New programs reflect difference between fiduciary and suitability requirements.
It's been a year since the Securities and Exchange
Commission released a new rule excepting certain brokerage
relationships from the Investment Advisers Act of 1940. The rule has
stirred controversy across the financial services business because it
allows brokers to do some of the same things registered investment
advisors (RIAs) do but without acting as a fiduciary responsible for
putting their clients' interests above their own.
One consequence of the new rule is that it has divided the retail financial services business into two separate worlds, one governed by fiduciary standards and the other governed by suitability rules. Caught in the middle in implementing the rule are financial planning software companies. Their job is to create the workflow and processes for delivering financial plans to clients, and that task is complicated by a weakness in the new broker-dealer exception rule.
The software companies, which are not regulated and are simply doing what their brokerage clients want, are changing their software programs so that the brokerages can comply with the exception rule. But in a reflection of the confusion created by the new rule, the modifications being made to the programs vary widely from one brokerage firm to the next. It's simply not clear where brokers cross the line and become advisors. The problem is that the SEC has not created a clear definition under the new rule, or in subsequent releases, of exactly what constitutes financial planning.
You have to pity the poor SEC and its staff, which are trying to protect the investing public while also creating a sensible regulatory framework. This is not an easy job. But when you look at the wide variance of modifications the financial planning software companies are making for brokerages trying to comply with the new rule, it's obvious that the new rule has created a lot of confusion, wasted the money of firms trying to comply with the ill-defined explanation of what constitutes financial planning, and is likely to prevent many investors from getting good financial advice.
Often called the Merrill Lynch rule, the exception rule was originally proposed by the SEC in 1999. It says brokers can give investment advice when it is incidental to fulfilling their role as a broker without acting as an advisor. In other words, it exempts brokers from registering as investment advisors when they give investment advice as part of the regular course of the business of being a broker. Drawing a clear line separating brokers from advisors is important because they have different responsibilities to clients that clients have a right to know about.
An RIA is a fiduciary and is regulated under the Investment Advisers Act of 1940. An RIA and investment advisor representative are required under the law to disclose all conflicts of interest to a client and must always put a client's interests first-above their own interests. Brokers don't have as high an obligation to do what's in the best interest of a client, but they must be confident an investment is suitable for a client. For instance, they are not required to disclose a conflict of interest unless not doing so would constitute fraud. So it created an uproar when the SEC in 1999 proposed a rule exempting brokerages from registering as investment advisors.
Because the originally proposed rule inspired so many comments from the industry and consumer groups, the SEC reconsidered the matter. The SEC did not make its proposed rule of 1999 final, choosing instead to make the proposed rule temporary while it considered the matter. After considering the exception rule for five years, the SEC re-proposed the final rule and it became fully effective January 31, 2006. The new rule makes a lot of sense.
The final release explained that the SEC allowed brokers to give investment advice without registering as investment advisors when it was part of providing brokerage services because that was what Congress intended when it originally enacted the Investment Advisers Act of 1940 and included the original broker-dealer exception rule in the Act. Since the Exchange Act of 1934 regulated brokerages, Congress did not want duplicate regulations to be imposed on the brokerage industry. So the SEC says it is simply acting in accordance with Congress' intent in crafting the key legislation governing investment advice.
Meanwhile, the brokerages have viewed the fee-based advice offerings they've developed in the last decade as similar to their full-service brokerage accounts, which they've offered for many decades. With a full-service brokerage relationship, investors expected more than just an order taker. The brokerages argue that their full-service accounts have now been replaced by fee-based accounts.
The way they look at it, investors who had a full-service brokerage account and paid full-service commission pricing always expected some advice from them and received it. The new fee-based accounts are just a way of repricing new service models where clients get some advice incidental to their brokerage relationship but do not pay a separate fee for that advice. The new accounts are sometimes called "fee in lieu of commission." While that's a little bit of a stretch, this also makes sense.
But in enacting the new rule, the SEC did a poor job of defining what exactly constitutes financial planning. As a result, the brokerages don't know how far they can go in creating a financial plan before they trigger a requirement to register as an advisor, and dually registered broker/advisors don't know when they cross over from being a broker to being an advisor. Even if a brokerage maintains an RIA and has reps that are dually licensed because they have passed a Series 65 or 66 investment advisor exam as well as securities sales licensing exams, it's difficult to know when a rep has crossed over to an advisory role when working on a financial planning issue with a client.
The rule does make clear certain instances in which a broker-dealer is providing financial planning services and would therefore be required register as an advisor. Those instances are when a brokerage provides advice as part of a financial plan or in connection with providing planning services. When a brokerage says it offers planning services and gives you a financial plan and then offers you investment advice, it's definitely acting as an advisor, the SEC says. Whether a client is charged for the plan or not does not matter. Beyond this point, however, is where the SEC gets into a murky, ill-defined area of exactly what a financial plan is.
