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Broker-Dealers and the Fiduciary Rule

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Scenario 4: The Department of Labor enacts its long-debated fiduciary rule, including the proposed best interest contract exemption. How does this change the way you charge and disclose fees? Which clients are most affected? How seriously does it affect your business?

Eric Schwartz, Cambridge Investment Research, Division IV: I just looked at the three outcomes; one would be the severe case that goes through more or less like originally proposed, and with all the paraphernalia, it could have a pretty major impact on our business. It may be that 10%, 20%, 30% of the business we now do couldn’t be done, or we don’t even know. It’s open.

Green: Is that because it wouldn’t make economic sense to do that business?

Schwartz: It’s all a question of how things are interpreted. They write these things, and then you have to have interpretations of what it means if you have one of these contracts. It may become standard operating procedure — no one ever said that Cshares are illegal or Bshares are illegal, but they wiped them out by basically saying you can only do them in certain circumstances in certain ways, which eliminated 90% of the current uses of them.

Depending on how they word it and then what the regulators choose to do with it once it’s worded, that could be extremely draconian.

The other extreme is it that it gets watered down and basically we have another 20 pages of paperwork to fill out, but it doesn’t have a really meaningful effect on our business. Maybe it eliminates the relatively small amount of business in alternative investments like REITs and IRAs. Some business is done but at most brokerdealers, it’s probably not more than 1%, 2% of their business.

Variable annuities is another wild card. It could squeeze back variable annuities in retirement accounts but not a lot of other things. That’s sort of a middle category. Maybe variable annuities and REITs can’t go into IRAs anymore de facto, even if not the law of it. That may be 5% or 10% of our business, but advisors have adopted that.

I believe [Phyllis Borzi’s] original position two years ago was, ‘If we can just get brokers and advisors completely out of that business and have everybody on S&P index funds or whatever, that would be a good outcome.’

Ralph DeVito, The Investment Center, Division II: Right, we’re going to probably somehow come up with a standard for our reps on the fee, whatever commission they can charge, by product maybe. Where fees are going to come into play, I don’t know.

Lon Dolber, American Portfolios, Division III: Just have them charge a retainer, all those that deal with that.

DeVito: Probably not.

Dolber: Not the way I see it. I could just say, “For any business that you do regarding these plans, you’ll charge a retainer based on X.” The rule doesn’t deal with retainers. It’s almost like you’re lacking an overlay manager in that case.

You’re not charging a fee against assets. You’re not charging a commission. You’re simply saying, “One of the particulars, one of the things on my list of things I do, is I can advise you on your retirement account here. I’ll charge you $2,500 a year for that.”

DeVito: I think that would be tough because they’re not used to that.

Green: Tough for the advisors? Tough for the clients?

DeVito: Probably both, but mostly the advisor.

Dolber: Eric, do you think the world deals with that, the retainer side?

Schwartz: I don’t know that answer. I wasn’t thinking about that, so I have not specifically asked. I’m sure our people have looked at it, but I can’t comment.

DeVito: The one thing we know for sure is there’s going to be more paperwork.

Schwartz: Killing trees is definitely not going out of style. As I say, there are workarounds a lot of times. There’s been a huge amount of change since all of us have been in the industry. Things that we thought were really going to be draconian, they didn’t really move the needle that much.

Dolber: It’s very different. You’re effectively giving a client an hourly fee. How can they argue against an hourly fee?

Schwartz: You didn’t say hourly. You said $2,500. Basically, if it’s a $500,000 account, it’s $5,000.

Dolber: Maybe not. Maybe you’re just going to charge a flat fee for the management of money, no matter where the accounts are at.

Schwartz: For where, yes. You can do that, but I’m saying you’ve got a $2 million client and a $100,000 client. You’re going to charge them the same $1,000?

David Stringer, Prospera Financial, Division I: The issue, though, is you’re still a fiduciary in that case. A fiduciary is 24/7. It’s ongoing responsibility for a fee. I think the question that you asked about who’s harmed. The very constituents they’re trying to help are the ones harmed.

I was a participant on the FSI DOL task force. I think FSI submitted a 35page document of issues. There’s a lot of ambiguity in how it’s interpreted.

Everybody wants this single standard from which to operate, but I think the BICE in particular is really just unworkable — for all firms, but in particular smaller firms. I think they’ve underestimated the cost of compliance in order to come up with these websites that talk about every product you possibly sell plus project 3-, 5-, 10-year performance, which is in direct conflict with FINRA and SEC rules.

