Until the Merrill rule is withdrawn, here's what we should do.
Anticipating the passionate letters to the editor by
some readers if I fail to frame this discussion properly, I'll begin
with a few thoughts and observations:
In my opinion, anyone offering fee-based investment advice to the public should be held to an absolute fiduciary standard. My letter to the SEC stating this position is one of many referenced in the release of the SEC's final Rule 202(a)(11)-1.
I also believe that the rule (aka the "Merrill Rule") should be withdrawn and replaced by a rule that unequivocally requires anyone offering investment advice for a fee to be registered as an RIA.
I support the FPA's decision to challenge the Merrill Rule.
Rule 202(a)(11)-1 is a reality.
Most retail clients make their investments through traditional brokerage relationships.
In adopting the rule, the SEC noted in its discussion that it "is designed to avoid application of the Advisors Act to broker-dealers merely because they re-price their full service brokerage or provide execution only or similar discount brokerage services in addition to full-service brokerage." The rule provides a "safe harbor" from required RIA registration based on two major elements:
"(a) Special compensation (1) ... based solely on its receipt of special compensation ... provided that:
(a)(1)(i) Any investment advice provided by the broker or dealer with respect to accounts from which it receives special compensation is solely incidental to the brokerage services provided to those accounts ..."
In accordance with the SEC's discussion and the rule itself, it is clear that the Commission is solely focused on "re-priced" (i.e., noncommission-based) brokerage accounts. Unfortunately, it seems that the SEC, in its efforts to clarify its position by providing an extensive discussion related to the rule, has led some broker-dealers to reconsider how they meet their traditional suitability requirements. The problem seems to be the wording of Part 2(b) which reads
"A broker dealer provides advice that is not solely incidental to the conduct of its business as a broker or dealer within the meaning of section 202(a)(11)(C) of the Advisors Act or to the brokerage services provided to accounts from which it receives special compensation ... if the broker or dealer (among other things, and without limitation):
(2) Provides advice as part of a financial plan or in connection with providing financial planning services and:
(i) holds itself out generally to the public as a financial planner or as providing financial planning services;
(ii) delivers to the customer a financial plan; or
(iii) represents to the customer that the advice is provided as part of a financial plan or in conjunction with financial planning services ..."
The format and language is somewhat convoluted, consequently, it is easy to see how a diligent and conscientious compliance officer might interpret the rule as a prohibition for any broker (including those offering solely commission-based products) to use any form of "planning" software to assist his or her client to make investment decisions. The fear is that any analysis might be interpreted as "in connection with ..." or "in conjunction with providing financial planning services."
By now most readers are wondering "So what? Why do I care? Just make everyone become an RIA!" The answer has multiple parts:
"If wishes were fishes" ... I too would like to see everyone in the financial services world held to the fiduciary standards of an RIA; unfortunately, neither you nor I can make it so (at least not immediately).
Most of the investing public is currently being served by licensed brokers, not RIAs.
As professionals, we are concerned about the quality of advice provided to all of the public, not just our clients; hence, we have a vested interest in having those advised by brokers receive the best possible advice available within the constraints of the brokers' regulatory environment.
Restricting the use of all forms of modern analytical support for brokers and their clients and reverting back to the traditional four-box suitability questionnaire (do you prefer capital preservation, income, growth or aggressive growth) would be a tragic, unintended consequence of the Merrill Rule.
The Answer, Part I-Our Role
What's the answer? I believe that as professionals, in spite of our objection to the current state of brokerage regulation, until those regulations are revised we owe it to the investing public to actively support those advisors subject to the rules of the NASD (i.e., the primary advisor for most investors) who seriously wish to meet their suitability standard.
What can a broker do to assist a client? They can incorporate elements of financial planning; however, they can't provide financial planning services. What is financial planning? In a very "pass-the-buck" conclusion, the Commission states, "Whether a communication represents that the services provided are financial planning services will depend on how a reasonable investor would understand the services described in the communication." No wonder compliance officers are losing their hair.
I believe planning practitioners are in a perfect position to help the broker-dealer industry accurately interpret the Commission's mandate. We are qualified to highlight those elements of the financial planning process that appropriately relate to suitability recommendations. By doing so, we will assist in protecting the public from being sold services based on misrepresentation (at least as much as we can within the constraints of existing regulation) while, at the same time, allowing conscientious brokers to more professionally assist their clients.
The Answer, Part II-The Specifics
To avoid being swept into the oft-dreaded regulations of the Investment Advisor Act, B-Ds must, in addition to eliminating all references to financial planning services (both obvious and subtle), eliminate those aspects of their current advisory process that the SEC highlights as elements of a financial plan: "... a wide spectrum of a client's long-term financial needs, including insurance, savings, tax and estate planning, and investments, taking into consideration the client's goals and situation, including anticipated retirement or other employee benefits."
However, the Commission specifically noted that "elements of financial have been, are, and should be a part of every broker-dealer's considerations as to the suitability recommendations ..." Based on MPT, the financial planning elements related to investment suitability would include the weighting of a clients risk tolerance and return needs leading to a client suitable allocation.
While there are innumerable programs available to advisors that assist in making this determination, most are indeed designed to provide long-term financial planning advice. If a broker does not want to run afoul of current regulations, he must carefully consider the nature of the software he selects. Even if the program allows for modular analysis, there is the risk that its comprehensive nature (e.g., tax, estate and insurance modules) may lead a client to believe that the brokers advice is part of a "financial planning service." In order to remain consistent with the rule and NASD requirements, brokers may properly assist their clients by using:
Software focused on empowering the client to arrive at an investment allocation, allowing a broker to provide specific suitable investment recommendations. This effort is entirely consistent with the Commission's observation that "... elements of financial planning have been, are, and should be part of every broker-dealer's consideration as to the suitability of their recommendations." As an occasional NASD arbitrator and expert witness on issues of suitability, I also know that most of the cases I've seen would have never occurred had the broker followed this process in developing his recommendations.
Objectives-based investment planning software. Cash flow-based planning software, with its significant focus on tax issues and detailed input, suggest to the average investor a much more comprehensive "financial planning" analysis. This runs counter to the SEC's warning: "Typically, what distinguishes financial planning from other types of advisory services is the breath and scope of the advisory services provided."
Limited client reporting. The printing (or even displaying) of comprehensive reporting elements, unnecessary for the purpose of solely establishing allocations and specific investment selections, also runs the risk of either purposely or inadvertently suggesting the delivery of advice beyond that appropriate for a suitable investment recommendation.
The Bottom Line
Brokers must forego the bells and whistles accompanying much of the current planning software if they wish to avoid having to register as investment advisors; however, that should not prevent them from appropriately using the power of modern analytics in arriving at suitable recommendations for their clients. Investment advisors/financial planners should vocally and publicly support the brokerage industry's appropriate use of these analytics. The ultimate beneficiary will be the client.
Harold Evensky is chairman of Evensky & Katz Wealth Management in Coral Gables, Fla.