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Brace for Impact

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Author’s Note: As you read this article, you will see that within two years your life will change. To assist in your planning, I have set up a Web page at

Louis S. Harvey is president of Dalbar, the nation’s leading independent research authority on financial services. In his tireless efforts to stay ahead of industry changes Lou studies laws and regulations as they are developed. In this interview Lou shares insights from his study of the Dodd-Frank Act, the Pension Protection Act and new regulations from the SEC, IRS and Department of Labor.

Bill: I want you to give me a 25,000-foot view of how the different provisions of your summer reading list will affect registered reps.

Lou: Let’s start with the Dodd-Frank Act. Section 913 assures that a large number of registered reps will be required by law to act in each client’s best interest instead of simply ensuring that products are merely suitable for a client. This “best interest” means that registered reps will have to conduct their business in a highly disciplined way and be able to prove that every recommendation was presented only because it was determined to be in the client’s best interest. This will require that entirely new processes are consistently used with each client.

Bill: You have studied the Pension Protection Act (PPA). That’s a 2006 law. Why has this come to your attention and how will it affect registered reps going forward?

Lou: The goal of the PPA that most affects registered reps is its stated intent to make unconflicted and affordable investment advice available to tens of millions of IRA holders and 401(k) participants. For example, as it stands today it is illegal to provide investment advice to an IRA holder if a rep earns a commission on the account. This has never been enforced so it is considered business as usual today. The PPA has instructed regulators to legalize this and other such conflicts but to insert a series of regulatory hurdles.

Bill: What are these hurdles?

Lou: The two biggest hurdles are that the rep cannot earn compensation that is based on the investments the client uses and that the rep must undergo a specialized audit each year. There are a number of others but these are the ones that give the greatest concern.

Bill: What about the regulations you are reading?

Lou: The Department of Labor has issued a new fee disclosure affecting 401(k) plans. This requires advisors to identify themselves as fiduciaries or as not fiduciaries and to specify the services they provide and the fees they charge for those services. This may sound calm and innocent, but its implementation will trigger massive change. As plan sponsors of expensive 401(k) plans recognize the fees they pay for non-fiduciary services, there is little doubt that these plans will be replaced.

I’ve also been studying the SEC’s proposed revisions to rule 12b-1. This rule puts a cap on 12b-1 fees and provides an alternative for brokers to add their own compensation.

The Dodd-Frank bill has ordered the SEC to study the effectiveness of current advisor regulations and to implement an improved system. At the core of the order is to ensure that all reps (RRs and IARs) have the same high standard that requires acting in the client’s best interest. I believe this will result in a harmonized standard between registered reps and registered investment advisors at even a higher standard than RIAs now have. Everyone selling to or advising clients will be required to act in the best interest of clients.

The final thing on my reading list is the enforcement provisions of various financial regulatory agencies. All of the federal agencies, and especially the agencies regulating financial services, have a huge increase in their enforcement budgets. It’s in the IRS. It’s in the SEC. And it’s in the Department of Labor.

Bill: Stronger enforcement of what?

Lou: Of existing regulations. The most obvious regulations are in the IRA area. The IRS is the regulator. However, they have never had staff to do any kind of enforcement in this area.

Bill: What do you expect to happen as a result of the IRS’s beefed-up enforcement budget?

Lou: Initially there’s going to be a lot of education, because very few people know that the regulations prohibit you from advising an IRA client unless you are a fiduciary. Following that you can expect inspections and penalties.

Bill: Let’s take some specific examples. An advisor may have some clients with IRA rollover accounts. Under these regulations, he cannot provide investment advice for the client unless he is acting as a fiduciary. Those regulations exist today, but they are not being enforced. Is that correct?

Lou: That is correct.

Bill: Registered representatives obviously manage billions of dollars in retirement funds. When will they be expected to perform as fiduciaries? What’s the timeline?

Lou: My estimate is about a year and a half from today. This means that the regulations have yet to be finalized. Normally there’s a period of time for people to adjust to the new regulations.

Bill: What do you think is the likelihood that these regulations will not have any teeth in them?

Lou: I’m going to say there’s about a 30 percent chance they will not have any teeth, meaning that the industry will prevail over these various regulators. Industry figures are using every device known to man to convince these regulators not to adopt stringent rules and then ultimately not to enforce them.

Bill: What are the implications if the regulators prevail and impose regulations bringing registered representatives under a fiduciary standard?