Dolber: It’s like the mutual fund disclosure, the document that FINRA wanted. Where did that go? They wanted a detailed disclosure document, every single expense in a mutual fund.

Stringer: The principle I think they operate from is, “We want to put something in place that we can verify.” That’s where they come up with their mindset about all of these “gotchas” or ways to verify that we’re operating with best standards in place.

This BICE, yeah, you can continue to do business the way you’ve always done it, but the paperwork and burden that we have to do to become compliant, to me it’s unworkable.

Green: Just so I’m clear, the unworkability comes from underestimating, as you said, the cost of complying with this regulation?

Stringer: Plus, I’m concerned that we won’t get it right on the front end. Then we have other regulatory entities that have their own standards. We’ve added complexity to it with another layer of oversight.

Schwartz: Certainly the SEC should be the one that’s doing this, not the DOL because then whatever they did would apply to IRAs and regular accounts. You have [a client] come in. They have an IRA and a regular account. You’re going to have two different standards and two different sets of paperwork to fill out. Talk about cumbersome.

DeVito: That opens up a whole other can of worms from a legal point of view. Why would you do it over here and not over there?

Schwartz: It may be that the DOL, whatever they do may automatically apply to all accounts before it’s all done because that one came first so everything else has to be paralleled. Otherwise you have to defend why. You weren’t allowed to sell [clients] this product over here, so you sold it over here instead. That’s some odd stuff.

Stringer: When you enter that agreement with a client, you now have legal responsibility that’s outside the arbitration process. It puts a new layer of liability to the organization. I just think that their intent is good.

Dolber: This is the problem. The government [goes] to war without thinking about what they’ll have to do after the war is over to sustain the region.

They should first create a data standard because there’s no data standard. There’s no product description standard. Think about it: You can create a rule or a law, but you have to monitor it. You have to know you’re getting compliance to it. You have to know you’re getting adoption.

You’ll never get adoption with this if you don’t have a data standard. Take all the manufacturers of product; if you want to be able to compare products across manufacturers, this is not really a question of how you charge. It’s really a question of how you see the transactions.

We have a high-definition TV standard in the United States. We don’t have four different standards.

The way Nationwide does its data is different from the way Jackson National does its data. There’s no standard. CARDS might be the closest thing. Guess what? You want to do what they’re talking about with the Department of Labor? You better have a way to monitor it, and you better have a way for the firms to comply with it, or you’ll never get adoption.

Schwartz: They seem to like to regulate us as the retail distributors of products in their vision, but they don’t try to regulate the producers of the product, the manufacturers.

DeVito: We’ve been saying that for years. If you’re going to yell at us or try to regulate us over B shares, which at the time they were wrong anyway and wanted to change, or C shares, why allow it? Why not, like you said, come up with a standard?

Dolber: Take the clearing firms. If you look at all the clearing firms and you look at all the DST and DAZL, they don’t even describe conversions, exchanges and switches the same way. Try and determine what’s a switch, what’s a conversion, what’s an exchange. You have to do programming. There’s no other way.

There’s no common way to describe a conversion from a C share to an A share. That could look like a switch. It won’t if you programically say, ‘Okay, it’s the same fund. It’s just a different share class.’ There’s no symbol that tells you [it’s the same] because they don’t have the willpower. FINRA has not gone to the SEC. The SEC is not going to the government. The Department of Labor is thrashing about with a rule but no way to enforce it, no way for us to adopt to it, no way for us to manage it. Data is the answer in my mind, but I’ve been talking about that for years.

Green: It sounds like you’re a little skeptical that that data would be forthcoming.

Dolber: Let me ask you, how far did the regulators get pushing insurance companies to declare that index annuities were a security? When it comes to pushing back against the insurance industry, they don’t see very great success, so they push back against us.

Eric, what you just said: It seems like they don’t really go to the vendors or manufacturers of product because how much pull do they have with them? They’re not members of FINRA.

Schwartz: You came right down to it. Even if [insurers] have a brokerdealer, it’s for distribution. The rules on manufacturers are smaller, so they have apparently no legal grounds to stop them from manufacturing a product they think is bad. They only have an ability to punish you when you sell that product.

Stringer: President Obama has said this is a cornerstone of his middleclass economics. He’s endorsed it. I think they got bad data. I think they’ve said, based on their studies, that the investing public is overcharged.

I don’t think they fully understand there are a lot of investors sitting in mutual funds that are paying their fee. They’re going to be orphaned, small accounts. My hope is that they’ll take their time and really listen to the comments because they’re going on with hearings right now. They’re getting an earful about how they need to change this, but they’ll be thoughtful about making these draconian changes. I think it could be pretty impactful in a negative way. I think they’ll hurt the people they’re trying to help.

