A week ago yesterday, the SEC endorsed a single fiduciary standard no less stringent that the one that has long governed investment advisors.
Good news for investment advisors, bad news for broker-dealers, case closed.
Not exactly. A closer look reveals that the list of winners and losers in the wake of last week’s fiduciary study is long and riddled with footnotes. The chief uncertainty remains how and when the SEC proceeds with developing the actual rules. Conceivably, future rulemakings might not follow the study or might create so many loopholes that the fiduciary standard is no longer a fiduciary standard.“Suddenly the whole brokerage industry could carry the mantle of we are fiduciaries as well. But underneath the whole thing is hollow,” said Rudy Adolf, the CEO of Manhattan-based Focus Financial, the industry’s largest aggregator. That’s his worry.
As an optimist, however, he and others believe that the SEC will go forward to impose a new regulatory regime on broker-dealers and advisors, one that includes a fiduciary standard for brokers and more stringent regulations for advisors.
List of winners and losers
RIABiz developed this list of winners and losers on the idea that the SEC would indeed use its study as a sort of long-term outline for rule-making. Thanks to many industry thinkers and executives who helped formulate the ideas.
I’m going with the losers first, because it’s the loss of business from the losers that is going to drive the growth for the winners. Just a reminder here of the number of advisors in each segment of the industry (stats are from Boston-based Cerulli).
Insurance broker-dealers: 96,000
Regional broker dealers: 38,000
RIAs: 33,000 – 34,000
Dually registered advisors: 14,000 (counted both as RIAs and in their broker-dealer category)
Introduction: Those whose business models are based on selling overpriced and/or proprietary products have the most to lose. In a fiduciary world, a proprietary product is – presto — an instant conflict of interest that must be disclosed. Overpriced proprietary products will put sellers into an even worse position.
Advisors who work for insurance broker-dealers make up the second largest segment of advisors. About half of them can’t sell anything but proprietary insurance, says Bing Waldert, a consultant with Cerulli Associates. Their business models appear to be the furthest from transitioning to a fiduciary world.
One particular kind of insurance agent stands to lose the most, said Barbara Roper, director of investor protection for the Consumer Federation of America.
“The insurance agents who call themselves financial advisers or financial planners and sell a few high-cost variable annuities and mutual funds have the most to lose. State and federal regulators have been struggling for years to use the tools available to them under the suitability rules to rein in abusive sales of variable annuities, but imposing a fiduciary duty would give them a whole new set of enforcement tools to bring to bear.”
WirehousesWirehouses stand to lose, but perhaps not quite as much as some people have expected. Many of them have spent recent years migrating to a fee-based model.
“The four wirehouses are the largest sponsor of managed accounts,” said Waldert. “They are well on their way to a fiduciary model.”
Still, wirehouses will be hurt, to the tune of billions of dollars, says Adolf, listing three ways the damage will play out.
• First, he says, the new regulation will cause even more brokers to question staying at the wirehouses. “What the broker is ultimately asking is: Why I am I paying the 60/70% tax to the wirehouse? I’m not getting anything for it. Now, I’m no longer held to the suitability standard.”
• Second, wirehouses will lose profits because it will become harder to distribute proprietary products, which are probably generally more profitable. Waldert agrees with this and notes that wirehouses will be hurt on a second, related front, as their ability to make proprietary trades of existing inventory is compromised.
• Third, wirehouses will be hurt by new disclosure requirements, Adolf says. “The traditional smoke-and-mirrors that drive the brokerage industry is going to be impossible. They are going to be facing a fundamental challenge to their business model.”
IBDs, especially small IBDsTo the extent that IBDs sell proprietary and high-priced products, they face the same risks and transition difficulties as wirehouses. Some IBDs are owned by insurance companies and sell the insurance companies’ products. “That’s the dirty little secret of IBDs,” said Waldert.
Like wirehouses, IBDs may face more defections as brokers begin to ask questions about whether a higher payment to the IBD is worth it, if they are no longer able to operate under a suitability standard. Like smaller RIAs, smaller IBDs may be especially vulnerable to higher compliance costs as a result of more regulation.
Small- to medium-sized RIAs
Compliance costs are set to rise as regulation increases. It may not be by huge amounts.
“I doubt compliance costs will really go up that much,” says Zachary Gronich, president of compliance firm RIA In A Box. “Say people have to start taking CEs, they’ll just find a way to take the cheapest, easiest CEs, like they do in any other professional area.”
Yet, how much is too much for any given firm? Many RIAs with less than $100 million in AUM are already facing higher compliance costs as a result of the switch to state oversight, which is likely to mean complying with multiple sets of regulations. (See: What advisors should know about the next sweeping change: the switch from SEC oversight to state regulation).
Regulations developed by the SEC may or may not apply to those RIAs under state oversight, but it’s a safe bet that at least some of them will – driving costs up even more.
Introduction: One hallmark of the companies that will end up winners will be the speed at which they adapt. The SEC’s actions are important and powerful – but they will merely speed up a process of market transformation that’s been under way for a while. All of the industry is entering a time of risk brought about by rapid change.
“Losers will let legislation lead them,” said Dan Inveen, principal of FA Insight in Seattle, Wash. “Winners will be led by the marketplace.”
Consumers will have more clarity about their investment advisors and the incentives driving those advisors. It won’t be a perfect world – but investors will have a better chance of making good decisions.
As One-Man Think Tank Columnist Ron Rhoades wrote last week, “If properly implemented, a 'uniform fiduciary standard’ adopted and applied both to investment advisers and to certain activities of broker-dealer firms, will enable consumers to discern when their financial and investment adviser is truly acting in their best interests.”