Lou: Probably the biggest implication is that revenue sources will change. For someone acting as a fiduciary, it becomes extremely difficult and impractical to operate under a commission structure. The built-in conflict of interest that one has to disclose to clients will become quite awkward. I think you’ll see a shift from a dependency on a manufacturer-paid compensation to one in which the firm adds their compensation in the form of a management fee or some other structure. This is huge.

Bill: For years, the major firms and countless consultants have been recommending advisors convert to a fee basis. What percentage of the registered rep income is fee-based?

Lou: It’s probably only about 20 percent.

Bill: What you’re telling me is that in a year and a half this may have to go to 100 percent, correct?

Lou: Yes, unless someone wants to go to 100 percent commission. This change in compensation is going to require a change in the structure of broker-dealers. In order to limit the conflict of interests, broker-dealers are going to have to split into two unaffiliated entities. One entity will focus on manufacturing and distribution of products, such as bringing new issues to market. This is the “caveat emptor” side and will have to be labeled as such.

The other entity would provide investment advice to clients. One of the casualties of this is that dual registration would disappear.

Bill: Let me clarify. Does this mean that registered reps who act as IARs would disappear? This means if someone wants to be a fee-based advisor, they cannot charge commissions, correct?

Lou: That is in no regulation but is where we will end up. I don’t know that the regulation will specifically say that. Here is the nuance. If you have to go to a client that you are charging a fee to and explain to them that you charge a commission to other people, that will be a bit of a hurdle, not as big of a hurdle as going to those whom you charge a commission and explaining you also do this kind of work for a fee. Another thing that I think will force the elimination of the whole mode of compensation is compliance. Compliance will have to second-guess the rep on every single client. Should this client be an IAR client and the next one is a registered rep client? It will just be an impractical situation to have advisors who are duly registered.

Bill: How does this affect so-called alternative investments?

Lou: To the extent that the broker-dealer is creating an alternative investment, it would have to be created on the caveat emptor side of the business. On the investment advice side of the business, it just becomes another available investment alternative, with no commissions.

Bill: So let me summarize. You are forecasting that in the new regulatory environment, broker-dealers that do create or distribute product would have to break up into two separate entities. Perhaps you would have two subsidiary firms reporting to a senior firm. But there would be a severe firewall between the two firms. Is that correct?

Lou: The influence of the caveat emptor side on the investment advice side will have to be minimal.

Bill: This is obviously going to impact the registered rep more than the registered investment advisor, correct?

Lou: Structurally, yes. But it does mean registered investment advisers are now going to have competition from the hundreds of thousands of registered reps that they don’t have competition from today.
Bill: Let’s say you wanted to give some advice to a registered rep who is 50 percent fee-based and 50 percent commission. What would you advise?

Lou: He or she has to move one direction or the other, not only driven by today’s compensation but whether or not the rep makes investment advice a central part of his business.

Bill: So you won’t be able to do the fee business and commissioned business?

Lou: It seems to me that if as a rep you make the majority of your living providing advice to clients, you need to move your business to fees. But you need to understand, that you will no longer be compensated by product manufacturing. You’re going to have to negotiate fees directly with clients.

Bill: Do you see fees going up or down as a result of this?

Lou: Great question. In the higher end of the client market, I see fees going down. People are going to be competing more aggressively for that market. However, at the lower end of the market, I see fees going up. You will have smaller clients of registered reps becoming unprofitable at rates charged to large clients. The advisors must increase fees to serve these clients.

Bill: Let’s throw 12b-1 fees into this mix. When do these regulations go into effect?

Lou: I don’t have a real good handle on this, and the reason is that the 12b-1 process is initiated by the SEC. They are in control of the timeframe, and don’t have any dictates from Congress. If I had to take a guess, I would say probably a couple of years but the implementation period is anybody’s guess.

Bill: How do you expect the regulation to take shape? What’s likely to be happening after two years?

Lou: The first thing that will happen is that a cap will be placed on how many total dollars can be paid out for any one client. That is the equivalent of the front-end load that client would have paid. The second is that the broker-dealer or RIA will impose its own fee.

Bill: So if you have had a client who has been paying one and a half percent in 12b-1 fees for some years, and the maximum commission would have been 6 percent, that income stream stops?

Lou: That’s right. And if half of your compensation is coming from long time12b-1 fees, you could lose half of your income.

