Until the Merrill rule is withdrawn, here's what we should do.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"Merrill Rule") should be withdrawn and replaced by a rule that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.
The Problem
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."
So What?
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.