Dolber: How come FSI never took up the data standard argument with the government? Why has it never been something they’ve been passionate about when it would solve so many issues for smaller firms, for mediumsized firms and for this issue?

Schwartz: I’ve been out [of the FSI board] for quite a while. I don’t know if you’ve been in any discussions where that’s been brought up. I have never heard that discussion.

Stringer: I can tell you that it seems like you have to fight the fire that’s in front of you. While [a data standard] is probably important, it doesn’t seem urgent. We have urgent issues. As long as I’ve been [on the FSI board], there’s always been an urgent issue that needs advocacy. There’s a limited budget. They’re fighting states. They’re fighting a lot of activity. It was CARDS before this. Now it’s the DOL. When you have a limited budget, you’ve got to pick your battles.

Green: Is part of the issue that it’s the DOL doing this and not the SEC?

Schwartz: That’s the bizarre part of it in the first place. The SEC is still going to have to address it at some point. I know why the SEC has backed away, because they had some Democrats and Republicans on there that couldn’t agree on anything. They should really have led the charge. This is their turf. Then it would at least be uniform.

Stringer: The DOL has the authority. They don’t have to go get legislative approval. They have the backing of the president. We’re going to deal with this in some form. The DOL doesn’t have any authority over any of the data standards.

They do have some authority over retirement accounts. They’re expanding their authority. It’s with the president’s backing, so we’re going to face something. I don’t think we’re going to get away with a pass.

Schwartz: No, we’re not going to get away with a pass.

Stringer: It’s going to have an impact. We just don’t know at this point. It’s very fluid.

Dolber: We’re going to have to manually handle thousands of transactions and make comparisons using paper because there’s no electronic way to do it easily.

Schwartz: If we actually have to do that, that is sort of unfathomable. As you said, you’re making forecasts of what you think the return is going to be and then what it would be and wouldn’t be under different scenarios. That’s really strange.

The regulators have never been successful at going after the really big insurance companies to get them to change. They have a pass. The reality is both the insurance companies and the large mutual fund complexes have a lot more money than we do.

Dolber: We can thank them for one thing. They’ve made the independent contractor status, even though the government, at times, has tried to change that. The insurance industry comes right at them because their agents are independent agents.

Schwartz: I’m not saying the insurance companies are bad or good. I’m just saying they have a lot of products that are scary in terms of [cost], but in the end the clients get their money because it’s guaranteed they get their money back. Or it’s guaranteed that if they die they get their benefit. They are mostly left alone between that and their financial clout. Going after the manufacturers isn’t going to be happening.

Stringer: I think another cost that they’re underestimating […] is the value of an advisor.

DeVito: You can’t measure it.

Stringer: When somebody is on their own right now, in a rising tide market, that argument holds water. Get into a choppy market or a bear market, where you need some real sound advice, somebody with some real experience in these markets who is going to hold their hand, and that argument falls apart.

If the small investor doesn’t have good advice in those turbulent times, that’s when I think they’re going to be harmed the most. That to me is the injustice of this particular DOL fiduciary: That constituency that needs the help the most, they’re the ones that are going to be harmed by this.

Schwartz: They were touting that the industry was costing the public $18 billion a year toward their retirement, which worked out to be somewhere between 10% and 20% of their retirement assets.

As far as I can tell, that study is based on, “Well, we’re charging 1% a year for 20 years, and the client’s not getting anything for that.” What happens if they got out at the bottom and got in at the top and lost 40% or whatever, bought a bunch of mutual funds and never checked to see if the same manager was still there?

[Regulators are] looking at the cost, but they never look at the benefit. The assumption is that the advisor isn’t giving any benefit. He’s just selling something and walking away. He just sold whatever happened to pay him the most.

Therein lies our effort with the DOL. It’s hard to explain to them what advisors actually do and why people benefit from it. 

Stringer: Those small accounts, that’s the perfect solution for the robo-advisor. They’re not going to have access to a professional necessarily, but they’ll be able to enter the order, get a nice pie chart with some nice index funds to get a lowcost solution.

Schwartz: Some [robo-advisors] are going to have call centers. You won’t necessarily get a person who’s had 30 years of experience and knows you personally, but if you’re panicking and the market’s falling, you call up and talk to somebody who said, “Maybe you should have been one notch lower on the risk scale. Why don’t we change that?”

