REGULATION BEST INTEREST: IS THIS THE BEST THE SEC CAN DO?

Stewart Mather

REGULATION BEST INTEREST: IS THIS THE BEST THE SEC CAN DO?

After years of deliberation, the Securities & Exchange Commission (SEC) just issued its proposed solution to problems many retail investors face as they seek professional advice from financial advisors who may not have their best interests in mind. Entitled “Regulation Best Interest” (Reg BI) and scheduled for implementation in 2020, its intent is to minimize harmful conduct by financial professionals and brokers, such as the sale of costlier investments, unnecessary portfolio turnover, undisclosed conflicts of interest and undue preference for proprietary investments.

The need for Reg BI came shortly after the demise of the Department of Labor’s “Fiduciary Rule” in June of last year—a rule requiring brokers to always act in the best interest of clients, putting what’s best for the client ahead of company profits. Originally scheduled to be phased in as early as April 2017, the U.S. Fifth Circuit Court of Appeals vacated the rule last summer, effectively killing it. While the DOJ rule applied only to retirement accounts, it required full disclosure of all fees, commissions and potential conflicts of interest. Prior to the rule, brokers had never been held to a fiduciary standard, rather a far weaker “suitability” standard, meaning investment choices and advice had to meet the minimum of being a suitable choice for a client’s situation.

Merrill Lynch embraced the Fiduciary Rule even before its implementation, mandating that IRAs were to be flat fee, no commission advisory accounts only. It even ran a national advertising campaign with the tag line “We’re committed to your best interest. Not the status quo.” Meanwhile, through its membership in the Securities Industry and Financial Markets Association (SIFMA), a powerful trade organization comprised of large brokerage and other financial service firms, Merrill supported the Federal Court challenge that ended up killing the rule. Several months later, not unexpectedly, Merrill reintroduced its commission-based sales model for investor IRAs, citing a need for “customer choice.”

Will Reg BI achieve its intended goals? To use a Greek analogy, Reg BI appears to be nothing more than a Trojan Horse, built and crewed by Wall Street brokerages and lobbyists like SIFMA, which will be viewed by many retail investors—mistakenly— as a victory trophy. However, just as the Trojans regrettably welcomed the Trojan Horse into the Gates of Troy—a decoy that allowed the Greeks to sack the city, Reg BI will allow some brokers to pillage investors with many of their hidden tricks as well. 

Let’s focus on three primary shortfalls within Reg BI. First, the SEC failed to define what the “best interest” of a client means. So, the “suitability” standard has now been replaced by a “best interest” standard which remains relatively undefined. In contrast, a Registered Investment Advisor (RIA) has always had to uphold a fiduciary duty to clients, meaning they must place a client’s interest before its own in all actions and decisions.

Unfortunately, many investors may now presume—wrongly—that a broker’s adherence to Reg BI is equivalent to meeting the far higher fiduciary standard. Given the 287,000 hybrid advisors who maintain both brokerage and RIA registration, the opportunity to shift between fees and commissions, and in and out of a fiduciary role, will further blur the lines between a broker and an RIA. Even while Reg BI no longer allows brokers to use the word “advisor” or “adviser,” investor confusion will increase as hybrid advisors may continue do so.

Second, the SEC—and the financial industry lobbyists supporting Reg BI—believe the solution to many problems is simply more disclosure, rather than an outright ban on such behavior. If, for example, a broker or firm has a significant conflict of interest, it can disclose or “minimize” (undefined by Reg BI) the conflict instead of eliminating it. Another example is the issue of broker sales contests, which often lead to unnecessary trading in an account. Contests are now reduced in scope due to Reg BI, but they can continue to occur if disclosed.

To structure these additional disclosures, the SEC issued its “Client Relationship Summary” (CRS) form for completion by brokers and given to clients. However, other than some boilerplate language required by the SEC, it remains at the discretion of brokerages to determine the level and amount of detail disclosed. As a result, the lack of a standardized CRS format makes it extremely difficult for investors to compare financial service providers, their fees or their services.

Third, the duration of the Reg BI responsibility for brokers and RIAs differs greatly. For brokers, Reg BI exists only on a transaction-by-transaction basis, incurring no further responsibility, such as portfolio oversight, after a transaction has been completed. In contrast, a RIA’s fiduciary responsibility continues throughout the length of a client relationship, irrespective of the timing or number of transactions which occur.

How significant is this SEC Trojan Horse? Let’s look at it solely through a retirement lens. There are 66 million Baby Boomers, with 10,000 reaching the age of 65 daily. Fifty-five million workers are enrolled in a 401(k), with $5.4 trillion in assets. IRAs, a retirement vehicle owned by 43 million households, total $8.8 trillion. Overall, 84% of newly opened traditional IRAs are funded solely with the rollover of an entire 401(k) balance. Such rollovers approached $500 billion per year recently. Given the aging of the Boomers and the growing level of 401(k) assets, the magnitude of rollovers will become a financial tsunami until the last Boomer reaches 65 in 2029.

But how will the shortfalls within Reg BI impact a prospective retiree? Currently, 60% of retirees consult a financial professional when making a rollover, and 75% of retirees use one to develop a retirement plan. Unfortunately, as a result of Reg BI, some brokers will continue their unscrupulous behavior as they pursue this growing pool of retirement money. Investors have every reason to remain vigilant as this Trojan Horse appears before them.  

The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The information and data in this communication does not constitute investment, or other professional advice. The Mather Group makes no warranty or representation, express or implied, nor does The Mather Group accept any liability, with respect to the information and data set forth herein. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Before investing, consider your investment objectives and risk tolerance.


The Mather Group

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