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Fiduciary trends drive changes in wealth management

From brokerage models to products and fees, demands on fiduciary responsibility will impact firms across the U.S.

When consumers ask financial advisors how to maximize return, minimize risk, and plan for the future, the assumption is that the advisor is acting in their clients’ best interest. However, when the advisor steers clients towards products with greater return, this assumption becomes questionable. What if the greater return comes at the expense of additional fees being charged to clients? This scenario has entered the minds of various legislators, regulators, governing bodies, and now, investors.

As stakeholders evaluate fiduciary responsibility, the wealth management landscape is beginning to change. Leading wealth management firms are marketing themselves as ‘meeting fiduciary standards’, to gain a competitive edge in the market. The U.S. Department of Labor (DOL) and individual states (e.g. Nevada) are already controlling fiduciary compliance through ongoing regulation. Other regulators, such as the SEC (Securities and Exchange Commission), are also assessing if and how they should act(i). 

The focus on fiduciary responsibility raises many questions for the wealth management industry. In this blog, we look at impacts on the brokerage model, products, fee structures and players themselves. 

Will the brokerage model survive in a fiduciary setting?

The advisory model is rapidly becoming the prominent vehicle for providing investment advice. Given the cost and complexity of proving fiduciary responsibility, brokerage players are struggling to adapt. With inherent conflicts of interest embedded in commission-based products, there may be a shift towards primarily self-directed offerings in the brokerage model. 
 
The cost of proving fiduciary responsibility stems from a variety of compliance measures. These include providing enhanced fee disclosures, increasing the supervision of advisors and monitoring client engagement. In addition, the process of ensuring that recommendations are in the best interest of the client can entail monitoring rollovers, supervising advice, and training advisors to meet a higher standard of care. In a brokerage model, transaction-based commissions (i.e. 12b-1 fees(ii)) often do not consistently offset costs of compliance. The process is further complicated due to additional conflicts of interest and incentives in comparison to advisory models. 
 
To survive, brokerage accounts may move to self-directed, in order to avoid the expansion of responsibility. On the other hand, advisory models tend to have fewer conflicts of interest given that their fee structures are better suited to cover the costs of servicing accounts where recommendations and account reviews are required. However, low balance accounts may still be a challenge to service. The cost of compliance with the DOL Fiduciary Rule presents an example of potential cost challenges ahead, if fiduciary responsibility continues to expand beyond retirement accounts. 

Cost of compliance

The DOL Fiduciary Rule has already caused some shift in motion. JP Morgan, for example, is planning to no longer accept commissions in retirement accounts(iii) . The Insured Retirement Institute is ‘orphaning’ (i.e. leaving an account without advisor) 155,000 low balance accounts due to cost to service(iv). And Morgan Stanley had a 219% increase in fee-based asset flows in the first quarter of 2017 vs. the first quarter of 2016(v).

The T shares, with a flat upfront fee of 2.5% and a yearly recurring fee of 0.5%, eliminate some conflicts of interest by providing a standardized compensation structure for financial advisors. The levelization across the funds permits a diverse product shelf without incentives to sell one versus the other. However, trails can still be seen as creating a conflict of interest by providing ongoing revenue to an advisor regardless of service.

Clean shares, developed to improve the conflict of interest dilemma, do not have sales loads or annual recurring 12b-1 fees for fund services. However, advisory firms can layer on additional fees given the absence of revenue sharing(vi).  

These improvements and adjustments in fee structure for retirement account products will need to be offered to all account types and product types as fiduciary requirements expand. The progress of the trend may be hastened by potential SEC thresholds as well as increasing competition driven by customers looking for conflict-free advice. 

Market consolidation

The expansion of fiduciary responsibility will lead to a sell-off of smaller wealth management businesses and firms not interested in developing processes to comply. The rationale behind this conclusion stems from the fact that it is costlier to prove a fiduciary standard of care. It requires providing justification for recommendations, removing conflicts of interest, and - subject to future rulings - periodic reviews of investor accounts.

The consolidation has already started, as broker-dealers act in response to the DOL Fiduciary Rule. MetLife sold its U.S. advisor unit to Massachusetts Mutual Life Insurance. American International Group sold its broker-dealer unit to private equity firm Lightyear Capital and Canadian pension manager PSP Investments(vii). 

To sum up:

The fiduciary expansion is leading to important changes in the wealth management industry.

  • The advisory model is rapidly becoming the prominent vehicle for providing investment advice and brokerage models are struggling to adapt.
  • Distributors are beginning to trim their product ranges, pressuring manufacturers to develop new product classes and fee arrangements.
  • The expansion of fiduciary responsibility is leading to a sell-off of smaller wealth management businesses and firms not interested in compliance.

Future steps taken by legislators, regulators and governing bodies may hasten or slow these trends, but the impact of fiduciary expansion has already begun and will continue in the coming years.

 

References

http://www.planadviser.com/Can-States-Pick-Up-DOL-Fiduciary-Enforcement-Slack/ & https://www.sec.gov/news/speech/remarks-economic-club-new-york#

ii A 12b-1 fee is an annual marketing or distribution fee on a mutual fund

iii http://www.investmentnews.com/article/20170314/free/170319972/j-p-morgan-moves-ahead-on-dropping-retirement-commissions

iv http://www.investmentnews.com/article/20170808/FREE/170809936/financial-trade-groups-to-dol-advisers-dumping-small-accounts

http://www.investmentnews.com/article/20170524/FREE/170529958/dol-fiduciary-rule-pushing-broker-dealer-assets-to-fee-based

vi http://www.marketwatch.com/story/are-clean-shares-best-for-your-retirement-account-2017-08-08

vii http://www.investmentnews.com/article/20160229/FREE/160229937/metlife-is-second-major-insurer-to-exit-the-brokerage-business-in 




 
 
 
 

About the Authors

Justin Gonlag and Connor Pietrak

 

Justin Gonlag is a managing principal at Capco New York, leading the fiduciary services practice. He has extensive experience of working with wealth management firms on aligning their business models to heightened fiduciary standards. Justin also leads the capital markets transformation initiatives at Capco, with a focus on risk management and financial regulatory reform.

Connor Pietrak is a consultant within Capco's fiduciary services practice, based in New York. He has experience in developing and implementing DOL compliance solutions for leading wealth management firms, with particular expertise in target operating model design and implementation.

 
 
 

The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.