A collision of regulatory events has given a boost to the industry’s move toward a fee-based business model — with some pundits predicting dramatic change in the compensation landscape.
As Lou Harvey, president of Dalbar, the Boston-based consulting firm, frames it: “Changing compensation is the topic of the day. All but the blind recognize the compensation schemes we have in place today are likely to change over the next few years. Certainly, it seems to me and a lot of other people that the general direction is away from order-flow type compensation, which is the basis for the retail business, to more of an RIA structure. The question is: When are we going to change and how do we do this painlessly?”
Not surprisingly, the event headliner is the overturning of the so-called Merrill Lynch rule, which shuts down fee-based brokerage accounts where money is managed without fiduciary oversight. At press time, wirehouses were scrambling to convert an estimated 1 million fee-in-lieu-of-commission brokerage accounts, holding over $300 billion in assets, to other platforms by the October 1 deadline.
But a number of other factors are in play as well: anticipated new fee disclosure requirements being pushed by the Department of Labor and some members of Congress; threats to 12b-1 fees; a fiduciary standard of care demanded of 401(k) advisors by the Pension Protection Act of 2006; and lawsuits alleging excessive fees in the retirement plan marketplace.
On top of that, the U.S. Securities and Exchange Commission has accelerated the delivery of the much anticipated RAND Corporation study comparing the ways broker-dealers and investment advisors operate and the effects on investors. The report, which could be released as early as December, could trigger further regulation that would redefine the advisory business model.
Top of mind, at the moment: a move toward fiduciary responsibility.
“The marketplace is going to demand a fiduciary standard and I expect the SEC will adopt one once it looks at the RAND report,” notes Duane Thompson, managing director of the Financial Planning Association’s Washington, D.C. office. “A lot of brokerage firms, at the rep level and senior executive level, see it coming. I don’t think anyone is ready to say it publicly yet for liability reasons. But it’s coming. We’re going to see new or different standards for advisory services.”
In the weeks leading up to the October 1 deadline forced by the reversal of what is formally known as Rule 202, firms were considering their options and pretty much keeping a low profile with the industry press.
But compensation experts were reporting industry chatter about what executive search consultant Mark Elzweig, president of New York City-based Mark Elzweig Co., described as “a new generation of advisory account” tied to a fiduciary standard.
“The brokers we’re talking to kind of shrug and say, ‘It’s the compliance department’s problem.’ They want these accounts and affirmation of their advisory status. As long as an account exists, there is no great anxiety or concern about the level of fiduciary responsibility they’ll have,” adds Elzweig. “And I just talked to a branch manager who said: ‘It’s a new generation of account. We’re set. Next case.’”
But a lot of industry observers don’t expect the transition to be routine.
Chip Roame, managing principal of Tiburon Strategic Advisors in Northern California, outlines four possible tactical solutions.
The majority of firms, Roame says, will convert most of their brokers into registered investment advisors, which will mean additional training and licensing. The second most popular solution will be to centralize advice. As Roame puts it: “A broker is still a broker, but if you want an advisory account he puts you on the phone with a central advisory department so he doesn’t cross the line, but they do.”
Next, he said, teams will develop that are structured to include both a broker and an investment advisor. “This is the real world,” he said. “You’re not going to tell some 73-year-old top producer that he needs to get another freaking license.” The least popular option will be to push clients back to commission-based relationships. “The firms and the advisors have worked so hard to annuitize their revenue,” Roame adds. “They don’t want to have that conversation. They don’t want that choice.”
Meanwhile, it’s clear that the changes in store aren’t confined to an October deadline.
Going forward, Roame says: “You have a collision of various regulatory issues that are all leading to one thing: fee-based advisory services and fiduciary responsibilities. I think the radical answer will be when one of these firms steps up and says, ‘We are no longer in the commission business. We only do fee business now.’ And I think we’ll see that advisory fiduciary shop emerge in the next five to 10 years.”
The Independent RIA ResponseThe RIA sector is experiencing the most dramatic growth in the industry, according to Cerulli research, and this “confluence of events” as compliance expert Les Abromovitz puts it, should only bolster the trend.
“We’re definitely seeing an increase in the number of brokers who are leaving their broker-dealer and registering as investment advisors. Perhaps they were sitting on the fence before this and the ruling made them decide it was time to take the plunge,” notes Abromovitz, senior consultant with National Compliance Services in Delray Beach, Fla.
