Advisors Riled Over E&O Premium Hikes

The cost of the typical errors and omissions (E&O) policy for financial advisors has climbed to 15% to 20% more than a year ago, and a similar increase looms for 2003. Most insurers are now renewing their reinsurance arrangements, which impact their costs going forward and hence the premiums they'll charge.

One advisor E&O carrier that has already finalized its reinsurance is hinting at premium hikes of 15% "or so" this year, says Andrew Fotopulos, executive vice president at Theodore Liftman Insurance, a Boston-based E&O broker.

To date, planners' premiums have risen mainly because of the stock market's post-March 2000 decline. Boatloads of clients with investments under water are asserting that the advisor placed them in unsuitable investments. In at least one case, an attorney rounded up three of an advisor's clients and brought a group of claims against him. The resulting economics are simple: As carriers shell out big bucks to defend, policy prices move higher. Other advisors opted to use their E&O deductibles to compensate clients who were complaining about small errors in executing orders, prompting carriers to raise future premiums.

The spate of complaints also has led to stricter underwriting standards, making coverage tougher to come by. If you go to the market with a lot of clients with losses, you may strike out. "The insurers are picky about (investment) losses," says Kent Anthony, president of First Group Insurance, a bank-owned agency in Sterling, Kan. Fotopulos says advisors with a history of claims are difficult to insure and carriers are now "not as willing" to underwrite those with SEC violations on their Form ADV.

Perhaps the biggest change in coverage is that activity in alternative investments may be excluded or, when available, extra pricey. Options, futures, limited partnerships and other exotic vehicles have been the subject of a significant number of suitability claims and charges that advisors were negligent in performing due diligence, says Bayard "Bud" Bigelow III of The Cambridge Alliance LLC in Vermont, national manager of First Specialty Insurance Company's advisor E&O program. "The problem is, the advisor can't possibly know enough about a very limited-purpose investment to be able to say that it is preferable to other investments that are generally available in the marketplace," says Bigelow. "Alternatives are very difficult to defend."

Planners' reactions to rising premiums have been varied. Some confess pleasant surprise that the 2002 jumps weren't higher. One Colorado planner who was outraged over a 46% premium hike complained-and got the carrier to drop it to 20%. "I went back to them and said, 'I don't use exotic products. I'm fee-only. You've insured me for 10 years and I have never had a complaint. I'm very conservative, and maybe you've forgotten this,'" says the advisor.

To control your E&O costs, consider a higher deductible or a change in the policy's limits. Most important, work to keep claims from happening. Solid documentation can successfully thwart claims by clients, who may recall only their side of the story. Make records of every phone conversation and keep copies of all correspondence. Bigelow recommends writing to each client every quarter, saying, "During this quarter, here's what happened to your investments, and here's what we did and why. Please sign and return to acknowledge that you understand."

Carefully consider this advice if you have been recommending hedge funds, which became widely available not so long ago, or real estate, today's investment darling, which Bigelow predicts will be the focus of the next wave of claims.

In the face of swelling premiums, prudent advisors are resigned to maintaining E&O coverage regardless of its cost.

Harris Creates New Unit For SBSB

Sullivan Bruyette Speros & Blayney (SBSB) could be the beneficiary of a surfeit of wealth management technology after the acquisition of SBSB by The Harris Bank closes. Harris is also establishing a separate unit to house independent advisory firms, indicating more transactions may be coming. The deal, first reported in last month's issue of Financial Advisor, is expected to be completed by early February.

Harris' acquisition of McLean, Va.-based SBSB is the Chicago-based bank's second acquisition of a major player in the wealth management arena in the last five months. Last fall, Harris purchased certain assets of MyCFO, once a high profile, high-tech start-up designed to serve technology tycoons, for $30 million. SBSB will be able to leverage technology from both Harris and MyCFO.

Sources say both transactions were negotiated by Jeff Roush, managing director of corporate development at Harris' private banking arm. Roush is involved in what appears to be an aggressive acquisition strategy as well as the integration of acquired firms into Harris.

SEC Launches All-Out Breakpoint Investigation

Concern over mutual fund breakpoint sales abuses is mounting among federal regulators and lawmakers, culminating in an all-out investigation to ferret out mutual fund investor overcharges.

"Several dozen firms are being examined," Securities and Exchange Commission spokesman Herb Perrone told Financial Advisor magazine.

National Association of Securities Dealers findings led the organization to alert the SEC to what appears to be numerous cases of broker failure to provide commission discounts. The NASD also put firms on notice that they are now required to review each mutual fund sale. Broker-dealers must "allocate the correct breakpoint to a transaction or override a broker's failure to do so," the NASD said in a letter to members.

The abuses have also attracted the ire of federal legislators, who are calling on regulators to bring enforcement action. "We are greatly concerned that fund investors have been overcharged as a result of brokers' failing to provide them with discounted rates as promised," new House Financial Services Committee Chairman Michael G. Oxley (R-Ohio) said in a letter hand-delivered to top cops at the SEC and the NASD January 7. "If firms have indeed been engaged in this type of misconduct, swift and severe penalties should be levied, and defrauded investors should receive full restitution," Oxley said in the letter, which was cosigned by Capital Markets Subcommittee Chairman Richard H. Baker (R-La.). Committee spokesperson Brookly McLaughlin said Oxley is "highly concerned and looking to monitor this."

Breakpoints are commission discounts typically offered on larger investments in A-shares of mutual funds. Enforcement cases brought by the SEC to date, however, have often been muddied by the fact that customers requested B-shares or were not allowed to use market timing strategies in A-shares, or because fund companies would not aggregate corporate retirement plan shares with personal shares.

