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A Hierarchy of Conflicts

I was talking with Knut Rostad, founder of the Institute for the Fiduciary Standard, about his recent conversations with people at the SEC.  He is cautiously optimistic that the “new SEC” is, for pretty much the first time in his career, open to hearing about how a fiduciary standard for all advice givers would be a significant step forward in consumer protection.  But he is also getting feedback that nobody at the top wants to alienate the staff—and the SEC staffers have mostly been hired by SEC leaders—going back 20+ years—who have been far more sympathetic to protecting wirehouse profit margins than protecting consumers.

The conversation made me realize that there hasn’t really been a framework for exactly how consumers could be protected from some of the more exploitive business practices in the financial services industry, practices which represent embracing (rather than avoiding) conflicts of interest that work, like the relentless forces of gravity, against the likelihood that consumers will get the best advice from their broker or rep.  There will be arguments that it is possible for brokers, agents and reps to defy these conflicts and do the right thing, just as an airplane or hot air balloon can seem to temporarily defy the laws of gravity.  But the incentives built into these conflicts will ultimately pull down the quality of advice, in some cases to levels which are blatantly harmful to consumers.

So what would such a framework look like?  I’m going to propose a hierarchy of conflicts, from most likely to harm consumers to least, from most difficult to ignore to least, and propose possible remedies for the SEC to consider.  The SEC staff is unlikely to adopt these suggestions in the next 12 months, but it might be helpful if we start clarifying what might make sense in a regulatory framework, and the priorities that the SEC might consider.

At the top of my conflict list is sales contests, which basically tell brokers what “investment opportunities” to sell and give them a financial incentive (and, of course, firm-wide recognition to the winners, which is an incentive in itself) to recommend them to their unwary customers.  I need hardly point out that whatever “investment opportunity” the brokerage firm is highlighting in these contests is, pretty much by definition, going to benefit the firm more than the consumer.  Or else why hold these contests in the first place?

But the SEC has banned these contests, right?  Apparently not very effectively.  The most recent report by the North American Securities Administrators Association (NASAA) found that 24-30% of broker-dealer firms were still holding sales contests, with differential compensation and extra compensation to the “winners.” 

What would be an appropriate remedy?  SEC examiners crawl all over independent advisor offices looking at the fine print of their disclosures, the nuances of their fee structures and whether they’re complying with rules yet unwritten about testimonials.  Would it be so hard for them to spend a little time examining whether brokerage reps are participating in sales contests?  And if the firms are found to be holding these contests, then I would propose that the SEC greatly increase the attention they give to these firms and the advice they give, effectively monitoring these things in real time.  Station an examiner in each office and monitor every single recommendation.

They might also consider these a breach of their regulations, and impose public sanctions, demand restitution to the consumers for whatever the differences are between these “investment opportunities” that the contest participants recommended and comparable ETFs, and make the company and its sales contest “winners” famous by disclosing the whole sordid mess, in detail, to the press.

The obvious next priority to put on the regulatory watch list is sales commissions.  I think it’s self-evident that any product that has to pay people to recommend it is probably not competitive on its own merits.  When a company decides to pay commissions to compensate its reps, it is deliberately opening them up to the temptation to recommend unsuitable investments and churn the customer’s account.  I was not surprised to see, in the NASAA survey, that 41% of brokerage and independent BD firms (firms, in other words, that pay commissions to their reps) recommended private securities, compared with practically zero for fee-only advisory firms.  44% of brokerage and independent BD firms recommended commissionable variable annuities and 55% recommended non-traded REITs—products which most fee-only advisors have no interest in because nobody is paying to them to HAVE an interest.  (And of course could be recommending publicly-traded REITs and the new commissionless, fiduciary annuity products—and have apparently chosen not to.)

NASAA did not survey insurance agents, who are exclusively compensated via commissions, but I would bet my hat that virtually none of them ever recommend ETFs or index funds as a better investment alternative to whole or variable life insurance.

If you made me king of the universe (nobody that I know of has ever nominated me for that role) I would banish commissions altogether in advice relationships.  But given the clout that Wall Street exerts over the whole regulatory apparatus, I will aim lower, and instead follow Rostad’s suggestion that the Reg BI disclosure forms be completely rewritten. 

Rewritten how?  When brokers offer the CRS form to their customers, it should distinctly tell them, in blunt language that I would be happy to ghost-write for the Commission, that the broker has chosen not to register with the Securities and Exchange Commission as an RIA, and therefore has voluntarily declined to be held to a standard where he or she would be obligated to offer advice in the best interests of the consumer/customer. 

That form would also say that the broker/rep is empowered to collect commissions from the sale of products which will almost certainly be inferior to whatever a registered RIA would recommend, and these commissions represent a powerful incentive to make those inferior recommendations.

Moreover (I as ghost-writer would add), the broker/rep is an agent of the firm, and therefore owes a legal obligation to put the interests of the company ahead of the interests of the customer.  That means (I would have the form specify) that the products and services that the broker/rep is recommending will be more beneficial to the firm than to the customer.  And, yes, I would use the terms “broker” and “rep” rather than “advisor.”

There is only one more clear priority on this list: in-house products.  When a company is in the manufacturing and distribution business, and it employs sales agents and people who recommend these and similar products to the public, there is a clear conflict that ought to at least be disclosed.  When somebody works in an advisory role for that fund or insurance company, then the product recommendations become strangely predictable—and would not be made with the best interests of the customer in mind.