Additionally, he said, the controversy over 12b-1 fees is also causing brokers to pull the trigger. One emerging argument: that the overturning of the Merrill Lynch rule may preclude a broker from receiving 12b-1 fees under a brokerage platform.
“It really is the perfect storm,” Abromovitz adds. “If you’re a broker and you have to decide ‘Gee, is it time for me to become an RIA?’ there are a lot of factors influencing your decision.”
Firms like TD Ameritrade and Charles Schwab are watching the marketplace carefully.
“We all recognize the size and power of the wirehouses. What will they do now? We see it as an opportunity. We’re seeing an uptick in assets coming from wirehouses,” notes Tom Bradley, president of TD Ameritrade Institutional, who attributes the hike to the broker-dealer exemption ruling and increasing investor awareness about the difference between brokers and investment advisors.
“I’m not predicting necessarily the demise of full-commission firms,” Bradley said. “But there will definitely be an uptick in the number of stockbrokers wearing two hats: sales and becoming an RIA within their firm — and some will push over the edge and go independent.”
Barnaby Grist, managing director of strategic business development for Charles Schwab Institutional, believes the overturning of the Merrill Lynch rule will serve as a “significant catalyst” for brokers to consider a move to the independent RIA marketplace.
Calling them “typically great people trapped in a difficult model,” Grist said: “I was talking to a wirehouse guy last week who said ‘I don’t want to be calling my clients now talking about the way I’m compensated. I want to be spending time talking to them about what this [market] volatility means, I want to reassure them that their goals are in good hands, and maybe I just want to spend a few minutes thinking about building my business.’ This is a major distraction to developing the business this broker wants to be developing. Is the Merrill Lynch ruling the primary reason we’re talking to him? No. But it’s another reminder for him that he doesn’t control his destiny.”
Not everyone foresees a rush to the independent RIA sector, however.
As Elzweig notes, “This new generation of wirehouse advisory accounts is a huge uptick for wirehouse brokers. It validates their role as advisors held to stringent standards. The introduction of these accounts will help keep many wirehouse brokers in the fold.”
Further, he said: “Most successful wirehouse brokers have accumulated significant amounts of deferred compensation and are eligible for unprecedented, eye-popping levels of upfront signing bonuses [should they migrate to another wirehouse.] They would need to forgo both to go independent. RIAs and independent firms who are anticipating a California gold rush-type exodus of wirehouse talent as a result of some subtle regulatory distinctions are likely to be disappointed.”
Assessing the ImpactWhat will the new landscape look like?
As Bill Dwyer, president of LPL Independent Advisor Services, puts it: “It’s not really about the Merrill rule; it’s about what’s in the best interest of consumers and how firms and advisors can service them profitably. Our advisors choose every day to do business on a brokerage basis or an advisory basis. The bigger issue is one that regulators are working on aggressively: determining the differences between the brokerage environment and the advisory environment — and protecting the consumer but allowing advisors to do business profitably in either environment.”
Industry insiders describe the new advisory platform as non-discretionary advisory accounts held to a fiduciary standard — and there is wide speculation that the accounts will be offered only to select brokers.
Harvey characterizes the firms’ dilemma as a risk management issue.
“The firms are going to have to make some really tough decisions. Do they take on the responsibility of being a fiduciary as an RIA so as to preserve this revenue and potentially grow it with advisors who have historically been stock jockeys? Or are they going to be selective and pick which broker is going to move into this and which is not? Right there, you’re creating another hail storm,” he said.
Also in play: the creation of a fiduciary culture.
“This is a big challenge for large institutional firms where you have a huge force,” notes Thompson. “The challenge is creating a fiduciary culture, which is critical to long-term relationships. That will be the key to aggregating assets on the brokerage side.”
Wirehouses, he added, are viable models that have been successful for decades and know how to adapt.
“Reps will say: ‘I always put my clients first and that may be true on an individual level, but corporate attorneys are going to get chills if they see that put into the client agreement. If something goes wrong, they are the deep pockets,” said Thompson. “Trends are gradual. Brokers have a low reputation, below that even of Congress. The term financial advisor will tank too unless they live up to a fiduciary standard. It’s coming. The question is how quickly the large firms will embrace it or not.”
Freelance writer Ellen Uzelac is based in Chestertown, Md.; the former West Coast bureau chief and national correspondent for The Baltimore Sun, can be reached at [email protected]