The RIA world
RIABiz chronicles a fast-growing but still nascent industry, made up of RIAs, custodians, tech companies and myriad other service providers. That industry as a whole just got a huge shot in the arm, as the SEC essentially said: ‘You’ve been following the right business model all along.’” No, clients aren’t reading the SEC’s web site – but the shift of thinking in the industry will trickle down.
The Investment Adviser Association and other advisor advocates have long made the case that what’s good for consumers is also good for RIAs. A healthier market in which there are fewer scandals related to “bad advisors” will benefit RIAs.
“We are looking for an effective regulatory scheme that protects investors,” said Neil Simon, government relations vice president for the IAA. (Top RIA lobbyist says insurance foes have been 'more effective’ in fiduciary battle but urges patience).
Larger and well-prepared RIAs
Along with imposing a fiduciary standard on broker dealers, the SEC says that RIAs should be held to higher regulatory standards. Eventually, those may look somewhat like the rules-based model that broker-dealers operate under. For instance, RIAs might have steeper licensing requirements.
All RIAs will pay the cost of those higher regulations (see Losers: small RIAs), but the large ones will be better able to bear those costs, giving them a competitive edge. In addition, large RIAs may be in a position to acquire those small firms that decide that being independent just isn’t in the cards anymore. “The time for the mom and pop RIA has passed,” said Mindy Diamond of Diamond Consultants.
Custodians and aggregators
As the flow of brokers increases from the wirehouse and IBD worlds, custodians will obviously benefit. So will the companies that have set themselves up as professional acquirers, like Focus Financial, HighTower, United Capital and Sanders Morris Harris Group. (See Sanders Morris Harris Group, serious competitor to the big roll-ups, launches bid from Texas).
Adolf says the growth at Focus, which now has $40 billion in AUM, is coming from two places: clients leaving the wirehouses, and brokers leaving the wirehouses. “A broker cannot look his client in the eyes any more and say it’s better for you if I go from Merrill Lynch to Morgan Stanley.”
The degree to which different custodians and aggregators have built strong fiduciary platforms varies, though, points out Don Trone, CEO of consulting and compliance firm Strategic Ethos.
Some TAMPs and other service providers
Some companies have already been positioning themselves as companies with the platforms that enable advisors to outsource some of their fiduciary obligations. Envestnet, for instance, has built in a fiduciary component of its technology platform. An example, says Jim Patrick, managing partner: an advisor making an investment decision for a client might be prompted to enter the fiduciary rationale for such a decision, establishing an (electronic) paper trail. The number of advisors on Envestnet’s platform grew to 19,620 in the third quarter from 13,542 in the year-earlier quarter; assets under administration grew to $126,350 billion from $85,198.
SEI and genworth have also gathered momentum as TAMPs, partially because of the wholesale switch of so many IBD reps to fee-based business (For more on TAMP growth:SEI turns a big corner but Genworth is still the big asset gatherer).
A fiduciary emphasis means more pressure on keeping fees and expenses low, says Trone. That’s bad news for service provides who aren’t efficient, but good news for those that are.
Longstanding advocates of the fiduciary standard
Associations like FPA and the National Association of Personal Finance Advisors, that promise education and a fiduciary stamp of approval will benefit, as well as designations, such as the CFP, which already require a fiduciary standard of care, says Trone. Some money managers, including Thornburg, Columbia, and Calvert, will also bask in the reflected glory of being on the right side of the debate, early. Among the custodians, TD Ameritrade, which came out vocally in favor of a fiduciary standard, is already winning kudos from advisor groups.
The SEC has finally taken action to elevate the standard under which broker-dealers operate. Moreover, it doesn’t need to wait for Congressional approval to start issuing rules (though it’s not clear when the agency that has a host of new obligations under Dodd-Frank financial reform will get around to building out the new regulatory regime it has envisioned).
Yes, the SEC last week issued a report that seemed to prefer user fees to pay for more SEC regulation of advisors rather than a new SRO or FINRA, causing celebration among those who consider FINRA as the devil.
The fiduciary study may have the more important – and trickier implications. If the rules that govern investment advisors and broker-dealers are harmonized, and both are operating under the same standard of care, it naturally begs the question of why two different regulators would be needed.
Some in the business believe the SEC is playing a very deep game to shift oversight to FINRA. I think it’s possible, which is why I include FINRA on the winner’s list.
“The SEC is lining up all of the facts so that later on the conclusion becomes painfully obvious (that they can’t regulate advisors with their current resources). Then comes the budget shortfall. It’s genius, what they’re looking to do, but it’s incredibly transparent,” said Brian Hamburger, CEO of legal and compliance firm MarketCounsel.
Compliance firms and lawyers
This is obvious.
Elizabeth’s note: Two people for whom I have a lot of respect view the fiduciary study as unalloyed bad news for independent advisors of all sizes and stripes – but they are in the minority among those I interviewed. They are Trone and Hamburger. Their argument basically boils down to one thing: in the past RIAs were different from broker-dealers. Under the new regulatory regime envisoned by the SEC study, they will not be. They’ve lost their marketing edge – on top of having to enter a world of increasingly complicated regulation.
“Independent RIAs have now lost one of their competitive advantages (that they are a fiduciary, and the broker is not), plus the time and expense for additional compliance is going to be considerable,” said Trone. “In addition, there are a considerable number of RIAs who have acknowledged fiduciary status, but don’t actually have a defined fiduciary process in place; now with increased oversight, they’ll need to have a process.”
Hamburger agrees: “We are basically succumbing to one class of financial advisor,” he said. “Independent advisors were rather ill-equipped to pick this fight. They have won the battle but are quickly losing the war.”
I’m interested to hear what readers think about our list of winners and losers.