Planners Embrace Possibility Of Tax-Free Dividends

Advisors across the country are hailing the Bush plan to eliminate the dividend tax as the catalyst that might return the stock market and corporate America to fiscal responsibility. The Financial Planning Association, based in Atlanta and Denver, has also endorsed the fundamental tax change.

However, the emergence of a small group of Republican opponents to the proposal prompted many Capitol Hill observers to predict that the President's proposal might be changed substantively before becoming law, given the Republicans' razor-thin margin in the U.S. Senate.

The initiative to wipe out taxes on dividends, a centerpiece of the White House's proposed $670 billion tax-cutting plan, would force the corporate world back to the place where profitability matters, says Don Schreiber, president of Wealth Builders Inc. in Little Silver, N.J. In addition to focusing investor attention on dividend-paying companies, "the days of cooked books and phantom profits would be over. You can't pay phantom dividends," the veteran planner says.

Eliminating the tax, which would cost the government $300 billion over 10 years, would have numerous implications on markets and products, says Christopher Cordaro, a principal with RegentAtlantic in Chatham, N.J. "Stocks with the ability to pay dividends would experience a one-time jump in value of up to 10% to 15%," Cordaro predicts. But long-term stock returns would be lower, just as muni-bond interest rates are lower today. Munis themselves may look less attractive compared with higher-yielding stocks. Such stocks will get even footing with real estate investment trusts (REITs) and publicly traded master limited partnerships (MLPs), which currently get pass-through tax treatment. At the same time, says Cordaro, the tax change would be the final nail in the coffin of variable annuities, which would essentially take tax-free dividends and turn them into ordinary income for tax purposes-not exactly a desirable outcome for such high fees.

"Tax-free dividends would force us all to be creative," Cordaro adds. "Would we construct high-dividend stock portfolios and then hedge against market risk to produce a stable tax-free income stream?"

While planners can't help but dream, they're also pragmatic. "It looks like Bush is throwing out big ideas that after compromise might give us tax-free dividends up to limit, like $3,000 to $5,000, says Paula Hogan, president of Hogan Financial Management in Milwaukee. "We'll wait and see before we make any investment or allocation changes."

Congress Set To Tackle Pension Reform-Again

The fight over pension reform should reignite this year. Both Republicans and Democrats in Congress already have announced plans to push ahead with bills that contain key differences.

On the first day of the new 108th Congress, Senate Minority Leader Tom Daschle, D-S.D., introduced "The Pension Protection and Expansion Act of 2003." The same day, House Education & Workforce Committee Chairman John Boehner, R-Ohio, announced he would reintroduce the Pension Security Act, which passed in the House last year but stalled in the Senate.

With Republicans having regained control of the Senate in the last elections, some observers speculate that the Boehner bill, with some amendments, may have a better chance of passing both houses this year. Others question whether pension reform truly will be a priority as the Enron debacle exits center stage and a possible war in Iraq and other issues dominate the agenda.

A major difference in the two pension proposals is their approach to investment advice. The Boehner bill allows companies that manage pension plans to give employees advice about diversification, but fees and conflicts would have to be disclosed before investment advice was delivered. The Daschle bill would expand the ability of 401(k) participants to get investment advice, but it would require that the advice come from an independent source. A similar requirement was included in a pension reform bill from Senate Democrats last year.

Duane Thompson, director of government relations for the Financial Planning Association, says he hasn't yet seen the 2003 bills. Last year, the FPA supported both proposals, but raised questions about the Boehner solution. "It's flawed, because it pretty much lets everyone under the sun give investment advice," Thompson says. The FPA's position is that investment advice to pension participants should be given only by registered independent advisors.

"Boehner assumes conflicts will be disclosed, but it leaves it up to the industry to come up with the standards. It's very hard to define in law what is effective disclosure," Thompson says.

Securities Profits Hit Seven-Year Low

The stagnant stock market has set back securities industry profits by seven years, according to a new study.

Despite a jump in revenues in the fourth quarter, the study by the Securities Industry Association (SIA) found that domestic profits for U.S.-based securities firms were expected to fall to $7.85 billion in 2002-the lowest total since 1995.

On a worldwide basis, U.S. securities firms were on track to see their profits dwindle to $20.7 billion, down 26.6% from last year and down 64.3% from the $58.0 billion earned in 2000, according to the study.

The figures were based on data covering the year through mid-December for New York Stock Exchange broker-dealers, according to the SIA.

"The continued downturn in the market, a sluggish economy and the weak equity-underwriting pace reduced securities firms' domestic revenues through most of the year," says Frank Fernandez, SIA senior vice president, chief economist and research director.

The drops came despite aggressive cost cutting at securities firms and a market rally in the fourth quarter.

The study found that total compensation costs in 2002 were $54.8 billion, which is down 9.5% from 2001 and 20.5% from 2000. Aside from layoffs, the main reason for the drop was reduced bonus payments and other forms of variable compensation. The study found that bonuses were down 35% in 2002, after being scaled back 12% in 2001.

Securities industry employment, as measured by the U.S. Labor Bureau, was at 708,300 in November, down from 733,100 at the beginning of the year. Employment levels are down 9.9% from their peak in April 2001.

"Firms that had managed headcount through attrition finally had to lay off employees in areas that were hard hit by the business downturn," Fernandez says. "In some cases, firms had to have subsequent rounds of layoffs when the first proved insufficient to control costs."