Bill: So what does the registered rep need to be doing between now and whenever this does ultimately take effect?

Lou: There are really two obvious options. One is to change the product they are using. The other is to change the fee structure where they can charge the client a comparable fee.

Bill: Only fiduciaries will be able to add a management fee to a product for which they were formerly receiving a 12b-1 fee, correct?

Lou: That is correct. The other action that reps will take is to switch clients out of investment products to insurance products that don’t have the limits. Of course, the less ethical reps may try to roll clients from one fund company to another to re-start the 12b-1 clock. This is not a good idea since the regulators are looking for that kind of churning.

Bill: Let’s look out two years. What do you see happening in the industry then?

Lou: The industry will very much be in a condition of upheaval, a lot of chaos, a lot of consolidation. Broker-dealers will have to build a massive amount of IAR infrastructure, and many of them just don’t have the capital to do that. So you’ll see a lot of consolidation. I expect to see a lot more reps moving around to firms more aligned with their desired method of doing business.

Bill: Do you see survival of a class of reps who are commission-only?

Lou: Yes, and I see them moving to firms that specialize in that.

Bill: How will variable products he governed in this new world?

Lou: Unlike fixed insurance products, variable products are under the jurisdiction of the SEC and will probably come under the 12b-1 regulations.

Bill: So the 12b-1 fees paid on countless hundreds of billions in variable annuities will stop?

Lou: As they reach their lifetime cap, they will stop. If they have already reached it, they stop. The insurance portion of these products is not a federally regulated product. So there can be a variety of regulations, state by state.

Bill: There’s been a lot of talk about bringing indexed annuities into the tent. Are these covered in these laws and regulations you have been reading?

Lou: I have not seen any specific reference in any of these regulations, but keep in mind, the SEC has been diligent in their efforts to bring these products under their regulatory tent.
From the 25,000-foot view, all of these regulations are giving enormous power to the SEC. With all that power, I suspect they will be able to grab the indexed annuities and put them in their tent.

Bill: If there is a single piece of advice you would give the individual registered rep, what is it?

Lou: Analyze the value you bring to most of your clients and source of revenue. You need to make a decision today what kind of business you’re going to have in two years. Are you going down the path of only selling the securities or are you going down the path of advising clients? Within a couple of years, I believe you will be forced to make that decision so making it today will reduce the pain later.

Bill: Tell me about the liability of being a fiduciary.

Lou: On the surface, being a fiduciary means you are acting in the best interest of your client. Failing to do so, you become personally liable for losses your clients incur even though losses are incurred by virtue of the market going down. That sounds awfully scary until you come to the realization that there is protection against that liability. What you have to do as a fiduciary is show that you have a process in place and that it is a prudent process. This means you must be able to show that the actions you took were well informed and deliberate. You must be able to show that you consistently exercise the process that you use. That is the ultimate protection that the advisor has. So if you conduct your business using prudent practices consistently, if the client loses money and you demonstrate you have done as much as a prudent person could do, you are protected. So the real liability is failing to be prudent.

Bill: I think what you really mean here is failing to prove you are prudent. You could have been prudent, but if you don’t have adequate documentation, you could be held liable, correct?

Lou: Exactly. The other protection you have is insurance. Insurance companies will give you this protection for a reasonable cost if you demonstrate you have been trained. Failing to have documented processes and consistently following up means you will have to pay the client when the market goes down.

Bill: So the risk to being a financial advisor goes up.

Lou: Definitely. The fiduciary risk is not just paying back commissions; it’s paying back the loss. I should also say that if you implement the definitive process your risk is dramatically reduced.

Bill Good is chairman of Bill Good Marketing. His Gorilla CRM System helps advisors double their production or work half as much. Visit His seminar program, “No More Pies!” helps advisors manage ETF portfolios by using technical analysis. Visit


Lou Harvey’s Crystal Ball

FAs will need to decide: are you fee-based or commission based. It will soon be impossible to operate as both.

A lot of revenue will disappear when the SEC’s regulations on 12b-1 fees go into effect.

Many smaller firms will not have the capital to create massive IAR infrastructure.

Registered reps who do not elect to become fiduciaries will not be able to manage 401K or IRA accounts.

Firms that originate and distribute products will have to break up into two subsidiaries, one that creates and sells products and the other that gives advice.

Advisory fees at the high end of the market are likely to come down. At the lower end, they are certain to increase.


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