The SEC release on the rule, issued April 12, 2005, contains this definition of planning:
"Financial planning services typically involve assisting clients in identifying long-term economic goals, analyzing their current financial situation, and preparing a comprehensive financial program to achieve those goals. A financial plan generally seeks to address 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. Typically, what distinguishes financial planning from other types of advisory services is the breadth and scope of the advisory services provided."
On December 16, 2005, to give further guidance to brokerages, in a letter made public by the SEC, Robert Plaze, the associate director of SEC's Division of Investment Management, which regulates advisors, responded to a letter from the General Counsel of the Securities Industry Association by reiterating that a financial plan addresses "a wide spectrum of a client's long-term financial needs."
"This is distinct," Plaze goes on to say in the letter, "from a financial tool that is used to provide guidance to a customer with respect to a particular transaction or an allocation of customer funds and securities based on the long-term needs of a client, but that is not applied in the context of the more comprehensive plan described above."
So these statements have served as the definition to firms trying to separate their brokerage from their advisory service. The problem with this definition of financial planning is that firms implementing an advice program don't know exactly what the SEC means when it says a plan covers a "wide spectrum" of a client's goals.
In February, Barbara Roper, the director of investor protection of the Consumer Federation of America, along with Mercer Bullard of Fund Democracy, a mutual fund shareholder rights group, blasted the SEC's definition of planning in a letter to Commission Chairman Christopher Cox. Roper and Bullard said Plaze's letter to the SIA "confirms our worst fears that the new rule defining financial planning as an advisory service would be eviscerated in its implementation."
Roper and Bullard make a case that brokerage firms can do financial planning without being regulated as advisors or acting as fiduciaries if they simply avoid doing comprehensive plans. "Under the interpretation of the staff letter, the provision of extensive personalized investment advice would only be considered an advisory service if it were provided in the context of a comprehensive financial plan," say the consumer advocates. They say the definition of financial planning "makes a mockery of the Commission's position on financial plans and financial planning services." They added: "Under this interpretation, a broker need only ensure that any financial plan provided to a client lacks some arguably important component of a 'comprehensive' financial plan in order to avoid regulation." In other words, what Roper and Bullard are saying is that if a broker leaves estate planning or insurance advice out of a financial plan, he can skirt the rule and not say he is not acting as a fiduciary, and the client won't even know.
Roper and Bullard would seem to have a good point, but as it turns out they're wrong. Yes, a brokerage could leave out some part of a plan-the insurance part or the education plan-and maintain it is technically not a comprehensive plan. But the brokerages aren't doing this. According to the financial planning software companies, the brokerages aren't even coming close to providing comprehensive plans in the broker versions of three of the most popular planning applications, NaviPlan, MoneyGuide Pro and Financial Profiles.
For instance, Emerging Information System Inc.'s (EISI) NaviPlan software has ten modules, including retirement, education, major purchases, life insurance, disability insurance, long-term-care insurance, estate planning, Monte Carlo simulation and emergency funds. Many brokerages use NaviPlan enterprise-wide on a server-based system, and the majority of them only allow their brokers to work in one or two modules, according to EISI spokeswoman Linda Strachan, a CFP licensee. Using more than that, they fear, triggers an advisory role. A few of the firms, Strachan says, allow brokers to work in three modules and only one allows them to use four. "The single-goal approach is probably the most popular one with our enterprise brokerage clients," says Strachan.
It's clear, based on interviews with the financial planning software companies, that the brokerages are all guessing at what the new rules allow them to do. Some brokerages only allow a financial assessment to be done in the software, while others only allow insurance planning. Some only allow brokers to use the planning software if they have passed the Series 65 exam. Some brokerage firms are not allowing any estate planning. None of the firms know for sure how far they can take it without triggering a role as an advisor and having to disclose that they are going to be acting as a fiduciary.
"Various firms see the rule applying in different ways to their businesses," says David Oates, director of marketing at Financial Profiles. Some firms, he says, tell reps they should not handle analyzing an annuity product for retirement in the same plan as an education funding assessment. "Their approach is that you have to deal with one issue and then create a separate analysis to address the other issue," says Oates.
What's unfortunate is that the new rule is making some brokerages limit very sharply the tools their brokers can use to provide advice. Since the SEC said in its explanation of the new rule that using a tool that handles only one aspect of a person's financial life, such as asset allocation, is fine, some brokers are using simple calculators instead of more powerful planning software that can do a better job. That's not good for investors.
According to Bob Curtis, CEO of Pie Technologies, the makers of MoneyGuide Pro, most brokerages are asking his company to create customized versions of the software that allow their reps to provide a risk tolerance questionnaire and establish their clients' goals. That, all can agree, does not constitute creating a financial plan and is only prudent for a broker. After all, a broker must know his client and make suitable recommendations, and finding out about how much risk a client would like to take and what his goals are is performing analysis that is necessary for a broker.
