are restricted to a discussion of the features and characteristics of the financial product.
- In contrast, “non-independent, restricted advice” results otherwise, and occurs when mutual fund employees recommend their own firm’s products, when insurance agents recommend insurance products that pay them (or their firm) a commission, or in any other situation other than when “independent advice” or “no advice” is provided.
A professional regulatory organization is created with individual, highly educated PFAs as licensed members. Bound together by a mission to serve the public interest, peer review (of different types) is instituted. Draconian routine examinations disappear, and are replaced by more frequent asset-verification (custody) exams to deter and detect actual frauds (such as Ponzi schemes), thereby better utilizing scarce governmental resources.
Ron A. Rhoades, JD, CFP® serves as the director of the personal financial planning program in the Gordon Ford College of Business at Western Kentucky University. This column represents his individual views and are not the views of any institution, organization, firm, clan or cult of which he has ever been associated or kicked out of.
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