In these cases, I would like the SEC to mandate that the person in an advice role highlight the in-house products that are being recommended, and offer (maybe this is going overboard, but…) a side-by-side comparison between the investment products recommended and other competing products that the person in the advice role could have recommended.  I would allow a committee of fiduciary advisors to select the comparison products and the characteristics that will be compared—including internal expenses, past performance and the presence of any commission incentives.

Interestingly, this would not simply impact the brokerage firms and insurance companies; a notable inclusion would be the Vanguard organization, whose team of CFP advisors exclusively recommend Vanguard funds when people come looking for investment and financial planning advice.  If these advisory sales reps really believe their products are the best possible recommendations, then they should not fear this level of disclosure.

I would also raise the scrutiny level of the so-called robo-advisory firms.  These companies might argue that their products and services are superior to the alternatives. I’m okay with the brazen sales pitch, but would still like to see them make these disclosures to their customers and let them decide if that’s true or not.  Schwab, in particular, should be disclosing where the cash in its robo-portfolios is deployed.

Those are, in my view, the most potentially harmful conflicts, and I would not be terribly upset if the SEC were to stop here.  But there are other conflicts that I think should be recognized in the RIA realm, that probably ought to be discussed with and disclosed to clients.

Start with TAMP relationships and preferential services offered by custodians.  This category of conflict basically has the consumer paying for services that represent direct conveniences for the advisory firm.  I listed TAMPs first because some of the fees that the client is paying are covering costs that the advisory would otherwise have to pay out of its own pocket—specifically, the costs of an investment and trading staff.   Yes, it’s possible for the advisory firm to offset the benefits it is receiving by charging dramatically less for its own role in the investment process, but there should be some way for the consumer to assess whether it would be more beneficial to be invested in a portfolio of ETFs rebalanced on a regular basis.

Similarly, there are conflicts built into the independent custodial model; the advisory firms are receiving software and practice management advice in return for bringing the custodians the business of their clients.  You can see this most clearly when Fidelity told some advisory firms that they weren’t profitable enough for the services they were receiving, and offered them a choice: to redeploy client assets into Fidelity funds, or pay a monthly fee for the custodial services they were receiving. 

Larger firms with more trading activity (and maybe a few Fidelity funds in their client portfolios) were not required to have these conversations, which clearly indicates that clients are paying for services that are benefiting the advisory firms that they work with.

I would recommend that the SEC institute a disclosure system where the custodians detail their revenues from payments for order flow and the haircut they earn on short-term cash allocations in client accounts, in a way that could be matched to individual client circumstances.  The calculation would add in the annual profits, per dollar, from in-house fund holdings.  Advisory firms would be required to make comparisons among the custodians based on these figures, and to disclose the numbers at least annually to their clients.  Shouldn’t they know how profitable they are to the custodian that the advisory firm has selected?  And an approximation of their annual expenses that are paying for advisory firm conveniences?

My next category would affect a relatively small number of advisory firms, but I think it would be fair for firms to disclose the referral arrangements they have with their custodians.  Are they making payments back to the custodian, or otherwise sharing the revenues paid by the client?  Are there arrangements whereby the advisory firm is disincented or forbidden from transferring those assets to another (potentially thriftier) custodian?  Theoretically, the custodian should be making referrals in the best interests of the client—finding the best advice option for each consumer.  Having a revenue incentive involved in the recommendation doesn’t sound very fiduciary to me.

Finally, you probably knew that I would eventually get to the AUM revenue model.  My concerns here came out of my own experience, years ago, looking for a financial advisor.  I walked into the office and met with a prominent advisor, who immediately wanted to see my investment statements.  He buried his nose in the reports, and then told me that I needed him to manage my assets.  In fact, I wasn’t looking for that kind of advice at all, but since then I’ve wondered at how every financial planning client (yes there are some exceptions, but…) just happens to need the advisory firm to manage his or her assets as a key initial recommendation.

There are other conflicts built into the model, but you know them already; the disincentive to tell clients to pay off their mortgage or put assets into an immediate annuity.  Whether or not somebody acts on those conflicts is not the point, just as it is not the point when the commission-compensated broker protests that he doesn’t make his investment recommends solely on the basis of the commission being offered.  The conflict provides a slanted decision board, and consumers should be informed of that fact.

How?  I’m honestly not sure what I would recommend to the SEC or state regulators on this topic.  One might propose a grid where the client could see what would be paid if the arrangement were based on AUM vs. a quarterly retainer vs. hourly or subscription, or whatever, but that chart would be arbitrary at best and unworkable at worst.  I would like the profession to acknowledge the conflicts in client conversations, and put this up as a topic for discussion as some of the higher priority conflicts are (hopefully) addressed.

The interesting thing about this list of conflicts and proposed regulatory measures is that I don’t think a single financial consumer would object to any of this, and 99% would cheer.  If the SEC were truly committed to vigorous consumer protection, then it would at least raise these possible remedies in a public forum, and see who objects and who supports.  I would expect the brokerage industry and the independent broker-dealers (who always disappoint me in their regulatory stances) to wind up alone in one corner objecting about restricting “choice,” when, in fact, we are not at all restricting the ability of consumers, once fully informed, to choose to work with brokers who are fighting to win sales contests and maximizing their commission revenue at the expense of their customers.  The other side of the room, at least 90% of it, would be individual investors who would be shocked to see how these conflicts are impacting their financial health.

Which cohort do you think the SEC should listen to?  When we lay it all out like this, isn’t it a bit strange that the SEC leadership and staff, whose organization is exclusively tasked with protecting consumers from financial harm, has vigorously, decisively resisted commonsense consumer protection proposals for the last 20 years?

And… Isn’t it about time that we held them accountable, no matter how much it might piss off the “staff?”