There’s some room for that, and I think some of our advisors will fill that space. As we were saying earlier, there will be a junior person in the branch who handles the smaller accounts that have somewhat of a quasirobo advisor situation.

Green: Are we overlooking anything with this focus on DOL and the change in ERISA? Are there other regulatory agendas in FINRA, the SEC, or even in the states that you’re worried about, that you think people should be paying more attention to?

Stringer: FSI does a good job in that regard. They built the Corel language. They just need the appropriation bill to attach it to and tax reform bill, whatever it is. I think they’ve got plenty of support on The Hill for that. I think they recognize that the independent advisor chooses to be independent.

We’re not forcing them to be. They want to be in control of their local expenses. This is not something we’re mandating to save ourselves. They earn their taxes. I don’t think they’re missing their opportunity to capture the government’s fair share of taxes on our segment of the industry.

Dolber: Is there a point where the charge would be at a level that the DOL could never argue that it wasn’t the cheapest cost?

Stringer: Zero.

Dolber: No, I know that. Not zero. They’re not suggesting it should be zero. What if you said it was 25 basis points? What if you just made a decision you were going to do every account that way at 25, 30, 40 basis points, and that would be the rule for your company? Would you have to do anything else?

Schwartz: It all depends on how this form comes out. It could be that if you’re charging anything, you have to fill this form out.

Dolber: Why, if it’s clear and evident that there could be no way it could be cheaper?

Stringer: Well, if it’s advisory and that’s their standard, what’s the need for your brokerdealer?

DeVito: What if the next guy comes out at 20 bps?

Schwartz: I used to think a mutual fund with 70 bps pricing or 60 bps pricing like American Funds was really, really low, and then ETFs came out at six. There are ETFs with six basis points. But yes, certainly in this environment, if you are charging 25 basis points to do everything everybody else is doing for 100, you would probably be in pretty safe shape.

All of this was preceded in the last four or five years by similar stuff in the 401(k) space. Basically, they are trying to get it so that no matter what option the plan or the plan member takes, the advisor that’s doing it makes the same amount.

Stringer: They’re trying to get rid of the conflicted advice, where you are incentivized to do one thing over another.

Schwartz: That was the predecessor to this thing on the IRAs, and I think that’s the same thing we’re working by. If you are giving advice, you should just be getting 25 basis points on the whole plan or on the individual IRA no matter what you do.

Dolber: With what you have in place, could you do it right now?

Schwartz: Twenty-five basis points?

Dolber: You would have to manage the models. You would manage the ETF model, you would manage it with the custodian that would charge you the least amount of money, and then you would take a little piece and the broker would take a piece. Would you have the systems to do it?

Schwartz: I don’t think we could afford to do it, because that would be cutting our pay 75%, and I don’t think too many of us are dropping 80% of our top line to our bottom line. So no, I don’t think any brokerdealer can do it. Even if you had the systems in place, no company is designed to reduce their top line by 75% and be profitable.

But that’s why it’s probably not going to go there, because I don’t think even the most draconian people in government want to see the entire financial services industry just stop overnight. That’s not exactly what they are trying to do. They’re trying to squeeze it, and I think they will succeed gradually over time.

As technology advances, as we all get more streamlined, there is an ability to survive at some lower amount. I don’t know if 25 [basis points] will do it. Obviously, the 25 is what the firms that are totally automated with almost no humans involved think they can do it for.

But I do think at 50, 60 basis points, we could do it. Not necessarily overnight, because you have to take some time to adjust, but I think that it’s conceivable that we could do it.

Green: Those firms that are doing it for 25 basis points, they are VC funded firms?

Schwartz: Yeah, they’re losing money. They’ve got $75 million, $100 million that they are burning through with 80 programmers, 100 programmers, and relatively zero dollars.

Dolber: At, at 50 basis points, the advisor can get 25 and the firm will get 25 between their expense and what they are going to keep. Would it be something like that? Is that what you be looking at? Would you be comfortable with 25?

Schwartz: No, I’m saying that I’m not assuming we are getting more of a cut that we are getting now.

Dolber: But if they are at 90%, they are going to get 90?

Schwartz: There’s two different things. One is what we call rep managed and one is what we call turnkey asset allocation models.

Dolber: But at 50, it would have to be robo. It wouldn’t be rep managed, it would be turnkey.

Schwartz: If it’s robo, and Betterment is getting 25 and the rep’s getting 25, that’s about what we are getting right now on an account in what we call our cap program, which is advisors. Then we are paying some money to the person who gives us the models, and we are paying the traders and all of that out of the 25. But if it’s rep managed, I don’t think they are going to say, “I’ll take a 50% payout.”