But Curtis says that brokerages don't know how far they can let their brokers take it from there. "The gray area is how far you can go toward giving comprehensive advice, where the line is drawn," says Curtis.
It seems like the SEC may actually have done this deliberately. According to the SEC's April 12, 2005, release on the rule: "We have concluded that it would be unwise for us to attempt to distinguish when a suitability analysis ends and financial planning begins, and we do not want to interfere in any way with a broker-dealer's fulfillment of its suitability obligations." So the agency was simply trying to avoid muddying the obligation of a broker to know his client and make suitable recommendations, and that's why it did not step too far into this area. But as a practical consequence, the brokerages are left to guess at how far toward a financial plan they can go without stepping over the line into advice. They're left waiting for the SEC to slap a firm on the wrist for violating the new rule.
"The SEC has not given a clear, concrete definition of what a financial plan is," says Daniel Vacca, managing director at FiSmart, a Birmingham, Ala., consulting firm that is training brokerages about how to introduce planning services into their organizations. "What I've seen generally is that when you get to three or four goals, that's when legal and compliance departments are stepping in and saying you're crossing over into planning and advice." Apart from the question of how far toward planning a broker can go, implementation of the exception rule through planning software programs actually is not difficult. The SEC has made it clear that a broker can wear two hats, an advisory hat in addition to a broker's hat. What's important is that when the broker changes hats, it must be made clear to a client or prospective client.
In planning software, when a broker crosses over into financial planning-whether by exceeding a specified number of goals or modules in a software program or by signing a client up for financial planning services-a disclosure can pop up in the software and require sign off and acceptance by the client before the program can begin and the planning services can be offered. It can also show up in a client report and require a signature then. "Disclosures should be made at the beginning and the end of the advisory relationship, and signed off on by the client," says Vacca.
Interestingly, the advisory relationship disclosure document can specify that the relationship begins with acceptance of the advisory agreement and creation of the financial plan and, more importantly, that the advisory relationship will terminate once the plan is delivered to the client or within 30, 60 or 90 days or by some other specific date. When the broker-advisor reverts back to his role as a broker, then another disclosure is required, and the SEC has suggested a plain-English disclosure about the nature of the difference between brokerage and advisory services:
"Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons' compensation, may vary by product and over time."
Vacca says he is advising brokerages to train their reps to draw distinct lines in meetings with clients to deliver financial plans. "The meeting should be solely for presenting the plan and its recommendations," says Vacca, a former director of financial planning at Morgan Stanley who is now consulting to large brokerages on this issue. "Implementation of the plan should not be discussed at that meeting. The plan should be crafted in that the client can take it to another broker and get it implemented there if he so chooses."
To me, all of this indicates the financial planning world is in the final stages of winning a decades-long battle with Wall Street. Yes, near-term the definition of financial planning should be clearer so that all the brokerages know when they are crossing the line. And hopefully the definition will only allow a broker to handle one or two goals with a client before triggering an advisory role.
But that issue will be fixed, if not by an overt statement from the SEC then by disciplinary actions against brokers crossing the line. And even if the line remains somewhat blurry for the next couple of years while those cases are developed, the new exception rule has broken important new ground by drawing distinctions between advisors and brokers and requiring far greater disclosures about the differences between the two.
The consumer press is going to get the word out about all of this, and it makes for good copy. The exception rule has not received a lot of coverage in the consumer press because the issues being debated are too nebulous to make for a dramatic feature story in Money or Smart Money or on personal finance TV shows. But once these new disclosures start popping up, once the press can write about a broker taking off one hat and donning another in the middle of an ongoing client relationship, the media will jump on the story, and consumers will soon come to understand the difference between an advisor and a broker much more easily than they ever were able to before.
It will be pretty obvious to a consumer when their advisor, a fiduciary dedicated to acting in your best interest, gives you a disclosure to sign saying he is switching roles to become a broker and subject to conflicts of interest. It will be pretty obvious when a consumer goes to an advisor and receives a retirement plan that does not address college funding, estate planning or insurance, or is told he'll have to come back for a separate meeting to address other parts of his financial plan. The press will love these stories and consumers will understand better than ever whether their advisor is a fiduciary. It's going to be a lot more difficult for brokers to pretend to be advisors when they're not. Wall Street has no choice under the new rule but to acknowledge this and start providing real planning. Thus financial planning will spread, uplifting the lives of many Americans.
At a recent conference, fee-only advisors derided the broker version of MoneyGuide Pro as "MoneyGuide Amateur." Instead these advisors should be celebrating that the regulatory system is at long last beginning to distinguish what they do from brokers. This ultimately will allow more people to get financial planning services because brokerages are going to have to start to provide real objective advice in order to compete, and that's a good thing for everyone-brokerages and consumers, and especially real financial planners.
Andrew Gluck, a longtime writer and
journalist, is CEO of Advisor Products Inc., a Westbury, N.Y.,
marketing company serving 1,500 advisory firms.