Dolber: You have to have the technology that allows you to build and manage models across any custodian. You have to be able to control the thirdparty manager, which means you have to do the executions.

Schwartz: Right, there are too many layers involved. One of the things we haven’t talked about here is that depending on where this goes, individual brokerdealers or groups of them may determine that they have to become selfclearing because they can’t afford to pay a clearing firm or a custodian and still make a living.

We’re a middleman in between a custodian — National, Pershing, Schwab, TD — and an advisor, and the client, and we’re one more layer in there. There have been some proposals in the past where if somebody was selfclearing, they could continue to get some compensation from the mutual funds. Well we, as brokerdealers, would not be able to.

If LPL is selfclearing and they could get 25 bps on a bunch of mutual funds and we can’t, and that’s going to be the model going forward, the four of us are going to get together and say, “Let’s go selfclearing together, because we can’t afford to individually.” Now we can get that money, which will allow us to be able to make enough under this new umbrella.

We can no longer get all this stuff we used to make, but there’s still some money over here the custodians get. We’re going to need a piece of that action if we’re going to survive. These are some important decisions I think all of us will be making. If DOL is really radical, we may be making them 12 months from now. Otherwise, we may be making them gradually over the next 10 years.

Dolber: Our goal is to go on the FIX network in the first quarter, and the FIX network is a common language for all the clearing firms. I will be able to execute transactions at any clearing firm, at any custodian using the FIX network.

My goal is to be totally agnostic, because once you are totally agnostic, then you can negotiate differently. But when you’re not in that position, your economics are controlled by somebody else.

This is one of the reasons we made this investment with TrustFort. We, right now, don’t use anybody else’s billing system that’s in TrustFort to bill against advisory assets. No matter who the custodian is, whether it’s Pershing, whether it’s TD, Schwab, we use one system to bill.

Schwartz: We do that, too. It’s too complicated to use different ones for everything, especially because some advisors have stuff in multiple places.

Andrus: You talked about being system agnostic and data agnostic a few times. Is that a push that’s going to come from regulators, or from a dominant provider where everyone is using the same provider? Or is it the individuals working together?

Dolber: There are providers that purport they do that. Envestnet purports they do that; you can use Envestnet and invest against assets held. But then they’re in the mix, so getting back into this commoditization discussion, I made a decision that I can’t use Envestnet because I have my own ideas about what we should develop. I don’t control Envestnet’s development schedule.

It was about the economics, but it was also about the control of development. For instance, we have $6 billion, $7 billion in variable annuity assets that are out of surrender. The contracts are good, but there’s no active management of the subaccounts. I don’t know, that sounds like it could be a fiduciary issue at some point even though it was sold on a commission basis.

How would you actively manage variable annuity subaccounts that are in good contracts? You can’t justify moving them out to generate other revenue, but at the same time, the broker has to get paid if he is going to actively manage those subaccounts. What system is out there that does that, other than going to an individual insurance company and using their system?

Green: But you’re also being the fiduciary in that way, right?

Dolber: But if we’re heading in that direction, why not embrace the horror, so to speak? Why not embrace the future? If that’s where we’re heading, then that’s where we’re heading, but I have to be able to control my technology to fit what I see happening down the road.

Schwartz: The biggest challenge in that, that makes people use other people’s technology, is that while your initial investment may have been relatively modest by standards of technology, can you really build all that? If you are, you’re building it at 5% of the cost of the big firms, so you have to be a lot smarter.

Dolber: You have to be agile. If you’re not, you could spend a lot of money, and you’re not going to have the scale to do it. Talk about clearing — maybe a firm of [Cambridge’s] size could go selfclearing; we couldn’t go selfclearing.

Schwartz: If people of our size could go selfclearing, you would’ve heard about a bunch of people having gone selfclearing.

Selfclearing used to be profitable at the size LPL did it when they were $1 billion, $2 billion, but it appears now that the price you can get from clearing firms and all the technology costs just go skyrocketing.

Dolber: I felt we could handle managing the advisory technology piece by making the acquisition, which is not as comprehensive or as complex as the clearing. Because I’m still using a clearing firm to do the actual execution, so to speak.

Schwartz: It’s tough. Obviously, the future belongs to those who don’t think in the box. When I decided I was going to be a brokerdealer specializing in fees just about exactly 20 years ago, everyone said, ‘A brokerdealer that specializes in fees? That’s like a car dealer that specializes in bicycles.’


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